U.S. Supreme Court Strikes Down Chapter 11 Structured Dismissals That Contemplate Distributions in Violation of the Bankruptcy Code, but Leaves a Loophole

March 27, 2017

On March 22, 2017, the Supreme Court issued its opinion in Czyzewski v. Jevic Holding Corp., No. 15-649, __ S. Ct. __, 2017 WL 1066259 (Mar. 22, 2017).

In a 6-2 decision, the Court held that a bankruptcy court may not order distributions that violate the priority scheme outlined in the Bankruptcy Code (11 U.S.C. § 101 et seq.) in connection with the dismissal of a chapter 11 case.  In so ruling, the Court upended a growing trend whereby chapter 11 cases are dismissed with "strings attached" for the benefit of parties with greater bargaining power, such as secured and general creditors, and at the expense of "dissenting mid-priority creditors."  Id. at *3.  However, the Court implicitly affirmed the practice of exiting administratively insolvent chapter 11 cases through structured dismissals (which do not authorize distributions in violation the Bankruptcy Code’s distribution scheme) instead of conversion to chapter 7–a fact that should give comfort to holders of distressed debt.  What’s more, by failing to address the providence of settlements reached during a bankruptcy case that alter the Bankruptcy Code’s priority scheme outside of a plan or a structured dismissal, the Court left open a loophole for creative bankruptcy participants to achieve the very result that the Court’s decision was intended to avoid.

Background on Structured Dismissals

As noted by the Court, "Chapter 11 foresees three possible outcomes."  Id. at *4.  "The first is a bankruptcy-court-confirmed plan."  Id.  "The second possible outcome is conversion of the case to a Chapter 7 proceeding for liquidation of the business and a distribution of its remaining assets."  Id.  "The third possible outcome is dismissal of the Chapter 11 case."  Id.

In many chapter 11 cases, substantially all of the debtor’s assets are sold to a third party free and clear of liens, claims, and encumbrances pursuant to section 363 of the Bankruptcy Code.  In such instances, the liens held by the debtor’s pre-filing creditors attach to the proceeds of sale.  Oftentimes, the face value of the claims secured by those liens exceeds the amount of the proceeds from the sale.  Because secured claims are paid before administrative and priority claims, in such situations the debtor is unable to satisfy its administrative or priority claims in full.  Consequently, the debtor is unable to confirm a chapter 11 plan of reorganization.  See 11 U.S.C. § 1129(a)(9).

With confirmation of a chapter 11 plan off the table, administratively insolvent chapter 11 debtors and their stakeholders must choose between converting the bankruptcy case to a case under chapter 7 or dismissing the bankruptcy case. 

Conversion to chapter 7 is often undesirable for at least two reasons.  First, a chapter 7 trustee is appointed upon conversion.  Chapter 7 trustees have a reputation for spending substantial sums of estate assets, which otherwise would be distributed to creditors, in pursuing litigation against other stakeholders.[1]  As a result, stakeholders in a chapter 11 case would often rather not see a chapter 7 trustee appointed.  Second, chapter 7 has a strict distribution scheme that may be undesirable to certain stakeholders.  See 11 U.S.C. §§ 725, 726.

Thus, in order to exit bankruptcy and avoid chapter 7, many chapter 11 debtors seek to simply have their cases dismissed.  In theory, a dismissal "aims to return [the parties] to the prepetition financial status quo."  Jevic, 2017 WL 1066259, at *4.  However, parties in interest often seek to sidestep the status quo and to instead have the bankruptcy court approve of a modified priority scheme in the order dismissing the chapter 11 case.  Many courts have obliged, and the practice of obtaining such so-called "structured dismissals" has flourished.

The Jevic Holding Corp. Structured Dismissal

In the Jevic Holding Corp. bankruptcy, a group of truck drivers sued Jevic and its equity owner, SUN Capital Partners, for a violation of the Worker Adjustment and Retraining Notification (WARN) Act related to their termination.  The truck drivers prevailed against Jevic on summary judgment and were awarded an $8.3 million priority claim in the bankruptcy.  While the WARN case against SUN continued, the bankruptcy case ran its course, and Jevic spent or distributed all of its assets save $1.7 million in cash and a fraudulent conveyance action against SUN and CIT Group, one of Jevic’s secured lenders.[2]  SUN refused to settle the fraudulent conveyance action if any portion of the proceeds of settlement would be distributed to the truck drivers on account of their $8.3 million priority WARN Act claim.  SUN’s refusal was based on its perception that the truck drivers would use any such distribution to finance their pending WARN litigation against SUN.

To side-step making a distribution to the truck drivers on account of their $8.3 million priority claim before making distributions to general unsecured creditors–as would have been required under the Bankruptcy Code’s distribution scheme–Jevic, the official committee of unsecured creditors, SUN, and CIT agreed to a settlement followed by a structured dismissal.  The key terms of the deal were as follows:

"(1) that the Bankruptcy Court would dismiss the fraudulent-conveyance action with prejudice; (2) that CIT would deposit $2 million into an account earmarked to pay the committee’s legal fees and administrative expenses; (3) that Sun would assign its lien on Jevic’s remaining $1.7 million to a trust, which would pay taxes and administrative expenses and distribute the remainder on a pro rata basis to the low-priority general unsecured creditors, but which would not distribute anything to [the truck drivers] (who, by virtue of their WARN judgment, held an $8.3 million midlevel-priority wage claim against the estate); and (4) that Jevic’s Chapter 11 bankruptcy would be dismissed."

Id. at *7.

The bankruptcy court entered an order approving the settlement and dismissing the chapter 11 case.

The Supreme Court Strikes Down the Jevic Structured Dismissal

The Jevic holding is very narrow.  The limited question addressed by the majority was this: "Whether a bankruptcy court has the legal power to order this priority-skipping kind of distribution scheme in connection with a chapter 11 dismissal."  Id. at *3.[3]  The Court answered with a resounding "no."  According to the Court: "A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic priority rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies."  Id. at *4.  Thus, all that the Court determined is that an order dismissing a chapter 11 cannot, at the same time, approve a priority-skipping distribution scheme.

Impact for Investors in Distressed Companies: the Court Leaves a Loophole

Although the Court’s decision somewhat restricts the options available for exiting a chapter 11 case, the decision is most significant for what it did not do–strike down structured dismissals altogether.  In fact, the Court specifically noted that dismissal is one of three possible outcomes in a chapter 11 case and noted that it was "express[ing] no view about the legality of structured dismissals in general."  Id. at *12.

In addition, the Court did not address the more general question originally presented in the petition for certiorari, namely, "[w]hether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme."  Id. at *15.  Thus, the Court left open the door for creative bankruptcy participants to obtain bankruptcy court orders that alter the Bankruptcy Code’s priority scheme prior to dismissal, then dismissing the bankruptcy case with the effect of those orders left intact. 


[1] Chapter 7 trustees are also paid a percentage fee for any assets that they recover.  See 11 U.S.C. § 326(a).

[2] The official committee of unsecured creditors was granted standing to prosecute the fraudulent conveyance action.

[3] Justices Thomas and Alito dissented.  They did not quibble with the majority’s reasoning on the merits.  However, they would have dismissed the writ of certiorari as being improvidently granted because, in their view, the petitioners recast the question presented from "[w]hether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme" to the "narrower–and different" question of "[w]hether a Chapter 11 case may be terminated by a ‘structured dismissal’ that distributes estate property in violation of the Bankruptcy Code’s priority scheme."  Jevic, 2017 WL 1066259, at *15.

 


Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the authors:

Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com)
Jeremy L. Graves – Denver (+1 303-298-5760, jgraves@gibsondunn.com)
Matthew G. Bouslog – Orange County (+1 949-451-4030, mbouslog@gibsondunn.com)

Please also feel free to contact the following practice group leaders: 

Business Restructuring and Reorganization Group:
Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com)
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com)
Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com)
David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com)


© 2017 Gibson, Dunn & Crutcher LLP

Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.