US Supreme Court confirms priority rules apply to a structured dismissal of a chapter 11 bankruptcy case

US Supreme Court

Restructuring e-Newsletter - Global Insight Series

Restructuring e-Newsletter - Global Insight

In its recent decision Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973 (2017), the United States Supreme Court held that a bankruptcy court may not approve a structured dismissal of a chapter 11 case that provides for distributions that fail to follow the standard priority rules, unless the affected creditors consent to such treatment.

A structured dismissal is one of three typical ways in which a chapter 11 case can come to an end. The first way is through a chapter 11 plan of reorganization or liquidation. The chapter 11 plan governs how to treat the debtor's debt and distribute the estate's assets. The second way a chapter 11 case can conclude is through a conversion to chapter 7. Upon conversion, a chapter 7 trustee will be appointed to liquidate and distribute the debtor's assets. The third way the case can end is by dismissal. A bankruptcy court may dismiss a chapter 11 case under section 349(b) of the Bankruptcy Code. Dismissal of the case would restore the parties' positions to those that existed before the bankruptcy. If perfect restoration is difficult or impossible, as was the case in Jevic, then the court may "for cause" alter the dismissal's normal restorative consequences; ie it may order a "structured dismissal."

The Supreme Court's ruling in Jevic preserves the Bankruptcy Code's priority system, which ensures that a debtor's assets are distributed in order of statutory priority − typically, senior creditors must be paid in full before junior creditors receive any distribution. Although the Bankruptcy Code does not expressly apply these rules to a structured dismissal, the Supreme Court clarified that courts should do so.

Background

In 2006, Sun Capital Partners, a private equity firm, acquired Jevic Transportation Corporation with money borrowed from CIT Group in a leveraged buyout. Just two years after the buyout, Jevic (and certain of its affiliates) filed for chapter 11. At the time of filing, Jevic owed US$53 million to its senior secured creditors and US$20 million to general unsecured creditors.

A group of former Jevic truck drivers filed suit in bankruptcy court against Jevic and Sun alleging WARN Act violations (the WARN Act litigation). The Bankruptcy Court granted summary judgment against Jevic in that action; US$8.3 million of that judgment was considered to fall into the bucket of "priority wage claims" that were entitled to payment before general unsecured claims but behind secured claims, under the Bankruptcy Code.

A second lawsuit was brought by the official committee of unsecured creditors against Sun and CIT. The committee alleged that the leveraged buyout hastened Jevic's bankruptcy by saddling it with debt that it was unable to service. In 2011, the Bankruptcy Court held that the committee had adequately pleaded claims of preferential and fraudulent transfer. In re Jevic Holding Corp., 2011 WL 4345204 (Bankr. D. Del. Sept. 15, 2011).

Thereafter, the committee, Sun, CIT and Jevic reached a settlement agreement that, among other things, called for a structured dismissal of Jevic's chapter 11 cases. Under the proposed structured dismissal, the WARN Act petitioners would receive no distribution, but lower-priority general unsecured creditors would receive a distribution.

The proposed settlement therefore called for a structured dismissal involving distributions that did not follow ordinary priority rules.

Approach of the Bankruptcy Court, District Court and Third Circuit Court of Appeals

Sun, CIT, Jevic and the committee asked the Bankruptcy Court to approve the settlement and dismiss the cases. The Warn Act petitioners and the Office of the United States Trustee objected, arguing that the structured dismissal violated the Bankruptcy Code's priority scheme by skipping the petitioners who had claims ranking higher than the low-priority general unsecured creditors who were to receive a distribution.

The Bankruptcy Court held that as the proposed settlement's distribution would occur through a structured dismissal (as opposed to through a chapter 11 plan where the Bankruptcy Code expressly provides that the ordinary priority rules apply), the distributions were not prohibited under applicable law. The Bankruptcy Court approved the settlement given the "dire circumstances" of the cases – namely, that there was "no realistic prospect" of a meaningful distribution to anyone other than the secured creditors; a plan of reorganization was unattainable; and there were not enough funds to operate a chapter 7 proceeding. In re Jevic Holding Corp., 2011 WL 4345204 (Bankr. D. Del. Sept. 15, 2011).

On appeal, the District Court affirmed the Bankruptcy Court's decision, holding that the Bankruptcy Code's priority rules were "not a bar to the approval of the settlement as [a settlement] is not a reorganization plan." In re Jevic Holding Corp., 2014 WL 268613, *3 (D. Del. Jan. 24, 2014).

On further appeal, the Third Circuit affirmed by a vote of 2 to 1, providing that when Congress codified the absolute priority rule, it did so in the specific context of plan confirmation and neither Congress nor the Supreme Court has ever held that the absolute priority rule applies to settlements in bankruptcy. The Third Circuit agreed with the Second Circuit's approach in In re Iridium Operating LLC that there should be some flexibility for bankruptcy courts to approve settlements. 478 F.3d 452 (2d Cir. 2007). The Third Circuit agreed that although the Bankruptcy Code and the Bankruptcy Rules do not extend the absolute priority rule to settlements in bankruptcy, the underlying policy – ensuring the predictable and fair treatment of creditors – applies in a settlement context. The Court therefore held that bankruptcy courts may approve settlements deviating from the Bankruptcy Code's priority rules only if they have "specific and credible grounds to justify [the] deviation." Id at 466.

The Third Circuit concluded that the Bankruptcy Court had sufficient reason to approve the structured dismissal in Jevic, because the settlement "remained the least bad alternative since there was 'no prospect' of a plan being confirmed and conversion to chapter 7 would have resulted in the secured creditors taking all that remained of the estate." The core issue was whether a settlement served the best interests of the estates. The Third Circuit opined that the Bankruptcy Court chose between approving a settlement that deviated from the priority scheme or rejecting it so a lawsuit could proceed that would deplete the estate, and that the second option would have served neither the interests of creditors or the estate.

The Supreme Court reverses

The Supreme Court reversed the Third Circuit and held that "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."

The Supreme Court conceded that, insofar as the dismissal of chapter 11 cases seek restoration of the prepetition status quo under section 349(b) of the Bankruptcy Code, a bankruptcy judge may "for cause, orde[r] otherwise.1" But this exception does not authorize a bankruptcy court to violate priority without the consent of the impaired creditors. Although there are instances where courts had approved interim settlements violating ordinary priority rules, those cases involved significant Bankruptcy Code-related objectives that the priority-violating distributions served to make disfavored creditors better off. By contrast, in Jevic there was no significant bankruptcy-related justification to violate ordinary priority rules.

The Supreme Court also disagreed with the Third Circuit's "rare case" exception for approving a priority-violating structured dismissal. Such an exception threatened to become a more general rule and could result in potentially serious consequences of departing from protections granted to particular classes of creditors. The Court opined that Congress did not authorize a "rare case" exception and courts should not diverge from procedures in the Bankruptcy Code. Lastly, the Supreme Court seemed to be particularly interested in the reasoning behind why the WARN Act petitioners were excluded from the settlement – because Sun did not want to fund litigation against itself – a reasoning that was perhaps not a significant bankruptcy-related justification to violate ordinary priority rules. Czyzewski v. Jevic Holding Corp., 137 S. Ct. 983 (2017).

Impact of Jevic: no payment out of turn?

Bankruptcy courts will now closely scrutinize settlement agreements that seek to deviate from the basic priority rules under the Bankruptcy Code. Jevic has recently been applied in In re Fryar where the Bankruptcy Court for the Eastern District of Tennessee rejected a proposed settlement agreement (that did not include a specific request for a structured dismissal) because the deal would pay some unsecured creditors out of turn without "serv[ing] a significant Code-related objective." In re Fryar, Case No. 16-13559 (SR) (Bankr. E.D. Tenn. Apr. 25, 2017).

As another example, in the Constellation bankruptcy case pending in Delaware, the bankruptcy court recently denied a settlement motion that ran afoul of Jevic. See Order Denying Joint Motion Approving Settlement, In re Constellation Enterprises LLC, et al., Case No. 16-11213 (CSS) (Bankr. D. Del. May 16, 2017), ECF No. 963. The proposed settlement transferred cash and lawsuit rights from the debtor to an unsecured creditor's trust. The trust was structured in a way that cut some priority creditors out of the distribution equation. The proposed settlement provided that the chapter 11 cases would be "(a) dismissed by structured dismissal on terms that are consistent with this Term Sheet and/or the Settlement and are otherwise acceptable to the Debtors, Creditors' Committee and Ad Hoc Noteholder Group, or (b) resolved by such other process as may be agreed to by the Parties and approved by the Bankruptcy Court." Id.

In response to objections, the debtors argued that the settlement did not involve the distribution of the estates' assets, was in the best interests of the estates, and would provide a distribution to unsecured creditors that otherwise would be impossible absent the settlement agreement. The hearing on the initial settlement motion was adjourned pending the Supreme Court's ruling in Jevic.

After the Supreme Court issued its decision in Jevic, the objecting parties argued that if the Bankruptcy Court approved the settlement, then this would provide a means to circumvent Jevic by permitting debtors to move assets out of the estates temporarily and then distribute them in violation of the standard priority rules. See The DDTL Parties Supplemental Objection, In re Constellation Enterprises LLC, et al., Case No. 16-11213 (Bankr. D. Del. May 5, 2017), ECF No. 948.

On May 16, 2017, Judge Cristopher S. Sontchi denied the settlement motion because there was no evidence before the court as to why priority creditors were not involved in the settlement agreement or why deficiency claim creditors were treated differently. The facts and the law constrained the judge to this decision, despite him noting that it may come at a cost to creditors.

The impact of the Jevic ruling appears to be trending in a clear direction. Bankruptcy courts, upholding the ruling in Jevic, appear unwilling to approve settlement agreements (even where a structured dismissal is not contemplated or is contemplated as an option) or structured dismissals that violate ordinary priority rules. The Supreme Court's ruling in Jevic will make it more difficult to effect creative solutions in cases where creditors are severely out of the money, and may result in more conversions from chapter 11 to chapter 7. Jevic has taken some of the teeth out of structured dismissals and has potentially eliminated a tool to negotiate creative solutions in difficult cases. Going forward, practitioners should be mindful of how they present settlements to the bankruptcy court where there is any deviation from the ordinary priority rules.


1 The Supreme Court did not "express a view on the legality of structured dismissals in general." Czyzewski v. Jevic Holding Corp., 137 S. Ct. 985 (2017).