The Supreme Court Rejects Use of Non-Consensual Structured Dismissals that Violate the Code’s Priority Rules in Jevic

Article

The Business Advisor

April 2017

On March 22, 2017, the Supreme Court issued its decision in Czyzewski v. Jevic Holding Corp., 580 U.S.____ (2017), reversing and remanding the decision of the U.S. Court of Appeals for the Third Circuit that approved a chapter 11 dismissal that violated the Code’s statutory priority scheme. As previously reported in our December 2016 edition of The Business Advisor, the Court granted certiorari to review the Third Circuit’s approval of a $3.7 million settlement of the chapter 11 estate’s fraudulent conveyance litigation against its secured lenders in a “structured dismissal,” which included priority-skipping final distributions to general unsecured creditors over the objection of Jevic’s terminated truck drivers, who received nothing on account of their uncontested Section 507 priority WARN Act claim of $8.3 million.

Framing the question before the Court as “whether a bankruptcy Court has the legal power to order this priority-skipping kind of distribution scheme in connection with a chapter 11 dismissal,” the Court’s answer leaves little room for misinterpretation:

In our view, a bankruptcy Court does not have such a power. 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.

Jevic, slip op. at pp. 1-2. Jevic was decided by a six-member majority of the Court. In their departure from the majority decision, the two dissenting Justices agreed with the respondent’s view that “structured dismissals” were not properly before the Court and believed the Court was “unwise” in deciding such a “novel and important question of bankruptcy law” without the benefit of the views of additional courts of appeal and full adversarial briefing.

Jevic also rejects the respondents’ argument that the petitioners lack Article III standing “because they have suffered no injury, or at least no injury that will be remedied by a decision in their favor.” Id. at 9. Concluding that the record can be read to show possible outcomes that are contrary to the respondents’ assumption that petitioners (Jevic’s priority wage claimants) would not receive any recovery from Jevic’s estate even if the bankruptcy Court did not approve the settlement and structured dismissal, the Court found that the decision appealed from did indeed result in a loss – and an injury to petitioners – sufficient for Article II standing purposes.

The Majority Opinion
The Court’s analysis starts with a review of the fundamentals of business bankruptcy cases, filed under either chapter 7 or chapter 11. Identifying the three potential outcomes for a chapter 11 case (confirmation of a plan, conversion to chapter 7, or dismissal), the Court focuses on the consequences of the “dismissal” option:

[a] dismissal typically “revests the property of the estate in the entity in which such property was vested immediately before the commencement of the case” – in other words, it aims to return to the prepetition financial status quo. [citing 11 U.S.C.] § 349(b)(3).

Jevic, slip op. at 3. The Court goes on to note that Congress recognized in §349(b) that situations may exist where “a perfect restoration of the status quo [is] difficult or impossible,” thereby permitting a bankruptcy Court “for cause to alter a Chapter 11 dismissal’s ordinary restorative consequences.” Id. Although not defined as such in the Bankruptcy Code, the Court identifies such chapter 11 dismissals that attach special conditions “for cause” by their often used label of “structured dismissals,” referring to such dismissals as an “increasingly common” practice, as recently chronicled in the Final Report of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11, 2012-2014. Id.

The Court then addresses the Code’s priority rules, noting that, while the Code’s chapter 7 provisions mandate strict compliance with such priority rules (see 11 U.S.C. §§725, 726), the chapter 11 provisions provide “somewhat more flexibility for distributions pursuant to Chapter 11 plans,” particularly with the consent of the affected parties. However, the Code makes clear that a bankruptcy Court cannot confirm a chapter 11 plan that contains priority-violating distributions over the objection of an impaired creditor class. (See 11 U.S.C. §§1129(a)(7), 1129(b)(2)).

As the Supreme Court saw it, the Jevic appeal concerned the interplay between the Code’s priority rules and a chapter 11 dismissal, but there was no statutory mandate in the Code to guide the bankruptcy Court’s actions:

Instead of reverting to the prebankruptcy status quo, [the Court] ordered a distribution of the estate assets to creditors by attaching conditions to the dismissal (i.e., it ordered a structured dismissal). The Code does not explicitly state what priority rules – if any – apply to a distribution in these circumstances.

Jevic, slip op. at 4. While the bankruptcy Court acknowledged that the distribution scheme it was approving did not follow the Code’s priority rules, that Court concluded that approval of the settlement was nonetheless justified “in light of the ‘dire consequences’ facing the estate and its creditors.” As the Supreme Court explained:

Specifically, the [Bankruptcy] Court predicted that without the settlement and dismissal, there was “no realistic prospect” of a meaningful distribution for anyone other than the secured creditor. A confirmable Chapter 11 plan was unattainable. And there would be no funds to operate, investigate, or litigate were the case converted to a proceeding in Chapter 7. [Citations omitted].

Id. at p. 8.

This led the Supreme Court to outline and answer the “basic question” before it as follows:

Can a bankruptcy Court approve a structured dismissal that provides for distributions that do not follow ordinary priority rules without the affected creditors’ consent? Our simple answer to this complicated question is “no.”

Id. at p. 11 (Emphasis added).

Critical to the Court’s reasoning was an analysis of the importance of the Code’s priority system – which has “long been considered fundamental to the Bankruptcy Code’s operation.” Id. at p. 12. Viewed in such prism, and against the backdrop of the Code’s clear statutory priority rules governing distributions in both chapter 7 liquidations and under chapter 11 plans, the Court expected “to see some affirmative indication of intent if Congress actually meant” to deviate from the Code’s statutory scheme for final distributions in a “structured dismissal.” Id. But the Court found nothing in the Code to evidence such intent, and similarly found no precedent in any prior Supreme Court or lower Court decision which sanctioned the Jevic-type nonconsensual “end-of-case distributions” in a chapter 11 case in violation of the Code’s priority scheme.

Noting the Court of Appeals’ reliance on the Second Circuit’s decision in In re Iridium, LLC, 478 F.3d 452 (CA2 2007) (authorizing priority-violating interim distributions of settlement proceeds), the Court reasoned that Iridium and other precedents allowing “non-final” distributions of estate value (e.g., “first-day” orders, “critical vendor” orders, and DIP lender “roll-ups”) each advanced “significant Code-related objectives that the priority-violating distributions serve.” Id. at p. 15. However, there was no similar “Code-related objectives” to warrant the priority-skipping final distributions in Jevic’s case, which the Court likened to the long-disapproved practice of a “sub rosa” plan with its attendant subversion of the Code’s chapter 11 safeguards. Id. at p. 16.

The Court also rejected the Third Circuit Court of Appeals’ “rare case” exception for Jevic’s unique factual circumstances, foreseeing that the uncertainty surrounding application of such an exception would cause such exception to become more of a general rule. The Court viewed a departure from the protections Congress granted to certain priority creditors, such as Jevic’s priority wage claimants, as having “potentially serious” consequences by effecting a change in the bargaining power that Congress established through the Code’s priority scheme. The Court therefore refused to graft a “rare case” exception to the Code’s priority rules in nonconsensual structured dismissals.

Lessons Learned from Jevic
What have we learned from Jevic?

For starters, we now know what the Court has decided. And the Court’s decision is clear on these two directives:

  1. the Code’s statutory priority scheme cannot be ignored in a chapter 11 dismissal that provides for distributions that do not follow ordinary priority rules without the affected creditors’ consent; and
  2. there can be no “rare case” exception to nonconsensual dismissals which deviate from the Code’s statutory priority scheme.

We also know that the Court’s decision is narrow: “[w]e express no view about the legality of structured dismissals in general,” slip op. at p. 14, citing to In re Buffet Partners, L.P., 2014 WL 3735804 (Bkrtcy. Ct. ND Tex., July 28, 2014) (approving a structured dismissal without objection). And, at least for now, the consternation among chapter 11 lawyers about the potential for the Court to wreak havoc by a ruling which would have rejected outright any distribution scheme which fails to conform to the Code’s priority scheme has been quelled.

Finally, we know that the Court’s decision leaves untouched the ability of bankruptcy Courts to exercise their discretion in a wide range of cases where no structured dismissal is involved, as the Court did not decide the propriety of the following distribution schemes:

  1. interim distributions that deviate from Code’s priority scheme;
  2. consensual deviations from the Code’s priority scheme which accompany final distributions made in accordance with the provisions of Code §1129; and
  3. priority-skipping “gifting” plans, under which a secured creditor voluntarily gives up value to a junior class of creditors.

What remains to be seen is how the Court’s somewhat narrow ruling in Jevic may be expanded in future cases with the potential to limit the “increasingly common” use of structured dismissals.