In a much anticipated decision issued on March 22, 2017, the United States Supreme Court determined in Czyzewski v. Jevic Holding Corp. (Jevic) that a “structured dismissal” of a bankruptcy case cannot include a distribution scheme to creditors that does not comply with the priorities provided for under the Bankruptcy Code. The decision looks at the policy underlying “basic priority rules” in bankruptcy cases and, in doing so, throws into question the future use of negotiated settlements in bankruptcy cases where some, but not all, creditors receive a benefit. As can be expected when the high court tackles a tool used in commercial bankruptcy cases, expect this decision to be carefully analyzed to identify and then test the boundaries.

What Happened?

Starting at the beginning, Jevic Transportation Corporation filed for Chapter 11 protection with the United States Bankruptcy Court for the District of Delaware two years after it was acquired through a leveraged buyout (LBO). The circumstances of Jevic’s filing led to two major lawsuits.

First, a group of former employees filed suit against Jevic for violation of certain notice requirements under state and federal Worker Adjustment and Retraining Notification Acts (WARN), resulting in a judgment in favor of the employees in the amount of $12.4 million, $8.3 million of which qualified for priority claim status under § 507(a)(4) of the Bankruptcy Code as unpaid employee wages and/or benefits.

Second, the unsecured creditors’ committee sued the purchaser (Sun) and lender of the LBO on a theory of fraudulent conveyance, arguing that the buyout rendered Jevic insolvent. Of importance to the issue at hand, the parties negotiated a settlement that included a “structured dismissal” of the Chapter 11 case as the case’s disposition. Rather than simply seek dismissal of the Chapter 11 case (or convert the case to a Chapter 7 liquidation), Jevic would seek an order from the Bankruptcy Court that, in addition to dismissing the case, would create a trust that would provide for a pro rata distribution among general unsecured creditors from the proceeds of the settlement, but would not provide any recovery to the employees on account of their asserted $8.3 million of (higher) priority claims. The effect was to skip over creditors who, under a strict waterfall analysis, might otherwise have received a recovery from estate assets (assuming any recovery from the estate was available).

The Bankruptcy Court approved this structured dismissal, reasoning that the deviation from the priority scheme in the Bankruptcy Code would occur pursuant to a structured dismissal (rather than approval of a Chapter 11 plan) because of “dire circumstances”; to wit, without funds from the settlement, which was premised on the structured dismissal, there was likely no prospect of distribution for any unsecured creditors. The district court and the Third Circuit also affirmed, holding that deviations from the priority scheme may be permitted by a court in “rare cases.”

The Jevic Ruling

The Supreme Court, in a 6-2 opinion drafted by Justice Breyer, reversed the lower courts and held that creditor priorities provided for in the Bankruptcy Code must be adhered to in making distributions to creditors in the context of a dismissal.

As an initial matter, the Court rejected Jevic’s argument that the priority creditors lacked standing to appeal because they were not harmed by the structured dismissal because, absent the settlement, there would be no recovery anyway to creditors, priority or otherwise. (Justice Breyer characterized Jevic’s position as follows: “Thus, even if petitioners are right that the structured dismissal was impermissible, it cost them nothing. And a judicial decision in their favor will gain them nothing. No loss. No redress.”). However, the Court found that the record did not support the propositions that the complaining employees could suffer no loss. “[T]he record indicates that a settlement that respects ordinary priorities remains a reasonable possibility.” Specifically, the Court noted that the rationale for why Sun, as the settling party, wanted to exclude the employees (specifically, because it was being sued by the employees under the WARN theory) no longer applied (because it had won that lawsuit):

It makes clear (as counsel made clear before our Court [citation omitted]) that Sun insisted upon a settlement that gave petitioners nothing only because it did not want to help fund petitioners’ WARN lawsuit against it. [citations omitted]. But, Sun has now won that lawsuit. [citation omitted]. If Sun’s given reason for opposing distributions to petitioners has disappeared, why would Sun not settle while permitting some of the settlement money to go to petitioners?

Moreover, the Court reasoned that “the fraudulent conveyance claim could have litigation value” for the priority creditors because the claims against the LBO parties would otherwise survive in a conversion to Chapter 7 (and be pursued by a trustee) or a simple dismissal (and be pursued by creditors directly using contingency counsel). In short, there would be potential value in those claims that may accrue to the benefit of the priority creditors. Hence, standing existed.

Moving on to the merits of the issue, the Court then addressed the issue of priority-skipping, holding that structured dismissals that provide for distributions that do not follow ordinary priority rules cannot be approved without the affected creditors’ consent.

We turn to the basic question presented: 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.”

The Court reasoned that “[d]istributions of estate assets at the termination of a business bankruptcy” normally take place through a Chapter 11 plan (whether reorganization or liquidation) or through a Chapter 7 case and, in either instance, the Code’s priority scheme applies. The Court observed that in Chapter 7 cases, “priority is an absolute command,” whereas in Chapter 11 cases there is “somewhat more flexibility,” but a priority violating plan cannot be confirmed over the objection of a dissenting creditor, even under the “cram-down” provided for under Section 1129(b) of the Bankruptcy Code. In looking at the priority structure, the Court reasoned that the priority system has “long been considered fundamental to the Bankruptcy Code’s operation,” and the importance of this system leads to the conclusion that Congress would not have been silent on the issue if it intended to allow structured dismissals as a major departure from the priority scheme. Further, nothing in the Bankruptcy Code authorizes a court to order a dismissal that makes end-of-case distributions of estate assets to creditors that would be flatly impermissible in a Chapter 7 or Chapter 11 scenario. As the Court observed [citations omitted]:

The importance of the priority system leads us to expect more than simple statutory silence if, and when, Congress were to intend a major departure. Put somewhat more directly, we would expect to see some affirmative indication of intent if Congress actually meant to make structured dismissals a backdoor means to achieve the exact kind of nonconsensual priority-violating final distributions that the Code prohibits in Chapter 7 liquidations and Chapter 11 plans.

The Court concluded: “We can find nothing in the statute that evinces this intent.” In its reasoning, the Court examined the provisions of Section 349(b) of the Bankruptcy Code that address dismissal and their purpose of providing for “a restoration of the prepetition financial status quo.” Noting that cases have provided for dismissal while preserving various orders entered during the case (pre-dismissal), the Court stated [citations omitted]: “Section 349(b), we concede, also says that a bankruptcy judge may, ‘for cause, orde[r] otherwise.’ But, read in context, this provision appears designed to give courts the flexibility to ‘make the appropriate orders to protect rights acquired in reliance on the bankruptcy case.’” The Court focused on interim distributions during a case, which it did not question as impermissible (see below), versus end-of-case distributions that typically occur under a Chapter 11 plan or through Chapter 7 liquidation:

Nothing else in the Code authorizes a court ordering a dismissal to make general end-of-case distributions of estate assets to creditors of the kind that normally take place in a Chapter 7 liquidation or Chapter 11 plan — let alone final distributions that do not help to restore the status quo ante or protect reliance interests acquired in the bankruptcy, and that would be flatly impermissible in a Chapter 7 liquidation or a Chapter 11 plan because they violate priority without the impaired creditors’ consent. That being so, the word “cause” is too weak a reed upon which to rest so weighty a power.

As mentioned above, the Court’s decision explicitly focuses on the timing of priority-violating payments, finding that departures from the priority scheme during a case may be permissible, but those at the end of a case being of concern. The Court reasoned that some types of distributions during a case — such as critical vendor payments — benefit the estate and creditors even though the payments to the creditor are not consistent with the Code’s priority scheme.

But in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve. Courts, for example, have approved “first-day” wage orders that allow payment of employees’ prepetition wages, “critical vendor” orders that allow payment of essential suppliers’ prepetition invoices, and “roll-ups” that allow lenders who continue financing the debtor to be paid first on their prepetition claims. [citations omitted]. In doing so, these courts have usually found that the distributions at issue would enable a successful reorganization and make even the disfavored creditors better off. [citations omitted].

On the other hand, analogizing the structured settlement in Jevic to the disfavored sub rosa plan (typically a sale of assets that also dictates the distribution of the sale’s proceeds to creditors), the Court reasoned:

By way of contrast, in a structured dismissal like the one ordered below, the priority-violating distribution is attached to a final disposition; it does not preserve the debtor as a going concern; it does not make the disfavored creditors better off; it does not promote the possibility of a confirmable plan; it does not help to restore the status quo ante; and it does not protect reliance interests. In short, we cannot find in the violation of ordinary priority rules that occurred here any significant offsetting bankruptcy-related justification.

Finally, the Court concluded that Congress did not intend to authorize a “rare case” exception that could be applied to sparingly examine a distribution of estate assets in contravention of the Code’s priority scheme. “[I]t is difficult to give precise content to the concept ‘sufficient reasons.’ That fact threatens to turn a ‘rare case’ exception into a more general rule.”

Observations

First, the Court “express[ed] no view about the legality of structured dismissals in general.” Thus, the decision does not, per se, invalidate the ability to have dismissals where the order preserves certain actions taken during the case (e.g., 363 asset sales outside of a plan). Nor does the opinion address the propriety of a distribution of non-estate assets as part of a settlement that skips over certain priority creditors. This could include the use of “gifting,” whereby a more senior lender makes a payment to more junior creditors, but the key may very well be whether the funds at issue are “estate assets” or derived from non-estate property. The decision also leaves open the use of a structured dismissal using estate assets if the creditors otherwise affected consent — which would not per se invalidate structured dismissals as opposed to make them more expensive. It is also noteworthy that the decision acknowledges the use of “interim” relief — whether favoring vendors, employees or DIP lenders — that “enable a successful reorganization” despite affecting the Code’s priority scheme. In the end, this decision will be carefully reviewed and likely tested to define its boundaries.