Absolute Priority Remains Absolute – US Supreme Court Holds Structured Dismissals Cannot Violate Priority Rules

by Dechert LLP
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In a highly anticipated bankruptcy opinion, the United States Supreme Court, in Czyzewski v. Jevic Holding Corp., held that courts may not approve structured dismissals providing for distributions that deviate from the priority rules prescribed in the Bankruptcy Code, absent consent of the affected creditors. In a 6-2 decision (which in truth was unanimous on the substance since the dissent addressed only a procedural issue),the Supreme Court reversed the Third Circuit, holding that a structured dismissal that paid nothing to priority claimants but provided distribution to general unsecured creditors impermissibly disregarded the priority scheme of the Bankruptcy Code. 

Factual Background

The case arises out of Sun Capital Partners’ (“Sun”) acquisition of Jevic Transportation Corporation (“Jevic”) through a leveraged buyout, with money borrowed from CIT Group Inc. (“CIT”). Two years after the acquisition, Jevic filed for chapter 11, leading to two lawsuits. In the first lawsuit, a group of former Jevic truck drivers (the “Petitioners”) were awarded a judgment against Jevic for failure to provide proper notice of termination in violation of state and federal WARN Acts. A portion of that judgment constituted a priority wage claim under section 507(a)(4) of the Bankruptcy Code, entitling the Petitioners to payment ahead of general unsecured creditors. In the second lawsuit, the official committee of unsecured creditors (the “Committee”), acting on behalf of the debtor’s estate and upon authority granted by the bankruptcy court, sued Sun and CIT for preferential and fraudulent transfers in connection with the LBO. 

Jevic, the Committee, Sun and CIT (the “Respondents”) negotiated a settlement agreement that called for the structured dismissal, providing for: (1) dismissal of the fraudulent transfer actions; (2) CIT’s payment of the Committee’s legal fees and expenses; (3) Sun’s assignment of certain funds to a trust to pay taxes and administrative expenses, with the remainder going to general unsecured creditors, provided that Petitioners, who held a priority claim, would receive no distribution; and (4) dismissal of Jevic’s chapter 11. 

The bankruptcy court approved the settlement over the objection of the Petitioners and the U.S. Trustee that the distributions provided for in the settlement violated the Bankruptcy Code’s priority scheme. The district court affirmed, holding that the priority rules were not a bar to approval as the settlement was not a plan of reorganization and therefore, did not have to follow the Code’s distribution scheme. In a 2-1 decision, the Third Circuit affirmed, holding that structured dismissals need not always respect priority. It is noteworthy that the Third Circuit attempted to limit the breadth of its approval by holding that priority-violating structured dismissals are permissible only in “rare cases” where “sufficient reasons” to do so exist.

Discussion

There are three possible conclusions to a chapter 11 case: confirmation of a chapter 11 plan of reorganization, conversion to a chapter 7 case for liquidation, or a dismissal of the case. In a dismissal, and pursuant to section 349 of the Bankruptcy Code, the court ordinarily attempts to restore the prepetition financial status quo, but may “for cause” alter the dismissal’s normal consequences if perfect restoration proves difficult or impossible, i.e., a structured dismissal. 

The Bankruptcy Code establishes priority rules for distribution of estates’ assets. Under sections 1129(a)(7) and 1129(b)(2)(B)(ii) in chapter 11, a court cannot confirm a plan that violates the absolute priority rule (i.e. no junior creditor may be paid unless more senior creditors are paid in full) over an objection of an impaired creditor class. Pursuant to sections 725 and 726 in chapter 7, distributions must follow the Bankruptcy Code’s prescribed priority order, i.e. no distributions to junior creditors prior to payment in full of senior creditors. The Bankruptcy Code, however, does not address what priority rules, if any, apply in a structured dismissal (which is not surprising since, as the Court notes, are not even mentioned in the Code).

The Court held that a distribution scheme ordered in connection with a structured dismissal cannot, without the consent of the affected parties, deviate from the priority rules for final distributions under the Bankruptcy Code. The Court notes that the priority scheme in the Bankruptcy Code “constitutes a basic underpinning of business bankruptcy law,” and if Congress intended to depart from it, for example in context of approval of dismissals under section 349, there must be an affirmative indication of its intent 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.” As the Court noted, “Congress… does not …hide elephants in mouseholes.”

And the Court found nothing in the Bankruptcy Code evincing such intent, nor did precedent support such conclusion. The opinion noted that, as distinguishable from the Jevic case, courts routinely approve interim distributions serving significant Bankruptcy Code related objectives, including various first-day orders. Those orders focus on enabling a successful reorganization. In contrast, a structured dismissal order is a final disposition and does not (i) preserve the debtor as a going concern, (ii) make disfavored creditors better off, (iii) promote the possibility of a confirmable plan, (iv) help restore the status quo, or (v) protect reliance interests (i.e. interests obtained by creditors as part of the bankruptcy case).

The Supreme Court flatly rejected the “rare case” exception based on “sufficient reasons” to disregard priority. The Court was blunt in holding that “it is difficult to give precise content to the concept [of] ‘sufficient reasons,’” and a rare case exception could turn into a more general rule. And in language that undoubtedly will be cited frequently, the Court held that “Congress did not authorize a ‘rare case’ exception ….We cannot ‘alter the balance struck by the statute’…not even in “rare cases.”

Implications

The holding of the Jevic decision could be seen as narrow in that it does not hold that all structured dismissals violate the Bankruptcy Code (although in a bracketed sentence the Court noted that “[w]e express no view about the legality of structured dismissals in general”); Only those that violate the priority provisions without consent are impermissible. 

Nevertheless, the decision could have far reaching implications by potentially limiting parties in developing and courts in adopting, creative solutions to difficult and unique issues that routinely arise in bankruptcy cases, where the solutions do not fit within the strict text of the Bankruptcy Code. Such lack of flexibility is likely to result in real economic cost to be borne by debtors, their creditors, added strain on the court system, and in certain systemically large cases, the economy as a whole. 

Yet, if one thing is clear, it is that the absolute priority rule will be respected, absolutely, in structured dismissals absent the consent of those who are entitled to priority treatment but are not receiving that treatment. 

Read the opinion »

Footnotes

1) Justice Thomas penned the dissent, with Justice Alito joining. The dissent notes that the Supreme Court granted certiorari on one question, while the Petitioners argued (and the Court decided) another. Given that switch, the dissent would dismiss the writ of certiorari as improvidently granted.

 

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