Supreme Court Kills "Structured Dismissals" While Saving Interim Distributions Favoring Trade Creditors over Bondholders

March 27, 2017

By: Alan Kolod, Alan E. Gamza, Kent C. Kolbig, and Bryan R. Podzius

The United States Supreme Court, by a six to two vote, has put an end to “structured dismissals” of bankruptcy cases, in which Bankruptcy Code § 349(b) is used to dismiss a case while also ordering the distribution of assets in a manner not permitted by the statutory priority scheme in Chapter 7 or Chapter 11 cases.   At the same time, it left such practices as interim distributions to trade creditors unscathed.   Czyewski v. Jevic Holding Corporation, 580 U.S. ___ (2017).  A copy of the decision is accessible here.

The Bankruptcy Court had entered an order in a Chapter 11 case that dismissed with prejudice the estate’s preference and fraudulent transfer claims against a secured creditor, provided for the secured creditor to pay $3.7 million toward administrative expenses and a distribution to unsecured creditors from its collateral and dismissed the case against the debtor which had no remaining assets.  Employees who received nothing on their wage claims that had priority over unsecured creditor claims challenged the dismissal order as violating their statutory priority and appealed.  The Third Circuit Court of Appeals affirmed, finding this to be a “rare case” that justified a departure from the enforcement of statutory priorities.  The Court of Appeals found the case to be “rare” because it accepted the assertions of the favored creditors that the estate’s claims had no value absent settlement and that no settlement would have been possible if the proceeds went to the employees who were also suing the secured creditor separately. Thus, the Court concluded that the order preserved value for others that the employees could not themselves have enjoyed. 

The Supreme Court rejected the reasoning of the lower courts.  The Court recognized that interim distributions that did not comply with statutory priorities were often approved in Chapter 11 cases in circumstances where they served significant Bankruptcy Code-related objectives, such as preserving going concern value, inducing concessions from the favored creditors, enhancing the potential recoveries of disfavored creditors or promoting the likelihood of a confirmable plan.  But it found that these considerations were absent from a structured dismissal of a liquidating debtor’s case where the final distribution violated the priority rights of creditors.

The Court further found that the record in the Jevic case did not support the self-serving assertions of the respondents that the fraudulent transfer claims had no value or that a settlement that respected statutory priorities was impossible.  It concluded that, by approving the structured dismissal, the Bankruptcy Court had deprived the employees of any chance to obtain the value of the settlement that went to unsecured creditors or, absent settlement, the right to themselves pursue the estate’s claims which on their face had value.   For that reason, the employees had been injured by the structured dismissal order and had standing to appeal.

The Court found no precedent for an order disregarding statutory priorities in a dismissal order and found no support for such an order in the language of the Bankruptcy Code, including § 349(b) which permits a dismissal order to limit restoration of the pre-petition status quo “for cause.”  It concluded the limited purpose of this provision was to allow a court to protect reliance interests that had arisen during the case.  The Court also found strong policy reasons for refusing to allow courts discretion to approve deviations from the statutory priorities.  According to the Court, permitting deviations from the statutory priorities for undefined “sufficient cause” would open the door to uncertainty with potentially serious consequences, including depriving creditor classes of their statutory protections, affecting the bargaining power of creditor classes, encouraging collusion and making settlements more difficult. 

Take-Aways

The two dissenting Justices did not take issue with the reasoning of the Court, but found that the issue on which certiorari had been granted (whether bankruptcy courts could approve distributions that departed from the Bankruptcy Code’s statutory priorities—on which the Courts of Appeals were divided) was not the issue actually argued by petitioners (which was limited to whether dismissal orders could disregard priorities—an issue which no other Court of Appeals had decided).  The dissenters criticized this as “bait and switch”, and felt that the Court should have dismissed the petition as improvidently granted.  Their preference was to allow the case law to further develop at the Court of Appeals level before deciding the structured dismissal issue.

The majority, in contrast, went out of its way to put an end to structured dismissals of the Jevic type.  It was obvious in Jevic that the estate’s preference and fraudulent transfer claims did have settlement value, or the secured creditor would not have agreed to pay administrative claims or to allow a distribution to unsecured creditors from its collateral.  The Court also saw no reason to credit the self-serving assertion that the secured creditor would never have settled with the employees so long as they were also prosecuting another litigation (an argument that was mooted during the appeal when the secured creditor prevailed in the other suit).  The real question was who was entitled to share in the undoubted value of the estate’s claims that were being settled, a question that the priority provisions of the Bankruptcy Code answered clearly.   The majority recognized that the mere threat of a structured dismissal gave the secured party, administrative creditors, debtor and creditors’ committee, acting together, the power to pressure the priority wage claimants to accept a lesser settlement or risk getting nothing at all.  To put an end to such “collusion”, the Court prohibited structured dismissals, without any possibility for deviation in “rare cases” or for “sufficient cause”.

What may have bothered the dissenters was that, the majority, without hearing any arguments against interim distribution orders (the issue on which certiorari had been granted) implicitly approved such orders on the ground they promote reorganizations.  Thus, such common practices as “roll ups” of pre-petition debt into DIP financings and of interim payments to unsecured trade creditors but not bondholders were left unscathed, with no one asking the question whether the policy arguments made by the majority might also apply to these departures from statutory priorities.

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