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Supreme Court Refuses to Allow End Run Around the Absolute Priority Rule in Structured Dismissals of Chapter 11 Cases

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On March 22, 2017, the Supreme Court of the United States decided Czyzewski v. Jevic Holding Corp., 580 U.S. __ (2017), holding that a bankruptcy court may not use a structured dismissal of a chapter 11 case to approve a distribution scheme that violates the absolute priority rule. In many middle-market cases, chapter 11 debtors had used this tool to get deals done and reorganize, despite their inability to confirm a chapter 11 plan.

The dispute arose from the structured dismissal of the chapter 11 case of Jevic Holding Corporation (“Jevic”). Jevic was acquired by Sun Capital Partners (“Sun”) as part of a leveraged buyout in 2006, with funds borrowed from CIT Group (“CIT”), whose loan was secured by the assets of Jevic. Two years following the LBO, Jevic filed for relief under chapter 11 of the Bankruptcy Code. At the time of the commencement of the chapter 11 case, Jevic had senior secured debt of $53 million owed to Sun and CIT, and in excess of $20 million owed to creditors holding tax and general unsecured claims.

The chapter 11 filing led to the petitioners (the former truck drivers of Jevic) commencing WARN Act litigation against Jevic and Sun for failing to provide them with the required 60 days’ notice of termination of their employment. The bankruptcy court granted the petitioners’ motion for summary judgment against Jevic, giving the petitioners a $12.4 million judgment, of which $8.3 million would be a priority wage claim under section 507(a)(4) of the Bankruptcy Code. The litigation against Sun remained pending at that time, but ultimately, the bankruptcy court ruled in favor of Sun on the basis that Sun was not the petitioners’ employer.

Separately, the bankruptcy court also authorized the Jevic creditors’ committee to bring an action against Sun and CIT for fraudulent transfer arising out of the LBO. Prior to the bankruptcy court’s ruling on the petitioners’ WARN Act claim against Sun, the parties ultimately reached a settlement of the fraudulent transfer litigation. By that point, however, Jevic’s only remaining assets were $1.7 million in cash and the fraudulent transfer claim against Sun and CIT. The settlement contemplated that the bankruptcy court would issue an order dismissing the chapter 11 case under the following terms:

(1) CIT would contribute $2 million to an account, which would be used to pay the committee’s legal fees and administrative expenses;
(2) Sun’s lien on the $1.7 million cash held by Jevic would be assigned to a trust, which would pay taxes and administrative expenses of the estate, with the balance being distributed pro rata to unsecured creditors; and
(3) no portion of the $1.7 million would be distributed to the petitioners, which held an $8.3 million priority wage claim against the Jevic estate.

Sun had insisted on the petitioners not receiving any distribution on the basis that the petitioners were still prosecuting the WARN Act claim against Sun, and Sun did not want to help fund the costs of that litigation.

The bankruptcy court approved the structured dismissal of the chapter 11 case on those terms. While the bankruptcy court acknowledged that the distribution scheme under the settlement violated the absolute priority rule, the court found that it nevertheless could approve the structured dismissal, because the distribution scheme was not part of a chapter 11 plan. The district court and the Third Circuit Court of Appeals affirmed the bankruptcy court’s structured dismissal of Jevic’s chapter 11 case.

At the Supreme Court, the respondents, Jevic and its lenders, first asserted that the petitioners lacked standing, because they had not suffered any injuries. They further asserted that the petitioners would not have received any distribution from the Jevic estate, because Sun would not have agreed to a settlement that contemplated any payment to petitioners, and the remaining $1.7 million cash was subject to Sun’s lien. The Court disagreed, reasoning that (1) Sun may have been willing to agree to a distribution to petitioners, since it had prevailed on the WARN Act claim; and (2) the fraudulent transfer claim against Sun and CIT may have had value that could have been prosecuted for the benefit of the petitioners.

Turning to the merits, in a 6 to 2 decision, the Supreme Court firmly stated that the priority scheme is fundamental to the Bankruptcy Code’s operation, and if Congress had intended to permit the use of a structured dismissal as a “backdoor” way to achieve a “priority-violating” distribution, it would have affirmatively expressed such intent. In the Court’s view, section 349(b) of the Bankruptcy Code requires that a dismissal of a chapter 11 case should result in a return to the prepetition status quo subject to only very limited exceptions. While the Court recognized that under section 349(b), the bankruptcy court may rule otherwise “for cause,” the Court found such provision “too weak a reed” to give it the power to violate the absolute priority rule. The Court also distinguished the cases in which bankruptcy courts approved customary interim distributions to unsecured creditors in violation of the priority rules such as those for payment of prepetition wages, critical vendor payments, and “roll-ups” to pay lenders who provide debtor in possession financing. The Court reasoned that such distributions may be necessary for a successful reorganization, which would ultimately serve the interests of creditors. That reasoning, however, would not apply to a structured dismissal, because “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.”

The Court also found the notion of permitting courts to disregard priority in “rare cases” as leading to uncertainty, where every case could turn into a rare case, with potentially serious consequences of departing “from the protections Congress granted to particular classes of creditors” The Court concluded that “Congress did not authorize a ‘rare case’ exception” and it cannot “alter the balance struck by statute” even in “rare cases.”

The Impact of the Decision

In a significant number of middle-market chapter 11 cases, the ability for the debtor to confirm a plan could be limited by circumstances similar to those that faced Jevic, i.e. (i) one or more significant senior secured creditors that are “underwater” because the amount of their secured claims swamps the value of their collateral, and (ii) the existence of a large outlier claim that cripples a debtor’s ability to confirm a plan like the petitioners in Czyzewski. Accordingly, structured dismissals provided an alternative avenue to “reorganize” in chapter 11 and keep a debtor entity operating despite its inability to confirm a chapter 11 plan. An important factor in Czyzewski appears to have been the existence of the fraudulent transfer action which would have funded some distribution to the petitioners under a plan as opposed to the structured dismissal. Ultimately, without citing it, the Supreme Court’s decision follows the reasoning of the Second Circuit Court of Appeals decision in In re DBSD North America, Inc., which found that distributions made from the secured creditors collateral that bypassed creditors in favor of equity holders also violated the Bankruptcy Code’s absolute priority rule. Accordingly, another exit door from chapter 11 has effectively closed.
1Justices Thomas and Alito dissented on procedural grounds stating that the issue decided by the majority was not the issue for which the Court had granted certiorari.

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