Opinion analysis: Bankruptcy priority rules may not be evaded in Chapter 11 structured dismissals
on Mar 23, 2017 at 6:38 am
Czyzewski v. Jevic Holding Corp. is the latest battleground in a 150-year struggle over whether senior creditors whose liens exhaust a bankruptcy estate, and junior creditors or equity holders with control over the bankruptcy proceeding, can combine to use bankruptcy processes to implement a division of value that skips over otherwise out-of-the-money intervening creditors over their objection. In the landmark case of Northern Pacific Railway Company v. Boyd, the court created the “absolute priority rule” to prevent just that eventuality in federal equity receiverships over 100 years ago, before any federal statutory reorganization procedure existed. Ever since and all along, bankruptcy practitioners struggling to make deals and solve practical problems have creatively fought, evaded, and sought to limit the scope of that prohibition. The most fashionable current step in this never-ending bankruptcy dance has been the “structured dismissal.” The court’s opinion in Jevic puts the brakes on this device by making clear that priority deviations implemented through non-consensual structured dismissals are not permitted.
The bankruptcy code provides three ways to end a Chapter 11 case: confirmation of a plan, conversion to a Chapter 7 liquidation, or dismissal. The code contemplates that dismissal will return the parties to their prebankruptcy positions, except to the extent the bankruptcy court orders otherwise. In a structured dismissal, however, the bankruptcy court’s dismissal order alters the rights and liabilities of the parties in ways that differ from the three options outlined in the code. Unlike a Chapter 11 plan, a structured dismissal does not require disclosure, voting by affected constituents and bankruptcy-court findings that the plan meets substantive and procedural legal standards, including compliance with the code’s priority rules. Unlike conversion to Chapter 7, a structured dismissal does not lead to a statutorily regulated liquidation consistent with established bankruptcy priorities. And unlike a straight dismissal, a structured dismissal does not simply return the parties to their prebankruptcy positions.
Jevic is a trucking company that filed under Chapter 11. During the bankruptcy proceeding, fraudulent-transfer claims against Jevic’s senior secured lenders were resolved by a $3.7-million settlement subject to a structured dismissal in which certain priority claims, based on employment-law violations under the Worker Adjustment and Retraining Notification Act, of truck drivers who worked for Jevic were skipped over. Had there been a settlement but no dismissal, and had the settlement proceeds been distributed under a plan or in a Chapter 7 liquidation, the workers’ priority claims would have entitled them to $1.7 million. Had there been no settlement but rather a straight dismissal or conversion, the fraudulent-transfer claims against the senior creditors would have revested in the workers or become an asset of the Chapter 7 bankruptcy estate, respectively. In the structured dismissal approved by the bankruptcy court over the workers’ objection, however, the workers received no proceeds, even as junior creditors received a distribution out of the settlement funds, and the fraudulent-transfer claims were extinguished.
The courts below approved this structured dismissal on the basis that no good alternative existed. No Chapter 11 plan could be confirmed given the estate’s inability to satisfy outstanding administrative and priority claims (i.e., the estate was “administratively insolvent”), and, in a Chapter 7 liquidation, no one other than the senior secured creditors would receive anything, because the fraudulent-transfer action would have to be abandoned for lack of resources to prosecute. In short, the lower courts concluded, the workers were no worse off in the structured dismissal, and other constituents were all measurably better off.
Justice Stephen Breyer wrote for the six-member majority (Chief Justice John Roberts and Justices Anthony Kennedy, Ruth Bader Ginsburg, Sonia Sotomayor and Elena Kagan, as well as Breyer himself). Jevic had raised a threshold objection, asserting that the truck drivers did not have standing to bring their claims. Breyer made short work of this argument, noting that it depended on two dubious propositions: that no bankruptcy settlement that included the workers was feasible, and that absent settlement the fraudulent transfer claims could not be prosecuted. The fact that the settling defendant asserted that it would not agree to a settlement that included workers who were separately suing it on WARN Act claims could well have been a bluff; in any event, the court noted, the settling defendant’s independent WARN Act liability had been subsequently resolved, removing that obstacle. Similarly, the bankruptcy court’s prediction that fraudulent-transfer claims with an apparent settlement value of $3.7 million were otherwise worthless was speculative. In short, the workers had standing to object to the structured settlement because a successful objection might result in value for them.
Passing to the merits, the court explained that the bankruptcy priority rules were “a basic underpinning of business bankruptcy law” that had long been considered “fundamental.” Given that statutory context, the absence of any express statutory authorization for structured or conditional dismissals involving non-consensual modifications of distributional priorities was fatal. The court acknowledged that the dismissal statute did expressly authorize a bankruptcy court to alter the status quo ante effect of a dismissal order for “cause.” But, the court reasoned, conditioning dismissal on a priority-deviating final distribution of estate assets was too much weight for “cause” to bear. The for-cause exception allowed the bankruptcy judge, upon dismissal, to protect reliance by third parties on intervening bankruptcy court orders or other intervening events; it was not to be employed as an end run around the code’s priority scheme. Finally, the court rejected the attempt of the U.S. Court of Appeals for the 3rd Circuit to identify “rare” circumstances justifying structured dismissal, expressing skepticism that any such exception could be appropriately defined and contained, and in any event finding no statutory warrant for it.
For bankruptcy insiders, the result in Jevic was not a surprise, particularly in light of the December 7 argument. Anticipated with more trepidation, however, were the scope of the decision and its implications for other sorts of bankruptcy court-approved priority deviations that had become common Chapter 11 practice.
Jevic places into serious doubt the continued viability of the already controversial practice of “gifting” — that is, implementing priority deviations out of collateral proceeds through Chapter 11 plans without intervening class consent, or, in Chapter 7 liquidations, by characterizing the distribution as a ”gift” of the secured creditor’s collateral rather than a distribution of estate assets. Although the court’s opinion never refers to the practice of “gifting,” or to the lower court cases adopting or limiting gifting theories, Jevic’s reasoning, especially the primacy it places on the code’s distributional provisions, is in serious tension with that practice. On the other hand, the court’s embrace of the opinion of the U.S. Court of Appeals for the 2nd Circuit in In re Iridium Operating LLC, which approved an interim priority-deviating settlement on a gifting theory, may give gifting proponents heart.
More importantly, however, the court went out of its way to draw a sharp line between interim orders entered by the bankruptcy court in connection with its administration of an ongoing bankruptcy case and the structured dismissal at issue in Jevic. The common Chapter 11 practices of first-day wage orders, critical-vendor orders, roll-ups and interim settlements were all expressly distinguished from the objectionable structured dismissal in Jevic, which, the court expressly noted, involved a final distribution inconsistent with the code’s priority scheme as part of the case’s final disposition. The court’s implicit ratification of these established practices to the extent they serve other reorganization objectives undoubtedly will be embraced by the bankruptcy community.
The most interesting nuance in the court opinion is its brief discussion of Section 363 sales, which are a kind of in-between disposition. These sale orders are “interim,” and do not typically order final distributions except perhaps to secured parties, but they generally are case-dispositive and preordain the shape of the final distribution. The court cited with apparent approval the Braniff and Lionel cases, two 35-year old authorities that overturned Section 363 sale orders as evasions of Chapter 11’s procedural requirements, and threw in a “cf.” cite to the more recent Chrysler case, which controversially approved such a sale in an order that the Supreme Court subsequently vacated as moot. Moreover, the court prominently cited (on the structured dismissal issue) the wide-ranging and much-debated “2014 Report of the American Bankruptcy Institute Chapter 11 Study Commission,” which also proposed substantial reforms of existing Section 363 practices. It is possible that Jevic may signal discomfort with at least some aspects of existing case-dispositive Section 363 practice, as well as the comfort with interim critical-vendor orders, roll-ups and the like to the extent they serve a good faith reorganization purpose expressly noted above.
Finally, an academic point: The court naturally and properly relied on the history of senior-junior collusion in bankruptcy to bolster its holding prohibiting non-consensual skips, but it also claimed that settlements will be facilitated by enforcing priority regimes strictly, citing well-known law and economics work. Whatever law and economics theory might otherwise maintain, however, the history of bankruptcy law suggests that the 3rd Circuit was not wrong in thinking that some degree of flexibility, ambiguity and uncertainty, rather than pristine enforcement of crisply defined legal priorities, is what best facilitates pragmatic resolution of complex Chapter 11 cases.
Justice Clarence Thomas, in a dissent joined by Justice Samuel Alito, argued that the court had been the victim of bait-and-switch, because the employees had reframed the question presented in their merits briefing and because, as reframed, the question presented did not warrant the court’s review. Thomas suggested that the court should dismiss the case as improvidently granted. He noted that Jevic, relying on Rule 24.1(a), had declined to address the reframed question in its merits briefing, a tactical decision that may now be second-guessed.