In the familiar scenario, a highly-leveraged debtor files for Chapter 11 bankruptcy and an asset sale takes place. The lender is paid (in whole or in part), but either way, there is not enough cash left over to fund a plan confirmation process, which requires payment in full of creditors holding priority claims. Faced with a compelling reason to elect bankruptcy to pursue a course of action—such as a going concern sale under Section 363 of the Bankruptcy Code—but the inability to satisfy other bankruptcy obligations required to confirm a Chapter 11 plan, a debtor faces two statutory options—conversion to Chapter 7 or straight dismissal. For their own reasons, the debtor, the lender(s), and a class of key stakeholders (e.g., the creditor’s committee, acting for the general unsecured creditors, or a sub-class of priority claims) may find either path unsavory.
Faced with these hurdles, creative bankruptcy attorneys developed a third path to address this situation: the structured dismissal. Structured dismissals share a typical set of facts: Following the sale of the company’s assets, the debtor, lender(s), and a key objecting class (creditors committee or a representative class of priority claims) strike a bargain in which the proceeds of sale are distributed to the settling parties as a condition to settlement and dismissal of the case, while at least one class of creditors in the priority scheme is skipped over and receives no distribution. These structured dismissals violated the absolute priority rule, in the sense that the settlement resulted in a senior creditor class “gifting” a portion of its entitlement to a junior class while skipping one or more intermediate classes of creditors. Courts that have approved structured dismissals that violated bankruptcy distribution rules have determined that dismissal on the terms proposed was in the best interests of the overall creditor body because at least some creditors were receiving a distribution, compared to the result if the case was converted to Chapter 7 or merely dismissed without conditions.
While structured dismissals are not specifically addressed in the Bankruptcy Code, three Bankruptcy Code provisions provide the authority for a structured dismissal. Section 349(b) of the Bankruptcy Code provides that a dismissal effectively returns the debtor and its creditors and counterparties to their pre-bankruptcy positions – “[u]nless the court, for cause, orders otherwise[.]” This provision has been interpreted as allowing courts to condition case dismissal to “to protect reliance interests acquired in the bankruptcy.”1
In addition, Section 305 (a) gives courts the ability to “dismiss a case … if the interests of creditors and the debtor would be better served” by a dismissal, and Section 1112 (b) (1) allows a court to convert or dismiss a Chapter 11 case “whichever is in the best interests of creditors and the estate.”
The absolute priority rule is the backbone of the Bankruptcy Code’s priority scheme. The absolute priority rule provides that a class of creditors with a higher priority must be paid in full before any distribution can be made to the next class of creditors or interest holders. The absolute priority rule follows the following priority scheme:
This payment scheme is fixed absent a creditor or creditor class consenting to less favorable treatment.
The propriety of structured dismissals that deviated from the absolute priority rule reached the Supreme Court in 2017. In Czyzewski v. Jevic Holdings Corp., 137 S. Ct. 973 (2017), the Court concluded that the proposed structured dismissal should not have been approved over the dissent of an affected class of creditors because its proposed payment structure violated the absolute priority rule. The Court’s decision overruled the Third Circuit’s holding in the case of In re Jevic Holding Corp. 787 F.3d 173 (3d Cir. 2015).
There was precedent in the Third Circuit for structured dismissals that violated the absolute priority rule, and in this case, the circuit court upheld the bankruptcy court’s approval of a structured dismissal in which a dissenting class of WARN Act claimants with priority claims were forced to accept a deal that left them with no recovery while other priority claims and the class of general unsecured creditors received a distribution.
The appeals court first determined that the bankruptcy court had the power, under Section 349, to issue binding, post-dismissal terms when sufficient cause exists. The court further concluded that was no nefarious attempt to use the settlement agreement to circumvent a plan of reorganization process or Chapter 7 conversion, and that a solicitation process to both prepare a plan and disclosure statement and gather votes from a creditor body to approve such a plan would have soaked up a considerable amount of the estate assets. Likewise, a conversion to Chapter 7 would entail many of its own new costs, all to the detriment of the creditors as a whole.
Finally, the Third Circuit agreed that “specific and credible grounds to justify [the] deviation”3 from the absolute priority rule existed. The justification that the appeals court found compelling was that the priority portion of the WARN Act claim was substantial (over $8 mm) and would have significantly reduced payments to other creditors. In fact, absent the proposed structured dismissal, the only parties to receive a distribution would be the secured lenders.
The WARN class, frozen out by the Third Circuit’s decision, appealed. The issue before the Supreme Court was whether a bankruptcy court has the power to bypass the absolute priority rule to approve dismissals. Citing section 349(b), Justice Breyer stated that the “for cause” standard was “too weak a reed upon which to rest so weighty a power.” The Court noted that certain well-established bankruptcy requirements militate against the bankruptcy court’s approval of dismissals that violated the absolute priority rule—in particular, that the absolute priority rule must be followed in Chapter 7 cases, a Chapter 11 plan cannot be confirmed over objections from senior creditors, and the parties requesting a dismissal must have consent from each senior priority creditor. The Court contended that abiding by the absolute priority rule fostered predictability for all parties, which in turn fostered a reduction in the cost of resolving Chapter 11 cases. Bargaining by and between classes of creditors would be simpler and more straightforward.
Finally, the Court prohibited the use of “rare exceptions” that would allow the bankruptcy court to ignore creditor priority for other equitable reasons. The Court argued that these rare exceptions would create more uncertainty, causing the exceptions to become the rule.
Post-Jevic, the absolute priority rule is here to stay, much to the relief of secured creditors and claim purchasers. However, Jevic doesn’t forbid structured dismissals, so how have they fared in the aftermath of Jevic?
The author is aware of structured dismissals being approved or disapproved in the wake of Jevic, and as of this writing, over thirty (30) published opinions have cited to Jevic. However, none of the published opinions (as of this writing) that cite the Jevic case have done so in order to approve, or not, a proposed structured dismissal. For example, in In re Claar Cellars LLC4, the court discussed Jevic in the context of whether Jevic prohibited interim cash collateral distributions made during a case that may violate the absolute priority rule (the answer is, no). The district court in In re Constellation Enterprises LLC5 discussed the bankruptcy court’s decision not to approve a structured dismissal in the wake of Jevic, though the issue appealed to the district court was standing, not the propriety of the bankruptcy court’s decision on structured dismissal.
These decisions, and others, can be found at The Jevic Files, an archive created by The Bankruptcy Protector to document the decisions made by courts that have referenced Jevic since its publication in 2017.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Help, My Business is In Trouble! And A Distressed Company and its Secured Lender. This is an updated version of an article originally published on July 13, 2015.]
1. Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 985 (2017).
2. Secured creditors have first priority to the proceeds of their collateral, but as a practical matter, in a successful Chapter 11 case, administrative claims are paid first, because Section 1129 of the Bankruptcy Code requires that administrative claims be paid in full in order to confirm a Chapter 11 plan.
4. 2020 WL 1238924 (March 3, 2020).
5. 587 B.R. 275 (Bankr. D. Del. 2018)
©All Rights Reserved. August , 2020. DailyDACTM, LLC
Mark S. Melickian is a partner at Sugar Felsenthal Grais & Helsinger LLP in Chicago, and is head of the firm’s Restructuring, Insolvency, and Special Situations group.
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