Last week, the United States Supreme Court issued a much-anticipated ruling limiting the use of a “structured dismissal” of a chapter 11 case. The Court determined that bankruptcy courts “may not approve structured dismissals that provide for distributions that do not follow ordinary priority rules without the consent of affected creditors.” The decision closes a loophole that could have allowed aggressive debtors and creditors to end-run around the Bankruptcy Code’s priority scheme, resulting in “changes in the bargaining power of different classes of creditors” and “risks of collusion, i.e., senior secured creditors and general unsecured creditors teaming up to squeeze out priority unsecured creditors.” The decision in Czyzewski v. Jevic Holding Corp. (“Jevic”) reversed a prior ruling by the Third Circuit Court of Appeals.

As the Supreme Court stated, there are three possible conclusions to a chapter 11 bankruptcy: (i) a plan of reorganization, (ii) conversion of the case to a chapter 7 liquidation, or (iii) dismissal of the case. A court ordering dismissal would generally attempt to restore the prepetition financial status quo. However, if that proves to be impossible, the court may, for cause, alter the dismissal’s normal consequences. This is generally referred to as a “structured dismissal.” These are most commonly seen in cases where a debtor has sold substantially all of its assets under section 363 of the Bankruptcy Code. Generally, parties in interest then agree to a structured dismissal in lieu of a chapter 11 liquidating plan to avoid a potentially costly confirmation process or conversion to chapter 7, adding a new layer of professionals and costs. Notably, both chapter 11 plans and chapter 7 liquidations are governed by basic rules of priority, ordained by the Bankruptcy Code, which determine the order in which assets are distributed. On the other hand, the Bankruptcy Code does not explicitly state what priority rules apply to a structured dismissal.

In Jevic, estate representatives had agreed to settle alleged preference and fraudulent conveyance claims relating to a leveraged buyout of the company. The settlement provided for a structured dismissal of the chapter 11 case and a distribution of $3.7 million in cash. This cash was to be distributed to pay tax claims and other administrative expenses, with the balance distributed on a pro rata basis to general unsecured creditors. However, the distribution scheme did not provide for any payment to former employees of the company who held wage claims, which, under the Bankruptcy Code, would be entitled to priority over general unsecured claims. These claimants objected to the approval of the settlement, arguing that the proposed dismissal would violate the Bankruptcy Code’s priority rules. The bankruptcy court overruled their objection, reasoning that the priority rules did not bar settlement approval since the payments would be made under a dismissal rather than a plan. Both the District Court and the Third Circuit Court of Appeals affirmed.

The Supreme Court reversed, holding that the structured dismissal approved by the bankruptcy court was impermissible. The Supreme Court found that the Bankruptcy Code did not permit, and Congress did not intend, a structured dismissal to act as a “backdoor” means to achieve a nonconsensual priority-violating final distribution otherwise prohibited in chapter 11 plans and chapter 7 liquidations. The final impact of this decision likely will not be fully known for some time. Prior to this ruling, structured dismissals were frequently the subject of objections from the United States Trustee (the “watchdog” of the bankruptcy process) irrespective of creditor consent. These and similar objections may be given more credence in the wake of Jevic, which could have a chilling impact on the use of structured dismissals. Seward & Kissel will have a more in-depth discussion of the Jevic decision and its potential impact in the Spring 2017 edition of the Bankruptcy & Reorganization Report. In the meantime, if you have any questions, please contact one of the attorneys listed below.