Jevic Holding Corp.: Supreme Court Shoots Down Non-Consensual, Priority-Skipping Structured Dismissals 6-2

The Supreme Court issued its much-anticipated ruling in Czyzewski v. Jevic Holding Corp., 580 U.S. ___ (2017)¹ on March 21, reversing the Third Circuit Court of Appeals’ affirmance of an order approving the distribution of the proceeds of settlement of bankruptcy estate causes of action to general unsecured creditors via structured dismissal, with no distribution to holders of priority wage claims.

The Court framed the question presented, and its ruling, very narrowly—twice.  First:

The question before us is whether a bankruptcy court has the legal power to order this priority-skipping kind of distribution scheme in connection with a Chapter 11 dismissal.

In our view, a bankruptcy court does not have such a power. A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic priority rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies.²

And later:

Can a bankruptcy court approve a structured dismissal that provides for distributions that do not follow ordinary priority rules without the affected creditors’ consent?  Our simple answer to this complicated question is “no.”³

In an apparent attempt to limit the disruptive impact of its ruling, the Court acknowledged and distinguished other priority-skipping distributions approved by lower courts, including specifically first-day orders for employee wages and critical vendors, and roll-ups of prepetition secured debt.⁴ (Though if the Court had wanted to remove all doubt as to its intentions, it might have chosen a case other than In re Kmart Corp., 359 F.3d 866, 872 (7th Cir. 2004) to cite for “discussi[on of] the justifications for critical vendor orders”….)⁵ 

The Court also specifically stated that it “express[es] no view about the legality of structured dismissals in general.”⁶

And even though the Court granted certiorari to resolve an apparent Circuit split as to whether the absolute priority rule must be satisfied with respect to settlements that distribute estate assets (more on that later),⁷ the Court’s opinion leaves the Second Circuit’s Iridium Operating LLC decision perfectly intact and, if anything, appears to endorse a key element of its reasoning.⁸

So apart from its preclusion of a specific type of structured dismissal going forward (and provision of fodder for another year of bankruptcy CLEs), what are the takeaways from Jevic? Here are our thoughts:

• Structured dismissals in general are alive and well in the Third Circuit. The specific type of structured dismissal affirmed by the Third Circuit is now verboten. But the Third Circuit’s conclusion that the Code permits structured dismissals as a general matter was undisturbed on appeal and thus remains precedential.
• Priority-skipping settlements in general are alive and well in the Second and Third Circuits. Again, implementing such a settlement in a structured dismissal is verboten. But the Third Circuit’s conclusion that the Code permits priority-skipping settlements that follow the Second Circuit’s flexible test in Iridium was undisturbed on appeal and thus remains precedential.
• Support for employee wage orders, critical vendor orders, and roll-ups. These three species of priority-skipping “interim” distributions were expressly recognized—for the first time in a Supreme Court opinion—and distinguished from the impermissible “final” distributions in the structured dismissal context. That will be at least worthy of a “cf.” cite in the applicable first-day motions going forward.
• Record, record, record. The Court based its Article III standing ruling on arguably dubious inferences drawn from a murky record, and it placed a lot of weight on a statement made to the bankruptcy court by counsel for one of the settling parties. It seems possible that a more complete record could have led to a different result on the threshold issue of standing.
• Code provisions permitting the bankruptcy court to “order otherwise, for cause.” The Court’s statutory analysis focused on § 349(b)’s “for cause, orders otherwise” language. This construct is used several other places in the Code, e.g., § 363(k) (authorizing limitation of credit-bidding rights), 1108 (authorizing limitation of debtor’s/trustee’s ability to operate the debtor’s business in chapter 11), and 363(c) (authorizing limitation of debtor’s/trustee’s ability to use/sell/lease property in the ordinary course of business). Thus, interpretation of these provisions going forward should at least be informed by the Court’s methodology and conclusions in Jevic.
• A shot in the arm for the sub rosa plan doctrine. The Court’s salutary citation to Braniff Airways, coupled with its citation and distinguishment of Chrysler, will result in a resurgence of “sub rosa plan” objections to § 363 sales.
• Fodder for objections to class-skipping gift plans. The Court’s broad statement that a bankruptcy court “cannot confirm a plan that contains priority-violating distributions over the objection of an impaired creditor class”⁹ will become standard fare in every objection to a class-skipping gift plan, but probably will not carry the day since it was dictum.

Factual and Procedural Background

Jevic Transportation, Inc. was a trucking company acquired by Sun Capital in 2006 in a leveraged buyout (LBO) financed by a group of secured lenders led by CIT Group. In May 2008, Jevic ceased substantially all of its operations, terminated the vast majority of its workforce, and filed for chapter 11 relief in Delaware. A group of terminated truck drivers commenced a class action adversary proceeding against Jevic and Sun for federal and state WARN Act violations, seeking an estimated $12.4 million in damages, of which they estimated $8.3 million would be entitled to § 507(a)(4) wage priority. The official committee of unsecured creditors in the case commenced an adversary proceeding against Sun and CIT, derivatively on behalf of Jevic’s bankruptcy estate, asserting fraudulent transfer theories on account of the 2006 LBO.

In March 2012, following several years of active litigation in the adversary proceedings, representatives of Jevic, Sun, CIT, the committee, and the WARN plaintiffs convened settlement negotiations concerning the committee’s fraudulent transfer suit. At that time, all of Jevic’s tangible assets had been liquidated, with the proceeds paid to the CIT lender group, and the only estate assets remaining were (i) $1.7 million in cash, which was subject to a lien in favor of Sun, and (ii) the causes of action against Sun and CIT. Jevic, the committee, Sun, and CIT entered into a settlement agreement whereby (i) the parties would exchange mutual releases and the fraudulent transfer suit would be dismissed, with prejudice; (ii) CIT would pay $2 million into an account earmarked to pay estate professionals and other administrative expenses; (iii) Sun would assign its lien on Jevic’s $1.7 million in cash to a trust, which would pay certain priority tax and administrative claimants (but not the WARN plaintiffs) and then distribute the balance to general unsecured creditors pro rata; and (iv) Jevic’s chapter 11 case would be dismissed. The only reason apparent from the record that the settlement did not provide for payment of the WARN plaintiffs from the $1.7 million cash was that Sun, at the time, was still a defendant in the WARN action and did not want to fund litigation against itself.¹⁰

The WARN plaintiffs objected to the settlement on the grounds that it distributed estate assets to junior creditors in violation of the Code’s priority scheme. The bankruptcy court overruled this objection, finding that the “dire circumstances” of the case warranted approval of the settlement notwithstanding its deviation from the priority scheme, to wit: (i) there was “no realistic prospect” of a meaningful distribution to anyone but Sun and CIT absent approval of the settlement, (ii) there was “no prospect” of confirmation of a chapter 11 plan, (iii) conversion to chapter 7 would be pointless because there were no unencumbered funds for a trustee to use to investigate or prosecute causes of action, and Sun and CIT had “stated unequivocally and credibly” that they would not do this deal in a chapter 7, and (iv) the WARN plaintiffs were not prejudiced by their omission from the settlement because their WARN claims were “effectively worthless” since the estate had no unencumbered funds.¹¹ The bankruptcy court entered an order approving the settlement on December 4, 2012. The WARN plaintiffs sought a stay pending appeal of that order, but the request was denied by the bankruptcy court and the WARN plaintiffs did not seek a further stay.

While the appeal was pending, the settlement was consummated. The trust was funded and issued more than 1,000 disbursement checks. And on October 11, 2013, Jevic’s chapter 11 case was dismissed.

On January 24, 2014, the Delaware District Court entered a memorandum order affirming the bankruptcy court’s approval of the settlement and, in the alternative, dismissing the appeal as “equitably moot in view of the settlement.”¹² The WARN plaintiffs appealed to the Third Circuit, which affirmed 2-1.¹³

The Third Circuit Decisions

The Third Circuit’s majority (Judges Hardiman and Barry) framed the “novel question of bankruptcy law” before it as follows: “may a case arising under Chapter 11 ever be resolved in a ‘structured dismissal’ that deviates from the Bankruptcy Code’s priority system?”¹⁴ It analyzed the question in two distinct parts: first, by considering “whether structured dismissals are ever permissible under the Bankruptcy Code,”¹⁵ then, by considering “whether settlements in [the structured dismissal] context may ever skip a class of objecting creditors in favor of more junior creditors.”¹⁶

On the former point, the WARN plaintiffs argued that there was no express statutory basis for a structured dismissal. The court agreed, but noted that (i) structured dismissals “are simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth) that remain in effect after dismissal,” and (ii) while § 349(b) of the Bankruptcy Code provides that the effect of dismissal of a chapter 11 case is to re-vest property in the debtor and to vacate prior orders of the court, that section “explicitly authorizes the bankruptcy court to alter the effect of dismissal ‘for cause’.”¹⁷ The WARN plaintiffs “argued forcefully” that Congress could not have intended this power to alter the effect of dismissal “for cause” to permit an end-run around the procedures governing chapter 11 plan confirmation and conversion to chapter 7. But the court thought the argument went too far on the facts of the case before it, reasoning as follows:

[E]ven if we accept all that as true, the [WARN plaintiffs] have proved only that the Code forbids structured dismissals when they are used to circumvent the plan confirmation process or conversion to Chapter 7. Here, the [WARN plaintiffs] mount no real challenge to the Bankruptcy Court’s findings that there was no prospect of a confirmable plan in this case and that conversion to Chapter 7 was a bridge to nowhere. . . .  For present purposes, it suffices to say that absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes, a bankruptcy court has discretion to order such a disposition.¹⁸

As to whether a priority-skipping settlement was permissible under the Bankruptcy Code, the court noted the split between the Fifth Circuit (AWECO) and the Second Circuit (Iridium) regarding whether bankruptcy settlements need to observe the absolute priority rule, and sided with the Second Circuit’s flexible approach (permitting deviation from absolute priority in appropriate circumstances) over the Fifth Circuit’s per se requirement (prohibiting deviation from absolute priority):

Given the dynamic status of some preplan bankruptcy settlements, it would make sense for the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure to leave bankruptcy courts more flexibility in approving settlements than in confirming plans of reorganization. For instance, if a settlement is proposed during the early stages of a Chapter 11 bankruptcy, the nature and extent of the estate and the claims against it may be unresolved. The inquiry outlined in Iridium better accounts for these concerns, we think, than does the per se rule of AWECO.¹⁹

Turning to the propriety of the priority-skipping settlement before it, the Third Circuit found that, while it was a “close call,” approval was appropriate because the settlement, “unsatisfying as it was, remained the least bad alternative since there was ‘no prospect’ of a plan being confirmed and conversion to Chapter 7 would have resulted in the secured creditors taking all that remained of the estate in ‘short order’” as determined by the bankruptcy court.²⁰

The dissent (Judge Scirica) agreed with the majority’s legal framework but found this was not an “extraordinary case” that would justify approval of a settlement that deviated from the Code’s priority scheme.²¹ First, the dissent was unconvinced that “the only alternative to the settlement was a Chapter 7 liquidation” and believed “[a]n alternative settlement might have been reached in Chapter 11, and might have included the WARN Plaintiffs.”²² (The majority rejected this “counterfactual premise that the parties could have reached an agreeable settlement that conformed to the Code priorities” and suggested it was tantamount to an impermissible de novo review of the lower courts’ factual findings.)²³ Second, the dissent believed the settlement raised some of “the broader concerns underlying the sub rosa plan doctrine” because it “reallocated assets of the estate in a way that would not have been possible” otherwise, and “effectively terminated the Chapter 11 case” without any of the safeguards of the plan confirmation process.²⁴ The dissent went on to suggest how it would implement the reversal of the lower courts’ orders (which, in light of the Supreme Court’s ruling, may well serve as the blueprint for the remaining proceedings in the case):

I would not unwind the settlement entirely.  Instead, I would permit the secured creditors to retain the releases for which they bargained and would not disturb any of the proceeds received by the administrative creditors either. But I would also require the bankruptcy court to determine the WARN Plaintiffs’ damages . . . , as well as the proportion of those damages that qualifies for the wage priority. I would then have the court order any proceeds that were distributed to creditors with a priority lower than that of the WARN Plaintiffs disgorged, and apply those proceeds to the WARN Plaintiffs’ wage priority claim. To the extent that funds are left over, I would have the court redistribute them to the remaining creditors in accordance with the Code’s priority scheme.²⁵

The Certiorari Petition, Briefing, and Dissent

The WARN plaintiffs filed a petition for certiorari stating, “The question presented, on which the courts of appeal are divided, is: Whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme.”²⁶ The petition identified AWECO, on the one hand, and Iridium and Jevic, on the other hand, as the contrary precedents on this question.²⁷ The Supreme Court granted certiorari on this question.²⁸

In their opening brief, the WARN plaintiffs stated the question presented more narrowly: “Whether a Chapter 11 case may be terminated by a ‘structured dismissal’ that distributes estate property in violation of the Bankruptcy Code’s priority scheme.”²⁹

Sun and CIT cried foul, noting in their answering brief that the Court’s rules prohibit changing the substance of the questions presented on appeal, and that the Court likely would not have granted certiorari on that question because it had only been addressed by a single federal court of appeals—i.e., the Third Circuit below.³⁰ Standing on procedure, Sun and CIT briefed the question presented in the petition for certiorari, arguing (i) the WARN plaintiffs lacked Article III standing because approval of the settlement had not caused them a legally redressable injury, and (ii) the Bankruptcy Code neither authorizes nor requires bankruptcy courts to reject chapter 11 settlements that do not follow the Code’s priority scheme.³¹ Their brief did not address the issue of structured dismissal other than to argue it was not properly before the Court.

Justice Thomas, joined by Justice Alito in dissent, agreed with Sun and CIT that the WARN plaintiffs had pulled an impermissible “bait-and-switch,” reasoning as follows:

Today, the Court answers a novel and important question of bankruptcy law. Unfortunately, it does so without the benefit of any reasoned opinions on the dispositive issue from the courts of appeals (apart from the Court of Appeals’ opinion in this case) and with briefing on that issue from only one of the parties. That is because, having persuaded us to grant certiorari on one question, petitioners chose to argue a different issue on the merits.  In light of that switch, I would dismiss the writ of certiorari as improvidently granted.

. . .

I think it is unwise for the Court to decide the reformulated question today, for two reasons. First, it is a novel question of bankruptcy law arising in the rapidly developing field of structured dismissals.  Experience shows that we would greatly benefit from the views of additional courts of appeals on this question. We also would have benefited from full, adversarial briefing. . . .  Second, deciding this question may invite future petitioners to seek review of a circuit conflict only then to change the question to one that seems more favorable.³²

Synopsis of the Majority Opinion

Undeterred by the nascent state of the law of structured dismissals, and the lack of adversarial briefing, the Court’s majority opinion (written by Justice Breyer) accepted the WARN plaintiffs’ formulation of the question presented, and dove right in. It began with a discussion of some bankruptcy “fundamentals,” ultimately landing on the following principles germane to the analysis:

• That the only three exits from chapter 11 are plan confirmation, conversion to chapter 7, or dismissal of the case;
• That under § 349(b), dismissal ordinarily “revests the property of the estate in the entity in which such property was vested immediately before the commencement of the case,” thus restoring the financial status quo; and
• That these restorative consequences of dismissal may be altered by the bankruptcy court “for cause.”³³

After a brief description of the factual and procedural background, the Court addressed the threshold question of the WARN plaintiffs’ Article III standing.³⁴ Finding the WARN plaintiffs had standing, the Court analyzed the statutory basis for approval of a priority-skipping structured dismissal.³⁵ Finding no such basis, the Court considered whether it was appropriate to recognize a “rare case” exception to the statutory scheme. Concluding it was not, the Court reversed and remanded.³⁶

The Standing Issue

Sun and CIT argued the WARN plaintiffs had suffered no “injury” that could give them Article III standing on appeal, because they would have had no recovery in the absence of the structured dismissal, and they would still get nothing if the structured dismissal were unwound on appeal. The Court rejected this argument, finding it rested upon claims that were unsupported by the record, namely: “(1) that, without a violation of ordinary priority rules, there will be no settlement, and (2) that, without a settlement, the fraudulent-conveyance lawsuit has no value.”³⁷

To the former point, the Court found that settlement “remains a reasonable possibility” because the record “makes clear . . . that Sun insisted upon a settlement that gave [the WARN plaintiffs] nothing only because it did not want to help fund [the] WARN lawsuit against it,” but that lawsuit had since been resolved in Sun’s favor.³⁸ 

To the latter point, the Court found that the fraudulent transfer claim “could have litigation value” because (i) it had an apparent settlement value of $3.7 million, (ii) if the case were converted, a chapter 7 trustee could pursue the claim with counsel working on a contingency basis, and (iii) if the case were dismissed, the WARN plaintiffs could pursue the claim themselves.³⁹ 

Thus, the Court concluded the WARN plaintiffs had been injured by the bankruptcy court’s approval of the structured dismissal. And it concluded further, without analysis, that a decision in the WARN plaintiffs’ favor on appeal “is likely to redress that loss.”⁴⁰

The Bedrock of Priority vs. the “Thin Reed” of § 349(b)

Turning to the merits, the Court noted the “Code’s priority system constitutes a basic underpinning of business bankruptcy law” and that such distributions “normally take place through a Chapter 7 liquidation or a Chapter 11 plan, both of which are governed by priority.”⁴¹ It went on to observe that in chapter 7 liquidations, priority is “an absolute command,” and that while chapter 11 plans “provide somewhat more flexibility,” a “priority-violating plan still cannot be confirmed over the objection of an impaired class of creditors.”⁴² Given the importance of the Code’s priority scheme, the Court reasoned,

we would expect to see some affirmative indication of intent if Congress actually meant to make structured dismissals a backdoor means to achieve the exact kind of nonconsensual priority-violating final distributions that the Code prohibits in Chapter 7 liquidations and Chapter 11 plans.⁴³

The Court found no such indication in § 1112(b), which merely permitted bankruptcy courts to “dismiss” chapter 11 cases, with no mention of distributing estate value to creditors. And it noted that § 349(b)(1)‑(3) contemplate “a restoration of the prepetition financial status quo.” And while conceding that § 349(b) permits the bankruptcy court to “order otherwise” for “cause,” the Court concluded that, read in context, this section “appears designed to give courts the flexibility to make the appropriate orders to protect rights acquired in reliance on the bankruptcy case.”⁴⁴ The Court continued:

Nothing else in the Code authorizes a court ordering a dismissal to make general end-of-case distributions of estate assets to creditors of the kind that normally take place in a Chapter 7 liquidation or Chapter 11 plan—let alone final distributions that do not help to restore the status quo ante or protect reliance interests acquired in the bankruptcy, and that would be flatly impermissible in a Chapter 7 liquidation or a Chapter 11 plan because they violate priority without the impaired creditors’ consent. That being so, the word “cause” is too weak a reed upon which to rest so weighty a power.⁴⁵

Distinguishing Iridium and First-Day Relief – “Interim” vs. “Final” Distributions

The Court acknowledged the Third Circuit’s reliance on Iridium for the proposition that priority-skipping settlements are not per se prohibited, but it distinguished Iridium as follows:

Iridium did not involve a structured dismissal.  It addressed an interim distribution of settlement proceeds to fund a litigation trust that would press claims on the estate’s behalf. The Iridium court observed that, when evaluating this type of preplan settlement, “[i]t is difficult to employ the rule of priorities” because “the nature and extent of the Estate and the claims against it are not yet fully resolved.” The decision does not state or suggest that the Code authorizes nonconsensual departures from ordinary priority rules in the context of a dismissal—which is a final distribution of estate value—and in the absence of any further unresolved bankruptcy issues.⁴⁶

Citing specifically employee wage orders, critical vendor orders, and roll-ups of prepetition secured debt, the Court acknowledged that lower courts have approved “interim distributions that violate ordinary priority rules.”⁴⁷ But it noted that with these cases “one can generally find significant Code-related objectives that the priority-violating distributions serve,” and that “courts have usually found that the distributions at issue would enable a successful reorganization and make even the disfavored creditors better off.”⁴⁸ In a structured dismissal, by contrast, the Court noted:

the priority-violating distribution is attached to a final disposition; it does not preserve the debtor as a going concern; 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.⁴⁹

Finding no “significant offsetting bankruptcy-related justification” for the priority-violating distributions sanctioned by the lower courts in this case, the Court concluded the distributions “more closely resemble proposed transactions that lower courts have refused to allow on the ground that they circumvent the Code’s procedural safeguards,”⁵⁰ citing the following cases:

• Braniff Airways, Inc., 700 F.2d 935, 940 (5th Cir. 1983) (prohibiting an attempt to “short circuit the requirements of Chapter 11 for confirmation of a reorganization plan by establishing the terms of the plan sub rosa in connection with a sale of assets”);
• In re Lionel Corp., 722 F.2d 1063, 1069 (2d Cir. 1983) (reversing a bankruptcy court’s approval of an asset sale after holding that § 363 does not “gran[t] the bankruptcy judge carte blanche” or “swallo[w] up Chapter 11’s safeguards”);
• In re Biolitec, Inc., 528 B.R. 261, 269 (Bankr. D.N.J. 2014) (rejecting a structured dismissal because it “seeks to alter parties’ rights without their consent and lacks many of the Code’s most important safeguards”);⁵¹ and
• (with a “cf.” signal) In re Chrysler LLC, 576 F.3d 108, 118 (2d Cir. 2009) (approving a § 363 asset sale because the bankruptcy court demonstrated “proper solicitude for the priority between creditors and deemed it essential that the [s]ale in no way upset that priority”).

Needless to say, each of these cases merits a fresh look by practitioners in light of the salutary citation from the Supreme Court. And the Court’s apparent harmonization of Braniff (the seminal “sub rosa plan” case) with Chrysler (which had famously rejected a “sub rosa plan” objection), will likely reinvigorate objections based on the “sub rosa plan” doctrine.

Rejection of a “Rare Case” Exception

The Court finished its analysis by considering whether, notwithstanding the result of its statutory analysis, it would be appropriate to recognize an exception for “rare cases” where “sufficient reasons” for disregarding priority are demonstrated, as the Third Circuit had apparently done in its decision. The Court rejected such an exception as improper and unworkable, reasoning as follows:

For one thing, it is difficult to give precise content to the concept “sufficient reasons.” That fact threatens to turn a “rare case” exception into a more general rule. Consider the present case. The Bankruptcy Court feared that (1) without the worker-skipping distribution, there would be no settlement, (2) without a settlement, all the unsecured creditors would receive nothing, and consequently (3) its distributions would make some creditors (high- and low-priority creditors) better off without making other (mid-priority creditors) worse off (for they would receive nothing regardless). But as we have pointed out, the record provides equivocal support for the first two propositions. And, one can readily imagine other cases that turn on comparably dubious predictions. The result is uncertainty. And uncertainty will lead to similar claims made in many, not just a few, cases.⁵²

The Court found that this state of affairs would have “potentially serious” consequences, including:

• “departure from the protections Congress granted particular classes of creditors”;
• “changes in the bargaining power of different classes of creditors even in bankruptcies that do not end in structured dismissals”;
• “risks of collusion, i.e., senior secured creditors and general unsecured creditors teaming up to squeeze out priority unsecured creditors”; and
• “making settlement more difficult to achieve.”⁵³