Settlement of LBO litigation led to a structured dismissal of a chapter 11 bankruptcy case that resulted in distributions to general unsecured creditors even though former employees with higher priority wage claims received nothing. The district court and Third Circuit affirmed the bankruptcy court dismissal, and the wage claimants sought and the Supreme Court granted certiorari.
The Supreme Court set the stage by identifying three possible outcomes for a chapter 11 bankruptcy: (1) a plan of reorganization can be confirmed that will govern any distribution of assets to creditors; (2) the case may be converted to a chapter 7 liquidation with a distribution of assets to creditors; and (3) the case may be dismissed.
Section 349(b)(3) of the Bankruptcy Code provides that generally dismissal “revests the property of the estate in the entity in which the property was vested immediately before the commencement of the case.” In other words, the goal is to unwind the bankruptcy and return to the prepetition status quo. However, a court may order otherwise “for cause.” A hybrid order that dismisses the case but also includes provisions typically found in a plan confirmation order (such as distributions to creditors, third-party releases, and leaving in place orders and transactions from the bankruptcy case) is sometimes referred to as a “structured dismissal.”
The court noted that the Bankruptcy Code establishes a basic system of priority: secured creditors come first (since they are entitled to receive the proceeds of their collateral); special classes of creditors, such as those with particular wage and tax claims, come next; general unsecured creditors have a lower priority; and equity holders are at the bottom of the list. Generally, claimants lower on the list receive nothing until those higher on the list have been paid in full.
This prescribed order of distribution must be followed in a chapter 7 liquidation. A chapter 11 offers more flexibility if a different order is approved by the court with the consent of the affected parties. However, there are limits, particularly if impaired creditors raise objections.
In this case there were two lawsuits: First, former truck drivers claimed that the debtor violated state and federal WARN acts by failing to provide at least 60 days’ notice before their termination. The bankruptcy court granted summary judgment to the claimants with a judgment that they contended was worth $12.4 million – of which $8.3 million constituted a priority wage claim entitled to payment ahead of general unsecured creditors.
The second lawsuit was a typical leveraged buyout (LBO) case. An equity firm (Sun) bought out the debtor’s shareholders with the purchase funded in part by a third-party (CIT) loan secured by the debtor’s assets. This meant that the shareholders received cash, while the debtor was left with senior secured debt to the detriment of its existing creditors. At the time the debtor filed bankruptcy it owed $53 million in senior secured debt to Sun and CIT, and more than $20 million to tax and general unsecured creditors.
The creditors’ committee was authorized to pursue preference and fraudulent transfer claims arising from the LBO against Sun, the debtor and CIT. By the time the parties tried to negotiate a settlement, the only assets left in the bankruptcy estate were the LBO claims and $1.7 million cash, which was subject to a lien held by Sun.
The settlement provided that (1) the LBO litigation would be dismissed with prejudice, (2) CIT would deposit $2 million earmarked to pay committee legal fees and administrative expenses, (3) Sun would assign its lien on the $1.7 million cash to a trust which would pay taxes and administrative expenses, and then distribute any excess pro rata to general unsecured creditors, with nothing to the wage claimants, and (4) the bankruptcy case would be dismissed. Sun apparently insisted on skipping the wage claimants because the WARN lawsuit against Sun was still pending at that time and it did not want to help finance the litigation.
While acknowledging that the distributions did not follow ordinary priority rules, the bankruptcy court concluded this did not bar approval and the settlement was justified given the “dire circumstances” facing the bankruptcy estate and creditors, since in its view without the settlement there was “no realistic prospect” of a distribution to anyone other than secured creditors. The district court agreed that the settlement did not have to follow standard priorities since the settlement was not a reorganization plan. In a split decision the Third Circuit also agreed that courts could “in rare instances like this one, approve structured dismissals that do not strictly adhere to the Bankruptcy Code’s priority scheme.”
After disposing of a standing issue, the Supreme Court framed the question before the court as: “Can a bankruptcy court approve a structured dismissal that provides for distributions that do not follow ordinary priority rules without the affected creditors’ consent?”
In the court’s view the priority system “constitutes a basic underpinning of business bankruptcy law.” In a chapter 7 case “priority is an absolute command.” While there is somewhat more flexibility in a chapter 11 plan, “a priority-violating plan still cannot be confirmed over the objection of an impaired class of creditors. See § 1129(b) [cramdown requirements]. The priority system applicable to those distributions has long been considered fundamental to the Bankruptcy Code’s operation.”
If Congress intended to permit a major departure from the priority system in the context of dismissals, the court would have expected an affirmative indication rather than silence. (“Congress… does not, one might say, hide elephants in mouseholes.”)
The court considered several arguments suggesting that there should be flexibility including: Section 349 provides that in a dismissal rather than reinstating the prepetition status quo a court may order “otherwise” for cause; and there is precedent in interim distributions for modifying the priority of distributions – such as first-day wage orders, critical vendor orders, and financing roll-ups. In each case the court rejected the argument and maintained its view that a departure from the standard distribution priority system could not be justified. Accordingly, the Supreme Court reversed and remanded.
The ability to avoid strict application of distribution priorities, at least to a limited extent, can be critical in a variety of circumstances (including single asset real estate cases) where there is not enough cash or other assets to go around and there is a recalcitrant claimant with leverage to block a resolution acceptable to everyone else. While this decision is a clear rejection of the use of a structured dismissal that does not comply with normal priorities, it may not be the end of this issue.
A dissent by Justice Thomas joined by Justice Alito points out that the court granted certiorari to decide “[w]hether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme.” This was purportedly the subject of a split among the Courts of Appeals. Subsequently the petitioners recast the question to the narrower and different question regarding structured dismissals.
In addition to objecting to the “bait and switch,” the dissent described this as a novel question in the rapidly developing area of structured dismissals. The court did not have the benefit of views from other Courts of Appeals, nor did it have full adversarial briefing (since the respondents declined to brief the new question). Consequently, the dissenters would have dismissed the writ as improvidently granted.
It remains to be seen whether creative advocates will find a way to revisit the issues decided in this case, and whether members of the court change their minds if they are presented with new arguments.
Vicki R Harding, Esq.