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Blocking A Bankruptcy End Run

Every bankruptcy is unique, but according to the law, there are only three ways a Bankruptcy Court can end a Chapter 11 proceeding: a confirmation of a reorganization plan negotiated between debtor and creditors; a conversion to a Chapter 7 liquidation; or a dismissal.

In theory, the dismissal is the simplest of the three. The bankruptcy filing is essentially nullified, and the court attempts to restore the parties to their states prior to the petition, at least to the extent possible.

In practice, the real world often proves messy. Sometimes conditions have changed to an extent that restoring all parties to their pre-filing position is difficult or impossible. This in part explains the rise of the structured dismissal as a sort of modified third option for resolving a bankruptcy proceeding. The Bankruptcy Code allows the court to adjust the consequences of a dismissal “for cause,” creating a hybrid order that lets the court permit certain actions without establishing a full-blown, court-approved Chapter 11 plan. A structured dismissal is, in basic terms, a dismissal with benefits.

The structured dismissal was an emerging fad in the bankruptcy law community, providing a way to get around the priorities that Congress established in the Bankruptcy Code. Under those priorities, and within certain limits, workers, children and ex-spouses, consumers who place layaway deposits and – of course – the attorneys and accountants who administer bankruptcy estates have priority in getting paid ahead of other unsecured creditors. These priorities cannot be modified by state law or the courts; the only way to skip a priority creditor is for that creditor to agree to be skipped in a Chapter 11 plan. A Chapter 7 liquidation includes no option to avoid these priorities at all. So structured dismissals became popular as a backdoor option for circumventing the congressional order of priority for creditors.

A six-member U.S. Supreme Court majority, consisting of the liberal justices plus Justice Anthony Kennedy and Chief Justice John Roberts, recently pushed that backdoor firmly shut.

In Czyzewski v. Jevic Holding Corp., certain creditors who would normally appear on Congress’ priority list (in this case, a group of former Jevic employees) objected to a structured dismissal that left them with nothing while providing a payout to unsecured creditors who would, in the normal order of things, have been given lower priority. Jevic countered that, if the Bankruptcy Court had not approved the structured dismissal, there would have been no available assets with which to pay the workers’ claims. In other words, the structured dismissal let some unsecured creditors get a distribution, even though the priority was out of order; the alternative would have been for all unsecured creditors to leave empty-handed.

The Third Circuit Court of Appeals upheld this structured dismissal as proper, not because it found that routinely violating the priority structure was acceptable, but because this was a “rare case” that offered “sufficient reasons” to disregard priority. In this instance, the sufficient reasons would be the fear that without skipping the workers’ claim, there would be no settlement, and thus no payment to any unsecured creditors at all. Some creditors would be better off while the group of skipped creditors, including the employees, would be no worse off.

The Supreme Court rejected this view. As Justice Stephen Breyer wrote in the majority opinion: “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.’”

The law’s provisions for deviating from the codified priorities during a bankruptcy proceeding “for cause” do not authorize this wholesale evasion of the priority structure, the majority ruled; deviations merely permit courts to allow for situations in which the continuing operations of a debtor during bankruptcy require adjustments. The majority further observed that most bankruptcies take place through Chapter 11 plans or Chapter 7 liquidations, both of which are bound by the priority system. Because of this, the justices wanted affirmative evidence that Congress intended structured dismissals as an exception to these rules. Such evidence does not exist in the Bankruptcy Code.

As for Justices Clarence Thomas and Samuel Alito (the two dissenting votes), even they did not question the outcome; they just felt the issue warranted further exploration in the lower courts. In his dissenting opinion, Thomas argued that the petitioners recast their argument after the high court agreed to hear the case, and that the Supreme Court could have benefited from additional views from the courts of appeals before deciding on what he viewed as a narrower question.

The decision in this case does not stop companies or individuals from negotiating with their creditors before a bankruptcy case is filed. But once the matter comes before the federal courts, whether through a voluntary or involuntary petition, rules are rules. The Supreme Court expressed no views either way on structured dismissals in which affected parties agree to terms, so they may not vanish entirely. But this decision makes clear that Bankruptcy Courts cannot throw the priority framework out in these instances.

The structured dismissal is a contradiction in terms: It declares that no game has been played, but it still determines winners and losers. That’s not how rules work, and the court was absolutely correct to recognize this.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us” and Chapter 4, “The Family Business."

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