Once a debtor files a chapter 11 bankruptcy proceeding, it must confirm a plan of reorganization or liquidate its assets under a liquidating chapter 11 or chapter 7 case. Confirmation requires compliance with all the provisions of chapter 11, including the absolute priority rule. What happens when a chapter 11 debtor is unable to effectuate the substantial consummation of a plan? In certain rare circumstances, a court may dismiss a bankruptcy case for “cause” as long as dismissal is in the best interest of creditors.[1] Section 1112(b)(4) provides a nonexhaustive list of grounds that constitute “cause” for dismissal or conversion. Dismissal may be appropriate where a debtor’s assets have been liquidated and there is nothing left to reorganize.
A dismissal has the effect of returning parties to their status quo before the bankruptcy occurred.[2] A recent trend among chapter 11 proceedings is the use of a structured dismissal to “wind[] up the bankruptcy with certain conditions attached instead of simply dismissing the case and restoring the status quo ante.”[3] Such conditions may include a release or releases of key individuals, protocols for reconciling and paying claims, “gifting” funds to unsecured creditors, and pre-dismissal settlements, to name a few.[4] Structured dismissals can work where all parties in interest agree and compliance with the provisions of the Bankruptcy Code would leave little or nothing for anyone. The cases and discussions that follow highlight the five top reasons structured dismissals fail.
Skipping Classes and Violating the Absolute Priority Rule Without Adequate Justification
Violation of the absolute priority rule is the foremost reason a structured dismissal might fail. The Third Circuit Court of Appeals recently upheld a structured dismissal in In re Jevic Holding Corp., despite the fact that it excluded a class of WARN Act claimants, but it did so with great consideration.[5] In Jevic, the assets of the estate had dwindled to $1.7 million after the sale of most estate assets to the largest unsecured creditor. The remaining assets were subject to a secured creditor’s first-priority lien, and there was no prospect of reorganization and no funds available to fund an orderly wind-down. The court authorized a settlement that skipped the WARN Act claimants because “the traditional routes out of [c]hapter 11 are unavailable and the settlement is the best feasible way of serving the interests of the estate and its creditors.”[6]
As the Third Circuit noted, settlements in bankruptcy must be fair and equitable, which necessarily requires adherence with the Code and its priority scheme. Citing In TMT Trailer Ferry, the Third Circuit recognized that the fair-and-equitable requirement applicable to plans “applies to compromises just as to other aspects of reorganizations.”[7] This standard incorporates the absolute priority rule, “under which creditors and stockholders may participate only in accordance with their respective priorities.”[8]
The Third Circuit recognized the struggle other courts have grappled with as to whether § 507 must be strictly followed when settlement proceeds are distributed in chapter 11 cases. In Matter of AWECO Inc., the Fifth Circuit Court of Appeals rejected a proposed settlement of a lawsuit against a chapter 11 debtor that would have transferred $5.3 million in estate assets to an unsecured creditor despite the existence of outstanding senior claims.[9] The court held that the “fair and equitable” standard applies to bankruptcy settlements, which requires compliance with the priority scheme in § 507.[10]
In contrast, the Second Circuit Court of Appeals in In re Iridium Operating LLC adopted a more flexible approach, authorizing a settlement distribution that delayed payment to an administrative priority creditor in favor of establishing a litigation fund against that same creditor from proceeds received through a settlement with the estate’s lenders and its unsecured creditors’ committee.[11] The Second Circuit noted that “whether a particular settlement’s distribution scheme complies with the Code’s priority scheme must be the most important factor for the bankruptcy court to consider when determining whether a settlement is ‘fair and equitable’ under Rule 9019, but a noncompliant settlement could be approved when the remaining factors weigh heavily in favor of approving a settlement.”[12] The Iridium court found that the benefits of avoiding costly litigation with the lenders and obtaining additional funds to litigate on behalf of the estate outweighed the contingent noncompliance with the absolute priority rule, insofar as the administrative claimant would be skipped only if it prevailed in the litigation and its claims exceeded its liability.[13]
Given the “dynamic status of some pre-plan bankruptcy settlements,” Jevic finds that it makes sense to give bankruptcy courts more flexibility in approving settlements than in confirming plans of reorganization.[14] However, if the fair-and-equitable standard is to have any teeth, it must mean that bankruptcy courts cannot approve settlements and structured dismissals devised to increase certain creditors’ shares of the estate at the expense of others. The Second and Third Circuits have held that bankruptcy courts may approve settlements that deviate from the absolute priority rule only if they have “specific and credible grounds to justify the deviation.”[15]
Structured Dismissal Is Not Used to Evade Costs and Protections of a Chapter 7
A structured dismissal is appropriate where neither confirmation of a chapter 11 plan nor an orderly liquidation in chapter 7 is a viable option for a debtor. The court in Biolitec rejected a structured dismissal where an orderly liquidation in chapter 7 was possible, but the structured dismissal was proposed solely to avoid additional expenses associated with liquidation.[16]
The settlement in Biolitec proposed the funding of a liquidating trust primarily through the transfer of most of the estate’s remaining assets and interests, the proceeds of any recoveries obtained in adversary proceedings, and a portion of any recovery obtained by the largest unsecured creditor in pending litigation against nondebtor affiliates. The proposed dismissal also authorized binding assignments of rights and releases of liability, modified the claims-distribution process, replaced the chapter 7 trustee with a liquidating trustee who was not subject to the duties and requirements of the Bankruptcy Code, and subordinated the claims of nondebtor affiliates in the absence of a court order. The court did not find that such a settlement was justified, primarily because any recovery obtained in the adversary proceedings already belonged to the estate, and the outcome of the pending litigation was questionable. The court noted that if a structured dismissal were allowed on such grounds as to avoid liquidation fees, “parties would rarely, if ever, convert to chapter 7 and the conversion option in section 1112(b) would essentially be rendered superfluous. Section 105 cannot be interpreted to create the authority for this result.”[17]
Lack of Unanimous Support
Consensual plans raise fewer concerns about whether some creditors are impaired at the expense of others. The bankruptcy court in Naartjie allowed a structured dismissal in part because it benefited both the debtor and the creditors and all parties consented.[18] In Naartjie, there were no causes of action to prosecute, no pending adversary proceedings, the claims-reconciliation process would be completed before the case was dismissed, and proper notice was given. The bankruptcy court emphasized that no economic stakeholders objected to the dismissal, but had there been such an objection, the outcome might have been different.[19]
Similarly, in In re Buffet Partners, the bankruptcy court approved a structured dismissal, emphasizing multiple times that not one party with an economic stake objected to the dismissal.[20] Both Naartjie and Buffet emphasize the importance of creditor support in structured dismissals. Courts heavily scrutinize structured dismissals when faced with opposition.
Lack of Disinterestedness
Generally, a chapter 11 liquidating trustee is appointed as an impartial estate representative to distribute assets in accordance with the priorities outlined in the Code. A settlement that allows certain parties extraordinary control over the liquidation process may not be approved. For example, the court in Biolitec, pursuant to the settlement, the liquidating trustee’s actions and authority would have been subject to the sole direction and consent of AngioDynamics, the estate’s largest creditor.[21] The court declined to approve the settlement, which proposed a claims-resolution process subject to the control of one unsecured creditor whose interests were in direct conflict with other claimants. The court noted that even if dismissing the case and avoiding administrative expenses would result in a greater pool of assets for distribution, this benefit might well be outweighed by the burden placed on creditors to prove their claims and litigate an uncertain claims-resolution and distribution process. “For obvious reasons, the interests of the creditor body as a whole are likely better served by the bankruptcy process, where claims are entitled to prima facie validity and the resolution of disputed claims is overseen by a disinterested chapter 7 trustee and the court.”[22]
The Structured Dismissal Resembles a Sub Rosa Plan
Settlement agreements proposed outside of a plan confirmation process that dispose of all claims against the estate, restrict creditors’ rights to vote, or dispose of substantially all of a debtor’s assets without providing adequate chapter 11 protections have been found to constitute improper sub rosa plans. The hallmark of a sub rosa plan is that it dictates the terms of a reorganization but fails to observe chapter 11’s safeguards of disclosure, voting, acceptance and confirmation. For example, the Fifth Circuit Court of Appeals in In re Braniff Airways Inc.[23] rejected an asset sale for similar reasons because it went well beyond the “use, sale or lease” of assets under § 363 and had the practical effect of dictating most of the terms of a future reorganization, thereby short-circuiting the requirements of chapter 11.[24] Accordingly, structured dismissals that resemble sub rosa plans may not be approved.
[1] See 11 U.S.C. § 1112(b).
[2] 11 U.S.C. § 349; see also H.R. Rep. No. 595, 95th Cong., 1st Sess. 338 (1977) (dismissal is intended to “undo the Bankruptcy case, as far as practicable, and to restore all property rights to the position in which they were found at the commencement of the case”).
[3] Official Comm. of Unsecured Creditors v. CIT Grp./Bus. Credit Inc. (In re Jevic Holding Corp.), 787 F.3d 173, 177 (3d Cir. 2015).
[4] Id.
[5] 787 F.3d at 181.
[6] Id. at 173.
[7] 390 U.S. 414, 424 (1968).
[8] Id. at 441. See 11 U.S.C. § 1129(b)(2)(B)(ii).
[9] 725 F.2d 293, 295-96 (1984).
[10] Id. at 298.
[11] 478 F.3d 452 (2d Cir. 2007).
[12] Id. at 464 (internal quotation marks omitted).
[13] Id. at 465-67.
[14] Jevic at 184 (citing Iridium, 478 F.3d at 464).
[15] Id. (citing Iridium, 478 F.3d at 464-66) (noting “[s]ettlements skipping objecting creditors in distributing estate assets raise justifiable concerns about collusion among debtors, creditors, and their attorneys and other professionals”).
[16] In re Biolitec Inc., 528 B.R. 261, 267 (Bankr. D.N.J. 2014).
[17] Id. at 269.
[18] In re Naartjie Custom Kids Inc., 534 B.R. 416, 417 (Bankr. D. Utah 2015).
[19] Id. at 427.
[20] In re Buffet Partners L.P., 2014 WL 3735804 (Bankr. N.D. Tex. July 28, 2014).
[21] Biolitec, 528 B.R. at 271.
[22] Id. at 271.
[23] 700 F.2d 935 (5th Cir. 1983).