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Structured Dismissals – How they Work Part III: The Best Interests of the Creditors Test

A.   Where We Left Off

Part II of this series focused on the first element of section 1112(b)'s dismissal test: whether "cause" exists for the court to dismiss or convert the case. Once the judge determines that cause exists, the court must dismiss or convert the case. As a result, a party seeking the approval of a proposed structured dismissal must prove that the structured dismissal is better for creditors than converting the case to a Chapter 7 liquidation. This article will address how to satisfy that "best interests of the creditors" test, and will examine an alternative means of approving a structured dismissal through section 305(a) of the Bankruptcy Code.

B.   How it Works – Best Interest of the Creditors Test

While courts must consider many case-specific issues when deciding whether a structured dismissal is better for creditors than converting the case to a Chapter 7 liquidation, they tend to consistently focus on a few key factors. Those factors include: (i) costs of conversion compared to dismissal; (ii) delays associated with each route; (iii) the ability of the debtor to manage its own dissolution; and importantly, (iv) what "bells and whistles" the debtor proposed in its structured dismissal.

Cost is generally one of the most important factors. In most cases seeking a structured dismissal, the debtor is already so low on cash that it cannot fund a successful reorganization. As a result, courts often express concerns about structured dismissals that will exhaust remaining resources without providing a significant distribution to creditors. With that said, courts will likely way the projected expenses of a structured dismissal against the costs associated with marshaling and liquidating assets in a Chapter 7 case. As commonly argued by proponents of structured dismissals, Chapter 7 trustee fees and related professional fees may greatly exceed costs associated with a structured dismissal, and could reduce the pool of funds available for distributions. By contrast, a structured dismissal containing voluntary administrative fee reductions, carve-outs, and low cost distribution mechanisms may clearly benefit creditors.

Courts will also take a hard look at the delays associated with a proposed dismissal, and weigh those against delays commonly found in conversions. Structured dismissal motions should clearly outline the timing associated with any out of court wind down and distribution scheme to show that creditors will be paid sooner than they would if the case was converted. As most courts are willing to acknowledge, converting a case almost guaranties substantial delays as the Chapter 7 trustee receives the case, comes up to speed, hires counsel, analyzes available assets, and then decides how to proceed. A structured dismissal motion that proposes the prompt payment of creditors is thus much more likely to be in the best interest of creditors.

Even if the debtor argues that a structured dismissal will be quicker and cheaper than a Chapter 7 liquidation, the court is unlikely to grant the motion if it has concerns about the debtor's ability to oversee its own liquidation. If the debtor is untrustworthy, is suffering from internal strife, or has a very poor relationship with other case parties, courts may instead lean in favor of entrusting the liquidation to an officer of the court in Chapter 7. Accordingly, the support of a creditors' committee or key third party may bolster a debtor's chances of punching through a structured dismissal. Third-party support shows that interested parties trust the debtor or its counsel, or that they will aid in the liquidation and keep the debtor accountable. After all, if the creditors are in favor of the structured dismissal, they've exhibited to the court that they think dismissal is in their best interest.

Finally, courts will take a hard look at the bells and whistles proposed in the structured dismissal to see whether those add-ons will adversely affect creditors' rights. Part IV of this series will address bells and whistles commonly found in structured dismissals in more detail. In summary, some of the common bells and whistles found in structured dismissals include: carve-outs for unsecured creditors; voluntary fee reductions; retention of jurisdiction to address post-dismissal disputes related to the motion; timely and orderly wind down of the debtor's business; and mechanisms to resolve claim disputes. While bells and whistles are what make structured dismissals so attractive and effective, some relatively common examples, such as third party releases, may violate the bankruptcy code and submarine the dismissal. Others may evidence unfair dealing between a debtor and its creditors such as a provision for the mandatory arbitration of all legal disputes. In such instances the movant is in a bind. They've already established cause for dismissal or conversion, which mandates the court do one or the other. As a result, adding various bells and whistles can be a high stakes game. To minimize risks, the movant should seek the support of a counterparty, such as the creditors committee. Doing so may send the message to the court that everyone is aware of the terms of the proposal, and comfortable with their effects.

Generally speaking, courts take a pragmatic approach when analyzing the above factors. Despite the United States Trustee's frequent objections to structured dismissal motions, courts usually rule that a structured dismissal is in the best interest of creditors when it will maximize the value of the debtor's estate and provide equitable distributions to creditors with minimal delay and costs.

C.   How It Works - Section 305(a) – Best Interests of Creditors and Debtor

Section 305(a) of the Bankruptcy Code may also provide grounds for entry of an order approving a structured dismissal. Section 305(a) states, in pertinent part, that a court "after notice and a hearing, may dismiss a case under this title…at any time if the interests of creditors and the debtor would be better served by such dismissal…." Unlike an order entered pursuant to section 1112(b), an order dismissing a case under section 305 is not subject to appeal which lends it great finality. On the downside, relief under section 305 is considered an extraordinary remedy requiring "more than a simple balancing of harm to the debtor and its creditors."

As a result, courts take a more vigorous analysis of the pros and cons of a structured dismissal under section 305. Typically, courts assess seven factors when determining whether to abstain from further involvement in a case by dismissal: (1) the economy and efficiency of administration; (2) whether another forum is available to protect the interests of both parties; (3) whether federal proceedings are necessary to reach a just and equitable solution; (4) whether there is an alternative means of achieving an equitable distribution of assets; (5) whether the debtor and the creditors are able to work out a less expensive out-of-court arrangement which better serves all interests in the case; (6) whether a non-federal insolvency has proceeded so far that it would be too costly to re-start using the federal bankruptcy process; and (7) the purpose for which bankruptcy jurisdiction has been sought.

In structured dismissal cases, many of the aforementioned factors weigh heavily in favor of dismissal. As noted above, structured dismissals are frequently more efficient, economical, and expedient than converting to Chapter 7 or proceeding with a liquidating plan of reorganization. Moreover, a structured dismissal may provide unsecured creditors with a greater distribution than they would otherwise receive, while still serving the purpose of federal insolvency proceedings, and satisfying the reasons why bankruptcy jurisdiction was originally sought. Various courts have agreed, and entered orders approving structured dismissals pursuant to section 305(a) of the Bankruptcy Code. With that said, given the extraordinary nature of a 305(a) dismissal, most practitioners and courts favor relief under section 1112(b).