SFTP Connection Fails with "Connection reset by peer" After Directory Permissions Are Set to 777

Issue

A connection using SFTP (Secure File Transfer Protocol) successfully authenticates and establishes a channel, but the connection is immediately terminated by the remote host with the error Connection to closed by remote host followed by Couldn't read packet: Connection reset by peer.

The failure occurs specifically after a user attempted to grant maximum permissions by setting the directories (e.g., /ftp/MY_TEST) to 777 (read, write, execute for all) and changing ownership away from root.

The verbose debug log shows the connection terminating after successful authentication:

debug1: Authentication succeeded (keyboard-interactive).
Authenticated to XXX.XXX.XXX.XXX ([XXX.XXX.XXX.XXX]:22).
...
debug1: channel 0: new [client-session]
...
debug2: channel 0: send open
debug3: send packet: type 90
...
Connection to XXX.XXX.XXX.XXX closed by remote host.
...
Couldn't read packet: Connection reset by peer