United States: How Absolute Is The Absolute Priority Rule In Individual Chapter 11 Cases?

Known as a bedrock principle in chapter 11 cases, the "absolute priority rule" serves as an important protection for creditors. In general terms, it requires senior classes of creditors to be provided for in full before a junior class can receive a distribution under a chapter 11 plan. While this rule continues to apply in business chapter 11 cases, courts are divided on whether it applies to individual chapter 11 debtors. This issue is not a mere consumer matter, but impacts creditors who have made loans to sole proprietorships or have loans guaranteed by such debtors. Given the dichotomy in the courts, creditors should understand how to navigate this issue.

A chapter 11 plan provides a distribution to classes of creditors to satisfy their claims against the debtor. Most creditors will have the right to vote to accept or reject the plan. If a class of creditors does not accept the plan, the debtor must resort to what is known as a "cram down" to confirm nonconsensual treatment of those creditors' claims. The Bankruptcy Code imposes a number of requirements to accomplish a cram down.¹ One of those key requirements is the absolute priority rule.² Put simply, unless a plan provides for full payment to a class of creditors holding senior interests, junior interests are prohibited from receiving or retaining any property. Additionally, a plan must satisfy several other statutory elements before it can be confirmed.

Creditors holding unsecured claims have the right to raise the absolute priority rule. A creditor can hold an unsecured claim a number of ways. It can hold a debt that is not secured by any assets. But it can also hold an unsecured deficiency claim to the extent its debt exceeds the collateral value.

Prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), the absolute priority rule precluded individual chapter 11 debtors from retaining prepetition assets unless the plan provided in full for a dissenting class of creditors. Thus, the debtor itself could not retain certain assets and might be unable to continue with its business. To avoid this result (and the higher administrative cost of chapter 11), some individuals seek relief under chapter 13 which does not impose the absolute priority rule. Many individuals who have fairly substantial debt and assets, however, are ineligible for chapter 13 and must resort to chapter 11.

The BAPCPA has spawned the current debate. Section 1129(b)(2)(B) (ii), which codifies the absolute priority rule, was amended to include language describing what assets an individual debtor could retain following plan confirmation. A split exists among the courts due to a difference in interpreting this language.

Some courts interpret the statutory modification to prohibit a debtor from retaining his or her prepetition assets, notwithstanding less than full repayment to other creditors (namely, unsecured creditors). In fact, several bankruptcy courts in California have announced that under the growing majority trend, the absolute priority rule continues to apply in individual cases. These courts contend that Congress did not intend to abrogate such a key protection for creditors and that chapter 11 for individuals need not mirror chapter 13. In contrast, other courts posit that a "plain reading" of the applicable code sections and the public policy of promoting rehabilitation support abrogation of the absolute priority rule in individual debtor cases. This divided approach can be observed in the Central District of California among the different judges sitting in the very same courthouse.

Due to the unsettled nature of the issue, creditors face uncertainty. In cases where the presiding bankruptcy judge upholds the absolute priority rule, creditors have a distinct advantage. These creditors will have greater leverage to negotiate an increased distribution through a plan or even prevent plan confirmation if the absolute priority rule is not satisfied. The debtor may also attempt to retain his or her prepetition assets by contributing "new value" to a chapter 11 plan.³ In this case, creditors could potentially receive a greater distribution equal to such value, which would be unavailable should the bankruptcy judge hold the absolute priority rule inapplicable.

In cases where the presiding judge will not apply the absolute priority rule, creditors may need to employ additional legal strategies to maximize their recovery. Such strategies include establishing that the debtor is unable to satisfy certain other plan confirmation requirements. One of those requirements is that the plan be proposed in good faith.⁴ Some courts have suggested that when a nominal distribution is proposed to unsecured creditors while the debtor retains his or her prepetition assets, such plan might not be proposed in good faith and, therefore, is not confirmable. In addition to this requirement, creditors can contest the plan on a number of other grounds, including feasibility or the "best interests of creditors" test (requiring distribution at least equal to liquidation values). The result, however, is that the creditor may face costlier and protracted court proceedings without assurance of success. While most plans are confirmed as a result of negotiations, the spectre of this issue may lead to a reduced recovery for creditors.

Given the number of published decisions by bankruptcy judges and the academic discourse on the subject, it appears the issue is positioned for appellate consideration. In the meantime, creditors should be mindful of this issue when dealing with individual chapter 11 debtors.

Footnotes

1 11 U.S.C. § 1129 sets forth the requirements to confirm a chapter 11 plan.

2 11 U.S.C. § 1129(b)(2)(B)(ii) codifies the absolute priority rule.

3 Although its existence is questioned by some courts, the "new value" exception enables a debtor to retain prepetition assets by contributing money or money's worth to fund a plan.

4 11 U.S.C. § 1129(a)(3) requires that a plan be proposed in "good faith and not by any means forbidden by law."

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