The Absolute Priority rule is alive and well for Chapter 11 cases

I. Explanation of absolute priority rule

Consumer debtors that do not qualify for protection under Chapter 7 or Chapter 13 of the Bankruptcy Code, are left with filing under Chapter 11, where they will come face-to-face with the absolute priority rule (the “APR”). The APR is a cornerstone of bankruptcy law. It was first developed by the Supreme Court in the late nineteenth-century to deal with widespread collusion in railroad reorganizations. To prevent unfair deals between senior creditors and equity holders, the Court held that “stockholders are not entitled to any share of the capital stock nor to any dividend of the profits until all the debts of the corporation are paid.”[1]

Simply stated, the APR establishes a hierarchy of rights in bankruptcy proceedings, commencing with secured creditors at the top of the heap and ending with equity holders (or the debtor when the case involves an individual) at the bottom. This rule recognizes that equity holders, or debtors, have less rights and entitlement to recovery of a bankrupt enterprise’s assets because they stood to reap the most if the entity succeeded. It also recognizes that equity-holders generally control the allocation of value and absent limitations, they would unfairly allocate a disproportionate share to themselves. “This rule assured those who did business with the corporation that if the business were dissolved the creditors would be paid before the insiders would recover their investments. In case of collapse, the creditors could count on payment in full before equity collected anything from the business assets.”[2]

Individuals debtors may find problematic their efforts to satisfy the APR because a Chapter 11 plan cannot be confirmed over the objection of a dissenting class of creditors if value is being allocated to the debtor, unless secured creditors and unsecured creditors are paid in full (see below discussion on the requirements for full payment), or the Plan meets the stringent “new value” test.[3] On a practical level, an individual debtor cannot retain any property in a Chapter 11,[4] unless all senior creditors are paid in full, including over an extended time period; all impaired classes accept the plan; or the debtor contributes what is known as “new value” in exchange for retaining its equity interests. [5]

II. How the rule applies in chapter 11

The APR evolved beyond a judicially created doctrine when Congress codified it as part of the Bankruptcy Code in 1978.[6] To confirm a Chapter 11 plan, all impaired classes must accept the plan.[7] However, a court may still confirm the plan (i.e., through a “cramdown”) if an impaired class rejects it, but only if the plan is otherwise “fair and equitable” within the meaning of the Bankruptcy Code, or, in some cases, the debtor contributes “new value” in accordance with that exception to the APR, and satisfies certain other criteria enumerated in §§1129(a)(1) through (a)(14).[8]

To be fair and equitable, a plan must provide property of a value, as of the effective date of the plan, equal to the allowed amount of a creditor’s claim or it must satisfy the APR. A plan can satisfy the APR if value is allocated in accordance with the APR – e.g., if unsecured creditors are not paid in full, the debtor receives no property.

Full payment to senior classes does not necessarily require a single payment of the full amount owed and does not have to be immediate or in accordance with existing debt instruments (except for loans on an individual’s principal residence, which cannot be modified), so long as the payment stream is accompanied with an appropriate interest rate and is otherwise “fair and equitable.” Thus, the deferred cash payments can be structured in many ways, so long as the restructured terms are “fair and equitable” in the view of the Court.

This makes the cramdown of a Chapter 11 plan difficult for individual debtors that have a lot of debt and limited means to repay that debt.[9]

III. After BAPCPA a minority of lower courts have held that the APR no longer applies in individual chapter 11 cases.

In 1988, the Supreme Court unanimously held the APR applied in individual Chapter 11 cases.[10] However, the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) that was enacted in 2005, led some courts to question whether the APR was still applicable in individual Chapter 11 cases.[11]

BAPCPA modified §1129(b)(2)(B)(ii) and added §1115. The interaction between these two provisions has generated some decisions holding that the APR no longer applies when the debtor is an individual, although the majority view, which is followed by five Circuit Courts, holds otherwise – i.e., the APR still applies and was not abrogated by BAPCPA.

Section 1129(b)(2)(B)(ii) provides that, “in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section.”[12] Similarly, §1115 provides, among other things, that “[i]n a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541…[post-petition earnings].”[13]

The split of authorities involves two different interpretations of §1115 and §1129(b)(2)(B)(ii), commonly referred to as the “broad” and “narrow” views. The Fourth, Fifth, Sixth, Ninth and Tenth Circuits follow the narrow view – i.e., BAPCPA did not abrogate the APR.[14]

No Circuit Court follows the “broad view” but bankruptcy courts that have done so interpret the added language in §1129(b)(2)(B)(ii) and the newly added §1115 to mean that a Chapter 11 debtor who proposes not to pay a rejecting class of unsecured creditors in full may nonetheless retain all of the debtor's non-exempt, pre-petition property as well as all post-petition property and earnings, and still obtain plan confirmation.

Courts have advanced two primary arguments to support the “broad view”. First, some reason that “the phrase ‘in addition to the property specified in section 541’ []mean[s] that Section 1115 absorbs and then supersedes Section 541 for individual chapter 11 cases.”[15] According to courts employing this analysis, “if Section 1115 entirely supplants Section 541 by specifically incorporating it and adding to it, the ‘included’ has a very broad meaning, essentially exempting individuals from the absolute priority rule as to unsecured creditors.”[16] This construction, in turn, leads to the position that Section 1129(b)(2)(B)(ii)'s exception extends to all property of the estate, including such things as prepetition ownership interest of nonexempt property. Id. Courts adopting this view further reason that it is “supported by the revisions in 2005 to bring individual chapter 11's more in line with chapter 13.” Id.

Other courts that apply the “broad view” reason that §§1129(b)(2)(B)(ii) and 1115 are ambiguous and conclude that Congress intended for the BAPCPA amendments to allow individual Chapter 11 debtors to retain non-exempt, pre-petition property as well as all post-petition property and earnings, and still obtain plan confirmation.[17]

The court in Roedemeier,[18] further concluded that several other BAPCPA amendments to Chapter 11 demonstrate that Congress intended Chapter 11 procedures concerning individual debtors to function more like those found in Chapter 13.[19] Accordingly, in its view, the Roedemeier court felt that eliminating the APR for individual debtors would be consistent with the perceived Congressional intent to harmonize the treatment of the individual debtor under Chapter 11 with those under Chapter 13, which has no APR.[20]

In contrast to the “broad view” of §1115 and §1129(b), a majority of courts, including five at the Circuit level, adopt what has been called the “narrow view” of the applicable statutes. And as with the broad view”, there are two lines of thought with respect to the “narrow view.” One reasons that the language of the statute is not ambiguous and merely refers to post-petition earnings.[21] “In contrast to the “broad view,” these courts hold that § 1115 merely adds to, but does not replace, §541's definition of estate property for individual debtors.”[22] They further conclude that Section 1115 “includes” in the estate only that property that was not already included by §541.”[23]

The other line of thought on the “narrow view” recognizes that there is ambiguity in the language of §1115 and §1129(b)(2)(B)(ii), but concludes that Congress would have expressly abrogated the APR if that was, indeed, its intention.[24] These courts reject the notion that the APR was repealed by implication, relying mainly upon Supreme Court precedent directing courts not to “read the Bankruptcy Code to erode past bankruptcy practice absent a clear indication that Congress intended such a departure.”[25]

IV. The views in the Northern District of Illinois.

The Seventh Circuit has not ruled on whether the APR still applies to individual debtors, but at least two bankruptcy courts within the Northern District of Illinois have held that it does still apply. In In re Batista-Sanechez,[26] Judge Schmetterer relied upon the weight of authority to reject the debtor’s contention that BAPCPA abrogated the APR.

Similarly, in In re Draiman,[27] Judge Squires adopted the narrow view and held the plain meaning of §1115 was limited to post-petition earnings and nothing in BAPCPA indicated Congress intended to abolish the APR. According to Judge Squires:

Though it is generally true that the changes instituted by BAPCPA intended for individual Chapter 11 cases to more closely track Chapter 13 cases, that purpose is not evident with respect to the absolute priority rule. There is no relevant legislative history on § 1115 which would indicate its intent was to abolish the absolute priority rule. Therefore, the Court relies only on the plain meaning of the statute which, as explained, states that § 1115 adds certain property to the bankruptcy estate and does not absorb § 541.

[1] Chi., Rock Island & Pac. R.R. v. Howard, 74 U.S. 392, 409-10, 19 L. Ed. 117 (1868). See also Friedman v. P+P, LLC (In re Friedman), 466 B.R. 471 (9 Cir. B.A.P. 2012) (The absolute priority rule originated as a judicially created doctrine emerging out of the realm of corporate, as opposed to individual, bankruptcy cases.”).

[2] Elizabeth Warren, A Theory of Absolute Priority, 1991 Ann. Surv. Am. L. 9, 37-38 (1991).

[3] See generally In re Roedemeier, 374 B.R. 264, 275 (Bankr. D. Kan. 2007) (reasoning that a new value plan is almost impossible for individual debtors to propose: “As a matter of fact, for most individual debtors, their future labor or services are the only significant source of new value they will have available to them, and Ahlers means they cannot propose a confirmable Chapter 11 plan.”).

[4] An interesting issue arises when the debtor must liquidate property to satisfy the APR, but cannot do so because there is no market for the property. In re Martin, 497 B.R. 349, 352 (Bankr. M.D. Fla. 2013) (“Of course, individuals do not have shareholders. So the absolute priority rule with respect to individuals was historically interpreted to preclude individuals from retaining any property if their creditors were not being paid in full under the plan[.]”).

[5] See Roedemeier, 374 B.R. at 275 (noting that individual debtors can rarely propose a new value plan because all of their postpetition earnings are estate property).

[6] See 11 U.S.C. § 1129(b)(2).

[7] 11 U.S.C. § 1129(a)(8).

[8] See 11 U.S.C. § 1129(a).

[9] See In re Shat, 424 B.R. 854 (Bankr. D. Nev. 2010) (pre-2005 law that made APR applicable to individual cases “had the effect of preventing individual debtors from keeping a business under a chapter 11 plan if they did not pay their unsecured creditors in full. Accordingly, had the Debtors filed their case before 2005, their Plan likely could not have been confirmed.”).

[10] Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S. Ct. 963, 99 L. Ed. 2d 169 (1988).

[11] See In re Rogers, 2016 Bankr. LEXIS 2398, at *18-19 (2016).

[12] 11 U.S.C. §1129(b)(2)(B)(ii).

[13] 11 U.S.C. §1115 (Section 1115 also states that “property of the estate includes, … All property of the kind specified in section 541 that the debtor acquires after the commencement of the case but before the case is closed, dismissed, or converted to a case under Chapter 7, 12, or 13, whichever occurs first; and (2) Earnings from services performed by the debtor after the commencement of the case …”).

[14] See Maharaj v. Stubbs & Perdue, P.A. (In re Maharaj), 681 F.3d 558 (4th Cir. 2012) (“the BAPCPA amendments did not abrogate the absolute priority rule is the Supreme Court's view, especially in the bankruptcy context, that implied repeal is strongly disfavored.”); In re Lively, 717 F.3d 406, 409 (2013) (“But even if the statutory language is ambiguous, then the “narrow view” must prevail, because the opposite interpretation leads to a repeal by implication of the absolute priority rule for individual debtors.”); Dill Oil Co., LLC v. Stephens (In re Stephens), 704 F.3d 1279 (10th Cir. 2013); Zachary v. California Bank & Trust, 811 F.3d 1191 (9th Cir. 2016); Ice House America, LLC v. Cardin, 751 F.3d 734 (6th Cir. 2014.

[15] In re Shat, 424 B.R. 854, 865 (Bankr. D. Nev. 2010).

[16] Id.

[17] Roedemeier, 374 B.R. 264 (“This Court similarly concludes that Congress intended for the new exception to the absolute priority rule for individual Chapter 11 debtors to be read broadly.”); In re O'Neal, 490 B.R. 837 (Bankr. W.D. Ark. 2013).

[18] 374 B.R. at 276,

[19] Id. (“Significantly, Chapter 13 does not impose the absolute priority rule on debtors. Taken together, these changes indicate Congress intended to extend the exemption from the absolute priority rule to individual Chapter 11 debtors as well.”).

[20] Id. See also In re Tegeder, 369 B.R. 477, 479-481 (Bankr.D.Neb.2007); SPCP Group, LLC v. Biggins, 465 B.R. 316, 320-324 (M.D. Fla. 2011); Friedman v. P+P, LLC (In re Friedman), 466 B.R. 471 (9th Cir. BAP 2012).

[21] In re Draiman, 450 B.R. 777, 821 (Bankr. N.D. Ill. 2011) (“the Court relies only on the plain meaning of the statute which, as explained, states that § 1115 adds certain property to the bankruptcy estate and does not absorb § 541.”).

[22] In re Rogers, 2016 Bankr. LEXIS 2398, at *23.

[23] Id. (citing Gbadebo, 431 B.R. at 229.).

[24] See In re Martin, 497 B.R. 349, 357 (Bankr. M.D. Fla. 2013) ("If Congress wanted to abrogate the absolute priority rule—one of the bedrocks of bankruptcy jurisprudence for many decades—it could have done so directly rather than by implication. And Congress could easily have done so by simply exempting individual debtors in the language of § 1129(b)(2)(B)(ii).").

[25] Hamilton v. Lanning, 130 S. Ct. 2464, 2467, 177 L. Ed. 2d 23 (2010). See generally In re Arnold, 471 B.R. 578, 587-88 (Bankr.C.D.Cal.2012) (absolute priority rule applies; ); In re Gbadebo, 431 B.R. 222, 227-230 (Bankr.N.D.Cal.2010); In re Mullins, 435 B.R. 352, 359-361 (Bankr.W.D.Va.2010); In re Gelin, 437 B.R. 435, 440-443 (Bankr.M.D.Fla.2010); In re Stephens, 445 B.R. 816, 820-821 (Bankr.S.D.Tex.2011); In re Walsh, 447 B.R. 45, 47-49 (Bankr.D.Mass.2011); In re Kamell, 451 B.R. 505, 507-512 (Bankr.C.D.Cal.2011); In re Lindsey, 453 B.R. 886, 891-905 (Bankr.E.D.Tenn.2011); In re Karlovich, 456 B.R. 677, 679-682 (Bankr.S.D.Cal.2010); In re Lively, 467 B.R. 884 (Bankr.S.D.Tex.2012).

[26] 505 B.R. 222, 227 (Bankr. N.D. Ill. 2014).

[27] 450 B.R. 777, 820-822 (Bankr. N.D. Ill.2011).