CLIENT ALERT
BANKRUPTCY
RECENT COURT DECISIONS HOLD THAT THE ABSOLUTE
PRIORITY RULE STILL PROTECTS CREDITORS OF INDIVIDUAL
CHAPTER 11 DEBTORS.
by Daniel F. Gosch
As the economic recovery continues to wind along through the up
and down nancial cycles that have been the hallmark of the last four
years, there can be little doubt that some individuals historically on
the higher end of the economic spectrum have felt the impact of the
crisis more than others. More than a few “high net worth individuals”
have seen personal fortunes eroded to a degree that has caused them
to consider what would have once been unthinkable—personal
bankruptcy. However, many times, the bankruptcy relief utilized most
often by individual debtors, Chapter 13, or Chapter 7, won’t be quite
the right t. The debt ceilings in Chapter 13 preclude some from ling.
Means testing, limited exemptions, and the fact that Chapter 7 is after
all a liquidation proceeding create diculty under that chapter. What’s
a poor high net worth debtor to do?
For some the answer has been an individual chapter 11 case. Individual
chapter 11 cases have historically not been the norm, because
they required that the individual debtor comply with the same
requirements to conrm a plan of reorganization that were applicable
to corporations and businesses. To conrm a plan of reorganization,
all classes of claims not paid in full in cash on the eective date of the
plan have to agree to the alternative treatment the plan proposes.
If they do not, the only way to conrm the plan over their dissent is
through what is called “cram down”—the process of conrming a plan
notwithstanding the dissent of an impaired class of creditors. In order
to “cram down” a plan on unsecured creditors, the plan must comply
with the so-called “Absolute Priority Rule”.
The Absolute Priority Rule has been part of bankruptcy jurisprudence
since at least 1939. It mandates that in a chapter 11 case no junior class
of claims or interests can receive or retain anything under the plan of
reorganization, unless senior classes of claims or interests are either
paid in full or consent (by voting yes on the plan) to the treatment that
pays them less than in full. In a corporate context, this means that
shareholders/equity (the lowest priority interest) cannot retain their
shares in the debtor if they pay unsecured creditors less than 100%
of their claims (unless the creditors agree to take less). While there are
some “exceptions” to this general rule (they aren’t critical here) for an
individual chapter 11 debtor, who plainly has no shareholders, this rule
meant that the debtor could not retain the property owned when the
case was led unless unsecured creditors were paid in full. Eectively
then, the Absolute Priority Rule provided unsecured creditors with a
“blocking vote” in an individual chapter 11 case, as the creditors could
demand that the debtor either pay the unsecured creditors in full, or
give up all of his or her pre-petition property to fund the plan. From
the debtor’s perspective, giving up all of one’s pre-petition property
would have the eect of rendering the whole “reorganization” process
meaningless, as a practical matter.
However, in 2005, Congress amended the Bankruptcy Code through
a set of amendments commonly referred to as “BAPCPA” (the
“Bankruptcy Abuse Prevention and Consumer Protection Act” of 2005).
One of the numerous BAPCPA changes altered the part of Section 1129
of the Bankruptcy Code that implements the Absolute Priority Rule.
What the change appeared to do was to permit an individual debtor
to conrm a plan of reorganization over the dissent of a senior class
of unsecured creditors even while retaining some or even all of his or
her property. Depending on how the new language was interpreted
a debtor could either retain all of his property or just additional
property obtained by the debtor after the commencement of the
bankruptcy case (typically a much more limited amount). If the correct
interpretation of the changed language was that a debtor could keep
all property (the so-called “broad view”), the eect would be that the
Absolute Priority Rule was eectively gone as it related to individual
chapter 11 debtors. Alternatively, if the correct view was that only the
more limited amount of post-petition property could be retained (the
so-called “narrow view”), then the Absolute Priority Rule would still be
alive and well.
After BAPCPA, the bankruptcy courts split over which of these two
interpretations was correct. There were a number of arguments
either way. Some courts that adopted the “broad view” concluded
that the statutory language plainly and unambiguously abolished the
Absolute Priority Rule. Others found the language ambiguous, but
still found that the amendment abolished the Absolute Priority Rule
because such a conclusion was consistent with what they perceived
as a Congressional desire to make individual chapter 11 cases more
like chapter 13 cases. On the other hand, the courts adopting the
“narrow view” found the language of the amendment ambiguous, and
concluded that Congress could not have intended to abrogate such a
longstanding concept as the Absolute Priority Rule through ambiguous
language. Recently, the Circuit Courts of Appeal in the United States
are starting to weigh in on the issue, and some consistency is starting
to appear in the analysis.
In re Maharaj 681 F. 3d 558 (4th Cir. 2012) was a prototypical example
of the criticality of adopting the “narrow” vs. the “broad” view. In this
case the debtors ran a small business (an auto body shop), and fell
into debt through their exposure to a fraud scheme. Because their
debts exceeded the chapter 13 debt limitations, and they desired to
continue their business, they led an individual chapter 11 case. Their
chapter 11 plan proposed to renance or continue to pay most of their
secured debt, and proposed to pay their unsecured creditors roughly
two cents on the dollar over ve years. The plan would be funded
by the debtors retaining and continuing to operate the existing pre-
petition business. However, if the Absolute Priority Rule applied, the
debtors would be unable to retain the pre-petition business assets
unless each of the classes of creditors under the plan voted to accept
page 1 of 2April 16, 2013
