Absolute Priority Rule (1)Some time ago I wrote in great detail about personal Chapter 11 bankruptcy.  In that post I discussed the application of one of the complexities of Chapter 11 bankruptcy to individual (as opposed to business) cases.  That complexity is the absolute priority rule.  At the time of the post, we had a patchwork of inconsistent case law on the topic, making the success of a personal Chapter 11 case dependent, in part, on the identity of the judge assigned to the case.

Things have been resolved ― at least in the Ninth Circuit ― and not in favor of individuals.  Let’s recall the setting:


I.  The Absolute Priority Rule


The absolute priority rule is an important idiosyncrasy of Chapter 11 that has no analogue in either Chapter 7 or Chapter 13 bankruptcy.  We’ll begin by describing the absolute priority rule in the business Chapter 11 context.


A.  The Business Chapter 11 Absolute Priority Rule


In bankruptcy not all debts are treated equally.  For example, the law distinguishes between secured debts ― debts that are secured by collateral that can be repossessed in the event of a default ― and unsecured debts.  Secured debts are not treated the same as unsecured debts because the secured creditor has special rights attached to the collateral securing the debt.

Even among unsecured debts there are distinctions.  Some are given priority over others.  The various priority classes are listed in 11 U.S.C. § 507(a).  This distinction sets the stage for the so-called absolute priority rule for Chapter 11.

As part of the Chapter 11, creditors are divided into classes according to the kind of debt they hold.  Similarly situated unsecured creditors are put into the same class.  Eventually the debtor proposes a plan of reorganization.  The plan states the treatment of each class.  The creditors then vote on the plan.

If a class of similarly situated creditors does not vote in favor of the plan (a dissenting class), then the Court will only confirm the plan if either:

a.  The dissenting creditors will be paid in full through the plan, pursuant to §1129(b)(2)(B)(i), or

b.  No one with a claim or interest that is junior to the claims of the dissenting creditor will get or retain anything under the plan, pursuant to § 1129(b)(2)(B)(ii).

The term that is used to refer to the situation where the Court confirms a Chapter 11 plan in spite of the existence of a dissenting class is “cram down.”

In simple terms, the absolute priority rule states that if a cram down is triggered, then if a class of creditors is not getting paid in full, any lower priority class gets nothing.  The lowest priority class is equity, i.e., the stockholders.

This concept is somewhat analogous to the idea in real estate law, where after a foreclosure sale the first mortgage holder gets paid in full before the second gets a penny, the second gets paid in full before the third gets a penny, etc.

In practical terms this usually means that if there is a cram down, then the owners – i.e., the shareholders – of a company in Chapter 11 will see their interest become worthless.  For example, when GM went into Chapter 11, the common GM stock was wiped out.  The only way for an owner of the old stock to have an ownership interest in the new company in a cram down is to add new value ― i.e., money ― to the reorganized company.  Then the new ownership interest is equal to the new value added.

Keep in mind that if either every class votes in favor of the plan of reorganization, or the dissenters all get paid in full, then there is no cram down, and the old equity holders may still retain some value in the reorganized company.  However, because equity is at the bottom of the barrel on the priority scale, it is usually wiped out.


B.  The Personal Chapter 11 Absolute Priority Rule


One hot topic in Chapter 11 jurisprudence has been the question of whether or not the absolute priority rule applies in a personal Chapter 11 bankruptcy case.

If there is an absolute priority rule in personal Chapter 11, that means that if the there is a cram down and the debtor has nonexempt assets, those assets could end up on the chopping block.  In an extreme reading of the absolute priority rule, it could mean that the debtor doesn’t get to keep anything at all.  We might see stark naked Chapter 11 debtors tossed into the street!  While this may have some X-rated entertainment value, it seems ridiculously draconian.

If there isn’t an absolute priority rule, then the individual debtor gets to keep all assets, whether or not they are exempt.

There has been a lack of unanimity among bankruptcy judges on this question.


1.  The Case Law Against The Absolute Priority Rule


On the one hand, some judges have taken the position that when the Bankruptcy Code was amended in 2005 to include the new § 1115, it created an exception to the absolute priority rule in the individual Chapter 11.  This is because 11 U.S.C. § 1129(b)(2)(B)(ii) provides (with emphasis added):

[T]he holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property, except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115 . . .

When this is coupled with § 1115 (emphasis added):

(a) In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541—

(1) 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 but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first.

(b) Except as provided in section 1104 or a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate.

A natural conclusion from this coupling is that there is no absolute priority rule in an individual Chapter 11.  This has been the conclusion of several bankruptcy courts.  See, e.g., In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007).


2.  The Case Law In Favor Of The Absolute Priority Rule


On the other hand, a few bankruptcy courts have asserted that the absolute priority rule does apply in a personal Chapter 11.  See, e.g., In re Gbadebo, 431 B.R. 222 (Bankr. N.D. Cal. 2010).

Since the 2005 Code amendment, courts that have seen an absolute priority rule in the individual Chapter 11 have at least accepted that the debtor gets to keep any exempt assets.   Even this is an improvement over the law prior to the enactment of BAPCPA, the 2005 amendment, where courts held that the individual Chapter 11 debtor could keep nothing.  See, e.g., In re Gosman, 282 BR 45 (Bankr. S.D. Fla. 2002).

Why do we care about the absolute priority rule in a personal Chapter 11?  The rule is crucial in determining what the debtor gets to keep in a crammed down Chapter 11.  If it looks like the debtor will lose most or all possessions, that debtor may decide not to use Chapter 11 at all.


II.  Also Sprach The Ninth Circuit 


For better or worse, the Ninth Circuit Court of Appeals has spoken.  In Zachary v. California Bank & Trust, No. 13-16402 (9th Cir. Jan. 28, 2016), the Court held:

This case presents an arcane but important question of first impression in this Circuit: Does the absolute priority rule continue to apply in individual chapter 11 reorganizations after the amendments to the Bankruptcy Code enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”)?  We hold that it does.

Thus, in the Ninth Circuit the absolute priority rule applies to personal Chapter 11 bankruptcies.  Ouch!  For the individual Chapter 11 debtor, this argues heavily in favor of doing a prepackaged bankruptcy so that the creditors are on board before the bankruptcy case is filed.

If you’re a debtor in the Central District of California who is considering using Chapter 11 to deal with your debts, call an attorney who is a board-certified bankruptcy law specialist to represent you in your Chapter 11 case.


Image based on Flickr (Licensed) by Scott Akerman