Although the absolute priority rule has been a staple in Chapter 11 proceedings for more than a century, 2005 bankruptcy code amendments created an exception that has blurred the intended meaning. A recent 9th Circuit ruling held that the absolute priority rule does not apply to individual debtors in Chapter 11 cases. Attorney Lesley Hawes examines this ruling and its implications for secured creditors and equipment lessors with unsecured guaranties.
The 9th U.S. Circuit Court of Appeals has issued a ruling on whether amendments to the bankruptcy code in 2005, when the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) became effective, created an exception to the absolute priority rule in Chapter 11 cases involving individual debtors. A divided panel of the U.S. Bankruptcy Appellate Panel of the 9th Circuit previously held that the absolute priority rule does not apply to individual Chapter 11 debtors, which is inconsistent with holdings of other circuit courts and the majority of lower courts nationwide that have addressed the issue.1
Over the years, the 9th Circuit has issued a number of bankruptcy decisions at variance with courts in other jurisdictions. This time the 9th Circuit did not. In Zachary v. California Bank & Trust,2 it agreed with published decisions of four other appellate courts,3 overruled the appellate panel’s Friedman decision and held that the amendments enacted by BAPCPA create only a limited exception to the property that may be retained by an individual debtor in order to confirm a Chapter 11 plan over the dissent of a class of unsecured creditors. In the 9th Circuit, and in most courts across the country, the absolute priority rule remains alive, well and applicable when an individual Chapter 11 debtor tries to cram down a plan over unsecured creditors’ objections.
The venerable absolute priority rule dates back more than a century. It applies in Chapter 11 reorganizations where a debtor attempts to cram down a plan and confirm it when the unsecured creditor class has voted against confirmation. The absolute priority rule was a judicial doctrine that was codified in the Bankruptcy Code of 1978.4
The absolute rule provides that, with respect to a class of general unsecured creditors that has voted against confirmation of the plan, creditors in that class must retain property or be paid at least as much as their allowed claims, and no class of claims or interests junior in priority to the general unsecured class will receive or retain anything under the plan on account of their junior claims or interests. Under the former version of the absolute priority rule — before the BAPCPA was enacted — the language stated the plan could be confirmed over the dissent of the unsecured creditor class only if “the holder of any claim or interest that is junior to the claims of such [unsecured creditor] class will not receive or retain under the plan on account of such junior claim or interest any property.”5 In other words, “every unsecured creditor must be paid in full before the debtor can retain ‘any property’ under a plan.”6
The issue the courts have wrestled with as a result of the enactment of BAPCPA is the effect of the expanded definition of “property of the estate” in an individual Chapter 11 case and new language added to section 1129(b)(2)(B)(ii). Prior to the 2005 amendments, property of the estate was defined in section 541 generally as all property of the debtor as of the commencement of the case. The BAPCPA added new section 1115 that applies in an individual debtor Chapter 11 case, stating that property of the estate includes, in addition to the definition in section 541, property “the debtor acquires after the commencement of the case but before the case is closed, dismissed or converted” and “earnings from services performed by the debtor after the commencement of case but before the case is closed, dismissed or converted.”
The amended code expands the scope of property comprising the bankruptcy estate of an individual in Chapter 11 to add post-petition earnings and property acquired by the individual debtor. In addition, the code7 now includes the following additional language (italicized): “the 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 in 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…”
It is clear that the language added by the BAPCPA creates an exception to the absolute priority rule in a Chapter 11 case involving an individual debtor, allowing the debtor to retain some property of the estate and still confirm a Chapter 11 plan over the objection of an unsecured creditor class — notwithstanding the absolute priority rule. The courts have wrestled with the scope of the exception.
Some courts, like the 9th Circuit in Friedman, have viewed the language as creating a broad exception to the absolute priority rule in individual Chapter 11 cases covering all property “that is included” in the bankruptcy estate under section 1115, which would extend not only to post-petition property acquired or earnings obtained by the debtor, but also any property of the estate under section 541, as that property is “included” in property of the estate of an individual debtor in section 1115. Other courts, including the 4th, 5t , 6th, 10th and now the 9th Circuits, have rejected that broad view, holding that only the additional post-petition property obtained by the individual debtor that is added to property of the individual debtor’s bankruptcy estate under section 1115 is subject to the exception to the absolute priority rule and allowed to be retained by the individual debtor in order to confirm the plan.
Zachary Analysis and Holding
The 9th Circuit framed the issue to be determined by looking to prior decisions of the circuit courts that described the two views of the impact of the amendments made by the BAPCPA. The 4th Circuit in Maharaj,8 noted that a “significant split of authorities” among bankruptcy courts between those subscribing to the narrow view and those adopting the broad view of the amendments. The courts that support the broad view hold that “Congress intended to include the entirety of the bankruptcy estate as property that the individual debtor may retain, thus effectively abrogating the absolute priority rule in Chapter 11 for individual debtors” in Maharaj. As a result, cases adopting the broad view permit an individual Chapter 11 debtor to retain almost all of the debtor’s pre- and post-petition property and still confirm a cram down plan over the objection of the unsecured creditor class.9
However, the majority of courts that have addressed the issue have adopted the narrow view of the effect of the 2005 amendments enacted in BAPCPA, which holds that a Chapter 11 individual debtor cannot “cram down a plan that would permit the debtor to retain prepetition property” and that the individual Chapter 11 debtor can confirm a plan by cram down “that permits the debtor to retain only post-petition property.”10
The statutory analysis turns on the meaning of the word “included” in the language added to section 1129(b)(2)(B)(ii). Those courts adopting the narrow view conclude that the term “included” as used in that provision means “added” or “taken into” the estate through the provisions of section 1115, which would mean the post-petition earnings and assets obtained by an individual debtor that would otherwise not have been property of the estate based on the provisions of section 541. The 9th Circuit found such a reading “as defining a new class of property that is exempt from the absolute priority rule nicely harmonizes the new provisions.”11 The 9th Circuit also found this interpretation to be consistent with the legislative history and with a fundamental tenet of statutory interpretation: if Congress intended to change existing law and eliminate the absolute priority rule in individual Chapter 11 debtor cases, it could have done so by simple and direct language.
Zachary’s Importance for Creditors
The 9th Circuit’s decision in Zachary is important for secured creditors and equipment lessors who may have unsecured guaranties and whose guarantors file bankruptcy after default on the underlying debt or lease. The narrow view ensures that dissenting unsecured creditors are protected from a cram down unless their claims are paid in full by limiting the property an individual debtor can retain in cramming down the plan. The broad view would have effectively eliminated the absolute priority rule in individual Chapter 11 cases and permitted individual debtors to retain almost all pre- and post-petition property of the estate while still allowing them to confirm a plan over the objection of the unsecured creditor class. The 9th Circuit’s decision to join with the other four circuit courts that have decided the issue and with the majority of courts across the country is also helpful for creditors by avoiding a circuit split and creating incentives for individual debtors to forum shop in filing Chapter 11 petitions in jurisdictions adopting the broad view of these amendments.
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