The Absolute Priority Rule Applies in Individual Chapter 11 Cases in Minnesota and the 8th Circuit.

For more detailed discussion on chapter 11 procedure, common issues and more, be sure to read Wartchow Law’s Chapter 11 Blog.

November 2015 caselaw update: The Bankruptcy Appellate Panel of the Eighth Circuit has recently aligned itself with several other jurisdictions in deciding that the Absolute Priority Rule applies in individual chapter 11 cases. This is according to the August, 2015 ruling in In re Woodward, 537 B.R. 894 (B.A.P. 8th Cir. 2015), with Judge Schermer stating: We hold that the absolute priority rule still applies in individual Chapter 11 cases to prevent debtors from retaining prepetition property. Our holding is supported by: (1) the language and context of § 1129(b)(2)(B)(ii) and 1115; (2) the absence of a clear indication by Congress of an intent to abrogate; and (3) the weight of existing authority.

The Absolute Priority Rule (“APR”) is codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code. Like chapter 11 law itself, the APR was envisioned for application to business chapter 11 cases and neglects to address the reasonable differences faced by individual debtors who, for one reason or another, file chapter 11 cases. (See also What is Individual Chapter 11 Bankruptcy and Why Would I file an Individual Chapter.)

At its most basic, an individual chapter 11 plan works similar to a chapter 13 plan as it regards the minimum distribution to general unsecured creditors: Individual debtors must pay the equivalent of their disposable income for 5 years to their unsecured creditors in order to be granted a discharge of the unpaid balance of debts. (Of course, there are other requirements in both chapters 11 and 13 regarding the payment of priority and secured debts, which this article does not address.) The Absolute Priority Rule further adds a second source of funds for distribution to creditors, in that it essentially directs an additional amount must be paid to the general unsecured creditors in order for the debtor to achieve reorganization and receive a discharge of debts. So what does that mean, exactly?

When the Absolute Priority Rule applies, the chapter 11 debtor must contribute “new value” in the form of funds equivalent to the value of all property of the bankruptcy estate that is retained by the debtor, presumably subject to the debtor’s available exemptions. This new value is in addition to the debtor’s 5 years’ disposable income requirement and, logically, new value cannot be funded from the debtor’s income since that income is already spoken for under the disposable income requirement. For the average chapter 11 debtor (and no chapter 11 debtor is ever really “average” otherwise they would file under another chapter), this means that they may keep almost nothing after reorganization: no income-producing real estate, not any business interests which generate the 5-year disposable income, essentially nothing of real value other than a debtor’s minimal exempt property. Fundamentally the APR requires that a chapter 11 debtor sell off all non-exempt assets to the highest bidder in order to reorganize, thus nullifying the very purpose behind chapter 11 and making plan confirmation over a creditor objection a practical impossibility. Very few (if any) individual debtors are willing to self-liquidate in this manner, as the very purpose behind chapter 11 is to enable the debtor to repay his or her unsecured creditors as much as is feasible over five years while retaining the very assets which form his/her livelihood and which typically generate the eventual distribution to unsecured creditors.

Arguably, the Absolute Priority Rule is only triggered when the chapter 11 plan is rejected, in that it does not receive the requisite class acceptance by vote of all creditor classes within the plan, or when the holder of an unsecured claim objects to confirmation of the chapter 11 plan. (‘Arguably’ because the 8th BAP in In re Woodward nevertheless applied the APR even though the plan was accepted by an impaired class and where there was a plan objection otherwise.) When a plan is rejected by a class of creditors, the additional “cramdown” confirmation requirements of 1129(b) are invoked, including the requirement that the plan be “fair and equitable”. In contrast, if a debtor’s plan receives the requisite class acceptance while only devoting his/her 5-year disposable income, then the requirements of APR may not be invoked assuming there are no plan objections otherwise.  However, if the plan is rejected by the general unsecured class—which can easily happen if there is one large creditor holding the majority of unsecured claims—the court may invoke the APR. When the APR applies, essentially it means that the debtor cannot retain the value of any non-exempt property and such value must be paid to his/her creditors.

Prior to the 2005 amendments, section 1115 of the Bankruptcy Code included a very narrow definition of property of the estate, so that in practice the chapter 11 debtors could only retain a nominal amount of equity in one vehicle, in their homestead and a handful of other exempt assets. This is the reason very few individual chapter 11 cases were filed prior to 2005 and almost none were successfully confirmed over a creditor objection. The 2005 amendments to the Bankruptcy Code expanded the definition of ‘property of the estate’ under 1115, accordingly making cramdown possible for individual debtors for the first time.

Since 2005, courts have been divided over whether the Bankruptcy Code amendments impliedly repealed the Absolute Priority Rule as it applies to individuals, with most to date taking the position that the APR applies to indivuals. For the courts that find that the APR still applies to individuals (including now Minnesota and the rest of the 8th Circuit as well as at least the 5th, 9th and 10th Circuits), these courts hold to the old standing practice that a chapter 11 debtor cannot achieve reorganization without paying his/her creditors not merely his/her 5-year disposable income but also the value of all assets, thereby forcing such individuals to liquidate their income-producing assets (again, an option which runs contrary to the purpose behind chapter 11 to achieve reorganization rather than liquidation). These courts that hold the APR applies to individuals are said to take a “narrow” view of the 2005 amendments. See In re Woodward, 537 B.R. 894 (B.A.P. 8th Cir. 2015); In re Lively, 717 F.3d 406 (5th Cir. 2013); Zachary v. California Bank & Trust, 811 F.3d 1191 (9th Cir. 2016); and In re Stephens, 704 F.3d 1279 (10th Cir. 2013).

Fewer courts have taken the “broad” view of the 2005 amendments to recognize that the Absolute Priority Rule undermines the essential purpose of chapter 11 law as applied to individual debtors. These courts identify the practical impossibility that APR poses to plan confirmation in almost every conceivable individual chapter 11 case that does not achieve majority acceptance from each creditor class. In finding that the 2005 amendments expand the definition of property of the estate that may be retained by a debtor, these courts rule that the APR is inapplicable in chapter 11 cases filed by individual debtors, such that debtors’ retention of their equity interests in businesses and other assets owned prepetition does not prevent them from “cramming down” plan that would result in less than a 100% distribution on unsecured claims. In other words under the “broad” view of APR, an individual debtor is entitled to retain most prepetition and postpetition property and nonetheless cram down a plan over an unsecured creditor’s objection. See In re Anderson, No. 11–61845–11, 2012 WL 3133895 (Bankr.D.Mont. Aug. 1, 2012); In re Shat, 424 B.R. 854 (Bankr.D.Nev.2010); In re Roedemeier, 374 B.R. 264 (Bankr.D.Kan.2007).

The Absolute Priority Rule is rooted in business chapter 11 law and was never intended to address the fundamental uniqueness of individuals utilizing chapter 11. The drafting of the Bankruptcy Code, including the 2005 amendments, fails to differentiate between an individual and a business. This futility of chapter 11 law has been further perpetuated by bankruptcy judges taking the narrow view APR, essentially leaving those unique, albeit few, individual debtors who are not eligible for either chapter 7 or chapter 13 without a practical bankruptcy solution. In this author’s opinion, the APR forces the individual chapter 11 debtor to self-liquidate in such a manner that undermines reorganization process when retention of such assets is necessary for funding the creditor distributions and, more importantly, essential to rehabilitation of the debtor.

Wartchow Law Office provides a comprehensive review of your liabilities and circumstances affecting a possible chapter 11 proceeding to best advise on all options including what chapter 11 can do to improve your future prospects. 

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