Applicability of the Absolute Priority Rule to Individual Chapter 11 Debtors

Applicability of the Absolute Priority Rule to Individual Chapter 11 Debtors

Matthew R. Strzynski, Krieg DeVault LLP

Kay Dee Baird, Krieg Devault LLP

Background of Chapter 11

The principal purpose of the Bankruptcy Code is to grant a fresh start to the honest but unfortunate debtor. See Marrama v. Citizens Bank of Mass., 549 U.S. 365, 367 (2007).

2


Chapter 11 of the Bankruptcy Code is designed to facilitate reorganization and rehabilitation of the debtor.

3


It is intended to avoid liquidations under Chapter 7, since liquidations have a negative impact on jobs, suppliers of the business and the economy as a whole, see U.S. v. Whiting Pools, Inc., 462 U.S. 198, 203 (1983).

4


Integral to the rehabilitation of the Chapter 11 debtor is the plan of reorganization.

5


A Chapter 11 plan that meets the requirements of section 1129(a) and is accepted by all impaired classes or creditors must be confirmed by the bankruptcy court. By contrast, if there are impaired classes that have not accepted the plan, the plan must conform to the dictates of section 1129(b).

6


Section 1129(b) permits a court to confirm a chapter 11 plan over the objection of creditor classes “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” 11 U.S.C. § 1129(b).

7

Background of Chapter 11Section 1129(b)(2)(B) requires unsecured creditors (i) to be paid the value of the allowed amount of the claim as of the effective date of the plan; or (ii) that senior creditors are paid in full before any party with a junior interest, including the debtor, receives or retains any property, except that an individual debtor may retain estate property under section 1115, subject to certain domestic support obligations. This provision is generally referred to as the “absolute priority rule.”

8

When Does the Absolute Priority Rule Come into Play?

Chapter 11 Bankruptcy Cases- Does not apply to individual Chapter 13

debtors or Chapter 7 debtors So often of little consequence to the average

consumer debtor that its importance is overlooked.

9

When Does the Absolute Priority Rule Come into Play? (cont.)

Individual chapter 11 debtor proposes a plan. Plan proposes for debtor to retain property and

yet creditors are not paid in full. Creditors then object to the plan on the basis of

the absolute priority rule. Question becomes whether rule applies to

individual Chapter 11 debtors.

10

Does the Absolute Priority Rule Apply to Individual Chapter 11 Debtors?

Pre-BAPCPA (2005), general agreement among the bankruptcy courts that the absolute priority rule applied to individual Chapter 11 cases, BUT split regarding whether an individual creditor could retain any property without paying unsecured creditors in full.

11

2005 Changes to Individual Chapter 11s

In 2005, Congress made significant changes to Chapter 11 as it applies to individual debtors. Congress added Section 1115, which states as follows:

12

2005 Changes to Individual Chapter 11s (cont.)

(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 –

13


(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, which ever occurs first; and

14


(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.

15


(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.

16


Congress amended section 1129(b)(2)(B)(ii) to except in individual cases “property included in the estate under section 1115, subject to the requirements of subsection (a)(14)” from the absolute priority rule.

17


Congress also added a projected disposable income test, similar to that in Chapter 13, to the confirmation requirements for individual Chapter 11 plans.

18

Rule Does Not Apply

When read plainly, the amendments to Chapter 11 with respect to individual debtors show that the absolute priority rule has been abrogated in favor of the projected disposable income test as the mechanism to protect unsecured creditors.

19

Statutory Language of Sections 1115 and 1129(b)Section 1129(b)(2)(B)(ii) permits the debtor to retain “property included in the estate under section 1115.” Section 1115(a) provides that property of the estate of an individual chapter 11 debtor includes the following:

20

Statutory Language of Sections 1115 and 1129(b) (cont.)

1. The property specified in section 541;

2. All section 541-type property acquired post-petition; and

3. Earnings from post-petition wages.

21

Statutory Language of Sections 1115 and 1129(b) (cont.)

The natural reading of the plain language demonstrates that section 1115 broadly defines property of the estate to include property specified in section 541 as well as property acquired post-petition and earnings from services performed post-petition.

22

Rule Does Not Apply

The protection offered to unsecured creditors by the absolute priority rule in individual Chapter 11 cases has been supplanted by the addition of the projected disposable income test.

23

Rule Does Not Apply (cont.)

The means test – which applies in Chapter 11 only to individual debtors – permits the holder of an allowed unsecured claim to object to confirmation of the debtor’s plan if the plan fails to pay that creditor in full, or the value of the property to be distributed under the plan is less than the debtor’s projected disposable income to be received during the 5-year period beginning on the date the first plan payment is due under the plan, or during the period for which the plan provides payments, whichever is longer. 11 U.S.C. § 1129(a)(15).

24

Rule Does Not Apply (cont.)

Though Chapter 13 debtors and individual Chapter 11 debtors are now subject to the projected disposable income test, significantly, chapter 13 does not impose the absolute priority rule on debtors.

25

Narrow View – Absolute Priority Rule Does Apply to Individual Chapter 11 Debtors

The “new emerging majority” Concludes that the absolute priority rule

continues in individual Chapter 11 cases, and the amendments to 11 U.S.C. §1129 only exclude the debtor’s future earnings and property acquired post-petition from application of the absolute priority rule.

26

Narrow View – Absolute Priority Rule Does Apply to Individual Chapter 11 Debtors

(cont.)

Read amendments to 11 U.S.C. §1129(b)(2)(B)(ii) as referring only to additional property brought into the estate by §1115, not property that would already be property of the estate under §541.

27

In re Gradebo, 431 B.R. 222(Bankr. N.D. Cal. 2010)

Rejected the treatises and courts which adopted the broad view.

Concluded that the language of 11 U.S.C. §1129(b)(2)(B)(ii) is unambiguous

- Reasoned that the phrase “included in the estate under section 1115” means added to the bankruptcy estate by §1115.

Reference to §541 was included in §1115 because without it, argument could have been made that an individual Chapter 11 debtor’s estate did not include pre-petition property.

28

In re Gradebo (cont.)

Fact that BAPCPA amended the Bankruptcy Code to make Chapter 11 more like Chapter 13 is not “persuasive evidence that Congress intended to eliminate the absolute priority rule as to individual [Chapter 11] debtors.”

“No one who reads BAPCA as a whole can reasonably conclude that it was designed to enhance the individual debtor’s fresh start.”

The new provisions of BAPCA were designed to “impose greater burdens on individual chapter 11 debtor’s rights so as to ensure a greater payout to creditors [which] was a frequently expressed overall purpose of BAPCPA: i.e. to ensure that debtors who can pay back a portion of their debts do so.”

29

In re Gradebo (cont.)

“[I]f §§ 1129(b)(2)(B)(ii) and 1115 are read to eliminate the “absolute priority” rule for individual chapter 11 debtors, the Court is faced with a procedural anomaly. If the plan proposes to pay them anything, the debtor is required to send them a ballot. Yet, their vote can be ignored. This makes no sense. The Court reads §§ 1129(b)(2)(B)(ii) and 1115 to eliminate the “absolute priority” rule only as to an individual chapter 11 debtor’s post-petition property. It bases this conclusion on both the language of the statute, both in isolation and viewed in the context of the Bankruptcy Code as a whole. It finds this reading most consistent with the intent of Congress as expressed in the legislative history.”

30

In re Gelin, 437 B.R. 435(Bankr. M.D.Fla. 2010)

Acknowledged text’s ambiguity but . . . Rejected the rational of the broad view which concludes

that § 1115 absorbs or supersedes § 541 to define property of the estate- Noted that neither §§ 541 or 103(a) were amended by BAPCPA

- Reasoned that phrase “in addition to the property specified in section 541” merely added property to the estate under § 1115

- Rationalized that “[I]f Congress truly meant to exempt an individual debtor’s entire estate, it likely would have referred to both §§ 541 and 1115” in § 1129(b)(2)(B)(ii).

31

In re Draiman, 450 B.R. 777(Bankr. N.D.Ill. 2011)

Similarly, court held that under § 1115, certain post-petition property is included in the bankruptcy estate in addition to the property set forth in § 541. § 1115 “adds property to the debtor’s estate which has already been established by § 541.”

32

In re Mullins, 435 B.R. 352(Bankr. W.D.Va. 2010)

Acknowledged real world application may cause unintended consequences but adopted the narrow view.

Reasoned that if Congress had intended to completely eliminate the absolute priority rule from individual Chapter 11 cases, it could have easily done so by saying in § 1129(b)(2)(B)(ii) “except that in a case in which the debtor is an individual, this provision shall not apply” rather than the language which Congress did use – “except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115.”

33

In re Mullins, 435 B.R. 352(Bankr. W.D.Va. 2010) (cont.)

Held that the absolute priority rule applies in individual Chapter 11 cases to property already owned by the debtor at the time of filing the petition (i.e. property included in the estate under § 541) but not to property brought into the estate by § 1115 (i.e. post-petition earnings and other property acquired post-petition).

34

In re Stephens, 445 B.R. 816(Bankr. S.D.Tex. 2011)

Held that “[t]he language ‘in addition to the property specified in section 541’ in the preamble to section 1115(a) would render surplusage the words ‘all property of the kind specified in section 541’ in section 1115(a)(1), if section 1115 is interpreted to include all property of the estate.”

35

In re. Karlovich, 456 B.R. 677(Bankr. S.D.Cal. 2010)

Concluded that the effect of the amendments to § 1129(b)(2)(B)(ii) was not to eliminate the absolute priority rule but to make it the same for individual and non-individual Chapter 11 debtors, like it was prior to BAPCPA.

- I.E. when property of the estate (for both individuals and non-individuals) did not include post-petition acquired property and earnings.

36

In re. Karlovich (cont.) If Congress wanted to eliminate the absolute priority rule for individuals,

it “could easily have added ‘except with respect to individuals’ at the beginning of § 1129(b)(2)(B)(ii), or stated than an individual could retain all property.”

Rejected broad view’s conclusion that BAPCA amendments were intended to make individual Chapter 11 cases more like Chapter 13 cases.

- Reasoned that if this was Congress’ intent, could have amended statutory debt ceilings for Chapter 13 cases, eliminate them all together, or set them significantly higher. Congress’ failure to do so, illustrates Congressional intent that Chapter 11 provisions would apply to individual Chapter 11 cases and that post-petition earnings of individual Chapter 11 debtors would be protected under § 1129(b)(2)(B) as they are in Chapter 13 cases under 11 U.S.C. § 1306.

37

In re Walsh, 447 B.R. 45(Bankr. D.Mass. 2011)

“Section 1115 deals with something more than post-petition income from services – it also brings in property described in section 541 but which is acquired post-petition.”

“Because it deals with post-petition section 541(a) property (a most awkward construction), Section 1115 does not include section 541(a) property as such.”

38

In re Kamell, 451 B.R. 505(Bankr. C.D.Cal. 2011)

Acknowledged that the statutory language of §§ 1129(b)(2)(B)(ii) and 1115 are ambiguous but opted not to follow the broad view.- Found that the legislative history for both statutes was “scarce,

equivocal and altogether unhelpful.”

- Because language was vague and unclear, court was unwilling to conclude that Congress meant to eliminate the absolute priority rule in individual Chapter 11 cases. “[M]ajor changes to existing practice will not be inferred unless clearly mandated[.]”

Congress is presumed to have knowledge of the interpretation of existing laws when it enacts new laws.

39

Documents

Applicability of the Absolute Priority Rule to Individual Chapter 11 Debtors