The Absolute Priority Rule is Not So Absolute for Individual Chapter 11 Debtors

on April 18, 2012 ·

Posted in Chapter 11 Plans,Claims,Cramdown

In Friedman v. P+P, LLC, the United States Bankruptcy Appellate Panel of the Ninth Circuit addressed whether or not the absolute priority rule applies in individual debtor chapter 11 cases.  This issue, which has been hotly contested in bankruptcy courts around the country since the 2005 enactment of the BAPCPA, divided the panel.  The majority held that the absolute priority rule does not apply in individual debtor chapter 11 cases.  Judge Jury dissented vehemently—she would hold that the absolute priority rule applies to an individual chapter 11 debtor’s prepetition property but not to postpetition property.  The divide in the Friedman panel exemplifies the difficulty bankruptcy courts nationwide face when trying to reconcile section 1129(b)(2)(B)(ii) and section 1115 of the Bankruptcy Code.

The Friedmans, a married couple who jointly own several technology businesses, sought chapter 11 protection in 2007 in the United States Bankruptcy Court for the District of Arizona.  The Friedmans’ chapter 11 plan proposed that the couple would retain interest in their technology businesses and that unsecured creditors, including the adversary in this case, P+P, would receive small monthly payments.  P+P objected to the plan and claimed, among other things, that it violated the absolute priority rule because the Friedmans were retaining a valuable interest in their companies but unsecured creditors were not being paid in full.  The bankruptcy court held that the absolute priority rule applies in individual debtor chapter 11 cases and rejected the Friedmans’ plan on this ground.

Section 1129(b)(2)(B)(ii) of the Bankruptcy Code, known as the absolute priority rule, provides that a plan can be found “fair and equitable” as to unsecured creditors despite a dissenting impaired class if holders of interests junior to the impaired class of unsecured creditors do not receive or retain interest in any property under the plan.  BAPCPA added an exception to this general rule: “in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115 . . . .”  Section 1115 of the Bankruptcy Code expands the definition of property of the estate for individual debtors to include, “in addition to the property specified in section 541,” property and earnings obtained postpetition.  The discordance between the majority and dissent’s reading of these provisions is primarily based on what meaning should be attributed to the words “in addition to.”

The majority held that property specified in section 541 is included in property of the estate as defined in section 1115.  Under this reading, an individual debtor is able to retain prepetition and postpetition property without violating the absolute priority rule because “property included in the estate under section 1115” is excepted from the rule.  This expansive reading of section 1115 makes the absolute priority rule inapplicable in individual debtor chapter 11 cases.  This view has been widely referred to as the “broad view.”  According to the majority, the broad view is consistent with congressional intent.  Many of the BAPCPA amendments regarding chapter 11 debtors borrowed provisions from chapter 13 of the Bankruptcy Code, so the majority reasoned that Congress intended for there to be symmetry between the two chapters for individual debtors.  Eliminating the absolute priority rule from individual chapter 11 debtors’ cases is consistent with this goal because the absolute priority rule does not apply to chapter 13 debtors.

Judge Jury, however, read the two provisions differently.  According to her dissent, “property included in the estate under section 1115” refers to postpetition property only and does not include prepetition property that becomes part of the estate through section 541.  She stated that postpetition property is excluded from the absolute priority rule but the rule still applies to prepetition property.  This perspective is commonly referred to as the “narrow rule.”  Judge Jury rejected the majority’s argument that Congress intended for there to be symmetry between the treatment of individual debtors under chapter 13 and chapter 11 of Bankruptcy Code.  She argued that “[i]ndividual chapter 11 debtors are not simply chapter 13 debtors with larger debts” because they enjoy rights and powers above and beyond those of a chapter 13 debtor.  Because of this, she asserted that symmetrical treatment between chapter 11 and chapter 13 is not warranted.  Judge Jury argued that adopting her view, likewise, would be consistent with congressional intent.  Judge Jury noted that the debtor-friendly approach adopted by the majority was at odds with the creditor-friendly BAPCPA amendments and the careful balance of interests created in chapter 11.  According to the dissent, a narrower reading would be more consistent with the purpose of the BAPCPA and Bankruptcy Code.

Nonetheless, Judge Jury’s reading of the interplay between chapter 11 and chapter 13 did not prevail.  For now, at least in bankruptcy courts in the Ninth Circuit, when it comes to individual chapter 11 debtors, the absolute priority rule is not so “absolute.”

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