Contributed by Erika del Nido
Joining the growing list of courts that have been asked to consider the issue of whether the absolute priority rule applies to individual debtors (including the United States Bankruptcy Appellate Panel for the Ninth Circuit, the Fourth Circuit Court of Appeals, and the Tenth Circuit Court of Appeals) the United States Court of Appeals for the Fifth Circuit is the latest of the courts of appeal to toss its hat in the ring on the issue. The court in In re Lively narrowly construed a statutory exception applicable to individual debtors to hold (as the Fourth and Tenth Circuits previously held) that the absolute priority rule applies to individual chapter 11 debtors.
In Lively, a chapter 11 individual debtor sought confirmation of his plan of reorganization, pursuant to which the debtor would retain his property and pay unsecured creditors a small dividend that exceeded the liquidation value of the assets dealt with by the plan. No objections to confirmation or competing plans were filed, but the impaired unsecured class of creditors voted to reject the plan. The bankruptcy court determined that the proposed chapter 11 plan failed to comply with the absolute priority rule and denied confirmation of the plan.
The absolute priority rule, as set forth in section 1129(b)(2)(B) of the Bankruptcy Code, provides that a chapter 11 plan is “fair and equitable” as to a class of dissenting unsecured claims if:
(i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or
(ii) 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 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, subject to the requirements of subsection (a)(14) of [section 1129].
11 U.S.C. § 1129(b)(2)(B). The debtor in Lively, who was an individual, conceded that his proposed plan would have violated the absolute priority rule but for the exception in section 1129(b)(2)(B), which was added in 2005 with the enactment of the BAPCPA amendments. The exception in 1129(b)(2)(B), the debtor argued, if read in conjunction with section 1115 of the Bankruptcy Code, exempts individual debtors from the absolute priority rule in its entirety. Section 1115 provides:
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.
11 U.S.C. § 1115(a). Relying on “a minority string of bankruptcy court authority,” the debtor espoused what has been referred to as the “broad view” of the BAPCPA amendment, arguing that, pursuant to section 1115 of the Bankruptcy Code, all “property specified in section 541” qualifies as “property included in the estate under section 1115” and may be retained by the debtor pursuant to section 1129(b)(2)(B)(ii) of the Bankruptcy Code. If the “broad view” applied, the debtor would be able to retain his prepetition property even though the unsecured class of creditors had voted to reject his plan. Courts adopting the “narrow view” of the BAPCPA amendment find that section 1115 supplements, but does not replace, the definition of “property of the estate” contained in section 541 — meaning that section 1115 includes property in an individual’s estate that was not already included by virtue of 541 (that is, property and earnings acquired postpetition).
The Fifth Circuit’s Analysis
On appeal, the Fifth Circuit rejected the debtor’s argument. Aligning itself with courts that have adopted the “narrow view” of the BAPCPA amendment, the court held that a “narrow” interpretation of section 1129(b)(2)(B)(ii) of the Bankruptcy Code is “unambiguous and correct, and the exception to the absolute priority rule plainly covers only the individual debtor’s post-petition earnings and post-petition acquired property.” The Fifth Circuit explained that both sections 1129(b)(2)(B)(ii) and 1115 of the Bankruptcy Code were adopted when the Bankruptcy Code was amended in 2005 so that individual debtors could not “reorganize in Chapter 11 under more favorable terms than those available to chapter 13 debtors.” Prior to the amendments, a chapter 13 debtor’s postpetition income could be recovered by creditors, but an individual chapter 11 debtor’s postpetition income was not recoverable by creditors. The court explained, “In § 1115, Congress remedied this potential inequity in Chapter 11 by adding to the § 541 definition the individual debtor’s post-petition earnings and property acquisitions.” The court elaborated that when Congress added the debtor’s postpetition property and earnings to the definition of “property of the estate” for individual chapter 11 debtors, Congress also had to modify the absolute priority rule so that an individual chapter 11 debtor would not be “saddled” with committing all postpetition property to satisfy the claims of its creditors.
The court noted that the debtor’s proposed reading of the absolute priority rule would lead “to a repeal by implication of the absolute priority rule for individual debtors,” and “[r]epeals by implication are disfavored and will not be presumed unless the legislature’s intent is ‘clear and manifest.’” The court concluded by observing that absent a clear directive from Congress, Congress meant to refine section 1129(b)(2)(B) – not reverse it – with its amendment in 2005.
The Fifth Circuit has joined the Fourth and Tenth Circuits in holding that the absolute priority rule applies to individual chapter 11 debtors, but other courts have disagreed. Although the Fifth Circuit has spoken, the debate is still alive.