Chapter 13 priority, Claims and Distribution

• Jurisdiction: United States

Chapter 13 priority, Claims and Distribution

§ 13.1 ~ What are we doing here?

We have seen earlier that in chapter 7, the job of the trustee is to "[c]ollect and reduce to money the property of the estate ... and close such estate as expeditiously as is compatible with the best interests of the parties in interest."¹ In chapter 11, it does not quite work that way. Still, the bedrock rules for collection and distribution provide a substrate to the chapter 11 plan, so it is important to know who gets paid and in what order. We take up these topics here.

§ 13.2 ~ Pro Rata

The basic rule of bankruptcy distribution is pro rata. If there is enough to pay 10 percent of all similar claims, then each creditor gets 10 percent of his claim.²

Example: Ted, the trustee of the estate of Della Debtor, is holding $1,440 for distribution. There are three claims. Della owes $1,200 to Rosa, $800 to Dana, and $400 to Charles — a total of $2,400. This means that the trustee has enough to pay 60 percent of all claims (1,440/2,400 = 0.6). Ted should pay Rosa $720 (1,200 x 0.6), Dana $480 (800 x 0.6) and Charles $240 (400 x 0.6). Note that 720+480+240 = 1,440, so everything checks.

Several points are worth noting about pro rata distribution. First, it applies only to the residual class — which is usually, although not necessarily, the unsecured class. Other classes get paid in order of "lien" priority or bankruptcy statutory priority.³ If a class is paid in full, there is no point in computing pro rata.

Example: Same as above, except that the $1,440 property held by the trustee includes $400 as proceeds of the sale of a widget in which Charles held a perfected security interest. Charles gets $400, discharging his secured claim. Della still owes $1,200 to Rosa and $800 to Dana — a total of $2,000. After distribution to Charles, she has $1,040, or enough to pay 52 percent of remaining claims (1,040/2,000 = 0.52). Ted pays $624 to Rosa (1,200 x 0.52) and $416 to Dana (800 x 0.52).

The secured creditor gets priority only to the extent of his claim, so in the previous case, if the widget had been worth $600, Charles still would have taken only $400 and no more. On the other hand, the secured creditor also gets priority only to the extent of his lien. So in the previous case, if Charles's (total) claim had been more than the value of his collateral, he would have been paid as a secured creditor to the extent of the collateral value and, as an unsecured creditor, pro rata with other unsecured creditors, for the remainder.

Example: Same as above, except that the portion of the $1,440 that derives from the widget sale is only $100. Ted pays $100 to Charles, discharging his secured claim, but it leaves Charles with an unsecured (deficiency) claim of $300. The total of (unsecured) claims is now $2,300 (1,200 + 800 + 300). The total assets available for distribution is $1,340. Ted has enough to pay 58.26 percent of unsecured claims (1,340/2,300, rounded), so Ted pays $699.13 to Rosa, $466.09 to Dana and $174.78 to Charles. Note that since Charles got $100 on his secured claim, as well as $174.78 on his unsecured claim, he winds up with some 68.7 percent of his total claim while the others get less.

Next, note the effect of pro rata distribution on non-bankruptcy law. We often say that bankruptcy is merely a procedural framework of state law rights. This assertion may be useful as an oversimplification, but it is no more than that. The discharge certainly does not just reflect a state law right and neither does pro rata distribution.

Finally, note that while we have done pro rata distribution for a thousand years, no one has ever (at least not until recently) offered a compelling explanation for it. We speak vaguely of equity and fairness without specifying just what is unfair about letting the race go to the swift, as it would without bankruptcy intervention. But here are two possible explanations.

One has passed into bankruptcy folklore as what you might call the Mad, Mad, Mad, Mad World explanation, after the comic chase movie where Sid Caesar and a whole bunch of other guys run themselves silly in search of hidden money. How much cheaper it would have been if they had simply pooled their resources and run a single search instead of half a dozen. Insofar as it implements pro rata distribution, the Bankruptcy Code makes a sharp departure from state law.

The other is perhaps more subtle and elegant. It comes from Prof. Thomas Jackson,⁴ who makes the case for bankruptcy as a kind of insurance. Suppose there was an "equal" race in which every creditor knows that it would win once out of every 10 times. On standard principles of risk reduction, Prof. Jackson argues, each creditor would gladly give up the chance for 100 percent of the pot 10 percent of the time in favor of10 percent of the pot every time. Prof. Jackson's example has been hugely influential among professors who write about bankruptcy, although it has had no obvious impact on the practice of law.

§ 13.3 ~ Bankruptcy as a Class Action

For the experienced litigator, one way to approach bankruptcy is to think of it as a kind of class action. Class action law aggregates similar claims to save waste, duplication and expense to the parties and to the court. Modern class action law is largely a child of the 1960s, but special pleaders for bankruptcy could rightly say that we have been doing it here for much longer.

This is most evident in the troubled history of the mass tort claims that arose out of asbestos exposure and, in particular, the case of Manville Corporation. Manville went through a huge and much-publicized chapter 11 in the bankruptcy court in Manhattan in the 1980s in which the participants attempted to reach closure on the tort claims. The deal unraveled almost from the start. District Judge Weinstein in Brooklyn asserted jurisdiction over the wreckage and virtually imposed a no-opt-out class action on all parties.⁵ Then the Second Circuit struck down the Weinstein settlement.⁶

The Second Circuit's decision rests in part on the inferiority of the Weinstein Rule 23 process as distinct from the bankruptcy process. For example, a chapter 11 reorganization may be approved only after approval by a favorable vote of impaired classes. The Weinstein Rule 23 process contained no such protection. As another example, any creditor may defeat a chapter 11 plan if he can show that he would get less under the plan than he would in liquidation. There was no such protection in the Weinstein Rule 23 class. The court was also troubled by the abrogation of first-in, first-out, which is more intriguing because one consequence of the typical asset bankruptcy case is that it supplants traditional state law (first-in, first-out scheme) in favor of a pro rata bankruptcy distribution.

§ 13.4 ~ Class Actions in Bankruptcy

A separate question is whether you can file a class claim in a bankruptcy case, essentially commencing a class action within the bankruptcy case. Bankruptcy Rule 7023 adopts the federal class action rule, but the rule is invalid without statutory support, and the Code itself is at least inexplicit on the subject. Section 501 specifies a number of "representatives" who may file claims, but the class representative is not on the list. Making a negative inference from silence, some courts have held that the claim is not authorized.⁷ Others have taken the negative inference in the other direction, holding that class actions should not be barred without clear expression of congressional intent.⁸

§ 13.5 ~ What's a Claim?

Section 726 directs the trustee to pay claims. Section 101(5)(A) says that "claim" means "a right to payment," whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmeasured, disputed, undisputed, legal, equitable, secured, or unsecured.⁹

The first thing to notice about the definition is that it is broad. Consider these three cases:

Daniel, Donald and Della were driving vehicles that injured (respectively) Peter, Paula, and Pam. Daniel, Donald, and Della each filed for bankruptcy relief. At the time of filing:

- Peter held a final nonappealable judgment against Daniel for $100,000.
- Paula had filed suit against Donald for an unspecified amount of damages. Donald has filed an answer in which he denies liability, but the case has not yet come to trial.
- Pam had just realized that she was injured. It had not yet occurred to her that Della might be liable or that she might have a cause of action against her.

Which of these, if any, holds a claim against the respective bankruptcy estates? The answer is that each has a claim. There may be problems valuing the claims held by Paula and Pam,¹⁰ but there is no doubt that the drafters meant to sweep them all in with the expansive language quoted above.

Similarly, consider the case of Harold, the holder of a zero-coupon bond issued by DebtorCo in the amount of $1,000, payable 10 years from today. DebtorCo files for bankruptcy today. Does Harold hold a claim? The answer is yes. His claim may not be matured, and there may be a corresponding problem of valuation, but the fundamental status is beyond doubt.

§ 13.6 ~ Claim vs. interest

If you are a stockholder rather than a creditor, you do not have a claim, but you do have an "interest." The term is not formally defined in the Code, but you can tease out the meaning pretty clearly. For example, § 1126 provides that a plan must be accepted by a majority in number, and two-thirds in amount of voting claims. It goes on to say that it must be accepted by two-thirds in amount¹¹ of "interests," meaning equity securities.

Occasionally, one comes across an instrument that looks something like equity and something like debt, including various sorts of instruments that are labeled as preferred stock but have debt-like features. As corporate finance practitioners become increasingly creative, we may see more of this. It is also possible for a...