Chapter 5 Chapter 11 Cramdown and the Absolute Priority Rule

• Jurisdiction: United States

Chapter 5: Chapter 11 Cramdown and the Absolute Priority Rule

I. Background and Overview

Individuals who file for chapter 11 bankruptcy are faced with the same issues confronting bankrupt business enterprises. While it may be fairly easy to commence a chapter 11 case, confirming a chapter 11 plan of reorganization requires significant thought and planning. There are a number of obstacles to overcome. This section will examine issues that may arise during the course of a debtor's attempt to negotiate acceptance of, and overcome the rejection of, a chapter 11 plan by a class of unsecured creditors. In the representation of an individual debtor, it is important to preemptively strate-gize for the potential rejection of the plan by an unsecured creditor class, because this knowledge will provide the debtor with the tools that can be used to negotiate a plan.

A. The Absolute Priority Rule

The absolute priority rule is a concept that originated out of the rules developed in equity receivership cases through the notion that a plan had to be fair and equitable with respect to its treatment of shareholders and creditors. This concept of fair and equitable treatment is demonstrated in the early railroad reorganization cases and was designed to provide for a fair treatment of unsecured creditors. The often-cited case of Northern Pacific Railway Co. v. Boyd¹⁶⁵ was the earliest Supreme Court case that illustrates the impact of the notion of fair and equitable treatment of unsecured creditors. In Northern Pacific, the Court affirmed the right of an unsecured creditor to pursue a collection remedy against property that had been sold years earlier pursuant to an equitable plan that omitted payment to unsecured creditors but provided payment and rights in a successor railroad to the ownership of the insolvent old railroad. The fact that equity received rights under the plan when unsecured creditors received nothing could not preclude the unsecured creditor from pursuing collection against the "reorganized" entity. This notion that fair and equitable treatment was required became what we refer to today as the "absolute priority rule."

B. The New Value Exception

The "new value exception" is designed, out of equitable principles, to provide circumstances for old equity to reacquire new ownership in the reorganized entity by payment of new consideration for the new equity. The absolute priority rule contained in the Bankruptcy Code at § 1129(b) requires that unless the unsecured creditor class accepts its plan treatment, if it is not paid in full then the junior equity class may not receive or retain any property on account of the plan. The new value exception can provide a means through which old equity can retain ownership in a cramdown situation under § 1129(b).

The Supreme Court indicated that the equity class could retain their interests in the debtor under certain circumstances, but new, substantial, and necessary consideration would have to be paid by equity for the interest. The new value exception was delineated in more detail by the Supreme Court in Case v. Los Angeles Lumber Products Co.¹⁶⁶ In Case, the Court readdressed the paramount position of creditors over the interests of equity in a reorganization under the Bankruptcy Act. The Court clearly held that there are times in reorganization cases where old equity may "make a fresh contribution and receive in return a participation reasonably equivalent to their contribution."¹⁶⁷ With payment of new value being an allowed basis under which equityholders may maintain their ownership in the estate assets or the enterprise, in the individual chapter 11 case the issue remains the same, but the determination of what the individual has to provide to maintain his or her interest remains a question to be determined on a case-by-case basis.

C. The Impact of BAPCPA on the Absolute Priority Rule

The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) provided numerous amendments to the Bankruptcy Code with respect to individuals. Many of the changes have been refined by judicial interpretation since the passage of BAPCPA. One of the changes that became clearer as court decisions developed is whether the absolute priority rule applies to individuals in a chapter 11 case. The early case law analyzing this issue gave rise to a clear split among bankruptcy courts as to whether the absolute priority rule applied to individuals. The split in authority was largely due to the amendments made to Bankruptcy Code §§ 1115 and 1129(b)(2)(B)(ii). These sections permit an individual in a cramdown situation, with respect to unsecured creditors, to retain property included in the bankruptcy estate under § 1115. The question then became, How much property could be retained by the individual in a cramdown?

D. 11 U.S.C. § 1115

The BAPCPA amendments added § 1115 to the Bankruptcy Code. Prior to 2005, § 541(a)(7) provided that post-petition income derived from the personal services of an individual was not property of the estate. The individual could include all or a portion of his or her income to fund a plan or pay creditors, but was were not required to do so. Section 1115 was added to the Code to include within the bankruptcy estate all income derived by the debtor from personal services, as well as all of the property described in § 541 that the debtor acquires after commencement of the case and before the case is closed, dismissed or converted to a case under chapter 7, 12 or 13.

This amendment had tremendous ramifications for the individual debtor. Once all assets including income were included in the estate, creditors could arguably have a say as to how the income was spent. In order to allow the debtor to confirm a plan over the dissenting vote of unsecured creditors, Congress amended § 1129(b) to allow the debtor to retain certain assets included in the estate under § 1115. In essence, § 1115 is a judicial carve-out of the absolute priority rule.

E. 11 U.S.C. § 1129(b)(2)(B)(ii)

The rules for cramming down a plan on unsecured creditors are generally contained in § 1129(b). Before BAPCPA, a chapter 11 plan could generally, with respect to individuals, be confirmed over the rejection of the plan by unsecured creditors if either (1) the plan paid the unsecured creditors in full or (2) the plan provided that there was no class junior to the unsecured creditor class that would "receive or retain under the plan on account of such junior claim or interest any property." Payment in full was never a very popular option in chapter...