Zachary v California Bank & Trust

Ninth Circuit Adopts Narrow Exception to Absolute Priority Rule

The U.S. Court of Appeals for the Ninth Circuit recently held that the Bankruptcy Abuse and Consumer Protection Act (BAPCPA) did not repeal the absolute priority rule as applied to individual Chapter 11 debtors. BAPCPA created an exception to the rule for individual debtors, but the exception extends only to property acquired after the commencement of the case. Consequently, debtors who want to keep prepetition property without creditor consent must pay unsecured creditors in full or “buy” the property back by providing new value to the estate for distribution to creditors.

In Zachary v. California Bank & Trust, No. 13-16402, 2016 U.S. App. LEXIS 1368 (9th Cir. Jan. 28, 2016), the debtors filed an individual bankruptcy case under Chapter 11 and placed their largest unsecured creditor, a bank, into its own class. The bank’s claim against the debtors was nearly $2 million but the debtors proposed to pay the bank only $5,000. The bank objected to confirmation of the debtors’ plan, arguing that the plan violated the absolute priority rule, which bars debtors from retaining any interest in estate property when a dissenting unsecured creditor has not been paid in full.

The bankruptcy court sustained the bank’s objection, disagreeing with an earlier decision by the Bankruptcy Appellate Panel in In re Friedman, 466 B.R. 471 (B.A.P. 9th Cir. 2012), that Congress intended abrogation of the absolute priority rule by the BAPCPA amendments to the Bankruptcy Code in 2005.

“Fair and Equitable” Treatment

Absent unanimous plan approval by creditors, a plan of reorganization filed under Chapter 11 may not be confirmed unless it treats each creditor class fairly and equitably. This means that if a creditor objects to confirmation of the debtor’s proposed plan, the bankruptcy court may confirm, or cram down, the plan over the creditor’s objection, only if the plan treats the objecting creditor fairly and equitably. An inherent requirement of fair and equitable treatment is the absolute priority rule.

The rule is codified in Sec. 1129(b)(2)(B)(ii) and provides that the debtor may not retain any property unless dissenting creditors are paid in full. Otherwise, the plan is not fair and equitable as to the dissenting creditors. Prior to BAPCPA, every dissenting unsecured creditor would have to be paid in full before the debtor would be allowed to retain any estate property. This is still required in non-individual cases. However, the extent to which the rule still applies in individual Chapter 11 cases is subject to disagreement.

BAPCPA Amendments

Sections 541, 1115, and 1129 implement the absolute priority rule post BAPCPA. Section 541, which was not altered by BAPCPA, provides that the bankruptcy estate is comprised of property belonging to the debtor as of the commencement of the case. Section 1115 was added by BAPCPA and provides that, in addition to the property specified in Sec. 541, property of the bankruptcy estate includes the debtor’s post-petition earnings and after-acquired property. Section 1115 applies only to individual debtors.

Finally, as amended by BAPCPA, Sec. 1129 provides that an individual debtor “may retain property included in the estate under Sec. 1115,” even in a cramdown. This is the exception to the absolute priority rule for individual debtors created by BAPCPA. Because Sec. 1115 has an internal reference to Sec. 541, a split has developed among bankruptcy courts concerning the scope of the exception. Does the exception apply to all of the debtor’s property or is it limited to property acquired by the debtor post-petition?

Competing Views

A minority of courts, including the Friedman court, interpret Sec. 1115 as adding property to the debtor’s estate that is in addition to the property listed in Sec. 541, thereby encompassing all property of the bankruptcy estate, not only property acquired post-petition. Accordingly, the absolute priority rule is entirely abrogated in individual debtor cases, a result the minority see as intended by Congress, or at least intent could be implied given the language used in Sec. 1115.

The Fourth, Fifth, Sixth, and Tenth Circuit Courts of Appeals and a majority of bankruptcy courts have adopted a narrower interpretation, holding that, although the exception to the absolute priority rule includes a cross-reference to Sec. 1115, which in turn references Sec. 541, the BAPCPA amendments only except from the absolute priority rule the debtor’s post-petition earnings and after-acquired property. The absolute priority rule is preserved as to the debtor’s prepetition property.

The Ninth Circuit joined the consensus of circuit courts and adopted the majority interpretation. According to the court, the BAPCPA amendments define a new class of property—post-petition earnings and after-acquired property—that is exempt from the absolute priority rule. The amendments do not exclude all property of the bankruptcy estate from the rule’s application. The court was reluctant to adopt the broader minority approach absent clear Congressional intent. It acknowledged the “double whammy” of the narrow approach: a debtor who is prevented by Chapter 13 debt limits from filing under that chapter must dedicate at least five years’ disposable income to the payment of unsecured creditors and cannot retain any prepetition property unless those creditors are paid in full. However, the court noted, if Congress wanted to abrogate the absolute priority rule for individual debtors, it could have done so “in a far more straightforward manner” than adding a cross-reference to Sec. 541 in Sec. 1115.

About the Author:

George Basharis, JD

George Basharis, J.D. is a practicing bankruptcy attorney in the Northern District of Illinois. He has represented dozens of individuals and small businesses in federal bankruptcy proceedings and related matters. George also advises the CINgroup on a variety of aspects regarding bankruptcy law. He has authored books, white papers, customer newsletters and conducted speaking engagements regarding bankruptcy.