The Ninth Circuit makes life much more difficult for individual Chapter 11 debtors

Debtors considering a personal bankruptcy under Chapter 11 previously had an edge in California that gave some added leverage against classes of creditors. A Ninth Circuit decision last year, however, eliminated that edge.

Overview of the Bankruptcy Chapters

As most lawyers and many lay people know, there are several types of bankruptcy cases – Chapter 7 (liquidation), Chapter 11 (reorganization) and Chapter 13 (wage earner reorganization) being the most common. In a Chapter 7 case, the debtor surrenders all non-exempt property to a trustee, who liquidates it for the benefit of the debtor’s creditors. In most cases, the debtor is then given a discharge of all liabilities, other than those non-dischargeable by statute. Chapter 13 is for individual debtors who wish to retain their property by paying some or all of their debts over a three or five year period. Chapter 13 debtors must submit a plan for approval by the Court and successfully complete the plan to get a discharge. There are statutory debt limits, however, in a Chapter 13 case. Generally, businesses and individuals with significant assets and liabilities are forced to seek refuge in Chapter 11, where they may reorganize but are forced to confirm a plan of reorganization to do so.

Chapter 11 and the “Absolute Priority Rule”

As part of any Chapter 11 case, creditors are segregated into “classes” according to the nature of debt they hold. Unsecured creditors with similar types of claims are put into the same class. A debtor proposes a plan of reorganization, stating how each class will be treated and then the creditors get to vote on the Plan. If a class of unsecured creditors objects to how their claims are treated in the Plan (a dissenting class), then the Court will only confirm the plan if either:

“a. The dissenting creditors will be paid in full through the plan, pursuant to §1129(b)(2)(B)(i), or
b. No one with a claim or interest that is junior to the claims of the dissenting creditor will get or retain anything under the plan, pursuant to § 1129(b)(2)(B)(ii).”

This is what is known as the Absolute Priority Rule, as it requires that a dissenting class of unsecured creditors must be paid in full before the debtor can retain any pre-petition property under a plan of reorganization.

In Re Zachary ends the California Chapter 11 “Cram Down” plan

Until January 2016, individuals who filed a Chapter 11 petition in California could confirm a plan of reorganization over the objections of a dissenting class of creditors through what was referred to as a “Cram Down” plan, without relinquishing control of their property. Unlike bankruptcy courts in other states, California courts held that the “Absolute Priority Rule” in Chapter 11 bankruptcies only applied to businesses, not to individuals.

On January 28, 2016, the Ninth Circuit reversed that position and held that the Absolute Priority Rule applies in all Chapter 11 cases, even if the debtor is an individual. In re Zachary, 811 F.3d 1191 (9th Cir. 2016).

Through the Zachary decision, the Ninth Circuit took up the question: What property may an individual debtor retain and not pay to creditors, without running afoul of the Absolute Priority Rule? The answer is: Only post-petition property that was acquired by the debtor after his or her bankruptcy petition was filed.

Summary of In Re Zachary

In Zachary, the husband and wife debtors filed a plan of reorganization by which they would retain ownership of the husband’s business, their personal residence, and a second home on Lake Tahoe that they rented out. Debtors David K. Zachary and his wife Annmarie S. Snorsky filed their petition in 2011. The appellee California Bank & Trust was the largest unsecured creditor with a claim of nearly $2 million.

Under the proposed Chapter 11 plan, California Bank & Trust would only be paid $5,000 on its $2 million claim, which would make it “impaired under the plan.” California Bank & Trust objected to the plan, arguing that the plan violated the Absolute Priority Rule under Section 1129(b)(2)(B)(ii).

The bankruptcy court agreed, concluding that the “‘Absolute Priority Rule still prevails’ in individual Chapter 11 bankruptcies after the enactment of BAPCPA.” The debtor appealed directly to the Ninth Circuit.

Prior to this Ninth Circuit decision, four other circuits weighed in on the issue and all agreed that BAPCPA did not repeal the Absolute Priority Rule as to individual Chapter 11 debtors. However, in the Ninth Circuit, the Court of Appeals had not ruled on the issue, although a Bankruptcy Appellate Panel decision had held the Absolute Priority Rule did not apply to individuals. In re Friedman, 466 B.R. 471 (B.A.P. 9th Cir. 2012). In Zachary, the Ninth Circuit expressly overruled Friedman.

The Absolute Priority Rule after Zachary

The Absolute Priority Rule means that if a Cram Down is triggered by a class of creditors objecting, then if that class is not paid in full by the Plan, any lower priority class gets nothing. The lowest priority class is equity, i.e., the stockholders. In practical terms this means that in a Cram Down, the owners will see their ownership become worthless. The only way for an owner of the old stock to have an ownership interest in the new company in a Cram Down is to contribute “new value” ― i.e., money ― to the reorganized company. Then the new ownership interest is equal to the new value added.

If every class votes in favor of the Plan, or the dissenting creditors get paid in full, there is no Cram Down, and the Absolute Priority Rule does not come into play. However, because equity is at the bottom of the barrel on the priority scale, it is usually wiped out.

The Zachary court noted that the debtors’ interpretation of the BAPCPA amendments would require the Court to find an implied repeal of an over 100-year-old rule. The Court rejected that approach, referring to numerous decisions which have held that Congress would not repeal a statute “in the most oblique way possible, and yet omit any mention of this remedy from the legislative history.”

The Debtors also contended that fairness and equity weighed in favor of finding repeal. The Court stated “our task is not to balance the equities, however, but to interpret the Bankruptcy Code.”

In Zachary, the Court held:

“This case presents an arcane but important question of first impression in this Circuit: Does the Absolute Priority Rule continue to apply in individual Chapter 11 reorganizations after the amendments to the Bankruptcy Code enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”)? We hold that it does.”

Zachary considered existing case law against the Absolute Priority Rule. Some bankruptcy courts have taken the position that, when the Bankruptcy Code was amended in 2005 to include the new § 1115, it created an exception to the Absolute Priority Rule for individual Chapter 11 debtors. These courts reasoned based on 11 U.S.C. § 1129(b)(2)(B)(ii), which provides (with emphasis added):

“[T]he 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 . . .”

The courts then considered § 1115:

“(a) 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.
(b) Except as provided in section 1104 or a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate.”

These courts thus concluded that it was natural to draw from these provisions that there is no Absolute Priority Rule in an individual Chapter 11. This has been the conclusion of several bankruptcy courts. See, e.g., In re Tegeder, 369 B.R. 477 (Bankr. D. Neb. 2007).

Zachary, however, found the reasoning more persuasive in the decisions in favor of the Absolute Priority Rule in a personal Chapter 11. See, e.g., In re Gbadebo, 431 B.R. 222 (Bankr. N.D. Cal. 2010).

Specifically, the Ninth Circuit said that it agreed with the Sixth Circuit in Ice House Am., LLC v. Cardin, 751 F.3d 734 (6th Cir. 2014), that § 1115 and the new clauses in § 1129(b)(2)(2)(B)(ii) that were added by BAPCPA define a new class of property that is exempt from the Absolute Priority Rule.

The Ninth Circuit said that the history of the Absolute Priority Rule strongly supports the “narrow view,” noting that Congress repealed the rule in 1952, only to reinstate it in 1978. According to the appeals court, when Congress intends to abrogate a rule, it knows how to do so explicitly.

The BAPCPA amendments don’t “impliedly repeal the long-standing Absolute Priority Rule,” the Ninth Circuit concluded, affirming the bankruptcy court’s judgment. For better or worse, the Ninth Circuit Court of Appeals has now spoken.

Conclusion

What it means is that the individual Chapter 11 debtor needs to reevaluate the prepackaged bankruptcy so that the creditors will get on board before the bankruptcy case is filed. In most instances, this will be a heavy lift.