Rule Protecting Creditors Applies in Individual Ch. 11 Cases

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By Diane Davis

June 29 — A bankruptcy court in the Third Circuit has sided with five circuit courts of appeal and held that the Bankruptcy Code's absolute priority rule applies to individual Chapter 11 debtors ( In re Rogers, 2016 BL 203434, Bankr. S.D. Ga., No. 14-40219-EJC, 6/24/16 ).

Judge Edward J. Coleman, III, of the U.S. Bankruptcy Court for the Southern District of Georgia concluded that the debtors' Chapter 11 plan violated the absolute priority rule because it allows the debtors to retain their non-exempt, prepetition property without paying unsecured creditors in full.

The court entered an order denying approval of the debtors' disclosure statement, but said that the debtors may amend their disclosure statement and Chapter 11 plan to meet the “new value” exception or to satisfy the absolute priority rule.

The court also plans to hold a valuation hearing to allow the parties to submit evidence regarding the value of the debtors' non-exempt property, including the debtors' ownership interest in their limited liability company Wetdog.

Split of Authority

“The absolute priority rule ‘requires that a “dissenting class of unsecured creditors . . . be provided for in full before any junior class can receive or retain any property [under] a plan,'” according to Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 (D. Michael Lynn et al. eds., 2016).

A significant split of authorities has developed following the 2005 enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) regarding the effect of the amendments on the absolute priority rule when the Chapter 11 debtor is an individual. Chapter 11 allows companies (or individuals) to enjoy protections from creditors while they seek to reorganize their debt or liquidate under a plan that must be approved by the bankruptcy court.

According to Bloomberg Law: Bankruptcy Treatise, “Congress qualified the absolute priority rule in section 1129(b)(2)(B)(ii) by adding at the conclusion of the subsection the following words: ‘except that in a case in which the [chapter 11] 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 this section.' Section 1115 of the Code expands the definition of section 541 by providing that in a case in which the debtor is an individual, ‘property of the estate' also includes property and earnings acquired postpetition by the debtor in its chapter 11 case (prior to the conversion of such individual debtor's case to a case under chapter 7, 12, or 13).”

‘Broad' v. ‘Narrow View.'

Under the “narrow” or majority view, which includes the Fourth, Fifth, Sixth, Ninth, and Tenth Circuits, individual Chapter 11 debtors who propose to cram down unsecured creditors may retain only the post-petition property and earnings referred to in Section 1115 and nothing more.

Some “broad view” courts, however, have reasoned that the plain language of Sections 1129(b)(2)(B)(ii) and 1115 eliminates the absolute priority rule as to an individual debtor's entire estate. Thus, the absolute priority rule no longer applies to any property of an individual debtor's estate.

Debtors as Personal Guarantors

Debtors Grant and Allisen Rogers own the company Wetdog, which owns Foley House Inn in Savannah, Ga. The debtors' primary source of income is from their management of the inn.

Wetdog obtained a loan of $1.9 million and granted Sterling Bank a first-in-priority lien on the inn, and the debtors executed a personal guaranty. Wetdog also obtained a loan from the Small Business Administration (SBA) for $1.3 million.

As a result of Wetdog's default, the debtors, as personal guarantors, became liable for the monthly payments. When they weren't able to make the payments, Wetdog's two largest creditors sued in state court to recover the amounts owed.

The debtors then filed a Chapter 13 petition, which allows individuals receiving regular income to obtain debt relief while retaining their property, but the debtor must propose a plan that uses future income to repay all or a portion of his debts over a three to five year period.

Debtors' Proposed Ch. 11 Plan

The debtors later converted their case to one under Chapter 11. Under the debtors' Chapter 11 plan, the debtors proposed to pay unsecured creditors yearly pro rata payments for five years, with the total amount distributed equaling 25 percent of their claims. The secured creditors wouldn't receive any payments because their claims are being paid in full in the related Wetdog case. The debtors also proposed to retain their non-exempt, prepetition property upon confirmation of the plan.

While in Chapter 11, the debtors continued to manage the inn as debtors-in-possession, and valued their principal asset, Wetdog, at $0. The debtors listed Belle (who purchased the loan) as an unsecured creditor with a contingent, unliquidated, and disputed debt of $1.8 million, but Belle filed an unsecured claim for $2 million. The SBA filed an unsecured claim for $1.2 million, and the amount hasn't been disputed by the debtors.

Parties' Arguments

The main creditors objected to the debtors' disclosure statement and plan, arguing that it violated the absolute priority rule, was not “fair and equitable,” failed the best interests test, and lacked good faith.

The U.S. Trustee also objected to the disclosure statement and plan, contending that it violated the absolute priority rule and the debtors improperly valued their ownership interest in Wetdog at $0.

The debtors argued that after BAPCPA, the absolute priority rule no longer applies in individual Chapter 11 cases.

Adopts ‘Narrow View.'

The bankruptcy court concluded that the decisions adopting the “narrow view” are “better reasoned,” and that “if Congress had intended to abrogate the absolute priority rule, it would have done so in a far less convoluted way, particularly in light of the well-established place of the absolute priority rule in bankruptcy jurisprudence.” Thus, the absolute priority rule still applies in individual Chapter 11 cases, the court said.

According to the bankruptcy court, the debtors' plan violated the absolute priority rule because it proposes to allow the debtors to retain property of the estate that isn't included in Section 1115 without paying unsecured creditors in full.

‘New Value Exception.'

Although it is rare for individual Chapter 11 debtors to meet the requirements for the “new value exception,” the court said that the debtors should be given the opportunity to do so. The “new value exception” applies in individual Chapter 11 cases, the court concluded.

“The new value exception ‘permits old equity owners to participate in a plan, without full payment to the dissenting creditors, if they make a new contribution (1) in money or money's worth, (2) that is reasonably equivalent to the value of the new equity interests in the reorganized debtor, and (3) that is necessary for implementation of a feasible reorganization plan,'” according to Bloomberg Law: Bankruptcy Treatise, pt. V, ch. 178 (D. Michael Lynn et al. eds., 2016).

The court said that it would need to determine the value of the non-exempt property that the debtors propose to retain. Once the value of the debtors' non-exempt property is determined, the debtors may file an amended disclosure statement and Chapter 11 plan to meet the “new value exception,” the court said.

James L. Drake, Jr., Savannah, Ga.; Shawna Y. Staton, and James L. Drake, Jr., PC, Savannah, Ga., represented debtors Grant Robert Rogers and Allisen Nicole Rogers.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com

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