Rule Protecting Senior Creditors Reaches Lone Ch. 11s

A weekly news service that publishes case summaries of the most recent important bankruptcy-law decisions, tracks major commercial bankruptcies, and reports on developments in bankruptcy reform in...

By Stephanie Cumings

Aug. 14 — Another court has sided with the majority of other courts and found that the Bankruptcy Code's absolute priority rule does apply to individual Chapter 11 debtors.

Since major changes were made to the Bankruptcy Code in 2005, courts have disagreed about whether the absolute priority rule is still applicable in individual Chapter 11 cases. Most courts, including four circuit courts, have found that it is. Judge Barry S. Schermer agreed with the majority view.

Although it did ultimately find that the absolute priority rule applies to Chapter 11 debtors, the court cast doubt on whether a 1988 Supreme Court case on this issue was rightly decided.

Amendments Upend Law

Individuals, as opposed to businesses, file to reorganize under Chapter 11 when their debts are too high to reorganize under Chapter 13. Chapter 11 debtors generally must adhere to the absolute priority rule, which says that a class of creditors that hasn't accepted the debtor's plan can't be forced to accept less than the full amount of their claim while any junior creditor or equity holder receives any property or retains any interest in the debtor under the plan.

The U.S. Supreme Court held in Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988) that the absolute priority rule does apply to individual Chapter 11 cases, but amendments to the Bankruptcy Code as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 called this ruling into question.

Courts Can't Agree

BAPCPA created an exception to the absolute priority rule for individual Chapter 11 debtors in that they “may retain property included in the estate under [S]ection 1115.” Courts have disagreed about what exactly constitutes “property included in the estate under [S]ection 1115.”

Section 1115 says that the property of an individual Chapter 11 debtor's estate includes not only pre-petition property designated by Section 541, but also certain post-petition property. A majority of courts, including the Fourth, Fifth, Tenth and most recently the Sixth Circuits, have found that the exception in the absolute priority rule only excepts that additional post-petition property that Section 1115 “include[s]” in the estate.

But other courts have held that “property included in the estate under [S]ection 1115” should include all property of an individual Chapter 11 debtor's estate, which would in effect exempt individual Chapter 11 debtors from the absolute priority rule entirely. Among the courts to adopt this approach are bankruptcy courts in Arkansas, Arizona, and the U.S. Bankruptcy Appellate Panel for the Ninth Circuit, according to research conducted by Bloomberg BNA. Courts disagree about the degree of ambiguity in the statutory language, the legislative history of the absolute priority rule, and the intent of Congress in enacting the BAPCPA.

Supreme Court Got it Wrong?

In this case, creditor Heritage Bank argued that the debtor's plan violated the absolute priority rule because it allowed her to keep her interest in Pathology Specialists LLC, where she worked as a pathologist. The Nebraska bankruptcy court sided with the minority approach, but the bankruptcy appellate panel reversed.

Wading into what it called the “murky jurisprudence surrounding the absolute priority rule,” the appellate court first cast doubt on whether Ahlers was correctly decided by the Supreme Court in the first place. Pursuant to Section 1129(b)(2)(B)(ii), the absolute priority rule applies to a “holder of any claim or interest,” and the court suggested that this phrase never should have encompassed individual Chapter 11 debtors.

“We suggest that there is no ‘interest' holder in an individual Chapter 11 case,” the court said. “The concept plainly applies to equity holders in the corporate or partnership Chapter 11 context, for example, but we do not believe that there is an individual Chapter 11 analogue. Ahlers simply assumed, without discussion, that the [d]ebtors were interest holders. [] But how can one hold an interest in oneself? We do not think this is possible.”

Congress's Intent

Nevertheless, constrained by the holding in Ahlers that an individual Chapter 11 debtor can be an interest holder, the appellate court held that “the absolute priority rule still applies in individual Chapter 11 cases to prevent debtors from retaining prepetition property.”

“Contextually, the only property [Section 1115] can take into the estate is postpetition property and income because prepetition property is already part of the estate under [Section] 541,” the court said.

Furthermore, the court said it believed Congress “would have employed clearer language to abrogate the absolute priority rule if it had so intended.” The court noted that “any mention of the absolute priority rule's abrogation is conspicuously absent” from the legislative history of the BAPCPA. The court also relied on the fact that the majority of courts, including four circuit courts, have adopted the “narrow” reading of the absolute priority rule exception that includes only post-petition property.

NACBA Disagrees

The National Association of Consumer Bankruptcy Attorneys (NACBA) filed a brief of this case arguing in favor of the minority view. NACBA is an “organization dedicated to serving the needs of consumer bankruptcy attorneys and protecting the rights of consumer debtors in bankruptcy,” according to its website. NACBA argued that many individual Chapter 11 debtors “who want to reorganize are forced into liquidation because of the application of the absolute priority rule.”

Under the narrow view, NACBA argued, it is “particularly difficult, if not impossible, for a sole proprietor and individual [C]hapter 11 debtor to propose a plan that can be confirmed over the objection of a creditor even if all the debtor’s disposable income is committed to the plan.”

“Congress, by its elaborate amendments to Chapter 11, intended that [the debtor] be able to propose a confirmable plan over the objection of a creditor, as long as she devoted to the plan all of her disposable income for five years and the plan is otherwise fair and equitable,” NACBA said. “Imposing on her the additional requirement that she not retain an interest in the business that pays her salary will make it impossible for her to propose a confirmable plan.”

The American Bankruptcy Institute plans to release an “Individual Chapter 11 Study and Report” with recommendations on this issue as part of its Commission to Study the Reform of Chapter 11.

Judges Arthur B. Federman and Anita L. Shodeen joined Judge Schermer on the three-judge panel.

The creditor in this case was represented by Kent E. Rauert of Svehla Barrows, York, Neb.

The debtor was represented by John C. Hahn of Jeffrey & Hahn, Lincoln, Neb.

To contact the reporter on this story: Stephanie Cumings in Washington at sacree@bna.com

To contact the editor responsible for this story: Jay Horowitz at mailto:%20jhorowitz@bna.com

Full text at: http://www.bloomberglaw.com/public/document/In_re_Suzette_Woodward_Debtor_Heritage_Bank_Creditor_Appellant_v_

NACBA's brief is at: http://www.bloomberglaw.com/public/document/Heritage_Bank_v_Suzette_Woodward_Docket_No_1506001_8th_Cir_Jan_05