Individuals in Chapter 11: Trapped in Debt?

The absolute priority rule in Individual Chapter 11 cases may make reorganization impossible for high income debtors.

Last month the Fourth Circuit Court of Appeals dealt a blow to the drive by consumer bankruptcy lawyers to eliminate the absolute priority rule in individual Chapter 11 bankruptcies. The absolute priority rule is simple: if a class of unsecured creditors in Chapter 11 votes to reject a debtor’s plan of reorganization that debtor has two choices: pay the creditors in full or give up non-exempt property.

In 2005 Congress drafted the creditor-friendly BAPCPA law that raised the bar for debtors to find relief in bankruptcy. BAPCPA made clear under new Section 1115 that in addition to the normal property of the estate, the income received by Chapter 11 individuals post-bankruptcy was also estate property. Moreover, BAPCPA changed the absolute priority rule to make clear that an individual Chapter 11 debtor “may retain property included in the estate under Section 1115”.

Many bankruptcy lawyers (and bankruptcy courts) took a broad view of this change. They argued that the new section dealing with the absolute priority rule and post-bankruptcy earnings didn’t say the individual debtor could retain “post-bankruptcy earnings” it said the debtor could retain “property included under Section 1115.” These bankruptcy lawyers reasoned that because Congress referred to the statute, and not the kind of property, the absolute priority rule didn’t prevent an individual debtor from keeping all of the property he brought into bankruptcy. Many courts and even an appellate panel in the Ninth Circuit agreed.

To their dismay, and the dismay of Chapter 11 individuals in Maryland, West Virginia, Virginia, North Carolina and South Carolina, the Fourth Circuit Court of Appeals took a narrow view and ruled that the absolute priority rule in its pre-BAPCPA form survived. As a result, if a debtor wants to retain any non-exempt property in Chapter 11 he must in effect agree to pay all creditors in full or otherwise obtain creditors’ consent.

Is this a debtor’s only choice? Not necessarily. For decades in corporate reorganizations courts have recognized a corollary to the absolute priority rule called the “new value exception”. Under the new value exception, if Chapter 11 stockholders contributed “money or money’s worth” that creditors could not otherwise reach the stockholders could keep their stock, even though unsecured creditors received less than full payment in a Chapter 11 plan. The new value exception is particularly well suited for corporate- style reorganizations where stockholders may contribute their own assets to the Chapter 11 company in order to in effect buy back their stock.

In individual Chapter 11 cases however, application of the new value exception is much more difficult. Where is the individual debtor to obtain this new value for the benefit of creditors? If the debtor borrows this money then he’s merely adding to his debt burden, contrary to bankruptcy’s fresh start philosophy. Similarly, requiring debtors to contribute exempt property to their reorganization would defeat a fundamental benefit afforded by the exemption statutes. Exemptions are available in every state and under federal law to ensure that debtors are not completely destitute when they emerge from bankruptcy.

Perhaps the bankruptcy lawyers fighting the application of the absolute priority rule have missed the mark. Perhaps it is the new value exception that needs to be changed. Under present law a promise of future payments – so-called “sweat equity” – is not a permitted form of new value according to the United States Supreme Court in the case of Norwest Bank Worthington v. Ahlers. Perhaps it is this case that Congress sought to overrule. After all, Congress has stated that an individual debtor may keep his post-bankruptcy earnings, now considered to be property of the bankruptcy estate, without violating the absolute priority rule. The time appears ripe to argue that contributing these earnings, the post-BAPCPA “sweat equity”, will restore some balance between debtors and their creditors and allow meaningful relief to individuals under Chapter 11 of the Bankruptcy Code.

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