While the majority of the cases covered by the Weil Bankruptcy Blog address issues arising in corporate restructurings, cases concerning individual debtors often offer interesting insights into the history and meaning of various provisions of the Bankruptcy Code. In In re Rogers, the United States Bankruptcy Court for the Southern District of Georgia provided a useful history of the absolute priority rule and analyzed its applicability to individual debtors’ chapter 11 cases.

Background

The joint debtors’ principal asset in their chapter 11 case was a 100% ownership interest in a holding company, Wetdog, which in turn owned an historic bed and breakfast in Savannah, Georgia. Wetdog was the debtor in a separate chapter 11 case. The debtors had two main creditors, Belle and SBA, both of whom filed unsecured claims. Under the debtors’ proposed plan of reorganization, all unsecured creditors received pro rata payments for a period of five years, except for Belle and SBA, who the debtors contended were being paid in full in the Wetdog bankruptcy proceeding.

Both Belle and the United States Trustee filed objections to the debtors’ disclosure statement. Belle asserted that the plan proposed by the debtors was “patently unconfirmable” and, therefore, the disclosure statement should not be approved, in part because the plan violated the absolute priority rule. At the conclusion of a preliminary hearing to approve the disclosure statement, the Court requested briefs on, among other things, whether the absolute priority rule still applied, after BAPCPA, to individual chapter 11 cases. The Court ultimately concluded that BAPCPA did not eliminate the absolute priority rule in individual chapter 11 cases, and that the “new value exception” to the absolute priority rule was applicable in individual cases. The Court found that the debtors’ plan, as proposed, violated the absolute priority rule and did not offer “new value” and could not be confirmed as drafted.

Analysis

The absolute priority rule is a requirement for cram-down of a plan on a class of objecting unsecured creditors. Specifically, the absolute priority rule, as applied in the cases of individual chapter 11 debtors, provides that unsecured creditors in a dissenting impaired class must be satisfied in full before the debtor is allowed to retain any property under the plan.

After BAPCPA, some courts questioned whether the absolute priority rule was still applicable in individual chapter 11 cases. As part of BAPCPA, section 1129(b) of the Bankruptcy Code was amended to provide that “in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirement of subsection (a)(14) of [1129].” Section 1115 was added to the Bankruptcy Code as part of the BAPCPA amendments, and expands the definition of “property of the estate” for individual chapter 11 debtors to include “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 . . .”

As the court discussed, a split has developed over the impact of the amendments on the absolute priority rule in individual chapter 11 cases into a so-called “broad” view and a “narrow” view. The “broad” view reads the BAPCPA amendments to provide that a chapter 11 debtor proposing not to pay a rejecting class of unsecured creditors in full may still be allowed to retain non-exempt, prepetition property, as well as postpetition property and earnings, and still satisfy the rule. These courts have concluded that by defining the property that debtors may retain and still cram-down a class of unsecured creditors in the way that BAPCPA did, Congress “intended to abrogate the absolute priority rule in individual chapter 11 cases.” The courts further hold that when section 1129(b)(2)(B)(ii) references property “included” by section 1115 of the Bankruptcy Code, it refers to all property that section 1115 references. These courts also apply a broad reading to section 1115, and generally find that section 1115 includes postpetition property and earnings, in addition to the prepetition property already established by section 541 of the Bankruptcy Code to be property of the estate.

Courts, including a number of Circuit Courts of Appeals, that have adopted the so-called “narrow” view regarding these provisions, have held that the amendments create a limited exception to the absolute priority rule for postpetition property and earnings, but do not contain an exception for additional property or prepetition property. Narrow view courts typically hold that section 1115 adds to, but does not replace, section 541’s definition of estate property for individual debtors. In other words, section 1115 only includes property that was not already included by section 541. Based on the language of section 1129(b)(2)(B)(ii), these courts hold that the absolute priority rule still apply to section 541’s pre-petition property, but exempts post-petition property and earnings covered only by section 1115.

The court concluded that the “narrow view” cases were better reasoned and adopted their holdings. Accordingly, the court found that the absolute priority rule applied in individual chapter 11 cases. Because the debtors’ plan allowed the debtors to retain property of the estate that was not covered by section 1115 of the Bankruptcy Code without paying unsecured creditors in full, the court concluded that the plan violated the absolute priority rule and that it would be appropriate for the court to deny approval of the debtors’ disclosure statement given the court’s conclusion that the debtors had not provided “new value” in satisfaction of the “new value exception” to the absolute priority rule.

Conclusion

Individual debtors should be aware of the interplay between the absolute priority rule and the provisions of the Bankruptcy Code governing property of the estate. Although indvidual debtors can retain prepetition property of the estate if they satisfy the “new value exception,” they should be mindful of the restrictions contained in the absolute priority rule as they formulate their plans.