For the past several years, creditors in the Ninth Circuit were confounded by an interpretation of the bankruptcy code that permitted individual chapter 11 debtors to retain a significant portion of their assets without creditor consent. The problem was particularly vexing in the context of high net worth individuals, some of whom held multiple ownership interests in entities that held valuable assets or generated significant income. That loophole was finally closed on January 28, 2016 when the Ninth Circuit Court of Appeals determined that the “absolute priority rule” applies in individual as well as corporate bankruptcy cases. Zachary v. California Bank & Trust (In re Zachary), 2016 U.S. App. LEXIS 1368.
The absolute priority rule, long applicable to corporate cases, generally provides that unless unsecured creditors are paid in full, no junior class may receive or retain any property under a plan of reorganization. The rule is a powerful tool for unsecured creditors that can both enhance their bargaining power regarding a plan, and help prevent a plan from being confirmed over their objection in a process commonly known as “cramdown.”
In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer protection Act, commonly known as “BAPCPA.” Various provisions of the BAPCPA combined to raise questions about whether the absolute priority rule applies to bankruptcy cases of individuals. Over time, courts in most jurisdictions ruled that it did. Not so in the Ninth Circuit. To begin with, bankruptcy courts in the Ninth Circuit issued contradictory rulings. Some ruled that the absolute priority rule applied to individuals, and other ruled that it did not. Obviously, these contradictory rulings created confusion and uncertainty regarding the rule and the administration of individual cases. In 2012, the Ninth Circuit Bankruptcy Appellate Panel stepped in. In Freidman v. P+P, LLC (In re Friedman), 466 B.R. 471 (9th Cir BAP 2012), the panel ruled that the absolute priority rule did not apply to individual chapter 11 cases. As a result, individual debtors were able to confirm plans of reorganization over the objections of unsecured creditors, while keeping valuable assets from the reach of creditors.
In Zachary the Ninth Circuit overruled Freidman, joining most other circuits in holding the BAPCPA did not do away with the absolute priority rule in individual chapter 11 cases. As a result, in the face of an objecting class of unsecured creditors, individual debtors in the Ninth Circuit must either pay the unsecured creditors in full, or must not retain any of their non-exempt property. Alternatively, they may avoid selling their property by “buying it back” in the form of providing new value to the bankruptcy estate for distribution to creditors. Either way, unsecured creditors in individual chapter 11 cases now have increased leverage to help achieve a more substantial return on their claims.