In re Maharaj, 681 F.3d 558 (4th Cir. 2012)

CASE SNAPSHOT

The Court of Appeals for the Fourth Circuit is the first court of appeals to determine whether the absolute priority rule continues to apply to individual chapter 11 debtors. Taking the "narrow view" adopted by certain courts, the Fourth Circuit held that the rule was not abrogated by the amendments of the Bankruptcy Abuse Prevention and Consumer Protection Act, and therefore affirmed the bankruptcy court’s order denying confirmation of the proposed plan.

FACTUAL BACKGROUND

The individual debtors owned and operated an auto body repair shop. As the victims of fraud, the debtors were saddled with considerable debts that exceeded the statutory limits for a chapter 13 filing. Accordingly, the debtors filed a chapter 11 petition and continued to operate their business as debtors in possession. The proposed plan of reorganization involved four creditor classes, only one of which—consisting of most general unsecured claims (Class III)—would be impaired. The plan provided that the debtors would continue to operate the business and use income from the business to pay the Class III creditors. The holder of Class I and IV claims—a bank with secured (Class I) and unsecured (Class IV) claims—voted to approve the plan. A secured auto lender (the lone Class II creditor) did not vote. Only one Class III creditor returned a ballot—and voted against the plan under which it would receive 1.7 cents on the dollar over a period of five years.

The debtors sought to have the bankruptcy court cram down and approve the plan. If the absolute priority rule were to apply, the Class III dissenting creditor must be paid in full in order for the plan to be crammed down because the debtors retained property under their proposed plan. Debtors argued that the absolute priority rule did not apply to individual chapter 11 debtors, and that if the rule did apply, the debtors would be forced to liquidate their business, would lack a source of income, and would be unable to make payments to creditors. The bankruptcy court held that the absolute priority rule continues to apply to individual chapter 11 debtors, and denied plan confirmation. The debtors appealed, and the bankruptcy court, on its own motion, certified its order for direct appeal to the Court of Appeals, because the judgment involved a question of law as to which there was no controlling decision; a panel of the Fourth Circuit Court of Appeals authorized the direct appeal.

COURT ANALYSIS

The court’s opinion began with a review of the judicial and statutory application of the absolute priority rule, noting that in the Bankruptcy Reform Act of 1978, Congress specifically incorporated the rule into section 1129(b)(2)(B)(ii) (this subsection allows the cram down of a plan that is "fair and equitable"). In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), amending section 1129(b)(2)(B)(ii) to read: "the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest in any property, except 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 requirements of subsection (a)(14) of this section." (Emphasis added.) Section 1115, which was added by BAPCPA, provides: "(a) In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541 – (1) 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…."

A "significant split of authorities has developed nationally among the bankruptcy courts regarding the effect of the BAPCPA amendments on the absolute priority rule when the chapter 11 debtor is an individual." As this court described it, some courts—including the bankruptcy courts for the Middle District of Florida, the Northern District of Indiana, the District of Kansas, the District of Nebraska, the District of Nevada, and the Bankruptcy Appellate Panel for the Ninth Circuit—have adopted the "broad view" that the BAPCPA effectively abrogated the absolute priority rule when the chapter 11 debtor is an individual. Some of the "broad view" courts rest their decision on the "plain" language of section 1129(b)(2)(B)(ii), holding that by including in that section a cross-reference to section 1115, which in turn references section 541 (the provision that defines the property of a bankruptcy estate), "Congress intended to include the entirety of the bankruptcy estate as property that the individual debtor may retain, thus effectively abrogating the absolute priority rule in chapter 11 for individual debtors." Other "broad view" courts determined that "reading the amendments to section 1129(b)(2)(B)(ii) as eliminating the absolute priority rule for individual debtor would be consistent with the perceived Congressional intent to harmonize the treatment of the individual debtor under Chapter 11 with those under Chapter 13, which has no absolute priority rule."

Still other courts—including the bankruptcy courts for the Central and Northern Districts of California, the Middle District of Florida, the Southern District of Georgia, the District of Idaho, the Northern District of Illinois, the District of Massachusetts, the District of Oregon, the Eastern District of Tennessee, the Southern District of Texas, and the Eastern and Western Districts of Virginia—however, have adopted a "narrow view," holding that the BAPCPA amendments "merely have the effect of allowing individual chapter 11 debtors to retain property and earnings acquired after the commencement of the case that would otherwise be excluded under section 541(a)(6) & (7)."

The Fourth Circuit noted that some courts reached their conclusions based on what they viewed was unambiguous statutory language (both broad and narrow views), while other courts determined that the language was ambiguous, and after examining Congressional intent, concluded that Congress did intend to abrogate the rule (broad view courts), or Congress did not intend to abrogate the rule (narrow view courts).

The Maharaj court determined that the statutory language was "ambiguous because it is susceptible to more than one reasonable interpretation." The court then looked "to the specific and broader context within which Congress enacted the BAPCPA, as well as a familiar canon of statutory construction, the presumption against implied repeal," and concluded that Congress did not intend to abrogate the absolute priority rule. "We arrive at the conclusion that Congress did not intend to alter longstanding bankruptcy practice by effecting an implied repeal of the absolute priority rule for individual debtors proceeding under Chapter 11."

The court was persuaded to adopt the narrow view primarily because: (i) if Congress had intended to abrogate the long-standing application of the absolute priority rule to chapter 11 individual debtors, it would have done so in a straightforward manner, such as by adding the words "except with respect to individuals" at the beginning of section 1129(b)(2)(B)(ii), or by simply increasing the debt limits for chapter 13 filings; (ii) there is no evidence that Congress intended to harmonize the treatment of chapter 11 individual debtors with the treatment of chapter 13 debtors; and, (iii) Congress intended that the BAPCPA amendments would improve bankruptcy law and practice by restoring personal responsibility in the system and ensuring that the system is fair for both debtors and creditors.

The court therefore affirmed the bankruptcy court’s denial of plan confirmation.

PRACTICAL CONSIDERATIONS

As the first Court of Appeals to decide this issue, one can expect the Maharaj opinion to carry great weight, particularly in "narrow view" jurisdictions. This court took substantial care to examine both sides of the issue, as well as the history of the absolute priority rule. The court certainly charted a clear roadmap for other courts to use—or disagree with—in future cases.