(If as many people who showed up to the 9th Circuit for Prop 8 showed up for the absolute priority rule, then the absolute priority rule might finally get the attention that it deserves from the U.S. Supreme Court!)

Yesterday, in Zachary v. California Bank & Trust,  the Ninth Circuit overturned the Ninth Circuit Bankruptcy Appellate Panel’s (BAP’s) prior holding on the absolute priority rule in In re Friedman, 466 B.R. 471 (B.A.P. 9th Cir. 2012). Agreeing with the Fourth, Fifth, Sixth, and Tenth Circuits, the Ninth Circuit held that the absolute priority rule continues to apply in individual Chapter 11 reorganizations, even after the 2005 BAPCPA amendments to the Bankruptcy Code. Our goal with this post is to brief the opinion while it’s still “big news.” We’ll follow-up later with some commentary and an update of our “APR Case Chart.

Factual Background

In Zachary, David Zachary and Annmarie Snorksy filed a voluntary joint individual Chapter 11 petition. Under their proposed plan, their largest unsecured creditor, California Bank & Trust (CBT), was placed in its own class. The debtors proposed to pay CBT $5,000 on its claim of approximately $2,000,000. CBT objected, arguing that the absolute priority rule prevented confirmation of the debtors’ plan. Notwithstanding Friedman (a 2012 “broad view” BAP case), the bankruptcy court sustained the objection. The debtors then sought and obtained a direct appeal to the Ninth Circuit.

The Absolute Priority Rule after BAPCPA

The Ninth Circuit begins by reviewing the two options available to all debtors, including individuals, to confirm a plan under Chapter 11. A debtor may confirm a plan by complying with each of the sixteen subparagraphs in 11 U.S.C. § 1129(a), including obtaining the consent of each class of creditors under § 1129(a)(8). Failing that, the debtor must obtain confirmation of the plan by “cramming down” the plan on dissenting creditors under 11 U.S.C. § 1129(b). A bankruptcy court may only confirm the plan under, among other requirements, the “cramdown provisions of § 1129(b) if the debtor complies with the “absolute priority rule” codified at § 1129(b)(2)(C)(ii).

As we’ve discussed previously, the absolute priority rule is a judicially-created doctrine that was codified in 1978. In essence, the rule “provides that a dissenting class of unsecured creditors must be provided for in full before any junior class can receive or retain any property under a reorganization plan.” Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988). The purpose of the absolute priority rule is to prevent deals between senior creditors and equity holders that would impose unfair terms on unsecured creditors. Thus, the absolute priority rule serves to enforce the priority of distributions mandated by the Bankruptcy Code.

However, Congress amended the Bankruptcy Code in 2005 with the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). BAPCPA made two changes relevant to the absolute priority rule.

First, Congress added § 1115. It provides that, in individual cases, “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, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first; and

(2) earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first.

Second, Congress amended the absolute priority rule itself. The pre-BAPCPA and post-BAPCPA versions of the APR are as follows:

Pre-BAPCPA

[T]he condition that a plan be fair and equitable with respect to a class includes the following requirements:

(B) With respect to a class of unsecured claims—

(i)             The plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or

(ii)           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 such junior claim or interest any property.

Post-BAPCPA

[T]he condition that a plan be fair and equitable with respect to a class includes the following requirements:

(B) With respect to a class of unsecured claims—

(i)             The plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or

(ii)           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 such junior claim or interest 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.

Narrow versus Broad View

At the risk of being overly simplistic, the split among the courts about these changes is whether an individual debtor can confirm a plan under the cramdown provisions of § 1129(b)(2)(B)(ii) while retaining (A) any portion (or all) of property of the estate that other sections of the Code will allow or (B) only the property and earnings acquired after the commencement of the case that are only property of the estate due to § 1115. In turn, there are two views: the “broad” view and the “narrow” view.

The broad view reads the word “includes” [in the newly-added § 1115(a)] and the word “included” [in the phrase, “property of the estate included under section 1115” in the amended § 1129(b)(2)(B)(ii)] together. Reading “included” broadly, the broad view concludes that a debtor’s pre- and post-petition income and property are “included” in the estate by virtue of § 1115. Therefore, all such property is excepted from the absolute priority rule, such that the rule does not apply in individual Chapter 11 cases.

Like the broad view, the narrow view reads the word “includes” and the word “included” together. However, it reads “includes” narrowly, concluding that a debtor’s post-petition income and property are the only types of property “included” in the estate by virtue of § 1115. Thus, under the narrow view, the absolute priority rule still applies to pre-petition (but not post-petition) assets in individual Chapter 11 cases.

Ninth Circuit Rejects In re Friedman

The Ninth Circuit starts by dismissing the broad view in a cursory fashion. It then turns its focus to the narrow view. Consistent with the narrow view, the Court characterizes the 2005 amendments as merely allowing the debtor to exclude from the absolute priority rule its post-petition property and earnings that would otherwise be included under § 1115.

It gets there by focusing on the word “included” in the phrase “the debtor may retain property included in the estate under section 1115.” Relying on the Sixth Circuit’s opinion in Ice House Am., LLC v. Cardin, 751 F.3d 734, 736 (6th Cir. 2014), the panel agrees that the word “included” better fits as applying to “property that § 1115 takes into the estate” rather than “property that § 1115 contains in the estate.” Thus, the Ninth Circuit concludes that the word “included” only encompasses the post-petition property and earning pulled into the estate by operation of § 1115, and not the property of the estate under § 541 (which Code section is referenced in § 1115).

By excluding the property already in the estate by operation of § 541, the Ninth Circuit found itself espousing the narrow view of the absolute priority rule (and, thus, rejecting Friedman). Like other narrow view courts, the Ninth Circuit also cites the legislative history of the absolute priority rule. And like those other courts, the Ninth Circuit is hesitant to endorse the broad view due to the lack of discussion in the legislative record of any implied repeal of the absolute priority rule. In other words, if Congress wanted to repeal the absolute priority rule in individual cases, then it should have done so explicitly.

Interestingly, the Ninth Circuit at least acknowledges that retaining the absolute priority rule in individual chapter 11 cases “works a ‘double whammy’ on a debtor” because the debtor must devote at least five years disposable income and cannot retain any pre-petition property if the debtor does not pay the creditors in full.

Conclusion 

By our count (which we are in the process of updating),  the Ninth Circuit’s about face on the absolute priority rule in individual cases (and rejection of In re Friedman) means that the debtor-friendly “broad view” is all but dead in the Circuit and Circuit-esque courts. Further, the remaining broad view cases aren’t getting any younger. Indeed, the “narrow view” is the overwhelming view, even if it’s not binding where we practice.

As Zachary shows, the narrow view can have severe consequences for debtors. In fact, the narrow view makes it extremely difficult, if not impossible, for individual debtors to confirm anything other than a consensual plan. However, the Ninth Circuit also points to the consequences for creditors: if the bankruptcy court had confirmed the plan, then the creditor would have received a mere 0.0025% on its claim–even we must admit that a 0.0025% recovery is difficult to sanction. Nevertheless, the narrow view treats a .0025% recovery in the same way that it treats a 99.9975% recovery.

We aren’t done with Zachary v. California Bank & Trust. We disagree with the narrow view and have more to say. In the meantime, check out our Absolute Priority Rule Case Chart–we’re pretty proud of it and, although we think Zachary is dead wrong, we’re grateful for the opportunity to update the list.

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