Exempt Property and the Absolute Priority Rule in Individual Chapter 11s

Journal Issue

Nov 2002

Column Name

Journal HTML Content

With the recent influx of mega-bankruptcies with allegations of fraud on behalf of
officers and directors, an increase in large individual chapter 11 bankruptcies will
surely follow. Indeed, officers and directors of some of the largest corporate
bankruptcies have incurred massive liabilities, while also amassing great wealth and
assets. In addition, some of these wealthy individuals have established residence in
states, such as Florida and Texas, with generous homestead exemptions.

Due to the wealth and sophistication of some of these individuals, many will opt
for chapter 11 bankruptcy, as opposed to chapter 7, in an attempt to control and
maintain their assets while attempting to discharge liabilities. As plans are filed,
issues will certainly arise regarding the ability to retain property, particularly exempt
property, when liabilities are discharged in chapter 11. Though a less-than-often
addressed issue, it will certainly attract more attention in the near future.

<h3>The Absolute Priority Rule</h3>

A cornerstone concept of chapter 11 reorganization is the absolute priority rule,
which states that a debtor may not, over the objection of an impaired, senior class
of claimants, receive or retain under the plan property or an interest on account of
such junior claim or interest in any property. See 11 U.S.C.
§1129(b)(2)(B)(ii). The absolute priority rule prevents a debtor from
discharging liabilities while retaining property.

When determining whether a debtor is retaining property in violation of the absolute
priority rule, it is important to consider whether the property is retained on account
of such junior claim or interest any property. Because of the phrase "on account of
such junior claim or interest," it is only logical that a debtor could retain property
if such property is retained for some reason other than on account of the pre-petition
interest, such as the contribution of additional consideration, or "new value." The
retention of property interests on account of additional consideration is commonly referred
to as the new value exception, which many argue survived Congress's enactment of the
Bankruptcy Code. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of America National Trust & Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 444, 119 S.Ct.
1411, 1417, 143 L.Ed.2d 607 (1999)</a>. However, a more logical
reading dictates that it is not an exception at all because the retention of property
due to additional consideration is wholly consistent with the express language of
§1129(b)(2)(B).

Arguments over the application of the new value exception resulted in much case law
on how to measure new value; whether new value is required when objecting creditors
are given the opportunity to submit competing plans; and whether the new value
exception applies when such new value is given for any reason other than business
reasons.

Such case law applies, directly and indirectly, to the application of the absolute
priority rule in individual chapter 11s which, after all, will often culminate in
an individual debtor attempting to retain property, both exempt and non-exempt, over
the objection of an impaired, senior class of claimants.

<h3>The Grant of New Value by Individual Debtors</h3>

As stated above, the new value exception allows a debtor to essentially buy
property from the bankruptcy estate under the guise of contribution of new value.
However, the Supreme Court has ruled that the contribution of new value must be
(a) "new" and "money or money's worth;" (b) necessary; and (c) reasonably
equivalent to the interest being retained. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Los Angeles Lumber Products Co., 308 U.S. 106, 121-22, 60 S.Ct. 1, 10, 84 L.Ed. 110 (1939)</a>.

The "new" requirement may be defined simply as "not currently part of the debtor's
bankruptcy estate." See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Treasure Bay Corp., 212 B.R. 520,
544-45 (Bankr. S.D. Miss. 1997)</a>. However, "necessary" is typically
defined as "necessary for an effective reorganization." See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Woodbrook
Associates, 19 F.3d 312, 319-20 (7th Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Maill
Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner Maill Partnership), 2
F.3d 899, 908 (9th Cir. 1993)</a>.

Yet an individual who is not self-employed is usually not providing new value for
business reasons. Instead, new value is contributed to prevent the loss of property
via the absolute priority rule. Although the "necessity" requirement of the new value
exception is a business rule and is most commonly found in commercial chapter 11s,
certain courts have found that the new value exception is simply inapplicable when not
necessary for the operation of a business. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Dowden, 143 B.R.
388, 393-95 (Bankr. W.D. La. 1989)</a>.

Even more difficult for the individual debtor is the usual lack of resources to
make a new value contribution, as future promises cannot support the new value
exception. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bank Worthington v. Ahlers, 485 U.S. 197,
203-04, 108 S.Ct. 963, 967-68, 99 L.Ed.2d 169
(1988)</a>. Thus, an individual will often lose his non-exempt property, consistent
with §1129(b)'s "fair and equitable" concept. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Aweco Inc.
(In re Aweco Inc.), 725 F.2d 293, 298 (5th Cir. 1984)</a> (the
term "fair and equitable" means that senior interests are entitled to full priority over
junior interests); citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Committee v. Anderson, 390 U.S. 414,
441, 88 S.Ct. 1157, 1171, 20 L.Ed. 2d 1 (1968)</a>.
However, such an analysis is not as easy, to the extent the new value exception
is easy, when the property sought to be retained is exempt under state law or the
Bankruptcy Code.

<h3>The Retention of Exempt Property</h3>

The Bankruptcy Code authorizes an individual debtor, regardless of chapter, to
retain exempt assets. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §522</a>. Exempt assets find their definition
in §522 or, when applicable, state law. State law exemptions can be very
generous, resulting in many legislative attempts to limit certain state exemptions such
as homestead. For example, Texas law allows a debtor to exempt his/her homestead
regardless of value, limited only by acreage. See TEX. PROP. CODE
§41.001-.002 (Vernon 2002). Thus, a Texas debtor could theoretically
discharge millions in liabilities, yet retain a homestead worth millions.

Therefore, when a wealthy debtor with a Texas homestead proposes a chapter 11
plan, he/she will undoubtedly seek to retain the homestead, despite impaired senior
classes, without even the inkling of new value. Certainly, such plan provisions will
cause vehement objections by impaired senior classes. After all,
§1129(b)(2)(B)(ii) states that a debtor may not receive or retain an
interest in property on account of such junior interest in any property without
distinction between exempt or non-exempt property. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Ashton, 107 B.R.
670, 674 (Bankr. D. N.D. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Yasparro, 100 B.R.
91, 95 (Bankr. M.D. Fla. 1989)</a>.

However, when a debtor retains his rights in exempt assets, he is only "retaining
that which is [his] absolute right to retain in any event." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Egan, 142
B.R. 730, 733 (Bankr. E.D. Pa. 1992)</a>. And when the property
sought to be retained is exempt, and no objections to the exemptions are timely
filed, the debtor's claim to such exemptions "is conclusively established." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at
733</a>, citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Freeland & Kronz, 503 U.S. 638, 643-44,
112 S.Ct. 1644, 1648-49, 118 L.Ed. 2d 280 (1992)</a>.
Thus, retention of an exempt asset is not on account of a previous interest, but
on account of this absolute right provided under applicable law. Indeed, the exemption
of property removes that property from the bankruptcy estate.

The retention of exempt property is also consistent with §1129(b)(2)(B)
because of the language "receive or retain under the plan." Exempt property is not
retained under a plan; it is retained as an exempt asset outside of the bankruptcy
estate. Regardless of the express language and intent of §1129(b)(2)(B), only
property that is part of the bankruptcy estate is used to satisfy claims against the
bankruptcy estate.

Thus, this author questions whether the bankruptcy court has jurisdiction over the
exempt property, excluding property brought into the bankruptcy estate via an objection
to the exemption, avoidance actions, etc. It should be noted that §1129(b) has
no such mechanism and, despite the absolute priority rule, does not appear to
undermine an individual's right to exempt property under applicable law.

Furthermore, policy dictates that the absolute priority rule not apply to exempt
property. As stated in Egan, an individual, non-farmer debtor has two options under
the Bankruptcy Code for filing and reorganizing: chapters 11 and 13. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §109</a>. However, §109(e) limits chapter 13 eligibility based on the
amount of an individual's debt. Thus, if §1129(b)(2)(B)(ii) is read to
prevent the retention of exempt assets, and a debtor exceeds the debt limits for
chapter 13, the only other option is chapter 7 liquidation.

Indeed, the purpose of the Bankruptcy Code is to encourage debtors to reorganize,
which bolsters the policy argument that §1129(b) should be read in conjunction with
§522 to allow an individual debtor to retain exempt property despite the absolute
priority rule. After all, chapter 13 allows the same result and it would be
inequitable to allow those with less debt to be eligible to retain exempt property,
while others in need of a fresh start must turn over the exempt property necessary
for a fresh start.

<h3>Conclusion</h3>

When an individual debtor files bankruptcy, federal and/or state law exemptions are
available. Under the laws of some states, this may result in what some would claim
is an inequitable result of discharging liabilities while allowing a debtor to retain
valuable assets. In other states, however, no such exemptions exist. While this
appears inequitable, and many seek legislative change, there are Constitutional issues
involved.

Specifically, the proposed limits upon homestead exemptions appear to violate the
Tenth Amendment of the U.S. Constitution, which gives the individual states the
right to create and enforce laws upon their residents. Thus, limiting state law
exemptions arguably encroaches upon the individual states' right to create personal
exemptions from liability. While these exemptions have resulted in abuse through
over-extensive pre-bankruptcy planning, avoidance actions exist to cure such abuses.
Nonetheless, exemptions are a factor that will come into play in the bankruptcies of
officers and directors of some of the largest corporations to have filed for bankruptcy
protection in this country.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Friday, November 1, 2002 - 12:00

Bankruptcy Rule

2002