All five courts of appeals to consider the question agree that the absolute priority rule still applies to an individual in chapter 11, despite what appeared to be an effort by Congress in 2005 to amend the statute by allowing individuals to retain property they owned before bankruptcy when cramming down a plan on a dissenting class.
On Jan. 28, the Ninth Circuit overruled its own Bankruptcy Appellate Panel’s Friedman opinion from 2012, which had been the leading judicial authority for the proposition that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, or BAPCPA, abrogated the absolute priority rule for individuals in chapter 11.
The decisions by the courts of appeals are a burden for owners of small businesses in chapter 11 because they give an effective veto power to a dominant creditor.
If there is one creditor with a large enough claim opposing a plan, the bankrupt is effectively barred from using cramdown to win confirmation. Consequently, the owner of a small business can be forced by one creditor with a large claim to liquidate or sell the business, even if the plan might have paid more than liquidation.
Originally engrafted by the courts onto the former Bankruptcy Act, which had been silent on the issue, the absolute priority rule was intended to prevent shareholders from receiving a distribution in chapter 11 if the plan was being crammed down on a dissenting class of creditors. When Congress codified the absolute priority rule in the 1978 Bankruptcy Code, it meant that individuals in chapter 11 using cramdown could not keep property.
To some observers, Congress intended in BAPCPA to change the rule by amending Section 1129(b)(2)(B)(ii) to create an exception to the absolute priority rule for individuals. BAPCPA at the same time added entirely new Section 1115, which brings property that was acquired after bankruptcy into the estate.
In the case before the Ninth Circuit, Bankruptcy Judge Thomas C. Holman of Sacramento, Calif., had bravely parted company with the Ninth Circuit appellate panel’s Friedman decision by holding that absolute priority remains a condition to cramming down a plan in an individual in chapter 11. Although he held that appellate panel opinions were not binding on him, the Ninth Circuit did not reach that issue when it overruled Friedman. Judge Holman authorized an appeal directly to the court of appeals.
The appeals court’s opinion by Circuit Judge Andrew D. Hurwitz acknowledged a “significant split of authorities” among lower courts, although the Fourth, Fifth, Sixth and Tenth Circuits all held that BAPCPA did not change the law. Those circuits rejected the broad view adopted by Friedman and several other lower courts that Congress intended in BAPCPA to abrogate absolute priority for individuals in chapter 11.
Judge Hurwitz followed what he called the narrow view, where courts interpret BAPCPA’s amendments to mean that an individual cannot cram down a plan on a dissenting class and retain pre-petition property of the estate. The amendments, he said, only allow an individual debtor to keep property acquired post-petition when cramming down a plan.
In substance, Judge Hurwitz and the other courts of appeals believe that Section 1115 put pre-petition property back that Section 1129(b)(2)(B)(ii) had taken out. Some commentators believe that BAPCPA includes a scrivener’s error that has an opposite effect from what Congress intended.
The Ninth Circuit conceded that the narrow view works a “double whammy” because an individual debtor must use post-petition income to pay creditors’ claims under the plan, while pre-petition property must also go to creditors. If Congress had intended to abrogate absolute priority for individuals, Judge Hurwitz said it could have done so “in a far more straightforward manner.” To overrule a judicially created concept, he said, Congress must make its intent “specific.”