The Circuits Agree: Absolute Priority Rule Applies in Individual Chapter 11 Cases

The decision in Zachary v. California Bank & Trust[1] brings the Ninth Circuit in line with the four other circuits that have concluded that BAPCPA did not abrogate the absolute priority rule in individual chapter 11 cases. The Ninth Circuit joined the Fourth,[2] Fifth,[3] Sixth[4] and Tenth Circuits[5] in adopting the “narrow view” to conclude that BAPCPA’s limitation on the absolute priority rule in individual cases[6] only applies to property added to the estate pursuant to § 1115 and not to § 541(a) property generally.

BAPCPA added § 1115(a), which provides:

In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in section 541 —

(a) 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

(b) 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.[7]

For individual debtors, BAPCPA also amended the absolute priority rule in § 1129(b)(2)(B)(ii) to provide as follows, with the language added by the amendment italicized:

(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 of 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.[8]

Two different interpretations of the statutory amendments emerged, which the Fourth Circuit described as follows:

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. Some courts have adopted the “broad view” that, by including in § 1129(b)(2)(B)(ii) a cross-reference to § 1115 (which in turn references § 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 courts, adopting the “narrow view,” have held that Congress did not intend such a sweeping change to Chapter 11, and 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 § 541(a)(6) & (7).[9]

The Ninth Circuit analyzed the issue as “what property may an individual chapter 11 debtor retain ‘without running afoul of the absolute priority rule’?”[10] The “narrow” approach indicates that the property excepted from the absolute priority rule is limited to property that is added to the estate by § 1115.[11] This raises the question: What type of excepted property may be added to the estate pursuant to § 1115?

The most obvious answer is the post-petition earnings of an individual debtor. Section 541(a)(6) removes such earnings from property of the estate, § 1115(a)(2) adds them back into the estate, and § 1129(b)(2)(B)(ii) provides that their retention by the debtor does not violate the absolute priority rule. However, that only addresses half of § 1115(a): Section 1115(a)(1) also includes “all property of the kind specified in section 541 that the debtor acquires after the commencement of the case….”[12]

Section 541(a), which was not amended by BAPCPA, has always included various types of property that become property of the estate after the petition is filed. These include property recovered,[13] property ordered to be transferred to the estate,[14] certain inheritances and similar property,[15] proceeds of property of the estate,[16] and property acquired after the commencement of a case.[17]

The Fourth Circuit, followed by the Ninth Circuit, apparently reads § 1115(a) as a reference to the types property described in § 541(a)(6) & (7).[18] Although the reference to § 541(a)(6) is likely a reference to earnings and, thus, to § 1115(a)(2), it is not clear what property of the debtor would be of a kind “that the estate acquires after the commencement of the case,”[19] and thus encompassed by § 1115(a)(1).

Certain types of property that may come within § 1115(a)(1) include:

a. property acquired with post-petition earnings;

b. property exempted from the estate;

c. when property is abandoned to the debtor pursuant to § 554, any value created by appreciation of the property or reduction of the lien;

d. an inheritance more than 180 days after the petition date; and

e. a claim arising from a post-petition tort committed against the debtor.

Creative attorneys, and the facts that can be presented in the wild variety of individual chapter 11 cases that occur, will likely supply many more; however, it is important to remember that the inclusion of an item in § 1115(a) only means that a debtor may retain that item without violating the absolute priority rule. Whether such property can meet the requirements of the “new value exception” to the absolute priority rule remains to be determined.