Recently, in Zachary v. Cal. Bank & Trust,[1] the U.S. Court of Appeals for the Ninth Circuit agreed with the Fourth, Fifth, Sixth and Tenth Circuits in holding that the absolute priority rule continues to apply to individual chapter 11 reorganizations, notwithstanding the 2005 BAPCPA amendments to the Bankruptcy Code. The Zachary decision clearly enhances the leverage of unsecured creditors in individual chapter 11 cases.
Facts in Zachary v. Cal. Bank & Trust
The debtors, David K. Zachary and Annmarie Snorsky, filed joint chapter 11 petitions in 2011. Their plan placed California Bank & Trust (CB&T) into its own class and proposed to pay it $5,000 on its claim of nearly $2,000,000 (a mere .0025 percent recovery on its claim). CB&T objected, arguing that the plan violated the absolute priority rule of § 1129(b)(2)B)(ii) of the Bankruptcy Code. The bankruptcy court sustained CB&T’s objection. After receiving certification of the appeal of the order sustaining CB&T’s objection from the bankruptcy court, the debtors appealed directly to the Ninth Circuit.
Brief Background on the Absolute Priority Rule
Under the absolute priority rule, a judicially created doctrine codified in § 1129(b)(2)(B)(ii) of the Bankruptcy Code, the claims of a dissenting class of unsecured creditors must be paid in full before any junior class can receive or retain property under a plan of reorganization. One of the goals of the absolute priority rule is to enforce the priority of distributions mandated by the Bankruptcy Code.
Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), § 1129(b)(2)(B)(ii) of the Bankruptcy Code was amended to allow individual chapter 11 debtors to retain property acquired after the petition date, as provided for in § 1115 of the Bankruptcy Code. Bankruptcy courts around the country have disagreed on whether an individual chapter 11 debtor can confirm a plan under the cramdown provisions of § 1129(b)(2)(B)((ii) of the Bankruptcy Code while (1) retaining any portion of property of the estate that other sections of the Bankruptcy Code allow (the “broad view”) or (2) only the property and earnings acquired after the commencement of the case (the “narrow view”).
Ninth Circuit Adopts the Narrow View
Through statutory analysis and interpretation, the court rejected the broad view. In short, the Ninth Circuit held that the word “included” in § 1129(b)(2)(B)(ii) of the Bankruptcy Code only covers the post-petition property and earnings brought into the estate under § 1115 of the Bankruptcy Code, as opposed to all property of the estate under § 541 (§ 541 is also referenced in § 1115). The Ninth Circuit also determined that accepting the debtors’ absolute priority arguments would require the court to find an implied repeal of an 100-year-old rule, and that if Congress had intended to repeal the absolute priority rule for individual chapter 11 debtors, it would have done so with a specific provision in the statute. The Ninth Circuit ultimately affirmed the bankruptcy court’s decision and held that a chapter 11 debtor may only cram down a plan that allows a debtor to retain post-petition property. In so holding, the Ninth Circuit expressly overturned the Bankruptcy Appellate Panel’s decision in Friedman v. P+P, LLC (In re Friedman).[2]
The Zachary decision essentially means that at least in the Ninth Circuit, in most cases an individual debtor cannot firm up a chapter 11 plan without paying unsecured creditors in full. Moreover, following Zachary it will be increasingly difficult for an individual chapter 11 debtor to now confirm anything other than a consensual plan.