Absolute Priority Doesn’t Require an Individual Debtor to Pay for Exempt Property

Taking sides on an issue where the lower courts are divided, the Ninth Circuit Bankruptcy Appellate Panel held that an individual in chapter 11 may confirm a plan and “retain exempt property without making a commensurate ‘new value’ contribution.” [Emphasis added.]

A real estate broker filed a chapter 11 petition to deal with priority tax claims and creditors claiming $260,000 for fraud and breach of contract. The debtor claimed a $150,000 Arizona homestead exemption in a home allegedly worth $300,000. The home was subject to a $156,000 mortgage.

The debtor filed a chapter 11 plan calling for a third party to contribute $15,000 to increase the distribution to unsecured creditors to about 5%. The contribution was designed to represent “new value” enabling the debtor to retain nonexempt property.

Dominated by creditors claiming $260,000, the unsecured creditor class rejected the plan, compelling the debtor to cram down the plan on unsecured creditors under Section 1129(b)(2)(b). Based on that section and virtually every requirement in Section 1129(a), the creditors objected to confirmation.

Bankruptcy Judge Brenda Moody Whinery of Tucson, Ariz., overruled the objections and confirmed the plan. 

The creditors appealed, but Robert J. Faris wrote the August 21 opinion for the BAP upholding confirmation. He affirmed most of the issues on appeal by finding no flaws in Judge Whinery’s findings of fact. For example, he said that the $15,000 of contributed new value allowed the debtor to retain nonexempt property.

Most prominently, Judge Faris addressed a question of first impression in the Ninth Circuit where lower courts are divided: May an individual debtor in chapter 11 retain exempt property without making a commensurate new value contribution?

The question implicates the so-called absolute priority rule in Section 1129(b)(2)(B). Judge Faris paraphrased the statute to mean that the court may cram the plan down on a dissenting class only if the plan “either provides for full payment of the dissenting class or provides that no junior class will receive or retain anything under the plan.” In other words, the creditors argued that the debtor violated the absolute priority rule by retaining exempt property for which the debtor paid nothing.

The rule has two exceptions. Section 1129(b)(2)(B)(ii) allows an individual debtor to retain post-petition property and income from post-petition services. The second exception is the so-called “new value” theory. 

Judge Faris explained that the exception applies if the value is new, substantial, is made in “money or money’s worth,” is necessary for a successful reorganization, and is “reasonably equivalent to the value or interest received,” citing Bonner Mall Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner Mall Partnership), 2 F.3d 899, 909 (9th Cir. 1993).

The creditors contended that the debtor contributed no new value equal to the value of his exempt assets.

Rejecting the creditor’s statutory interpretation, Judge Faris reworded Section 1129(b)(2)(B)(ii) to say that the debtor may not receive or retain “‘any property . . . under the plan on account of [the debtor’s interest] . . . .’” He held that “exempt property is not properly included within the phrase ‘any property’ under the absolute priority rule.”

Judge Faris reached his conclusion for two reasons.

First, Judge Faris said that a “debtor does not retain exempt property either ‘under a plan’ or ‘on account of the debtor’s interest . . . .’ Rather, the debtor retains exempt property due to the exemption statutes.” The debtor, he said, would not retain exempt assets “under a plan” because the “debtor would be entitled to the exempt property even if no plan were confirmed.”

Second, Judge Faris said that the creditor’s interpretation of Section 1129(b) would conflict with Sections 522(c) and (k), which provide that exempt property “is not liable for the payment of prepetition claims or administrative expenses.” He said that “[r]equiring a debtor to pay for exempt assets via a new value contribution would effectively make those assets available to creditors.”

Consequently, Judge Faris concluded that “the bankruptcy court did not err in allowing [the debtor] to retain his exempt property without making a corresponding ‘new value’ contribution.”