Ninth Circuit Holds That the Absolute Priority Rule Still Applies in Individual Chapter 11 Cases

In Zachary v. California Bank & Trust, ___ F.3d ___ , 2016 WL 360519 (9th Cir. Jan. 28, 2016) (“Zachary”), the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) held that the absolute priority rule, codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code, continued to apply to individual chapter 11 cases following the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”).  In so holding, the Ninth Circuit overruled the decision of the U.S. Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) in In re Friedman, 466 B.R. 471 (9th Cir. BAP 2012) (“Friedman”), and adopted the “narrow view” of the individual debtor exception to the absolute priority rule.

To read the full opinion, click here: http://cdn.ca9.uscourts.gov/datastore/opinions/2016/01/28/13-16402.pdf

FACTS

In September 2011, David K. Zachary and Annmarie S. Snorky (the “Debtors”) filed a joint voluntary petition for relief under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Eastern District of California (the “Bankruptcy Court”)—thereby commencing the subject bankruptcy case.

Thereafter, the Debtors proposed several chapter 11 plans of reorganization.  By and through the operative plan (the “Plan”), the Debtors proposed paying creditors over a term of years and, thereafter, retain their interests in certain rental property and an engineering practice.  Of particular relevance here, the Debtors proposed paying California Bank & Trust (“CBT”) the sum of $5,000 over five years with 3% interest on account of the nearly $2,000,000 unsecured claim asserted by CBT.  Thus, CBT’s claim was impaired under the Plan.  CBT objected to the Plan.  In sum, CBT argued that the Plan violated the absolute priority rule by allowing the Debtors (equity interest holders) to retain their interests in the rental property and engineering practice without paying CBT (a senior unsecured creditor) in full.  In response, the Debtors sought to confirm  the Plan over CBT’s objection (i.e., “cram down” the Plan), relying on Friedman to argue that the absolute priority rule does not apply in individual chapter 11 cases following the enactment of BAPCPA.

The Bankruptcy Court disagreed with the Debtors and the holding in Friedman, and sustained CBT’s objection to the Plan.  The Debtors timely appealed.  The Debtors also moved to certify the appeal for direct review by the Ninth Circuit, which motion the Bankruptcy Court granted.

REASONING

The question presented on appeal has been much debated since 2005: Does the absolute priority rule continue to apply in individual chapter 11 reorganizations after the amendments to the Bankruptcy Code enacted as part of BAPCPA?  In sum, the Ninth Circuit held that the rule continues to apply in individual chapter 11 bankruptcy cases.  In reaching this conclusion, the Ninth Circuit first reviewed the origins of the absolute priority rule and the applicable amendments enacted through BAPCPA. 

As recounted in Zachary, the absolute priority rule (as it is colloquially known) is a long-standing principle in bankruptcy law tracing its roots to the early twentieth-century railroad bankruptcies.  In sum, the absolute priority rule “provides that a dissenting class of unsecured creditors must be provided for in full before any junior class can receive or retain any property under a reorganization plan.”  Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988).  Since its inception, the absolute priority rule has migrated in and out of applicable bankruptcy codes and statutes.  The modern manifestation of the absolute priority rule is codified as section 1129(b)(2)(B)(ii) of the Bankruptcy Code.

Prior to the enactment of BAPCPA, the absolute priority rule provided as follows: “[T]he condition that a plan be fair and equitable with respect to a class [of creditors] includes the following requirements: … (B) With respect to a class of unsecured claims— … (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.”  11 U.S.C. § 1129(b)(2)(B)(ii) (1994).  Thus, as the Ninth Circuit remarked, “under the pre-BAPCPA Bankruptcy Code, it was clear that ‘every unsecured creditor must be paid in full before the debtor can retain “any property” under a plan.’”  Zachary, at *2, quoting Ice House Am., LLC v. Cardin, 751 F.3d 734, 737 (6th Cir. 2014) (“Ice House”). 

The enactment of BAPCPA, however, created an exception to this immutable rule in the context of individual chapter 11 bankruptcy cases.  “Three provisions of the post-BAPCPA Bankruptcy Code intertwine to implement the absolute priority rule”—namely, sections 541, 1115, and 1129(b)(2)(B)(ii).  Zachary, at *3.  Section 541 defines “an estate in bankruptcy as ‘comprised of all’ the property enumerated in that section, ‘wherever located and by whomever held,’ including ‘all legal or equitable interests of the debtor in property as of the commencement of the case.’”  Id. (emphasis in original), quoting 11 U.S.C. § 541(a).

Section 1115, a provision added to the Bankruptcy Code by BAPCPA, includes after-acquired property within the gamut of estate property in the context of individual chapter 11 bankruptcy cases.  More precisely, section 1115 provides as follows:

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

(1) 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

(2) 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.

11 U.S.C. § 1115(a) (emphasis added); see Zachary, at *3.

The final provision governing the post-BAPCPA application of the absolute priority rule is section 1129(b)(2)(B)(ii), which was amended by BAPCPA to include the italicized language below:

[T]he condition that a plan be fair and equitable with respect to a class [of creditors] includes the following requirements:

. . ..

(B) With respect to a class of unsecured claims—
. . ..
(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.

11 U.S.C. § 1129(b)(2)(B)(ii) (emphasis added); see Zachary, at *3.

As the Ninth Circuit noted, “[t]he new clauses in subsection (B)(ii) plainly create an exception to the absolute priority rule that applies only to a chapter 11 ‘case in which the debtor is an individual.’”  Zachary, at *3.  The BAPCPA amendments, however, failed to address the scope of the exception “[o]r, put another way, what property … an individual chapter 11 debtor [may] retain ‘without running afoul of the absolute priority rule.” Id., quoting Friedman, 466 B.R. at 487 (Jury, Bankr. J., dissenting).

Due to the absence of guidance regarding the scope of the exception established by BAPCPA, “[t]wo conflicting positions have emerged: the ‘broad view’ and the ‘narrow view.’” Zachary, at *4.  Under the broad view, which the BAP adopted in Friedman, “an individual debtor is entitled to retain most prepetition and postpetition property and nonetheless cram down a plan over an unsecured creditor’s objection.”  Id., citing Friedman, 466 B.R. at 482, In re Anderson, No. 11-61845-11, 2012 WL 3133895, at *7 n.6 (Bankr. D. Mont. August 1, 2012), In re Shat, 424 B.R. 854, 868 (Bankr. D. Nev. 2010), and In re Roedemeier, 374 B.R. 264, 276 (Bankr. Kan. 2007).  Under the narrow view, on the other hand, “an individual debtor may not cram down a plan that would permit the debtor to retain prepetition property that is not excluded from the estate by [section] 541, but may cram down a plan that permits the debtor to retain only postpetition property.”  Zachary, at *4.

Like many others, the split in authority regarding the scope of the exception to the absolute priority rule relates to a question of statutory interpretation.  As succinctly stated by the Ninth Circuit, the key to the scope of the exception “is determining what the word ‘included’ means in the phrase of [section] 1129(b)(2)(B)(ii) stating that ‘the debtor may retain property included in the estate under section 1115.’”  Id.

Courts employing the “broad view” hold that, for purposes of the absolute priority rule, section 1115 acts as a conduit of sorts through which all property is included in the estate of an individual chapter 11 debtor; thus, in the opinion of these courts, “included” in section 1129(b)(2)(B)(ii) refers to both prepetition property defined by section 541 as well as postpetition (after-acquired) property incorporated into the bankruptcy estate under section 1115.  As explained by the majority in Friedman:

“Included” is not a word of limitation. To limit the scope of estate property in [sections] 1129 and 1115 would require the statute to read “included, except for the property set out in Section 541” (in the case of [section] 1129(b)(2)(B)(ii)), and “in addition to, but not inclusive of the property described in Section 541” (in the case of [section] 1115).

Friedman, 466 B.R. at 482 (footnote omitted).

Courts employing the “narrow view,” on the other hand, view estate property in individual chapter 11 cases as consisting of two tranches.  The first tranche consists of prepetition property, which becomes property of the estate on the petition date by operation of section 541.  The second tranche consists of postpetition property, which becomes property of the estate upon acquisition by the debtor by operation of section 1115.  Under this view, only postpetition property—i.e., property “included in the estate under section 1115”—is exempt from the absolute priority rule.  11 U.S.C. § 1129(b)(2)(B)(ii).  The linguistic nuance of this interpretation is explained by the U.S. Court of Appeals for the Sixth Circuit (the “Sixth Circuit”) in Ice House:

The critical language in [section] 1129(b)(2)(B)(ii) is that “the debtor may retain property included in the estate under section 1115.”  And the key word within that language is “included.”  “Include” is a transitive verb, which means it “shows action, either upon someone or something.”  The action described by “include” is either “to take in as a part, an element, or a member” (first definition) or “to contain as a subsidiary or subordinate element” (second definition).  The first definition (“to take in”) describes genuine action—grabbing something and making [it] a part of a larger whole—whereas the second definition (“to contain”) lends itself, more dryly, to a description of things that are already there—“the duties of a fiduciary include….”  The first definition is plainly the better fit in [section] 1129(b)(2)(B)(ii): converted into the active voice, [section] 1129(b)(2)(B)(ii) refers to property that [section] 1115 includes in the estate, which naturally reads as “property that [section] 1115 takes into the estate,” rather than as “property that [section] 1115 contains in the estate.”  Thus—employing this definition and converted into the active voice—[section] 1129(b)(2)(B)(ii) provides that “the debtor may retain property that [section] 1115 takes into the estate.”

Ice House, 751 F.3d at 738-39 (internal citations omitted).  Applying this linguistic analysis to the scope of the absolute priority rule under BAPCPA, the Ninth Circuit stated: “Under this reading, ‘what [section] 1115 takes into the estate is property “that the debtor acquires after the commencement of the case,”’ and it is only ‘thatproperty’ that ‘“the debtor may retain” when his unsecured creditors are not fully paid.’” Zachary, at *5 (emphasis in original), quoting Ice House, 751 F.3d at 739 (quoting 11 U.S.C. §§ 1115(a), 1129(b)(2)(B)(ii)) (internal punctuation omitted).

Based on its review of the potential interpretations of “included” in section 1129(b)(2)(B)(ii), the Ninth Circuit in Zachary agreed with the Sixth Circuit—finding that reading sections 1115 and 1129(b)(2)(B)(ii) “as defining a new class of property that is exempt from the absolute priority rule nicely harmonizes the new provisions.”  Zachary, at *5.

After adopting the plain language interpretation underlying the “narrow view,” the Ninth Circuit addressed the policy concerns and Congressional intent arguments leading several courts to follow the “broad view.”  Those courts generally contend that Congress enacted BAPCPA to bring individual chapter 11 cases in line with chapter 13 reorganizations, which are not subject to the absolute priority rule (or an analogous rule), and that imposing the absolute priority rule on individual chapter 11 debtors is onerous.

With respect to the former, the Ninth Circuit found the contention unpersuasive.  The Ninth Circuit opined that if Congress desired to align individual chapter 11 cases with chapter 13 cases by eliminating the absolute priority rule, Congress had the authority to expressly repeal the absolute priority rule (as it did in 1952) or to make the rule inapplicable to individuals; however, Congress did neither in BAPCPA.  Zachary, at *5-6.  The Ninth Circuit further opined that if Congress wanted to provide more individual debtors that ability to reorganize free of the absolute priority rule, Congress could have simply raised the debt limits in section 109, which would have allowed more individual debtors to file under chapter 13.  Zachary, at *6.  Once again, however, Congress did not raise the debt limits for chapter 13 debtors.  Id.  As Congress did not expressly act to alter the applicability of the absolute priority rule to individual chapter 11 debtors (except with respect to after-acquired property), the Ninth Circuit declined to do so in its stead.  Id. 

Lastly, the Ninth Circuit addressed the burden of the absolute priority rule on individual chapter 11 debtors.  Although sympathetic to the burden placed on individual chapter 11 debtors, the Ninth Circuit disregarded the purported equitable concerns—stating, “[o]ur task is not to balance the equities … but to interpret the Bankruptcy Code.”  Id. (“We acknowledge that retaining the absolute priority rule in chapter 11 cases works a ‘double whammy’ on a debtor because, under the BAPCPA amendments to [section] 1129(a)(15), [a debtor] ‘must dedicate at least five years’ of disposable income to the payment of unsecured creditors, and—unlike a debtor in Chapter 13—is also subject to the absolute-priority rule (and thus cannot retain any pre-petition property) if [the debtor] does not pay those creditors in full.”).

Ultimately, the plain language interpretation prevailed, and the Ninth Circuit in Zachary affirmed the Bankruptcy Court order sustaining CBT’s objection to the Plan.

AUTHOR’S COMMENTARY

Bankruptcy practitioners in the Ninth Circuit have long awaited a decision resolving the dispute regarding the scope of the individual debtor exception to the absolute priority rule under BAPCPA.  While the Friedman decision provided some guidance, due to questions regarding the precedential effect of BAP decisions, bankruptcy court decisions remained unpredictable—rendering it difficult, if not impossible, for attorneys to provide reliable advice to their clients on this issue.  Absent Supreme Court or en banc review, the Zachary opinion provides a reliable basis for practitioners to advise clients and formulate plans in individual chapter 11 cases, which remain prevalent in many parts of the Ninth Circuit.

The question, however, that will likely remain due to equitable concerns is whether the interpretation adopted by the Ninth Circuit is correct.  While alternative interpretations are conceivable, a plain reading of the statutory language lends itself to the conclusion that property “included” in the estate by section 1115 means just that—property added to the bankruptcy estate by section 1115, not all estate property. 

Beyond the plain language, the Zachary interpretation also recognizes the interrelated nature of the amendments instituted by BAPCPA.  More precisely, pursuant section 1115, property acquired by individual chapter 11 debtors is now included in the definition of estate property—thereby expanding the scope of the estate.  Thus, it is logical to conclude that the additional protections afforded by the amendments to section 1129(b)(2)(B)(ii) (an amendment that specifically references section 1115) was intended to provide additional protection for this new class of estate property, not all estate property.

Similarly, the Zachary interpretation also maintains the status quo or balance found in pre-BAPCPA absolute priority rule jurisprudence.  Pre-BAPCPA, the absolute priority rule applied to all estate property; however, at the time, estate property did not include after-acquired assets in individual chapter 11 bankruptcy cases.  BAPCPA, however, altered this paradigm—adding property acquired by the debtor postpetition to the estate pursuant to section 1115.  Thus, to read the amendment to section 1129(b)(2)(B)(ii) as applying solely to estate property acquired postpetition maintains the same balance struck prior to BAPCPA (at least with respect to the absolute priority rule) between the rights of debtors and creditors.  While not a canon of statutory interpretation, the logical relationship between these interrelated provisions certainly lends some credence to the Ninth Circuit’s interpretation.

While the Zachary opinion addresses an essential question regarding the post-BAPCPA absolute priority rule, several questions still remain, including whether the reference in section 1129(b)(2)(B)(ii) to section 1129(a)(14) was the result of a scrivener’s error (as has been suggested (see Zachary, at *5 n. 4)), and, if it was, how courts will address this error absent Congressional amendment to address the same, and how the decision will affect individual bankruptcies in the Ninth Circuit—i.e., will more individuals be forced to file under chapter 7 because they cannot obtain a better result in chapter 11 due to the applicability of the absolute priority rule (and increased administrative expenses) and they have too much debt to file under chapter 13?

Notwithstanding any pending debates, open questions, or potential implications, the Zachary opinion is a significant ruling for Ninth Circuit practitioners—one likely to impact the way attorneys advise their clients and formulate chapter 11 plans in individual cases and that may reshape the bankruptcy landscape in the Ninth Circuit for years to come.

These materials were written by Insolvency Law Committee member Michael T. Delaney of Baker & Hostetler LLP in Los Angeles, California (mdelaney@bakerlaw.com).  Editorial contributions were provided by Insolvency Law Committee member and Publications Subcommittee Chair Peter J. Gurfein of Landau, Gottfried & Berger LLP in Los Angeles, California. 

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

Co-Chair
Leib Lerner 
Alston & Bird LLP
Leib.Lerner@alston.com

Co-Chair
Corey Weber 
Brutzkus Gubner Rozansky Seror Weber LLP
cweber@brutzkusgubner.com

Co-Vice Chair
Asa S. Hami 
SulmeyerKupetz, A Professional Corporation
ahami@sulmeyerlaw.com

Co-Vice Chair
Reno Fernandez 
Macdonald Fernandez LLP
Reno@MacFern.com