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Does the “Absolute Priority Rule” Still Apply in Individual Chapter 11 Cases?

The Absolute Priority Rule (APR) is a long-established principle that in Chapter 11 cases creditors’ claims take priority over shareholders’ claims. Pre-BAPCPA, cases such as In re Gosman, 282 B.R. 45 (Bankr. S.D. Fla. 2002) held that the retention of even exempt property by an individual debtor in a Chapter 11 Plan violates the absolute priority rule unless unsecured creditors are paid in full. Given the many changes made to Chapter 11 by BAPCPA, does the APR still apply? Two recent cases hold that it does not.

In re Roedemeier, 374 B.R. 264 (Bankr. D. Kan. 2007) and In re Tegeder, 349 B.R. 477 (Bankr. D.Neb. 2007) both find that newly added 11 U.S.C. § 1115 changes the pre-BAPCPA application of the APR.

Roedemeier, a dentist, submitted a Chapter 11 Plan that proposed paying his creditors about 3% of his general unsecured debt, while letting him retain his ownership interest in his dental practice, an LLC. The general unsecured creditors voted against the Chapter 11 Plan, and the Debtor sought a cramdown under § 1129(b).

The Court found that the changes made to Chapter 11 by BAPCPA were designed to make it function much more like Chapter 13. Specifically, it noted that:

1. § 1115 brings property the debtor acquires postpetition into the estate;

2. § 1123(a)(8) calls for the plan to provide for payment to creditors from the postpetition earnings;

3. the exception in § 1129(b)(2)(B)(ii) allows the debtor to keep property included in the estate under § 1115, without paying in full a class of unsecured creditors that rejected his or her plan;

4. § 1129(a)(15) authorizes the debtor to overcome an objection to the plan made by a single unsecured creditor by proposing to distribute under the plan property worth at least as much as the debtor’s projected disposable income for a five-year period;

5. § 1141(d)(5) ordinarily delays the entry of the debtor’s discharge until completion of all payments under the plan; and

6. § 1127(e) permits modification of a confirmed plan even after substantial consummation for certain purposes.

The Court concluded:

“Significantly, Chapter 13 does not impose the absolute priority rule on debtors. Taken together, these changes indicate Congress intended to extend the exemption from the absolute priority rule to individual Chapter 11 debtors as well. If a class of unsecured creditors who are not to be paid in full under an individual Chapter 11 debtor’s plan can bar the debtor from keeping any prepetition property (which will nearly always include the debtor’s interest in whatever business the debtor engages in) by rejecting the plan and invoking the absolute priority rule — that is, if the new exception in § 1129(b)(2)(B)(ii) is read narrowly — then it is difficult to see what purpose these other, related amendments can serve.”

As in Roedmeier, the debtor in Tegeder operated a business, and filed for Chapter 11 relief. His Plan proposed paying general unsecured creditors during the last three years of a ten year plan. General unsecured creditors voted against the Plan, and Tegeder sought to obtain confirmation by an § 1129(b) cramdown.

The Court quoted § 1115, and noted that several commentators (4 Norton Bankruptcy Law & Practice 2d § 84A:1; Bankruptcy Practice for the General Practitioner § 12:27 n.28; and 3 Bankruptcy Practice Handbook § 14:152 n.1 (2d ed.)) had found that this added provision eliminated the APR in individual Chapter 11 cases. He held that the “absolute priority requirements imposed by Code 1129(b)(2)(B)(ii) were waived by permitting a debtor to retain property included in the estate under 1115.”

What do cases such as Roedemeier and Tegeder mean for individual Chapter 11 debtors? First, they remove a potent tool that in the past has allowed creditors to exert pressure for concessions and more favorable plan treatment. Second, while not turning Chapter 11 into a sort of “Super Chapter 13,” they nevertheless attempt to make the Chapter 11 procedure more “Chapter 13-like,” if not in application, then in result. With the increased debt load borne by individuals and the resulting increase in individuals ineligible for Chapter 13 choosing to file for Chapter 11, these distinctions will prove to be even more important.

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  1. From Business Bankruptcy, Part 1 : Bankruptcy Law Network | Nov 11, 2007

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