In re Lively, 717 F.3d 406 (5th Cir 2013) –

An individual debtor that ended up in chapter 11 bankruptcy after his debts exceeded the chapter 13 limits proposed a plan of reorganization that allowed him to keep all of his property while paying unsecured creditors only a small dividend.  The bankruptcy court denied confirmation of the plan on the basis that it violated the absolute priority rule.  It then certified the question of whether the absolute priority rule applies in individual debtor cases for immediate appeal to the 5^th Circuit.

Although there were no objections to confirmation and the unsecured class voted “overwhelmingly” to accept the client plan by dollar amount, a majority of the class by number voted to reject – thus triggering the cramdown provisions of the Bankruptcy Code.

In a cramdown, under what is known as the “absolute priority rule” (section 1129(b)(2)(B) of the Bankruptcy Code) a class of unsecured claims that has rejected the plan (1) must receive payment in full of the claims, or else (2) holders of junior interests and claims must not receive anything on account of their claims and interests “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.”

Section 1115 of the Bankruptcy Code applies to individual chapter 11 debtors and provides that property acquired by the debtor and earnings from services performed by the debtor after the bankruptcy case begins and before the case is closed, dismissed, or converted are included as property of the bankruptcy estate.  (Also, for reference, subsection (a)(14) relates to payment of domestic support obligations.)

Courts have split in their interpretation of this exception from the absolute priority rule.  The “narrow” interpretation is that individual debtors can exclude only their post-petition earnings and acquisitions, but not property that already would have been included in the bankruptcy estate under section 541 of the Bankruptcy Code.  The “broad” approach construes section 1115 as subsuming or superseding section 541 entirely, thus effectively doing away with the absolute priority rule for individual debtors.

Both section 1115 and the exception from the absolute priority rule were added in the 2005 bankruptcy amendments (BAPCPA).  In laying out its analysis of the “plain reading” of section 1129(b)(2)(B)(ii) in light of section 1115, the 5^th Circuit noted that both provisions were adopted in 2005 in order to coordinate (at least to some extent) chapter 13 and chapter 11 cases.  This is an issue because individual debtors can be forced into chapter 11 if their debts exceed the chapter 13 debt limits.

As described by the court: Under chapter 13, a debtor’s post-petition “disposable income” is subjected to creditor claims.  Without modification, a chapter 11 debtor would not have to use any post-petition earnings  to satisfy creditors.  To address this potential discrepancy, Congress included an individual debtor’s post-petition earnings and property acquisitions to the section 541 definition of property of the bankruptcy estate.  However, since section 1115 covers all post-petition earnings (as opposed to chapter 13, where the concept of disposable income allows a deduction for expenses), a modification of the absolute priority rule was required so that a debtor would not have to lose all post-petition earnings in the event of a cramdown.

The 5^th Circuit felt that the statute was unambiguous.  But even if there was a question, the court was clear that the narrow view was the correct view, and was emphatic in rejecting the “broad” view.   It characterized the broad view as abrogating the absolute priority rule for individual debtors, which it described as “a cornerstone of equitable distribution for chapter 11 debtors for over a century.”  It called the result of an indirect repeal of this rule both “startling” and “unacceptable.”  Accordingly, it affirmed the bankruptcy court’s judgment denying confirmation of the debtor’s plan of reorganization since it agreed that the absolute priority rule was applicable.

The general expectation is that a chapter 11 proceeding is an attempt to reorganize a business (although it can also be used for a liquidation).  However, as highlighted by the court, an individual debtor may end up filing a chapter 11 proceeding simply because the debtor fails to qualify for a chapter 13 since his or her debts exceed the chapter 13 limits.  It seems likely that the absolute priority rule is not the only area where the circumstances of an individual debtor seeking personal relief are not a particularly good match with a chapter 11 proceeding that is structured to deal with reorganizing a business.

Vicki R. Harding, Esq.