May 28, 2014

Double Whammy: Sixth Circuit Upholds Absolute Priority Rule in Individual Chapter 11

by Guest Blogger

What's the difference between an individual Chapter 11 and a Chapter 13?

No Whammy

In light of the Sixth Circuit's recent Ice House America, LLC v. Cardin, there are now two major differences:

Difference #1: Chapter 11 has an absolute priority rule (and Chapter 13 doesn't)

Difference #2: Individuals will still file Chapter 13 (and they won't be filing Chapter 11 if they can help it)

At issue in Ice House is whether the absolute priority rule applies in individual Chapter 11s. The debtor, Cardin, owed the dissenting creditor, Ice House, in excess of $1.3 million pursuant to an outstanding judgment. Cardin could not file a Chapter 13 because his debts exceeded the eligibility limits in Section 109, so he filed a Chapter 11. He was unable to obtain the affirmative votes of Ice House's class, so endeavored to invoke the cramdown (i.e., the "confirm over the objection of a dissenting class") provisions of Section 1129(b). One of those requirements is that the plan be "fair and equitable" as to each impaired dissenting class, and in order to be "fair and equitable" to a dissenting unsecured class â at least in corporate Chapter 11s â the plan must satisfy the absolute priority rule. That rule states that no junior class can retain any property unless the dissenting senior class is paid in full. That "junior class" here was Cardin himself, who proposed to retain property even though Ice House was not being paid in full.

Cardin's position â which was accepted by the bankruptcy court â is that the 2005 BAPCPA amendments to the Code abrogated the absolute priority rule as it applied to individuals. The argument is essentially that Congress attempted to make individual Chapter 11s resemble "super-duper" Chapter 13s, which have no absolutely priority rule, but which instead require that the debtor dedicate all of his or her projected disposable income to creditors for a specified period of time. Did BAPCPA supplant the absolute priority rule with a projected disposable income test in individual Chapter 11s?

There are a couple of specific amendments to examine. The first is the expansion of the definition of "property of the estate" in Section 1115. BAPCPA added a new subsection to Section 1115 which, for the first time, expanded the definition of "property of the estate" to include post-petition property and earnings. The new section's language tracks very closely the language of Section 1306 which makes post-petition property/earnings estate property in a Chapter 13 case.

Congress also changed the language of the absolute priority rule text itself, and only as it applies to individual Chapter 11s. After the junior-class-may-not-retain-property prohibition, it adds this exception: "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 (a)(14)." See 11 U.S.C. § 1129(b)(2)(B)(ii).

Additionally, Congress added to individual Chapter 11s a requirement that, if any unsecured creditor objects, the plan proponent must contribute all of his or her projected disposable income to pay creditors, very much like the parallel requirement in Section 1325 that applies to Chapter 13s. See 11 U.S.C. § 1129(a)(15).

Those three changes -- (i) post-petition property of the estate; (ii) which the debtor may retain; (iii) provided the debtor pays all of its projected disposable income to creditors â make the post-BAPCPA statutory regime sound an awful lot like a Chapter 13, where there is no absolute priority rule. However, in Ice House, the Sixth Circuit reversed the bankruptcy court's determination that the absolute priority rule did not apply. What made the Sixth Circuit (and every other Court of Appeals) rule that it does apply?

I think the reason is that the amendments are just really poorly drafted. This issue is the wording of this particular phrase â "the debtor may retain property included in the estate under section 1115" â in See 11 U.S.C. § 1129(b)(2)(B)(ii). The court adopted the "narrow" view of this language, and construed it to mean that the debtor may retain only that property which section 1115 adds to the property of the estate pile, and not property (namely â pre-petition property) that was already there under Section 541(a). It is clearly the correct decision based on the text with which the courts are reckoning, but as the Sixth Circuit acknowledges, it hits individual debtors with a "double-whammy" because they have to satisfy both the projected disposable income test (which corporate Chapter 11s do not) and an absolute priority rule (which Chapter 13 debtors do not).

Every bankruptcy law professor has probably explained the conceptual difference between a Chapter 7 and a Chapter 13 to his or her students in this way: in a Chapter 7, the debtor trades the past (i.e., pre-petition non-exempt assets) to protect the future (i.e., gets a discharge and has no forward-looking obligations). In a Chapter 13, the inverse is true -- the debtor trades the future (i.e., payments into the plan for a specified period of time) to protect the past (i.e., gets to keep certain pre-petition non-exempt assets).

If Congress wants invididual Chapter 11s to resemble Chapter 13s, the absolute priority rule just doesn't fit. Why would someone file an individual Chapter 11 if it is -- by definition -- impossible to deliver on the "keep current property in exchange for future income" deal that Chapter 13 offers?