Fifth Circuit Finds That Absolute Priority Rule Applies in Individual Chapter 11 Cases

Joining the Fourth and Tenth Circuits, the Fifth Circuit has ruled that BAPCPA did not implicitly repeal the absolute priority rule in individual chapter 11 cases.    Matter of Lively, No. 12-20277 (5th Cir. 5/29/13), which can be found here.

What Happened

The case involved a Debtor who initially filed chapter 13 and then converted to chapter 11 because his debts exceeded the chapter 13 debt ceiling.    The Debtor then proposed a plan in which he proposed to keep his pre-petition non-exempt property while paying creditors more than they would receive in a liquidation.   Although no creditor filed an objection to the plan and the plan was approved by more than 2/3 in dollar amount, several small creditors voted against the plan, causing it to fail to meet the majority in number test under 11 U.S.C. Sec. 1126(c).    The Bankruptcy Court found that the plan could not be confirmed based upon its failure to satisfy the absolute priority rule. 

The Bankruptcy Court authorized a direct appeal to the Fifth Circuit.   Because no party had objected below, the case proceeded with an Appellant but no Appellee.   Unfortunately, the lack of an opponent was not sufficient to carry the day for the Debtor.   In an opinion written by former Chief Judge Edith Jones, the Court concluded that the absolute priority remains viable in individual cases.

BAPCPA Confuses Things

The Debtor's argument focused on some awkward language contained within sections 1115 and 1129(b)(2)(B)(ii) which indicated that the absolute priority rule had been modified.   There are three relevant statutory sections:

First, section 1115 provides that property of the estate in an individual case included property acquired post-petition, including earnings from personal services.

Second, section 1129(a)(15) provides that in an individual case in which an unsecured creditor objected, the Debtor must submit his projected disposable income under the plan for a period of five years.    

Finally, section 1129(b)(2)(B) provides that a plan would be fair and equitable with regard to a rejecting class of claims if:

(i) the plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim; or

(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.    (emphasis added).

*--The reference to subsection (a)(14) should probably refer to subsection (a)(15) instead.

The statutory provisions add certain post-petition property to the estate, require the Debtor to make payments of projected disposable income if a creditor objects and allow the Debtor to retain "property included in the estate under section 1115."     This required an examination of just what property was included by section 1115.   According to section 1115(a) 

(a) 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 . . . ; and

(2) earnings from services performed by the debtor after the commencement of the case. . . . . 

Courts which have examined this language have divided between a "narrow" interpretation holds that "property included in the estate under section 1115" refers only to the post-petition property added to the estate, while the "broad" interpretation holds that section 1115's reference to "property specified in section 541" refers to all section 541 property.   Under the broad interpretation, because section 1115 encompassed all section 541 property, the Debtor could retain all of his property without violating the absolute priority rule.

The Fifth Circuit Unconfuses Things 

The Fifth Circuit's opinion offers a very cogent explanation of why the narrow interpretation is correct. 

To answer Lively's question, we use standard tools of statutory interpretation, which focus on the language of the statute taken in the context of the Bankruptcy Code of which it is a part. (citation omitted). So doing, we are inclined to agree with the bankruptcy court in this case that the "narrow" interpretation is unambiguous and correct, and the exception to the absolute priority rule plainly covers only the individual debtor's post-petition earnings and post-petition acquired property. But even if the statutory language is ambiguous, then the "narrow view" must prevail, because the opposite interpretation leads to a repeal by implication of the absolute priority rule for individual debtors. (citation omitted).

A plain reading of § 1129(b)(2)(B)(ii) in light of § 1115(a) is that both provisions were adopted when BAPCPA was passed in order to coordinate individual debtor reorganization cases to some extent with Chapter 13 cases, whose debt limit may throw debtors like Lively into a Chapter 11 reorganization. See 11 U.S.C. § 109(e). Had Chapter 11 remained unaltered, Lively could reorganize in Chapter 11 under more favorable terms than those available to chapter 13 debtors. Chapter 13 subjects a debtor's post-petition "disposable income," including his salary and earnings, to creditor claims as a plan confirmation requirement. Before the BAPCPA amendments, however, an individual Chapter 11 debtor would only have to satisfy the absolute priority rule with assets that were "property of the estate" at the date of filing for relief; the individual debtor's personal post-petition earnings were not subject to liability to satisfy his creditors. In § 1115, Congress remedied this potential inequity in Chapter 11 by adding to the § 541 definition the individual debtor's post-petition earnings and property acquisitions. Other effects of this amendment were to bring such property interests within the protection of the automatic stay, (citation omitted), which benefits the individual debtor, while enabling court supervision of the debtor's use of those interests.  (citation omitted).

When the debtor's post-petition property and earnings were added to Chapter 11, however, Congress also had to modify the absolute priority rule so that a debtor would not be saddled with committing all post-petition property to satisfy creditors' claims. (citation omitted). This most natural reading of the amendments renders no Code provision superfluous and reveals a reasonable purpose.

Opinion, pp. 6-8.

It is hard to argue with the Court's logic.   While it would have been nice for individual debtors to get a pass from compliance with the absolute priority rule, the general thrust of BAPCPA was to make things more difficult rather than easier for debtors. A major liberalization of the Code's requirements would have been out of character with the rest of the legislation and would likely have been a mistake.   However, the language does not lead to this conclusion.    

There are two points to take away from this opinion.   The first is that it is important to talk to creditors during the balloting process.    If two small creditors had changed their votes from no to yes, then the class would have carried and the plan would not have violated the absolute priority rule.   When small unsecured creditors vote no on a plan, sometimes they are only looking for minor accomodations.   This is part of the bargaining process envisioned by chapter 11 and should be embraced by debtor's attorneys.

The second is that the Court stated that Lively violated because the plan allowed him to "retain the above-listed valuable non-exempt pre-petition assets."   Opinion, p. 3.   While this was just a comment in passing, it is some authority for the position that the absolute priority rule does not prohibit retention of exempt property.   Because exempt property is not property of the estate, it should not be considered under the absolute priority rule.