The absolute priority rule has proved particularly vexing to judges and attorneys alike in the Ninth Circuit for several years. This was a result of the Ninth Circuit’s interpretation of the bankruptcy code that allowed individual chapter 11 debtors to retain a significant portion of their assets without the consent of their creditors. Finally, in one of the most important local bankruptcy cases of 2016, the Ninth Circuit finally closed this loophole in Zachary v. California Bank & Trust (In re Zachary), 811 F.3d 1191 (9th Cir. 2016).
A chapter 11 plan of reorganization must be fair and equitable to a class of creditors. The absolute priority rule mandates that a chapter 11 repayment plan must provide for a dissenting class of unsecured creditors to be paid in full before an individual debtor may retain any non-exempt property. An objecting creditor’s plan treatment will only be considered fair and equitable if it complies with the absolute priority rule.
In Friedman v. P+P, LLC (In re Friedman), 466 B.R. 471 (9th Cir BAP 2012) the Ninth Circuit held that the absolute priority rule did not apply to individual chapter 11 cases. As a result of this distinction, a concern arose among legal professionals and the commercial credit industry about the effect of the resulting legal interpretation (loophole) which allowed individual chapter 11 debtors with a high net-worth, often from owning interests in wealthy companies, to retain property without fully paying unsecured creditors in a chapter 11 plan.
Federal courts across the Unites States have typically interpreted the question as to what property a chapter 11 debtor may retain without violating the absolute priority rule with two interpretations, the “broad” view and the “narrow” view.
Until Zachary, the Ninth Circuit applied the broad view holding that Congress intended to include the entirety of the bankruptcy estate as property that the individual debtor may retain, thus effectively eliminating the absolute priority rule in Chapter 11 for individual debtors. This view allows an individual debtor to retain most prepetition and postpetition property, including a cram down of a creditor’s claim despite its objection.
Courts applying the “narrow” view hold “that the BAPCPA amendments merely have the effect of allowing individual Chapter 11 debtors to retain property and earnings acquired after the commencement of the case that would otherwise be excluded under § 541(a)(6) & (7).” In re Maharaj, 681 F.3d 558, 563 (4th Cir. 2012). Thus, 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 § 541 but may cram down a plan that permits the debtor to retain postpetition property only.
In Zachary, the Ninth Circuit abandoned the “broad” view and adopted the “narrow” view by overruling Friedman. The result is that if a class of unsecured creditors objects to its treatment under a chapter 11 plan of reorganization, individual debtors in the Ninth Circuit must either pay the unsecured creditors in full or may not retain any non-exempt property. Of course, a debtor may keep such property by providing new value to the bankruptcy estate for distribution to creditors.
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