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BANKRUPTCY BEAT: Connecticut Bankruptcy Court Rules on Issue of First Impression: Whether The Absolute Priority Rule Is Applicable In Individual Chapter 11 Cases   

Posted by Jessica Grossarth
November 3, 2014

Chief United States Bankruptcy Court Judge Julie A. Manning decided an issue of first impression in this District and the Second Circuit on September 4, 2014 in In re Richard and Stephanie Lucarelli and Lucarelli’s Executive Answering Service, LLC, Jointly Administered Case No. 13-30305 (“Lucarelli”). The issue was whether the absolute priority rule applies in individual chapter 11 cases following the Bankruptcy Abuse Prevention and Consumer Protection Act’s (“BAPCPA”) amendments in 2005. Judge Manning held that as a result of BAPCPA’s amendments, the absolute priority rule applies in individual chapter 11 cases in a modified form and has not been eliminated.

The absolute priority rule is implicated in a “cram down” situation.  In a Chapter 11 case, a proposed plan may be confirmed consensually if all 16 paragraphs of 11 U.S.C. Section 1129(a) are satisfied. Alternatively, a proposed plan may be confirmed non-consensually by “cram down” if the plan proponent satisfies all paragraphs, with the exception of paragraph (8)  of Section 1129(a), which requires acceptance of the plan by each impaired class, and the plan does not discriminate unfairly and is fair and equitable with respect to each impaired dissenting class under the plan. 11 U.S.C. Section 1129(b)(1).  The absolute priority rule, which was at issue in Lucarelli, generally provides that in order for a “cram down” to be “fair and equitable,” every unsecured creditor in a dissenting impaired class must be paid in full before the debtor is permitted to retain “any property” under the plan. 11 U.S.C. Section 1129(b)(2)(B)(ii).

As the absolute priority rule’s historical roots stem from corporate, as opposed to individual Chapter 11 cases, it was unclear for some time whether the absolute priority rule applied in individual Chapter 11 cases.  The United States Supreme Court clarified the answer to that question in Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S. Ct. 963 (1988) and Toibb v. Radloff, 501 U.S. 157, 111 S.Ct. 2197 (1991).  Following Ahlers and Radloff and until BAPCPA’s amendments in 2005, it was clear that individual debtors could file Chapter 11 cases and the absolute priority rule applied in those cases.

BAPCPA’s amendments to the Bankruptcy Code in 2005 modified Section 1129(b)(2)(B)(ii) and added Section 1115, which read together called into question the foregoing Supreme Court precedent which applies the absolute priority rule to individual Chapter 11 cases.  Specifically, Section 1129(b)(2)(B)(ii) as modified provides that: “(B) With respect to a class of unsecured claims… (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.  See 11 U.S.C. Section 1129(b)(2)(B)(ii) (emphasis added).  Section 1115, entitled “Property of the estate,” provides that:

(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 but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first; and

(2) earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12, or 13, whichever occurs first.

(b) Except as provided in Section 1104 or a confirmed plan or order confirming a plan, the debtor shall remain in possession of all property of the estate.

See 11 U.S.C. Section 1115. 

The interpretation of Section 1129(b)(2)(B)(ii) and Section 1115 has been a point of divergence amongst courts since introduced to the Code.  Consensus has emerged around two interpretations, commonly referred to the “broad” and “narrow” views.  The broad view interprets the added language to mean that an individual Chapter 11 debtor who proposes not to pay a class of rejecting unsecured claimants in full may nonetheless retain property specified in 11 U.S.C. Section 541 – all of the debtor’s non-exempt pre-petition property as well as all post-petition property and earnings and still obtain confirmation.  The “narrow” view reads both Section 1129(b)(2)(B)(ii) and Section 1115 as creating a limited exception to the absolute priority rule in that an individual Chapter 11 debtor whose plan proposes not to pay a class of rejecting unsecured claimants in full may retain only the post-petition property and earnings referred to in Section 1115 and nothing more.

The Bankruptcy Court in Lucarelli engaged in a statutory analysis and concluded that the language of the relevant clauses of both Section1129(b)(2)(B)(ii) and Section 1115 are ambiguous.  Analyzing the canons of construction, the Bankruptcy Court concluded that the broad view would amount to an implied repeal of the absolute priority rule in individual Chapter 11 cases, and this could not be what Congress intended because there was no “clear indication” to effect an implied repeal.  Additionally, the Bankruptcy Court found the legislative history to be unenlightening as to the meaning of these statutes taken together.

As a result of the ambiguity of the statutes, the established canon disfavoring implied repeal and the lack of any useful legislative history, the Bankruptcy Court stated it had no choice but to adopt the “narrow view.”  However, the Court acknowledged the anticipated problems with its own holding including: 1) the resulting practical effect of making confirmation of a nonconsensual plan in a Chapter 11 case highly unlikely, if not virtually impossible; 2) Chapter 11 reorganization will be far less attractive to individual debtors because of the “double whammy”, i.e. the debtor having to both dedicate the value of five years of projected disposable income to the payment of unsecured creditors and complying with the absolute priority rule if those creditors are not paid in full; and 3) requiring an individual debtor in a nonconsensual situation to undergo the functional equivalent of a liquidation.

Despite the foregoing issues, the Bankruptcy Court stated that these are the unfortunate results of the statutes’ language, and that there was not sufficient clear evidence of Congressional intent to rule any way other than how it ruled.  The Bankruptcy Court declined to address the two natural corollary issues of whether the debtors were in compliance with Section 1129(a)(15) which requires the debtors to commit the value of their disposable net income over a five (5) year period and whether the debtors’ proposed “new value” was sufficient to confirm the plan over the objection of an unsecured creditor in the case.

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