Court Holds Absolute Priority Rule Applicable in Individual Chapter 11 Cases

In the first circuit court opinion to address the issue, the United States Court of Appeals for the Fourth Circuit recently held that the absolute priority rule applies in cases filed by individual debtors under Chapter 11 of the United States Bankruptcy Code. In re Maharaj, 681 F.3d 558 (4th Cir. 2012). This decision further magnifies the conflict in the courts that have decided the issue.

The Debtors were the owners and operators of an auto body repair shop in Chantilly, Virginia. Their debts exceeded the limits for proceeding under Chapter 13 of the Bankruptcy Code, so they filed a voluntary petition under Chapter 11. The Debtors maintained the auto body shop throughout the case and continued to operate as debtors-in-possession.

In 2010, the Debtors filed a Chapter 11 Plan of Reorganization (the “Plan”) with the bankruptcy court. The Plan contained four classes of creditors: Class I represented a $3.5 million claim by Access Bank, secured by the Debtors’ real property, which was to be refinanced with Access Bank; Class II consisted of a claim by an automobile lender, secured by the Debtors’ vehicle, pursuant to which the Debtors’ daughter would continue to make regular payments; Class III contained general unsecured claims, which would be paid an estimated 1.7% out of future earnings; and Class IV contained Access Bank’s unsecured claims, which would also be subject to the refinancing of Access Bank’s secured claim. Access Bank voted in favor of the Plan on account of Class I and IV. Class II did not vote, as it was unimpaired. Discover Bank, the holder of a small unsecured claim, was the only other creditor to vote and voted to reject the Plan. Thus, Class III was deemed to have rejected the Plan.

The Debtors subsequently sought to confirm the Plan over the dissent of Discover Bank pursuant to section 1129(b) of the Bankruptcy Code, a procedure commonly referred to as a “cram down.” In order to effectuate such a cram down, the Debtors argued that the bankruptcy court should apply the “broad view” of the BAPCPA amendments and find that the absolute priority rule no longer applied to individual Chapter 11 debtors, based upon the changes to section 1129(b)(2)(B)(ii) and the addition of section 1115 to the Bankruptcy Code. The “broad view,” adopted by at least one bankruptcy appellate panel, one district court and five bankruptcy courts, holds that by including in § 1129(b)(2)(B)(ii) a cross-reference to § 1115 (which in turn references § 541, the provision that defines property of the estate), Congress intended to include the entirety of the bankruptcy estate as property that the individual debtor may retain, thus effectively abrogating the absolute priority rule in individual Chapter 11 cases. Some of the courts adopting the “broad view” have done so on the basis of the plain language of § 1129(b)(2)(B)(ii). Others have found the language to be ambiguous but have nonetheless found that Congress intended to abrogate the absolute priority rule for individual Chapter 11 debtors, based upon a perceived attempt by Congress to make Chapter 11 more like Chapter 13.

The bankruptcy court refused to adopt the “broad view” of the BAPCPA amendments, instead adopting the “narrow view” adopted by over a dozen separate bankruptcy courts. The “narrow view” finds that Congress did not intend such a sweeping change to the Bankruptcy Code and that the BAPCPA amendments merely allowed individual Chapter 11 debtors to retain property and earnings acquired after the commencement of the case that would otherwise be excluded under § 541. Similar to the courts adopting the “broad view,” the courts adopting the “narrow view” are not uniform in doing so. Some argue that the plain language of § 1129(b)(2)(B)(ii) preserved the absolute priority rule for individual Chapter 11 debtors. Others find that if Congress intended to abrogate a concept as integral as the absolute priority rule, it would have done so in a more straightforward way.

The Debtors appealed, and the bankruptcy court, on its own motion, certified its order for direct appeal to the Fourth Circuit.

The Circuit Court began its analysis by finding that the language in question was ambiguous, as it lends itself to more than one reasonable interpretation. This was evident from the split of authority on the issue and the “plausible, competing arguments” advanced by the various courts. As such, the Circuit Court looked to the context in which the language was used and the broader context of the statute as a whole and agreed with the “narrow view” courts that BAPCPA preserved the absolute priority rule in the individual Chapter 11 context.

The Circuit Court also pointed to the Supreme Court’s view, especially in the bankruptcy context, that implied repeal is strongly disfavored and found that there was no clear indication (either in the text itself or in the legislative history) that Congress contemplated any sort of abrogation. They went on to state that this was fatal to the “broad view” for at least two reasons: (i) Congress discussed in the BAPCPA legislative history other instances where the intent was to change long-standing bankruptcy practices, and (ii) the absolute priority rule had been abrogated (in part) once before in 1952 (before being reinstated with the advent of the Bankruptcy Code in 1978), and Congress did so clearly and unequivocally. In the words of the Circuit Court: “History shows that Congress knows how to abrogate the absolute priority rule, and it has not done so here.”

Finally, the Circuit Court dismissed: (i) the notion that Congress intended to abrogate the absolute priority rule for individual Chapter 11 debtors in order to harmonize such proceedings with those in Chapter 13, finding that this could have been easily accomplished by raising the Chapter 13 debt limits; and (ii) the public policy arguments set forth by the Debtors (namely that application of the absolute priority rule for individuals is harsh), finding that BAPCPA was a creditor-oriented change and that Congress would have been much more clear if it believed that public policy called for abrogation of the absolute priority rule.

The holding in Maharaj can be construed as a “win” for creditors in individual chapter 11 cases, as it provides an avenue to block confirmation of a plan and can provide leverage in negotiations with individual debtors. However, with the conflict in the courts that have decided the issue, only time will tell if the Fourth Circuit’s interpretation of the Bankruptcy Code will be uniformly applied across the country.