Sixth Circuit Court of Appeals: Individual Chapter 11 Debtors Cannot Retain Pre-Petition Property Pursuant to a Nonconsensual Chapter 11 Plan if Creditors are not Paid in Full

In a recent decision, the United States Court of Appeals for the Sixth Circuit reversed a bankruptcy court decision from the United States District Court for the Eastern District of Tennessee which held that the absolute-priority rule, codified at 11 U.S.C. § 1129(b)(2)(B)(ii), did not apply in light of the 2005 amendments to the Bankruptcy Code (“BAPCPA”).  The absolute-priority rule provides that every unsecured creditor must be paid in full before a debtor can retain “any property” under a nonconsensual Chapter 11 plan for reorganization.

Prior to BAPCPA, it was undisputed that the absolute-priority rule barred individual Chapter 11 debtors from retaining any property of the bankruptcy estate under a nonconsensual plan unless all creditors were paid in full.  BAPCPA added to the definition of “property of the estate” in Chapter 11 cases to include post-petition property in a new section, § 1115, which supplemented the broader §541.  BAPCPA also amended the absolute-priority rule as applied to individual debtors by including language that stated an individual debtor was allowed to retain property of the estate under § 1115.  This created confusion in some bankruptcy courts, which interpreted these amendments to eliminate the absolute-priority rule as applied to individual debtors.

The Sixth Circuit joined the Fourth, Fifth, and Tenth Circuits in finding that Congress did not intend to eliminate the absolute-priority rule in individual Chapter 11 cases through the BAPCPA amendments to §§ 1115 and 1129 of the Bankruptcy Code.  No other Circuit Court of Appeals has decided this issue. The Sixth Circuit reasoned that BAPCPA merely limited the scope of the absolute-priority rule as applied to individual debtors to pre-petition property.  The court reasoned that if Congress intended to completely abrogate the absolute-priority rule for individual Chapter 11 debtors, it would have done so with a much simpler amendment to 11 U.S.C. § 1129(b)(2)(B)(ii).

The ruling makes it clear that the absolute-priority rule still applies to individual chapter 11 debtors post-BAPCPA.  As a practical matter, creditors asserting claims in individual Chapter 11 cases must be prudent in reviewing the plan for reorganization, and following the Sixth Circuit’s decision, it is more likely that creditors will object to these plans because it is clear that the absolute-priority rule is still good law.

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