In Zachary v. Cal. Bank & Trust, 811 F.3d 1191 (9^th Cir. 2016), the Ninth Circuit Court of Appeals determined that the absolute priority rule applies to individual Chapter 11 cases.  This significantly limits the property an individual debtor can keep if a class of unsecured creditors votes against confirmation of a plan of reorganization.

The absolute priority rule can be found at 11 U.S.C. § 1129(b)(2)(B)(ii), but it must be read in context.  When a chapter 11 debtor in possession files a plan of reorganization, the plan will provide for various classes of creditors.  Members of a class vote for or against plan confirmation.  One such class can be comprised of creditors holding unsecured claims.  11 U.S.C. § 1129 contains numerous requirements for confirmation.  One of these, 11 U.S.C. § 1129(a)(8), requires that with respect to each class of claims or interests either (1) such class has accepted the plan or (2) such class is not impaired under the plan.  So, Section 1129(a)(8) can be satisfied in two ways: (1) the class votes for (accepts) the plan, or (2) the plan provides for the class to be paid in full.  If an unsecured class doesn’t accept the plan, and the plan doesn’t provide for full payment of the claims of the class, Section 1129(a)(8) is not satisfied and, absent an exception, the plan cannot be confirmed.

For the exception, we look to 11 U.S.C. § 1129(b)(1), which provides that if the only confirmation requirement of 11 U.S.C. § 1129(a) not satisfied is the requirements of Section 1129(a)(8)[1], then the court can nevertheless confirm the plan if the plan is “fair and equitable to each such class.”  This brings us to 11 U.S.C. § 1129(b)(2)(B)(ii), which states two ways that the requirements for the “fair and equitable” determination can be satisfied as to a class of unsecured claims.  First, the test can be satisfied if the plan provides for full payment or satisfaction of the claims in that class as of the effective date.  Second, if unsecured creditors in an objecting class are not being paid in full on the effective date of the plan, then the “fair and equitable” test can be satisfied if 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 [the “absolute priority” rule], except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115[2], subject to the requirements of subsection (a)(14) of this section [the exception to the absolute priority rule].”  Emphasis and internal comments added.

The absolute priority rule “provides that a dissenting class of unsecured creditors must be provided for in full before any junior class can receive or retain any property under a reorganization plan.”  Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 202 (1988), citing In re Ahlers, 794 F.2d 388, 401 (1986).  The equity or ownership interest of a debtor has a lower priority than that of an unsecured claim.  11 U.S.C. §726(a).

The underlined language above is part of the revisions to the Bankruptcy Code in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, and the question Zachary addressed was whether the new language authorized a debtor to retain non-exempt pre-petition property when a dissenting impaired class of unsecured creditors was not being paid in full.  So, what is “property included in the estate under section 1115”?  And if property, including property acquired pre-petition, is not estate property, could a debtor retain it pursuant to the underlined portion of 1115?  Section 1115 “expands the definition of ‘property of the estate’ in Chapter 11 cases to include, for the first time, property obtained by the debtor ‘after the commencement of the case.’  And all such property, absent some other amendment to the Code, would be subject to the absolute-priority rule.”  Ice House Am., LLC v. Cardin, 751 F.3d 734, 738 (6^th Cir. 2014).  Does this mean that property acquired by a debtor before the bankruptcy is not estate property?

Zachary agreed with Ice House that the new language in 11 U.S.C. § 1129(b)(2)(B)(ii) only exempts from property of the estate that property which is acquired after the commencement of the Chapter 11 case.  Zachary, at 1198.  So, if there is an objecting class, a debtor can keep only exempt pre-petition property and property acquired after the commencement of the bankruptcy, and cannot retain non-exempt pre-petition property.

Individuals and their attorneys must be aware of Zachary in considering whether to file an individual chapter 11 case, particularly if it is possible that there will be one or more dissenting classes of unsecured creditors.