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Sixth Circuit Rules that Individual Chapter 11 Debtors are Subject to the Absolute Priority Rule

One of the fundamental tenets of a business bankruptcy reorganization plan under Chapter 11 of the Bankruptcy Code is the "absolute priority rule." This rule, codified in section 1129(b)(2)(B)(ii) of the Bankruptcy Code, provides that every unsecured creditor must be paid in full before the debtor can retain any property under a reorganization plan. Chapter 11, however, is not solely the domain of business debtors. Individuals (who more commonly seek protection under Chapters 7 and 13) may also file for Chapter 11. So how does the absolute priority rule affect individual debtors? That issue is analyzed in a recent opinion, Ice House America, LLC v. Cardin, issued by the U.S. Court of Appeals for the Sixth Circuit.

The facts of the case are relatively simple. The individual debtor, Cardin, filed for Chapter 11 (his assets were too large to file under Chapter 13) and proposed a plan of reorganization that would pay his largest unsecured creditor, Ice House America, less than ten cents on the dollar for its $1.545 million claim. Cardin also proposed to remit to Ice House any disposable income earned by him during the five years following the plan's confirmation. The plan also provided that Cardin would be entitled to retain assets (equity in a home, truck and ice machines) with equity totaling nearly $200,000, once loans to creditors secured by those assets were paid off.

Ice House America (not surprisingly) voted against the plan. Thus Cardin was left to seek confirmation of a nonconsensual plan - a "cramdown" plan. Section 1129(b) of the Bankruptcy Code creates an exception that allows for the confirmation of a cramdown plan if "the plan . . . is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan." A plan must satisfy the absolute priority rule in order to be "fair and equitable."

Ice House America and the U.S. Trustee objected to the plan on the basis that it violated the absolute priority rule in that Cardin proposed to retain assets under the plan while impairing the claim of Ice House America. Cardin argued that the 2005 amendments to the Bankruptcy Code eliminated the absolute priority rule as applied to individual debtors. The Bankruptcy Court agreed with Cardin and confirmed the plan. Ice House America appealed the decision, and the U.S. District Court certified the question presented for direct appeal to the Sixth Circuit. The Sixth Circuit reversed the Bankruptcy Court, ruling that individual debtors are subject to the absolute priority rule.

The court began its analysis with a review of what constitutes "property of the estate," which is property available for distribution to creditors. Section 541(a)(1) of the Bankruptcy Code defines "property of the estate" as "all legal or equitable interests of the debtor in property as of the commencement of the case." As part of the 2005 amendments to the Bankruptcy Code, Congress expanded the definition (in a new Bankruptcy Code section 1115) to include property acquired by the debtor "after the commencement of the case." However, Congress also amended section 1129(b)(2)(B)(ii) to add the following italicized language:

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.

Ice House argued that this new language, which indisputably allows an individual Chapter 11 debtor to retain some property, only applies to post-petition property that is added to the estate by section 1115. Cardin, on the other hand, argued (and the Bankruptcy Court agreed) that the language is broader in scope, excepting all property - both pre- and post-petition - from the absolute priority rule, thus exempting individual debtors entirely from the implications of the absolute priority rule.

After analyzing the meaning of the word "included" as used in section 1115, the court determined that "included" meant property taken into the estate after a case is filed, rather than property included in the estate at the time it is filed. The court relied upon this distinction in reversing the Bankruptcy Court, ruling that the exception created by the amendment to section 1129(b)(2)(B)(ii) only applies to post-petition property acquired by an individual debtor, and thus pre-petition property is subject to the absolute priority rule. The court noted that its interpretation is consistent with the Fourth and Tenth Circuit Courts of Appeal, the only other circuits to have reached the issue.

So what are the implications of the court’s ruling? Besides resolving ambiguity regarding an important issue for plan confirmation, it will focus parties more intently on not just the extent and scope of an individual debtor’s assets in a Chapter 11 case, but also the timing of when such assets were acquired.

Categories: 6th Circuit Court of Appeals, Chapter 11

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practice focuses on bankruptcy, municipal law, collections, and trial-level and appeals litigation. In the bankruptcy arena, she represents primarily Chapter 7 trustees. Laura has handled a wide range of trial and appellate matters for individual and business clients and has appeared before the U.S. Sixth Circuit Court of Appeals, the Michigan Court of Appeals, and the United States Bankruptcy Court for the Western District of Michigan, as well as Michigan circuit and district courts across the state.

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