Recent Court Decisions Hold That The Absolute Priority Rule Still Protects Creditors Of Individual Chapter 11 Debtors

As the economic recovery continues to wind along through the up and down financial cycles that have been the hallmark of the last four years, there can be little doubt that some individuals historically on the higher end of the economic spectrum have felt the impact of the crisis more than others. More than a few "high net worth individuals" have seen personal fortunes eroded to a degree that has caused them to consider what would have once been unthinkable - personal bankruptcy. However, many times, the bankruptcy relief utilized most often by individual debtors, Chapter 13, or Chapter 7, won't be quite the right fit. The debt ceilings in Chapter 13 preclude some from filing. Means testing, limited exemptions, and the fact that Chapter 7 is after all a liquidation proceeding create difficulty under that chapter. What's a poor high net worth debtor to do?

For some the answer has been an individual chapter 11 case. Individual chapter 11 cases have historically not been the norm, because they required that the individual debtor comply with the same requirements to confirm a plan of reorganization that were applicable to corporations and businesses. To confirm a plan of reorganization, all classes of claims not paid in full in cash on the effective date of the plan have to agree to the alternative treatment the plan proposes. If they do not, the only way to confirm the plan over their dissent is through what is called "cram down" - the process of confirming a plan notwithstanding the dissent of an impaired class of creditors. In order to "cram down" a plan on unsecured creditors, the plan must comply with the so-called "Absolute Priority Rule".

The Absolute Priority Rule has been part of bankruptcy jurisprudence since at least 1939. It mandates that in a chapter 11 case no junior class of claims or interests can receive or retain anything under the plan of reorganization, unless senior classes of claims or interests are either paid in full or consent (by voting yes on the plan) to the treatment that pays them less than in full. In a corporate context, this means that shareholders/equity (the lowest priority interest) cannot retain their shares in the debtor if they pay unsecured creditors less than 100% of their claims (unless the creditors agree to take less). While there are some "exceptions" to this general rule (they aren't critical here) for an individual chapter 11 debtor, who plainly has no shareholders, this rule meant that the debtor...