Sixth Circuit Joins Appellate Courts Holding That The Absolute Priority Rule Applies In Individual Chapter 11 Cases

A little over a year ago, I authored an article addressing the question of whether the "Absolute Priority Rule" applied to Chapter 11 bankruptcy cases filed by an individual. That article, which focused on the decision of the Fourth Circuit Court of Appeals in In re Maharaj 681 F. 3d 558 (4th Cir. 2012), noted that the trend appeared to be towards the conclusion that the Absolute Priority Rule did apply in such cases—but that in Michigan, the issue had not yet been addressed by the Sixth Circuit Court of Appeals. That has now changed.

Some quick review: The "Absolute Priority Rule" mandates that in a chapter 11 bankruptcy 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 to the treatment that pays them less than in full (i.e., by voting yes on a plan of this type). Prior to 2005, for an individual chapter 11 debtor this rule meant that the debtor could not retain pre-petition property (owned when the case was filed) unless unsecured creditors were paid in full—instead that pre-petition property would have to be contributed in some fashion to fund the plan. Effectively then, the Absolute Priority Rule provided unsecured creditors with a "blocking vote" in an individual chapter 11 case, as creditors could demand that the debtor either pay the unsecured creditors in full, or give up all of his or her pre-petition property to fund the plan. This created real problems for individual chapter 11 debtors who might want to fund a plan by running a post-petition business that would use the prepetition property.

However, amendments to Section 1129 of the Bankruptcy Code in 2005 called into question whether the Absolute Priority Rule continued to apply in individual chapter 11 cases, by allowing an individual chapter 11 debtor to retain some property even though creditors weren't paid in full. The question was what property could be retained? Depending on how the new language of the Code added at that time was interpreted, a debtor could either retain all of his property (including pre-petition property) or just the additional property that became property of the debtor's estate after the commencement of the bankruptcy case (typically a much more limited amount). If the correct interpretation of the changed language was the former, the effect would be that the Absolute Priority Rule was effectively gone as it...