Pay now or later.Individuals may want to think twice before seeking relief under chapter 11 following a recent decision from the Ninth Circuit Court of Appeals. In Zachary v. California Bank & Trust, the Ninth Circuit affirmed a bankruptcy court’s order denying confirmation of a plan of reorganization in which individual debtors proposed to retain their pre-petition and post-petition property but to pay a dissenting unsecured creditor just .26% of the creditor’s claim. The Ninth Circuit held that the absolute priority rule still applies to individual chapter 11 debtors, and that individual chapter 11 debtors may not confirm a plan under which they retain prepetition property if they do not pay dissenting creditors in full.

In Zachary, David Zachary and Annmarie Snorsky filed a joint chapter 11 petition. California Bank & Trust (CB&T) was their largest unsecured creditor with a claim of approximately $1.9 million. In their third amended plan of reorganization, the debtors put CB&T in its own class and proposed to pay CB&T $5,000.00 on account of its $1.9 million claim. CB&T objected to confirmation, arguing that the plan violated the absolute priority rule.  The absolute priority rule provides that a dissenting class of creditors must be paid in full before any junior class can receive or retain any property under a plan of reorganization.  CB&T argued that the debtors’ plan could not be confirmed because it permitted the debtors to retain their prepetition property even though CB&T was not being paid in full (and in fact was being paid only .26% of its claim).  The bankruptcy court sustained CB&T’s objection and denied confirmation.

On appeal, the Ninth Circuit noted the split between the majority “narrow view” and the minority “broad view” of the absolute priority rule that has developed since the 2005 amendments to the Bankruptcy Code (known as the “Bankruptcy Abuse Prevention and Consumer Protection Act of 2005” (BAPCPA)). BAPCPA added section 1115 to the Code.  Section 1115 expands an individual chapter 11 debtor’s estate to include earnings and property acquired after the petition is filed and before the case is closed, dismissed, or converted. BAPCPA also amended section 1129(b)(2)(B)(ii) to provide that an individual debtor may retain property included in the estate under section 1115.  The question in Zachary was whether sections 1115 and 1129(b)(2)(B)(ii) created an exception to the absolute priority rule so that an individual debtor may retain property that he or she acquires before commencement of the case when the creditors are not paid in full.  Courts adopting the broad view have interpreted sections 1115 and 1129(b)(2)(B)(ii) to allow an individual debtor to retain all estate property whether acquired pre- or post-petition.  These courts have essentially held that the absolute priority rule no longer applies to an individual debtor.  Conversely, the courts adopting the narrow view have interpreted sections 1115 and 1129(b)(2)(B)(ii) to allow an individual debtor only to retain property acquired post-petition.

The Ninth Circuit adopted the narrow view and held that an individual debtor may not retain pre-petition property when creditors are not paid in full.  The court held that interpreting sections 1115 and 1129(b)(2)(B)(ii) as defining a new class of property that is exempt from the absolute priority rule “nicely harmonizes the new provisions.” The court also reasoned that if Congress had intended to eliminate the absolute priority rule for individual chapter 11 debtors (i.e., the broad view), it would have done so in a more straightforward manner. After all, Congress repealed the absolute priority rule in 1952 and then reinstated it in 1978, “demonstrating that when it intends to abrogate the rule, it knows how to do so explicitly.”

By its opinion in Zachary, the Ninth Circuit joined the Fourth, Fifth, Sixth, and Tenth Circuits in adopting the narrow view of the absolute priority rule. The decision in Zachary, as well as the prior decisions in the sister circuit courts, is a “double-whammy” for individual debtors in chapter 11. Individual chapter 11 debtors cannot confirm a plan over the objections of creditors unless they relinquish both five years’ of post-petition disposable income (as provided for in section 1129(a)(15)(B)) and prepetition property. Debtors may need to brace themselves for longer, more protracted negotiations with unsecured creditors, and should prepare themselves to part with prepetition property. Enabling a fresh start for the individual chapter 11 debtor has just become a more difficult endeavor, and may force more individual debtors into chapter 7.