In an important decision, the Ninth Circuit Court of Appeal has settled a disputed question among California and other western bankruptcy judges to the advantage of lenders and other creditors. The court held that the long-standing “absolute priority rule” still applies in individual Chapter 11 cases, notwithstanding the 2005 amendments to the Bankruptcy Code. Under this rule, an individual Chapter 11 debtor must pay every objecting unsecured creditor in full before the debtor can retain any pre-bankruptcy property under a plan of reorganization. Because few individual debtors have the resources to pay in full, the ruling effectively removes Chapter 11 as a reorganization tool for individuals.
In Zachary v. California Bank & Trust, the Chapter 11 debtors proposed to pay the bank, their largest unsecured creditor, only $5,000 on its claim of nearly $2,000,000. Objecting to its proposed treatment under the plan, the bank argued that the plan violated the absolute priority rule. The debtors countered that after the 2005 amendments to the Bankruptcy Code, the rule did not apply in individual Chapter 11 cases. Thus, the debtors argued, they could still confirm their plan of reorganization over the bank’s objection and retain most of the property that they owned prior to filing for bankruptcy.
The appellate court rejected the debtors’ argument. It determined that, notwithstanding certain changes to the Bankruptcy Code in 2005, individual Chapter 11 debtors can retain only property and earnings acquired after the bankruptcy filing when confirming a reorganization plan over the objection of their unsecured creditors.
The significance of this case cannot be overstated. Unless the Supreme Court were to rule otherwise, there is now no question that individuals who file for Chapter 11 bankruptcy protection in California must pay their objecting unsecured creditors in full in order to retain any pre-bankruptcy property under a plan of reorganization. This definitive holding therefore gives creditors more leverage in negotiating the treatment of their claims in individual Chapter 11 cases and the ability to defeat a plan in most cases.
Our attorneys are available to answer questions or provide assistance regarding Chapter 11 negotiation and strategy.
