Judge Robert Kwan Rules that the Absolute Priority Rule Still Applies in Individual Chapter 11 Cases

In re Arnold,  — B.R. — , 2:12-bk-15623 (Bkrtcy, C.D. Ca. May, 2012  Kwan.J.)

Issue:   Does the absolute priority rule still apply in individual chapter 11 cases?

Holding:   Yes.

Judge Robert Kwan

The debtors here filed a individual chapter 11.  They own a number of pieces of real property.  They filed a chapter 11 disclosure statement and plan and US Bank objected on the basis that the disclosure statement did not contain adequate information and that the plan was patently unconfirmable because it violates the absolute priority rule.  The US Bank unsecured claim was based on a deficiency on property which the debtors had guaranteed.

Judge Kwan agreed with US Bank and refused to approve the disclosure statement.  As to whether the disclosure statement contained adequate information, the court found that the options given to unsecured creditors were confusing, did not advise creditors which option would apply, and did not advise creditors of the significance of various court rulings on the various options.  The disclosure statement also advised creditors that the debtors would make a new value contribution of $250,000 “at their election” but did not say where that money was going to come from and therefore the feasibility of making the contribution.

As to the absolute priority rule, Judge Kwan ruled that the absolute priority rule still applies in individual chapter 11 cases notwithstanding the Friedman BAP case.  He began by commenting that it was evident that US Bank was going to vote no and that its claim was more than 2/3s of the unsecured class.  He next commented that the BAP rulings are not binding on bankruptcy courts noting the split of authority almost everywhere.  He next discussed Friedman and noted that Friedman did not have an appellee and therefore did not have the benefit of argument from both sides.  He then walks through the basics of plan confirmation and the absolute priority rule.  He then discusses section 1115 especially from a grammatical or dictionary perspective.  For example, “In technical grammatical terms, the specific question is whether ‘in addition to property specified in section 541’ is an ‘adjectival phrase’ or an ‘adverbial phrase.'”    Judge Kwan next goes through the legislative history of section 1115.

Judge Kwan then discusses policy considerations saying, “Finally, strong policy considerations require the application of the absolute priority rule to individual Chapter 11 cases.”  “There is no need for an individual debtor-in-possession to negotiate with creditors to seek their consent and solicit their votes for a reorganization plan if the debtor knows in advance that he or she can resort to cramdown and keep his or her prepetition property regardless of any vote in a plan confirmation process.”  He makes a great point that elimination of the absolute priority rule essentially raises the debt limits for chapter 13 cases and if that’s what Congress wanted, it would have been easy to do that.   “Excepting financially sophisticated individual Chapter 11 debtors with complex personal investments, as here, from the absolute priority rule and allowing them to retain such investments despite their overleveraging does not seem justified in light of the legislative history of BAPCPA and what Congress sought to accomplish in that act.”

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