Secured Creditors and the Absolute Priority Rule
In bankruptcy cases, creditors often look to the absolute priority rule as a basis for objecting to a debtor’s plan. The rule provides a useful protection against cramdown, prohibiting confirmation where junior classes are treated more favorably than more senior classes. While objections based on the absolute priority rule are usually raised by unsecured creditors, secured creditors sometimes raise objections under the rule. This article explores issues secured creditors face in raising objections to confirmation based on the absolute priority rule.
I. Cramdown and the Absolute Priority Rule
Section 1129(a) of the Bankruptcy Code sets forth 16 requirements that a debtor generally must satisfy to confirm a Chapter 11 plan. See 11 U.S.C.A. § 1129(a) (2006) (”The court shall confirm a plan only if all of the following requirements are met”). One of these requirements is that each impaired class of creditors must accept the plan. See 11 U.S.C.A. § 1129(a)(8). There is an exception to this requirement, though, in Section 1129(b). That section provides that a plan can be “crammed down” on a dissenting impaired class if the plan does not discriminate unfairly, and is fair and equitable. See 11 U.S.C.A. § 1129(b)(1).
The Bankruptcy Code defines “fair and equitable” differently for secured and unsecured claims. A plan is typically not considered fair and equitable with respect to a dissenting class of secured claims unless the plan provides for the full payment or the realization of the indubitable equivalent of the allowed amount of each secured claim. See 11 U.S.C.A. § 1129(b)(2)(A). With respect to a dissenting class of unsecured claims, a plan is generally not fair and equitable if it violates the absolute priority rule. See 11 U.S.C.A. § 1129(b)(2)(B)(ii). The gist of the absolute priority rule is that a junior class of creditors may not receive or retain any property on account of its claims unless the claims of a dissenting senior class are satisfied in full. See Id.
The express inclusion of the absolute priority rule in Section 1129(b)(2)(B)(ii) (which relates to unsecured claims), but not in Section 1129(b)(2)(A) (which relates to secured claims), raises a few questions. First, does a secured creditor even have standing to object to confirmation based on a violation of the absolute priority rule? Second, can an under-secured creditor object, on absolute priority rule grounds, because of the plan’s treatment of the unsecured portion of its claim? Finally, if the absolute priority rule cannot be applied to secured claims as an express requirement of Section 1129(b)(2)(A), can it be applied as an implicit element of “fair and equitable?”
II. Standing to Object Based on Violation of the Absolute Priority Rule
Many courts prohibit fully secured creditors from objecting based on allegations that a plan violates the absolute priority rule. In In re New Midland Plaza Assoc., a fully secured creditor objected to confirmation of the plan on grounds that it violated the absolute priority rule. 247 B.R. 877, 884 (Bkrtcy.S.D.Fla. 2000). Specifically, the creditor pointed to the fact that general partners of the debtor would retain their interests under the plan, while unsecured creditors would receive less than the full amount of their claims.
According to the Court in New Midland, allowing a secured creditor to block confirmation under the absolute priority rule eviscerates the vote of classes of unsecured creditors. Id. at 895. The Court held as a matter of law that a fully secured creditor, whose treatment under a plan is fair and equitable and not unfairly discriminated against, does not have standing to assert the absolute priority rule to block confirmation of an otherwise confirmable plan. Id. at 893-94, 895. See also Corestates Bank, N.A. v. United Chemical Tech., Inc., 202 B.R. 33, 54-55 (E.D.Pa. 1996) (refusing to extend the absolute priority rule to fully secured creditors as an implicit requirement to confirmation under Section 1129(b)); see also In re Arden Props., 248 B.R. 164, 173-74 (Bankr.D.Ariz.2000) (”[T]he absolute priority rule applies only to unsecured classes, not to secured claims, the requirements for which are separately set forth in Section 1129(b)(2)(A), which says nothing about the timing of repayment nor any comparison to the treatment of any other classes.”); Friedman, 14 Cardozo L.Rev. at 1505 (”[T]he Code explicitly applies the absolute priority rule to unsecured claims and equity interests, but does not mention it in relation to secured claims. Few decisions under the Code have been found which specifically consider how the absolute priority rule still applies to secured creditors under the Code.”).
Secured creditors are also prohibited by many courts from objecting that the plan violates the absolute priority rule with respect to an unsecured creditor’s claim. This is generally considered by courts as a matter of simple statutory construction. Section 1129(b)(1) states that, in order to be confirmed over the objection of a class of impaired creditors, the plan must be fair and equitable with respect to the dissenting class. Thus, a plan need not be fair and equitable (nor comply with the absolute priority rule) with respect to a creditor that accepts the plan. So, if the unsecured creditor class accepts the plan, there cannot be a violation of the absolute priority rule with respect to its claims. Thus, a fully secured creditor would again lack standing to raise such an objection. See In re Cypresswood Land Partners, I, 409 B.R. 396, 437 (Bankr.S.D.Tex. 2009) (secured creditor lacked standing to object that the plan violated absolute priority rule); 5 Collier on Bankruptcy ¶ 1129.03[4][e] (15th ed. 1991) (”[i]t is important to note that the application of the so-called ‘absolute priority’ rule applies only in cases when a class of unsecured claims or equity interests is impaired and does not accept the plan”).
III. Undersecured Creditors and the Absolute Priority Rule
An issue upon which most courts agree, is that, unlike fully secured creditors, undersecured creditors have a definite basis for asserting the absolute priority rule. Undersecured claims are generally bifurcated: the creditor has a secured claim to the extent of the value of his collateral, and an unsecured claim for any debt exceeding value of the collateral. As a result, the undersecured creditor typically receives a vote in the general unsecured class. The undersecured creditors, like the rest of the creditors in the unsecured class, may object to confirmation of the plan for a violation of the absolute priority rule.
This scenario played out in a recent case in the Bankruptcy Court for the Southern District of Georgia. See In re Global Ship Systems, LLC, 391 B.R. 193 (Bkrtcy.S.D.Ga. 2007). Global Ship Systems was a Chapter 11 case in which the unsecured portion of a secured creditor’s undersecured claim dominated the unsecured creditors’ class. 391 B.R. 193 at 208. As such, no plan could be confirmed over the creditor’s objection, except pursuant to Section 1129(b), the cramdown provision. Id. Finding that the debtor’s proposed plan violated the absolute priority rule, the Court lifted the stay and allowed the secured creditor to foreclose on its collateral. Id. In this way, an undersecured creditor may have an advantage over a fully secured creditor when it comes to blocking confirmation of a plan.
IV. Absolute Priority Rule as an Implicit Part of “Fair and Equitable”
While many courts limit the applicability of the absolute priority rule to unsecured creditors (or undersecured creditors), there are some courts that have allowed fully secured creditors to raise the issue. Courts that have applied the absolute priority rule in relation to secured claims have found that the rule is an implicit requirement of the entirety of Section 1129(b) and not just of any individual subsection. See, e.g., In re Elijah, 41 B.R. 348 (Bankr.W.D.Mo. 1984) (holding that a plan proposing that a creditor’s first lien be substituted with a junior lien on other collateral violated the absolute priority rule). In In re Miami Center Associates, Ltd., 144 B.R. 937 (Bankr.S.D.Fla. 1992), Aetna held a secured claim in excess of $38 million. In its reorganization plan, the debtor sought to defer Aetna’s repayment for ten years, while the debtor’s partners retained their interests in the debtor. The court held that such a plan was not fair and equitable and violated the absolute priority rule. In answering the debtor’s contention that the absolute priority rule was inapplicable, the court stated:
The debtor argues that the absolute priority rule, which precludes equity interest from surviving where senior interests have not been fully paid, is purely a creature of statute … available only to unsecured creditors. This Court (as well as several others) disagrees. The absolute priority requirement is implicit in § 1129(b)(1) and (2), imposing a “fair and equitable” standard on cram-down plans.
Id. at 941. Similarly, in In re Monarch Beach Venture, Ltd., 166 B.R. 428,434-35 (C.D.Cal. 1993), the court held that the absolute priority rule is an implicit part of the “fair and equitable” requirement for confirmation of plan under the cramdown provision of Section 1129(b)(2)). In so holding, the Monarch Beach court relied in part on the following portion of legislative history:
The general principle of [§1129(b)] permits confirmation notwithstanding nonacceptance by an impaired class if that class and all below it in priority are treated according to the absolute priority rule. The dissenting class must be paid in full before any junior class may share under the plan. If it is paid in full, then the junior classes may share. Treatment of classes of secured creditors is slightly different because they do not fall in the priority ladder, but the principal is the same.
H.R.Rep. No. 95-595, 95th Cong., 1st Sess. 413 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6369.
V. Conclusion
In some courts, where the absolute priority rule is held an implicit part of “fair and equitable” requirement of Section 1129(b), secured creditors may be able to block plans that equity holders do retain an interest or otherwise violate the absolute priority rule. In many other courts, though, a secured creditor has no standing to assert an absolute priority rule objection unless it is undersecured and is voting as part of an unsecured class.
By Evening of Dancing Atop Bar at Coyote Ugly Leads to Loss of Smell, Lawsuit.
Ms. Brittany Barnes decided to enjoy a night out in Nashville. During the course of the evening, she found herself dancing on top of a bar at a bar called Coyote Ugly. Unfortunately at some point she fell and suffered injuries, including a “permanent loss of smell.” She claimed it was the bar’s fault for allowing the bar surface to be slippery and for not warning her of the slippery bar. The bar responded by saying that the bar surface was fine, and the fall was caused by Ms. Barnes’s state of inebriation. The bar also claimed Ms. Barnes’s loss of smell was caused by other factors, including a history of smoking, not the fall in the bar. Experts on issues ranging from bar safety to medical causation on loss of sense of smell were retained.
Where Ignorance Truly Is Bliss: Failure to Disclose Potential Lawsuit in Bankruptcy Not a Bar to Future Suit
In the past year, I’ve blogged a few times about the consequences of failure to disclose assets and claims in a bankruptcy. See Be Prepared to Fully Disclose in Bankruptcy or Suffer the Consequences, November 17, 2010; Disclosure in Bankruptcy: When Too Little and Too Late Bar a Lawsuit, April 5, 2010.
Triple Bogey for Golf Course Investor: “Reasonable Reliance” for Nondischargeability Under Section 523(a)(2)(B)
An investor in a golf course provided his partner with an incomplete financial statement with the knowledge that the partner would use the financial statement to shop around for a loan to the golf course. The investor claimed that he believed that the partner would fill in the missing parts of his financial statement (notably, the missing parts related to additional undisclosed liabilities, not undisclosed assets). The partner was successful in obtaining a loan, with the investor as the borrower. The golf course operations ultimately could not service the loan. When the investor was pursued for payment, he filed a voluntary Chapter 7. The bank that had relied on the incomplete financial statement objected to discharge.
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