First, a word of warning: the absolute priority rule only applies in Chapter 11 bankruptcy cases and so has little consequence for the average consumer debtor. Individuals usually file Chapter 13 or Chapter 7 bankruptcy cases. However, individuals, as well a businesses, can file Chapter 11 cases and sometimes have to, such as when they want to reorganize and are over the debt limits for Chapter 13. Like in Chapter 13, a Chapter 11 debtor usually proposes a plan. The absolute priority rule comes into play when a class of similar situated creditors do not agree with the plan. The Court will only confirm a plan over the objections of this dissenting group of creditors if:
1. The dissenting creditors will be paid in full, see 11 U.S.C. § 1129(b)(2)(B)(i), or
2. No one with a claim or interest that is junior to the claims of the dissenting creditor will get or retain anything under the plan, see 11 U.S.C. § 1129(b)(2)(B)(ii) (called a “cramdown”).
There are controversial exceptions to this rule (such as the so-called “new value” exception which I may blog about later). However, this is the basic rule. Often the owners of a company want to retain an ownership interest in the reorganized company. In the context of a confirmation battle, the absolute priority rule prevents the retention of an equity interest by the owners if a cramdown is being proposed because the stockholders are junior to the interests of the unsecured creditors. The rule has even been applied to the exempt property of an individual in Chapter 11. This is very controversial and many believe that despite the absolute priority rule the exemption provisions of the Bankruptcy Code, 11 U.S.C. § 522, should be interpreted to allow individuals to keep exempt property even in Chapter 11 cramdown plans.
Nicholas Ortiz, Boston Bankruptcy Attorney
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Last modified: October 22, 2012