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How Chapter 11 Works for Individuals

In 1978, Congress completely overhauled our bankruptcy laws, replacing the Bankruptcy Act of 1898 with the modern Bankruptcy Code. The new Bankruptcy Code creating what we now know as Chapter 7, Chapter 9 (for governmental entities), Chapter 11 (reorganization) and Chapter 13 (for consumers with a regular income).

The next 38 years have seen modifications, some major, others less so. Among other things, Congress has added Chapter 12 (for family farmers and fishermen) and Chapter 15 (to address international bankruptcy issues). In 2005 Congress refocused the bankruptcy laws for individuals by adding a test to qualify for Chapter 7 and making Chapter 11 for individuals who want to reorganize more like Chapter 13.

One of those changes to Chapter 11 for individuals was to change what assets (property of all types) must be included in the bankruptcy process for the benefit of creditors . Before 2005, it was just the assets which existed on the day the bankruptcy case was filed. The new law expanded that to include property which the individual debtor might receive even after the bankruptcy case is filed - the post-bankruptcy property. This change created a challenge for individual Chapter 11 debtors, for their lawyers and for the Judges deciding their cases.

Since the early 1900's in the railroad reorganization cases, Courts began to create a rule which required the full payment of a senior class of creditors before a junior class of creditors could be paid anything. This has come to be known as "the absolute priority rule". To understand the rule, it is important to know that the Bankruptcy Code sets up classes of creditors - certain creditors belong in certain types of classes and, as a result, have specific rights. The classes are "ranked" for payment. The class with the lowest priority in an individual case, is the debtor him or herself. In other words and with some modest exceptions for something called "exempt" property, all of the creditors must be paid in full before the Debtor is allowed to keep anything for him or herself. Courts have also developed one very important exception to the absolute priority rule, called the "new value exception", but that exception is not relevant to this article.

The combination of adding post-bankruptcy property into the mix and the absolute priority rule made it very difficult for individuals to file Chapter 11. In very general terms and subject to some further technical exceptions, if the individual Debtor wanted to keep more than exempt property, the reorganization plan either had to have: (1) the consent of every class of creditors, or (2) it had to provide for the full payment of all creditors. Both are very high barriers.

Since 2005, lawyers and judges have looked for a way around this problem so that individuals could use Chapter 11 while still making sure that creditors were treated fairly and would be paid more than creditors would get if the Debtor just filed Chapter 7. This was viewed as a win-win: creditors would get paid more than they would receive in a Chapter 7 while Debtors were given a reason NOT to file Chapter 7 because they could keep more of their assets. Some Judges concluded, for various reasons, that the specific language of the 2005 changes just eliminated the absolute priority rule for individuals in Chapter 11 cases. Without the absolute priority rule, Debtors could keep more property so long as creditors were treated fairly. This came to be known as the "broad view".

Other Judges concluded that the absolute property rule remained in effect and was not changed or eliminated by the 2005 law which meant that individual Debtors either had to get creditor consent or propose a plan to pay creditors in full. This came to be known as the "narrow view."

After more than 10 years of wrangling over this technical issue, the debate is over - at least in most of the Country. Joining the 5th, 6th and 10th Circuits, the 9th Circuit has now formally adopted the narrow view in a case called Zachary v. California Bank & Trust, Case No. 13-16402, ___ F.3d ___ (9th Cir. 1/29/2016). A full copy of the Court's Opinion is linked here.

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