Exempt Property and the Absolute Priority Rule in Individual Chapter 11s

Exempt Property and the Absolute Priority Rule in Individual Chapter 11s

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With the recent influx of mega-bankruptcies with allegations of fraud on behalf of officers and directors, an increase in large individual chapter 11 bankruptcies will surely follow. Indeed, officers and directors of some of the largest corporate bankruptcies have incurred massive liabilities, while also amassing great wealth and assets. In addition, some of these wealthy individuals have established residence in states, such as Florida and Texas, with generous homestead exemptions.

Due to the wealth and sophistication of some of these individuals, many will opt for chapter 11 bankruptcy, as opposed to chapter 7, in an attempt to control and maintain their assets while attempting to discharge liabilities. As plans are filed, issues will certainly arise regarding the ability to retain property, particularly exempt property, when liabilities are discharged in chapter 11. Though a less-than-often addressed issue, it will certainly attract more attention in the near future.

The Absolute Priority Rule

A cornerstone concept of chapter 11 reorganization is the absolute priority rule, which states that a debtor may not, over the objection of an impaired, senior class of claimants, receive or retain under the plan property or an interest on account of such junior claim or interest in any property. See 11 U.S.C. §1129(b)(2)(B)(ii). The absolute priority rule prevents a debtor from discharging liabilities while retaining property.

When determining whether a debtor is retaining property in violation of the absolute priority rule, it is important to consider whether the property is retained on account of such junior claim or interest any property. Because of the phrase "on account of such junior claim or interest," it is only logical that a debtor could retain property if such property is retained for some reason other than on account of the pre-petition interest, such as the contribution of additional consideration, or "new value." The retention of property interests on account of additional consideration is commonly referred to as the new value exception, which many argue survived Congress's enactment of the Bankruptcy Code. See Bank of America National Trust & Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 444, 119 S.Ct. 1411, 1417, 143 L.Ed.2d 607 (1999). However, a more logical reading dictates that it is not an exception at all because the retention of property due to additional consideration is wholly consistent with the express language of §1129(b)(2)(B).

Arguments over the application of the new value exception resulted in much case law on how to measure new value; whether new value is required when objecting creditors are given the opportunity to submit competing plans; and whether the new value exception applies when such new value is given for any reason other than business reasons.

Such case law applies, directly and indirectly, to the application of the absolute priority rule in individual chapter 11s which, after all, will often culminate in an individual debtor attempting to retain property, both exempt and non-exempt, over the objection of an impaired, senior class of claimants.

The Grant of New Value by Individual Debtors

As stated above, the new value exception allows a debtor to essentially buy property from the bankruptcy estate under the guise of contribution of new value. However, the Supreme Court has ruled that the contribution of new value must be (a) "new" and "money or money's worth;" (b) necessary; and (c) reasonably equivalent to the interest being retained. See Case v. Los Angeles Lumber Products Co., 308 U.S. 106, 121-22, 60 S.Ct. 1, 10, 84 L.Ed. 110 (1939).

The "new" requirement may be defined simply as "not currently part of the debtor's bankruptcy estate." See In re Treasure Bay Corp., 212 B.R. 520, 544-45 (Bankr. S.D. Miss. 1997). However, "necessary" is typically defined as "necessary for an effective reorganization." See In re Woodbrook Associates, 19 F.3d 312, 319-20 (7th Cir. 1994); Bonner Maill Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner Maill Partnership), 2 F.3d 899, 908 (9th Cir. 1993).

Yet an individual who is not self-employed is usually not providing new value for business reasons. Instead, new value is contributed to prevent the loss of property via the absolute priority rule. Although the "necessity" requirement of the new value exception is a business rule and is most commonly found in commercial chapter 11s, certain courts have found that the new value exception is simply inapplicable when not necessary for the operation of a business. See In re Dowden, 143 B.R. 388, 393-95 (Bankr. W.D. La. 1989).

Even more difficult for the individual debtor is the usual lack of resources to make a new value contribution, as future promises cannot support the new value exception. See Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 203-04, 108 S.Ct. 963, 967-68, 99 L.Ed.2d 169 (1988). Thus, an individual will often lose his non-exempt property, consistent with §1129(b)'s "fair and equitable" concept. See United States v. Aweco Inc. (In re Aweco Inc.), 725 F.2d 293, 298 (5th Cir. 1984) (the term "fair and equitable" means that senior interests are entitled to full priority over junior interests); citing Protective Committee v. Anderson, 390 U.S. 414, 441, 88 S.Ct. 1157, 1171, 20 L.Ed. 2d 1 (1968). However, such an analysis is not as easy, to the extent the new value exception is easy, when the property sought to be retained is exempt under state law or the Bankruptcy Code.

The Retention of Exempt Property

The Bankruptcy Code authorizes an individual debtor, regardless of chapter, to retain exempt assets. See 11 U.S.C. §522. Exempt assets find their definition in §522 or, when applicable, state law. State law exemptions can be very generous, resulting in many legislative attempts to limit certain state exemptions such as homestead. For example, Texas law allows a debtor to exempt his/her homestead regardless of value, limited only by acreage. See TEX. PROP. CODE §41.001-.002 (Vernon 2002). Thus, a Texas debtor could theoretically discharge millions in liabilities, yet retain a homestead worth millions.

Therefore, when a wealthy debtor with a Texas homestead proposes a chapter 11 plan, he/she will undoubtedly seek to retain the homestead, despite impaired senior classes, without even the inkling of new value. Certainly, such plan provisions will cause vehement objections by impaired senior classes. After all, §1129(b)(2)(B)(ii) states that a debtor may not receive or retain an interest in property on account of such junior interest in any property without distinction between exempt or non-exempt property. See In re Ashton, 107 B.R. 670, 674 (Bankr. D. N.D. 1989); In re Yasparro, 100 B.R. 91, 95 (Bankr. M.D. Fla. 1989).

However, when a debtor retains his rights in exempt assets, he is only "retaining that which is [his] absolute right to retain in any event." In re Egan, 142 B.R. 730, 733 (Bankr. E.D. Pa. 1992). And when the property sought to be retained is exempt, and no objections to the exemptions are timely filed, the debtor's claim to such exemptions "is conclusively established." Id. at 733, citing Taylor v. Freeland & Kronz, 503 U.S. 638, 643-44, 112 S.Ct. 1644, 1648-49, 118 L.Ed. 2d 280 (1992). Thus, retention of an exempt asset is not on account of a previous interest, but on account of this absolute right provided under applicable law. Indeed, the exemption of property removes that property from the bankruptcy estate.

The retention of exempt property is also consistent with §1129(b)(2)(B) because of the language "receive or retain under the plan." Exempt property is not retained under a plan; it is retained as an exempt asset outside of the bankruptcy estate. Regardless of the express language and intent of §1129(b)(2)(B), only property that is part of the bankruptcy estate is used to satisfy claims against the bankruptcy estate.

Thus, this author questions whether the bankruptcy court has jurisdiction over the exempt property, excluding property brought into the bankruptcy estate via an objection to the exemption, avoidance actions, etc. It should be noted that §1129(b) has no such mechanism and, despite the absolute priority rule, does not appear to undermine an individual's right to exempt property under applicable law.

Furthermore, policy dictates that the absolute priority rule not apply to exempt property. As stated in Egan, an individual, non-farmer debtor has two options under the Bankruptcy Code for filing and reorganizing: chapters 11 and 13. See 11 U.S.C. §109. However, §109(e) limits chapter 13 eligibility based on the amount of an individual's debt. Thus, if §1129(b)(2)(B)(ii) is read to prevent the retention of exempt assets, and a debtor exceeds the debt limits for chapter 13, the only other option is chapter 7 liquidation.

Indeed, the purpose of the Bankruptcy Code is to encourage debtors to reorganize, which bolsters the policy argument that §1129(b) should be read in conjunction with §522 to allow an individual debtor to retain exempt property despite the absolute priority rule. After all, chapter 13 allows the same result and it would be inequitable to allow those with less debt to be eligible to retain exempt property, while others in need of a fresh start must turn over the exempt property necessary for a fresh start.


When an individual debtor files bankruptcy, federal and/or state law exemptions are available. Under the laws of some states, this may result in what some would claim is an inequitable result of discharging liabilities while allowing a debtor to retain valuable assets. In other states, however, no such exemptions exist. While this appears inequitable, and many seek legislative change, there are Constitutional issues involved.

Specifically, the proposed limits upon homestead exemptions appear to violate the Tenth Amendment of the U.S. Constitution, which gives the individual states the right to create and enforce laws upon their residents. Thus, limiting state law exemptions arguably encroaches upon the individual states' right to create personal exemptions from liability. While these exemptions have resulted in abuse through over-extensive pre-bankruptcy planning, avoidance actions exist to cure such abuses. Nonetheless, exemptions are a factor that will come into play in the bankruptcies of officers and directors of some of the largest corporations to have filed for bankruptcy protection in this country.

Journal Date: 
Friday, November 1, 2002