The principle behind the absolute priority rule is simple: unsecured creditors should be paid before the debtor is entitled to retain property of the bankruptcy estate. In a corporate setting the absolute priority rule operates to ensure that an unsecured creditor is paid in full before a shareholder is able to retain its ownership interest in a corporate debtor. Although straightforward in the corporate setting, application of the absolute priority rule is more complex in individual chapter 11 bankruptcy cases.

Prior to the 2005 BAPCPA amendments, the absolute priority rule applied similarly to both individuals and corporations. However, post-BAPCPA, a debate has arisen over whether the absolute priority rule has been abrogated in individual chapter 11 bankruptcy cases. As we discussed in a previous post (Caveat Creditor), a minority of courts have adopted a so-called “broad view,” which provides that individual chapter 11 debtors may retain both pre-petition property and post-petition earnings without having to pay unsecured creditors in full.  In effect, this “broad view” abrogates the absolute priority rule in regards to individual debtors. Nevertheless, the majority of courts have adopted a “narrow view,” which provides that an individual may retain only post-petition earnings without paying unsecured creditors in full. Under the “narrow view,” the absolute priority rule continues to apply to pre-petition interests or assets.

In the case of In re Martin, the Bankruptcy Court for the Middle District of Florida recently confirmed its adherence to the narrow view. In Martin, the debtor proposed to pay its unsecured creditors 5% of the value of their claims, while retaining three non-exempt investment properties upon confirmation. The debtor argued that the absolute priority rule had been abrogated by the BAPCPA amendments, and the class of unsecured creditors cried foul.

As Judge Jenneman held in In re Gellin, Judge Williamson adopted the “narrow view.” In making its determination, the court noted that one of the overarching congressional purposes of the BAPCPA amendments was to impose greater burdens on Chapter 11 debtors and to promote greater payouts to creditors, and abrogation of the absolute priority rule would run contrary to this purpose.

What should creditors and bankruptcy practitioners take away from Martin? First, under both the “broad view” and “narrow view” interpretations, individual chapter 11 debtors may retain post-petition earnings without paying unsecured creditors in full. Second, even though Martin represents a majority view on the subject, creditors should be prepared to encounter contrary case law. Because application of the absolute priority rule is critical to the treatment of unsecured creditors, we will continue to follow bankruptcy courts locally and nationally and inform you of any changes or shifts in the law.