Idle Threats of Bankruptcy after Ice House America, LLC

In almost every out-of-court workout situation, when the negotiations get tough and the debtor does not like the terms proposed by the creditor, it is more than common for the debtor to state: “Well, we will just see you in bankruptcy court.” In some situations involving individuals with significant debt, the creditor can sleep a little easier based upon the Sixth Circuit’s recent ruling upholding the absolute priority rule in individual Chapter 11 cases.

Individuals are eligible to file bankruptcy under numerous chapters of the bankruptcy code, including chapters 7, 13, and 11. Chapter 13 is known as the “wage earner” plan, and debtors are required to produce either a 3- or 5-year plan to pay off their creditors and/or bring debts current. Chapter 13, however, is limited to only certain individuals with debts below a specified amount. Currently, Chapter 13 filers must have unsecured debt in an amount less than $383,175.00 and secured debt in an amount less than $1,149,525.00.

At least in the Sixth Circuit, one of the many differences in what is required to confirm a plan under Chapter 11 as opposed to Chapter 13, is satisfying what is known as the “absolute priority rule.” The absolute priority rule (see 11 U.S.C. § 1129(b)(2)(B)(ii)) only applies in Chapter 11 cases; however, there is a split among the circuits on the whether the absolute priority rule applies when an individual — rather than a business — is seeking to confirm a Chapter 11 plan.

Until its ruling in Ice House America, LLC v. Cardin, the Sixth Circuit Court of Appeals was silent as to whether the rule applied. The debate among the federal circuits lies in the wording of the bankruptcy code after the 2005 amendments. Courts are either taking a narrow reading of the code’s language (as the Sixth Circuit did) or a broad reading of the text. For an excellent analysis of the case, please see my colleague Brian Meldrum’s Creditors’ Sidebar blog post.

In short, the absolute priority rule requires that if any senior class of impaired unsecured creditor(s) objects to the proposed plan, no junior class (i.e., the individual debtor) may retain property unless the objecting senior class is paid in full.

For example, an individual proposes a Chapter 11 plan where she proposes to pay an unsecured judgment creditor 10 cents on the dollar, while the debtor retains her home, cars, and various other assets. The judgment creditor could object because the plan does not satisfy the absolute priority rule. Under Ice House, the judgment creditor’s objection would be well taken and the debtor could possibly have to amend her plan.

What this means for creditors — especially unsecured creditors — in out-of-court workout situations, is that the debtor’s threat to file bankruptcy may only be an idle one. If the creditor can determine that the debtor exceeds the Chapter 13 debt limits, then the debtor has only two viable bankruptcy options: (1) file Chapter 7 and have a trustee liquidate non-exempt assets to satisfy the creditors’ claims or (2) file Chapter 11 and either organize to pay objecting senior unsecured creditors in full or prepare give up certain personal property. In this situation, a debtor may not like his/her bankruptcy options and may be more willing to acquiesce to creditor’s restructuring terms. With that in mind, the Sixth Circuit’s upholding of the absolute priority in individual Chapter 11 cases may provide the necessary leverage for creditors to obtain more favorable terms when negotiating a workout with an individual debtor.