How does the absolute priority rule of Chapter 11 play in the confirmation process?  Are there any exceptions to it?  Can the owners of a company retain their equity interests in a Chapter 11 plan?  The Tenth Circuit (Kansas) adheres to the doctrine that the absolute priority rule of Chapter 11 applies in individual cases.

The absolute priority rule comes into play during the Chapter 11 plan confirmation process.  Under Bankruptcy Code § 1129(b)(1), a creditor’s plan objection will be upheld if the plan: (1) discriminates unfairly; or (2) is not fair and equitable with respect to each non-accepting class of claims or interests that is impaired under the plan.  In this context, “impaired” means that the plan alters the rights of a class of creditors compared to the contractual rights prior to bankruptcy.

For a dissenting class of impaired unsecured creditors, a plan is “fair and equitable” only if the allowed value of the claim is to be paid in full, or if the holder of any claim or interest that is junior to the dissenting creditors will not receive or retain any property under the plan on account of such junior claim or interest.  See 11 U.S.C. § 1129(b)(2)(B)(ii).  This condition is generally referred to as the absolute priority rule.

The new value exception solves the problems created by the absolute priority rule.  The new value doctrine opens the door for plan proponents to overcome the absolute priority rule by requiring equity holders to make a substantial and essential contribution in exchange for their continued ownership of the debtor.  To be substantial, most courts require that the contribution (i.e., new value) be: (1) a present contribution; (2) freely tradable in the market; and (3) money or money’s worth.  To be essential, the case law generally mandates that this new contribution be directly related to the success of the reorganization plan.

The absolute priority rule was originally a judicially created concept; that is, it was created by case law.  In practice, it provides a much needed way to resolve the problems created by the artificially strict barriers created by the absolute priority rule.  Anyone considering filing a Chapter 11 bankruptcy case, or any type of bankruptcy case in general, should contact Phillips & Thomas LLC for a free consultation of their options.  

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