BAP Precedent Is Absolute: Bankruptcy Court Defers to BAP and Holds that the Absolute Priority Rule Does Not Apply to Individual Chapter 11 Debtors

Contributed by Elizabeth Hendee
A recent decision from the United States Bankruptcy Court for the District of Arizona, In re Sample, No. 2:10-38373-DPC (Bankr. D. Ariz. July 15, 2013), addresses two interesting issues: (i) whether the absolute priority rule found in section 1129(b)(2)(B)(ii) of the Bankruptcy Code applies to individual chapter 11 debtors and (ii) whether bankruptcy courts are bound by Bankruptcy Appellate Panel decisions.  In Sample, the individual debtors’ proposed chapter 11 plan would violate the absolute priority rule, if that rule applied to the case.  The debtors, relying on the decision of the United States Bankruptcy Appellate Panel for the Ninth Circuit, Friedman v. P+P, LLC, argued that the plan did not have to comply with the absolute priority rule because the Samples are individuals.  As previously discussed in this blog, in Friedman, the Ninth Circuit BAP held, over a dissent, that the absolute priority rule does not apply to individual chapter 11 debtors.  The District of Arizona falls within the Ninth Circuit; therefore, if BAP precedent is binding on bankruptcy courts, the bankruptcy court would have to follow the Friedman ruling.  Southwestern Business Finance (SBF), a creditor of the debtors, argued that BAP precedent is not binding on bankruptcy courts and urged the court to follow the multiple decisions of circuit courts outside the Ninth Circuit that have held that the absolute priority does apply to individual chapter 11 debtors.  Even though the Sample court expressly disagreed with the Ninth Circuit BAP’s holding in Friedman, it concluded that it was bound by that ruling.  Accordingly, the bankruptcy court overruled SBF’s objection to the debtors’ plan.
The Absolute Priority Rule
As we have written about in the past, the issue of whether the absolute priority rule applies to individual debtors’ chapter 11 cases has been hotly contested by circuit and bankruptcy courts over the past few years.  Multiple courts of appeals, including the Fourth, Fifth, and the Tenth Circuit, have held that the absolute priority rule does apply to individual chapter 11 debtors.  On the other hand, many bankruptcy courts and the Ninth Circuit BAP have found that the absolute priority rule does not apply in individual debtor chapter 11 cases.
These divergent holdings are the result of differing readings of sections 1129(b)(2)(B) and 1115 of the Bankruptcy Code.  Section 1129(b)(2)(B) provides that a plan can be found “fair and equitable” as to unsecured creditors despite a dissenting impaired class if holders of interests junior to the impaired class of unsecured creditors do not receive or retain interest in any property under the plan.  The enactment of BAPCPA in 2005 added an exception to this general rule: “in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115 . . . .”  Section 1115 of the Bankruptcy Code expands the definition of property of the estate for individual debtors to include, “in addition to the property specified in section 541,” property and earnings obtained postpetition.  Courts that have found that the absolute priority rule does apply to individual chapter 11 debtors read section 1115 as supplementing, but not replacing, the definition of property of the estate contained in section 541 of the Bankruptcy Code.  Courts that have found that the absolute priority rule does not apply to individual chapter 11 debtors, such as the Ninth Circuit BAP, read section 1115 as incorporating and superseding section 541 and thus excepting from the absolute priority rule property and earnings obtained postpetition as well as prepetition property referenced in section 541.
Precedential Value of BAP Decisions
The Ninth Circuit BAP has held that decisions of the BAP are binding on all bankruptcy courts in the Ninth Circuit unless contrary authority exists in the district court for the district in which the bankruptcy case is being heard.  The Judicial Counsel of the Ninth Circuit established the BAP, in part, to create a consistent, uniform body of bankruptcy law throughout the circuit.  The BAP’s mandate that the panel’s decisions be binding on Ninth Circuit bankruptcy courts is consistent with this goal.  Although the Ninth Circuit has not yet held that bankruptcy courts must follow BAP precedent, bankruptcy judges generally have deferred to the BAP when a BAP decision is “on point” and “not meaningfully distinguishable,” even if the bankruptcy judge disagrees with the relevant precedent.
Here, Friedman is certainly “on point.”  Friedman squarely addressed the issue before the bankruptcy court — whether the absolute priority rule applies in an individual debtor’s chapter 11 case.  Further, the bankruptcy court was not aware of any District of Arizona decisions addressing this absolute priority rule issue.  Accordingly, the court followed the opinion of the Ninth Circuit BAP and held that, because the debtors are individuals, the absolute priority rule did not apply to the Samples’ chapter 11 plan.
Notably, in its brief order, the court stated that it “tends to favor the dissenting decision” in Friedman, suggesting that, if it had not been bound by the BAP precedent, the bankruptcy court may have ruled differently.  Here, however, given the precedential value granted to Ninth Circuit BAP decisions, including Friedman, the court’s opinion on the absolute priority rule issue is essentially irrelevant. Unless the Ninth Circuit or U.S. Supreme Court finds differently (or the Ninth Circuit BAP has a change of heart), the law is absolute: the absolute priority rule does not apply to individual chapter 11 debtor cases in the Ninth Circuit.