How the Absolute Priority Rule Affects Creditor Payments in Chapter 11
The absolute priority rule dictates the hierarchical order in which creditors’ claims are addressed during a debtor’s Chapter 11 reorganization. It is intended to ensure that senior creditors are paid in full before junior creditors or equity holders receive any distribution, thereby promoting fairness and predictability in the process.
The absolute priority rule was established by the courts to prevent inequitable distributions during bankruptcy reorganizations. It has been codified in Bankruptcy Code Section 1129(b)(2), which outlines the “fair and equitable” standard required for plan confirmation over the objection of an impaired class. In fact, deviations from the rule can result in the denial of approval.
In practice, the absolute priority rule mandates that a dissenting class of creditors must be paid in full before any junior class can receive or retain any property under a reorganization plan. For instance, if unsecured creditors do not consent to the proposed plan, they must be fully satisfied before equity holders retain any interest in the debtor’s assets. This mechanism prevents owners or shareholders from unjustly benefiting at the expense of higher-priority creditors.
While the absolute priority rule is stringent, there are certain exceptions. One is the “new value” corollary, which allows equity holders to retain their interests if they contribute new, substantial, and necessary capital to the reorganized entity. This contribution must be in money or money’s worth and must be reasonably equivalent to the value of the retained interest. Additionally, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 introduced changes affecting individual Chapter 11 debtors, allowing them to retain certain property and earnings acquired post-petition, thereby modifying the absolute priority rule in specific contexts.
For Chapter 11 debtors, adherence to the absolute priority rule requires careful structuring of reorganization plans to ensure compliance and to gain the necessary approvals from creditor classes. Failure to honor the priority of claims can lead to plan rejection by the bankruptcy court. Creditors, on the other hand, rely on this rule to protect their interests. This assurance influences their willingness to negotiate and support reorganization efforts.
The Law Offices of Michael Jay Berger, based in Beverly Hills, has wide experience representing debtors in Chapter 11 proceedings. Our firm offers comprehensive legal services to ensure that reorganization plans are structured effectively and in compliance with all applicable laws, safeguarding clients’ interests throughout the bankruptcy process. Call 310-271-6223 or contact us online for a free consultation.
