Understanding the Absolute Priority Rule and Its Exceptions
The absolute priority rule, as set forth in Section 1129(b)(2) of the U.S. Bankruptcy Code,., is integral to a Chapter 11 reorganization plan getting confirmed by the court. The plan must adhere strictly to a hierarchical system of claim priority, which dictates the sequence in which creditors are paid. The rule is meant ensure fairness in the distribution of assets during Chapter 11. However, certain exceptions may apply.
In a Chapter 11, claims are categorized broadly into several types: secured claims, administrative expense claims, priority claims, and general unsecured claims. Secured claims are those backed by collateral, giving the creditor a lien on specific assets of the debtor. Administrative expense claims include the costs of preserving the estate and expenses incurred in the reorganization process itself, such as legal and professional fees. Priority claims are those designated by the bankruptcy code as having elevated status, which includes certain taxes and wages owed to employees. General unsecured claims, which lack collateral security or statutory priority, include a variety of debts such as bondholder claims and trade debts.
At its core, the absolute priority rule mandates that higher priority claims must be satisfied in full before any payment can be made to lower priority claims. Furthermore, for equity interest holders to retain any interest in the debtor company or to receive any distribution under the plan, all creditor claims must be fully satisfied.
Nevertheless, there are notable exceptions that can influence the rule’s application. One is the “voting exception,” which permits junior creditors or equity holders to receive distributions under the plan if the senior class of creditors has voted in favor of the proposed plan. This allows for more flexible restructuring arrangements, especially in complex cases where maintaining operational continuity and maximizing estate value may necessitate deviation from strict priority adherence.
Another exception is the “new value doctrine.” This legal principle allows junior creditors or equity holders to retain their interest in the debtor under the reorganization plan by contributing new value to the reorganized entity. The contribution must be substantial, necessary for the reorganization, and must be made in exchange for the retained interest or claim. The new value doctrine is intended to facilitate the infusion of fresh capital into the debtor company, which can be vital to the success of the reorganization process.
These exceptions to the absolute priority rule underscore the flexibility inherent in Chapter 11 proceedings, designed to allow for equitable and practical solutions tailored to the specific circumstances of each case. While the relative interests of creditors must be protected, the reorganization should also support the ongoing viability and growth of the debtor company, ultimately benefiting all parties involved.
The Law Offices of Michael Jay Berger in Beverly Hills routinely obtains plan confirmations for California companies in financial distress. Call {PHONE} or contact us online to schedule a free consultation.
