May 3, 2013
by Christopher M. McDermott
Pite Duncan, LLP
USFN Member (California)
The decline in the national real estate market over the past few years has caused mortgage lenders to suffer significant losses in Chapter 11 bankruptcy proceedings due to a debtor’s ability to reduce the lenders’ secured claims to the current fair market value of real property, which is not secured solely by a debtor’s principal residence (commonly referred to as a “cramdown”). A cramdown of a loan results in bifurcating a creditor’s claim into secured and unsecured claims.
The rise of cramdowns in Chapter 11 bankruptcy cases has naturally led to a substantial increase in the amount of unsecured claimants, which has in turn given these unsecured claimants a louder voice than ever before in individual Chapter 11 bankruptcy cases. One of the most powerful defenses to the cramdown of a Chapter 11 plan that is available to an undersecured creditor is the absolute priority rule, which has been a lightening rod for litigation over the past few years.
The absolute priority rule prohibits a debtor from retaining pre-petition property of the estate if the dissenting class of unsecured creditors is not paid in full. This effectively means an unsecured creditor would have to be paid in full before the debtor could retain pre-petition property (which includes the property related to the cramdown). In 2011, this author’s firm obtained a favorable, published decision in the matter of In re Kamell, 451 B.R. 505 (Bankr. C.D. Cal. 2011), for denial of confirmation of a debtor’s plan that proposed to cramdown a loan by approximately $1,400,000. More specifically, as the unsecured class rejected the plan and the debtor did not propose to pay the unsecured creditors in full, the court concluded that the plan violated the absolute priority rule.
Courts across the country are divided on the rule’s continued application to individual debtors after the 2005 BAPCPA amendments and have come to adopt one of two opposing viewpoints, commonly known as the “broad view” and the “narrow view.” Advocates of the “broad view” assert that the 2005 BAPCA amendments eliminated the absolute priority rule’s application to individual debtors. Contrastingly, “narrow view” supporters assert that the 2005 amendments simply established that post-petition property is exempt from the absolute priority rule, whereas the absolute priority rule remains applicable to pre-petition property.
In January, in the matter of In re Stephens, 704 F.3d 1279 (10th Cir. 2013), the U.S. Court of Appeals for the Tenth Circuit adopted the “narrow view” and provided a current tally of published decisions on this issue indicating that, as of the date the Stephens opinion was published, only the Bankruptcy Appellate Panel for the Ninth Circuit and five bankruptcy courts (one of which was affirmed by a district court) have adopted the “broad view,” whereas the U.S. Court of Appeals for the Fourth Circuit and seventeen bankruptcy courts (and now the Tenth Circuit) have adopted the “narrow view.”
The clear majority adopting the “narrow view” suggests courts are finding it increasingly difficult to hold that Congress intended to abrogate this rule that is such a fundamental protection for creditors in Chapter 11 bankruptcy cases. It appears inevitable that there will soon be a circuit split on the absolute priority rule and, given the rule’s significance in Chapter 11 bankruptcy cases and the current lack of uniformity in its application, it is reasonable to assume the matter will be ruled on by the U.S. Supreme Court within the next few years. Until then, mortgage lenders should consult with their local bankruptcy counsel and determine whether to utilize the absolute priority rule to prevent plan confirmation and as a tool to leverage more favorable treatment of their claims in a debtor’s Chapter 11 plan.
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