Bankruptcy Newsletter
Paying Senior Creditors First Under the Absolute Priority Rule
In a Chapter 11 bankruptcy case for business reorganization, a bankruptcy court must only confirm a debtor’s business reorganization plan if the plan is “fair and equitable” to the impaired class of creditors in the case. When determining whether to confirm a debtor’s Chapter 11 reorganization plan as “fair and equitable,” a court will apply the Absolute Priority Rule (Rule). The Rule generally requires that “senior” classes of creditors be paid in full before any value can be provided to a “junior” class.
Payment Requirements
Codified in Title 11 of the U.S. Bankruptcy Code, the Absolute Priority Rule essentially requires that creditors be paid in the following order of priority:
- Secured claims (lien holders)
- Claims incurred during the course of the bankruptcy
- Pre-petition priority claims (taxes, wages, consumer deposits)
- Claims of unsecured creditors
- Equity holders (stockholders)
Each of these classes of creditors is further categorized as priority and non-priority. For example, the category “unsecured creditors” will be further subdivided into “priority unsecured creditors” and “non-priority unsecured creditors.”
Application of the Absolute Priority Rule
The Absolute Priority Rule only applies when at least one of the senior impaired classes in a Chapter 11 case does not accept the debtor’s reorganization plan, and a bankruptcy court must decide whether to confirm the debtor’s plan notwithstanding the creditors’ objection.
Priority Withstands Dissent
A bankruptcy court will confirm a debtor’s plan for reorganization, over the objection of a dissenting class of senior unsecured creditors, as long as the terms of the Absolute Priority Rule are satisfied. This means that a court will confirm a debtor’s reorganization plan if either (1) the unsecured creditors are paid in full, or (2) the equity holders will not receive any value under the plan.
The New Value Exception
Although not explicitly adopted by the Bankruptcy Code, some courts have recognized the validity of what has come to be known as the New Value Exception to the Absolute Priority Rule. This exception permits equity holders to receive value under a reorganization plan (such as ownership of the reorganized business), if they contribute additional funds to the debtor and such funds are considered necessary for the success of the debtor’s reorganization.
However, in 1999, the U.S. Supreme Court put a limit on the application of the New Value Exception. The court held that the exception should not apply to allow an old equity holder to receive value for contributing to the reorganization of a debtor’s business, if the equity holder is the “exclusive” participant in reorganization or the only one allowed to contribute to the reorganized entity.
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