MORTGAGE DELINQUENCIES AFTER CHAPTER 11 BANKRUPTCY

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            As we approach the middle of 2016, it is interesting to look back and see the effects of the bulge of filings from 2009-2011. During that time, the filings in Jacksonville routinely approached 12,000 cases per year.

            With the end of the boom now approaching five (5) years, it is particularly interesting to see the effects of the surge in Chapter 11 filings. After the 2005 Bankruptcy Code Amendments were passed, it became quite acceptable to file an individual Chapter 11 case in an effort to deal with substantial mortgage debt related to investment properties. That turned out to be exactly what thousands of real estate investors did when the real estate market crashed.

            The Chapter 11 filing allowed the investors to match cash flow from the rental properties to a restructured mortgage based upon a valuation of the investment properties. Unlike homestead properties, the protection against modification did not extend to investment properties. Chapter 11 plans would strip down an investment property to the current value, change interest rates and extend the term of the amortization period in an effort to make the properties cash flow for the investors. These restructured rental units formed the basis for repayment of secured debt and unsecured debt in most individual chapter 11 plans.

            The typical individual Chapter 11 plan was a 5 year plan. That means that we are approaching the end of the cycle for completion of the Chapter 11 Plan payment period. So what is happening with the mortgages which were restructured in the Chapter 11 Plans? If the Debtor successfully completed a Chapter 11 case and received a discharge, the answer is familiar.

            In almost every case, our office is seeing mortgage servicers fail to comply with the terms of the discharged plan. Some failures are small, with servicers just misapplying payments over the term of the plan. Others are more substantial. Failures include the wrong principal balance, interest rate, amortization term or other aspects of the Chapter 11 modification of the mortgage.

            This is a repetition of the Chapter 13 issues that our office has been fighting for years. As in Chapter 13, it is very difficult to complete a Chapter 11 plan and comply with the payment structure of the modified mortgage. However, the benefit for such compliance is supposed to outweigh the effort upon completion of the Plan. The hard working debtor is supposed to have a new mortgage with a modified principal balance, interest rate and term as ordered by the Court. Unfortunately, the failure of the mortgage servicers to adjust the mortgage to comply with the Plan has the potential to undo all of the hard work of the client.

            Our office spends considerable time after the completion of every Chapter 11 case to ensure that all mortgages are current and in compliance with the Plan. We do this at no cost to our clients to ensure that they do not have to call us in a panic 6 months after discharge with the fear that a home is going to be foreclosed due to the errors of the mortgage company.

            If you are experiencing post discharge issues with your mortgage company, give us a call. We will review your situation and give you an honest opinion of whether the mortgage company is in error.

            At Mickler & Mickler, we attend Court on a regular basis. We have the experience and knowledge to ensure that you receive the correct advice when confronted with difficult financial decisions related to filing bankruptcy. Contact us at 904.725.0822 or bkmickler@planlaw.com.

 

Bryan K. Mickler

Landlord-Tenant Law: Commercial Eviction and Chapter 11

A commercial tenant facing eviction may find relief under Chapter 11 of the Bankruptcy Code, particularly if the tenant fell behind on payments as the result of a temporary decline in income. While a Chapter 11 debtor cannot compel its landlord to reduce the monthly rent or eliminate past due rent, the filing of a Chapter 11 Petition will stop an eviction action and allow the debtor time to formulate a plan of action.

Absent abandonment or consent by the tenant, the landlord must file an eviction lawsuit in order to take possession of the business premises.[i] Once the landlord files a lawsuit to evict the commercial tenant, the tenant can stop the eviction action by filing of a Chapter 11 Reorganization.[ii] This allows the tenant time to remain in possession while it determines the best course of action. Bankruptcy Code Section 365 gives the tenant a deadline of 120 days to assume or reject the lease.[iii] The tenant may request that the bankruptcy court extend this deadline by 90 days, allowing up to 210 days for the tenant to assume or reject the lease.[iv]

Once the deadline arrives, in order to assume the lease and remain in the property, the tenant will need to provide a plan for promptly curing the pre-petition arrears.[v] The bankruptcy court’s interpretation of “prompt” cure will depend on the unique facts of each case, such as the remaining term of the lease.[vi] For instance, twelve months to cure arrears should be considered sufficiently “prompt” when the tenant has three years remaining on a five year lease. [vii] In contrast, curing pre-petition arrears over the remaining life of the lease will almost certainly be deemed inadequate by the bankruptcy court.[viii]

Should the tenant’s income prove insufficient to maintain the regular lease payment and cure the arrears within a reasonable period of time, Chapter 11 still offers the benefit of additional time to negotiate a reduced rent with the landlord. If the tenant cannot cure the arrears or reach an agreement with the landlord, the tenant must find an alternative location or close the business. If closure proves the only viable option, the tenant can file a Chapter 11 Plan of Liquidation or convert the case to a Chapter 7 in order to efficiently wind down the business and address any corporate liability for future rent or liquidated damages under the lease.

In summary, Chapter 11 may be a viable for a commercial tenant wishing to defend an eviction action and remain in possession of its business premises. For further information, contact an experienced professional to know your legal rights.

 

[i] Florida Statutes § 83.05.

[ii] 11 U.S.C. § 362(a).

[iii] 11 U.S.C. § 365(d)(4)(A).

[iv] 11 U.S.C. § 365(d)(4)(B).

[v] 11 U.S.C. § 365(b)(1)(A).

[vi] In re Embers 86th Street, Inc., 184 B.R. 892, 900 (Bankr. S.D.N.Y. 1995).

[vii] In re Citrus Blvd Imaging Ctr., LLC, 2012 Bankr. LEXIS 2208, at *11-12 (Bankr. N.D. Ga. 2012).

[viii] In re Gold Standard at Penn, Inc., 75 B.R. 669, 673 (Bankr. E.D. Pa. 1987).

FDCPA Violations for Proofs of Claims in Chapter 13 Cases

FDCPA Claims in Chapter 13 for Stale Proof of Claims

I have previously written about the potential for FDCPA claims after filing for bankruptcy and having a debt collector contact you regarding a debt that was discharged in the bankruptcy filing.

http://www.planlaw.com/bankruptcy-and-the-fair-debt-collection-practices-act-understanding-your-consumer-rights/

Essentially, the attempt to collect a debt that had been discharged in a previous filing was generally a violation of the FDCPA since the FDCPA prevents the collection of debts not owed by a consumer. Our office has vigorously defended the attempts to collect discharged debt for the past several years from collectors looking to pay pennies on the dollar for old debt in hopes that it could be collected. Most collectors never bother to check the status of the debt, previous settlements, bankruptcy or any other factor which may make a debt uncollectible. Instead, the collector just purchases a set of accounts and begins collection activity immediately. For a shocking look at the business of selling collection accounts check out this story: http://www.nytimes.com/interactive/2014/08/15/magazine/bad-paper-debt-collector.html

Another method of attempting to collect debts which are not collectible by collectors is to actually chase people after they have filed for Chapter 13. There is a huge business of selling debt to collectors by the original creditor after a person has filed for Chapter 13 relief. The collectors buy the debt for pennies on the dollar, file a claim for the full amount and hope to make more from the Chapter 13 payoff than they paid for the account. If they weren’t making money this way, the collectors would not continue to buy the accounts and file claims.

 One reason the bankruptcy accounts can be so cheap is that they can be very old. Recently, I have seen claims from the 1990s filed in Chapter 13 cases. Claims continue to be filed by collectors long past the date that the law allows them to be collected. In Florida, the statute of limitations for claims is five (5) years from the date of the default.

 Recently, the 11th Circuit Court of Appeals in Atlanta issued an opinion which may finally put an end to the practice of filing stale claims in Chapter 13 cases. Crawford v. LVNV Funding, http://law.justia.com/cases/federal/appellate-courts/ca11/13-12389/13-12389-2014-07-10.html

 Crawford found that filing a Proof of Claim in a Chapter 13 case for a debt which is uncollectible under a State statute of limitations was a violation of the FDCPA. When a debt collector violates the FDCPA, they are responsible for the up to $1,000.00 in damages and attorney’s fees and costs. Damages may be doubled if the State Statute regulating collection has also been violated. Our office has been actively checking all proofs of claims in every Chapter 13 case that we have filed in the past two years to determine if there have been claim violations. This effort will, hopefully, result in recoveries for our Chapter 13 clients, increased distributions to legitimate creditors and possibly shorter plan periods for some clients.

 If you feel that you may benefit from a Chapter 13 filing or a review of claims in your case, contact our office at 904.725.0822 for a free consultation.

Bryan Mickler

bkmickler@planlaw.com

CHAPTER 11 AND 13 BANKRUPTCY DUE TO RISING RENTS?

A GREATER NEED FOR CHAPTER 11 AND 13 BANKRUPTCY DUE TO RISING RENTS?

            A recent article regarding rising rents served as a follow up to a blog that appeared on this site last year. http://www.nytimes.com/2014/04/15/business/more-renters-find-30-affordability-ratio-unattainable.html?hpw&rref=business&_r=0

In that last blog post, the rising home prices in many Florida cities appeared to be the result of investor hedge funds purchasing rental properties for cash. http://www.planlaw.com/is-the-american-dream-dead-in-jacksonville-fl/ That activity was causing a run up in the prices of homes which would typically be middle class living in many cities. The result was a loss of opportunity for home purchases and a greater need to save homes that are currently owned by middle class families.

Now, it appears that rents are rising to a level where they may be unaffordable for many middle class families. As with mortgages, the typical ratio for housing expense in rentals is approximately 30% of a household’s gross income. However, 50% of all renters now spend more than 30% of their gross income on rent. The problem appears to be getting worse as rents continue to rise due to a combination of low vacancy rates and low wage increases.

So what can the average homeowner do to escape the rising rental problem? Try to keep that house and avoid paying high rental rates seems to be the obvious solution. If you currently have a home that is behind and subject to foreclosure – the best solution may be to cure the arrearage on a primary residence with a Chapter 13 Plan or restructure an investment property with a Chapter 11. Chapter 13 can allow for a cure of all arrears over a 60 month period of time or by modifying the mortgage if the homeowner is eligible. Chapter 11 allows investment properties to be valued to the market value of the home even if the mortgages on the property are much greater than the value. Interest rates and maturity dates can also be changed on investment properties.

Saving a primary residence will allow the homeowner to avoid higher rental rates that may areas are experiencing now. If you currently are looking to save an investment property, then rising rental rates could be used to fund a Chapter 11 Plan to save the investment property for future retirement planning or other long term goals. Contact us to discuss your options.

At Mickler & Mickler, we attend Court on a regular basis. We have the experience and knowledge to ensure that you receive the correct advice when confronted with difficult financial decisions related to filing bankruptcy. Contact us at 904.725.0822 or bkmickler@planlaw.com.

 

Bryan K. Mickler

The Chapter 11 Plan of Reorganization and Voting Process

The goal of Chapter 11 generally is to restructure a Chapter 11 debtor’s monthly debt service and thereby improve cash flow to maintain a viable business. This can be accomplished by reducing principal owed, extending the length of a loan, and reducing the interest rate. The Chapter 11 Plan of Reorganization outlines these new terms that will form the basis for the new contractual rights between the debtor and creditors.

The debtor, a creditor, or another party in interest may file a Chapter 11 Plan. However, only the Debtor is permitted to file a Plan during the first 120 days after the Chapter 11 case is filed, or 180 days in a small business case.  After this exclusivity period expires, a creditor or party in interest may propose a Plan. Practically speaking a creditor rarely proposes a Plan, and therefore the Debtor is typically the “plan proponent”.

The Plan outlines the substantive rights of the debtor and creditors. In conjunction with the Plan, depending on the complexity of the case, the debtor must also prepare and file a Disclosure Statement to give more information to creditors regarding the debtor and the proposed Plan. After notice and a hearing the Bankruptcy Court determines whether or not to approve the Disclosure Statement as containing adequate information under 11 U.S.C. § 1125.

Once the court approves the Disclosure Statement, the Debtor provides the Plan and Disclosure Statement to each creditor in the case along with a ballot for voting to accept or reject the Plan. In order to successfully obtain confirmation of a Plan of Reorganization, Section 1129(a)(10) of the Bankruptcy Code requires that the plan proponent obtain the acceptance of at least one impaired class. This is assuming at least one class of claims under the Plan is impaired, which is virtually certain to be the case in most any Chapter 11 Plan.

Although one class in the Plan may contain multiple claims, typically, most classes in a Plan will contain the claim of a single creditor. Therefore, to meet this requirement outlined in Section 1129(a)(10) only one creditor must vote to accept the Plan in order to reach confirmation.  Although a Plan accepted by one creditor may technically meet the confirmation requirements, in practice a court may not confirm a Plan that merely meets the minimum requirements.

Where a class in the Plan contains only one creditor, calculating the acceptance or rejection of that class is straightforward. This will be the case for most secured claims, which are loans secured by collateral such as a house, car, building, equipment, or inventory. Unlike secured claims which are each placed in their own respective class, the class of general unsecured claims will contain many unsecured claims. Thus, the calculation of class acceptance or rejection may require a calculation consistent with 11 U.S.C. § 1126. This Code Section provides that a class has accepted the Plan if at least two-thirds (2/3) the dollar amount and greater than one-half (1/2) in number have accepted the Plan.

As an example, assume the Debtor owes four unsecured debts, Creditor A – $10,000, Creditor B – $15,000, and Creditor C – $25,000, and Creditor D – $50,000. If Creditor A & B accept and Creditor C & D reject the Plan, the unsecured class has rejected the Plan as only 1/2 the number of claims has accepted and the number must be greater than 1/2 the number of claims. If Creditor A, B, and C accept and Creditor D rejects then more than 1/2 the number has accepted, but less than 2/3 the dollar amount has rejected and therefore the unsecured class has rejected.

If Creditor A, B, and D accepts and Creditor C rejects then the conjunctive requirements for class acceptance have been met, 3/4 of the dollar amount has accepted and 3/4 of the number of claims has accepted, and therefore the unsecured class has accepted. As a final illustration, if three of the creditors were to abstain from voting, and Creditor A were to accept, the unsecured class would therefore accept the Plan under Section 1126 as only those claims that accept or reject are counted when calculating the class acceptance or rejection. Even though Creditor A held the small claim of $10,000, since the other creditors failed to vote, this creditor dictates the outcome of the voting.

This voting process is only one of the many aspects of a Chapter 11 case. At Mickler & Mickler, we deal with these issues in Chapter 11 cases on a daily basis. We hold the knowledge to guide an individual or business through this complicated process. Contact us at 904.725.0822 or tjking@planlaw.com should you need counsel regarding your financial situation. The consultation is free.

Wells Fargo and the administrative hold after filing for Bankruptcy

WELLS FARGO BANK AND THE FREEZE ON BANKRUPTCY ACCOUNTS

            I’ve been meaning to write about this issue for some time, but it gets pushed to the side to deal with more current issues usually. However, just when I think that Wells Fargo has ceased to be a problem in Bankruptcy, the “administrative hold” on accounts will pop back up and cause real problems for individuals or companies attempting to reorganize through Chapter 13 or Chapter 11.

            The administrative hold is Wells Fargo’s way of throwing a wrench into the ability of individuals or companies to reorganize even if the individual or company does not owe any money to Wells Fargo. Wells will scan the bankruptcy filings each night for the entire United States. If it gets a hit for an individual (even if the other account holder did not file) or a company, it will freeze the entire account for some undetermined period of time. Fortunately, the bank limits the freeze to accounts that contain more than $5,000.00 on the date of the filing.

             Wells claims that it is preserving the assets of the bankruptcy estate for the benefit of the Trustee (See 11 U.S.C. § 542(b) requiring turnover of property to Trustee). While some sense can be made of that reasoning in a Chapter 7, the reorganization purpose of Chapter 13 and Chapter 11 do not support the reasoning of Wells. Short of Court Order, Wells will not release the funds in the account despite the fact that the Chapter 13 debtor needs the funds to commence payments. In a Chapter 11 case, the bank will only release the funds to a DIP account at Wells Fargo or require the individual or company to go to a branch and pick up a check issued to the entity as DIP. This is despite the fact that the Chapter 11 Debtor is really the Trustee and Wells has no duty to preserve the funds for a third party trustee.

         Unfortunately, the administrative hold is here to stay. The Courts (outside of the 9th Circuit in a Chapter 7 case) have not found that such an activity is a violation of the automatic stay despite the damage that has been caused to companies by the action of freezing a corporate account needed for day to day operations. We recently encountered this when a towing company was forced to delay responding to stranded motorists after filing Chapter 11 since Wells had frozen its operating account. This company was in Chapter 11 and owed no money to Wells. It took over 24 hours to move the funds to a Wells Fargo bankruptcy account and allow access to the funds.

        The takeaway from this story is that Wells will continue to freeze accounts with no reason in the future. If you are considering filing any type of bankruptcy, be sure to understand the consequences of having a Wells Fargo account. Also, be sure that your attorney can warn you of such a consequence before you file so that you are not left without funds to meet your daily living expenses.

            At Mickler & Mickler, we attend Court on a regular basis. We have the experience and knowledge to ensure that you receive the correct advice when confronted with difficult financial decisions related to filing bankruptcy. Contact us at 904.725.0822 or bkmickler@planlaw.com.

 

Bryan K. Mickler

 

Bankruptcy Predictions for 2014 and Beyond

BANKRUPTCY PREDICTIONS FOR 2014 . . . AND BEYOND

            With 2013 behind us, it is time to look ahead to what 2014 will bring to the Bankruptcy World. First, a look at 2013. Filings in the Jacksonville Division continued the decline that started in 2010. 2013 filings were down 8% from 2012 levels and down 35% from the 2010 peak of over 11,000 cases.

            What is causing the decline? The average person will say that unemployment has dropped significantly since 2010 and that has helped lower filings. However, bankruptcy filing rates have historically never been tied to unemployment, health care expenditures or any number of reasons that typically are blamed for increased filing rates. Instead, bankruptcy filing rates have risen and fallen almost perfectly in line with the availability of credit. See chart at: http://www.creditslips.org/creditslips/2011/08/one-more-time-with-feeling.html

               So based on the availability of credit, what can we expect for 2014? The good news for everyone except bankruptcy practitioners is that it looks like 2014 will be more of the same declines, just maybe not as steep. Short term credit appears to be increasing which has the effect of pushing down bankruptcy filing rates since people will borrow to put off filing bankruptcy. Greater amounts of long term credit and household debt will inevitably cause the bankruptcy filing rates to increase.

               This is why the 2010 to present drop in filings is easily explainable. After the collapse of the financial markets in 2008, there was no credit available for 2-3 years for the average person. Lack of home equity, tighter credit card standards and almost no unsecured lines of credit created a cash basis for most households. Coupled with high household debt levels, this caused a dramatic upswing in filings from 2008-2010. That has slowly starting to change since 2010 with the increase in available credit brought about by the growth in the economy and housing values. The decline in bankruptcy filings will inevitably reverse itself as long term credit/household debt level increases over the next 12-24 months.

               As in 2008, long term increases in household debt levels coupled with a sharp pullback in the availability of credit due to actual or perceived economic weakness will result in an increase in bankruptcy filings. Most likely, that scenario will not play out for the next year or two as the economy continues to improve. It will be interesting to see how the coming 2014 mortgage standards (tougher underwriting) will impact the availability of mortgage credit and the bankruptcy filing rate. Stay tuned for more on that in a later post.

            At Mickler & Mickler, we attend Court on a regular basis. We have the experience and knowledge to ensure that you receive the correct advice when confronted with difficult financial decisions related to filing bankruptcy. Contact us at 904.725.0822 or bkmickler@planlaw.com.

 

Bryan K. Mickler

Can One Mistake Lead to Filing Bankruptcy?

CAN ONE BAD DECISION LEAD TO FILING BANKRUPTCY?

            Lately, our office has noticed a new trend: Bankruptcy filings for people with only one bad debt. How is this possible? Doesn’t the normal bankruptcy filing result from years of financial problems finally becoming too large to deal with any longer? Not necessarily.

With the financial crisis over the past five years many people significantly reduced their debt burden each month. Cars were paid off and not replaced every 2-3 years, houses were repaired instead of sold and replaced with larger more expensive versions and even credit cards were paid off and kept at a $0.00 balance each month. The overriding issue for people became to keep what they had and not to constantly upgrade and incur new debt.

The financial downturn also lead to a decrease in collection activity. As weird as it sounds, the fact that finances were so dire meant that judgments and collection activity became worthless if there was no ability to pay on the part of the Debtor. Now that the financial markets appear to have recovered somewhat, collection activity is starting to pick up again.

So what about the one mistake that people can make which can lead to bankruptcy? With the accumulation of “paid for” assets such as bank accounts, cars, non-homestead property, equipment or inventory, people and/or companies become vulnerable to a judgment creditor attempting to collect on a new or old judgment. We’ve seen several instances recently of exactly this type of situation, where paying down property has led to the need to file a bankruptcy. Not necessarily to deal with the debt itself, but to protect the paid off property that is subject to a judgment. Even one judgment is usually enough to cause tremendous financial pain to people or companies since the amount of the judgment is more than can be paid off immediately.

Chapter 13 and Chapter 11 bankruptcies offer the opportunity to preserve assets that have been paid off, while offering the ability to work out a partial or complete repayment plan to the judgment creditor. The amount of repayment in any plan is based upon the value of the paid for assets (non-exempt only) and the left over income each month after living expenses have been paid.

CONCLUSION

            Asset protection is a valid reason for seeking bankruptcy protection. Don’t let one mistake ruin years of financial good behavior. Learn how to keep your assets and manage your financial issues by contacting our office.

At Mickler & Mickler, we attend Court on a regular basis. We have the experience and knowledge to ensure that you receive the correct advice when confronted with difficult financial decisions related to filing bankruptcy. Contact us at 904.725.0822 or bkmickler@planlaw.com.

 

Guarantor Issues in Chapter 11

Guarantor Issues in Chapter 11 Cases

            Everything was going so well – you have filed the Chapter 11 case for the corporate debtor and are progressing nicely in the case. Then the main shareholder calls your office in a panic – “I’ve been sued!!!” You immediately start dreaming of huge sanction awards against a malevolent creditor that ignored your corporate Chapter 11. But, alas, the creditor has sued the principal as a guarantor on the corporate debt.

This situation is all too common and can cause substantial harm to the corporate case. Judgments against shareholders can result in garnishment of funds needed to cover corporate shortfalls, result in execution on the corporate stock or cause the shareholder to abandon the corporate case.

If your shareholder cannot or will not consider an individual bankruptcy filing, there are still options available to protect the shareholder (and your corporate case) through the corporate Chapter 11. Our office will, depending on the type of Plan being proposed or the particular situation, file an adversary proceeding in order to extend the provisions of the stay to the non-debtor.

The Chapter 11 Court has the equitable powers under Section 105(a) to enjoin the continuation of collection activities against the non-debtor, which would significantly impact the Debtor’s ability to successfully reorganize. See Carway v. Progressive County Mut. Ins. Co., 183 B.R. 769, 775 (S.D. Tex 1995).

As a general rule, the automatic stay will normally apply to non-debtors only “when a claim against the non-debtor will have an immediate adverse economic consequence for the debtor’s estate.” Queenie, Ltd. v. Nygaard, Int., 321 F.3d 282, 287 (2d.Cir.2003). As cited by the Queenie Court, examples are a claim to establish an obligation of which the debtor is a guarantor, McCartney v. Integra National Bank North, 106 F.3d 506, 510-11 (3d Cir. 1997), a claim against the debtor’s insurer,   Johns-Manville Corp. v. Asbestos Litigation Group (In re Johns-Manville Corp.), 26 B.R. 420, 435-36 (Bankr. S.D.N.Y. 1983) (on rehearing), and actions where “there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant . . .,” A.H. Robins Co. v. Piccinin, 788 F.2d 994, 999 (4th Cir. 1986). Capital contributions from the shareholder are also a good reason to extend the provisions of the stay to the non-debtor. The fact that the co-debtor’s capital contributions are available to fund Debtor’s Plan warrants extension of the stay to the necessary co-debtor. See In re Hamlin’s Landing Joint Venture, 81 B.R. 651, 653 (Bankr. M.D. Fla. 1987).

If you are considering Chapter 11 for a corporation and have a personal guarantee issue, consider the above when deciding on which attorney’s office to utilize. Ask how the attorney will handle a situation where a personal guarantee action has been filed. Our office has the experience to recommend the appropriate course of action in such a situation, whether it requires filing a separate bankruptcy petition or attempting to stay the suit through an extension of the automatic stay.

Contact our office at 904.725.0822 or bkmickler@planlaw.com for a free consultation regarding filing bankruptcy.

 

The Applicability of the Absolute-Priority Rule to Nonprofit Debtors

The absolute-priority rule was a judicial invention intended to prevent equityholders and secured creditors from colluding to the detriment of unsecured creditors.[1] The Bankruptcy Reform Act of 1978 codified the absolute-priority rule at 11 U.S.C. § 1129(b)(2)(B)(ii), which requires for dissenting unsecured creditors to be paid in full before equityholders may retain property under a reorganization plan.

The absolute-priority rule is “generally applied to for-profit corporations facing bankruptcy, where an equityowner seeks to retain property, often represented by stock.”[2] The applicability of the absolute-priority rule to a nonprofit debtor presents an uncommon question. The only two circuit courts of Appeal to decide the issue have found the absolute-priority rule does not apply to nonprofit debtors.

Seventh Circuit: Absolute-Priority Rule Does Not Apply to a Nonprofit Electric Utility     The Seventh Circuit analyzed the absolute-priority rule in the context of an electric utility cooperative.[3] The Seventh Circuit ruled that members (equityholders) of a nonprofit debtor did not hold “interests” in the debtor and therefore the debtor’s reorganization plan did not violate the absolute-priority rule. The dissenting unsecured creditor in Wabash objected on the grounds that the member cooperatives retained control of the reorganized debtor and received some economic benefit from the reorganized debtor. The Seventh Circuit found the “member cooperatives…do not improperly retain property ‘on account of’ either their patronage capital accounts (which are mere refunds of overpayments) or their control over [the Debtor].”[4] Identifying three indicia of ownership (control, profit share and ownership of corporate assets), the Wabash court determined that retention of managerial control was insufficient to trigger the absolute-priority rule in the context of an electric utility.

In concluding that the member cooperatives did not retain an interest in the reorganized debtor, the Seventh Circuit relied on Indiana state law as it pertains to nonprofits in general as well as regulation on Indiana utility companies. Generally, Indiana law prohibits nonprofit companies from paying dividends to its members and provides that, upon dissolution, any equity in assets escheats to the state.[5] As to utility regulations, the Seventh Circuit found it important that Indiana law prohibited the debtor from charging customers more than the cost of electricity provided.[6]

Thus, the Seventh Circuit’s decision is limited to some extent as the debtor was an electric utility. However, the decision still may generally apply to any nonprofit chapter 11 debtor. Provisions similar to the Indiana statutes noted in Wabash may exist in the law of one’s jurisdiction. For example, under Florida law, nonprofit corporations are prohibited from making distributions to its members, subject to limited exceptions.[7]

Ninth Circuit Expands on the Wabash Decision     Ninth Circuit relied on Wabash in ruling that an international labor union was not an owner of its local branches for purposes of the absolute-priority rule.[8] In the Teamsters case and unlike the circumstances in Wabash, the debtor held a contingent future interest in the assets of any dissolved local union. The Ninth Circuit found this insufficient to establish ownership without any other indicia of ownership. The Ninth Circuit noted the rationale behind the absolute-priority rule as it pertains to for-profit chapter 11 debtors. The concern of an equityholder is purely an economic one, focused on the profitability of the corporation.

Other courts have applied slightly different rationale in reaching the same conclusion as the Seventh and Ninth Circuits.Rather than focusing on the interest retained by equityholders, the court in In re Save Our Springs Alliance Inc.[9] found that a nonprofit corporation simply has no equityholders. The debtor in that case existed to promote water conservation in west Texas. The court did not find it necessary to examine the indicia of ownership or other factors, but cited the circuit court decisions that the proposition that the equityholders did not retain an interest in the reorganized debtor.

Conclusion     The applicability of these decisions to other types of nonprofit organization will largely hinge on the stated purpose of a given debtor and the existence of monetary incentives for the equity holders provided in a proposed plan of reorganization. As explained by the Ninth Circuit, the absolute-priority rule exists to prevent abuse by debtors with solely pecuniary motivation, which is the motivation of most business ventures. The same rationale behind the absolute-priority rule fails where the debtor exists to serve a community function, such as in the context of a labor union, electric cooperative, historical society, environmental protection group or religious organization.

1. See In re Wabash Valley Power Ass’n, 72 F.3d 1305, 1314 (7th Cir. 1996).

2. Sec. Farms v. Gen. Teamsters (In re Gen. Teamsters), 265 F.3d 869, 873 (9th Cir. 2001).

3. See In re Wabash Valley Power Ass’n, 72 F.3d 1305.

4. See In re Wabash, 72 F.3d at 1320.

5. Id. at 1309.

6. Id. at 1313-1314.

7. See Florida Statutes § 617.1301.

8. Sec. Farms v. Gen. Teamsters (In re General Teamsters), 265 F.3d 869, 874 (9th Cir. 2001).

9. 3388 B.R. 202, 245 (Bankr. W.D. Tex. 2008), aff’d, 2009 WL 8637183 (W.D. Tex. Sept. 29, 2009), aff’d, 632 F.3d 168 (5th Cir. 2011).

This posting was originally published as an article in the American Bankruptcy Institute (ABI) Young and New Members Journal, Volume 10, Number 3 / September 2012, which can be accessed at:http://www.abiworld.org/committees/newsletters/Young/vol10num5/king.html.