The Absolute Priority Rule Torpedoes Settlements in Individual Chapter 11 Cases (Part One)

By Donald L. Swanson

I don’t need to see a study or commission report for the title of this article.
I’ve seen the problem play out many, many times in real life.
Here is an attempt to explain.

Some Propositions

Proposition # 1: When one party has 0% odds of success at trial, a mediation effort is a complete waste of time.

Proposition # 2: The absolute priority rule is a Chapter 11 plan confirmation standard requiring that creditors either, (1) be paid in full, or (2) agree to something less.

Proposition # 3: Many individual Chapter 11 debtors who can’t pay all debts in full have 0% odds of getting a Chapter 11 plan confirmed over objection of creditors insisting on liquidation.

Proposition # 4: Individuals are living beings who need a “fresh start”– entities aren’t . . . and don’t.

A Farm Crisis Days Illustration

These propositions are based on long and hard experience from the 1980s Farm Crisis days.

Here is how it worked, back then, in pre-Chapter 12 days:

–Most farms are sole proprietorships, so farmer reorganizations are almost always individual Chapter 11s.

–The Farm Crisis is precipitated by, (1) a dramatic drop in prices of corn, beans, cattle, hogs, used equipment, farm land, etc., and (2) an interest rate spike beyond 18%.

–Farmers in Chapter 11 are, uniformly, unable to pay their debts in full — it’s not even close.

–Primary secured creditors have no interest in anything other than complete liquidation.

–Chapter 11 farmers want to keep the farm together and will fight-to-the-death toward this end — but they rarely succeed because of the absolute priority rule.

–Chapter 11 farmers eventually run out of cash, and farms are liquidated by secured creditors, resulting in huge deficiencies and large tax liabilities, neither of which can be paid.

In Northwest Bank v. Ahlers, 485 U.S. 197 (1988), the United States Supreme Court says the absolute priority rule “applies” in Chapter 11 farmer cases, despite empathizing like this: “we do not take lightly” and we “sympathize” with “the plight of the American farmer.”

Settlement efforts back then almost always fail because debtors have no bargaining chip. This is precisely why Congress enacted Chapter 12 for farmers.

Today’s Reality

So . . . fast forward to today. The absolute priority rule still applies in individual Chapter 11 cases.

And the pathologies of the Farm Crisis days remain today for individual debtors. Such pathologies include this: the absolute priority rule torpedoes mediation (and other settlement) efforts in many individual Chapter 11 cases, when creditors can’t be paid in full.

That’s a problem for individuals who need a fresh financial start.