In In re Juarez, 603 B.R. 610 (9th Cir. BAP 2019), the Bankruptcy Appellate Panel of the U.S. Court of Appeals for the Ninth Circuit addressed a question of first impression in the circuit with respect to property that is exempt from creditor reach: it adopted the view that, under the "new value exception" to the "absolute priority rule," an individual Chapter 11 debtor intending to retain such property need not make a "new value" contribution covering the value of the exemption.

Background

Before filing his Chapter 11 petition in June 2017, Ubaldo Juarez borrowed $200,000 from Edgar Todeschi and Georgina Ponce in 2011. Todeschi and Ponce subsequently sued Juarez in Arizona state court in 2014 for breach of contract, breach of good faith and fair dealing, unjust enrichment, negligent misrepresentation, fraud, and constructive trust.  Juarez thereafter filed his Chapter 11 petition due in part to the expenses incurred from this litigation. Todeschi and Ponce filed a proof of claim in the Chapter 11 case in the amount of $261,390.40, to which Juarez did not object.

In the debtor's bankruptcy schedules filed with the bankruptcy court, Juarez listed his residence with a value of $300,000. The residence was encumbered by a lien valued at $156,000, and Juarez availed himself of a statutory exemption of $150,000 covering his remaining equity in the home.

Under the terms of his first proposed plan and disclosure statement, Juarez would pay Class 4 general unsecured creditors, including Todeschi and Ponce, $20,467.44 over five years, along with a $10,000 "new value" contribution to be provided in the third year of the plan by Juarez's partner, Leticia Arreola. If this funding source failed, Juarez pledged to sell his residence to make the new value contribution. The plan also provided that Juarez would keep the title to his home. The bankruptcy court approved the disclosure statement and scheduled a plan confirmation hearing.

Todeschi and Ponce objected to the proposed plan on several grounds, including that the plan was not fair and equitable under Section 1129(b) of the Bankruptcy Code because it did not satisfy the "absolute priority rule" or the "new value" exception thereto. The Class 4 creditors rejected the plan, and the bankruptcy court denied confirmation, reasoning in part that because Arreola did not have the money as of the trial date, and would only make the contribution in the third year of the plan, the proposed "new value" contribution was not "money or money's worth." Moreover, because the $10,000 contribution amounted to less than 5% of Juarez's total unsecured debt, the bankruptcy court found that it was not "substantial." For these reasons, the bankruptcy court concluded that the plan failed to satisfy all the requirements of the "new value" exception to the "absolute priority rule."

Juarez subsequently filed an amended plan that addressed the shortcomings identified by the bankruptcy court including, among other things, increasing the "new value" contribution to $15,000, to be paid as of the effective date of the amended plan. In addition, the amended plan increased the payment to Class 4 general unsecured creditors to a total of $33,580. The bankruptcy court approved the disclosure statement, but Todeschi and Ponce objected to the amended plan, reiterating their prior arguments under the "absolute priority rule" and contending, among other things, that the amended plan was unfair under Section 1129(b) because Juarez would retain all of his assets without fully paying unsecured creditors.

The bankruptcy court held a confirmation hearing on Jan. 23, 2019, overruling Todeschi and Ponce's objection from the bench and confirming the amended plan. The bankruptcy court reasoned, among other things, that the amended plan satisfactorily addressed the Section 1129(b) objections and the court's earlier concerns. Further, the bankruptcy court concluded that the amended plan provided that Juarez would "not receive or retain under the plan on account of a junior claim or interest any property. Instead, [Juarez] retains property on account of an infusion of new value into the plan. Such value has been determined [to be] sufficient for confirmation purposes." Todeschi and Ponce filed a notice of appeal and a motion for stay pending appeal, which motion the bankruptcy court denied. On appeal, the Bankruptcy Appellate Panel held that the appeal was not equitably moot, and therefore the Panel could exercise appellate jurisdiction.

The 'Absolute Priority Rule'

Under Section 1129(b) of the Bankruptcy Code, a bankruptcy court can only confirm a chapter 11 plan that is "fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan." Where a class of unsecured claims fails to accept the plan by the requisite majorities, the "absolute priority rule" prevents the court from confirming the chapter 11 plan unless no junior class will receive or retain "any property" under the plan on account of its claim or interest. See 11 U.S.C. Section 1129(b)(2)(B); see also Zachary v. California Bank & Trust, 811 F.3d 1191, 1194 (9th Cir. 2016).

There are two exceptions to this rule, however. First, individual debtors may retain post-petition property and income from post-petition services under Section 1129(b)(2)(B)(ii). Second, a junior class may receive or retain property pursuant to a "new value" contribution if the junior class offers "value" to the reorganized debtor that is: new; substantial; money or money's worth; necessary for a successful reorganization; and reasonably equivalent to the value or interest retained. See, e.g., In re Brotby, 303 B.R. 177, 195 (9th Cir. BAP 2003).

On appeal, Todeschi and Ponce argued under the fifth element of the new value exception that Juarez's new value contribution was insufficient, because the contribution did not equal the value of the residence. The appellants argued that, should the debtor wish to retain his $300,000 home, he would have to contribute at least the value of the exemption, or $144,000, to the bankruptcy estate. This issue raised by Todeschi and Ponce presented a question of first impression in the Ninth Circuit.

The Bankruptcy Appellate Panel took note that the decisions on this question, issuing from other nonprecedential jurisdictions, were divided. And while the appellants urged the panel to accept the "better analysis" that exempt assets are nonetheless subject to the "absolute priority rule," the panel held otherwise. In reaching this decision, the court first reasoned that the absolute priority rule only comes into play if the debtor retains any property under the plan "on account of" the debtor's interest. Because the debtor does not retain exempt property "under the plan" or "on account of the debtor's interest," but instead by virtue of applicable exemption statutes, the debtor would be entitled to exercise his right to exempt the property even had no plan been confirmed.

In addition, the panel noted that the interpretation of Section 1129(b) urged by Todeschi and Ponce would create a conflict between that section and Sections 522(c) and (k) of the Bankruptcy Code, which provide that exempt property is not liable for the payment of pre-petition claims or expenses. Thus, "requiring a debtor to pay for exempt assets via a new value contribution would effectively make those assets available to creditors." Therefore, the panel held that the bankruptcy court did not err in allowing Juarez to retain his exempt property without making a corresponding "new value" contribution, and affirmed the bankruptcy court's ruling.

Conclusion

The Bankruptcy Appellate Panel's holding will provide greater clarity for both debtors and general unsecured creditors with respect to a contested Chapter 11 plan. Attorneys advising individual debtors should be conscious of the advantage this decision creates when seeking to craft a confirmable Chapter 11 plan over the objections of an impaired class of unsecured creditors. Similarly, counsel for creditors challenging a proposed plan under the new value exception to the absolute priority rule must be aware of the distinct treatment given exempt and nonexempt property under that rule. Additionally, the Panel's analysis will likely guide other circuits addressing this question for the first time.

As of the date of publication, an appeal of the Bankruptcy Appellate Panel's decision is pending before the Ninth Circuit Court of Appeals.

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights.

Malcolm Bates, an associate with the firm, practices in the area of  business reorganization and financial restructuring.