Absolute Priority Rule: 5 Ways Small Business Owners Keep Equity Anyway

Under the Bankruptcy Code, if an entire class of unsecured creditors objects to your reorganization plan and they aren’t paid in full, you can’t retain your equity. That is the absolute priority rule. There are in fact at least five ways in which you as the small-business owner can avoid the absolute priority rule: pay in full, get the vote, Subchapter V, new value, or the individual debtor exception.

You can avoid the absolute priority rule by paying in full all creditors whose entire class would otherwise not vote in favor of your plan. Because these creditors have been paid in full, the absolute priority rule does not apply to your retention of equity.

You can avoid the absolute priority rule and retain equity if the impaired class of creditors actually votes in favor of your Chapter 11 plan. For purposes of voting, a class of creditors is considered to accept your Chapter 11 plan if at least two-thirds in amount of the claims, and more than one-half in number of those creditors vote in favor of it.

Assuming that there is more than one class of creditors and some class of creditors vote in favor of the plan, the court can still confirm a plan even if one or more classes of creditors vote against the plan. A cramdown of an entire class of creditors is allowable if the plan is fair and equitable to them.

Subchapter V

You can bypass the absolute priority rule by filing under Chapter 11, Subchapter V, the Small Business Reorganization Act. Under Subchapter V, unlike under traditional Chapter 11, you also have the option of retaining your equity if the unsecured creditors vote against the plan. In effect, a Subchapter V plan can require you, in order to retain your equity, to give all of your profits to your creditors for a period of at least 3 years, and up to 5.

One benefit of a subchapter V case: No U.S. Trustee quarterly fees. A trustee gets appointed every time. Further, you alone can file a plan of reorganization; no creditor can step in and file its own. There are also time restrictions: You must file your plan no more than 90 days after the petition date, unless the court extends it. A big minus: if your payments look like they will be only reasonably likely, your plan must include remedies such as liquidating nonexempt assets.

But Subchapter V can slip away. In Cleary Packaging, for example, the owner’s company faced a nearly $5 million state-court judgment for tortious interference. The Fourth Circuit held willful and malicious debts were not dischargeable in Subchapter V, not even for companies. The debtor dropped to traditional Chapter 11.

New Money in Return for Equity

You can bypass the absolute priority rule and retain equity in a small business by putting in substantial new money in return for equity. Not every court accepts the new value exception. Those courts that do (in the Fourth and Ninth Circuits, for example) require five things for this exception:

• 1) your new money must be truly new, not in the guise of a loan or credit;
• 2) your new money must be substantial;
• 3) you must provide money or something easily convertible to money;
• 4) your new money must be necessary to the reorganization; and
• 5) your new money must provide a benefit reasonably equivalent to the equity you are keeping.

Cleary also tried the new value route. Although his company’s debts amounted to nearly $5 million, he promised to chip in $25,000 from his personal accounts in exchange for equity, forgive a wage claim, offer his $35,000 loan, and work for the business for free in exchange for his keeping 100% of the business. The court rejected all but the cash, saying $25,000 was not substantial, comprising under 0.5% of the claims. The plan called for creditors to receive about $1.38 million, and he would keep 100%. That $25,000 was 1.8% of the amount the plan would pay. Cleary contended his equity was worthless. But the court thought the company did have some value since it was profitable. Separately, the Supreme Court in 203 North LaSalle (1999) rejects a plan of reorganization giving old owners the exclusive right to put in new money, in absence of a market test.

File as an Individual

The fifth way you can bypass the absolute priority rule and still retain equity in a business is to file as an individual (such as a sole proprietorship) debtor in Chapter 11. In 2005, Congress added a way to avoid the absolute priority rule if you file in Chapter 11 as an individual owner (but not if you file as a business). Case law (a 2016 Ninth Circuit case, Zachary, and a 2014 Sixth Circuit case, Ice House) holds that a debtor can’t keep pre-petition property. But you can keep some property acquired after you file.

How do you decide which of the five ways to try to keep your business? If you can’t get the impaired creditors to vote for your plan, you have 4 options: pay in full, Subchapter V, new value, and individual debtor. How you choose among those four options depends on how much money you have to pay to creditors in a fair plan, the benefit you see to filing Subchapter V, what new money you may be able to contribute, and whether your business is a sole proprietorship.

Bottom line: if you choose new value, the bar is high. Creditors can attack a small contribution as not substantial without a costly valuation fight. Don’t be cheap: bring real cash, not sweat equity or loans.