Can A Senior Creditor Voluntarily Give Assets To A Lower Creditor In Chapter 11 Bankruptcy?
In a Chapter 11 case each creditor is classified into tiers, or classes. Some creditors, such as a secured creditor like a mortgage, will have the highest priority. Some classes have priority, but not the highest priority, such as expenses of the bankruptcy estate or expenses that are incurred for the process of the Chapter 11 itself. At the bottom of the priority hierarchy are unsecured creditors.
The Absolute Priority Rule
The Absolute Priority Rule says that each class must be paid in full, before any creditor in any lower tier can ever be paid. The only way that any given creditor can get less than what it is owed is if the creditors in the tier below it don’t receive anything.
But it is always in the debtors’ best interest for all creditors to approve of a plan. Because of this, lower creditors, who may receive nothing, still have voting power, and still must be treated fairly in a proposed Chapter 11 plan.
Voluntarily Sidestepping the Rule
There is a trend in Chapter 11 bankruptcy, for higher, senior creditors to voluntarily agree to give a lower creditor some of the debtor’s assets or funds, while leaving out a middle tier. In return, the lower tier creditor votes to approve of the plan.
For example, let’s assume there are three tiers in a given Chapter 11 bankruptcy case. Normally, Tier 1 must be paid in full before Tier 2 gets paid, and Tier 2 must get paid before Tier 3. But what if Tier 1 agreed that it would voluntarily give Tier 3 some of the debtor’s funds, thus leaving Tier 2 as the only class of creditors that isn’t paid?
On the one hand this should seem allowable—if a high priority creditor wants to give something to another creditor, it should be able to. On the other hand, this agreement does violate the Absolute Priority Rule. Many courts have refused to approve proposed Chapter 11 plans, where this kind of agreement exists.
Despite that, the process of a senior class of creditors “gifting” things to lower classes is still considered part of the negotiation process of a Chapter 11 case, and the ultimate test to see whether a bankruptcy plan should be approved is whether or not the plan is fair and equitable to all creditors. Furthermore, many courts see such agreements as something favorable, especially where, without the agreement, only one tier of creditors would ever get paid.
Courts also recognize that rigidity would prevent many Chapter 11 plans from ever getting approved, and some dynamic give and take is necessary to get all creditors to agree on a plan (although not all creditors have to approve of a plan—a court can always approve a plan over creditors’ objections, so long as the plan is fair).