Farmers, Bankruptcy and the “Absolute Priority” Rule

Overview

Financial and economic continue to predominate in numerous parts of the ag economy.  Current statistics show that economic woes are the most difficult in the dairy sector and other areas on a regional basis – particularly parts of the Great Plains and the Upper Midwest. 

Initially passed in the midst of the farm debt crisis of the 1980s, Chapter 12 bankruptcy is uniquely tailored to address the needs of farmers in financial distress.  That’s particularly true because of a special tax rule and the ability to avoid something known as the “absolute priority” rule of Chapter 11.  However, appropriate planning must be utilized for a farmer to take advantage of Chapter 12.

The peril of a farmer not being eligible for Chapter 12 bankruptcy – that’s the topic of today’s post.

Foreseeing Problems

I was asked during a recent radio interview what I would tell a farmer or rancher facing potential financial problems if there was only one piece of advice I could give.  My response – “listen to your wife.”  Why?  In many farming and ranching operations, the operating spouse simply works in the business of farming or ranching rather than working on it.  There is a big difference between the two.  The spouse that works on the business is the one keeping the books and records, tracking income and expense and monitoring the financial strength of the business.  The operating spouse often is not tuned-in to these important aspects of the business.  Instead, if lenders will continue to lend, the farmer can continue doing what they do best – farm, ranch and… sign lending documents without having legal counsel review them.  But, this can lead to ignoring financial problems until it’s too late.  Then, it might be necessary to liquidate assets. 

Chapter 12

This is the problem that Chapter 12 was designed to address.  Chapter 12 allows a farmer to downsize the operation so that it can continue.  The business gets reorganized, not liquidated.  While the sale of assets to “right-size” the operation can trigger significant taxes, Congress added 11 U.S.C. §1222(a)(2)(A) with the overhaul of the Bankruptcy Code in 2005.  Under that provision (and an amendment to it that took effect for new Chapter 12 cases on or after October 26, 2017), a Chapter 12 debtor can treat claims arising out of “claims owed to a governmental unit” as a result of “sale, transfer, exchange, or other disposition of any farm asset used in the debtor’s farming operation” to be treated as an unsecured claim that is not entitled to priority under Section 507(a) of the Bankruptcy Code, provided the debtor receives a discharge.  The amendment addressed a major problem faced by many family farmers filing under Chapter 12 where the sale of farm assets to make the operation economically viable triggered gain which, as a priority claim, had to be paid in full before payment could be made to general creditors.  Even though the priority tax claims could be paid in full in deferred payments under prior law, in many instances the debtor operation did not generate sufficient funds to allow payment of the priority tax claims in full even in deferred payments.  That was the core problem that the 2005 provision attempted to address.

Among other eligibility requirements, a farmer must have aggregate debt not exceeding $4,411,400.  That is presenting a very real problem for many farmers at the present time.  If Chapter 12 is not available because a farmer has debt exceeding the limit, what are the options?  In terms of bankruptcy, the only viable options are a Chapter 7 liquidation bankruptcy and a Chapter 11 reorganization.  But, in terms of reorganization, Chapter 11 is not nearly as favorable to the farm debtor as is Chapter 12 for the reasons noted below.  Thus, for a farmer with excessive debt the strategy would be to identify and liquidate underperforming assets; repay creditors; and get the debt limit beneath the $4,411,400 threshold.  That will allow the farmer to file Chapter 12 and get a stronger bargaining position in negotiating a debt settlement with creditors and get favorable tax treatment upon sale, etc., of farm assets.

The Perils of Chapter 11

Chapter 11 is the general reorganization provision for individuals and firms operating a business.  There is no debt limit associated with Chapter 11, but major drawbacks of Chapter 11 include the relatively short time the debtor has to overcome existing financial problems, and an absolute priority rule that prohibits debtors from retaining ownership of their property unless unsecured creditors receive 100 percent of their claims.

The absolute priority rule.  Under 11 U.S.C. §1129(b)(1), a creditor's plan objection will be upheld if the plan: (1) discriminates unfairly; or (2) is not fair and equitable with respect to each non-accepting class of claims or interests that is impaired under the plan.  In this context, "impaired" means that the plan alters the rights of a class of creditors compared to the contractual rights prior to bankruptcy.  The rule arose from several railroad case about a century ago.  For example, in Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), the debtor’s reorganization plan proposed to not pay the claims of junior creditors.  The Court refused to approve the plan.  Instead, the Court concluded that an “absolute priority rule,” as applied to a dissenting class of impaired unsecured creditors, must result in a plan being "fair and equitable."   As codified, the “fair and equitable” test (i.e., the “absolute priority rule”) is satisfied only if the allowed value of the claim is to be paid in full, or if the holder of any claim or interest that is junior to the dissenting creditors will not receive or retain any property under the plan on account of such junior claim or interest.  See 11 U.S.C. §1129(b)(2)(B)(ii).  

The absolute priority rule came up in a recent Wisconsin bankruptcy case involving a dairy.  In In re Schroeder Bros. Farms of Camp Douglas LLP, No. 16-13719-11, 2019 Bankr. LEXIS 1705 (Bankr. W.D. Wisc. May 30, 2019), a dairy was structured as a limited liability partnership (LLP). The LLP filed Chapter 11 in late 2016. At the time the Chapter 11 petition was filed, the debtor was ineligible to file Chapter 12 because aggregate debts exceeded the limit for Chapter 12 eligibility. The bankruptcy court confirmed the debtor’s reorganization plan in mid-2018. The debtor became unable to make plan payments and the committee of unsecured creditors motioned for the appointment of a liquidating trustee. The debtor objected on the basis that the sale of any assets would trigger capital gain taxes, and the combination of those taxes, the liquidating trustee’s fees, attorney fees and committee attorney fees would completely consume the sale proceeds of the encumbered real estate, farm equipment and cattle rendering the estate insolvent and leaving the individuals subject to pay the unpaid income taxes.

The debtor subsequently claimed that total debts had fallen beneath the debt limit for a Chapter 12 filing and sought to convert the Chapter 11 case to Chapter 12. Doing so would allow the debtor to take advantage of 11 U.S.C. §1222(a)(2)(A) (the predecessor to current 11 U.S.C. §1232) so that capital gain taxes could be treated as an unsecured claim. The committee of unsecured creditors asserted that the non-priority treatment of capital gain taxes was a non-issue because the debtor, as a pass-through entity, had no liability for any taxes. Instead, it would be the partners of the LLP that would have personal liability for taxes arising from asset sales. The debtor claimed it could elect to be taxed as a corporation via IRS Form 8832 upon making an election. Doing so, the debtor claimed, would result in the capital gain taxes being discharged as an unsecured claim. The committee claimed that the debtor was ineligible to convert to Chapter 12 because it was ineligible at the time the petition was filed.

The bankruptcy court agreed with the committee of unsecured creditors.  The original petition date of the debtor’s Chapter 11 filing is the measuring date for the debtor’s Chapter 12 eligibility.  However, when the debtor filed Chapter 11, the debtor was ineligible for Chapter 12.  The bankruptcy court also pointed out that the debtor’s bankruptcy filing did not impact the debtor’s tax status. The bankruptcy court reasoned that allowing the debtor to make an election to be treated for tax purposes as a corporation would violate the absolute priority rule of 11 U.S.C. §1129(b)(2)(B) – a mainstay of Chapter 11. The absolute priority rule, the court noted, bars a court from approving a plan that gives a holder of a claim anything unless objecting classes have been paid in full. Thus, the proposed conversion of tax status would dilute the class of unsecured creditors and shift unfavorable tax treatment to the detriment of creditors. Accordingly, the bankruptcy court determined that the proposed tax election was not in the best interests of the debtor, the bankruptcy estate or the creditor and denied the tax election. The bankruptcy court approved the appointment of a liquidating trustee. 

Conclusion

For farmers and ranchers, proper planning is the key to dealing with financial distress so they can utilize the advantages of Chapter 12.  In the In re Schroeder Bros. case, a suggested approach for the dairy would have been to file the election to be treated as a C corporation at least one year before filing the bankruptcy petition. Then a pre-petition partial liquidation could have been utilized to get the debt level within the Chapter 12 limit. If the LLP couldn’t be treated taxwise as a C corporation, the farmer would have needed to file Chapter 12 individually to utilize the tax provisions of 11 U.S.C. §1232.  In the alternative, two jointly administered petitions could have been filed. 

Chapter 11 has serious limitations and is clearly disadvantageous compared to Chapter 12. It’s never too early to seek out competent legal counsel.  A great deal of advance planning is often required to obtain the best possible result in a difficult situation.