The absolute priority rule is the Chapter 11 bankruptcy principle that senior creditors must be paid in full before any junior class or equity holder receives anything under a reorganization plan. It matters most when a debtor asks a court to confirm a plan over the objection of a creditor class, and it explains why business owners usually lose their equity when their company reorganizes. Two significant carve-outs, one for small businesses using Subchapter V and a contested one for individual debtors, change the picture considerably.
The Order of Payment in Chapter 11
Federal bankruptcy law arranges claims into a strict order under 11 U.S.C. § 507, and each level must be fully satisfied before the next level sees any money.1Office of the Law Revision Counsel. 11 USC 507 Priorities Domestic support obligations come first, followed by the administrative costs of the bankruptcy itself, then unpaid pre-filing wages and benefits within statutory caps, certain tax claims, secured creditors up to the value of their collateral, general unsecured creditors, and finally equity holders.
Owners sit at the bottom because they took the most risk when they invested. The trade-off for that risk was a shot at profit, and when the company cannot pay its debts, the trade-off runs the other way. Under the absolute priority rule, owners keep their stake only if every creditor class above them either agrees to less or gets paid in full.2Office of the Law Revision Counsel. 11 USC 1129 Confirmation of Plan Because most companies filing Chapter 11 owe more than they are worth, the usual result is that existing ownership interests get cancelled.
When the Rule Actually Applies
The rule does not kick in when every creditor class votes to accept the plan. It applies during a cramdown, the process where a court confirms a plan over the objections of a dissenting class. Cramdown lives in 11 U.S.C. § 1129(b), which requires that the plan not discriminate unfairly among classes of similar priority and that it be “fair and equitable” toward the dissenting class.2Office of the Law Revision Counsel. 11 USC 1129 Confirmation of Plan
“Fair and equitable” is where the absolute priority rule lives. For a class of unsecured creditors, a plan is fair and equitable only if either the class is paid in full or no class junior to it receives or retains any property under the plan.3Office of the Law Revision Counsel. 11 US Code 1129 – Confirmation of Plan That second prong is what stops owners from retaining equity when unsecured creditors reject the plan and are getting less than the full value of their claims.
Company valuation drives most cramdown fights. A debtor has every reason to argue the business is worth just enough to satisfy senior claims and no more, leaving nothing that could be diverted to junior classes. Objecting creditors push the value up. The absolute priority rule only blocks junior distributions when a senior class is being shortchanged, so if the business is actually worth enough to cover everyone at par, the rule is not violated in the first place.
How Owners Can Still Keep Equity: The New Value Exception
There is one recognized way for owners to retain their stake without paying creditors in full. Under the new value exception, owners can keep equity if they contribute fresh capital to fund the reorganization. The Supreme Court set out the requirements in Case v. Los Angeles Lumber Products Co. (1939): the contribution must be in money or money’s worth, and it must be reasonably equivalent to the equity interest the owners are getting.4Cornell Law Institute. Case v Los Angeles Lumber Products Co
Promises of future work do not qualify. In Norwest Bank Worthington v. Ahlers (1988), farm debtors argued their future labor and management expertise should count as new value. The Supreme Court disagreed, holding that a promise of future services is intangible, unenforceable, and cannot be sold on any market for something creditors could use today.5Cornell Law Institute. Norwest Bank Worthington v Ahlers
The Market Test
Even a real cash contribution is not enough on its own. In Bank of America v. 203 North LaSalle Street Partnership (1999), the Supreme Court held that old equity holders cannot be given an exclusive right to buy into the reorganized company. Without some competitive process, there is no way to verify that the owners’ proposed price reflects fair market value. The Court did not spell out exactly what the market test must look like, but plans that reserve a protected, competition-free equity opportunity for existing owners violate § 1129(b)(2)(B)(ii).6Justia U.S. Supreme Court Center. Bank of America Nat Trust and Sav Assn v 203 North LaSalle Street Partnership
Put those pieces together and the exception is narrow. Owners must contribute real money rather than labor, in an amount that reflects genuine market value rather than a lowball estimate, through a process that other bidders could enter.
Small Businesses: The Subchapter V Carve-Out
The absolute priority rule does not apply in Subchapter V cases. This matters because many small business owners filing Chapter 11 today use Subchapter V, and the rules are fundamentally different.
The Small Business Reorganization Act of 2019 created Subchapter V as a streamlined path through Chapter 11 for businesses with debts below a statutory cap, currently $3,024,725.7U.S. Department of Justice. Subchapter V Section 1181(a) makes § 1129(b), the provision containing the absolute priority rule, inapplicable in these cases.8Office of the Law Revision Counsel. 11 USC 1181 Inapplicability of Other Sections
Subchapter V uses its own cramdown standard in § 1191. A court can confirm a plan over creditor objections if the debtor commits all projected disposable income for three to five years to plan payments, the plan does not discriminate unfairly, and the court finds the debtor can make the required payments.9Office of the Law Revision Counsel. 11 USC 1191 Confirmation of Plan A small business owner can retain full ownership even when unsecured creditors are not paid in full, as long as the disposable income commitment is met. That is a sharp departure from the traditional rule and a large part of why Subchapter V has become popular.
Individual Chapter 11 Debtors
How the absolute priority rule applies to individuals filing Chapter 11 is unsettled. The 2005 Bankruptcy Abuse Prevention and Consumer Protection Act added § 1115, which expands the bankruptcy estate for individual debtors to include post-filing earnings and property acquired after the case begins.10Office of the Law Revision Counsel. 11 USC 1115 Property of the Estate At the same time, Congress added a carve-out to § 1129(b)(2)(B)(ii) allowing an individual debtor to “retain property included in the estate under section 1115.”2Office of the Law Revision Counsel. 11 USC 1129 Confirmation of Plan
Courts have split on what that means. Some read the language broadly, concluding that BAPCPA effectively eliminated the absolute priority rule for individual debtors. Others read it narrowly, applying the rule to pre-petition property while shielding only post-petition earnings. The stakes are real: under the broad view, an individual can keep all their assets even if unsecured creditors take a haircut; under the narrow view, only future income is protected. Courts have also disagreed about whether exempt property such as a homestead or retirement accounts can be retained without violating the rule. Anyone filing an individual Chapter 11 case needs to know which interpretation the local bankruptcy court follows, because that answer can decide whether they keep their home or their retirement savings.