The Sheppard Mullin Finance & Bankruptcy Law Blog is designed to apprise financial institutions on the current issues that directly impact their business as well as advising on best practices to solve the multidisciplinary problems presented by business insolvencies.
In In re Spanish Peaks Holdings II, LLC, Case No. 15-35572 (9th Cir. Sept. 12, 2017), the Ninth Circuit Court of Appeals held that a bankruptcy trustee may use Section 363(f) of the Bankruptcy Code to sell real property free and clear of unexpired leases without affording the non-debtor lessees the right to retain possession of the property. In reaching its decision, the Ninth Circuit also rejected an argument made by the buyer that the appeal was moot under Section 363(m) of the Bankruptcy Code, holding that Section 363(m) only applies to the transfer itself, as opposed to the free and clear aspect of the sale. A copy of the opinion may be found here.
One of the core powers of a bankruptcy trustee or debtor-in-possession is the ability to assume or reject executory contracts and unexpired leases. This power allows the trustee to keep the deals that they believeare good for the estate and shed those that burden the estate, facilitating the trustee’s ability to reorganize or maximize the value of estate assets in liquidation. However, the Bankruptcy Code is in many ways a delicate balancing of competing interests, and here Congress did not leave the non-debtor counterparties to leases completely out in the cold. The Bankruptcy Code rather includes a number of protections for such parties that have the apparent intent of softening the blow of the trustee’s rejection power on such parties. In the case of lessees, the Bankruptcy Code provides in Section 365(h) that a non-debtor lessee whose unexpired lease is rejected by the trustee-lessor may still opt to pay rent and remain in possession of the property for the duration of the lease, or reject the lease and vacate.
Another core power of a trustee or debtor is the power to sell assets of the debtor’s estate free and clear of liens, claims, encumbrances and other interests pursuant to Section 363(f) of the Bankruptcy Code. This permits the trustee to maximize the value of the estate’s assets by providing buyers with clear title and relative certainty that the asset will be free from liens, litigation, and other issues. Indeed, it is to take advantage of this specific statutory provision that many bankruptcies are filed, as without the cleansing imprimatur of a bankruptcy court, distressed assets may be unsaleable, or at a minimum, significantly depressed in price.
These two powers – the power to reject leases and the power to sell free and clear – come in conflict in Spanish Peaks, which was a chapter 7 liquidation involving a resort property in Montana. The two leases at issue were a 99 year lease for a restaurant property that paid $1,000 per year in rent and a 60 year commercial lease that paid $1,285 per year in rent. Both leases were made to entities related to the debtor and its founders, and both were significantly below market.
The largest creditor in the case by far was the secured lender, whose $122 million debt was secured by a mortgage on the property. The chapter 7 trustee and the lender worked out a plan for liquidating the debtor’s property that involved selling the property “free and clear of all liens” at an auction. The secured lender, a special purpose entity, ended up as the winning bidder at the auction for $26.1 million.
The bankruptcy court approved the sale “free and clear” under Section 363(f), except for some specified permitted encumbrances. However, the sale order did not specify whether the two leases mentioned above would survive the sale. Despite the fact that the lessees had objected at the sale hearing, the bankruptcy court stated that it had not ruled on their objection one way or the other in approving the sale, and directed the parties to file further motions. The secured lender filed a motion for a determination that the sale of the property was free and clear of the two leases.
Bankruptcy Court Ruling:
In considering the secured lender’s motion, the bankruptcy court conducted a “case-by-case, fact-intensive, totality of the circumstances” analysis in which it found and expressly relied upon the following facts: (i) the restaurant lessor had not operated a restaurant on the property in several years; (ii) the leases were well below market; (iii) the leases were executed at a time when all parties were controlled by the same person; (iv) the secured lender’s mortgage was senior to leases; and (v) the leases were not protected from foreclosure of the secured lender’s mortgage by subordination or non-disturbance agreements. The bankruptcy court also noted that the lessees had never sought adequate protection for their leasehold interests prior to the sale, and had provided no evidence that they would suffer economic harm if their possessory interests were terminated.
Relying on the above factual findings, the bankruptcy court held that the sale was free and clear of the two leases, which had no possessory rights under Section 365(h) as a result. The district court affirmed, and the lessees appealed to the Ninth Circuit.
Ninth Circuit Ruling:
The Circuit noted that a majority of courts to have considered the interplay between the trustee’s ability to sell free and clear in Section 363(f) and the non-debtor lessee’s right to retain possession of the property under Section 365(h) had found Section 365(h) to trump Section 363(f) under the “specific prevails over the general” canon of statutory interpretation. However, the Seventh Circuit in In re Qualitech Steel Corp., 327 F.3d 537 (7th Cir. 2003), had found Section 363(f) to prevail in the apparent conflict due to the fact that Section 363(f) permitted sales to be free and clear of “any interest,” and did not provide any exception for leases entitled to the protections of Section 365(h). The Seventh Circuit reasoned that Section 363(f) and Section 365(h) do not conflict because a non-debtor lessee has the ability to request adequate protection under Section 363(e). That ability to request adequate protection protects the lessee in the sale context, while the ability to retain possession protects the lessee in the lease rejection context.
The Ninth Circuit affirmed the lower courts and agreed with the Seventh Circuit’s reasoning in Qualitech Steel. The Ninth Circuit, citing to the canon of statutory interpretation that courts must “read the statutes to give effect to each if we can,” agreed in particular with the Seventh Circuit’s reasoning that Section 363(f) and Section 363(h) do not conflict. The Circuit Court stated that “section 363 governs the sale of estate property, while section 365 governs the formal rejection of a lease. Where there is a sale, but no rejection (or a rejection, but no sale), there is no conflict.” Spanish Peaks, slip op. at p. 15.
In reaching its decision, the Ninth Circuit rejected an argument by the secured lender that because there was a good faith finding under Section 363(m) and the sale had been consummated, the appeal was moot under Section 363(m). Section 363(m) is meant to provide buyers in bankruptcy with protection from the often lengthy appeal process, and therefore incentivize them to bid, by providing that the reversal or modification of a sale order on appeal “does not affect the validity of a sale.”
In a brief footnote, the Circuit Court took an extremely narrow view of the protections provided by Section 363(m), concluding that Section 363(m) only protects the validity of the transfer itself, as opposed to the issue of whether the sale was free and clear of particular liens, claims, or interests. Since the lessees did not seek to overturn the transfer, but merely to determine that the leases were still in force, the Circuit Court found that Section 363(m) did not apply to render the appeal moot. Spanish Peaks, slip op. at p. 9, n. 4.
The Spanish Peaks decision is an important one altering the field of play in bankruptcy cases for trustees, lessees, and leasehold mortgagees in the Ninth Circuit.
As to its effect on trustees and lessors, the opinion essentially gives them a new way of stripping unexpired leases from a property in bankruptcy. While the Ninth Circuit relies heavily on the fact that a court can order adequate protection, such awards are typically monetary and therefore are not as helpful to lessees wanting to stay in possession of their premises as is the clear right to retain possession embodied in Section 365(h).
However, the Spanish Peaks formula may not be easy for trustees and lessors to copy in the future. The bankruptcy court’s “totality of the circumstances” approach relies heavily on a number of factors unique to the case, including the fact that the lessees were controlled by the same party as the debtor-lessor when the leases were signed, were well below market and for extremely lengthy terms, and the restaurant lessee in particular had not even operated a restaurant on the leased premises in several years. All of these facts added a pretextual gloss on the lessees’ claims that they should be entitled to remain in possession of the property.
Further, trustees and debtors-in-possession in general are dealt a potentially significant blow by the Circuit Court’s footnote rejecting the secured lender’s Section 363(m) argument. Limiting the protections of Section 363(m) to the transfer only, as opposed to the entire sale transaction, severely limits the protections of that section. Consider a hypothetical situation in which a buyer buys a piece of property for $5 million in bankruptcy free and clear of a $10 million lien. To provide the buyer with protection from an appeal of the transfer only is meaningless. What the buyer wants and needs to know in order to go forward with its bid in the first place is that it is not going to be saddled with the $10 million lien after it closes. The Circuit Court’s limitation on Section 363(m) has the potential to depress prices received by bankruptcy estates in all sales, and perhaps turn debtors and their lenders away from the bankruptcy process altogether.
For lessees and leasehold mortgagees, the opinion is a call to take precautions both before and after a bankruptcy filing by the lessor. One way to protect the leasehold is, as the Circuit Court notes, through a subordination or non-disturbance agreement that prevents the lessor’s lender from wiping out the lease in a foreclosure. However, the ability to obtain such an agreement pre-petition is dependent on the parties’ bargaining power, and may not be available in many cases, especially situations such as this one where the fee interest is encumbered by a significant mortgage loan. As for what can be done once the bankruptcy is filed, the primary suggestion of the Circuit Court is to seek adequate protection immediately. Other potential options for a leasehold mortgagee would be to seek relief from stay to foreclose on the leasehold mortgage, or move the court for an early determination on rejection.
Further, in the same manner that the “all facts and circumstances” approach detracts from this opinion’s appeal to trustees and lessors, it softens the blow for lessees and leasehold mortgagees, in that it will not be easy to replicate in a standard case. Lessees and leasehold mortgagees may thus be well-advised to “tell the story of the deal” in the recitals of the lease and the leasehold deed of trust in order to distinguish the deal from that in Spanish Peaks – e.g., by adding recitals establishing that the parties are not related, that the rent is at market rate, etc.
Finally, from a purely academic point of view, the case seems to be a perfect illustration of Karl Llewellyn’s assertion that for every canon of statutory interpretation that may be cited in support of a given outcome in a case, another canon of statutory interpretation may be cited in support of the opposite outcome. Here, the Ninth Circuit notes that the majority of courts going the other way cite to the “specific controls over the general” canon, reasoning that Section 363 is a general power to sell and Section 365 deals with leases more specifically and thus should control. However, in support of the opposite outcome, the Ninth Circuit cites a different canon, one in which the court reads statutes to give effect to each if it can (and to avoid conflict). No reason is given why one canon should be preferred to another. The Ninth Circuit’s reason for citing a canon at all seems to be to cancel out the citation of the majority courts’ canon.
In In re Lehman Bros. Holdings Inc. 855 F.3d 459 (2d Cir. 2017), the United States Court of Appeals for the Second Circuit affirmed a district court order subordinating the claims of former Lehman Bros. (“Lehman”) employees for undelivered equity-based compensation to those of the defunct bank’s general creditors. The Court determined the compensation benefits were securities that had been purchased by the former employees when they agreed to receive them in exchange for their labor and the asserted damages arose from those purchases, requiring the claims’ subordination under the Bankruptcy Code. The decision is important to employees and employers weighing the value of hybrid compensation packages and creditors seeking to safeguard their priority position among bankruptcy claimants.
In Lehman Bros., claimants received, as part of their compensation package, restricted stock units (“RSUs”) that gave them a contingent right to own Lehman common stock at the conclusion of a five-year holding period. However, RSUs that remained unvested when Lehman filed for bankruptcy became effectively worthless, leading affected employees holding these RSUs to feel shortchanged. Seeking relief, claimants filed proofs of claim in Lehman’s bankruptcy proceeding for cash payments equivalent to the amounts previously paid to them in RSUs. Lehman in turn filed omnibus objections to the claims on the grounds that, as the claims arose from the purchase or sale of securities, 11 U.S.C. § 510(b) required that they be subordinated to the claims of Lehman’s general creditors.
Section 510(b) of the Bankruptcy Code provides in part that, in bankruptcy proceedings, claims for damages arising from the purchase or sale of a security of the debtor must be subordinated to all claims or interests that are senior to or equal the claim or interest represented by the security. This section safeguards the “absolute priority rule” in bankruptcy which holds that creditors are entitled to be paid ahead of shareholders in the distribution of corporate assets. In other words, security holders may not gain parity with creditors simply by alleging claims arising from the purchase of the securities.
The Second Circuit affirmed. It held that, pursuant to Section 510(b), the former employees’ claims were subordinated to general creditor claims because (1) the RSUs are securities, (2) the claimants acquired them in a purchase, and (3) the claims for damages arose from those purchases.
In determining the RSUs are securities, the Court turned to 11 U.S.C. § 101(49), which sets forth fifteen interests that are included in the definition of “security” and seven interests that are excluded. The Court explained that the inclusive list is not exhaustive and contains a residual clause that covers any “other claim or interest commonly known as ‘security.’” 11 U.S.C. § 101(49)(A)(xiv) (the “Residual Clause”). The Court held that while RSUs arguably qualify as securities pursuant to one of Section 101(49)’s specific examples, they nonetheless qualify as securities pursuant to the Residual Clause as they possess hallmark characteristics of securities, including voting rights, receipt of dividends, and of most significance, the “same risk and benefit expectations as shareholders.” However, the Court cautioned that not all RSUs are necessarily created equal, leaving open the possibility that other interests may fall outside the definition of securities under different facts.
The Court then concluded the RSUs were “purchased,” a term that has been construed broadly in this context to include the receipt of equity securities in exchange for labor. This “bargained-for exchange,” the Court affirmed, was the result of claimants’ “economic decision based on rational self-interest” and therefore qualified as a purchase for purposes of Section 510(b).
Finally, the Court held that the claims for damages arose from the purchase of RSUs. The Court reasoned that the asserted claims would not have arisen but for claimants’ agreement with Lehman to receive part of their compensation in RSUs, demonstrating the requisite causal link.
The claimants advanced several other arguments that the Court found unpersuasive. First, claimants argued that Lehman had an obligation alternatively to perform their obligations by paying cash in exchange for claimants’ labor because the promised RSUs never vested. However, the Court held claimants received all the compensation they were due under the governing employee incentive agreement in the form of the RSUs themselves.
Second, claimants asserted that they are entitled to restitution since Lehman repudiated its contractual obligation to issue stock to RSU holders when it filed for bankruptcy, entitling claimants to the reasonable value of the services they rendered to Lehman. The Court held that such a claim requires a legal injury that was lacking where the RSUs claimants were entitled to receive were no longer of value.
Finally, claimants argued that a decision by Lehman to remove certain contractual provisions relating to RSUs that stated RSUs were to be subordinated to creditor claims in bankruptcy evinced Lehman’s intent to treat RSU holders as general creditors in the event of bankruptcy. The Court dismissed this argument as resting entirely on speculation.
The decision in Lehman appears to reaffirm courts’ willingness to broadly construe the concepts of security, purchase and causation that are central to the claim subordination mandate of Section 510(b). The ruling has important implications for a number of potential stakeholders, including employees with similar equity-based compensation interests, employers seeking to utilize creative equity-based benefits in hybrid compensation packages and creditors concerned with preserving the seniority of their claims in bankruptcy.
In a May 15, 2017 Bankruptcy Court decision (Gardens Decision) from California’s Central District (In re Gardens Regional Hospital and Medical Center, Inc. (Bankr. C.D.Cal., May 15, 2017, No. 1617463), Judge Ernest M. Robles wrote that the grant of oversight and approval authority given to California’s Attorney General over buy/sell and change-in-control transactions between nonprofit sellers of health facilities and for-profit buyers of health facilities (see, California Corporation Code Section 5914 (Section 5914)) is limited to those situations in which a nonprofit seller has an active California health facility license at the time of closing. As written by Judge Robles, the Gardens Decision concludes that transactions between nonprofit sellers and for-profit buyers fall outside the scope of Section 5914 if the assets at hand do not include an operating, California-licensed health facility. As a nonoperational, unlicensed health facility, the transaction at issue is not a health facility transaction subject to Section 5914 and, in turn, Attorney General oversight and approval.
The Gardens Decision is currently being considered, discussed, and appealed for its conclusions regarding the California Attorney General’s ability to oversee and approve nonprofit/for-profit health facility transactions. Yet, the decision at the heart of the case—to close the hospital—was made by a debtor, Gardens Regional Hospital and Medical Center, Inc. (Gardens), without any consideration of how the closure of Gardens’ eponymous general acute care hospital (Hospital) would impact the Attorney General’s ability to exercise its Section 5914 oversight and approval authority in the event of a future change-of-ownership or change-in-control transaction between Gardens and a for-profit entity.
According to Gardens, the decision to terminate Hospital operations resulted from Gardens’ realization that, with no remaining Hospital operating funds, and a lack of willing lenders to provide Gardens with new financing to continue Hospital operations, it had no choice but to cease Hospital operations, close and lock the Hospital’s doors, and request that its general acute care hospital license be placed in suspense by the California Department of Public Health.
And the Question is….
If the Gardens Decision has set forth a new option for nonprofit sellers and for-profit buyers to negotiate and close health facility transactions without Attorney General oversight and approval, the proper inquiry at the outset of negotiations between a nonprofit seller and a for-profit buyer is:
Are the benefits that may arise from avoiding Attorney General oversight and approval of health facility transactions greater than the unavoidable difficulties and financial consequences of closing a health facility?
Gardens Regional Hospital and Hospital – The Abridged Edition
The Hospital, as owned and operated by Gardens, was a 137-bed facility with an intensive care unit, a cardiac unit, and an emergency department, located in Hawaiian Gardens, California. When operational, the Hospital served a patient population that included a significant number of California Medicaid (Medi-Cal) beneficiaries, uninsured/under-insured patients, and indigent patients. In June of 2016, facing financial difficulty, Gardens commenced a voluntary Chapter 11 case. The following month, after Gardens went through a multi-day auction process, the Bankruptcy Court approved the sale of the Hospital to one of the Hospital’s bidders—a for-profit entity.
As required by Section 5914, Gardens submitted the proposed sale transaction to the Attorney General for review and approval. The Attorney General approved the sale subject to specific conditions, including a requirement that the buyer provide $2.25 million per year in charitable care for six years—a significant increase above the amount of charity care historically provided by the Hospital, as well as by similarly-situated community hospitals. As a result of this and other conditions applied by the Attorney General to the for-profit buyer, the acquisition cost to the buyer effectively increased over $20 million; the buyer walked away from the transaction.
In January of 2017, the Court granted an emergency motion to close the hospital based upon the Court’s finding that Gardens’ ongoing financial struggles could potentially place the Hospital’s patients at risk. By February of 2017, all patients had been discharged from the Hospital and/or transferred to alternate facilities. Notwithstanding the negative financial impact on any future Hospital sale transactions (e.g., the loss of the Hospital’s value as a going concern), Gardens decided to close the Hospital and place the Hospital’s general acute care license in suspense. With the Hospital closed, Gardens sought to sell off its Hospital assets—including the building lease, the suspended license, furniture, and inventory—without Attorney General oversight.
The Bankruptcy Court and the Gardens Decision
As described in the Gardens Decision, the Attorney General contended that, by permitting the sale to proceed without Attorney General oversight and approval, the sale would encourage other health facilities to temporarily cease operations in order to evade regulatory oversight—thereby defeating the public health benefits envisioned by Section 5914. The Court countered that since the Hospital assets at issue suffered a significant loss in value (see above), “it defies credulity to assume that other nonprofit hospitals would voluntarily close to escape the Attorney General’s review of a sale, when closure results in such significant value destruction.” Further, the Court concluded that the Attorney General’s position, “ignores the reality that closing a hospital is time-consuming, costly, and requires fastidious planning.” Finally, the Court asserted that its ruling did not conflict with the legislative intent of Section 5914 because, “with [Gardens’] charitable assets being exhausted, nothing remains to be protected by the Attorney General.”
The Attorney General has filed an appeal with the U.S. District Court for the Central District of California to overrule the Gardens Decision and the Bankruptcy Court’s conclusion that the closed Hospital did not qualify as a health facility. In re Gardens Regional Hospital and Medical Center, Inc., Docket No. 2:17-cv-03750 (C.D. Cal. May 18, 2017).
The Balancing Act – Avoiding Attorney General Oversight and Approval v. Accepting a Reduction in the Seller’s Asset Value
Before deciding to relinquish or suspend a health facility license to avoid the Attorney General’s oversight and approval authority as set forth in Section 5914, the nonprofit seller and the for-profit buyer must consider such a strategy’s costs and benefits.
If the parties to such a health facility transaction are willing to relinquish or suspend the hospital’s license and terminate hospital operations prior to the time of closing, the nonprofit seller and the for-profit buyer will not have to enter into the often protracted negotiations with the Attorney General and will not have to accept the often onerous ongoing requirements that the Attorney General may impose on the buyer to get approval for the buyer’s acquisition of the hospital assets.
The Attorney General posts its most recent decisions granting conditional consent to nonprofit hospital transactions on its website at https://oag.ca.gov/charities/nonprofithosp. Although a review of past Attorney General decisions shows that the Attorney General develops unique conditions to address every transactions’ distinct facts and circumstances, there are common Attorney General consent conditions that are routinely applied for a period of five to ten years after the close of a transaction. For example, the Attorney General often imposes the following conditions on buyers:
Maintain the facility as a general acute care hospital and continue certain specialty services deemed essential (e.g., emergency medical services);
Provide a minimum amount of charity care and community benefit services;
Participate in the Medicare and Medicaid (Medi-Cal) programs;
Comply with any capital investment commitments in the Definitive Agreement; and/or
Submit yearly compliance reports to the AG.
The application of the above conditions, as well as any unique conditions that the Attorney General may apply on a case-by-case basis, may compel a buyer to demand purchase price reductions and other concessions from the seller in order to close a transaction. As in the case of Gardens, such reductions and/or concessions may cause either the seller or the buyer to walk away from the transaction.
In order to avoid the imposition of such Attorney General conditions, as well as the financial hits that often come from such conditions, the parties may conclude that avoiding Attorney General conditions—in Gardens style—may be the best way to ensure that the parties consummate the transaction.
If the parties to a transaction decide to walk down the Gardens path, the seller will need to undertake an onerous hospital closure process as required under California law. For example, the State-mandated closure process includes: (i) submission of a written notice to CDPH and to the public at least 30 days prior to hospital closure; (ii) participation in public hearings; (iii) transfer of all hospital patients to appropriate health facilities prior to closure in accordance with CDPH regulations and policies; (iv) submission of written notices to all hospital patients regarding the impending hospital closure and the procedures to be implemented by the seller for the transfer of hospital patients; and (v) numerous other requirements made necessary under California law. In addition to the foregoing, before a seller decides to close its hospital in order to avoid Attorney General oversight and approval, the seller must balance the potential negative financial impact that may result. For example, if the hospital is closed prior to the sale transaction, the value of the hospital assets may be significantly diminished based on the hospital’s nonoperational status. In the present case, Judge Robles acknowledged that the Hospital assets suffered an approximately $8 million loss in value as a result of the Hospital closure.
Balancing the Benefits and the Detriments
This balancing of potential financial impacts of the acceptance or avoidance of Attorney General oversight and approval will undoubtedly prove difficult for the parties to a health facility transaction—whether done in the bankruptcy context or otherwise. Prognostication is always a tricky business, even with the best of expert advice and guidance. Nevertheless, it is worth considering whether, after the Gardens Decision, a decision to avoid the Attorney General’s oversight and approval at the outset of a transaction will create the same level of risk that Gardens experienced.
In the Gardens case, Gardens submitted notification to the Attorney General and, as a result of the Attorney General’s conditions, Gardens eventually decided to close the Hospital to avoid the ongoing costs of Hospital operations and to avoid the Attorney General’s participation in a subsequent transaction. Because of the foregoing, the Attorney General’s attention was already focused on Gardens when Gardens determined that there was no need to notify the Attorney General regarding the subsequent asset sale. Moreover, it is worth noting that even if Gardens had not submitted the notification, the Attorney General would have likely been aware of the situation through its review of bankruptcy notifications and filings on a routine basis.
If the seller to a nonprofit/for-profit transaction decides to suspend or terminate its hospital license at the beginning of a transaction, the Attorney General will not be on notice of the proposed transaction. This fact may prevent the Attorney General from asserting its authority over the transaction under Section 5914. Therefore, the parties and the transaction may not be subject to the same level of Attorney General scrutiny in the case of Gardens.
Is the lack of Attorney General oversight reason enough to pursue the Gardens’ course of action? No, but the Gardens Decision may tip the scales in favor of the termination or suspension of a hospital’s license to avoid the potential pitfalls associated with Attorney General review.
The ultimate decision for buyers and sellers in healthcare transactions rests in significant part on the ultimate results of the Gardens Decision’s pending appeal. Nevertheless, the Gardens Decision, as it stands today, creates an option that may have not been considered by nonprofit sellers and for-profit buyers before its issuance.
*Brittany Walter is a summer associate at Sheppard Mullin.
On March 22, 2017, the Supreme Court in Czyzewski v. Jevic Holding Corp., 580 U.S. __ (2017) held that a bankruptcy court does not have the power to approve a structured dismissal of a bankruptcy case that violates the Bankruptcy Code’s priority scheme unless the affected parties consent.
The federal Bankruptcy Code is nearly 40 years old, and as one might expect, bankruptcy practice has evolved in a myriad of ways since its enactment. One such Darwinian creation is the development and increasing use of the so-called “structured dismissal” as the means to resolve a chapter 11 bankruptcy case. The Bankruptcy Code contemplates in Sections 305 and 1112 that a chapter 11 bankruptcy case may be resolved by dismissal, but provides in Section 349 that the effect of such a dismissal will be to restore the parties to the status quo ante as if the bankruptcy was never filed – that is, unless the bankruptcy court “for cause, orders otherwise.”
A structured dismissal seizes on the “for cause, orders otherwise” language in Section 349, and typically seeks the bankruptcy court to authorize certain distributions of estate funds, to approve a related settlement or sale, and/or to approve certain releases of major parties in the case. A key feature of structured dismissals is also that the bankruptcy court’s orders entered during the case will remain in effect despite the dismissal. Since dismissals, including structured dismissals, are sought by motion they are much quicker and cheaper to do than a chapter 11 plan. In addition, they allow the main parties in the case to control the resolution of the case in a way that conversion to a chapter 7 does not, given that conversion to a chapter 7 involves appointment of a new chapter 7 trustee to represent the estate, as well as an associated additional layer of administrative expense. The structured dismissal is also typically faster than the general timeline for resolution of a chapter 7 case.
For all of these reasons, structured dismissals have been increasingly used as vehicles to resolve a case, in particular in situations where the expense of a chapter 11 plan process does not appear warranted – e.g., cases with limited funds that are insufficient to pay administrative or priority creditors, cases where the debtor’s assets have been sold and all that remains is to distribute the limited proceeds, or cases where a settlement obviates the debtor’s need to obtain a discharge through a plan.
Many structured dismissals simply seek authorization to distribute funds to creditors according to the priorities set forth in the Bankruptcy Code. In other words, they do not seek to violate the so-called “absolute priority rule” of Section 1129(b) of the Code.
However, Jevic presented a different situation. The structured dismissal approved by the bankruptcy court in Jevic involved a settlement between the debtor’s secured creditors and the official committee of unsecured creditors, after the committee had alleged certain fraudulent conveyance actions on behalf of the estate arising out of a leveraged buyout of the debtor that subsequently turned sour. Importantly, the settlement and the structured dismissal in Jevic provided for a violation of the absolute priority rule. In particular, certain proceeds of the settlement payment made to the estate would be paid to general unsecured creditors even though priority wage creditors would receive nothing.
It is plain that this result would be impossible in a chapter 11 plan setting under the cramdown procedures of Section 1129(b), which provide that the absolute priority rule must be obeyed with respect to any class of creditors that rejects the plan (though it may be violated with respect to classes of creditors that accept the plan). It is also plain that such “class-skipping” could not occur in a chapter 7 liquidation, where strict adherence to the absolute priority rule is mandated at all times.
The Supreme Court in Jevic reasoned that in light of the emphasis on adhering to the priority scheme in the chapter 11 plan context and the chapter 7 liquidation context, the Bankruptcy Code would need to specifically authorize violations of the priority scheme in the context of dismissals in order for them to pass muster. Judge Breyer for the majority felt that the word “cause” in Section 349 was simply not a sufficiently specific authorization of priority violations, terming it as “too weak a reed upon which to rest so weighty a power.” See, Jevic, slip op. at p. 14. Further, unlike first day wage orders or critical vendor orders, the Court found there to be no furtherance of a reorganization or other bankruptcy purpose in the priority-violating structured dismissal, since it was occurring at the end of the case. Id. at pp. 15-16.
The Supreme Court also concluded that the reasoning of the Third Circuit, which held that priority-violating structured dismissals could be appropriate in “rare cases,” created an exception that threatened to swallow the rule. Id. at p. 17.
While the Supreme Court professed to express no opinion on the legality of structured dismissals in general (slip op. at p. 14), the Jevic decision clearly lays out the ground rules for parties seeking court approval of a structured dismissal going forward. That is, parties must either propose a structured dismissal that strictly obeys the absolute priority rule, or they must obtain the consent of any class of creditors that does not receive the treatment afforded to it under the absolute priority rule.
It will be interesting to follow subsequent decisions in the structured dismissal space. In particular, how will the consent of a so-called “skipped class” be obtained? And, how are its members even determined, given that there is no plan on file that classifies creditors? Does the movant need to classify all creditors in its dismissal motion and then affirmatively go out and obtain their approval? And, is that approval determined by the voting rules applicable to plans in Section 1126 of the Code? Since structured dismissals are sought by motion, it is likely that parties seeking approval of structured dismissals will argue that failure to object constitutes the necessary consent. Indeed, this has some basis in the Jevic opinion, as the Court in distinguishing the Buffet Partners case from the Northern District of Texas noted that there, no one with an economic stake in the case had objected. Jevic, slip. op. at p. 14. Thus, the issue of how to determine the consent of a skipped class will likely only arise if a party in that class does lodge an objection.
Further, the Jevic case in effect grafts one subset of plan confirmation standards onto the structured dismissal framework – the standards and case law surrounding the absolute priority rule. Will other plan confirmation standards also be grafted onto the structured dismissal framework? One can imagine objecting parties arguing bad faith under Section 1129(a)(3), or that creditors must do better in the dismissal than they would in a hypothetical chapter 7 liquidation under Section 1129(a)(7) (the so-called best interests of creditors test). If courts allow other plan confirmation considerations such as these to ride the coattails of the absolute priority rule into the structured dismissal world, it may have the effect of obviating much of simplicity, ease, and benefit of structured dismissals. In that scenario, a Supreme Court opinion that clarifies the law on structured dismissals may have the effect of also undermining even those dismissals that would pass muster under the new standards by making them less desirable.
In a recent November 17, 2016 opinion, Delaware Trust Co. v. Energy Future Intermediate Holding Company LLC, Case No. 16-1351, the Third Circuit Court of Appeals reversed two lower court opinions by holding that make-whole premiums can be enforceable even if the debt was automatically accelerated by a voluntary bankruptcy filing. The Third Circuit’s opinion is significant because it now puts borrowers on notice that under New York law, a debtor filing for bankruptcy may not necessarily be allowed to avoid redemption provisions and any related make-whole premiums similar to those involved in this case. Instead, in specifically examining the intent and language of those provisions, courts may, as the Third Circuit did here, read such automatic acceleration provisions and optional redemption provisions in harmony.
Energy Future Holding Company LLC and EFIH Finance Inc. (collectively, “Energy Future”) borrowed over $4 billion at a 10% interest rate by issuing notes secured by first- and second-priority liens on Energy Future’s assets. The Indentures governing the loans had two important provisions relevant to the Third Circuit’s opinion:
1. Redemption Provision – the Indentures provided that Energy Future could redeem all or part of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed plus the “Applicable Premium” and interest. This Applicable Premium was understood to be a “make-whole” premium – a provision designed to compensate the noteholders for the interest they would have earned had the Notes not been redeemed early.
2. Acceleration Provision – the Indentures also included an acceleration provision which provided that all outstanding notes would become immediately due and payable if Energy Future were to file for bankruptcy.
Energy Future sought to refinance its debt, but wanted to avoid having to pay the make-whole premiums under the redemption provision. Prior to filing for bankruptcy protection, Energy Future expressed its belief that it could do so if it sought to refinance its debt with bankruptcy court approval. The lower courts agreed and held that Energy Future did not have to fund the make-whole premiums.
The Third Circuit’s Opinion
The Court of Appeals for the Third Circuit reversed the lower courts and held that because Energy Future had voluntarily redeemed the Notes, it was obligated to perform under the redemption provision and pay the make-whole premiums to the noteholders. In enforcing both the redemption and acceleration provisions, the Third Circuit reasoned that it “must give effect to the intent of the parties as revealed by the language of their agreement” and that there was nothing in the agreement which provided that the acceleration provision had any “bearing on whether and when the make-whole is due.” Although Energy Future argued that the make-whole provision was in essence a pre-payment premium that could not be enforced once the debt was accelerated, the Third Circuit rejected that argument, stating that “by avoiding the word ‘prepayment’ and using the term ‘redemption,’ [the parties to the agreement had] decided that the make-whole would apply without regard to the Notes’ maturity.” Stated otherwise, in scrutinizing the language of the applicable provisions, the Third Circuit held that there was no conflict between the redemption and acceleration provisions in the Indentures, and that the redemption provision remained enforceable even in a post-bankruptcy context.
Enforcing both the redemption and acceleration provisions here was significant in that the Third Circuit favored the noteholders and put debtors on notice that filing for bankruptcy may not necessarily allow debtors to avoid redemption provisions requiring the payment of make-whole premiums. Indeed, the Third Circuit emphasized the importance of interpreting the language of the Indentures at issue and put the burden on the borrower, not the noteholders, to clearly state the parties’ agreement – “if [Energy Future] wanted its duty to pay the make-whole optional redemption to terminate on acceleration of its debt, it needed to make that clear that [the acceleration provision] trumps [the redemption provision.]” A similar case rejecting the enforceability of make-whole premiums in the post-bankruptcy context is currently on appeal before the Second Circuit in MPM Sillicones, LLC., Case No. 14-22503-RDD (“Momentive”). It remains to be seen whether the Second Circuit will follow the Third Circuit’s ruling.
Where do marketplace lenders and secondary loan market participants find themselves on the issue of preemption of state usury laws after the June 27 denial of the petition for a writ of certiorari in Madden v. Midland by the U.S. Supreme Court?
In Madden v. Midland, the US Court of Appeals for the Second Circuit refused to follow the “valid-when-made” rule when considering the scope of federal preemption of state usury laws under the National Bank Act. The court held that the NBA did not bar the application of state usury laws to a national bank’s assignee. In considering the applicability of the National Bank Act to a loan in the hands of a non-bank assignee, the Second Circuit considered a number of cases upholding preemption of state usury laws under the National Bank Act but invoked a seemingly new rule for applying section 85 of the National Bank Act (permitting a national bank to charge interest at the rate permitted by its home state). The Second Circuit concluded that preemption is only applicable where the application of state law to the action in question would significantly interfere with a national bank’s ability to exercise its power under the National Bank Act. The court reasoned further that where a national bank retained a “substantial interest” in the loan, the application of the state usury law would conflict with the bank’s power authorized by the National Bank Act.
Madden v. Midland involved a debt collection matter where Madden, who lived in New York, objected to Midland’s attempt to apply a 27% interest rate to Madden’s credit card debt. Midland had acquired the credit card debt from a subsidiary of Bank of America after the debt had become delinquent and charged-off. Midland had successfully asserted at the lower court that it too was allowed under the section 85 of the National Bank Act to charge interest at the rate allowed by the laws of the state where the assignor bank was located when the loan was originated. The Second Circuit reversed the decision and held that the National Bank Act did not bar the state law usury claim that the rate at which post-assignment interest could accrue was governed by New York law. However, it did not decide on the usury question and instead remanded to the District Court the issue of the validity of the Delaware choice of law provision contained in the Change In Terms, which was the contract applicable to the credit card debt.
The Second Circuit decision issued in May of 2015 was an unexpected divergence from a long standing principle that has facilitated loan sales in a variety of contexts. Before Madden v. Midland, buyers and sellers of debt relied on the apparently settled principle that, if a loan was valid when made, it could not become usurious upon assignment. In addition, many marketplace lenders without their own lending licenses have relied on the “valid-when-made” rule in their loan origination programs by contracting with national or state banks to originate loans for them.
In May of 2016, the U.S. Solicitor General and the Office of the Comptroller of the Currency filed a brief at the request of the U.S. Supreme Court. The brief criticized the Madden decision and argued that the Second Circuit’s preemption analysis was incorrect. It emphasized the impact the court’s ruling could have on the ability of national banks to fully exercise the power to convey to an assignee the right to charge the maximum interest rate allowed under the national bank’s home state. However, it was also the Solicitor General’s position that Supreme Court review of the case was not warranted for several reasons, including that there was no conflict among the circuits on the preemption issue in question as the preemption cases from the other Circuits did not address the specific question presented in the Madden case. Further, the Solicitor General criticized the parties for failing to adequately present the full range of preemption arguments, suggesting that the court of appeal’s failure to appreciate the scope of a national bank’s powers under section 85 of the National Bank Act and the importance of the “valid when made” rule, may have been attributable to the lack of clarity in the briefing. The Solicitor General also pointed to the interlocutory nature of the decision and the fact that there was still a state law issue to be decided by the District Court as yet another reason for not supporting the U.S. Supreme Court taking the case.
Although Madden v. Midland applies directly only to cases where a national bank is selling or assigning a loan, the policy underlying the decision to limit the exporting authority under the NBA might also be applied to a state bank’s rate exportation powers under Section 27 of the Federal Deposit Insurance Act (the state bank equivalent to section 85 of the National Bank Act). Secondary market participants and marketplace lenders now wait for the decision from the District Court on remand. If the court upholds the Delaware choice of law provision, market participants may manage the impact of the Madden v. Midland decision by electing a favorable choice of law provision in the underlying debt contract. That at least will provide an option for continuing to work with national banks despite the Madden case. Unfortunately, that solution will not work for buyers and sellers of existing loans, although presumably such parties are not too inconvenienced by a limit on the post-assignment interest that can be charged on a loan after substantial interest has already accrued, particularly if they have purchased the debt at a substantial discount. Other lenders may continue to rely on the state banks’ ability to export interest rates. In that situation, lenders should choose state banks whose state has a generous interest rate cap and is outside the Second Circuit.
The group impacted most by the Madden v. Midland decision appear to be marketplace lenders who acquire a loan shortly after origination and therefore have essentially all accruing interest at risk of challenge. One alternative option adopted by one on-line marketplace lender picking up on the “substantial interest” distinction in the Madden decision, is to require the bank loan originator to maintain an on-going economic interest in all loans after sale and receive certain payments on the loans only when borrowers made payments.
What remains following the Supreme Court’s refusal to hear Madden v. Midland is an outlier Second Circuit on the issue of the “valid-when-made” rule, and the blueprint for how to apply preemption under the National Bank Act as provided by the Solicitor General in its brief, a brief that as noted above clearly considers the Madden v. Midland decision to be wrong. Unfortunately, until such time as the right case comes along, market participants will have to make adjustments to accommodate the decision as necessary to address its impact on their particular situation.
 Notably, Madden conceded that Midland could collect the principal and all of the interest that accumulated during the period that the national bank held the debt, even though that rate was higher than Midland could have charged.
In a recent decision, the U.S. Bankruptcy Court for the District of Delaware refused to enforce a provision in the debtor’s LLC operating agreement requiring a unanimous vote of the debtor’s members to authorize the debtor to file for bankruptcy. In re Intervention Energy Holdings, LLC, et al., 2016 Bankr. LEXIS 2241 (Bankr. D. Del. June 3, 2016). The provision at issue required the consent of all the debtor’s LLC members to file for bankruptcy, including the consent of a member that was a secured creditor holding one unit of ownership in the debtor’s LLC which it bargained for and received pursuant to a forbearance agreement. In refusing to dismiss the debtor’s bankruptcy case, the Court concluded that such an arrangement giving the secured lender a so-called “golden share” was “tantamount to an absolute waiver” of the debtor’s right to seek bankruptcy protection and therefore void as a matter of federal public policy.
In Intervention Energy, two companies, Intervention Energy, LLC (“Intervention Energy”) and its parent company, Intervention Energy Holdings, LLC (“Holdco”), were established under the laws of Delaware to engage in oil and natural gas exploration and production. In January 2012, the companies entered into a Note Purchase Agreement with an institutional investor (“Secured Lender”). In October 2015, the Secured Lender declared an event of default based on the companies’ failure to comply with certain covenants under the Note Purchase Agreement. In December 2015, the companies and the Secured Lender entered into a forbearance agreement, pursuant to which the Secured Lender agreed to waive all defaults and Holdco was required to amend its LLC operating agreement to (i) admit the Secured Lender as a member of Holdco holding one common unit and (ii) require the approval of each holder of common units of Holdco prior to any bankruptcy filing. Concurrently with entry into the forbearance agreement, Holdco amended its operating agreement to give effect to the forgoing requirements.
In May 2016, both companies filed voluntary chapter 11 petitions. Thereafter, the Secured Lender filed a motion to dismiss Holdco’s bankruptcy filing on the ground that Holdco did not have the requisite authority to file for bankruptcy because it failed to obtain the prior consent of the Secured Lender, as the holder of one common equity unit, as required by Holdco’s LLC operating agreement.
The parties raised a number of arguments under Delaware corporate law regarding the ability of an LLC to abrogate its fiduciary responsibilities and contract away the right to file bankruptcy. The Court found it unnecessary to address these arguments because it viewed the federal public policy issue as case dispositive. To that end, the Court held that the provision requiring the unanimous consent of the equity holders was unenforceable as it violated the federal public policy prohibiting “agreement[s] to waive the benefit of bankruptcy.” Specifically, the Court explained that:
A provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.
The case is a reminder that certain provisions restricting a borrower’s ability to file bankruptcy, particularly those that grant equity positions to lenders without any corresponding fiduciary duty owed to the borrower, are often held to be unenforceable. At the same time, the case highlights the importance of thoughtful structuring of lending transactions, and careful drafting of loan documents, to minimize the risk of loss or otherwise account for such risk when negotiating pricing.
On May 16, 2016, the United States Supreme Court in Husky International Electronics v. Ritz held that the phrase “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code may include fraudulent transfer schemes that were effectuated without a false representation. Section 523(a)(2)(A) provides that an individual debtor will not be discharged from certain debts to the extent that those debts were obtained by false pretenses, false representations or actual fraud. The Court’s decision in Husky resolved a conflict in the interpretation of actual fraud under section 523(a)(2)(A) between the Fifth and Seventh Circuits.
The case arose when Chrysalis Manufacturing Corp. (“Chrysalis”) could not satisfy approximately $164,000 in debt that it owed to Husky International Electronics, Inc. (“Husky”). Husky later discovered that Daniel Lee Ritz, Jr. (“Ritz”), a director and thirty percent owner of Chrysalis, transferred large sums of money to other entities that he controlled for several years.
When Ritz filed for bankruptcy protection under chapter 7, Husky commenced an adversary proceeding in the bankruptcy court. Husky sought a determination that Ritz was personally liable for Chrysalis’ debt under a Texas law that allows creditors to pursue shareholders for unpaid corporate debt and that the debt owed to Husky was non-dischargeable under section 523(a)(2)(A).
Following a trial on the issues, the district court determined that Ritz was personally liable under the Texas statute, but because the debt was not obtained by conduct that constituted actual fraud under section 523(a)(2)(A) the debt was dischargeable. The case was appealed to the United States Court of Appeals for the Fifth Circuit, which affirmed the district court. The Fifth Circuit determined that while Ritz may have hindered the ability of the Husky to collect its debt, Ritz did not make false representations and thus did not commit actual fraud as required by section 523(a)(2)(A).
The Majority Opinion
In a seven member majority opinion written by Justice Sonia Sotomayor, the Supreme Court reversed and remanded the Fifth Circuit decision. Justice Sotomayor began the analysis of the majority by noting that when Congress enacted the Bankruptcy Code in 1978, it added the phrase “actual fraud” to the types of conduct that were non-dischargeable under the Bankruptcy Act of 1898. Justice Sotomayor noted that the majority presumes that by amending the types of non-dischargeable conduct, Congress did not intend actual fraud to be the same type of conduct as false representation.
The majority opinion also reviewed the historical common law interpretation of the phrase “actual fraud.” The majority noted that as far back as the English Parliament’s enactment of the Statute of 13 Elizabeth in 1571, fraud did not require a misrepresentation and simply occurred when a person hid assets from creditors. Further, the majority observed that previous Court precedent, dating back to the nineteenth century, interpreted the phrase as involving any type of conduct done with “wrongful intent.” Based on this historical legacy, the majority concluded that false representations are not a required element of actual fraud.
Justice Sotomayor next examined the Ritz’s arguments against interpreting actual fraud to include fraudulent transfers under section 523(a)(2)(A). First, Ritz argued that doing so would render duplicative two other subsections of section 523(a) that address debts arising from fraud in a fiduciary capacity and from willful and malicious conduct. While the Court observed that some types of non-dischargeable conduct may overlap among the various subsections of section 523(a), adopting Ritz’s view would eliminate the meaningful distinctions between those subsections. The Court also rejected Ritz’s argument that including fraudulent conveyances into the type of non-dischargeable conduct at issue would render section 727(a)(2) of the Bankruptcy Code redundant. Again, the Court noted that while there may be some overlap, the two statutes are meaningfully different. Section 727(a)(2) makes non-dischargeable all debt if, in the one year prior to a bankruptcy, the debtor transferred, removed, destroyed, mutilated, or concealed property with the intent to hinder, delay, or defraud a creditor. Unlike section 727(a)(2), the majority noted, section 523(a)(2)(A) does not have a timing element and only renders certain debts non-dischargeable.
Further, the majority rejected Ritz’s argument, which was adopted by Justice Clarence Thomas in his dissent, that fraudulent transfers are not included under actual fraud because the debts were not “obtained by . . . actual fraud” as required by the language in section 523(a)(2)(A). The majority acknowledged that in fraudulent transfer schemes the transferor does not obtain debts; however, in certain “rare” instances a debt may be traceable to the fraudulent transfer and thus may be non-dischargeable. The Court declined to consider whether Ritz obtained his debts by fraudulent transfer and instead remanded that issue to the Fifth Circuit for further determination.
The majority’s view that actual fraud under section 523(a)(2)(A) may occur due to fraudulent transfers without misrepresentations is a limited one. The majority recognized that the instances where the debt was “obtained by” actual fraud are rare and usual. Until the lower courts determine whether the debt incurred by Ritz was “obtained by” fraudulent transfers, it is not clear whether the debt at issue is non-dischargeable.
It is significant, however, that the majority noted that “there is no need to adopt a definition for all times and all circumstances” with respect to what constitutes “actual fraud.” This statement leaves open the possibility that the Court may expand the definition in the future and thereby broaden the type of conduct that is not dischargeable in bankruptcy.
In a news conference today President Obama addressed rules and proposed regulations announced Thursday intended to help the U.S. fight tax evasion and other crimes connected to anonymous offshore companies and accounts. The announcements come after a month of intense review by the administration following the first release of the so-called Panama Papers, millions of documents stolen or leaked from Panamanian law firm Mossack, Fonseca. The papers have revealed a who’s who of international politicians, business leaders, sports figures and celebrities involved with financial transactions accomplished through anonymous shell corporations.
The new regulations include a “customer due diligence” rule requiring banks, mutual funds, securities brokers and other financial institutions to determine, verify and keep records about the actual ownership of the companies with whom they do business. The administration has also proposed regulations requiring owners of foreign-owned “single-member limited liability companies” to obtain employer identification numbers from the IRS. In an effort to increase transparency and address “the problem of global tax avoidance,” both rules are intended to make more easily discoverable the actual ownership of offshore companies and accounts, allowing for easier investigation of suspected fraud, tax evasion and money laundering. Currently, companies can do business in the U.S. anonymously by registering in states that do not require full disclosure of actual ownership.
The new rules create regulatory obligations for a broad array of financial institutions, and potential new obligations for off-shore investors. A further release of Panama Papers is expected on Monday, with the identities of many U.S. companies and individuals involved in such “anonymous” shell corporations likely to be revealed, and greater scrutiny of such transactions and the financial institutions involved with them likely to follow.
The doctrine of equitable mootness provides that Chapter 11 reorganization plans will be deemed moot, and therefore not subject to appellate review, if a plan has been substantially consummated and granting appellate relief would impair the rights of innocent third parties relying on the confirmation order. Since the development of the court-created mootness doctrine nearly a quarter century ago, courts have grappled with applying it in such a way as to strike an adequate balance between the need for finality, and the need to exercise the court’s jurisdiction and preserve the right to appellate review. The standard interpretation in bankruptcy was that once the debtor took definitive steps to put the Chapter 11 plan in place (i.e., “substantial consummation”), and the objecting creditor neglected to gain a stay of the plan confirmation order pending appeal, then any appeal was presumed to be “equitably moot” and therefore subject to dismissal by the appellate court.
However, in the recent case of JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Props. Inc. (In re Transwest Resort Props., Inc.), 801 F.3d 1161 (9th Cir. 2015), a divided panel of the U.S. Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) ruled that, despite substantial consummation of the subject plan, a creditor’s appeal of a Chapter 11 plan confirmation order should not be dismissed on equitable mootness grounds. In so holding, the Ninth Circuit applied a four-part test to determine that the creditor’s appeal was not equitably moot: (1) whether the appellant sought a stay pending appeal; (2) whether substantial consummation of the plan occurred; (3) whether the relief sought would affect third parties not before the court; and (4) whether the relief sought would entirely unravel the plan. The Ninth Circuit held that, although substantial consummation is a factor that weighs in favor of equitable mootness, the law requires that the court still examine the third and fourth prongs of the equitable mootness test.
In reversing the district court’s dismissal of an appeal and remanding to the district court for disposition of the merits, the Ninth Circuit held that review of the creditor’s appeal would not unfairly affect third parties or completely unwind the plan. Specifically, regarding the issue of third party rights, the court determined that the third party at hand was not the type of innocent party that was meant to be protected. Rather, the third party was a sophisticated investor that funded the plan, and was vocal and active throughout the bankruptcy case, and should have known that appellate review was possible. Finally, reasoned the majority, the bankruptcy court could devise equitable relief without entirely unraveling the plan. Even the opportunity for partial relief would render the appeal not moot.
In a dissenting opinion, Judge Milan D. Smith, Jr. argued that the court’s ruling was grossly inequitable to the third-party plan sponsor. According to Judge Smith, the majority’s decision will deter future investment in reorganizing debtors, thereby diminishing the value of bankruptcy estates, disadvantaging creditors and hindering reorganization efforts. Judge Smith instead maintained that considerable weight should be rendered to substantial consummation of a plan and further advocated that the court place greater weight on promoting finality in the bankruptcy process.
More recently, on April 8, 2016, the Ninth Circuit issued its opinion in First Southern Ntl. Bank v. Sunnyslope Housing Ltd. Partnership (In the Matter of: Sunnyslope Housing Ltd. Partnership), No. 12-17241 (9th Cir. 2016), which further extended its holding in Transwest. Reversing the district court’s judgment affirming the bankruptcy court’s confirmation of a Chapter 11 plan, the Ninth Circuit held that the creditor’s appeal was not equitably moot despite the fact that funding for the reorganization plan had been furnished by an equity investment from a third-party investor, and the plan had been substantially consummated. The court concluded that the plan was based on an improper valuation of a creditor’s secured interest in real property and that the debtor had improperly been permitted to exercise the cram down provisions of section 506(a) of the Bankruptcy Code and retained the property at issue in exchange for a new payment plan that permitted the debtor to pay the creditor an amount equal to the present value of the secured claim at the time of bankruptcy. The debtor argued that the value of the creditor’s secured interest should be determined with certain affordable housing restrictions in place, but the Ninth Circuit disagreed. Instead, the panel held that all of the restrictive covenants and provisions that the debtor sought to invoke to restrict the project to affordable housing and to the decreased rental income that would consequently be collected, resulted from positions that were junior and expressly subordinated to the creditor’s interest.
As in Transwest, the panel in Sunnyslope was unconvinced that the third-party investor was the type of innocent third party intended to be protected by the doctrine of equitable mootness. Rather, the court found that the third party was a sophisticated investor intimately involved in the development of the plan and was aware that the creditor had filed notices of appeal. Furthermore, according to the court, the creditor’s failure to seek a stay from the Ninth Circuit could not have given the third party reasonable cause to conclude that the creditor had abandoned its challenge, yet the third party made a conscious decision to proceed nonetheless. The Ninth Circuit ultimately held that the unraveling of the plan would not have a negative impact on parties intended to be protected by the doctrine. Accordingly, it reversed and remanded to the district court for further proceedings.
The Ninth Circuit’s holdings in Transwest and Sunnyslope indicate that an equitable mootness analysis continues to be both circuit-driven and fact-dependent. Ultimately, the Transwest and Sunnyslope decisions confirm that under the law of the Ninth Circuit, a plan’s substantial consummation does not establish a presumption of equitable mootness. Therefore, even where a Chapter 11 reorganization plan has been substantially consummated (regardless of whether or not the appellant sought a stay of the plan’s consummation pending appeal), a court may consider an appeal of the confirmation order on its merits if a remedy could be fashioned that would not entirely unravel the plan or detrimentally impact “innocent” third parties. Furthermore, the majority in Transwest acknowledges the great discretion that bankruptcy courts have in formulating such a remedy. Whether that remedy is equitable, however, is contingent upon the structure of the plan, the timing of implementation, and the bankruptcy court’s capacity to fashion relief in such a way as to address the appellant’s justifiable objections without unwinding the plan.
In the U.S. Court of Appeals of the Third Circuit (the “Third Circuit”), however, the scope and applicability of the equitable mootness doctrine is entirely different than in the Ninth Circuit. On January 11, 2016, Aurelius Capital Management, LP (“Aurelius”) filed its petition for a writ of certiorari in the Supreme Court of the United States. Aurelius’ petition was in response to a decision arising out of the Third Circuit affirming the dismissal of Aurelius’ appeal of a plan confirmation order entered in a Chapter 11 proceeding despite Aurelius’ objections. See In re Tribune Media Co., 700 F.3d 272 (3d Cir. 2015). Remarking that the Supreme Court has never reviewed the equitable mootness doctrine, Aurelius contended that the Supreme Court’s review was necessary to achieve uniformity and a certain measure of restraint to the interpretation and application of the doctrine. Aurelius’ petition for certiorari, however, was denied. As a result, the holdings and analyses in Transwest and Sunnyslope should guide the actions of those contemplating an appeal of a confirmation order in the Ninth Circuit.