Rev Op Group v. ML Manager LLC (In re Mortgages Ltd.), 771 F.3d 623 (9th Cir. 2014) –

Under the terms of a debtor’s confirmed plan of reorganization, an entity (ML Manager) was designated to manage the debtor’s portfolio of mortgage loans.  The issue in this appeal was whether ML Manager was authorized to act as an agent for pass-through investors in selling loans over the objection of some of the investors.

The debtor (Mortgages Ltd.) made mortgage loans for investments in real estate.  It raised money to fund the loans from investors who received “pass-through” fractional interests in the property securing the loans and resulting loan payments.  The investors acquired an actual interest in the loans, and the debtor acted as their servicing agent.

Under the confirmed plan ML Manager managed the remaining loans in the debtor’s portfolio.  When it sought to sell some loans, some of the pass-through investors (Rev Op Group) objected.  In the context of cross-motions for summary judgment, they contended that as an agent ML Manager could not sell if any investor/“principal” objected.

In response, ML Manager argued that it did not have simple agency authority revocable at will by the principal.  Rather it had an interest in the underlying loan pool, so that it had an agency coupled with interest that was not revocable.  ML Manager also contended that all investors executed documents designating it as their agent, and that the agency documents had been properly transferred to ML Manager.

The Rev Op Group investors denied that they executed agreements with agency provisions.  While they acknowledged signing “Subscription” and “Revolving Opportunity” agreements, they contended that the versions they signed did not include a provision binding the signers to an agency relationship.  Further, even if they had executed agreements with an agency provision, they claimed the agreements were not properly assigned to ML Manager.

The bankruptcy court assessed the investor denials using a standard of implausibility:  It concluded that since the group admitted signing documents with the same name, the denials were implausible.  Thus, the bankruptcy court granted the ML Manager motion for declaratory judgment that the investors had executed documents designating it as an agent.

The court also rejected the investor motion for partial summary judgment on the basis that (1) ML Manager had an agency coupled with an interest and (2) it was properly assigned the agency agreements.  Thus, ML Manager had irrevocable authority to act, including to sell or liquidate interests of all investors in the property, including objecting investors.

Subsequently ML Manager filed two motions to sell properties in the portfolios.  The bankruptcy court overruled the Rev Op Group investors’ objections and approved the sales.

The investors appealed all of the orders.  The district court approved the first sale order on the basis that ML Manager had an agency coupled with interest and properly applied its business judgment.  It then affirmed the rest of the orders.  The district court held that the investor denials that they signed agreements with agency provisions “were a ‘sham’ and thus should be disregarded.”  The investors then filed an appeal of each of the district court orders.

On appeal to the 9th Circuit, ML Manager began by moving to dismiss the appeals as equitably moot.  Although the court dismissed the appeals of the sales orders, it addressed the declaratory relief as a separate matter.

Four factors considered in determining whether an appeal is equitably moot are (1) whether the appellant sought a stay (since otherwise it has not fully pursued its rights), (2) if the stay was sought and not granted, whether substantial confirmation of the plan occurred, (3) whether a remedy may have an effect on third parties, and (4) whether the bankruptcy court can fashion effective and equitable relief without “completely knocking the props out from under the plan.”

In this case the appellant did seek a stay, but was not successful due to the inability to post a bond.  Since the party had been diligent in pursuing a stay, the court moved on to consider whether or not there had been substantial confirmation of the plan.  Under the Bankruptcy Code, this is defined as (1) transfer of all or substantially all of the property that the plan proposes be transferred, (2) assumption by the debtor (or its successors) of the business or management of property dealt with under the plan, and (3) commencement of distribution.

The court emphasized that “transfer” is distinct from “distributions.”  Examples of a transfer are transfer of stock, transfer of a security interest, transfer of notes, transfer of property in satisfaction of claims, etc.  In contrast, distributions means payments to creditors in satisfaction of their debts.  Transfers must be substantially complete, while commencement of distributions is all that is required for substantial confirmation.  In this case there was substantial confirmation.  However that still did not necessarily mean that the appeal was moot.

The next issue is whether third parties are affected in a way that is inequitable.  In this case a decision in favor of the investors would not disturb past sales, only prospective sales.  The court felt this would not unduly affect third parties.

This brought the court to the final issue of whether the bankruptcy court could devise an equitable remedy.  If the 9th Circuit reversed, the bankruptcy court could proceed with discovery with respect to the denials, require that ML Manager obtain consent, or require that ML Manager properly transfer the agency agreements.  Although incomplete relief, this could be accomplished without totally upsetting the bankruptcy plan.

On the substance of the appeal, the investors argued that (1) the bankruptcy court was wrong in applying the “plausibility” standard in rejecting their denials, (2) even if the investors were subject to an agency agreement, ML Manager did not have an irrevocable agency power, and (3) the court erred when it determined the agency agreements were properly transferred.

The 9th Circuit concluded that the bankruptcy court erred because it did not apply the current standard in rejecting the investors’ denials that they signed agreements with agency provisions.  A court cannot disregard a statement in a pleading unless the statement was either made in bad faith under Federal Rule of Civil Procedure (FRCP) 11 or could be struck under FRCP 12(f) as an insufficient defense, redundant, immaterial, impertinent, or scandalous.

Instead, the bankruptcy court followed an earlier 9th Circuit decision that held that a statement could be disregarded if it was obviously a “sham” or “clearly frivolous.”  However, that decision was made before Rule 11 was modified.  Under the earlier version, the court could strike pleadings if they were a “sham and false.”  That is no longer authorized.  Thus, the 9th Circuit’s prior holding that a court “has ‘free-standing authority to strike pleadings simply because’ it believes them to be a sham is no longer valid.”

Consequently the 9th Circuit reversed the bankruptcy court’s determination that the investor group had executed the agreements with agency provisions and were bound by those agreements.

It seems surprising that the lower courts did not recognize that they were applying an outdated standard.  When dealing with legislation and regulations, it is critical to remember that they can change over time so that decisions interpreting a particular section may no longer be relevant.