In an October 19, 2010 opinion arising out of the Scotia Pacific bankruptcy cases, the Fifth Circuit ruled that reorganized Scotia and its affiliate Pacific Lumber Company were obliged – nearly 2½ years after Scotia’s reorganization plan was consummated – to pay Scotia’s former secured lenders approximately $30 million on account of a mistake made by the bankruptcy judge in calculating the amount owed to the secured lenders for the use of their collateral during the bankruptcy cases.

Judge Edith H. Jones, writing for the Fifth Circuit, concluded that the bankruptcy court had erred in not including $29.7 million, generated during the bankruptcy cases from the sale of the timber, in the § 507(b) claim granted to the secured lenders under the terms of cash collateral orders entered by the bankruptcy court. Section 507(b) of the Bankruptcy Code gives secured creditors the ability to receive “superpriority” administrative claims, which must be paid in full upon emergence from bankruptcy, if the protection granted for the value of collateral is inadequate. Section 507(b) is a method of protecting the assets of a secured lender that are used by debtors during a reorganization.

In opposition, Mendocino Redwood Company and Marathon Structured Finance Fund, purchasers of the reorganized debtors under Scotia’s reorganization plan, argued that the Fifth Circuit’s previous September 2009 opinion confirming the plan precluded reconsideration of the secured lenders’ § 507(b) claim, and that the substantial consummation of the plan also mooted any such issue.

The Fifth Circuit rejected these arguments in ruling that the § 507(b) facet of Scotia’s confirmed, consummated reorganization plan could be modified on appeal even though the plan had been implemented. Applying a functional test, the Fifth Circuit found the § 507(b) issue to implicate “independent factual inquires, unrelated to confirmation,” that “could not have been raised” in the appeal of the confirmation order. Citing its previous September 2009 opinion in the case, the court also ruled that the consummation of the plan did not moot the § 507(b) issue, because the purchasers were “sophisticated investors” who could foresee adverse consequences to their position and “opted to press the limits of bankruptcy confirmation and valuation rules.”

The ruling now means that the secured lenders must receive $29.7 million, despite the fact that the reorganized debtors may no longer have adequate liquid assets and the purchasers did not calculate the additional acquisition cost into their purchase price. Importantly, Judge Jones also wrote that, at the time the bankruptcy court considered confirming Scotia’s reorganization plan, it did not include this additional cost into its analysis of the feasibility of the plan.