The U.S. Court of Appeals for the Fifth Circuit, on Oct. 19, 2010, corrected a bankruptcy court’s calculation of a secured lender group’s superpriority administrative claim more than two years after consummation of the debtor’s Chapter 11 reorganization plan. In re SCOPAC et al., F.3d__, 2010 WL 4069525, at *2-3, *5-6 (5th Cir. Oct. 19, 2010) (Jones, Ch.J.) [“Pacific Lumber II”]; see also In re Pacific Lumber Co., 584 F.3d 229, 242 (5th Cir. 2009) [“Pacific Lumber I”] (plan “substantially consummated within weeks of confirmation”). Essentially, the court reversed the bankruptcy court’s failing to include certain asset sale proceeds as part of the lenders’ pre-bankruptcy collateral package when determining the amount of the lender group’s priority claim. That claim was based on the debtor’s failure to provide the required “adequate protection” for the lenders’ collateral. “[A]dequate protection of a secured creditor’s collateral and its fallback administrative priority claim are tradeoffs for the automatic stay that prevents foreclosure on debtors’ assets: the debtor receives ‘breathing room’ to reorganize, while the present value of [the lender’s collateral] is protected throughout the reorganization.” Pacific Lumber II at *6.
The debtor had used the encumbered timber sale proceeds, part of the lenders’ collateral, to pay professional fees during the Chapter 11 case. In the court’s words, to “deprive the [lenders] of this amount [by ignoring its existence] would undermine a fundamental protection for secured parties whose collateral is used by the debtor during its reorganization….” Id. at *9.
Pacific Lumber Company (“Palco”) and five affiliated entities, including the wholly owned Scotia Pacific Company (“Scopac”), filed Chapter 11 petitions on Jan. 28, 2007. The debtors grew, harvested and processed redwood timber. Scopac was a special purpose entity with 200,000 acres of redwood timber. Pacific Lumber I at 236.
The debtors’ primary creditors included Noteholders owed $714 million, a bank (the “Bank”) owed $36.2 million and a private equity fund (the “Fund”) owed $160 million. The Noteholders had a lien on substantially all of Scopac’s assets, subject to the Bank’s senior lien. Pacific Lumber II at *1; see also Pacific Lumber I at 236-37.
Noteholders’ Replacement Liens and Superpriority Administrative Expense Claim
The bankruptcy court entered orders allowing the debtors to use the Noteholders’ and the Bank’s cash collateral during the reorganization case. In exchange, as “adequate protection,”1 the court granted the Noteholders and the Bank a replacement lien on assets not already subject to the existing liens. The cash collateral orders contained this specific language:
[A] first priority, perfected replacement lien and security interest in all the property of Scopac of the same type as the Prepetition Collateral in which [Bank] and the [Noteholders] do not have a lien … and in the Cash Collateral of Scopac, to the extent of the post-petition diminution of its interests in the Prepetition Collateral and the Cash Collateral.
Id., at *7. “Further, the orders were perfectly clear that the ‘proceeds and product of the Prepetition Collateral constitute cash collateral.’” Id. Finally, the court also gave the Noteholders and the Bank a fallback superpriority administrative expense claim to the “extent of the post-petition diminution of their interests,” pursuant to Bankruptcy Code § 507(b).2 Id. at * 1, *6-7.
Bankruptcy Court Rulings
The bankruptcy court in Pacific Lumber eventually terminated the Debtors’ exclusive period for filing a Chapter 11 reorganization, enabling the Fund to propose a plan (the “Fund Plan”) that would give it the equity of the reorganized companies. The Noteholders objected to this plan, arguing, among other things, that it artificially de-valued their secured claim. Arguing separately, they asserted a superpriority administrative expense claim pursuant to Code § 507(b) for the “substantial post-petition decline” in the value of their collateral reflected in the Fund Plan. Pacific Lumber I at 244; Pacific Lumber II at *2.
After hearing “extensive valuation testimony,” the bankruptcy court found that the value of Scopac’s timber, its primary asset, was worth “not more than $510 million” but delayed entry of a confirmation order to consider the Noteholders’ superpriority administrative expense claim under Code § 507(b). Pacific Lumber I at 238-38; Pacific Lumber II at *2-3. The Noteholders thus had an unsecured deficiency claim of more than $200 million. Pacific Lumber I, 584 F.3d at 238.
The bankruptcy court then held further hearings, focusing on the Noteholders’ § 507(b) claim. Undisputed testimony showed that Noteholders’ collateral at the beginning of the reorganization case included $48.7 million in non-timber assets owned by Scopac. Additional testimony showed that the Scopac estate generated an additional $29.7 million in proceeds from the sale of timber during the reorganization. Pacific Lumber II at *7. But the bankruptcy court failed to recognize the timber sale proceeds as the Noteholders’ cash collateral and failed to account for this amount in determining the amount of the Noteholders’§ 507(b) claim.
The bankruptcy court deducted the Bank’s superior claim of $36.2 million and another $8.9 million that Scopac had paid to the Noteholders’ professionals to arrive at the following calculation of the Noteholders’ remaining interest in the Scopac non-timber collateral: please click here.
Moreover, the bankruptcy court reasoned, the timberland collateral had not declined in value during the reorganization. The Noteholders thus held a secured claim of $513.6 million: $510 million based on their lien against the timber assets and a net $3.6 million lien on Scopac’s non-timber assets. The Fund agreed to modify its reorganization plan to provide for payment of this amount. In denying the Noteholders an administrative expense claim based on Code § 507(b), the bankruptcy court reasoned that the Noteholders were entitled to no more than a $513.6 million secured claim after confirming the Fund Plan on July 8, 2008. Pacific Lumber II at *3, *7; see also Pacific Lumber I at 238-39.
The Noteholders filed separate appeals from the § 507(b) order and the Confirmation Order. Although the bankruptcy court denied the Noteholders’ request for a stay of confirmation pending appeal, the Fifth Circuit entertained a direct appeal without a stay. Id.
Pacific Lumber I [Confirmation Appeal]
The Fifth Circuit affirmed the bankruptcy court’s confirmation order on Sept. 29, 2009. See Pacific Lumber I. It noted, however, that the bankruptcy court “may have made a mathematical error and deprived the Noteholders of [a] post-petition administrative priority claim,” remanding the case “for a determination of the value of this administrative priority claim and the extent to which effective relief is available.” Id. at 250; see also id. at 248 (“With the exception of collateral that may have been left out of the valuation, the court's [valuation decision] is not clearly wrong.” (emphasis added)).
Pacific Lumber II [§ 507(b) Appeal]
The Noteholders had also appealed from the § 507(b) order to the district court (the “§ 507(b) Appeal”). They argued that the bankruptcy court had undervalued their administrative priority claim.
Jurisdiction of § 507(b) Appeal
The district court dismissed the § 507(b) Appeal on Feb. 6, 2010, ruling that the “[§] 507(b) Order [was] an integral part of the Confirmation Order.” Further, because the Confirmation Order was pending in the Fifth Circuit, the district court held it lacked jurisdiction to consider the § 507(b) Appeal separately. Bank of New York Trust Co. v. Scotia Pacific LLC, Civil No. CC-08-259 (S.D.Tex. Feb. 6, 2009).
The Fifth Circuit reversed the district court’s dismissal of the § 507(b) Appeal, holding that it challenged the “bankruptcy court's ruling on the diminution in value of the secured claim after the petition date and the status of sales proceeds of collateral before confirmation. These are independent factual inquiries, unrelated to confirmation,” and their consideration “could not have had the effect of interfering with [the Confirmation Appeal] or circumventing it. … Indeed, the bankruptcy court held separate hearings on the § 507(b) motion, the parties briefed the issue apart from confirmation and the bankruptcy court deliberately issued its ruling on the motion in a separate order. Both the parties and the bankruptcy court treated the two issues distinctly.” Pacific Lumber II at *4. The Fifth Circuit thus chose to “follow their lead.” Id.
Equitable Mootness Doctrine Inappropriate
The court then refused to dismiss the appeal as equitably moot. “[E]quitable mootness is designed to protect concerns unique to bankruptcy” by recognizing “that there is a point beyond which a court cannot order fundamental changes in reorganization actions.” Id. at *5 (citing Manges v. Seattle-First Nat'l Bank (In re Manges), 29 F.3d 1034, 1038-39 (5th Cir. 1994)). Nontheless, the Court of Appeals refused to apply the doctrine here, holding that “so long as there is the possibility of ‘fractional recovery,’ the Noteholders need not suffer the mootness of their claims.” Id. at *6. “Equitable mootness should … not be a shield for sharp or unauthorized practices. Applying equitable mootness too broadly to disfavor appeals challenging the treatment of secured debt carries a price. It … destabilizes the credit market for financially troubled companies. …” Pacific Lumber I, 584 F.3d at 244 n.19.
According to the court, it would be inappropriate to rely on equitable mootness in Pacific Lumber II when it had previously considered issues directly related to confirmation in Pacific Lumber I. Moreover, “that a judgment might have adverse consequences to [the Fund as the debtor’s acquirer] is not only a natural result of any ordinary appeal — one side goes away disappointed — but adverse appellate consequences were foreseeable to [the Fund] as sophisticated investors who opted to press the limits of bankruptcy confirmation and valuation rules.” Pacific Lumber II at *6 (citing Pacific Lumber I at 244).
Bankruptcy Court’s Failure to Include Timber Sale Proceeds
The court ultimately found that the bankruptcy court had “undervalued the Noteholders' priority administrative § 507(b) claim by $29.7 million.” Id. at *9. In the court’s view, the Noteholders, as secured lenders, were entitled to “first seek adequate protection for diminution of the value of the property and then, if the protection ultimately proves inadequate, a priority administrative claim under § 507(b). Section 507(b) of the Bankruptcy Code allows an administrative expense claim under § 503(b) when adequate protection payments prove insufficient to compensate a secured creditor for the diminution in the value of its collateral.” Id. at *6 (internal citations omitted).
The bankruptcy court here had granted the Noteholders a replacement lien, subject only to the Bank’s superior lien, in any “proceeds and product” generated by the collateral, plus a “superpriority administrative claim to the extent” of any post-bankruptcy diminution of this interest. Id. at *1. But the bankruptcy court failed to recognize the Noteholders’ lien on the $29.7 million of collateral sale proceeds received by the estate during the reorganization case. Indeed, “[t]he cash collateral orders protected the Noteholders in two ways. [First,] they protected against a diminution in the value of the $48.7 million cash collateral that existed at the date of filing.” Id. at *7. Second, they “specifically granted a continuing lien in the proceeds of the prepetition collateral, i.e., the $29.7 million [of] generated proceeds from timber sales during the reorganization.” Id. If these liens proved inadequate, the Noteholders also had a § 507(b) claim. According to the Fifth Circuit, the bankruptcy court erred because it “entirely omitted the second component [the $29.7 million of asset sale proceeds] from its calculations and failed to credit those proceeds to the Noteholders' § 507(b) claim.” Pacific Lumber II at *1, *6-7.
Thus, the Fifth Circuit calculated the correct amount owed to the Noteholders as follows.
The court remanded the appeal with orders to enter judgment for the Noteholders on their $29.7 million administrative priority claim. Id. at *1, *7.
- Pacific Lumber II is consistent with other appellate rulings protecting secured lenders’ claims from lower courts’ undervaluations or from their failure to protect collateral. See, e.g., In re United Airlines, Inc., 564 F.3d 873, 879 (7th Cir. 2009) (held, bankruptcy court improperly valued lenders’ collateral so as to reduce secured claim by ignoring value of comparable collateral and by arbitrarily selecting discount rate for valuing future rentals; “[r]eal prices are much more informative than lawyers’ talk.”); In re Urban Communicators PCS Limited Partnership, 394 B.R. 325 (S.D.N.Y. 2008) (held, bankruptcy court improperly reduced post-bankruptcy contractual interest due oversecured creditor when debtor solvent and shareholders would benefit); In re Murel Holding Co., 75 F.2d 941, 942 (2d Cir. 1935) (held, debtor’s offer to repay balance of secured debt in balloon payment 10 years after confirmation of plan with interim interest payments but no requirements to protect collateral, inadequate).
- A party challenging the secured lender’s claim must move quickly. In re Tools-4-Hire, Inc., 2010 WL 3938368 (Bankr. D. Mass. Oct. 5, 2010) (held, reorganization debtor could not recover alleged overpayments to secured lender because debtor’s obligation to lender had been fixed when court confirmed debtor’s reorganization plan and could not be relitigated).