Interested chapter 11 plan investors, beware. A recent decision by the United States Court of Appeals for the Ninth Circuit held that even after the chapter 11 plan has been confirmed and substantially consummated and your money has been invested, an appeal can go forward even if a victory for the appellants would change the chapter 11 plan terms on which you relied and substantially diminish the value of your investment. In other words, the appeal is not equitably moot notwithstanding substantial consummation.
As a reminder, “equitable mootness” is a doctrine that enables a court to dismiss an appeal from a bankruptcy confirmation order where, as a result of the plan going effective, granting the requested relief would be inequitable because the transactions are complex and difficult to unwind, and doing so would impact the rights of innocent third parties.
The take-away here is location matters. Fortunately for plan investors, not all circuits hold the same view as the Ninth Circuit on the issue of equitable mootness. Read some of our prior posts on equitable mootness here! And for those who might think that you will never ever invest in a chapter 11 plan when the bankruptcy case is pending in the Ninth Circuit, think again. As we describe below, there are ways for investors to protect themselves even in the Ninth Circuit.
In 2007, five related entities acquired two Westin hotel properties. The acquisition was financed by two loans: (i) a $208 million loan to two operating companies secured by liens on the two hotels (the “Mortgage Loan”) and (ii) a $21.5 million loan to the two intermediary companies, secured by liens on the intermediary companies’ ownership interests in the operating companies (the “Mezzanine Loan”). The intermediary companies were wholly owned by a holding company. In 2010, all five entities filed for chapter 11 in the United States Bankruptcy Court for the District of Arizona. Each of the two secured lenders, which were undersecured as of the bankruptcy filing, filed a proof of claim. The lender under the Mortgage Loan elected to exercise its right under section 1111(b)(2) of the Bankruptcy Code, which permits an undersecured creditor to elect to retain its lien for the full amount of its claim, avoiding the bifurcation of its claim between secured and unsecured, and foregoing any recourse that it may have as an unsecured creditor.
The debtors filed a joint plan of reorganization funded with a $30 million investment by a third-party plan sponsor, who would become the sole owner of the operating companies, and proposed to dissolve the intermediary companies and cancel their equity interests in the operating companies. In addition, the chapter 11 plan proposed to reinstate the Mortgage Loan with a modified repayment schedule, including a balloon payment after 21 years. The proposed restructured Mortgage Loan terms also included a “due-on-sale” clause, requiring the reorganized debtor to pay the entire remainder of the Mortgage Loan immediately upon a sale or refinancing of the Westin hotel properties within the 21-year period. The due-on-sale clause would not apply, however, between years five and fifteen of the loan. If the lender under the Mezzanine Loan voted in favor of the plan, the lender would be entitled to a small percentage of surplus cash flow in the future. After the plan was proposed, the lender under the Mortgage Loan acquired the Mezzanine Loan and voted both positions against the plan.
The lender objected to confirmation arguing that (i) the exception to the due-on-sale clause during years five through fifteen negated the lender’s rights under section 1111(b) and (ii) the bankruptcy court misapplied the requirement under section 1129(a)(10) that, “[i]f a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan [must have] accepted the plan” because the bankruptcy court applied this requirement on a “per plan” basis instead of a “per debtor”. The bankruptcy court confirmed the chapter 11 plan over these objections finding that the plan satisfied the “cram down” requirements of section 1129(b).
The lender filed a timely appeal of the confirmation order and a motion to stay consummation of the plan pending appeal to avoid rendering the appeal moot. The stay request was denied by the bankruptcy and district courts. When the district court later considered the appeal on the lender’s two objections, it held that the appeal was equitably moot because the plan had been substantially consummated. The lender appealed to the Ninth Circuit and for the reasons set forth below, the Ninth Circuit reversed the district court’s decision to dismiss the appeal on equitable mootness grounds and remanded for further proceedings.
The Ninth Circuit identified four considerations to determine whether an appeal has been rendered equitably moot: (1) whether a stay was sought; (2) whether substantial consummation of the plan had occurred; (3) the effect a remedy may have on third parties not before the court; and (4) whether the bankruptcy court could fashion effective and equitable relief “without completely knocking the props out from under the plan and thereby creating an uncontrollable situation for the bankruptcy court.”
The Ninth Circuit considered each of these four factors. First, the Ninth Circuit determined that the lender was diligent about seeking appellate review of its two objections to the plan and a stay of plan consummation. Second, although the Ninth Circuit agreed that the plan had been substantially consummated because, inter alia, the third-party plan sponsor had assumed control over the operating debtors and the intermediary companies’ equity interests in the operating debtors had been extinguished, the Ninth Circuit held that, unlike other circuits (including the Second Circuit), substantial consummation does not create a presumption that an appeal is moot. With respect to the third factor, the Ninth Circuit determined that the only party that would be affected by the appeal and any remedies relating thereto would be the third-party plan sponsor. According to the Ninth Circuit, a savvy investor who had been actively involved in the plan confirmation and subsequent appeals was not the type of innocent third party that the doctrine of equitable mootness was intended to protect.
Finally, the court found that an equitable remedy could be fashioned, even if such remedy would only provide partial relief to the lender, without completely undoing the plan. With respect to the due-on-sale exception, the Ninth Circuit stated that an equitable remedy could include reducing the length of the exception (even if only by one day). With respect to the lender’s objection that section 1129(a)(10) needed to be applied on a per debtor basis, the Ninth Circuit determined that the equitable remedy would be payment of the Mezzanine Loan in full, but even a payment of less than the full amount, such as one dollar, would still provide an appropriate partial remedy that would not cause an undoing of the plan.
It is worth mentioning (particularly for those of you in the Second Circuit where substantial consummation creates a presumption that an appeal is equitably moot) that Judge M. Smith wrote an impassionate dissent stating that the remedies suggested by the majority’s decision were “grossly inequitable” to the third-party plan sponsor and “would surely jeopardize the reorganization.” Judge Smith disagreed with the majority’s conclusion that the doctrine of equitable mootness was not intended to protect the interests of a third-party investor and held that significant weight should be accorded to substantial consummation of a plan of reorganization. Notably, Judge Smith stated that the majority’s conclusions will have the effect of discouraging potential investors from relying on the finality of bankruptcy court confirmation orders or from investing in struggling properties until all bankruptcy litigation is concluded, which may impede the goals of chapter 11 reorganizations.
WORDS OF WISDOM FOR POTENTIAL PLAN INVESTORS
As this decision from the Ninth Circuit demonstrates, the law on the doctrine of equitable mootness continues to be both a circuit-specific and a fact-driven analysis. We’ll do our best to keep you up-to-date on recent case law considering this doctrine.
In the meantime, as a potential plan investor, remember the rule of location, location, location. Make sure you understand the law on equitable mootness in the jurisdiction in which the bankruptcy case is pending before you make your investment. Better yet, if you are negotiating with the debtor before the case is filed, request that the bankruptcy filing be made in a venue that has more investor-friendly views on equitable mootness. If that is not an option and you are “stuck” in the Ninth Circuit or a jurisdiction with similar (or unknown) views on equitable mootness, you can still protect yourself. Make sure that your obligation to close is contingent on all appeals being resolved in your favor, rather than simply relying on the fact that there is no stay of the confirmation order. You can always decide to waive the condition if the appeal filed is not something that, if successful, would threaten the value of your investment. And if the debtor refuses to give you such a walk-away right, at least you will know the risks eyes wide open and can make your investment decision accordingly.