Equitable Mootness Applies to Chapter 9 Municipal Debt Adjustments, Ninth Circuit Says

Like its Bankruptcy Appellate Panel three years ago, the Ninth Circuit held that an appeal from a chapter 9 municipal reorganization can be dismissed under the doctrine of equitable mootness.

“Adamantly” dissenting, one judge on the three-judge panel would have ruled that a Takings Clause claim for just compensation under the Fifth and Fourteenth Amendments is not subject to the bankruptcy power and is automatically excepted from discharge, regardless of whether the appeal otherwise would be dismissed as equitably moot.

The Condemnation Claim

Two decades ago, the city of Stockton, Calif., exercised its power of eminent domain by condemning property to build a road. Although the owner had accepted $90,000 and waived rights to further compensation, the litigation posture became muddled when the city failed to complete the condemnation proceedings within five years as required by state law.

The owner then commenced a so-called reverse condemnation proceeding to seek greater compensation. However, Stockton filed its chapter 9 petition in 2012, halting proceedings in state court. The city listed the creditor’s claim as unsecured, and the creditor filed an unsecured claim for about $4.2 million.

The creditor objected to confirmation of the city’s chapter 9 municipal debt-adjustment plan. The creditor contended that his reverse condemnation claim was protected by the Fifth and Fourteenth Amendments and could not be impaired by the plan. Implementing settlements with workers, unions and bondholders, the bankruptcy court overruled the objection and confirmed the plan.

The plan became effective in early 2015. Meanwhile, the creditor appealed the confirmation order but never sought a stay pending appeal.

The Ninth Circuit accepted a direct appeal that was argued in November 2016. One judge on the panel retired before a decision came down, necessitating the appointment of a third judge to break the tie vote. The new judge reviewed the papers, listened to a recording of oral argument, and sided with the chief judge.

The Majority Opinion

Chief Circuit Judge Sidney R. Thomas dismissed the appeal as equitably moot, writing for himself and Circuit Judge Ronald M. Gould, who was added to the panel after Circuit Judge Alex Kozinski retired. Judge Thomas also ruled that the appeal failed on the merits.

Before explaining why, Judge Thomas said that if “there is a confirmed bankruptcy plan that deserves finality . . . it is Stockton’s.”

Judge Thomas recited Ninth Circuit law on equitable mootness, laid out in JPMCC 2007-C1 Grasslawn Lodging LLC v. Transwest Resort Properties Inc. (In re Transwest Resort Properties Inc.), 801 F.3d 1161 (9th Cir. 2015). For ABI’s discussion of Transwest, click here.

For an appeal to be equitably moot, four factors come into play under Transwest: (1) Did the appellant seek a stay; (2) was the plan substantially consummated; (3) what are the effects on third parties not before the court, and (4) can the court fashion a remedy that will not “knock the props” out from under the plan?

Only the last two factors were in dispute. Regarding the effect on third parties, Judge Thomas said that reversal of confirmation would undermine settlements with unions, bondholders and capital markets creditors, not to mention the citizens of Stockton who depend on the city for services. Although the creditor contended that he only sought monetary relief, Judge Thomas said that the multi-million-dollar claim would question the city’s long-term financial plan underlying the debt adjustment.

With regard to the fourth factor concerning a remedy, Judge Thomas rejected the creditor’s contention that he was seeking only a monetary recovery. Reversing the confirmation order, the judge said, “would mean dismantling the confirmed reorganization plan, which is the only relief [the creditor] seeks.”

Judge Thomas ruled that the appeal must be dismissed as equitably moot because the “reorganization train has left the station. . . . To reverse [confirmation] at this stage would create chaos and undo years of carefully negotiated settlements.”

Like the BAP in late 2015, Judge Thomas ruled that a challenge to Stockton’s plan was equitably moot, citing Franklin High Yield Tax-Free Income Fund v. City of Stockton (In re City of Stockton), 542 B.R. 261, 264-265 (B.A.P. 9th Cir. 2015).

On the merits, the creditor argued that the Takings Clause exempted his claim from the reorganization. Even assuming the appeal was not equitably moot, Judge Thomas said that the argument was “not viable on this record.”

Judge Thomas said that a Takings Clause claim “is only implicated in bankruptcy if the creditor has actual property rights.” Evidently conceding that the Takings Clause provides protection to a creditor claiming “actual property rights,” he said that a debt can be adjusted in bankruptcy if the creditor only has a right to monetary relief, citing the Collier treatise.

With regard to that issue, Judge Thomas noted how the creditor himself had filed only an unsecured claim and claimed no interest in property. In addition, there was a final state court judgment rejecting the creditor’s claim to property rights.

According to Judge Thomas, the state court had only left the creditor with “an unliquidated and unsecured monetary damage claim” that could be affected by the chapter 9 plan.

The Dissent

Circuit Judge Michelle T. Friedland dissented, saying up front that “the Fifth Amendment’s requirement that the government provide just compensation for any taking of private property constrains the powers granted to Congress by the Bankruptcy Clause of Article I. Takings claims should therefore be excepted from discharge in bankruptcy.”

Therefore, Judge Friedland said, “equitable mootness has no role to play here” because the creditor only sought to have his claim excepted from discharge. She thus reached the merits, again disagreeing with the majority and saying that the creditor “should be allowed to proceed” with his inverse condemnation claim in state court.

On the constitutional issue, Judge Friedland believes that municipalities “are obligated to provide just compensation for any taking of private property, regardless of bankruptcy laws.” She read Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555 (1935), to mean that the Takings Clause “constrains the power conferred by the Bankruptcy Clause of Article I.” Similarly, she understood U.S. v. Security Industrial Bank, 459 U.S. 70 (1982), to mean that the bankruptcy power is subject to the prohibition against taking private property without just compensation.

Therefore, Judge Friedland concluded that “claims for just compensation should be excepted from discharge, such that they survive any bankruptcy intact.”

On the merits, Judge Friedland believed that the creditor had not waived rights to just compensation under state law. To preserve his claims, she said the creditor was only obliged to object to confirmation. The applicability of rights under the Takings Clause did not depend on whether the claim was classified as secured or unsecured, she said.

Furthermore, Judge Friedland said, the Bankruptcy Code does not require a creditor with a nondischargeable claim to file a proof of claim. Citing Bankruptcy Rule 4007(b), she said that a complaint seeking an exception to discharge may be filed at any time.

Recognizing that the creditor never filed a separate pleading to except the debt from discharge, Judge Friedland said he accomplished the equivalent by “unequivocally” maintaining throughout that “his claim for just compensation was ‘protected by the Fifth and Fourteenth Amendments’” and could not be impaired by the plan or treated as a mere unsecured claim.