In bankruptcy cases, it is common for appellate courts to decline to review orders confirming substantially consummated chapter 11 plans because of the “equitable mootness” doctrine—a judge-created abstention rule intended to protect both the finality of reorganization and the expectations of third parties. Recently, however, the U.S. Court of Appeals for the Fifth Circuit decided Bank of N.Y. Trust Co. v. Official Unsecured Creditors’ Committee (In re Pacific Lumber Co.), 584 F.3d 229 (5th Cir. 2009), which substantially limits the applicability of equitable mootness in bankruptcy appeals and raises important issues for practitioners to consider in contentious plan confirmation proceedings.
In Pacific Lumber, the Fifth Circuit re-examined doctrine in the context of an appeal filed by the secured creditors that objected to the treatment of their claims under a chapter 11 plan. The court found that equitable mootness did not prevent appellate review of most of the noteholders’ claims, despite the fact that no stay had been obtained pending appeal and the reorganization had been substantially consummated. In so doing, the Fifth Circuit indicated a willingness to limit the doctrine of equitable mootness in order to preserve substantial legal issues for appellate review.
In Pacific Lumber, a group of noteholders objected to a chapter 11 plan of reorganization confirmed pursuant to the cramdown provisions of §1129(b). The plan authorized the free-and-clear sale of the noteholders’ collateral to newly created entities owned by the plan proponents. In exchange, the noteholders were to receive a cash payment equal to the value of their collateral, a lien on certain pending unrelated litigation and an unsecured deficiency claim. However, the plan did not provide the noteholders with the opportunity to credit-bid. At confirmation, the bankruptcy court determined that the noteholders were undersecured by approximately $226.4 million and that the plan complied with the Bankruptcy Code.
The noteholders appealed on a number of grounds, including that the plan (1) improperly denied them the right to credit bid and significantly undervalued their secured claims, (2) improperly calculated their administrative claim, (3) improperly treated impaired and unsecured classes, and (4) improperly granted third-party releases. Although the bankruptcy court granted the noteholders’ motion to certify the appeal to the Fifth Circuit, neither the court nor a motions panel of the Fifth Circuit stayed confirmation of the plan. Prior to the hearing on appeal, however, the plan proponents substantially consummated the plan. They then sought to dismiss the appeal as equitably moot on the basis that unwinding the plan would have an adverse impact on third parties and would prevent a successful reorganization.
The Fifth Circuit began its analysis by noting that equitable mootness is a “judicial anomaly” that allows appellate courts to abstain from exercising jurisdiction in favor of finality of reorganizations and protecting the expectations of third parties. In contrast to Article III mootness, which prevents adjudication when a ruling would have no effect, equitable mootness applies when appellate review would have too much effect on a confirmed plan. Although the doctrine of equitable mootness was firmly rooted in the Fifth Circuit’s jurisprudence, the court focused on the need to balance the competing interests of finality with the rights of a party to challenge an adverse ruling.
In evaluating whether an appeal is equitably moot, the Fifth Circuit has historically considered, “(i) whether a stay has been obtained, (ii) whether the plan has been ‘substantially consummated and (iii) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.” In re Manges, 29 F.3d 1034, 1039 (5th Cir. 1994). The Pacific Lumber court indentified several additional factors that must be balanced against the expectations of third parties and the success of the plan to determine whether a court should abstain from appellate review based on equitable mootness.
First, appellate courts must be particularly sensitive of secured creditors’ property rights and “proceed with caution” prior to declining review based on a judge created abstention doctrine. Second, appellate review should not be declined just because the creditor could not obtain full relief without impairing the feasibility of the plan or effecting third parties not before the court. If the appellant prevails, the court may be able to grant partial relief rather than abstaining from the entire appeal. Third, equitable mootness applies to specific claims and not to entire appeals. Thus, each claim must be evaluated against the impact of granting relief on the entire reorganization. Fourth, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) amendments that authorized direct appeals to the appellate courts were intended to both expedite appeals and generate binding appellate precedent in bankruptcy. Congressional intent could be thwarted if equitable mootness is used to prevent appellate jurisdiction over properly certified appeals on important issues.
After balancing those factors, the court held that equitable mootness did not prevent appellate review of the plan’s treatment of the noteholders’ secured claims. In determining that the expectations of third parties would not be impacted by a reversal of the bankruptcy court’s decision, the Fifth Circuit refused to “invent hypotheticals” to demonstrate that the expectations of third parties, other than the plan proponents, could still be preserved even if the court reinstated or re-evaluated the noteholders’ liens. The court made this determination despite the fact that the debtors had been dissolved and their assets transferred to new entities that raised $325 million in exit financing, hired new management, entered into new contracts and obtained regulatory approval to operate. The court found that any adverse consequences to the plan proponents themselves was a natural part of the appeal process that should have been foreseeable to sophisticated investors who chose to push the boundaries of plan confirmation and valuation as part of a cramdown plan. Therefore, the court undertook an analysis of the merits of the noteholders’ objections to the plan’s treatment of their secured claims.
The Fifth Circuit next considered whether the noteholders’ challenge to the bankruptcy court’s calculation of their purported administrative claim was equitably moot. The court found that awarding full relief to the noteholders on their purported $11 million claim would not imperil a reorganization involving hundreds of millions of dollars. Therefore, the claim was subject to appellate review.
The court also found that the noteholders’ challenge to the legality of the third-party release provisions was not equitably moot. The plan provided releases to the plan proponents and other nondebtor third parties. The court found that its review of the third-party releases on the merits was essential to the transparency and integrity of the chapter 11 process. The goal of protecting the integrity of the process clearly outweighed the goal of limiting appellate review of the release provisions.
On the other hand, the Fifth Circuit rejected as equitably moot the noteholders’ claims that the plan improperly impaired and gerrymandered several classes of claims and unfairly discriminated against the noteholders’ unsecured deficiency claims. Although recognizing the “apparent arbitrariness” of the impairment and noting that the bankruptcy court’s findings related to the separate classification were “troubling,” the court held that the impairment and classification claims were equitably moot. The plan had been substantially consummated, and smaller unsecured creditors already received more than $50 million in payments on their claims. The only way to remedy the impairment and classification issues, the court found, was to unwind a substantially consummated plan, which would have impermissibly affected third-party expectations. Therefore, the noteholders’ objections to those plan provisions were equitably moot.
The Pacific Lumber court clearly signaled a willingness on the part of the Fifth Circuit to preserve significant issues for appellate review even after substantial confirmation of a confirmed plan. This position may force plan proponents to bear a significant amount of risk related to the possible reversal of a substantially consummated plan. This risk is heightened if the plan impacts a secured creditor’s property rights. As a result, Pacific Lumber may require parties to make additional efforts to resolve contentious plan issues prior to confirmation. Alternatively, plan proponents may seek to delay substantial consummation of a chapter 11 plan until after all appeal rights have been exhausted. In either event, Pacific Lumber warrants a careful review of the risks associated with consummating a chapter 11 plan prior to resolution of all appeal rights.