Second Circuit Ducks a Critical Vendor Appeal

By invoking equitable mootness, the Second Circuit has made a critical vendor order virtually unreviewable after confirmation of a chapter 11 plan.

In chapter 11, the debtor prevailed on the bankruptcy court to approve a so-called critical vendor motion, allowing full payment before confirmation of prepetition claims owing to unsecured creditors whose cooperation was seen as critical to a successful reorganization.

A creditor appealed the critical vendor order but did not seek a stay pending appeal. The district court affirmed on the merits, prompting a second appeal to the circuit. Click here to read ABI’s report on the district court affirmance.

While the appeal was pending in the circuit, the debtor confirmed its chapter 11 plan.

The creditor assigned two errors: (1) The bankruptcy court improperly delegated its judicial authority to the debtor to decide who should be paid, and (2) the bankruptcy court improperly withheld the identities of the creditors being paid.

In a nonprecedential, per curiam opinion on February 18, the Second Circuit dismissed the appeal as equitably moot.

The appeals court laid out Second Circuit authority and the five factors to consider in dismissing bankruptcy appeals under the judge-made principle of equitable mootness. See Frito-Lay, Inc. v. LTV Steel Co. (In re Chateaugay Corp.), 10 F.3d 944, 949–50 (2d Cir. 1993). Once a debtor’s plan has been substantially consummated, the Second Circuit presumes that an appeal is equitably moot.

The appeals court rejected the creditor’s argument that equitable mootness did not apply because the creditor was not appealing confirmation. “Our precedent is clear,” the Second Circuit said, “that equitable mootness can be applied ‘in a range of contexts,’ including appeals involving all manner of bankruptcy court orders.”

The appeals court said that the creditor’s argument “makes little sense” because it “overlooks the important interest of finality that attaches once a reorganization plan is approved and consummated.” The circuit decided to apply equitable mootness “even though [the appellant] has not expressly asked us to reject the bankruptcy court’s approval of [the debtor’s] plan of reorganization.”

Turning to the merits of equitable mootness, the appeals court decided that the creditor had “clearly failed” to satisfy the five Chateaugay factors, most prominently by failing to seek a stay or even an expedited appeal.

In terms of disruption, the circuit court said that the relief sought on appeal “could cause tens of millions of dollars in previously satisfied claims to spring back to life, thereby potentially requiring the bankruptcy court to reopen the plan of reorganization.” Moreover, the court said, “it would likely be highly disruptive for the creditors that received these funds to return them more than a year later.”

The circuit court dismissed the appeal as equitably moot.

In a footnote, the appeals court declined to rule on disclosure of the identities of the creditors whose claims were paid. The appellant had “no cognizable interest” in finding out who was paid “if it lacks the ability to parlay them into a possible financial recovery.”

Observations

On the first appeal, District Judge Cathy Seibel wrote a formidable opinion upholding the critical vendor order on the merits. It’s unfortunate that the Second Circuit sidestepped an issue of significance that arises in almost every major chapter 11 case in the Southern District of New York.

In terms of applying equitable mootness to the case on appeal, the Second Circuit may have misapprehended the effect of reversal.

Arguably, requiring critical vendors to disgorge payments would not upset the plan. Critical vendors would be disgorging whatever they received before confirmation that was in excess of their recoveries under the plan. The excess recovered by the debtor could mean greater dividends to other creditors. If there be any doubt about upsetting the plan, the circuit court could remand the question to the bankruptcy court rather than ruling on its own.

This writer submits that disclosing the identities of recipients of preconfirmation payments would not be meaningless relief. Without disclosure, how is the creditor body to know whether improper favoritism motivated the debtor’s selection of critical vendors?

Admittedly, something seems wrong about compelling disgorgement from critical vendors who were not parties to the appeal. Still, major initiatives that occur in most large chapter 11 cases should be subject to review in the circuit as activities that escape review but are likely to recur.