Is Equitable Mootness Disappearing in the Ninth Circuit?
Reprinted with permission from the May 6, 2016 issue of The Legal Intelligencer. © 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
A great deal has been written in recent weeks about the Ninth Circuit's decision in First Southern National Bank v. Sunnyslope Housing, Case No. 12-17241 (9th Cir. Apr. 8, 2016), in which a divided panel set aside the order confirming the debtor's Chapter 11 plan of reorganization. Much of the commentary has focused on the majority's interpretation of 11 U.S.C. 506(a), which governs the value of a secured claim, and Judge Richard A. Paez of the U.S. Court of Appeals for the Ninth Circuit's dissent from the majority's opinion. Of equal interest and broader significance, however, is the fact that the Ninth Circuit heard the appeal at all.
The debtor, Sunnyslope Housing, operated a 150-apartment housing project. The primary financing was provided by a secured loan guaranteed by the U.S. Department of Housing and Urban Development (HUD), which required that the project be operated as affordable housing. Subordinate financing was provided by the city of Phoenix and the state of Arizona, which likewise imposed certain restrictions on the use of the property.
In 2009, the debtor defaulted on the senior loan. HUD took over the loan and sold it to First Southern National Bank Inc. As part of the sale, HUD released the agreement that required the property to be used for affordable housing. Accordingly, the only remaining affordable housing restrictions on the property related to the subordinate loans. First Southern filed a foreclosure complaint in state court, but before a foreclosure sale could be completed, the debtor was put into bankruptcy.
In its plan of reorganization, Sunnyslope sought to retain ownership of the real estate property over First Southern's objection. Under the "cram down" provision of 11 U.S.C. Section 1129(b), Sunnyslope could do so, provided that First Southern retained its lien and received deferred cash payments totaling at least the present value of its secured claim. First Southern filed an action pursuant to Section 506(a) of the Bankruptcy Code seeking to determine the amount of its secured claim. At the crux of the dispute was whether the collateral securing the claim should be valued as though it were free of the affordable housing covenants, which would be wiped out in a hypothetical foreclosure, or based upon its actual continued use as affordable housing.
The bankruptcy court found that the value of the property was $3.9 million, based on the continuing application of the affordable housing covenants as well as the value of certain tax credits. The bankruptcy court also confirmed Sunnyslope's plan, which proposed to pay First Southern's allowed claim over 40 years. First Southern appealed. The bankruptcy court and the district court both declined to grant First Southern a stay of the confirmation order pending appeal. Later, the district court affirmed the confirmation of the plan. Subsequently, the plan of reorganization was consummated through the infusion of $1.2 million of new equity from a third-party investor, Cornerstone at Camelback LLC, which took over ownership and operation of the apartment complex.
First Southern appealed to the Ninth Circuit in June 2013, but did not seek a stay at that level. Almost three years later, the Ninth Circuit found that First Southern's secured claim should have been valued based not on the debtor's actual use of the property, but on what First Southern could have received in foreclosure. The majority noted that "if there were a foreclosure sale, there is no doubt that the restrictive provisions would be swept away, giving First Southern's interest a value of at least $7 million." The court concluded by not only reversing the valuation of First Southern's secured claim, but also setting aside the confirmation order altogether.
In a lengthy dissent, Paez argued that the majority fell afoul of the U.S. Supreme Court's decision in Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997). In Rash, the Supreme Court expressly rejected using a hypothetical foreclosure sale as the starting point for valuation under Section 506(a). Instead, the Supreme Court explained, "Section 506(a) calls for the value the property possesses in light of the 'disposition or use' in fact 'proposed,' not the various dispositions or uses that might have been proposed." In Paez's view, Rash mandates that Sunnyslope's actual use of the property for affordable housing was the proper guide for valuation, rather than a foreclosure sale that would not take place.
Some observers have raised concerns about the effect of Sunnyslope on the ability of property owners to maintain their affordable housing status in reorganization over the objections of a secured lender. Indeed, the Ninth Circuit majority conceded that its opinion will likely "have the negative effect of eliminating the use of the Sunnyslope project for affordable housing." Ultimately, though, the reach of Sunnyslope's substantive decision may be somewhat limited by its facts, since it presents a fairly unusual set of circumstances under which the lender's collateral would be worth substantially more in a foreclosure sale than through continued use.
The broader impact of Sunnyslope comes from the Ninth Circuit's procedural ruling (in which Paez concurred) that First Southern's appeal was not equitably moot. Equitable mootness is a judge-made abstention doctrine based on an unwillingness to alter the outcome of a plan of reorganization where it would be inequitable to do so. The doctrine recognizes the importance to all parties of a measure of finality in bankruptcy proceedings.
The Ninth Circuit has identified four factors it considers in determining whether an appeal should be dismissed as equitably moot: whether a stay was sought; whether substantial consummation of the plan has occurred; the effect that a remedy may have on third parties not before the court; and whether the bankruptcy court can fashion effective and equitable relief without completely knocking the props out from under the plan.
In some circuits, substantial consummation of a plan creates a strong presumption of equitable mootness. The Ninth Circuit, by contrast, is less friendly to the doctrine of equitable mootness and puts the burden squarely on the party asserting the doctrine to establish that there is no effective relief remaining that a court could provide.
In Sunnyslope, there was no question that First Southern had failed to seek a stay from the Ninth Circuit or that the plan had been substantially consummated. Cornerstone, a third party, had funded the plan of reorganization and faced both the loss of its investment and potentially heavy tax liabilities if the plan were unraveled. Moreover, it had owned and operated the Sunnyslope apartment complex for almost three years. Presumably, under Cornerstone's ownership, Sunnyslope had contracted with other third parties during that time, such as vendors, service providers and families in need of affordable housing. Reversing the order confirming the debtor's plan would throw all of those third-party rights and obligations into question.
Nonetheless, that is precisely what the Ninth Circuit did, holding that the plan of reorganization must be set aside. The Ninth Circuit found, essentially, that First Southern was excused from seeking a stay, since the stay likely would not have been granted. Furthermore, the Ninth Circuit placed significant weight on the fact that First Southern had filed two separate notices of appeal, which "made plain its intent to pursue the matter on appeal." This is a curious position, since every appeal involves the filing of a notice. If notice of intent to appeal is an adequate substitute for obtaining or even seeking a stay pending appeal, then the first of the Ninth Circuit's equitable mootness factors effectively has been vitiated.
The Ninth Circuit noted that the plan had been substantially consummated, but gave no apparent weight to this factor. Instead, the court focused on the third factor, "whether modification of the plan of reorganization would bear unduly on the innocent." While conceding that Cornerstone would be adversely affected by the unraveling of the plan, the court determined that Cornerstone was not the kind of innocent third party the doctrine of equitable mootness is designed to protect. The court found that Cornerstone was a sophisticated investor; Cornerstone was involved in the development of the plan of reorganization; Cornerstone knew that First Southern vigorously disputed the valuation on which the plan was based; and Cornerstone had notice of First Southern's appeal. In short, the Ninth Circuit concluded, Cornerstone funded the plan at its own risk. There was no discussion by the court of the impact that the unwinding of the plan might have on third parties truly remote from the bankruptcy process — such as trade vendors and tenants — who had contracted with Sunnyslope, under Cornerstone's ownership, over the past three years.
Sunnyslope is the most recent salvo chipping away at the doctrine of equitable mootness in the Ninth Circuit, and should caution plan sponsors, who cannot assume that an unstayed confirmation order and fully consummated plan are truly final until every appeal is decided. While the implications of the decision remain to be seen, investors may begin to condition the funding of plans on the prior disposition of all appeals, discount the valuation of debtors' assets to account for the added risk, or simply decide not to sponsor plans of reorganization in the Ninth Circuit. The increased uncertainty caused by the erosion of the doctrine of equitable mootness will undoubtedly make reorganizing in the Ninth Circuit more challenging. It will be interesting to see if any other circuits follow suit.
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