Third Circuit Invokes Equitable Mootness to Bar Appeal of Gifting Chapter 11 Plan
In In re Nuverra Environmental Solutions, Inc., 834 Fed. App'x 729 (3d Cir. 2021), the U.S. Court of Appeals for the Third Circuit handed down a long-awaited ruling that could have addressed, but ultimately did not address, the validity of "gifting" chapter 11 plans under which a senior creditor class gives a portion of its statutorily entitled recovery to one or more junior classes as a means of achieving consensual confirmation. By avoiding the merits and holding that an appeal of an order confirming a "horizontal gifting" plan was equitably moot, the Third Circuit skirted a question that continues to linger in the aftermath of the U.S. Supreme Court decision in Czyzewski v. Jevic Holding Corp., __ U.S. __, 137 S. Ct. 973 (2017). In that case, the Supreme Court invalidated final distributions to creditors departing from the Bankruptcy Code's priority scheme as part of a nonconsensual "structured dismissal" of a chapter 11 case.
The court-fashioned remedy of "equitable mootness" bars adjudication of an appeal when a comprehensive change of circumstances has occurred such that it would be inequitable for a reviewing court to address the merits of the appeal. In bankruptcy cases, appellees often invoke equitable mootness as a basis for precluding appellate review of an order confirming a chapter 11 plan. See, e.g., In re LCI Holding Company, Inc., 802 F.3d 547, 554 (3d Cir. 2015) (stating that the doctrine "comes into play in bankruptcy (so far as we know, its only playground) after a plan of reorganization is approved" and ruling that equitable mootness would not cut off the authority to hear an appeal outside the plan context).
The doctrine of equitable mootness is sometimes criticized as an abrogation of federal courts' "virtually unflagging obligation" to hear appeals within their jurisdiction. In re One2One Commc'ns, LLC, 805 F.3d 428, 433 (3d Cir. 2015); In re Charter Commc'ns, Inc., 691 F.3d 476, 481 (2d Cir. 2012). According to this view, dismissing an appeal on equitable mootness grounds "should be the rare exception." In re Tribune Media Co., 799 F.3d 272, 288 (3d Cir. 2015).
Substantially similar tests have been applied by most circuit courts of appeals in assessing whether an appeal of a chapter 11 confirmation order should be dismissed under the doctrine. Those tests generally focus on whether the appellate court can fashion effective and equitable relief. See, e.g., PPUC Pa. Pub. Util. Comm'n v. Gangi, 874 F.3d 33, 37 (1st Cir. 2017) (considering whether: (i) the appellant diligently pursued all available remedies to obtain a stay of the confirmation order; (ii) the challenged chapter 11 plan had progressed "to a point well beyond any practicable appellate annulment"; and (iii) providing relief would harm innocent third parties); JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Props., Inc. (In re Transwest Resort Props., Inc.), 801 F.3d 1161, 1167–68 (9th Cir. 2015) (applying a four-factor test, including whether the court "can 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"); Tribune, 799 F.3d at 278 (considering "(1) whether a confirmed plan has been substantially consummated; and (2) if so, whether granting the relief requested in the appeal will (a) fatally scramble the plan and/or (b) significantly harm third parties who have justifiably relied on plan confirmation"); Search Market Direct, Inc. v. Jubber (In re Paige), 584 F.3d 1327, 1339 (10th Cir. 2009) (applying a six-factor test, including the likely impact upon a successful reorganization of the debtor if the appellant's challenge is successful); In re United Producers, Inc., 526 F.3d 942, 947–48 (6th Cir. 2008) (three-factor test); TNB Fin., Inc. v. James F. Parker Interests (In re Grimland, Inc.), 243 F.3d 228, 231 (5th Cir. 2001) (three-factor test); see also In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 2021 WL 438891, **6-7 (1st Cir. Feb. 8, 2021) (holding that the doctrine of equitable mootness was not abrogated by the U.S. Supreme Court's ruling in Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019), and that the doctrine applied to dismiss an appeal of an order approving a plan in a proceeding under the Puerto Rico Oversight, Management, and Economic Stability Act).
A common element of almost all of these tests is whether the chapter 11 plan has been substantially consummated. Section 1101(2) of the Bankruptcy Code provides that "substantial consummation" of a chapter 11 plan occurs when substantially all property transfers proposed by the plan have been completed, the debtor or its successor has assumed control of the debtor's business and property, and plan distributions have commenced.
Nuverra Environmental Solutions, Inc. ("NES") filed a prepackaged chapter 11 case in May 2017 with $500 million in secured debt and a value of approximately $300 million. NES proposed a chapter 11 plan under which: (i) secured noteholders received new stock, representing an estimated 55% recovery, but forfeited $190 million in deficiency claims; (ii) unsecured noteholders received a combination of new stock and cash amounting to a 4–6% recovery; and (iii) trade and certain other business-related unsecured claims (collectively, "trade claims") were paid in full. Secured noteholders agreed to fund payments to holders of unsecured noteholder and trade claims, which otherwise would have received nothing under the plan.
The unsecured noteholder class voted to reject the plan. One unsecured noteholder ("Hargreaves") objected to confirmation, arguing that: (i) the plan's proposed treatment of the dissenting unsecured noteholder class was not "fair and equitable," a requirement for cram-down confirmation under section 1129(b)(1) of the Bankruptcy Code, because the plan distributed less value to that class than to the trade claim class; and (ii) the plan's classification scheme was improper because unsecured noteholder claims and trade claims should not have been separately classified because they were "substantially similar" within the meaning of section 1122(a) of the Bankruptcy Code.
The bankruptcy court overruled the objection and confirmed the plan. The court determined that separate classification of the unsecured noteholder claims and the trade claims was reasonable because trade creditors were critical to the success of reorganized NES.
The bankruptcy court also considered whether the plan satisfied section 1129(b)(1)'s mandate that a chapter 11 plan cannot "discriminate unfairly" with respect to rejecting classes of creditors and shareholders. Applying a test (the Markell test) used by many courts in determining whether a plan "discriminates unfairly," the court found that the disparate treatment of the unsecured noteholder and trade creditor classes gave rise to a rebuttable presumption of unfair discrimination. However, it determined that the presumption had been rebutted because the unsecured noteholder class was "indisputably out of the money and not, otherwise, entitled to any distribution under the [B]ankruptcy [C]ode's priority scheme[,] and … the proposed classification and treatment of the unsecured creditors fosters a reorganization of these debtors."
The court also held that, because the plan distributions to unsecured creditors were "gifted" by the secured creditors from property to which they otherwise would have been entitled, rather than property of the estate—sometimes referred to as "horizontal gifting"—the plan satisfied the "absolute priority rule," which, broadly stated, precludes any distribution to junior creditors unless more senior creditors are paid in full or agree otherwise.
Hargreaves appealed the confirmation order to the district court. The district court denied his emergency request to stay the confirmation order beyond the 10-day period specified in the order.
The district court affirmed. As an initial matter, the court ruled that the appeal was equitably moot. In particular, the district court concluded that NES had "substantially consummated" its chapter 11 plan and that the relief sought by Hargreaves—equal distributions to unsecured noteholders and trade creditors—would "require undoing the [p]lan" and necessarily result in harm to third parties. Specifically, the court noted, "disgorgement would require the clawback, not only of cash payments made to hundreds of individual creditors, but also the clawback of stock that is trading on the national stock exchange, and may now be held by third parties who purchased these securities in the ordinary course."
Nevertheless, the district court addressed the merits of the appeal. It found no fault with the bankruptcy court's conclusions. Among other things, the district court explained that, although "vertical gifting"—gifting in a manner that skips over an intermediate junior class of dissenting creditors—violates the absolute priority rule under Third Circuit precedent, horizontal gifting does not. We provide a more detailed discussion of the bankruptcy and district court rulings and the legal concepts involved.
Hargreaves appealed the ruling to the Third Circuit.
The Third Circuit's Ruling
A divided three-judge panel of the Third Circuit affirmed, but skirted the merits. Instead, the majority ruled that the district court correctly held that the appeal was equitably moot.
Initially, the court explained that Hargreaves, who was the only creditor in the unsecured noteholder class to appeal the confirmation order, sought as a remedy for the alleged unfair discrimination an individual payout of $450,000, equal to a 100% recovery on his claim, but only 0.45% of NES's $173 million enterprise value.
Applying the Tribune test for equitable mootness, the Third Circuit concluded that NES's chapter 11 plan had been substantially consummated, but acknowledged that the relief sought, "an individual payout of a relatively small sum," might not "fatally scramble the plan." However, the court held that such relief "is not permitted by the Bankruptcy Code" because it would: (i) violate section 1123(a)(4), which states that a chapter 11 plan must "provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment"; and (ii) contravene the purpose of the prohibition of unfair discrimination, which "applies only to classes of creditors (not the individual creditors that comprise them), and then only to classes that dissent" (citations and internal quotation marks omitted).
According to the Third Circuit, Hargreaves could not "properly … propose that the appropriate remedy is to pay him only and no one else in his class." It also explained that, if every creditor in the unsecured noteholder class were to be paid in full, the $40 million payment would drain 23.3% of the value of reorganized NES—thus scrambling the plan. The Third Circuit accordingly ruled that Hargreaves's appeal was equitably moot.
In a concurring opinion, Circuit Judge Cheryl Ann Krause sided with NES, but not for the reason cited by the majority. She criticized the majority for "abdicating our jurisdiction" on the basis of equitable mootness—a "narrow" doctrine she has previously decried as "legally ungrounded and practically unadministrable."
According to Judge Krause, because the relief requested by Hargreaves did not threaten to fatally scramble the chapter 11 plan or significantly harm the interest of reliant third parties, the appeal was not equitably moot, and the court should have considered the merits of the appeal. Important issues that should have been addressed, she explained, include: (i) whether "individualized relief" is permitted by section 1123(a)(4) when one member of a class objects to a less-favorable treatment under a plan, but others do not; (ii) whether the Supreme Court's ruling in Jevic "foreclose[s] preferential treatment of a sub-class through horizontal gifting"; (iii) whether the unfair discrimination test "focus[es] on the plan's results or the process" that produced them; and (iv) the limits of chapter 11 plan classification schemes. Judge Krause then summarily stated that she would have upheld confirmation of NES's plan on the merits.
Senior-class gifting is an important tool for building consensus on the terms of a confirmable chapter 11 plan. The district court's ruling in Nuverra dispelled speculation that Jevic might presage an end to all kinds of gifting chapter 11 plans, but many anticipated that the Third Circuit would provide additional circuit-level guidance on the issue. It elected not to do so. Thus, courts in that circuit will continue to grapple with an issue that is increasingly a common feature of many chapter 11 plans.
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