Ninth Circuit Holds That Appeal From Unstayed Order Confirming Plan Over Secured Creditor's Objection Is Not Equitably Moot

April 15, 2016

The Ninth Circuit’s split decision in the matter of Sunnyslope Housing Limited Partnership, No. 13-16164 (9th Cir. April 8, 2016) is significant both for its substantive ruling on collateral valuation and its procedural ruling on equitable mootness. Its substance concerns how collateral is valued for cramdown purposes when a debtor is not putting the property to its highest and best use. The decision has even broader significance from a procedural standpoint, because it represents the further erosion of equitable mootness as a means of providing finality in the case of substantially consummated plans, as well as for its seemingly inconsistent application of caveat emptor to a plan sponsor and a distressed loan purchaser. 

A bank purchased an $8.5 million senior secured HUD-guaranteed loan from HUD (which had honored its guaranty) for roughly $5 million, knowing that the property was subject to junior restrictive covenants that limited its use to affordable housing. So restricted, the property’s value was only $2.6 million, according to the debtor. Unrestricted, its value was over $7 million, according to the bank. The debtor proposed a chapter 11 plan in which the property would continue to be used for affordable housing and argued that the bank’s secured claim should be assigned the lower value under section 506(a) of the Bankruptcy Code in light of that proposed use of the property. The bank argued that the property (and thus its secured claim) should be valued as if the property’s use was unrestricted because HUD had released its recorded regulatory agreement when it conveyed the loan, and the other restrictive covenants were junior in priority to the bank’s interest and so should not reduce the value of the bank’s secured claim. The bankruptcy court agreed with the debtor that the property should be valued in light of its proposed use as affordable housing (but increased the valuation to $3.9 million on account of certain tax credits). The district court affirmed.

The bank appealed the confirmation order and tried but failed to obtain a stay pending appeal from the bankruptcy court and district court. After the district court affirmed the confirmation order and denied a stay pending appeal, the plan sponsor made its $1.2 million equity contribution. The bank appealed but did not seek a stay of the order from the Ninth Circuit.

The Ninth Circuit reversed. First, it held that the appeal was not equitably moot, even though the confirmation order was unstayed and the plan was substantially consummated, and even though the plan sponsor might not recover its contribution and would be subject to $1.5 million in tax liabilities because the property had been part of a section 1033 exchange. In part, the panel ruled that it was not necessary to obtain a stay or even to seek a stay from the Ninth Circuit, acknowledging that it rarely grants such stays in any event. More significant, however, was the panel’s assessment that the plan sponsor was not the type of innocent third party protected by the equitable-mootness doctrine. Instead, it was a sophisticated party that knew the valuation was disputed and proceeded to fund anyway. “The failure of [the bank] to seek a stay from this court could not have given [the plan sponsor] reasonable cause to conclude that [the bank] had abandoned its challenge. [The plan sponsor] made a conscious decision to proceed nonetheless.”  

This ruling represents what appears to be the continuing erosion of the doctrine of equitable mootness: Under the approach articulated by the majority, an unstayed order confirming a plan that has been substantially consummated will not be insulated from appeal (and potential reversal) as equitably moot, unless reversal of the confirmation order will prejudice third parties (such as third-party creditors who had no involvement in the plan process and have already received plan distributions that would have to be recovered in the event of reversal). Importantly, the dissent did not take issue with the holding on mootness. In particular, although the opinion does not focus on this fact, the Ninth Circuit has previously held that a secured creditor’s appeal that seeks only to alter the treatment of its claim is not equitably moot. In re Transwest Resort Properties, 801 F.3d 1161, 1170-71 (9th Cir. 2015) (holding that secured creditor’s appeal from confirmation order was not equitably moot because, in part, “the two forms of relief sought—distribution of money from Reorganized Debtors to Lender or reinstatement of Lender's liens—would alter only the relationship between Reorganized Debtors and Lender.”).

The majority then held that because the bank’s interest was not subject to any restrictions on the use of the property, its secured claim must be valued under section 506(a) for cramdown purposes as if the property’s use was unrestricted. The fact that there would be no foreclosure “does not mean that the secured value of [the bank’s] secured claim may be suppressed by conditions subordinated to its position and attached to loans made by junior creditors.” Curiously, the panel referenced chapter 13’s inapplicable cramdown provision (section 1325 of the Bankruptcy Code) rather than the provision applicable to chapter 11 plans (section 1129). Because section 506(a) applies in both chapters, however, it seems that this apparent mistake ultimately did not affect the court’s analysis.

The majority distinguished the Supreme Court’s decision in Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997). Rash held in a cramdown context that a tractor must be assigned replacement value rather than foreclosure value because it was being retained under the plan. According to the majority, however, the property’s “replacement value” may not be based on “the specific way the debtor elects to use it.” Instead, “replacement cost” means the cost to the debtor to acquire comparable property, by which the majority meant the cost of a comparable apartment complex without the use restrictions (and thus, effectively, fair market value). Cramdown “does not authorize a substantial reduction in the amount of the secured value simply because the bankruptcy process itself means that the creditor cannot actually foreclose on the property.” The majority noted that while it was “unfortunate” that the affordable housing would be lost, not allowing HUD to effectively release its regulatory agreement would reduce the value of its defaulted loans in the secondary market.

Interestingly, while the majority ruled that the plan sponsor assumed the risk that the unstayed confirmation order would be reversed on appeal because it was a sophisticated party that was aware of the dispute when it funded the plan, the majority did not tag the bank with the bank’s own assumption of risk. As Circuit Judge Richard Paez observed in dissent, however, the bank was a sophisticated party that purchased the HUD loan fully aware of the debtor’s use of the property and the covenants restricting the debtor’s use of the property. In fact, the bank had acquired the loan for far less than its face value, presumably for that reason. In Judge Paez’s view, the clear language of section 506(a) required that the bank’s secured claim be calculated based on the debtor’s proposed disposition of the collateral. Under this view, the majority erred in holding that the property must be valued based on its value to the creditor (effectively, foreclosure value), when the statute and Rash plainly instruct that the collateral is to be valued based on the debtor’s actual use of the collateral and not its hypothetical foreclosure value. 

It is worth noting that the secured creditor had another potential argument available to it that might have obviated the need to address the proper test for valuing collateral—namely, the “best interests” test of section 1129(a)(7) of the Bankruptcy Code. Under that test, a dissenting creditor must receive property with a value, as of the plan effective date, which is no less than the dissenting creditor would receive in a chapter 7 liquidation. The secured creditor in Sunnyslope could have argued that in a chapter 7 liquidation, the secured creditor could have obtained relief from the stay (there being no equity in the property for the estate) and foreclosed on the property (thereby wiping out the junior restrictions on its use).