Lookback Period: Eight Weeks (Part 2)

Contributed by Debra A. Dandeneau.
We continue our bankruptcy cram course today with Part 2 of the Lookback Period – Eight Weeks.
Property Co-Owner Not Off the Hook in Refusing to Sign Mortgage
Ben Farrow’s piece, [Un]signed, Sealed, Delivered: Is It Still Yours? focused on equitable subrogation and how a lender might apply it when a property co-owner refuses to execute a new mortgage when the other co-owner refinances an earlier mortgage that was signed by both parties.  Applying D.C. law, the court in In re Stevenson allowed the subsequent lender to step into the shoes of the original lender under the jurisdiction’s  five-prong test for equitable subrogation:  (1) The new lender paid off the prior mortgage so it could protect its “own interest” by having a first priority mortgage; (2) the new lender did not “act as a volunteer” because the mortgage was consideration for its loan; (3) the new lender was not liable for the prior mortgage; (4) the proceeds from the new loan paid off the entire prior mortgage; and (5) subrogation would “not work any injustice to the rights of others.” 
Ninth and Third Circuits Continue to Whittle (Hack?) Away at Equitable Mootness
One wonders whether in a few years plan proponents will have to change their strategies relating to mooting out an appeal from a confirmation order.  As discussed in two blog entries during this period, circuit courts continue to limit the principle that allows an appeal from an order confirming a plan to be dismissed on the grounds that the plan was substantially consummated, and the court will be unable to unscramble the egg, close Pandora’s box, put Humpty Dumpty back together again, or [choose your favorite other metaphor].
In light of The Ninth Circuit’s decision in JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Props., Inc., one might question what it takes for a chapter 11 plan to moot out an appeal from a confirmation order. Jessica Diab explained in A Word from the Ninth Circuit:  Substantial Consummation Is Not the Final Word! that the Ninth Circuit shrugged off concerns about protecting a third party investor against potential changes in a confirmed plan as a result of an appeal by the mortgage lender, concluding that a savvy investor that had been actively involved in the plan confirmation and subsequent appeals was not the type of “innocent” third party that the doctrine of equitable mootness was intended to protect.  It is worth noting that, in a strong dissent, Judge Smith noted that the effect of the opinion will be to discourage potential investors from investing until and unless a confirmation order is final and non-appealable, which could delay considerably a debtor’s emergence from chapter 11.
One might be tempted to write off the Ninth Circuit if the Third Circuit were not keeping up with the Ninth Circuit in its approach.  Charles Persons described the Third Circuit’s history on equitable mootness and its recent decision on the matter in Equitable Mootness on Life Support. The Third Circuit Further Pares Back the Abstention Doctrine in One2One Communications.  Indeed, Charles noted that In re One2One Communications reads like a plea from the Third Circuit to put an end to the doctrine of equitable mootness.  In that case, in which the appealing creditor also argued that the doctrine of equitable mootness was unconstitutional (an issue that the Third Circuit said it had no authority to decide), the Third Circuit framed the issue as whether “the plan could be retracted with great difficulty.”  The debtor had no publicly traded securities and had only one secured creditor with a claim under $100,000.  Its plan did not provide for “new financing, mergers or dissolutions of entities, issuance of stock or bonds, name change, change of business location, change in management or any other significant transactions.”  The debtor listed a number of post-confirmation transactions that would be difficult to unravel, but the Third Circuit brushed these off, noting,“These  transactions, including the investment by the Plan Sponsor, the commencement of distributions, the hiring of new employees and entering into various agreements with existing and new customers are likely to transpire in almost every bankruptcy reorganization where the appealing party is unsuccessful in obtaining (or fails to seek) a stay.”
I Guess We Can Say These Tenants “Reveled” in Their Right to Elect to Remain in Possession
Section 365(h) of the Bankruptcy Code protects lessees under real property leases rejected by debtor lessors by permitting those lessees to elect to remain in possession during the remaining term of the rejected lease (including extensions at the option of the lessee).  One possible way around this protection, though, is to argue that lessees’ rights under their agreements are not “true leases” entitled to the protection of section 365(h).  This was the tactic employed by the Revel Entertainment debtors and discussed in Yvanna Custodio’s entry, Puh­lease, It’s a Lease:  Bankruptcy Court Upholds Agreements as True Leases Entitled to Section 365(h) Protections.  Both the debtors and the purchaser of their assets (and successor to their rights) attempted to bar tenants from using premises leased by the debtors on the grounds that the leases were actually management or joint venture agreements outside the ambit of section 365(h).  Applying New Jersey law, though, the bankruptcy court disagreed and held that the leases were, in fact, true leases.  More importantly, the court went on to hold that section 363(f), which permits a sale free and clear of interests under certain circumstances, could not trump (oh, that’s another case) the rights of lessees under section 365(h).
Recent Decisions Demonstrate Inconsistent Approaches to Recharacterizing Loans as Equity
Seeking to recharacterize a loan as a disguised equity contribution, particularly when the lender is an insider of the debtor, is a favorite weapon in creditors’ arsenal.  Two recent articles discuss the approaches taken in some of the circuits and demonstrate that the circuit in which a case is pending will play a significant role in determining how likely a creditor’s challenge to a loan will be.  In Debt or Equity?  Which Circuit?  Recent Cases on Equitable Recharacterization, Brenda Funk discussed two cases relating to a “loan” made by an insider.  One arose in the Fourth Circuit, which has squarely held that the bankruptcy court’s equitable powers permit recharacterization.  Not surprisingly, the loan in that case was recharacterized.  The other arose in the Eighth Circuit, where the Court of Appeals has not ruled on whether the bankruptcy court’s equitable powers extend that far.  Because, however, the typical factors applied in determining recharacterization tipped towards finding a “true loan,” the court did not have to address whether the remedy of rechacterization was available in the Eighth Circuit.
In Tenth Circuit Declares “No Recharacterization Without Justification,” Christopher Hopkins discussed a split decision in the Tenth Circuit, in In re Alternate Fuels, Inc., that held that recharacterization is permitted under the bankruptcy court’s 105(a) equitable powers, but made it clear that the recharacterization remedy should be used sparingly.  Applying factors first set forth by the Tenth Circuit in Sender v. The Bronze Group, Ltd. (In re Hedged Investments Assoc., Inc.), the court noted that the promissory notes at issue were valid and enforceable under state law and refused to recharacterize notes held by the debtor’s sole equityholder.  Notably, although undercapitalization is a frequently cited factor, the majority cautioned against too much reliance on such factor, reasoning that the market for rescue financing  would be chilled if the recharacterization analysis placed too disproportionate weight on the poor capital condition of faltering entities.
Fewer (Creditors) Is More When It Comes to a Debtor’s Challenge to an Involuntary Filing
In most large cases, the issue of how many creditors must commence an involuntary case is irrelevant because the debtor typically will have more than the twelve creditors needed to require at least three petitioning creditors.  Abigail Lerner, however, reported on one case in which counting the number of outstanding creditors was crucial to the outcome of the involuntary case in Bankruptcy Court Reinforces the Notion That Counting Number of Eligible Creditors Commencing an Involuntary Case Really Counts.  In In re The District at McAllen, L.P., only two creditors filed the voluntary petition.  Therefore, it was crucial that the debtor prove that it had at least twelve creditors.  But, as the decision reminds us, not just any creditors.  To count as an eligible creditor for purposes of calculating the number of creditors, the creditor’s claim had to be not contingent, not subject to a bona fide dispute as to liability or amount, not held by an insider of the debtor, and unsecured.  After eliminating claims of taxing authorities with fully secured claims, insiders, creditors owed more to the debtor than they were owed by the debtor, and tenants of the debtor who held contingent claims, the number of creditors was reduced to below twelve, and only one valid petitioning creditor was required.
Tenth Circuit Clarifies individual Exemption for Distributions from Retirement Plans
Although the Weil Bankruptcy Blog tends to focus on issues relating to corporate reorganizations, we remain interested in noteworthy decisions that affect individual debtors.  Debra McElligott discussed one such case in Same Dollars, Different Treatment:  Tenth Circuit Holds That Distributions From a Retirement Plan Do Not Fall Within  the Colorado State Law Exemption Statute.  In the case, Gordon v. Wadsworth (In re Gordon), the Tenth Circuit interpreted Colorado’s exemption statute and held that payouts from individual debtors’ 401(k) retirement accounts are not exempt assets.  One issue that was somewhat unclear was whether the court’s decision extends to all payments from retirement accounts.  Debbie concludes, however, that the reasoning of the decision appears to limit its effect to prepetition payments from such accounts.