Restructuring

Contributed by Kyle J. Ortiz
The United States Court of Appeals for the Third Circuit recently held in In re Philadelphia Newspapers, LLC, No. 11-3257 (3d Cir. July 26, 2012) that an appeal cannot be dismissed as equitably moot solely on the basis that a chapter 11 plan has been substantially consummated.  The underlying action concerned a request for an administrative expense claim pursuant to section 503(b) of the Bankruptcy Code in connection with an alleged postpetition act of defamation.  Prepetition, the claimants sued the debtors (the parent company of the Philadelphia Inquirer) alleging that the Inquirer had published defamatory articles about the claimant’s charter school company.  After the bankruptcy filing, claimants asserted administrative expense claims based on articles posted on the Inquirer’s website postpetition that allegedly linked to the earlier articles.  The Bankruptcy Court for the United States District Court for the Eastern District of Pennsylvania held that the claimants had failed to demonstrate entitlement to an administrative expense claim.
Shortly after the bankruptcy court’s decision, the debtors sold all of their assets for $105 million under the terms of their chapter 11 plan.  As part of the purchase agreement, the buyer agreed to assume certain administrative expense claims, but not the defamation claims.
On appeal to the United States District Court for the Eastern District of Pennsylvania the district court held that the appeal was “equitably moot” because the debtor’s plan “had been substantially consummated and no stay was sought.”  The doctrine of equitable mootness allows for dismissal of a bankruptcy appeal where granting an appellate remedy would knock the props out from under a confirmed plan.  Notwithstanding its conclusion that the appeal should be dismissed under the equitable mootness doctrine, the district court went on to consider the merits and affirmed the bankruptcy court’s decision that the claimants had failed to demonstrate any entitlement to an administrative expense claim because courts have “uniformly held” that the mere posting of a link to another article containing allegedly defamatory remarks “is not a distinct tortious conduct upon which a defamation claim can be grounded.”  The claimants then appealed to the Third Circuit.
The Third Circuit held that the district court erred when it concluded that the appeal was equitably moot based on the plan’s substantial consummation.  The appellate court found the equitable mootness standard applied by the district court to be overly broad and held that the equitable mootness doctrine should only be invoked in situations where “a successful appeal would be fatal to a plan,” leading to a “perverse outcome” such as “injury to third parties . . . who have relied on [a] confirmed plan.”
To determine if the claimant’s appeal would result in such an outcome, the court stated that the district court should have considered the “prudential factors” set forth in the Third Circuit’s decision in In re Continental Airlines, which are:

(1) whether the reorganization plan has been substantially consummated, (2) whether a stay has been obtained, (3) whether the relief requested would affect the rights of parties not before the court, (4) whether the relief requested would affect the success of the plan, and (5) the public policy of affording finality to bankruptcy judgments.

The Third Circuit noted that the district court had only considered the first two “prudential factors.”  Furthermore, the district court had misapplied the first factor, which the Third Circuit held, despite its literal language, “requires that a court consider whether allowing an appeal to go forward will undermine the plan, and not merely whether the plan has been substantially consummated under the Bankruptcy Code’s definition.”
Applying this first factor, the appellate court noted that, although the plan was substantially consummated in a “definitional sense,” a ruling in favor of the claimants would not “upset” the plan.  Turning to the second factor, the court stated that it is largely duplicative of the first and should only carry weight if failure to seek a stay results in a reorganization plan being confirmed.  Although that is exactly what occurred in the present case, the court stated that the claimants should not be faulted for failing to seek a stay because the debtors should have set aside sufficient funds under the plan to provide for the contingency that the claims would become allowed.  With regard to the third factor, the court noted that because the plan provided for a mechanism to pay disputed administrative expense claims, the appeal could proceed without causing substantial harm to other creditors.  The court found that the plan’s success, the fourth factor, would not be affected should the appeal be successful because the administrative expense request was not considered by the purchaser buying the debtors assets pursuant to the plan and only represented 1.7% of the value of the assets sold pursuant to the plan.  In light of the above findings, the Third Circuit concluded that the first four factors weighed in favor of a finding that the appeal was not equitably moot and should be permitted to proceed.  Additionally, although the court acknowledged that the fifth factor favored equitable mootness because allowing the appeal to proceed would necessarily run the risk of interfering with the finality of the bankruptcy court’s decision, this factor was not controlling because the appeal would not unscramble the plan or upset the rights of other parties.
The Third Circuit’s analysis and holding raises numerous issues.  The first is what sort of possible impact an appeal must have before it will be considered to have the potential to “undermine” a plan.  In the present case, the court characterized an administrative expense claim for 1.7% of the value of the purchase price as insignificant and unlikely to upset the plan or the rights of other parties.  Those at risk of having their payout under the plan reduced by 1.7% likely would not agree with that assessment.  In this case, the purchaser expressly agreed to assume certain administrative expense claims, but had not agreed to assume the risk of liability for the defamation claims.  Thus, it is quite possible that the buyer may not have been willing to purchase had it known there was a risk the value of the assets they were purchasing could be reduced by such an amount.  One issue the Third Circuit did not address is the possible cumulative effect of numerous “small” appeals chipping away at the foundation of a plan.  In large and complex bankruptcies the cumulative effect of several smaller appeals could have a disruptive impact on a confirmed plan and significantly impact the rights of those who relied on the finality of a confirmed plan.
These questions may have been left unresolved because the Third Circuit wants district courts to consider these issues on a case by case basis by applying the “prudential factors.”  The Third Circuit in Philadelphia Newspapers seemed most bothered by the impression that the district court had failed to undertake any analysis and based its equitable mootness holding solely on the substantial consummation of the plan.  The Third Circuit did, however, hint at broader concerns about the balance of power between bankruptcy and district courts.  This concern was expressed in a footnote where the appellate court highlighted the unease expressed by Judge (now Supreme Court Justice) Alito in his dissent in the Continental case.  In the Continental dissent, Judge Alito posited that an expansive use of the equitable mootness doctrine risked placing “too much power in the hands of bankruptcy judges,” because it can foreclose appellate review of bankruptcy court orders confirming plans.
Whatever the Third Circuit’s ultimate intent was, the decision adds an element of uncertainty for debtors and creditors alike as to the finality of confirmed chapter 11 plans.  For the defamation claimants in Philadelphia Newspapers, however, reversal of the equitable mootness decision turned out to be a pyrrhic victory because the Third Circuit also affirmed the district court’s judgment that the claimants were not entitled to administrative expense priority on their defamation claims.