Stockton's Bankruptcy Plan Safe From Unhappy Creditors

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By Stephanie Cumings

Dec. 17 — The City of Stockton, Calif., can rest easy after a bankruptcy appellate court refused to unravel its bankruptcy plan, finding that upsetting the plan could have a “potentially devastating impact” (Franklin High Yield Tax-Free Income Fund v. City of Stockton (In re City of Stockton), 2015 BL 408028, B.A.P. 9th Cir., No. 12-32118-CMK, 12/11/15).

Certain funds managed by Franklin Templeton Investments that are creditors in the bankruptcy complained that the $6.1 million they got in the bankruptcy plan was an insufficient portion of the over $35 million they were owed.

Judge Randall L. Dunn said that upsetting the plan at this stage would be too detrimental to other creditor groups that helped painstakingly negotiate settlements to make the plan possible, and therefore the appeal was dismissed under a doctrine called “equitable mootness.” The court also had no problem with Franklin receiving only about 1 percent of its $30 million unsecured claim, noting that Franklin was treated no worse than the other unsecured creditors who voted to accept the plan.

Equitable mootness has been a contentious topic in some circuits recently, including the Ninth Circuit.

Extensive Negotiations With Creditors

After three years of extensive negotiations, Stockton was able to exit bankruptcy in February 2015 (27 BBLR 296, 2/26/15). Stockton's negotiations with various creditor groups were largely successful, with Franklin as that only major creditor group not to reach a settlement.

Franklin opposed the bankruptcy plan, but its objections were overruled and the plan was confirmed (26 BBLR 1531, 11/6/14). Under the plan, Franklin got the full value of its secured claim and ended up getting about 17.5 percent of what it was owed overall. Like other unsecured creditors, it only received about 1 percent of its unsecured claim. Franklin tried to stay the implementation of the plan pending an appeal, but the bankruptcy court denied the motion to stay.

City Citizens Depending on Plan

Franklin appealed the order confirming the plan, arguing that the plan wasn't proposed in good faith, that it was unfairly discriminatory, and that it wasn't in the best interests of creditors, among other things. Throughout the bankruptcy process, Franklin complained it was being unfairly targeted for cuts while city pensions were being protected.

The bankruptcy appellate panel found in this case that the appeal was equitably moot, which means that despite the merits of the appeal, it would be too difficult at this point and potentially damaging to other parties to try and unwind the plan.

As a threshold matter, the court found that equitable mootness does in fact apply to Chapter 9 bankruptcies, meaning municipal bankruptcies. The court said that the doctrine has a “legitimate role to play in bankruptcy reorganization cases of all types.”

“Several hundred thousand residents depend on the [c]ity to provide future services, including police and fire protection,” the court said. “They have a legitimate concern for finality that is served by appropriate application of equitable mootness.”

‘Potentially Devastating Impact.'

The Ninth Circuit's four-factor test for applying equitable mootness looks at whether or not a stay was sought, whether or not the plan has been substantially consummated, the potential effects on third parties, and whether or not the court can grant some kind of relief without completely “knocking the props out from under the plan.”

Even though Franklin did seek a stay in this case, which weighed in its favor, the court still found the appeal moot. First, the parties agreed that the plan had already been substantially consummated.

Next, the court said reversing the confirmation order would have a “potentially devastating impact on creditor constituencies whose settlements with the [c]ity were incorporated in the [p]lan and who [were] not appearing before [the court] in this appeal,” and would leave the bankruptcy court with “an unmanageable situation on remand.”

‘Best That Can Be Done.'

“However,” the court said, “we further conclude that to the extent Franklin seeks through its appeal only a greater payment on its unsecured claim, as it concedes in the [o]bjection, an effective remedy is theoretically possible, and that claim is not equitably moot.”

But the court went on to reject Franklin's arguments on the merits that it deserved a greater portion of its unsecured claim. The court said the bankruptcy court didn't err in finding the plan was proposed in good faith.

The court also said the bankruptcy court correctly evaluated the best interests of the creditors, which is evaluated differently in a Chapter 9 municipal bankruptcy than in a Chapter 11 business reorganization. In Chapter 11, creditors can't be paid less than they would have gotten in a hypothetical Chapter 7 liquidation. As the court noted, this test doesn't transfer over to Chapter 9 because municipalities can't be liquidated.

“Ultimately, the question as to whether the [p]lan was the ‘best' available proposal for the [c]ity to pay its creditors while maintaining its capacity over time to provide essential services to its citizens as opposed to any alternative, including dismissal of the [C]hapter 9 case, was a factual finding for the bankruptcy court to make in light of the evidence before it,” the court said. “The bankruptcy court, after considering the evidence presented by the [c]ity and Franklin, determined that the [p]lan before it was ‘the best that can be done.' We conclude that the ‘best interests' test in [C]hapter 9 considers the collective interests of all concerned creditors in a municipal plan of adjustment rather than focusing on the claims of individual creditors.”

Equitable Mootness Controversy

Equitable mootness has become a controversial doctrine this year in the Third Circuit. In her concurrence in In re One2One Commc'ns, LLC, 805 F.3d 428 (3d Cir. 2015), Judge Cheryl Ann Krause had harsh words for the doctrine (27 BBLR 1013, 7/23/15).

“I write separately, however, because I do not believe we should persist in our failed attempts to cabin this legally ungrounded and practically unadministrable ‘judge-made abstention doctrine,'” Krause said. “Rather, the time has come to reconsider whether it should exist at all, and, if we conclude it should, to reform it substantially.”

Another Third Circuit judge, Judge Thomas L. Ambro, vigorously defended the merits of equitable mootness in an opinion that came out shortly after One2One called In re Tribune Media Co., 799 F.3d 272 (3d Cir. 2015) (27 BBLR 1179, 8/27/15).

The Ninth Circuit has recently experienced similar judicial discord over the issue, according to research by Bloomberg BNA. In JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Props., Inc. (In re Transwest Resort Props., Inc.), 801 F.3d 1161 (9th Cir. 2015), the court found an appeal wasn't equitably moot and warned that “[c]ourts must be cautious in applying equitable mootness when a party has been diligent about seeking a stay.” The court also rejected the argument that “substantial consummation [of the plan] creates a presumption that the appeal is moot.”

But Judge Milan D. Smith, Jr., argued in his dissent that equitable mootness was appropriate in this case and that “substantial consummation should be [the] ‘foremost consideration' in assessing equitable mootness.” Smith stressed the importance of encouraging third parties to rely on the finality of plan confirmations, saying that it's “critical to facilitating complex reorganizations.”

Judges Meredith A. Jury and Robert J. Faris joined Dunn on the three judge panel.

James O. Johnston of Jones Day, LLP, Los Angeles, and Joshua D. Morse of Jones Day, LLP, San Francisco, represented Franklin.

Christopher Cariello of Orrick, Herrington & Sutcliffe LLP, New York, Marc Aaron Levinson of Orrick, Herrington & Sutcliffe LLP, Sacramento, Calif., and Robert Loeb of Orrick, Herrington & Sutcliffe LLP, Washington, represented the city.

To contact the reporter on this story: Stephanie Cumings in Washington at sacree@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com