Over the past several years, certain circuits criticized the Equitable Mootness doctrine for its lack of statutory basis and effect of avoiding review of chapter 11 plans on the merits. However, the Third Circuit recently held in In re Nuverra Environmental Solutions, Inc. v. Hargreaves, Case No. 18-3084, 834 Fed. Appx. 729 (3d Cir. Jan. 6, 2021), that the Equitable Mootness doctrine is still alive and well.
The Third Circuit rejected the appeal of Hargreaves, a creditor who timely objected to the chapter 11 plan and timely appealed the bankruptcy court’s entry of the plan’s confirmation order, because the plan was already substantially consummated and could not be unwound. Further, the Third Circuit held that it could not grant Hargreaves “individualized relief” because such relief would violate Bankruptcy Code § 1123(a)(4)’s restriction on preferential treatment of class members and § 1129(b)(1)’s prohibition on unfair discrimination between classes.
In a concurring opinion, Judge Krause rejected the application of Equitable Mootness, finding the majority did not sufficiently analyze whether disparate treatment of creditors within a class is permissible on appeal when parties choose not to object to, or appeal confirmation of, the plan. Judge Krause also noted that denial of the appeal on Equitable Mootness grounds precluded consideration of substantive arguments and development of the Third Circuit’s bankruptcy jurisprudence.
While Judge Krause’s concurring opinion highlights difficulties plan objectors face when appealing plan confirmation, the majority opinion signals that Equitable Mootness is still a healthy doctrine in the Third Circuit.
By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)
One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate.
Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.
In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company.
The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.
Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.
We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.
We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.