Another chapter has unfolded in Austin’s development wars with the denial of the plan of reorganization proposed by the Save Our Springs Alliance. In re Save Our Springs (S.O.S.) Alliance, Inc., No. 07-10642 (Bankr. W.D. Tex. 4/11/08). While the case was a defeat for the debtor, it provides a wealth of useful case law for chapter 11 lawyers. It also provides a detailed examination of issues unique to a non-profit corporation attempting to reorganize. The issues discussed here could easily apply to a church or a cooperative as well.
Background
SOS is a “citizen action group whose primary purpose is to advance community awareness of water pollution and to protect water sources such as Barton Creek, the watershed in the surrounding community, and the Edwards Aquifer, which is the primary or only water supply in central and south Texas.” Memorandum Opinion, p. 4. One method that SOS used to advance its goals was to pursue litigation against developers.
Three of those lawsuits ended badly for SOS with the nonprofit being ordered to pay hundreds of thousands of dollars in attorney’s fees. This posed a quandary for the debtor. The corporation depended upon its contributions for its funding. However, environmentally minded donors were unlikely to make contributions for the purpose of paying attorney’s fees to developers. As a result, contributions either dried up or came with strings attached which prohibited their use to pay the judgments.
In addition to the judgment creditors, SOS owed $175,000 to Kirk Mitchell, one of its founders and largest donors. Mr. Mitchell had guaranteed a bank loan to SOS and was forced to pay off the debt when his guaranty was called. This left Mr. Mitchell holding a claim secured by all of the debtor’s assets.
SOS filed chapter 11 to try to work out of this dilemma. It proposed a plan which offered to raise $60,000 in contributions to pay its unsecured creditors. Those creditors were divided into three classes despite the fact that they would each receive a pro rata share of the same pot. Class 4 contained the claim of Sweetwater Austin Properties, LLC, the largest judgment creditor. Class 5 consisted of two other judgment creditors whose judgments were not yet final. Class 6 consisted of its other unsecured creditors, including the deficiency claim of Kirk Mitchell. Classes 4 and 5 voted to reject the plan, while Class 6 voted to accept. The debtor negotiated settlements with the two judgment creditors in class 5 which resulted in their votes changing to accept the plan.
This left the debtor in a confirmation battle with its largest creditor. The pleadings framed issues of which party was acting in good faith. The debtor accused Sweetwater of casting its ballot in bad faith for the ulterior motive of putting the environmental group out of business, while Sweetwater accused the debtor of gerrymandering its classes to engineer acceptance by a class and offering an infeasible yet inadequate payment to creditors.
The Court conducted the confirmation hearing over five days and then took the case under advisement. The Court’s 68-page ruling addressed the following issues (plus several others):
1. Whether SOS as a small business debtor had met its burden to extend the 45 day period to confirm a plan;
2. Whether the ballot of Sweetwater should designated as having been cast in bad faith;
3. Whether the debtor improperly gerrymandered its unsecured classes;
4. Whether the plan met the chapter 7 liquidation test;
5. Whether the plan was feasible;
6. Whether the plan satisfied the absolute priority rule; and
7. Whether the plan was proposed in good faith.
Timely Confirmation
Section 1121(e)(3) posed a difficult problem for the court. The Code requires a small business chapter 11 debtor to confirm its plan within 45 days after being filed. The confirmation hearing began on the last day of the period. The debtor filed a motion to extend the 45 day period which was heard on the first day of trial. Sweetwater argued that the debtor had failed to meet its burden to show that it was more likely than not that the debtor would confirm a plan within a reasonable time. With only one day of testimony received, it was objectively impossible to tell whether the plan was likely to be confirmed.
This raised a conundrum. If taken literally, a debtor could never obtain an extension to confirm a plan unless the confirmation hearing had already proceeded to the point where it was clear that the debtor was going to win. As a result, the more complex the case, the less likely it was that the debtor could meet its burden to gain an extension of time to complete the confirmation hearing. As the court pointed out:
“(U)nless a debtor is able to file and obtain a hearing on its motion to extend time well in advance of the end of the 45-day period, no purpose would be served by hearing the motion to extend time separately from the confirmation hearing. That is because the evidence that would allow the court to make the factual findings required by §1121(e)(3) is virtually the same as that which would be offered at the confirmation hearing. Thus, in most instances the debtor will have to act so that the confirmation hearing itself can be scheduled, conducted and concluded, and an order entered, within 45 days of the date the plan is filed. In many if not most cases this presents virtually insurmountable obstacles, particularly when the plan is amended after filing.”
Memorandum Opinion, at 30-31.
The Court found that the strict deadlines imposed by BAPCPA were unworkable. In their place, the court substituted a requirement that the debtor act promptly to bring its case and to trial and to request an extension of time.
“The Court finds BAPCPA’s small business confirmation deadlines provisions—the onerous showing required under §1121(e)(3) to get an extension, combined with the accelerated timeline for making that showing under §§1121(e)(3) and 1129(e)—are simply unworkable under the facts of this case. The Court is therefore reluctant to impose on the Debtor the full consequences of a failure to meet §1121(e)’s deadline, inasmuch as that failure was due to the impossibility of the Court’s receiving and considering the evidence in time to make the findings required to rule on the requested extension of that deadline.”
Memorandum Opinion at 34. As a result, the Court extended the deadline through the ruling on confirmation. However, because the Court denied confirmation of Debtor’s plan, it declined to grant the Debtor any further extension.
Motion to Designate Ballot
The opinion also considered whether the creditor’s ballot was cast in bad faith. Section 1126(e) allows the Court to disregard a ballot “whose acceptance or rejection . . . was not in good faith.” Although this provision is infrequently used, it will allow a ballot to be disregarded when the creditor acts with an unacceptable ulterior motive. The Debtor contended that Sweetwater opposed the plan for the ulterior purpose of putting SOS out of business and avoiding litigation over future developments. Sweetwater, on the other hand, contended that it merely sought to obtain the best recovery for its claim.
The Court found that it was not bad faith for a creditor to act according to its economic self-interest. Moreover, the creditor was entitled to be the sole judge of what was in its economic self-interest. As a result, the Debtor could not successfully argue that the creditor must be acting in bad faith because it would not receive a better bargain if the Debtor’s plan was denied.
The Court quoted from a leading opinion which stated:
“Too, what debtors think represents a ‘good deal’ may not look so rosy from a creditor’s point of view, and the voting process is expressly designed to give creditors the opportunity to express how the plan looks to them. The fact that a creditor may not know what is good for it, therefore, can again, of itself, not be grounds for disqualifying that creditor’s vote.”
Memorandum Opinion, page 39, quoting In re The Landing Associates, Ltd., 157 B.R. 791, 807 (Bankr. W.D. Tex. 1993).
Additionally, the Court found that the creditor was acting in its economic self-interest where it sought to prevent confirmation of the plan for the purpose of undercutting the Debtor’s ability to litigate the allowance of the creditor’s claim. This motivation also related to the creditor’s economic self-interest.
Ultimately, the Court found that it was just as likely that the creditor was acting in a defensive posture (that is, to prevent the debtor from imposing an unfavorable result on it) rather than offensively (that is, to take out a rival in the development wars).
Classification
The classification scheme in this case was reminiscent of the one from In re Greystone III Joint Venture, 995 F.2d 1274 (5th Cir. 1991). In Greystone, the Debtor proposed two classes of unsecured claims based on their separate legal status and motivation to vote on the plan. However, the plan provided the same treatment to both. The Fifth Circuit rejected this argument, finding that there was a presumption that all similar claims be classified together and that “thou shalt not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan.” The Fifth Circuit found that separate classification could be warranted based on legitimate business reasons, but that legitimate business reasons were not present when the debtor proposed to give the two classes exactly the same treatment.
In this case, the Court found that the plan as originally proposed contained gerrymandering between classes 4, 5 and 6. However, once the Debtor settled with the creditors in Class 5, those claims were no longer similar in nature to the claims in classes 4 and 6. There were good business reasons for separately classifying the claims in class 5 because the treatment of those claims included additional provisions relating to the settlement. “A creditor’s ongoing involvement in litigation with the debtor has been held to be . . . a non-creditor interest, justifying separate classification of the claim.” Memorandum Opinion, at 47. Thus, although the plan as originally proposed involved unacceptable gerrymandering, and although the plan continued to gerrymander the separate classification of classes 4 (Sweetwater) and 6 (general unsecured creditors), separate classification of class 5 was not only permissible but required. This meant that the debtor succeeded in obtaining one accepting class of claims despite the gerrymandering finding.
Chapter 7 Liquidation Test
While Sweetwater argued that the debtor did not meet the best interests of creditors test, this was not a particularly difficult burden to meet. In this case, the Debtor was a non-profit corporation dependent on contributions for its operations. The Debtor convincingly testified that its meager assets, consisting of a conservation easement, some office furniture and computers, its name and its mailing list, were worth much less than the secured debt against them. As a result, any payment to unsecured creditors exceeded what they would receive in a chapter 7 liquidation. Like the union in In re General Teamsters, Warehousemen and Helpers Union Local 890 (9th Cir. 2001), the right to collect future contributions was not an asset which could be liquidated in a chapter 7 case.
Feasibilty
Feasibilty proved to be the Achilles Heel of this plan. The Debtor proposed to raise a fund of $60,000 to pay its unsecured creditors. The Court found that to satisfy the feasibility standard “a reasonable prospect of success must be shown” and that most courts require “specific, concrete evidence to support feasibility.” Memorandum Opinion, page 53.
The Plan allowed the Debtor 60 days to raise the $60,000 payment to be made to unsecured creditors. However, as of confirmation, the Debtor only had commitments for $12,500. The Court found that under this record, feasibility was lacking.
“The evidence was clear that the Debtor had not raised the $60,000 as of the confirmation hearing. The fact that SOS built into its Plan a delay in its obligation to obtain those funds does not relieve it of its burden to show that it will be able to perform under the Plan. True, under the terms of para. 7.3, it would not be in default the moment an order confirming the plan were entered but would have time to obtain more contributions to fund the Creditor Settlement Fund. However, it offered no evidence at the hearing to show that it could meet that obligation—no commitments, no evidence of relevant past performance, nothing. On the contrary, Kirk Mitchell testified that as of the date of the hearing he had expressly not agreed to contribute any amount to be used to fund the Creditor Settlement Fund.”
Memorandum Opinion at 53.
The Debtor argued that because the plan provided that failure to raise the necessary funds would be an event of default which would return the parties to the status quo that feasibility was a non issue. The Court found that, “Such a provision, rather than curing the Debtor’s failure to show the Plan is feasible, merely highlights that failure.” Memorandum Opinion at 57.
Thus, because the Debtor’s contributors would not commit to fund the Plan in advance, the Plan was defeated.
Absolute Priority Rule
While the absolute priority rule is a major focus of most chapter 11 cases involving cram-down, it was of little consequence to SOS. The absolute priority rule requires that junior classes not receive or retain any interest unless senior classes are paid in full. In the typical case, equity must be cancelled unless unsecured claims are paid in full. However, a non-profit corporation does not have equity holders. The members of a non-profit corporation may direct its affairs, but do not own an interest in the corporation. The laws of most states provide that upon dissolution, the assets of a non-profit corporation must be transferred to another non-profit entity.
In this case, Sweetwater made the novel argument that claims of insiders should be subordinated and not receive any distribution unless its claim was paid in full. Thus, the creditor argued that insider claims should be treated as de facto equity. The Court dismissed this argument, stating that “Several courts have expressed the opinion that the claim of an insider or equity holder may not be treated unequally unless the insider or equity holder used superior knowledge concerning the debtor’s affairs in an unfair manner or equitable subordination principles otherwise apply.” Memorandum Opinion at 61.
Good Faith
Good faith is shown where the plan is “proposed with the legitimate and honest purpose to reorganize and has a reasonable hope of success.” In re Sun Country Development, Inc., 764 F.2d 406, 408 (5th Cir. 1985). The Court found that, “”While the question is a close one precisely because of the Plan’s impermissible classification scheme and the small size of the payments proposed, the Court nevertheless finds that its provisions for Sweetewater’s claim . . . does not amount to bad faith.” Memorandum Opinion at 64.
One issue considered by the Court was whether the Debtor had played fast and loose with its donations for the purpose of evading creditors. Once the Debtor had judgments rendered against it, contributors began making “restricted” gifts which could not be used to pay the judgments. However, these restricted funds were commingled with the Debtor’s other assets. On the eve of bankruptcy, the Debtor transferred $31,156.21 into an Education & Outreach Fund. Based upon a tracing analysis, the Court found that at least half of these funds were unrestricted funds and that a portion of the restricted funds had been spent on other purposes. The Court found that the portion of these funds constituting “restricted” funds were not property of the estate despite the fact that they had been commingled. The Court also found that these facts did not establish bad faith.
“The Court finds, however, that the Debtor’s apparent unauthorized use of restricted funds should not override the express intent of the donors, and should therefore not destroy the overall character of the funds as restricted. The evidence on the issue was limited to the Debtor’s inability to explain the accounting that indicates its use of some of the funds was not authorized. The Court finds, however, that there was insufficient evidence to establish any sort of complicity between the Debtor and the donors, and or malfeasance or bad faith on the part of the Debtor. Confirmation of this Debtor’s Plan has presented a number of unusual and even unique issues, including what a Debtor in SOS’s position can and must offer creditors when its source of income is donors who have the right to choose whether or not to fund a plan. Based on all the evidence presented and the totality of the circumstances of this case, the Court finds and concludes that there was no credible evidence that the Plan was proposed with bad intent or malfeasance, or in contravention of any applicable law.”
Memorandum Opinion at 67-68.
Where Does This Leave the Parties?
At the end of the day, the Debtor’s Plan was not confirmed. The Debtor is past its 300 day window to propose a plan and past its 45-day window to confirm the previously filed plan. On the other hand, the Debtor’s assets remain encumbered by a lien held by a friendly party which greatly exceeds their value. Donors cannot be forced to contribute funds to pay the claim of Sweetwater. As a result, it appears that the decision leaves the parties in a stalemate.
Disclaimer: The law firm that I work for was a small unsecured creditor in this case. We voted to accept the plan.
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