Thursday, October 02, 2008

Equitable Mootness Fails to Prevent Disgorgement

The Schlotzsky's case got a little woolier as the Fifth Circuit ordered that an appeal over funds disbursed from a reserve account could not be dismissed based upon equitable mootness. Wooley v. Faulkner, No. 07-50912 (5th Cir. 8/28/08).

The Schlotzsky's case involved disputes between John and Jeffrey Wooley and the Debtor. Prior to a change in management, the Wooleys (who had been officers and directors) had made secured loans to the company with the approval of the then Board of Directors. After bankruptcy, the Unsecured Creditors' Committee brought suit for equitable subordination. In an elaborate mechanism, the Wooleys received a distribution of $2,867,600 on their secured claim, but had to post a letter of credit for $2,939,200 in case the equitable subordination case went against them. Additionally, the plan created a $500,000 reserve to pay any additional secured claims allowed. After the Bankruptcy Court rendered judgment subordinating the secured claims, the Plan Administrator moved to disburse the funds in the reserve account, which the Bankruptcy Court approved. Some of the funds were used to pay the Plan Administrator's attorneys. The Wooleys appealed the adverse orders on equitable subordination and disbursement of the reserve fund.

The Fifth Circuit reversed the judgment granting equitable subordination. Wooley v. Faulker, 532 F.3d 355 (5th Cir. 2008); see "5th Circuit Rejects Equitable Subordination Claim with Deepending Insolvency Aspect," A Texas Bankruptcy Lawyer's Blog (7/1/08).

Having disposed of the first appeal, the Fifth Circuit then turned its attention to the reserve fund account. The Plan Administrator raised several arguments, but the most interesting one was equitable mootness. There are numerous instances in which equitable mootness will prevent an appeal from proceeding where a stay pending appeal is not obtained and the parties have acted in reliance on the order. In those cases, the appeal may be dismissed for equitable mootness. Plan confirmations are the type of order to which equitable mootness may apply.

The Fifth Circuit described the doctrine as follows:

'The concept of [equitable] 'mootness' from a prudential standpoint protects the interest of non-adverse third parties who are not before the reviewing court but who have acted in reliance on the plan as implemented.' The ultimate question to be decided is whether the Court can grant relief without undermining the plan and thereby, affecting third parties. For the doctrine of equitable mootness to apply, the Court must determine: "...(i) whether a stay has been obtained, (ii) whether the plan has been 'substantially consummated,' and (iii) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.'
Opinion, p. 6.

At first blush, the requirements seemed to be satisfiable. The Wooleys had asked for a stay pending appeal, which was denied and the plan had been substantially consummated. The difficult question was whether the appeal would affect the rights of parties not before the court or the success of the plan. The Wooleys made a wise tactical decision to limit their appeal to seeking disgorgement only of the fees paid to the Plan Administrator's counsel. The Fifth Circuit was quick to point out that they were not seeking the return of money paid to third party creditors.

In an interesting use of a double negative, the Fifth Circuit stated that the Plan Administrator's counsel "is not a party who is not before the court." (italics in original). In other words, even though the Plan Administrator's counsel was not a formal party to the appeal, they were before the court in a very practical sense of the term. The Fifth Circuit also noted that equitable mootness should not be used to prevent the disgorgement and return to the estate of attorney's fees.

In the final analysis, the Fifth Circuit remanded the case for a determination of the additional secured claim held by the Wooleys and ordered that the Plan Administrator's attorneys disgorge their attorney's fees paid out of the reserve to the extent necessary to satisfy whatever secured claim was allowed.

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