Sunday, April 13, 2008

Plan Proposed by Environmental Advocate Save Our Springs Alliance Denied Based Upon Lack of Feasibility

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.


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).


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 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.

Tuesday, April 08, 2008

Fifth Circuit Clarifies Requirements of Rule 9011

The Fifth Circuit has written a new opinion requiring strict compliance with Rule 9011 prior to awarding sanctions. The Cadle Company v. Pratt, No. 07-10457 (4/8/08). Specifically, the Fifth Circuit held that prior to seeking sanctions under Rule 9011, the movant must serve a copy of the actual motion on the respondent 21 days prior to filing it and that a mere letter threatening sanctions was inadequate.

In Pratt, the Cadle Company objected to a debtor's discharge. The debtor failed to disclose his right to receive payments under his mother's will, but testified persuasively that he owed more in loans received from his mother than the distribution he would have received from her estate. Subsequently, the Cadle Company learned that the debtor had received loans from his mother's estate after her death. It is not clear from the opinion why this fact was significant. Perhaps Cadle viewed the estate loans as disguised distributions or perhaps they contradicted the testimony that loans were made during the mother's lifetime. At any rate, the Cadle Company blamed the debtor's lawyer for the non-disclosure of this fact.

Prior to filing a motion for sanctions, the Cadle Company sent not one but two letters to the debtor's lawyer alleging a Rule 9011 violation. However, when the motion came up for hearing, the Bankruptcy Court denied it because: (a) the Cadle Company had not served its proposed motion on the debtor's lawyer 21 days before filing it; and (b) the debtor's lawyer did not do anything sanctionable. The Bankruptcy Court then went on to award sanctions against the Cadle Company for bringing a frivolous motion for sanctions.

On appeal, the District Court affirmed the denial of the Cadle sanctions motion, but remanded the award of sanctions against Cadle for further consideration. Cadle appealed to the Fifth Circuit.

The Fifth Circuit affirmed the denial of the Cadle sanctions motion. It held that an informal notice did not meet the requirements of Rule 9011. In pertinent part Rule 9011 provides:

"The motion for sanctions may not be filed with or presented to the court unless, within 21 days after service of the motion (or such other period as the court may prescribe), the challenged paper, claim, defense, contention, allegation, or denial is not withdrawn or appropriately corrected, except that this limitation shall not apply if the conduct alleged is the filing of a petition in violation of subdivision (b)."

While the rule is not a model of drafting clarity, the Fifth Circuit sided with the Fourth, Eighth, Ninth and Tenth Circuits and rejected an opinion from the Seventh Circuit to hold that Rule 9011 requires that the party to be sanctioned be served with the actual motion 21 days before it is filed.

The practical difficulty lies in reconciling the language "may not be filed with or presented to the court" with "after service of the motion." On the one hand "service of the motion" is typically understood to refer to service of a motion which has been filed with the court. On the other hand, the preceeding language, says that the motion may not be filed until 21 days after it has been served. The Fifth Circuit reconciles this conflict (without expressly addressing it) by holding that the motion must be served before filing (and presumably then served again after filing).

The ruling of the Court of Appeals smooths over a difficultly worded rule. It adopts a policy position that sanctions should be an exceptional remedy and not just an added bonus for a victorious party. By requiring pre-filing "service" of the proposed motion, it requires the aggrieved party to stop and methodically lay out why the pleading is sanctionable rather than merely firing off a letter in anger or an excess of testosterone.

In addition to its main focus, the opinion contains an interesting discussion of finality for purposes of appeal. In this case, the District Court reversed and remanded. Only final orders may be appealed from the District Court to the Fifth Circuit. In this case, the Fifth Circuit held that the portion of the District Court opinion which affirmed the denial of sanctions to the Cadle Company was final and could be appealed, while the portion which remanded the sanctions against the Cadle Company was interlocutory and could not be appealed. The fact that a single order could be partially appealable and partially non-appealable provides a trap for the unwary. Here, appellate practice is like voting in Chicago or South Texas: appeal early and often.

Wednesday, April 02, 2008

Minority Position on Surrendering Vehicles Subject to Hanging Paragraph Gains Support; Automobile Lenders Allowed Deficiency Claims

Some of the architects of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) have said that they would not change a word of this complex legislation. However, some of those words have left judges scratching their heads. One of the more troublesome provisions has been the so-called “hanging paragraph” of 11 U.S.C. Sec. 1325(a). Immediately following Sec. 1325(a)(9), it provides that the valuation provisions of Sec. 506(a) do not apply to a loan for purchase of a vehicle for personal use incurred within 910 days prior to bankruptcy.

In one context, the hanging paragraph is clear. If a debtor intends to retain a 910-day vehicle, he must pay the full amount owed regardless of its value. However, does the same logic apply in reverse? If the debtor elects to surrender the vehicle, must the lender give credit for the full amount of the debt regardless of the value?

The symmetry of an anti-valuation provision which applied in both directions (that is, retaining or surrendering) appealed to several courts. In fact, it became known as the majority position. Examples of this position include In re Payne, 347 B.R. 278 (Bankr. S.D. Ohio 2006); In re Turkowitch, 355 B.R. 120 (Bankr. E.D. Wis. 2006); In re Gentry, 2006 WL 3392947 (Bankr. E.D. Tenn. 11/22/06); In re Quick, 360 B.R. 722 (Bankr N.D. Okla. 2007).

However, several recent appellate decisions may have shifted the weight of authority. Four cases from the Sixth, Seventh and Eighth Circuits have all held that surrender of a 910-day vehicle does not prevent the creditor from filing an unsecured deficiency claim. In re Long, 2008 U.S. App. LEXIS 4549 (6th Cir. 3/4/08); AmeriCredit Financial Services, Inc. vs. Moore, 2008 U.S. App. LEXIS 2497 (8th Cir. 2/5/08); Capital One Auto Finance vs. Osborn, 515 F.3d 817 (8th Cir. 2008); Matter of Wright, 492 F.3d 829 (7th Cir. 2007). These cases take a broader look at the application of Sec. 502 and 506 to determine that a deficiency claim is not barred. Basically, they hold that Sec. 506(a) only applies to determination of a claim secured by property of the estate. Once the secured property is surrendered, the estate no longer has an interest in property to be valued. From that point, the issue shifts to Sec. 502, which determines allowance of claims. Because Sec. 502 does not contain any provision requiring disallowance of a 910-day deficiency claim, the claim should be allowed.

Within Texas, this shift in position should not affect a major change. Several Texas courts were already following the “minority” position adopted by the recent appellate opinions. In re Aguerro, No. 07-12195 (Bankr. W.D. Tex. 3/30/08)(Gargotta, B.J.); In re Newberry, 2007 Bankr. LEXIS 1589 (Bankr. W.D. Tex. 2007)(McGuire, B.J.); In re Gay, 375 B.R. 343 (Bankr. E.D. Tex. 2007)(Parker, B.J.).

In most cases, allowing or disallowing a deficiency claim will not have a major effect on the debtor, since the typical chapter 13 plan pays unsecured creditors mere pennies on the dollar. However, in some instances it could make a lot of difference. In re Esparza, No. 06-31040 (Bankr.W.D. Tex. 5/9/07) was just such a case. In Esparza, the debtors financed two vehicles with GECU. One vehicle was purchased within 910 days and the other was not. The debtors elected to surrender the 910 day vehicle, which resulted in a deficiency. Because the two loans were cross-collateralized, the deficiency from the surrendered vehicle attached to the retained vehicle. Because the balance owed on the retained vehicle was small enough, the value of this vehicle was sufficient to secured both the remaining value on the vehicle financed and the deficiency on the surrendered vehicle. If the one vehicle could have been surrendered in full satisfaction of the debt, the amount to be paid on the retained vehicle would have been much less. Thus, because the hanging paragraph did not mandate full satisfaction of the debt, the debtors had to pay an extra $11,809.84 as a secured claim. The only way to have avoided this result would have been to retain both vehicles (in which case the 910-day vehicle would have been required to be paid in full) or to surrender both vehicles in which case the deficiency, if any, would have been a mere unsecured claim).

Note: The original version of this article erroneously referred to In re Dominquez, No. 06-31167 (Bankr. W.D. Tex. 5/11/07) instead of In re Esparza, No. 06-31040 (Bankr. W.D. Tex. 5/9/07). The article has been corrected and now refers to the appropriate case.