Third Circuit Reiterates Narrow Application of Equitable Mootness Doctrine

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[authors: Christopher J. Updike, Michael A. Stevens]

The United States Court of Appeals for the Third Circuit recently reiterated its position that the doctrine of equitable mootness should only apply if granting relief on appeal would undermine a consummated bankruptcy plan. In In re Philadelphia Newspapers, LLC, the Third Circuit held that the United States District Court for the Eastern District of Pennsylvania abused its discretion when summarily finding that the appeal at issue was equitably moot simply because the appellants failed to seek a stay and the debtors’ plan had been substantially consummated. Upon a more careful review of the equitable mootness test enunciated by the Third Circuit en banc in In re Continental Airlines, 91 F.3d 553 (3d Cir. 1996), the Philadelphia Newspapers court found that the appeal should proceed. However, it ultimately affirmed the ruling of the district court that managers of a charter school were not entitled to an administrative expense claim for the debtors’ postpetition internet publication of an article that linked to other allegedly defamatory articles that the debtors published prepetition. See In re Philadelphia Newspapers, LLC, 2012 WL 3038578 (3d Cir. July 26, 2012).

Equitable Mootness

The doctrine of “equitable mootness” remains a tricky concept. Unlike constitutional mootness, which requires dismissal of an appeal if it is impossible for the court to grant any effectual relief, equitable mootness occurs when, even though relief could conceivably be fashioned, implementation of such relief would be inequitable.  The difference is inability versus unwillingness to alter the outcome on appeal. Thus, equitable mootness is cautiously applied to avoid unnecessarily undermining an appellant’s statutory right to appeal.

Courts consider different combinations of prudential factors when determining whether to dismiss an appeal on equitable mootness grounds, including: (i) whether the debtors’ bankruptcy plan has been substantially consummated, (ii) whether a stay has been diligently sought and obtained, (iii) whether the relief requested would affect the rights of third parties not before the court, (iv) whether the relief requested would affect the success of the debtor’s plan, (v) the policy favoring the finality of bankruptcy decisions, (vi) whether the relief requested will affect the reemergence of the debtor as a revitalized corporate entity, and (vii) whether the appellant’s challenge is legally meritorious or equitably compelling. The Third Circuit employs a test using the first five of these factors.

Courts disagree as to which factor is most important. The foremost concern for some is whether the rights of third parties will be affected (Sixth and Tenth Circuits), while others emphasize whether the debtor’s plan has been substantially consummated (Second and Third Circuits). In some jurisdictions, failure to seek a stay may, by itself, render a party’s appeal equitably moot (Ninth Circuit). There is even a circuit split as to the standard for reviewing equitable mootness decisions (de novo v. abuse of discretion) and the applicable burden of persuasion (steadfast burden on party asserting equitable mootness v. shifting burden upon showing of substantial consummation).

The Supreme Court has yet to settle any of these disparities and has denied petitions for writs of certiorari with respect to equitable mootness decisions on at least three separate occasions, perhaps due to a hesitancy to interfere with district courts’ discretionary balancing of equitable and prudential considerations in bankruptcy appeals.

Background

Prior to commencement of the Philadelphia Newspapers chapter 11 cases, the managers of a charter school initiated a defamation action in Pennsylvania state court against the debtors in response to articles that The Philadelphia Inquirer published regarding the management of the charter school. During the postpetition period, the debtors published an online editorial that referenced these articles and provided a link to a webpage where readers could access the articles. The managers filed administrative expense requests against the debtors, arguing that they held postpetition defamation claims because the editorial’s reference and link to the articles constituted a “republishing” of the original articles and new acts of defamation. The debtors objected to the administrative expense requests, and after an evidentiary hearing, the bankruptcy court held that the managers failed to demonstrate their entitlement to an administrative expense.

The managers timely appealed this ruling, but did not seek a stay pending appeal. Before the district court ruled on the merits of the appeal, the bankruptcy court confirmed the debtors’ fifth plan of reorganization, and the sale of substantially all of the debtors’ assets pursuant to the plan was consummated. In a very cursory order, the district court held that the appeal was rendered equitably moot based solely on the fact that the plan had been substantially consummated and the managers had not sought a stay, without any consideration of the other Continental factors. However, the district court went on to consider the merits of the appeal and affirmed the bankruptcy court’s denial of the managers’ administrative expense requests.

The Third Circuit’s Decision

On appeal, the Third Circuit took issue with the district court’s equitable mootness determination. As an initial matter, the Third Circuit held that the district court misapplied the first factor of the Continental test – whether the debtor’s plan has been substantially consummated. Although facially straightforward, the Court held that this factor “requires that a court consider whether allowing an appeal to go forward will undermine the plan, and not merely whether the plan has been substantially consummated under the Bankruptcy Code’s definition,” an interpretation that renders the first Continental factor practically duplicative of the fourth (whether the relief requested would affect the success of the plan). Philadelphia Newspapers, 2012 WL 3038578, at *4.

The Third Circuit’s expansion of this factor appears to have begun with its 2003 decision in United States Tr. v. Official Comm. of Equity Sec. Holders (In re Zenith Elecs. Corp.), 329 F.3d 338 (3d Cir. 2003), where the Court also overturned a district court’s equitable mootness decision because it erred in applying the first factor. According to the Zenith court, the factor “does not merely entail a formalistic inquiry into whether the plan has been substantially consummated under the definition in the Bankruptcy Code,” but also requires a consideration of “the probability that granting the appeal would unravel the plan.” Zenith, 329 F.3d at 343-44. Thus, the Zenith court held in that case that the appeal was not equitably moot because the relief requested – disgorgement of $76,500 in professional fees – would not necessitate the reversal or unraveling of the entire reorganization plan.

In Philadelphia Newspapers, the Third Circuit again held that although the debtors’ plan had been substantially consummated in the definitional sense, the allowance of the appellants’ administrative expense requests – which would only account for 1.7% of the debtors’ sale proceeds – would not upset the plan because the plan provides for the payment of allowed administrative expenses from a segregated account. Therefore, the first factor weighed against equitable mootness.

Notably, the Third Circuit found a similar appeal equitably moot in Contintental. In that case the debtors’ secured lenders sought adequate protection in the form of an $117 million administrative expense claim, which was denied by the bankruptcy court. The disallowance was incorporated into the court’s confirmation order because consummation of the debtors’ plan was conditioned upon the total amount of allowed administrative expenses not exceeding a cap negotiated between the debtors and their proposed investors under the plan. If the secured lenders’ administrative expense claim was allowed, the cap would have been busted, allowing the investors to walk and thereby jeopardizing the debtors’ reorganization. Following disallowance of the claim, the lenders sought, but did not obtain, a stay pending appeal and the plan was consummated. The district court refused to hear the appeal as equitably moot and the Third Circuit affirmed the decision.

The Philadelphia Newspapers court, however, distinguished Continental. The administrative expenses at issue in Continental were obviously larger, but more importantly, both the plan and the sale agreement in Philadelphia Newspapers provided that the debtors, rather than any third-party purchaser or investor, would be responsible for the payment of administrative expenses. Thus, allowing the administrative expenses sought by the charter school managers would not necessarily knock the props out from under the Philadelphia Newspapers plan, as was the case in Continental.

The Court then went on to analyze the remaining factors of the Continental test, but noted that they largely “duplicate”, “replicate”, or “support” the first factor. Philadelphia Newspapers, 2012 WL 3038578, at *4-5. Thus, the Third Circuit conflated its equitable mootness test to a single rule: “a court should only apply the equitable mootness doctrine if doing so will ‘unscramble complex bankruptcy reorganizations when the appealing party should have acted before the plan became extremely difficult to retract.’” Id. at *5 (quoting Nordhof Invs. v. Zenith Elecs. Corp., 258 F.3d 180, 185 (3d Cir. 2001)). Upon review, the Third Circuit held that this strict standard was not satisfied.

Despite electing to hear the appellants’ appeal, the Third Circuit ultimately agreed with the bankruptcy court and district court that the appellants were not entitled to an administrative expense because the act of referencing and posting a link to an article on the internet did not constitute a republication of the allegedly defamatory articles that would give rise to a new claim for defamation under Pennsylvania state law.

Conclusion

With the Philadelphia Newspapers decision, the Third Circuit reemphasizes that equitable mootness should be handled with care. When Justice Alito served on the Third Circuit, he cautioned that the doctrine of equitable mootness places far too much power in the hands of appellate judges, and this judicial reticence influenced the Philadelphia Newspapers court. Indeed, despite reviewing equitable mootness decisions for abuse of discretion, the Third Circuit has now overturned such decisions on at least two occasions.

In Philadelphia Newspapers, the district court’s opinion was clearly deficient and subject to reversal. However, in an attempt to restrain the doctrine of equitable mootness, the Third Circuit appears to have muddied the waters. As admitted in the Philadelphia Newspapers decision, the Third Circuit’s expansion of the first Continental factor is redundant of the fourth, and all of the factors effectively ask the same question.

Perhaps the Third Circuit will eventually abandon the Continental test entirely and proceed with the more simplistic rule espoused by the Philadelphia Newspapers court, which, in sum, instructs courts to refrain from finding an appeal equitably moot unless it would substantially undermine a debtor’s plan. Under this standard, an appeal is not equitably moot if any form of intermediate relief can be crafted or if the relief sought on appeal is only tangentially related to the plan. Under any recitation of the standard, however, parties should remain wary when consummating transactions under a chapter 11 plan in reliance on this doctrine.

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Published In: Bankruptcy Updates, Civil Procedure Updates, Civil Remedies Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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