The Prudence of Finality: Equitable Mootness and Involuntary Creditors

by Cyrus B. Kornfeld*

The doctrine of equitable mootness grows out of the complexity of bankruptcy proceedings. Bankruptcy involves not only the rights of creditors against debtors, but also competing creditor rights. Chapter 11 adds to the complexity, introducing the additional interests of public and private investors. The eventual bankruptcy settlement that emerges from a Chapter 11 process is the result of negotiation among these three parties: 1) the debtor corporation, 2) the creditors, both voluntary and involuntary, and 3) investors, public and private. Each party has unique interests. The alchemy of any given settlement negotiation will therefore defy later attempts at analysis. Such review by later courts invites notions of “unscrambling of an egg,” a metaphor used frequently in discussions of Chapter 11.

When the claims of involuntary creditors against third party debtors have been discharged in bankruptcy, to what extent should the doctrine of equitable mootness enjoin review of those discharges? This piece argues that while equitable mootness plays a role in bankruptcy proceedings, the doctrine is prone to abuse, and it must be strictly controlled by a balancing of rights and the system’s interest in finality in bankruptcy. New concerns about third party releases also mean that in some cases courts should look for evidence of sophisticated parties exploiting the bankruptcy code.

Bankruptcy’s interest in finality also supports the existence of equitable mootness. In bankruptcy, the power of the law and the state intervenes to restore creditor confidence otherwise broken by the debtor’s insolvency. Investors’ belief in the finality of bankruptcy settlement helps support this confidence. The need for finality is particularly significant in Chapter 11, where the power of the state serves to rehabilitate corporations and bring them back into solvency. Continuing unresolved issues make investment by new creditors less likely, therefore defeating the purpose of the system.

Complexity.² Finality.³ Courts invoke these powerful reasons to support the doctrine of equitable mootness. It should continue to exist. However, it’s application should be monitored by factors that incorporate third party interests, as well as a new sensitivity to corporate manipulation of the bankruptcy process.

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Equitable mootness has been affirmed in a majority of circuit courts and stands up to the challenges that have been leveled against it.⁴ One particular line of attack has emerged from the application of “expressio unius” reasoning to the bankruptcy code. Bankruptcy courts are not allowed to make “substitutions of underlying law.”⁵ Since equitable mootness appears nowhere in the code,⁶ some might argue that its application should be forbidden as an unjust extension of the power of bankruptcy courts.⁷

The prudential nature of equitable mootness should allay expressio unius concerns. Despite its name, “equitable mootness” is a prudential and not an equitable doctrine.⁸ In the case In re City of Detroit, the Sixth circuit explains: “Unlike conventional mootness, equitable mootness is not concerned with the court’s ability or inability to grant relief; it is concerned with protecting the good faith reliance interests created by implementation of the bankruptcy plan from being undone afterwards.”⁹ The doctrine is not only widespread, but it has not been disturbed by congressional action since the creation of Chapter 11 in 1978. Some might consider Congress’s silence over such a long period to be an endorsement of the status quo.

The Supreme Court has recently quieted constitutional concerns about equitable mootness. In Stern v. Marshall, the Supreme Court held that bankruptcy courts were reviewable by Article III courts, but it in no way implied that equitable mootness endangered Article III review.¹⁰ If present, such a threat would need to rise to the top of any analysis under modern principles of Constitutional Avoidance.

Attacks have also been made on the unity of circuit approaches to equitable mootness. Different circuits apply different tests to determine when equitable mootness is appropriate. The Sixth Circuit uses a three-factor test,¹¹ the Fourth Circuit uses a four-factor test,¹² and the Third Circuit uses a five-factor test that incorporates interest in the finality in bankruptcy in addition to party-focused concerns.¹³ However, all equitable mootness regimes are laid out according to a balance between the rights of the parties supporting the bankruptcy plan and the rights of the parties attacking it.¹⁴ All different factor layouts essentially encapsulate this essential balance: complex party interests in the context of the general interest in finality,¹⁵ and ripple effects emanating from further litigation.¹⁶

The factors that courts use to apply equitable mootness bear out this emphasis on balance. The claims of a challenging party are taken into account in such analyses, with larger claims rendering courts more willing to sweep mootness aside.¹⁷ Large and serious enough claims can prompt the retraction of equitable mootness in cases where plaintiff success would impinge on the total amount of funding available for the bankruptcy settlement.¹⁸ Courts are less likely to apply mootness where a given action is partible from the whole case.¹⁹ There is acceptance across factor-systems that this balance should include third parties to a bankruptcy who have nonetheless invested in rehabilitated corporations.²⁰

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The courts have calibrated the application of equitable mootness using factors. This allows selective use of the doctrine: building up faith in the finality of bankruptcy agreements, while protecting creditor rights. There is a new concern however, one that was brought up by the fact pattern in the 25^th Annual Duberstein Moot Court Competition, that deserves a factor all its own. In cases where there are 1) discharges against third parties, 2) for debts incurred to involuntary creditors, reviewing courts must take into account evidence of strategic activity when deciding whether or not to apply equitable mootness to a matter.

Undesirable strategic behavior is possible when debts incurred to involuntary creditors are discharged against reinvesting third parties. Sophisticated parties can use the bankruptcy process to have liability discharged and then use equitable mootness to defend against further litigation.

Imagine, as in the Duberstein fact pattern, a large corporation that produces personal computers. Such a corporation would no doubt have a division for designing and producing batteries for its computers. Imagine that this corporation spun off its battery division as a private corporation, and eventually divested itself of enough ownership to avoid alter-ego liability. Batteries can have undiscoverable defects that only emerge after months of use and widespread distribution. These defects can be catastrophic. With such a corporate structure, however, all of the liability for a defect would rest with the battery producer. This is an outcome of corporate law, not bankruptcy law, yet bankruptcy extends further protection to the now third-party, former parent corporation from the claims of involuntary creditors. By reentering at the bankruptcy stage, the third party can obtain discharges against itself: heading off preliminarily any liability that might accrue to it. Leveraging its power and financial resources, the third party corporation can bargain hard for far less than it would normally have been forced to pay in a traditional liability proceeding.

The Second Circuit has already remarked on the potential for abuse in non-debtor release.²¹ The Third Circuit has also barred the usage of equitable mootness in review of mass-torts cases.²² These courts’ sensitivity reflects the need for a new factor protecting from corporate coercion.

Large, sophisticated parties have already made use of the bankruptcy code to escape liability systematically in the past,²³ and they could use such principles to their advantage against involuntary creditors in the future. Allowing equitable mootness to be used strategically would contribute to a disturbing trend in which corporate liability became easier and easier to shrug off through bankruptcy, but private debt became increasingly difficult for private citizens to discharge.²⁴

There must be a new factor to check this strategic behavior, one directly focused on manipulation of the system by sophisticated parties in cases of third party discharge. No consumer makes a corporate bankruptcy calculation when setting out to buy a laptop battery. Such consumers should not be effectively prevented from engaging in litigation down the line because of an ironclad combination of corporate separation, third party discharge, and equitable mootness. Liability for exploding batteries should not be decided in a bankruptcy settlement process. Such cases should be placed in the area of mass torts—where they belong.

* In this post, Cyrus B. Kornfeld (‘18) uses his experience at the Saint John’s Duberstein Moot Court Competition to discuss the dynamics of equitable mootness in Chapter 11 bankruptcy. The fact pattern in the 2017 Saint John’s Duberstein competition involved a third party discharge on tort claims arising from an exploding battery. The company that manufactured the batteries, Padco, had become insolvent and had filed for Chapter 11 bankruptcy, preventing full recovery by involuntary creditors. As part of the bankruptcy 1) Padco merged into a solvent company, Gadget, and 2) hundreds of millions of dollars of bonds were raised to pay for the merger and the launch of a new line of products. The bankruptcy agreement paid the tort creditors 10% of their assessed claims. Appellant, Megan Kuzienewski, and a minority of others refused to accept the payment, but were voted down by a majority within the class pursuant to the mechanics of Chapter 11. Critically, the discharge of liability applied not only to tort creditors’ claims against Padco (the company in bankruptcy), but to Gadget as well. The defective batteries were produced at a time when Gadget held a majority position in Padco, though stayed enough out of its affairs to not warrant a piercing of the corporate veil. Kuzienewski challenged the settlement reached, and sought to sue according to a novel theory of liability. The author wrote and argued on whether mootness should apply to litigation.

2. See, e.g., In re Chateaugay Corp., 988 F.2d 322, 325 (2d Cir. 1993).

3. See, e.g., In re Zenith Electronics Corp., 329 F.3d 338, 347 (3d Cir. 2003).

4. See, e.g., In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir., 2005); In re Diet Drugs, 582 F.3d 524, 552–53 (3d Cir. 2009); In re Pac. Lumber Co., 584 F.3d 229, 241, 243 (5th Cir. 2009); In re City of Detroit, Michigan, 838 F.3d 792, 798 (6th Cir. 2016); In re Transwest Resort Properties, Inc., 801 F.3d 1161, 1172 (9th Cir. 2015); In re Paige, 584 F.3d 1327, 1336 (10th Cir. 2009).

5. Raleigh v. Ill. Dept. of Revenue, 530 U.S. 15, 24–25 (2000).

6. See 11 U.S.C. § 364(e).

7. Id.

8. See Lexmark Int’l, Inc. v. Static Control Components, Inc., 134 S. Ct. 1377, 1388 (2014).

9. In re City of Detroit, Michigan, 838 F.3d 792, 798 (6th Cir. 2016).

10. See Stern v. Marshall, 131 S.Ct. 2594, 2599 (2011).

11. See City of Detroit, 838 F.3d at 798 (“(1) whether a stay has been obtained; (2) whether the plan has been ‘substantially consummated’; and (3) whether the relief requested would significantly and irrevocably disrupt the implementation of the plan or disproportionately harm the reliance interests of other parties not before the court,”).

12. See Behrmann v. Nat’l Heritage Found., 663 F.3d 704, 713 (4th Cir. 2011) (“(1) whether the appellant sought and obtained a stay; (2) whether the reorganization plan or other equitable relief ordered has been substantially consummated; (3) the extent to which the relief requested on appeal would affect the success of the reorganization plan or other equitable relief granted; and (4) the extent to which the relief requested on appeal would affect the interests of third parties.”).

13. See In re Philadelphia Newspapers, LLC, 690 F.3d 161, 170 (3d Cir. 2012). (“(1) whether the reorganization was ‘substantially consummated,’ (2) whether a stay has been obtained, (3) whether the relief would affect the rights of non-litigating parties, (4) how relief would affect the success of the bargain struck, and (5) the public policy of the finality of bankruptcy.).

14. See, e.g., In re Paige, 584 F.3d 1327, 1336 (10th Cir. 2009).

15. See, e.g., In re Philadelphia Newspapers, LLC, 690 F.3d 161, 170 (3d Cir. 2012). “(1) whether the reorganization was ‘substantially consummated,’ (2) whether a stay has been obtained, (3) whether the relief would affect the rights of non-litigating parties, (4) how relief would affect the success of the bargain struck, and (5) the public policy of the finality of bankruptcy.”

16. See, e.g., In re Tribune Media Co., 799 F.3d 272, 280 (3d Cir. 2015); In re Semcrude, L.P., 728 F.3d 321, 324 (3d Cir. 2013).

17. See, e.g., In re Transwest Resort Properties, Inc., 801 F.3d 1161, 1172 (9th Cir. 2015).

18. See, e.g., In re Pac. Lumber Co., 584 F.3d 229, 241 (5th Cir. 2009).

19. See, e.g., In re Semcrude, L.P., 728 F.3d 321 (3d Cir. 2013).

20. See, for example, the third factor in the Sixth Circuit test: “disproportionately harm the reliance interests of other parties before the court,” In re City of Detroit, Michigan, 838 F.3d 792, 798 (6th Cir. 2016); or the third factor in the Third Circuit test “Whether relief would affect the rights of non-litigating parties,” In re Philadelphia Newspapers, LLC, 690 F.3d 161, 170 (3d Cir. 2012).

21. See In re Metromedia Fiber Network, Inc., 416 F.3d 136, 142 (2d Cir. 2005).

22. See In re Diet Drugs, 582 F.3d 524, 552–53 (3d Cir. 2009).

23. See Enough Already, The Economist (2004), http://www.economist.com/node/3196317 (Detailing the way the airline companies used Chapter 11 to systematically avoided liabilities arising from a change in the industry).

24. See Robert Kuttner, The Age of Double Standards, The American Prospect (2005), http://prospect.org/article/age-double-standards.