Fifth Circuit Doesn't Save the Save Our Springs Alliance But Time May

Another chapter in the Austin development wars has played out as the Fifth Circuit affirmed the Bankruptcy Court ruling denying confirmation of the plan of reorganization proposed by the Save Our Springs (SOS) Alliance, Inc. Matter of Save Our Springs (SOS) Alliance, Inc., No. 09-50990 (1/26/11). However, intervening developments have helped to keep the feisty environmental activist group alive. You can read the opinion here.

What Happened

The Fifth Circuit described the facts this way:

S.O.S. is a nonprofit charitable organization that sues municipalities and developers to ensure what it believes is responsible use of the Edwards Aquifer in the Texas Hill Country. Two of its lawsuits resulted in sizable awards of attorney’s fees to the defendants in those suits. One of the defendants, the Lazy Nine Municipal Utility District, assigned its award to Sweetwater Austin Properties, L.L.C. (“Sweetwater”). Unable to pay the awards, S.O.S. filed for bankruptcy in April 2007.

Opinion, p. 2.

The Court's description is accurate, although couched in measured, legal language. SOS was born out of a citizen revolt at an all night city council meeting about a proposed development. Since that time, SOS has waged legal holy war against developers in sensitive areas of the Edwards aquifer. Several of those lawsuits blew up in their face, resulting in large judgments for attorneys fees.

In its plan, SOS divided unsecured creditors into three classes and proposed to pay them $60,000 on a pro rata basis. The Bankruptcy Court rejected the SOS plan on the grounds that it had not demonstrated that it would be able to raise the $60,000 and that it had impermissibly gerrmandered the unsecured creditor classes. Because SOS was a "small business debtor," it was required to confirm a plan within 300 days. By the time the case was tried and the opinion was delivered, SOS was outside the 300 day window. SOS tried to change its designation as a small business debtor, but the Court did not allow this. As a result, the Bankruptcy Court dismissed the case.

The Fifth Circuit considered three issues on appeal:

1. Did the Debtor prove that the plan was feasible, that is, that it could raise the money?

2. Was the Debtor's separation of creditors into different classes permissible?

3. Should the Court have allowed the Debtor to change its small business designation?

The Court ruled against the Debtor on all grounds.

Feasibility, Fair and Equitable and the Non-Profit Debtor's Dilemma

The case of a non-profit debtor involves an interesting application of the absolute priority rule. Under the absolute priority rule, the requirement that a plan be "fair and equitable" includes the requirement that junior interests not receive or retain any interest unless unsecured creditors are paid in full or consent to the plan. However, a non-profit does not any equity holders. As a result, this requirement does not apply. It also means that the amount that a non-profit must pay to unsecured creditors in a cram-down situation is somewhat arbitrary.

The amount that a non-profit must pay is governed by the following rules:

1. The debtor must pay more than creditors would receive in a chapter 7 liquidation. This is often an easy test to meet because many non-profits have few if any tangible assets.

2. The plan must be filed in good faith. That means that the debtor must be legitimately trying to reorganize instead of simply avoiding payment of its debts.

3. The plan must satisfy the uncodified requirements of the "fair and equitable" test. Although "fair and equitable" includes the requirement that equity not retain any interest unless unsecured creditors consent or are paid in full, it also can include the Bankruptcy Court's estimation of whether the plan is "fair and equitable" in a general sense, sort of a judicial smell test.

4. Finally, the plan must be feasible. The debtor must be able to pay what it promises to pay.

The good faith, fair and equitable and feasible standards can impose conflicting demands. If a plan proposes to pay less than the debtor is capable of paying, then the plan may not be proposed in good faith or be fair and equitable. If the debtor proposes to pay more than it is capable of, then the plan is not feasible.

In this case, it appears that the debtor was so concerned with proving that it could not afford to pay more than the $60,000 proposed that it failed to prove that it could pay this amount.

The Court of Appeals summarized the evidence on feasibility in this manner:

At the five-day confirmation hearing, S.O.S. presented evidence of its strong fundraising history, indicated that it had pledges for $20,000 of the fund after soliciting its top donors, and expressed confidence that it could raise the rest within the sixty-day period. S.O.S.’s executive director testified, however, that it would be difficult to raise the rest of the funds, because many of S.O.S.’s donors wanted to prevent their money from going to judgment creditors in bankruptcy. Moreover, the executive director noted that it would be “extremely difficult” to take money from S.O.S.’s general operating fund, because “[w]e struggle to meet our monthly overhead every month,” and S.O.S. had told its general-fund donors that their money would not go to pay judgment creditors.

Opinion, p. 3. Based on this evidence, the Bankruptcy Court concluded that SOS "offered no evidence at the hearing to show that it could [raise the $60,000]--no commitments, no evidence of relevant past performance, nothing."

The Fifth Circuit found that evidence of past fundraising was insufficient given that "raising funds during bankruptcy is more difficult than at other times" and that its donors were reluctant to contribute to pay judgment creditors.

The Fifth Circuit also dismissed the $20,000 in pledges because they were not firm commitments, only accounted for one-third of the amount required and that its major donors had been tapped.

At the Fifth Circuit, the standard of review is whether the Bankruptcy Court committed clear error. In my view, the Bankruptcy Court was overly dismissive of the evidence of past fundraising and the partial commitments. Unfortunately, the Debtor provided the Court with ammunition for this finding when it poor mouthed its ability to pay more. The Debtor could have won the feasibility battle by doing its fundraising in advance (with monies held in trust pending the court's ruling) or by having its major donors guaranty that they would make up any shortfall, but that would have opened it up to a charge that it was intentionally underpaying. By focusing on the wrong side of the equation, the debtor lost the feasibility battle.

Gerrymandering

An additional requirement for confirmation is that a plan be approved by at least one class of impaired creditors. If one creditor holds more than 33% of the unsecured claims, the debtor will not be able to obtain an impaired, accepting class unless the debtor has a secured class of creditors to accept the plan or can divide its creditors into multiple classes. In this case, the debtor apparently did not have any secured creditors, so it divided its unsecured creditors into three classes.

Separate classification of unsecured creditors became more difficult following the Fifth Circuit's ruling in Matter of Greystone III Joint Venture, 995 F.2d 1274, 1278 (5th Cir. 1991) that "ordinarily 'substantially similar claims,' those which share common priority and rights against the debtor's estate, should be placed in the same class." The Fifth Circuit backed away from this statement somewhat in In re Briscoe Enterprises II, Ltd., 994 F.2d 1160 (5th Cir. 1993)(finding that debtor had good business reasons for separate classification of unsecured claims). However, one part of the Greystone ruling which remains sacrosanct is that to justify separate classification, a debtor must treat the separate classes differently and have good business reasons for doing so.

In this case, the Debtor sought to have each of the three classes of unsecured claims share in the same pot of $60,000 on a pro rata basis. Thus, the Court of Appeals concluded, "SOS's plan treats all its unsecured creditors identically, so they should all have been in the same class absent a legitimate reason to classify them separately." Opinion, p. 7.

The Debtor argued that it had separately classified Sweetwater because Sweetwater had non-creditor interests. The Fifth Circuit acknowledged that this reason, if proven, would have been sufficient.

S.O.S. contends that the bankruptcy court erred, because Sweetwater has two “non-creditor interests” justifying separate classification. A non-creditor interest can justify separate classification if it gives Sweetwater “a different stake in the future viability” of S.O.S. that may cause it to vote for reasons other than its economic interest in the claim. (citation omitted). If such non-creditor interests in fact exist, they would justify S.O.S.’s classification scheme

Opinion, p. 8. It is certainly plausible that Sweetwater was motivated to punish SOS for its environmental zealotry. However, Sweetwater's principal testified that he just wanted to get his claim paid. Ironically, the Fifth Circuit found that Sweetwater's vote was not motivated by a desire to avoid future litigation with the Debtor because the litigation did in fact continue notwithstanding denial of the plan and dismissal of the case.

Given these facts, it would have been almost impossible to have the Bankruptcy Court's finding set aside as clearly erroneous. However, the opinion is significant because it explicitly recognizes that non-creditor interests are a proper reason for separate classification. Thus, the argument could work in a case with better evidence, such as a creditor which readily admitted its motives or one where the creditor would gain a non-economic benefit from the debtor's demise.

The Small Business Designation and Judicial Estoppel

As noted above, the long battle over confirmation caused the Debtor to run out the 300 day clock for confirming a plan. The Debtor argued that the Court erred in not allowing it to revoke its small business designation. The Fifth Circuit noted that while debtors can typically amend filings "as a matter of course at any time before the case is closed," that judicial estoppel was properly invoked to prevent the Debtor from doing so in this case. Having received the benefits of the small business designation, the Debtor could not renounce it once it became burdensome. This finding is unremarkable.

Meanwhile Back at the Sweetwater Ranch

While the appeal of the Bankruptcy Court order was ongoing, developments continued to occur on other fronts. SOS challenged the Sweetwater judgment on the basis that the judgment was rendered by a judge who had been defeated in his primary election and was therefore ineligible to preside over the trial. A Travis County District Court agreed and vacated the judgment, prompting one of SOS's attorneys (not Weldon Ponder) to proclaim "We won" on a bankruptcy listserve. However, that victory was taken away by the Third Court of Appeals. Sweetwater Austin Properties, LLC vs. SOS Alliance, Inc., 299 S.W.3d 879 (Tex. App.--Austin, 2009, pet. den.).

In October 2010, Sweetwater lost its property in one of the largest foreclosures in Travis County. The Bank resold the development within a month. Thus, despite the setbacks, SOS outlasted its adversary. It is not clear whether Sweetwater, the Bank or the new owner controls the judgment now.

Disclosure: My firm did some work for SOS prior to the bankruptcy. We voted our unsecured claim in favor of the Debtor's plan.