In a seminal pair of decisions, Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) and Ashcroft v. Iqbal, 556 U.S. 662 (2009), the United States Supreme Court clarified that the pleading standard under Federal Rule of Civil Procedure 8(a) requires that a complaint contain sufficient factual allegations to state a claim to relief “that is plausible on its face.” Neither Twombly nor Iqbal addressed, however, whether this “plausibility” standard also applies to denials under Federal Rule of Civil Procedure 8(b). In its recent decision in In re Mortgages Ltd., 771 F.3d 623 (9th Cir. 2014), the Ninth Circuit Court of Appeals weighed in and held that the “plausibility” standard does not apply to denials.

The debtor in this case, Mortgages Ltd., was a private lender that made loans secured by real estate located in Arizona. Mortgages Ltd. funded its lending operations, in part, by selling fractional interests in its loans to investors. Under this arrangement, the investors owned their fractional interests in the Mortgages Ltd. loans in which they invested.

After Mortgages Ltd.’s bankruptcy filing, the Bankruptcy Court confirmed a plan that created an entity known as ML Manager LLC to manage and liquidate Mortgages Ltd.’s loan portfolio. Issues arose regarding ML Manager LLC’s authority to manage and liquidate the fractional interests in the Mortgages Ltd. loans owned by various investors, including a group of investors known as the Rev Op Group.

ML Manager LLC eventually filed a complaint seeking a declaratory judgment from the Bankruptcy Court on the issue of its authority to control and sell investors’ loan assets. ML Manager LLC asserted in its complaint that the Rev Op Group and other investors executed certain documents that granted Mortgages Ltd. an irrevocable agency power to manage and liquidate their loan assets, that the agency power was transferred to ML Manager LLC by the confirmed plan, and that ML Manager LLC therefore had authority to control and liquidate the Rev Op Group members’ assets over their objections. In their answers, the Rev Op Group members admitted signing certain documents in connection with their investments, but denied executing documents that granted any agency authority with respect to their loan assets.

In a novel ruling, the Bankruptcy Court held that the Twombly / Iqbal “plausibility” standard applied to the Rev Op Group’s denials and that, based solely on the pleadings, the Rev Op Group’s denials regarding the alleged agency authority were not plausible. Accordingly, the Bankruptcy Court entered judgment in favor of ML Manager LLC on the agency authority issue.

On appeal, the Ninth Circuit held that the “plausibility” standard does not apply to denials and reversed the Bankruptcy Court’s declaratory judgment. In doing so, the Ninth Circuit reasoned that a court may only disregard statements in a pleading under Rule 11 (for bad faith) or under Rule 12(f) (for matters that are scandalous, immaterial, impertinent, etc.), and that the Bankruptcy Court had not tested the Rev Op Group’s denials under either of those standards. “Courts cannot examine statements in an answer or other pleading and decide, on the basis of their own intuition, that the statements are implausible or a sham and thus can be disregarded.” Accordingly, the Bankruptcy Court erred by “effectively resolv[ing] those allegations” in the Rev Op Group’s denials “on the merits.”

With this decision, the Ninth Circuit has now clarified that Rule 8(b) does not require defendants to plead denials under a heightened “plausibility” standard in federal court. This decision is also notable for providing further clarification on other bankruptcy-related issues, including equitable mootness and substantial consummation of a bankruptcy plan.

In the interest of full disclosure, Bryan Cave LLP represented the appellants—the Rev Op Group—in the bankruptcy case and appeal discussed herein.