When it comes to voting on a plan, Section 1126(e) of the Bankruptcy Code provides that a bankruptcy court may designate (or disallow) the votes of any entity whose vote to accept or reject was not made in “good faith” (a term that is not defined in the Bankruptcy Code). On June 4, 2018, the United States Court of Appeals for the Ninth Circuit issued a decision reversing that of the lower courts and holding that a bankruptcy court may not designate claims for bad faith simply because (1) a creditor offers to purchase only a subset of available claims in order to block a plan of reorganization, and/or (2) blocking the plan will adversely impact remaining creditors. This decision confirms that a creditor may cast its votes in order to protect its own interests. On the other hand, bad faith may be found where a creditor votes in order to obtain some benefit to which it was not otherwise entitled or for some ulterior purpose unrelated to its role as creditor.
Pacific Western Bank, through its wholly-owned entity Coastline RE Holdings Corp., held the senior secured debt on the real property of debtor Fagerdala USA – Lompac, Inc. Fagerdala filed for Chapter 11 relief on August 14, 2014, and filed a first amended plan of reorganization on April 27, 2015. The plan placed Pacific Western’s secured claim in Class 1, and general unsecured claims in Class 4. All classes of claims were deemed impaired; accordingly, Fagerdala needed the approval of at least one impaired class in order to confirm the plan.1
Pacific Western purchased a large number of—but not all—general unsecured claims in order to block Fagerdala’s proposed plan, as blocking the plan was in Pacific Western’s economic interest. Ultimately, Pacific Western purchased more than half of the claims by number, but only approximately ten percent by value. Fagerdala filed its second amended plan on June 2, 2015. Pacific Western voted its secured claim, as well as the claims it had purchased, against the plan, which was sufficient to block the plan.2
Fagerdala moved to designate Pacific Western’s votes with respect to the purchased claims, arguing that the purchase was not made in good faith. At the bankruptcy court hearing, Pacific Western stated that it had good and specific reasons for not attempting to purchase certain claims. The bankruptcy court responded that, as a matter of law, it was not going to consider Pacific Western’s motivation or rationale for offering to purchase only a subset of claims. The bankruptcy court granted Fagerdala’s designation motion, stating that “…a creditor’s conduct in further of its own interest should not result in an unfair disadvantage to other creditors…” and “[a]llowing [Pacific Western] to block confirmation by purchasing such a small percentage of the unsecured debt would be highly prejudicial to the creditors holding most of the unsecured debt.” On appeal, the district court affirmed the designation of the purchased claims. Pacific Western appealed to the Court of Appeals for the Ninth Circuit.
The Court of Appeals reversed and vacated the bankruptcy court’s order granting the motion to designate. The Court of Appeals distinguished between a case where a creditor purchases additional claims in order to protect its own economic interests, which does not demonstrate bad faith or an ulterior motive unrelated to collection of its claim as creditor, as opposed to a case where a creditor attempts to gain some benefit to which it was not otherwise entitled (e.g., a competitor purchasing claims to destroy the debtor’s business in order to further its own).
The Court of Appeals stated that neither of the two facts relied on by the bankruptcy court—either alone or together—was sufficient to support a finding of bad faith. First, the conclusion that Pacific Western’s failure to make an offer to all unsecured creditors evidenced bad faith is not supported by case law or the Bankruptcy Code. While offering to purchase all claims is an indicia of good faith, failing to do so cannot itself evidence bad faith. Second, the Court of Appeals disagreed with the bankruptcy court’s finding that if Pacific Western’s purchased claims were voted, it would “have an unfair advantage” and be “highly prejudicial” to other creditors, noting that the bankruptcy court incorrectly examined only the negative effects of Pacific Western’s purchases, but did not consider its motivation (to protect its interests as a creditor). Bad faith is determined when a creditor was not attempting to protect its own economic interests, but was instead attempting to obtain a benefit to which it was not otherwise entitled.
As the Court of Appeals stated, “[m]erely protecting a claim to its fullest extent cannot be evidence of bad faith. There must be some evidence beyond negative impact on other creditors.” Because the bankruptcy court expressly refused to consider Pacific Western’s motivations, or determine whether it was seeking an “untoward advantage over other creditors for some ulterior motive,” the Court of Appeals vacated the bankruptcy court’s order granting Fagerdala’s designation motion and remanded the case to the bankruptcy court.
The Court of Appeals cited its prior decision in In re Figter 3, where it noted that if bad faith could be found any time a claim is purchased to block approval of a plan, there would be no incentive to purchase claims. This decision is good news for creditors who can now safely execute on a strategy to block confirmation of a plan that puts its current interest as a creditor at risk. The decision also serves as a reminder, however, that a purchaser’s motivations for purchasing claims will be considered by the bankruptcy court, and so a creditor should be prepared to prove that its actions were in furtherance of its own proper interests and not for an impermissible ulterior motive unrelated to its role as creditor.
1 If all of the confirmation requirements set forth in the Bankruptcy Code, other than the requirement that all impaired classes vote in favor of the plan, are met, the bankruptcy court can still confirm the plan via “cram down” if the plan does not “discriminate unfairly” and is “fair and equitable” with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
2 A class of claims has accepted a plan if the plan has been accepted by voting creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims. Because Pacific Western purchased more than half of the claims by number, it was able to block the plan, even though it only voted approximately 10% by value of all outstanding claims.
3 Figter Ltd. v. Teachers Ins. & Annuity Ass’n of Am. (In re Figter), 118 F.3d 635 (9th Cir. 1997).
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