Acquisition of Claims for Plan Control

In addressing the debtor's motion to designate the votes in respect of the claims acquired by Pacific Western, the bankruptcy court focused solely on Pacific Western's decision to selectively buy general unsecured claims. Pacific Western's rationale included avoiding buying claims valued at zero, claims controlled by insiders or that would tip off the debtor as to Pacific Western's strategy, and claims to which the debtor objected.

Although counsel for Pacific Western advised the bankruptcy court that its acquisition of a blocking position was to further its only goal — “to do what was best for Pacific Western economically” — the bankruptcy court stated that, “as a matter of law,” it would not consider Pacific Western's motivation or rationale for only offering to buy a subset of claims. Id. at 853. Instead, noting that the debtor's plan “proposed to pay general unsecured creditors in full within 60 days of confirmation,” the bankruptcy court held that designation of the votes was appropriate because Pacific Western would have an “unfair advantage over the unsecured creditors who did not receive a purchase offer and who hold the largest percentage of claims in this case in terms of amount.” In re Fagerdala USA-Lompoc, Inc., Case No. 14-34642-tmb, at 310 (Bankr. D. Or. Sept. 1, 2015).

Citing Figter, where the Ninth Circuit “specifically noted that the secured creditor offered to purchase all of the unsecured claims at issue,” the bankruptcy court reasoned that “[a]llowing [Pacific Western] to block confirmation by purchasing such a small percentage of the unsecured debt in this case would be highly prejudicial to the creditors holding most of the unsecured debt ….” Id. Accordingly, the bankruptcy court designated Pacific Western's votes with respect to the purchased claims. The district court affirmed the bankruptcy court's decision. Pacific Western Bank, et al. v Fagerdala USA-Lompoc, Inc. (In re Fagerdala USA-Lompoc, Inc.), Case No. 3:15-cv-01792-MO (D. Or. April 21, 2016).

The Ninth Circuit

In reversing, the Ninth Circuit held that neither the failure to make a purchase offer to all unsecured creditors nor the prejudice to other unsecured creditors is, by itself, sufficient to support a finding of bad faith to justify designation of votes under section 1126(e). The court acknowledged that the concept of good faith under 1126(e) is “fluid,” but held that “no single factor can … inexorably demand an ultimate result, nor must a single set of factors be considered.” 891 F.3d at 855, citing Figter, 118 F.3d at 639.

Reiterating its holding in Figter, the court held that “[a]n entity acts in bad faith when it 'seeks to secure some untoward advantage over other creditors for some ulterior purpose.'” Importantly, bad faith “explicitly does not include 'enlightened self interest, even if it appears selfish to those who do not benefit from it.'” 891 F.3d at 855, citing Figter, 118 F.3d at 639. Purchasing claims merely for the purpose of protecting a creditor's own existing claim by blocking confirmation of a plan “'does not demonstrate bad faith or an ulterior motive … [and] is not to be condemned.” 891 F.3d at 855, citing Figter, 118 F.3d at 639

The court noted that in Figter, the creditor's offer to purchase all claims was only one of several factors resulting in a finding that the creditor's votes were cast in good faith and that it acted to protect its interests as the major creditor in the case. The court stated that “offering to purchase all claims is certainly an indicator of good faith; failing to do so cannot be evidence of bad faith.” 891 F.3d at 855 (emphasis in original). The court reasoned that since the Bankruptcy Code requires only a numerical majority to block acceptance of the plan by a class, “[d]oing something allowed by the Bankruptcy Code and case law, without evidence of ulterior motive, cannot be bad faith.” Id. Accordingly, Pacific Western's decision not to offer to purchase all general unsecured claims was not bad faith.

The court disagreed with the bankruptcy court's reliance on a Georgia bankruptcy court decision holding that “'[t]he creditor's conduct in furtherance of its own interest … should not result in unfair disadvantage to other creditors or the debtor.'” Id. at 856, citing In re Pleasant Hill Partners, 163 B.R. 388, 395 (Bankr. N.D. Ga. 1994). “'[I]f [the creditor] acted out of 'enlightened self interest, it is not to be condemned simply because it frustrated [the debtor's] desires. That is true, even if [the creditor] purchased [the] claims for the very purpose of blocking confirmation of [the debtor's] proposed plan.'” 891 F.3d at 856, citing Figter, 118 F.3d at 639 (emphasis added by Fagerdala court).

Bad faith is evidenced by a creditor attempting to “obtain some benefit to which [it] w[as] not entitled.” 891 F.3d at 856, citing Figter, 118 F.3d at 638 (emphasis added by Fagerdala court). The court cited examples of bad faith: a non-preexisting creditor purchasing claims for the purpose of blocking an action against it; competitors purchasing claims to destroy the debtor's business and eliminate competition; or a debtor arranging to have an insider purchase claims to block a competing plan. 891 F.3d at 856-57, citing Figter, 118 F.3d at 639. “The bankruptcy court erred both by considering the effect on other creditors, without additional evidence of bad faith, and not making actual findings on Pacific Western's motivations.” 891 F.3d at 857.

Other Courts

While the Ninth Circuit's decision was consistent with its prior decision in Figter and those of other courts that have held that a creditor must have an “ulterior motive,” apart from some of the examples cited by the court, exactly when a creditor's motive crosses the line and becomes the kind of ulterior motive justifying a finding of bad faith and designation of the vote under section 1126(e) is not always clear. Clearly, Pacific Western was not voting its acquired unsecured claims in an effort to improve the treatment of general unsecured claims which claims were going to be paid in full within 60 days of the plan's effective date; its admitted intention was to block the plan because of how its secured claim was going to be treated.

That is an acceptable ulterior motive, at least according to the Ninth Circuit. Yet, there is legislative history suggesting that a court has the ability to designate the vote of an entity that held conflicting claims in two classes. See, In re Dune Deck Owners Corp., 175 B.R. 839, 846 n.13 (Bankr. S.D.N.Y. 1995). Without more, however, courts are reluctant to disenfranchise a creditor. See, In re Adelphia Commc'ns Corp., 359 B.R. 54, 61 (Bankr. S.D.N.Y. 2006) (creditor's ownership of claims in several affiliated debtors does not, by itself, amount to bad faith sufficient to justify designating votes cast in favor of the plan). Designation under section 1126(e) should be used “sparingly, as the 'exception, not the rule.'” DISH Network Corp. v DBSD N. Am., Inc. (In re DBSD N. Am. Inc., 634 F.3d 79 101-102 (2d Circ. 2010), citing In re Adelphia Commc'ns Corp., 359 B.R. 54, 61 (Bankr. S.D.N.Y. 2006).

The Second Circuit

In DBSD, the Second Circuit upheld the designation of votes in respect of claims acquired by DISH Network, an indirect competitor of the debtor and part-owner of a direct competitor. DISH's goal was not to maximize its return on the acquired claims, but to use the claims “as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD's spectrum rights ….” DBSD, 634 F.3d at 104. Evidence of DISH's motives was established “by DISH's own admissions in court, by its position as a competitor to DBSD, by its willingness to overpay for the claims it bought, by its attempt to propose its own plan, and especially by its internal communications, which … showed a desire to 'obtain a blocking position' and 'control the bankruptcy process for this potentially strategic asset.'” Id. at 104-05 (footnotes omitted). The Second Circuit expressly did not rule on whether the result would have been different if DISH had been a pre-existing creditor or create a per se rule against purchasing claims with a view toward taking control of the debtor. Id. at 105.

In Adelphia, interdebtor issues caused a group of holders of Adelphia Communications Corp. (ACC) Senior Notes to seek the designation of votes of: 1) certain other ACC Senior Noteholders who also held notes of ACC subsidiary Arahova Communications Corp. (Arahova); 2) accounts managed by W.R. Huff Asset Management Co., some of which held both notes of ACC and Arahova; and 3) members of the Arahova Noteholders Committee who also held ACC Senior Notes. Adelphia, 359 B.R. at 55-56. The votes were cast in favor of a plan that certain ACC Senior Noteholders agreed to that settled interdebtor issues and contained certain benefits, including broad releases, which would be withheld from creditors voting against the plan. Id. at 59. The bankruptcy court had previously expressed its disapproval of “scorched earth” litigation tactics by Arahova Noteholders intended to create leverage to improve their recoveries, but did not conclude such tactics were unethical or sanctionable. Id. at 58.

The bankruptcy court identified badges of bad faith to justify designation of creditor votes that included votes designed: 1) to assume control of the debtor; 2) put the debtor out of business or otherwise gain a competitive advantage; 3) destroy the debtor out of pure malice; or 4) obtain benefits under a private agreement with a third party which depends on the debtor's failure to reorganize. Id. at 61, citing In re Dune Deck Owners Corp., 175 B.R. at 844-45.

In refusing to designate the votes, the Adelphia court found that despite the use of “distasteful and heavy handed” tactics it did not like, it concluded that the tactics were, at bottom, designed to enhance the creditors' recovery in the cases. 359 B.R. at 63. The fact that the creditors held notes of more than one debtor competing for, effectively, the same pool of assets, and their use in the plan of a “death trap” denying releases and payment of fees to those ACC Senior Noteholders that did not vote to accept the plan, were not sufficient reasons to designate the votes. Id. at 63-65.

Conclusion

As cases like Fagerdala, Figter and Adelphia make clear, courts will be reluctant to find the requisite ulterior motive that demonstrates bad faith sufficient to designate a creditor's vote when the primary motive is to improve the creditor's recovery on its claims against the debtor. Even when, as in Adelphia, a creditor chooses to sacrifice recovery on a claim against one debtor for a better recovery against an affiliated debtor, such conflicting positions will not justify designation.

Acquisition of claims to block a plan to protect or enhance the recovery by a creditor (even if that enhancement might be gained by defeat of a plan enabling foreclosure under non-bankruptcy law) will generally be permissible. The risk to a creditor being disenfranchised increases where certain facts are present including an effort to take control of the debtor (particularly if the effort is by a non-pre-existing creditor or a competitor), or obtain benefits generally unavailable to other creditors, or other facts that seem inconsistent with maximizing recovery on the creditor's claim against the debtor.

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Jeff J. Friedman is a partner in the Insolvency and Restructuring Group at Katten Muchin Rosenman LLP in New York. He may be reached at [email protected] or 212-940-7035.