Ninth Circuit Rules that Purchasing Claims to Block a Bankruptcy Plan is PermissibleAugust 2018
The Ninth Circuit recently held that a secured lender’s purchase of unsecured claims to block a debtor’s plan of reorganization was not improper, vacating a Bankruptcy Court decision which had determined that the lender had acted in bad faith, and had designated the votes on its claims. The ruling in In re Fagderala 1 is important for lenders, particularly in single-asset real estate cases, because it gives lenders another tool to challenge plans of reorganization.
In single-asset real estate cases, debtors often pursue (or threaten) cram-down plans of reorganization in which the secured lender’s claim is nonconsensually restructured. While secured lenders may not accept such treatment, a debtor can nevertheless obtain approval of a so-called cram-down plan under section 1129 of the Bankruptcy Code, if it is able to obtain the acceptance of one class of creditors holding impaired claims. To accomplish the latter, debtors often propose sufficiently generous payments to the unsecured creditor class.
In chapter 11, a class accepts a plan if it is approved by the holders of claims representing two-thirds in amount and a majority in number. For instance, a case with $300,000 in unsecured claims held by 25 creditors would require approval by creditors holding at least $200,000 in claims and the affirmative vote of at least 13 creditors. In single asset real estate cases, debtors are often able to make attractive offers to unsecured creditors because the amount of such claims is often low, meaning the cash cost is modest.
To prevent such plans, lenders sometimes offer to purchase claims in the unsecured class for the purpose of blocking class acceptance. When that happens, debtors sometimes challenge the lender’s actions as not being in good faith, and ask the Bankruptcy Court to designate those claims as having voted in favor of the plan. The Bankruptcy Court has the power to designate votes in this manner, but there must be good cause for such a draconian remedy. In Fagderala, the debtor owned real property worth approximately $6 million, encumbered by a $4 million mortgage held by Pacific Western Bank. The debtor proposed a plan that impaired the claims of both Pacific Western Bank and the unsecured creditors. In response, Pacific Western purchased the claims of some – but not all – unsecured creditors, enough to block acceptance of the plan of reorganization by the class.
At the reorganization plan’s confirmation hearing, the Bankruptcy Court held that because Pacific Western had not offered to purchase the claims of all unsecured creditors, it was acting in an unfair manner to creditors who did not receive the offer. Consequently, it designated the votes of the unsecured claims held by Pacific Western Bank as being in favor of the plan. The Bankruptcy Court refused to take testimony on Pacific Western Bank’s motivation for purchasing less than all of the claims and confirmed the plan. Pacific Western Bank appealed to the District Court, which affirmed the Bankruptcy Court’s decision.
On appeal to the Ninth Circuit, the decisions below were reversed and remanded, as the court found that Pacific Western Bank’s actions in buying claims to protect its interest were not improper. The Bankruptcy Court had focused on two main issues in its decision, namely the fact that Bank did not make an offer to purchase all unsecured claims; and the question of whether it would have had an unfair advantage that would have been highly prejudicial to other creditors, if it had voted its purchased claims.
First, the Ninth Circuit discussed general principals of good faith under 1126(e) of the Bankruptcy Code and, relying on the Court’s previous decision in In re Figter 2, found that an entity acts in bad faith when it “seeks to secure some untoward advantage over other creditors for some ulterior purpose.” The fact that a creditor has purchased claims to protect its own claim does not by itself demonstrate bad faith or an ulterior motive. The Ninth Circuit then analyzed the grounds relied upon by the Bankruptcy Court for its decision, and found that while offering to purchase all the claims in a class is an indicator of good faith, not doing so does not constitute bad faith. The Ninth Circuit had previously decided in Figter that purchasing claims to block a plan is not bad faith. Following that logic it held that because blocking a plan takes only a numerical majority of the class, or a majority of the class by value, purchasing only claims representing a blocking position is not bad faith conduct: “Doing something allowed by the Bankruptcy Code and case law, without evidence of ulterior motivation, cannot be bad faith. Not offering to purchase all of the claims in a class (to later use those claims to block a plan) is not – alone – sufficient to evidence bad faith necessary to designate votes under section 1126(e).”
Finally, the Ninth Circuit turned to the Bankruptcy Court’s focus on the effect of blocking a plan on other creditors. The Bankruptcy Court ruled that Pacific Western Bank’s actions would result an unfair advantage over other creditors that would be highly prejudicial. The Ninth Circuit rejected that logic, finding that the Bankruptcy Court erred in focusing solely on the negative effect of the claim purchase on other creditors, rather than Pacific Western Bank’s motivation for the purchase, as required for designation under section 1126(e). “Merely protecting a claim to its fullest extent cannot be evidence of bad faith. There must be some evidence beyond negative impact on other creditors.”
The Fagderala ruling gives lenders another weapon to use to defeat plans of reorganization. The holding that purchasing a blocking position in the unsecured claims class to defeat a plan of reorganization is not per se evidence of bad faith is perhaps even more important. While debtors may still seek to designate votes in cases involving contested confirmations, Fagderala establishes that bar for imposing that remedy has been significantly raised.
1. In re Fagerdala USA – Lompoc, Inc., 891 F3d 848 (9th Cir. 2018).
2. Figter Ltd. v. Teachers Ins. & Annuity Ass’n of Am., 118 F.3d 635 (9th Cir. 1997).