DBSD Case Upholds Designation of Votes Cast By a Claims Purchaser
The right to vote to accept or reject a plan of reorganization is one of the key rights given to impaired creditors in the Chapter 11 bankruptcy process. Generally, in Chapter 11 bankruptcy cases, it is up to the collective opinion of impaired creditors to decide whether a plan is acceptable. While the right to vote on a plan is fundamental, not all creditors are entitled to vote their claims. Notably, creditors whose claims are not impaired by a plan, or who will receive no distribution on a plan, or whose claims are subject to an objection are not entitled to vote. In addition, the Bankruptcy Code allows the bankruptcy court to “designate,” or, in effect, to disregard, the votes of any entity whose acceptance or rejection of such plan was not in good faith. The Bankruptcy Code, however, provides no guidance about what constitutes a bad faith vote to accept or reject a proposed Chapter 11 plan.
A recent decision by the 2nd U.S. Circuit Court of Appeals in the In re DBSD North America case sheds new light on certain circumstances that may lead a court to designate the votes of a creditor. It also raises several questions – specifically, where a creditor buys claims against a debtor in bankruptcy with the intention to not maximize its return on the debt, but to gain a blocking position with respect to the debtor’s plan of reorganization so that the creditor can gain control of the debtor’s assets, it may be appropriate for the bankruptcy court to designate the votes of that creditor. See In re DBSD North America, Inc., 634 F. 3d 79 (2d Cir. 2011). The 2nd Circuit’s decision in DBSD should be a significant consideration for any investor that purchases claims against a debtor, or even debt against a company on the eve of its bankruptcy, with the hope of using those claims to acquire the assets of the company or to control its bankruptcy case as it now runs the risk that its vote to accept or reject a plan for the debtor, and thereby control the debtor’s reorganization process, will be disregarded.
The Background of the DBSD Case
DBSD was founded in 2004 to develop a mobile communications network that would use both satellites and land-based transmission towers. In its first five years, DBSD made progress toward this goal, successfully launching a satellite and obtaining certain spectrum licenses from the FCC, but it also accumulated a large amount of debt. Because its network remained in the developmental stage and had not become operational, DBSD had little if any revenue to offset its mounting obligations.
On May 15, 2009, DBSD filed a voluntary petition in the U.S. Bankruptcy Court for the Southern District of New York, listing liabilities of $813 million against assets with a book value of $627 million. Of the various claims against DBSD, the principal claims included a $40 million revolving credit facility secured by a first-priority security interest in substantially all of DBSD’s assets bearing an initial interest rate of 12.5 percent (the “First Lien Debt”), and $650 million in 7.5 percent convertible senior secured notes due August 2009 (the “Second Lien Debt”). The Second Lien Debt held a second-priority security interest in substantially all of DBSD’s assets. At the time of filing, the Second Lien Debt had grown to approximately $740 million.
After negotiations with various parties, DBSD proposed a plan of reorganization which provided that the holders of the First Lien Debt would receive new obligations with a 4-year maturity date and the same 12.5 percent interest rate, but with interest to be paid in kind, meaning that for the first four years the owners of the new obligations would receive as interest more debt from DBSD rather than cash. The holders of the Second Lien Debt would receive the bulk of the shares of the reorganized entity, which the bankruptcy court estimated would be worth between 51 percent and 73 percent of their original claims. The holders of unsecured claims would receive shares estimated to be worth between 4 percent and 46 percent of their original claims. Finally, the existing shareholder would receive shares and warrants in the reorganized entity.
Meanwhile, DISH Network Corp. (“DISH”), although not a creditor of DBSD before its filing, had purchased the claims of various creditors after its bankruptcy filing with an eye toward acquiring DBSD’s spectrum rights. As a provider of satellite television, DISH has launched a number of its own satellites, and it also had a significant investment in TerreStar Corporation, a direct competitor of DBSD’s in the developing field of hybrid satellite/ terrestrial mobile communications. DISH desired to enter into some sort of transaction with DBSD in the future, if DBSD’s spectrum could be useful in its business.
Shortly after DBSD filed its plan, DISH purchased all of the First Lien Debt at its full face value of $40 million, with an agreement that the sellers would make objections to the plan that DISH could adopt after the sale. As DISH admitted, it bought the First Lien Debt not just to acquire a “market piece of paper” but also to “be in a position to take advantage of [its claim] if things didn’t go well in a restructuring.” Internal DISH communications also promoted an “opportunity to obtain a blocking position in the [Second Lien Debt] and control the bankruptcy process for this potentially strategic asset.” In the end, however, DISH was unable to buy enough claims to control the class of Second Lien debt holders.
In addition to voting its claims against confirmation of the proposed plan, DISH argued that the plan was not feasible and that the plan did not give DISH the “indubitable equivalent” of its First Lien Debt as required to cram down a dissenting class of secured creditors under 11 U.S.C. § 1129(b)(2)(A). Separately, DISH proposed to enter into a strategic transaction with DBSD, and requested permission to propose its own competing plan (a request it later withdrew).
DBSD responded by moving for the court to designate that DISH’s vote rejecting the plan was not in good faith. 11 U.S.C. § 1126(e). The bankruptcy court agreed, finding that DISH, a competitor to DBSD, was voting against the plan “not as a traditional creditor seeking to maximize its return on the debt it holds, but ... ‘to establish control over this strategic asset.’ ” In re DBSD North America, Inc., 421 B.R. 133, 137 (Bankr. S.D.N.Y. 2009) (quoting DISH’s own internal presentation slides). The bankruptcy court therefore designated DISH’s vote and disregarded DISH’s wholly-owned class of First Lien Debt for the purposes of determining plan acceptance under 11 U.S.C. § 1129(a) (8). Id. at 143. The bankruptcy court also rejected DISH’s objections to the plan, finding that the plan was feasible and that, even assuming that DISH’s vote counted, the plan gave DISH the “indubitable equivalent” of its First Lien Debt claim and could thus be crammed down over DISH’s dissent. In re DBSD North America, Inc., 419 B.R. 179, 203, 208-209 (Bankr. S.D.N.Y. 2009).
After designating DISH’s vote and rejecting all objections, the bankruptcy court confirmed the plan. The district court affirmed. While the 2nd Circuit affirmed the bankruptcy court’s decision to designate DISH’s vote, it reversed the order confirming the plan.1
Designation of Votes under section 1126(e)
Section 1126(e) permits courts to designate a vote on a plan that was not made in “good faith.” The Bankruptcy Code provides no guidance about what constitutes a bad faith vote to accept or reject a plan. Rather, § 1126(e)’s “good faith” test effectively delegates to the courts the task of deciding when a party steps over the boundary. See In re Figter Ltd., 118 F.3d 635, 638 (9th Cir. 1997). Case by case, courts have taken up this responsibility.
The designation of votes under section 1126(e) is “the exception, not the rule” and should be used sparingly. In re DBSD, 643 F.3d at 102; In re Adelphia Commc’ns Corp., 359 B.R. 54, 61 (Bankr. S.D.N.Y. 2006). For this reason, a party seeking to designate another’s vote bears the burden of proving that it was not cast in good faith. See id. Merely purchasing claims in bankruptcy “for the purpose of securing the approval or rejection of a plan does not of itself amount to ‘bad faith.’” In re DBSD, 643 F.3d at 102; In re P–R Holding Corp., 147 F.2d 895, 897 (2d Cir. 1945); see In re 255 Park Plaza Assocs. Ltd. P’ship, 100 F.3d 1214, 1219 (6th Cir. 1996). Nor will selfishness alone defeat a creditor’s good faith; the Code assumes that parties will act in their own self interest and allows them to do so. In re DBSD, 643 F.3d at 102.
Section 1126(e) comes into play when voters venture beyond mere self-interested promotion of their claims. In re DBSD, 643 F.3d at 102 “[T]he section was intended to apply to those who were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled.” Id., In re Figter Ltd, 118 F.3d 635, 638 (9th Cir. 1997). A bankruptcy court may, therefore, designate the vote of a party who votes “in the hope that someone would pay them more than the ratable equivalent of their proportionate part of the bankrupt assets.” Young v. Higbee Co., 324 U.S. 204, 211, 65 S.Ct. 594, 89 L.Ed. 890 (1945). The bankruptcy may also designate the vote of one who votes with an “ulterior motive,” that is, with “an interest other than an interest as a creditor.” In re DBSD, 643 F.3d at 102, See also Revision of the Bankruptcy Act: Hearing on H.R. 6439 Before the House Comm. on the Judiciary, 75th Cong. 181 (1937)(statement of SEC Commissioner William O. Douglas).
In rendering its opinion in DBSD, the 2nd Circuit was careful to note that, “not just any ulterior motive constitutes the sort of improper motive that will support a finding of bad faith.” In re DBSD, 643 F.3d at 102. “After all, most creditors have interests beyond their claim against a particular debtor, and those other interests will inevitably affect how they vote the claim.” Id. For instance, trade creditors who do regular business with a debtor may vote in the way most likely to allow them to continue to do business with the debtor after reorganization, or as interest rates change, a fully secured creditor may seek liquidation to allow money once invested at unfavorable rates to be invested more favorably elsewhere. Id. As the 2nd Circuit further stated, “allowing the disqualification of votes on account of any ulterior motive could have far-reaching consequences and might leave few votes upheld.” Id.
In trying to define, then, what type of ulterior motive would lead to a finding of bad faith, the 2nd Circuit cited a 1936 case, Texas Hotel Securities Corp. v. Waco Development Co., 87 F.2d 395 (5th Cir. 1936), as an example of where the creditor’s ulterior motive supported a finding of bad faith. In that case, Conrad Hilton purchased claims against a debtor to block a plan of reorganization that would have given a lease on the debtor’s property — once held by Hilton’s company — to a third party. Id. at 397– 99. Hilton and his partners sought, by buying and voting the claims, to force a plan that would give them again the operation of the hotel or otherwise reestablish an interest that they felt they justly had in the property. Id. at 398. The district court refused to count Hilton’s vote, but the court of appeals reversed, seeing no authority in the Bankruptcy Act for looking into the motives of creditors voting against a plan. Id. at 400.
The Texas Hotel Securities case prompted Congress to require good faith in connection with voting claims. As the Supreme Court noted, the legislative history of the predecessor to § 1126(e) “make[s] clear the purpose of the [House] Committee [on the Judiciary] to pass legislation which would bar creditors from a vote who were prompted by such a purpose” as Hilton’s. Young 324 U.S. at 211 n. 10. Following the Texas Hotel Securities case, modern cases have designated creditor votes as having been cast in bad faith in a number of circumstances, but a central theme is an effort by a creditor to purchase claims in order to gain or maintain control over the debtor’s assets rather than to protect their interest as a creditor. In In re Allegheny Int’l, Inc., 118 B.R. 282, 289–90 (Bankr. W.D. Pa. 1990), a court found bad faith because a party bought a blocking position in several classes after the debtor proposed a plan of reorganization, and then sought to defeat that plan and to promote its own plan that would have given it control over the debtor. In In re MacLeod Co., 63 B.R. 654, 655–56 (Bankr .S.D. Ohio 1986), the court designated the votes of parties affiliated with a competitor who bought their claims in an attempt to obstruct the debtor’s reorganization and thereby to further the interests of their own business. In In re Applegate Prop., Ltd., 133 B.R. 827, 833–35 (Bankr. W.D. Tex. 1991), the court found bad faith where an affiliate of the debtor purchased claims not for the purpose of collecting on those claims but to prevent confirmation of a competing plan.
In the DBSD case, the 2nd Circuit found that DISH’s conduct fit within the pattern of conduct that constituted a lack of good faith in voting under section 1126(e). “In effect, DISH purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD’s spectrum rights, not toward protecting its claim.” In re DBSD, 643 F.3d at 102. The 2nd Circuit rejected the arguments put forth by the Loan Syndications and Trading Association and DISH that the court’s holding would deter future creditors looking for potential strategic transactions with Chapter 11 debtors from exploring such deals for fear of forfeiting their rights to vote their claims. The 2nd Circuit responded by stating that its decision should deter only attempts to obtain a blocking position in voting on a debtor’s plan and thereby control the bankruptcy process in order to gain a strategic asset of the debtor. Id. at 105. The court declined in its decision to address the situation in which a preexisting creditor votes with strategic intentions. Id. The court further emphasized that its opinion imposes no categorical prohibition on purchasing claims with acquisitive or other strategic intentions. Id. The determination of whether a vote has been properly designated is a fact-intensive question that must be based on the totality of the circumstances, according considerable deference to the expertise of bankruptcy judges. Id.
Impact of DBSD On Strategic Transaction to Acquire a Debtor In Bankruptcy
The DBSD decision casts doubt on strategies to acquire a debtor or its strategic assets, block a proposed plan or control a bankruptcy case by purchasing claims. Such strategies will likely face a challenge from a disappointed debtor or other creditor that the investor’s votes should be designated. Certainly, a competitor that purchases claims in a debtor’s bankruptcy case will face a serious challenge to any vote that will block a debtor’s plan. The 2nd Circuit’s decision was buttressed by particularly bad facts. The court was clearly troubled by the fact that DISH acquired the claims and began to execute its strategy only after DBSD had proposed its plan. As the 2nd Circuit stated, under circumstances different than those set out in the DBSD case, the purchase of claims for acquisitive or other strategic purposes may be appropriate. For example, if DISH had acquired its claims early in the case, or in conjunction with the formulation of a plan after a debtor had lost exclusivity, would that have made the analysis different? What exactly the circumstances must be for the purchase of clams to be appropriate, however, is any one’s guess as the court provided no further guidance.
Perhaps the bigger question left by the DBSD decision might be its impact on prepetition acquisition of claims and debt, especially in connection with a “loan to own” strategy. Will an investor that purchases claims or debt prior to a debtor’s bankruptcy case run the risk of having the votes on its claims designated if it attempts to acquire the debtor or assert control over the debtor’s assets? That question remains to be determined. Debtors and other disappointed creditors that oppose a prepetition creditor’s efforts to gain control over a debtor through the voting process will likely try to extend the DBSD decision to prepetition purchases of claims. The DBSD decision will, at a minimum, give debtors and other creditors additional leverage in negotiating with strategic investors. Debtors and creditors could rely on DBSD as precedent to litigate the good faith of any plan proposed by such an investor and in an attempt to disqualify such an investor’s vote against any other plan
Still, the “loan to own” strategy has been a popular mechanism for investors to gain control over troubled companies. A prepetition agreement with the debtor may be critical in executing a loan to own strategy in bankruptcy so that the creditor can propose a plan or sale with the debtor’s cooperation. Investors interested in acquiring a debtor in bankruptcy should consult with experienced bankruptcy counsel before embarking on such an acquisition.