The Bottom Line

The Ninth Circuit recently held, in In re Fagerdala USA – Lompoc, Inc., No. 16-35430, 2018 WL 2472874 (9th Cir. June 4, 2018), that a creditor may purchase just enough unsecured claims to obtain a blocking position to plan confirmation, and that doing so is not, per se, bad faith. In so holding, the Circuit court also recognized that the fact that other creditors may be adversely affected by the purchaser’s blocking position is not evidence of bad faith. Instead of considering the negative effect of the purchase on other creditors, the bankruptcy court should examine for evidence of a bad faith motivation (e.g., a competitor seeking to put the debtor out of business or a non-creditor defendant seeking to derail plan litigation against it).

What Happened?

Background

Fagerdala USA – Lompoc, Inc. (the “Debtor”) owned real property worth approximately $6 million. A secured creditor (the “Bank”) held claims in excess of $3.95 million secured by the real property. The Debtor filed a chapter 11 plan, placing the Bank’s claim in class 1, and the general unsecured claims in class 4. All claims were deemed impaired by the plan.

To block the Debtor’s plan, the Bank had purchased enough unsecured claims to obtain a blocking position in class 4. The Bank did not seek to acquire all unsecured claims, and only made offers to those claims that would enable its vote to block confirmation. The purchased claims constituted at least one half of class 4 in number, but only ten percent of the claims by value.

The Debtor moved to designate the votes of the purchased claims under section 1126(e) of the Bankruptcy Code, arguing that the Bank did not purchase those claims in good faith. The Bankruptcy Court granted the motion, concluding that designation was appropriate because the Bank would have an “unfair advantage” over other unsecured creditors who did not receive a purchase offer and who hold the largest percentage of claims in the class by amount. Additionally, the Bankruptcy Court stated that the purchase was highly prejudicial to the other creditors who held most of the unsecured debt, particularly because the Bank did not offer to purchase all of the unsecured claims. The Bankruptcy Court then confirmed the Debtor’s plan and the Bank appealed. The District Court affirmed the Bankruptcy Court’s designation of the purchased claims.

Ninth Circuit Opinion

The Bankruptcy Court focused on two main facts in its designation decision, namely: (1) the Bank did not make an offer to purchase all unsecured claims, and (2) if the Bank voted its purchased claims, whether it would have had an unfair advantage that would have been highly prejudicial to other creditors. The Ninth Circuit found that neither of these facts were relevant under section 1126(e), and reversed the decisions of the Bankruptcy and District Courts.

First, the Ninth Circuit discussed general principals of good faith under 1126(e) and, relying on the Court’s previous decision in Figter Ltd. v. Teachers Ins. & Annuity Ass’n of Am. (In re Figter), 118 F.3d 635 (9th Cir. 1997), 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.

Next, the Ninth Circuit turned to the Bankruptcy Court’s first consideration, that the Bank’s failure to offer to purchase all the unsecured claims in the class was cause for designation. The court found that while offering to purchase all the claims in a class is certainly an indicator of good faith, the failure to do so does not constitute bad faith. The Ninth Circuit previously found in Figter that purchasing claims to block a plan is not bad faith. Thus, the Court found that because blocking a plan takes only a numerical majority of the class, or majority of the class by value, purchasing only that portion of the class that allows for 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).” As such, purchasing only those claims needed to meet the voting threshold was not, per se, improper.

Finally, the Court turned to the Bankruptcy Court’s focus on the effect of blocking a plan on other creditors. While the Bankruptcy Court found that the Bank would have an unfair advantage over other creditors that would be highly prejudicial, the Ninth Circuit held that the Bankruptcy Court erred in focusing solely on the negative effect of the claim purchase on other creditors, rather than the 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 [to designate the Bank’s claims.” Examples of such bad faith motivation given by the Ninth Circuit include a non-preexisting creditor buying a claim for purposes of blocking an action against it or a competitor purchasing a claim to destroy the debtor’s business in furtherance of the competitor’s own business.

Why This Case Is Interesting

The case extends existing Ninth Circuit authority that had previously found that the offer to purchase all unsecured claims to block a plan was not evidence of bad faith warranting designation under section 1126(e) of the Bankruptcy Code. This case expands that precedent to say that only offering to purchase enough claims to obtain a blocking position and defeat the voting requirement is not, per se, bad faith. Other evidence of bad faith is required by section 1126(e). Nor should the court consider the negative impact of the claim purchase – and resulting blocking position – on other creditors. Bad faith requires an examination of the motivation of the creditor other than a motive seeking to protect its claim.