Does this sound familiar? A newly formed entity purchases distressed bank debt after the debtor has proposed a reorganization plan. The purchaser obtains a blocking position and uses its negotiating leverage to obtain control of the plan process and ultimately the borrower’s assets, which have strategic importance to the purchaser. Although this scenario might be considered typical in special situations investing, the Second Circuit Court of Appeals recently ruled, in connection with the DBSD bankruptcy case, that such conduct may amount to "bad faith" and permit a court to disallow the vote of purchaser on the pending plan of reorganization.1 This client alert discusses this recent opinion2 and its potential implications for “strategic” distressed investors.
In the chapter 11 case of DBSD North America, Inc. (“DBSD”), DISH Network (“DISH”), whose wholly-owned subsidiary is a direct competitor of DBSD, purchased all of DBSD’s outstanding first lien debt at par and approximately 17% of the second lien debt that was not subject to a plan support agreement requiring it to vote in favor of DBSD’s plan. DBSD’s proposed plan provided for the repayment of the first lien debt with a new secured note and for the holders of second lien debt to receive equity in reorganized DBSD.
DBSD sought to “designate” or disallow DISH’s votes in the first lien and second lien classes rejecting DBSD’s plan of reorganization under Bankruptcy Code section 1126(e), which allows a court to designate the votes of “any entity whose acceptance or rejection of such plan was not in good faith….”
DBSD alleged that DISH acted in bad faith based on the following:
- DISH overpaid for the first lien debt by paying a purchase price of par after the debtor filed a plan that provided for the repayment of such debt with a new secured note, evidencing that DISH was not interested in making a profit on the debt itself.
- DISH only purchased second lien debt not subject to a plan support agreement so that it could vote these claims to reject the plan.
- DISH attempted to propose its own plan and approached the debtor about a strategic transaction.
- DISH’s internal documents demonstrated that it purchased the first and second lien debt for the purpose of gaining control of DBSD.
The bankruptcy court concluded that DISH’s actions constituted bad faith and therefore its votes in both the first lien and second lien classes should be designated because DISH did not act to maximize recovery on its claim, but rather to gain control of DBSD outside of either the “traditional” plan or asset purchase process.
THE SECOND CIRCUIT OPINION
On appeal, the Second Circuit Court of Appeals affirmed the decision of the bankruptcy court. The Second Circuit recognized that the Bankruptcy Code does not define “good faith” and restated certain basic principles:
- Designation of votes is a remedy that should be used sparingly as the exception, not the rule;
- Merely purchasing claims in bankruptcy for the purposes of securing the approval or rejection of a plan does not of itself amount to bad faith; and
- A court should only designate votes when creditors are not attempting to protect their own proper interests but are, instead, attempting to obtain some benefit to which they were not entitled, i.e., exercising votes with an “ulterior motive” or an interest other than as a creditor.
Moreover, the Second Circuit recognized that “whether a vote has been properly designated is a fact-intensive question” subject to the “considerable deference” of bankruptcy judges. See DISH Opinion at 47.
The Second Circuit concluded that the bankruptcy court permissibly designated DISH’s vote because “it 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.” See id. at 44.
The Second Circuit based its determination on the findings of the bankruptcy court that DISH, an indirect competitor of DBSD:
- purchased a blocking position in a class of claims after a plan had been proposed;
- did not intend to maximize its return on the debt purchased, but rather wanted to enter into a strategic transaction with DBSD; and
- intended to use its status as a creditor to gain an advantage for itself that would not be available had DISH proposed a plan as an outsider or made a traditional bid for DBSD or its assets.
The Second Circuit, in certain respects, attempted to narrow and clarify its ruling by stating that (i) acquisitions and other strategic transactions benefit all parties in bankruptcy and creditors should continue to pursue such transactions, (ii) there is “no categorical prohibition on purchasing claims with acquisitive or other strategic intentions,” and (iii) the opinion leaves “for another day the situation in which a preexisting creditor votes with strategic intentions.” See id. at 46.
Other statements in the DISH Opinion seem, however, to undercut these clarifications. For example, the DISH Opinion states that its ruling should only deter attempts by purchasers to “obtain a blocking position” and thereby “control the bankruptcy process for [a] potentially strategic asset” and that using claims “bought to secure an advantage in pursuing that strategic transaction” can support a finding that the purchaser acted in bad faith. See id. at 45-46. These broad statements call into question the viability of a fundamental strategy of distressed investors: purchasing a significant position in a fulcrum security in order to obtain control of the equity of a reorganized debtor.
Unfortunately, numerous issues remain unresolved by this decision, such as: (i) whether the ruling will apply in a situation where an investor acquired the blocking position in the debt post-petition but prior to the filing of a plan, (ii) whether the ruling will apply to a purchase of debt by a non-competitor of the debtor, (iii) what constitutes a “strategic acquisition” and (iv) whether a court would consider designation of votes in the event the request is made by another creditor in the case instead of the debtor. The DISH Opinion also appears troubling for club deals or other “ad-hoc” groups of investors in that the broad language could be used to designate votes of a group of investors that collectively obtain a blocking position with a view to obtaining control of a mutually strategic asset.
Given the broad language described above, it is difficult to predict how courts within the Second Circuit, and elsewhere, will apply the holding of the DISH Opinion. Will courts limit application of the DISH Opinion to instances where the creditor in question is a direct or indirect competitor seeking to control the debtor’s assets for a competitive advantage? Will courts extend the holding to all creditors obtaining a blocking position when employing “loan-to-own” strategies? Either way, we expect that the broad language in the DISH Opinion will likely lead to increased litigation with respect to the claims and positions taken by strategic distressed investors.
In order to mitigate the risk of a "bad faith designation" and the consequent loss of voting rights, distressed investors with strategic intentions should, depending on the facts and circumstances, carefully consider whether to (i) purchase debt before a disclosure statement or plan has been filed, and (ii) pay a market purchase price (or less) for claims. This will help establish an intent to earn a profit on the claims. In addition, a direct or indirect competitor of the debtor (possibly including funds with material investments in the debtor's industry) should study the DISH Opinion and subsequent developments carefully before acquiring claims solely in order to control the debtor’s bankruptcy proceedings and obtain a competitive advantage with respect to the debtor’s assets.