In so holding, the Court sanctioned the lender’s motive of purchasing claims to block the plan for the purpose of protecting its own existing claim. The Court held that the relevant bad faith inquiry under 11 USC § 1126(e) requires a motive which is ulterior to the purpose of protecting a creditor’s economic interest in a bankruptcy proceeding.

Background

The lender held a senior lien fully secured by the debtor’s real property. The debtor’s proposed “cramdown” plan sought to extend and modify the terms of the mortgage without the lender’s consent.

In a successful move to block Debtor’s proposed “cramdown” plan, the lender purchased a majority in number of the claims in the general unsecured class and voted them against the plan.

The debtor moved to designate the lender’s votes of the purchased unsecured claims under 11 USC § 1126(e) on the ground that the lender did not acquire the unsecured claims in good faith. At the hearing on the debtor’s designation motion, the lender’s counsel admitted to the bankruptcy court that the lender did not make an offer to buy every claim in the unsecured class.

The bankruptcy court granted designation, finding bad faith where the lender’s outright purchase of a “blocking position” in unsecured claims would be “highly prejudicial” to and result in an “unfair advantage” over the unsecured creditors who did not receive a purchase offer and who held most of the unsecured debt. Focusing primarily on the “negative effect of the action” to the other creditors, the bankruptcy court explicitly stated: “as ‘a matter of law,’ it was not going to consider [the lender’s] motivation or rationale for offering to purchase only a subset of claims.” Id. at 853.

Ninth Circuit’s Decision

The Ninth Circuit reversed the bankruptcy court’s designation of the lender’s purchased claim and confirmation of the debtor’s plan.

The Court held the bankruptcy court erred when it found bad faith in the lender’s acts of self-interest—purchasing the unsecured claims to block “cramdown”—without evidence of an ulterior motive and when it did not make actual findings on the lender’s motivations. In reaching its decision, the Court noted that the bad faith inquiry is not a consideration of the negative effects of the creditor’s self-interested acts, but rather the proper inquiry looks to whether the creditor acted with an “ulterior motive.”

The Court noted examples of “ulterior motive” for which bad faith may be found: a creditor purchasing junior debt for the purpose of blocking litigation against it; a competitor purchasing debt to destroy the debtor’s business and enhances its own; and a debtor arranging to have an insider purchase claims. The examples highlight that the “ulterior motive” is distinct from acting in protection of one’s own claim, and instead, has to do with acting to secure some untoward advantage or benefit to which the creditor was not entitled.

Conclusion and Takeaways

This case is significant because it serves as a reminder that, in the Ninth Circuit, creditors may purchase claims as a defensive move to protect their economic interests in the bankruptcy proceeding. However, Fagerdala also warns non-creditors or investors looking to purchase claims as an offensive move to gain some kind of benefit or untoward advantage over the Chapter 11 debtor that doing so is at the risk of designation.

With the purchased unsecured claims removed from voting considerations, the debtor had sufficient creditors in the general unsecured class to accept the plan, and the bankruptcy court ultimately confirmed the debtor’s fourth amended plan.

On appeal, the district court affirmed the bankruptcy court’s designation of the purchased unsecured claims.