The U.S. Court of Appeals for the Third Circuit has ruled that a debtor may not reduce the number of votes required to confirm a chapter 11 plan of reorganization by purchasing certain claims. Such vote “gerrymandering” resulted in an unconfirmable plan, the court ruled. In re Machne Menachem, Inc., 233 Fed. Appex. 119, 2007 WL 1157015 (3d Cir. Apr. 19, 2007 (Pa.)).

Machne Menachem was a nonprofit company that operated a summer camp in Pike County, Pa. In 2001, amid a battle for control among its board of directors, the company filed a petition for bankruptcy. Machne submitted a plan for reorganization, as did one of its former directors, Yaakov Spritzer. Following the voting, the bankruptcy court entered an order confirming the debtor’s plan over Spritzer’s objection.

Spritzer argued that confirmation of the debtor’s plan had been secured in bad faith. He argued that Levi Heber, the son of a director of the debtor, had purchased the claims of four unsecured creditors. This purchase allegedly was arranged by the debtor, which then was able to move the purchased claims from “Class Four” (which contained non-insider, unsecured claims), to “Class Five” (which contained insider, unsecured claims).

The bankruptcy court determined that the mere fact that the debtor purchased a creditor’s interest for the purpose of securing approval of the plan did not amount to bad faith.

However, on appeal, the district court relied on case law suggesting that the purchase of claims by a debtor or insider can be an indication of bad faith, and ruled that the purchase of the claims and their reassignment to another class resulted in an unconfirmable plan.

The Bankruptcy Code requires a debtor’s plan to be approved by at least one impaired class of creditors, the court noted. 11 U.S.C. § 1129(a)(10). In the case at hand, the only such class was Class Four, which had approved the debtor’s plan by a vote of seven claims to four.

The four claims purchased by Heber could have altered the outcome, the district court noted. The purchase of claims outside the plan allowed the debtor to reclassify them to reduce the number of votes required for confirmation, the court determined. Hence, the purchase and reclassification of claims effectively “gerrymandered” Class Four to secure confirmation, the district court concluded.

The Third Circuit agreed. “As we’ve previously stated, vote manipulation by the gerrymandering of classes ‘seriously undermines’ the ‘critical confirmation requirements set out in Section 1129(a)(8) (acceptance by all impaired classes) and Section 1129 (a)(10) (acceptance by at least one impaired class in the event of a ‘cram down’),” the court stated, citing precedent. Further, the debtor provided “scant support for rebutting the conclusion that its plan was confirmed by impermissible gerrymandering of classes.”

In addition, the Third Circuit noted that the district court had found that the payment of creditors outside of the plan or reorganization violated the Bankruptcy Code provision requiring “the same treatment for each claim or interest of a particular class.” 11 U.S.C. § 1123 (a)(4).

“We agree … that the debtor’s orchestration of the purchase of claims outside the plan of reorganization undermined the critical confirmation requirements of the bankruptcy code,” the Third Circuit concluded.