When a company or individual files a Chapter 11 case it may file a proposed plan of reorganization and then seek acceptance of its proposed plan by creditors and confirmation by the court. The bankruptcy code provides that a proposed plan of reorganization may provide for different creditor classes consisting of similarly situated creditors. 11 U.S.C. § 1122(a). Whether a particular class approves or rejects a plan can often determine whether the plan is confirmed or not. A secured creditor, often in its own creditor class, facing the potential confirmation of a plan it doesn’t want, may try to buy claims from a class consisting of unsecured creditors to try to control the voting in that class and defeat confirmation of the plan. 11 U.S.C. § 1126(e) provides that the court may designate an entity whose acceptance or rejection of the plan was not solicited or procured in good faith, and a plan proponent can seek to have purchased claims designated. A “designated” claim will not be counted as part of the voting for acceptance or rejection of a plan.
A secured creditor, on the advice of its counsel and seeking to defeat a plan of reorganization proposed by the debtor-in-possession in a Chapter 11 case, purchased just enough unsecured claims to block acceptance by the class. With a minimal expenditure, it bought claims so that it controlled more than 50% in number of claims in the class, though the purchased claims represented only 10% of the claims in the class by amount, thus putting itself in a position to block confirmation of the plan under 11 U.S.C. § 1126(c).
The bankruptcy court, on a motion of the debtor-in-possession, “designated” the purchased claims under 11 U.S.C. § 1126(e) so that the secured creditor could not vote them. Without these “no” votes, the unsecured creditor class voted to accept the plan and the plan was confirmed. The secured creditor appealed to the District Court, which sustained the Bankruptcy Court, and then to the Ninth Circuit, which reversed. Pac. W. Bank v. Fagerdala USA-Lompoc, Inc. (In re Fagerdala USA-Lompoc, Inc.), 891 F.3d 848 (9th Cir. 2018).
The Ninth Circuit noted that no definition of “good faith” is provided in the Bankruptcy Code and expanded the holding of an earlier case, In re Figter Ltd. v. Teachers Ins. & Annuity Ass’n of Am. (In re Figter), 118 F.3d 635 (9th Cir. 1997). In Figter, a secured creditor had made an offer to every member of the unsecured creditor class to purchase that creditor’s claim so that the secured creditor could vote those claims against plan confirmation. The Figter court found that this was a “good faith” exercise of enlightened self-interest. The secured creditor, by offering to buy all creditors’ claims at 100% of the claim amount, was giving all members of that class the opportunity to be paid in full. But in Fagerdala, the secured creditor offered to purchase only some, but not all claims, thus leaving the “excluded” claims exposed to worse treatment than the purchased claims, even though the claimants were all members of the same class under the plan. The bankruptcy court found this was “bad faith”.
The Ninth Circuit disagreed. The claims should be designated only if the purchasing secured creditor exhibited an “ulterior motive”. The correct inquiry was into the motive of the purchaser rather than the effect of the purchase on other creditors. An ulterior motive could be found where a claim buyer was trying to achieve an “outside benefit” to which it was not entitled, such as a non-preexisting creditor purchasing a claim for the purpose of blocking an action against it or a competitor purchasing claims to destroy the debtor’s business and further its own. No such factor was of record in Fagerdala and the Ninth Circuit reversed.
The Ninth Circuit’s opinion in Fagerdala is an advance for creditors trying to control the confirmation process by buying claims. But I wonder whether at some point a court may consider the tension of Fagerdala and 11 U.S.C. § 1122(a), which, again, requires that claims in a class must be substantially similar to other claims in the class.