June 12, 2018 - In a decision of importance to the distressed loan trading market, the United States Court of Appeals for the 9th Circuit in In re Fagerdala recently held that a bankruptcy court cannot “designate” (disqualify) a lender’s vote on a plan of reorganization simply because (i) it offered to purchase only a subset of available claims in order to block the plan, and/or (ii) blocking the plan will adversely affect the remaining creditors. As Schulte Roth & Zabel notes in its recent memo, the court reached “a sensible result, ensuring creditors can act in their own economic self-interest.”
Background. The lender held a senior secured claim of close to $4MM secured by property worth approximately $6MM. The debtor filed for Chapter 11 protection and proposed a plan of reorganization that would impair both the secured and unsecured creditors. Under Section 1129 of the Bankruptcy Code, a debtor can “cram down” the plan on the secured creditors only with the approval of one impaired class whose approval requires both a majority in number and by percent of value of the class. The senior lender purchased the majority in number (but a much smaller percentage of the value) of the unsecured claims to obtain a blocking position in the unsecured creditor class. The debtor moved to “designate” the votes relating to the purchased claims arguing that because the lender offered to purchase only a subset of the claims they had not been purchased in “good faith”. The lender countered that it had good business reasons for not offering to purchase all the claims.
The bankruptcy court ruled that the lender acted in bad faith and designated its vote, ruling as a matter of law that it did not need to consider the lender’s motivation or rationale for offering to purchase only a majority in number of claims. He concluded that the lender’s “conduct in further of its own interest should not result in an unfair disadvantage to other creditors” and that they should not be prejudiced by the lender’s obtaining a blocking position by “purchasing such a small percentage of the unsecured debt.” As a result, the plan was confirmed. The lender appealed to the District Court which affirmed.
The Court of Appeals reversed, holding that neither the fact that the lender offered to buy only a subset of the claims or the purported prejudice to the unsecured creditors, by themselves, are sufficient to support a finding of bad faith. Notably, the Court found that a creditor may act in its own self-interest and, in contrast to Dish v. DBSD, a controversial 2nd Circuit decision, buying claims to protect that interest does not, by itself, demonstrate bad faith or an ulterior motive.