In the case, In re Fagerdala USA-Lompoc, Inc., 891 F.3d 848 (9th Cir. 2018), the Ninth Circuit affirmed a creditor’s ability to block a debtor’s “cramdown” by purchasing junior debt to protect its own claim. The court reversed the bankruptcy court’s decision to designate claims for bad faith pursuant to 11 U.S.C. § 1126(e). In doing so, the court thereby sanctioned the creditor’s motive of purchasing claims to block the Chapter 11 plan for the purpose of protecting a pre-existing claim. Thus, Fagerdala illustrates that, in bankruptcy proceedings, at least in the Ninth Circuit, creditors may purchase claims to protect their economic interests.
The basis for the Ninth Circuit’s decision was that a creditor acting in its self-interest by purchasing unsecured claims to block “cramdown” did not constitute bad faith unless the evidence showed the creditor acted with a motive ulterior to the purpose of protecting its economic interest in the bankruptcy case.
Suggested examples of “ulterior motive” by the court were a creditor purchasing claims to block litigation against it, a competitor purchasing debt to eliminate the debtor’s business and improve its own, or a debtor having an insider purchase claims. With its holding that any bad faith analysis under 11 U.S.C. § 1126(e) requires evidence of some “ulterior motive,” the Ninth Circuit has apparently made it clear that a non-creditor or strategic investor purchasing claims to better itself at the expense of the Chapter 11 debtor will constitute “bad faith.’
The holding mandates that a bankruptcy court may not designate or disqualify claims for plan voting purposes based on bad faith under 11 USC § 1126(e) on the mere findings that a creditor did not offer to purchase all the claims available in order to block a plan of reorganization, and/or a creditor’s purchase of claims to block a plan would have a negative effect on the interests of other creditors.
In Fagerdala, a creditor held a senior lien fully secured by the debtor’s real property. The debtor’s proposed Chapter 11 plan of reorganization attempted to extend and modify (cramdown) the terms of the mortgage without the consent of this creditor. To block the debtor’s proposed plan, the creditor then purchased a majority of the general unsecured class of claims and voted against the plan.
The debtor moved to designate (disqualify) the lender’s votes of the purchased unsecured claims under 11 USC § 1126(e) based on the lender allegedly not acquiring the unsecured claims in good faith. The evidence showed that the creditor did not offer to buy each and every claim in the unsecured class.
The bankruptcy court agreed with the debtor and granted designation, finding bad faith in the creditor’s outright purchase to place it in a “blocking position” of unsecured claims that was “highly prejudicial” to and would result in an “unfair advantage” over those unsecured creditors who did not receive a purchase offer and who also held the majority of the unsecured debt. The bankruptcy court focused on the “negative effect of the action” to the other creditors, and that: “as ‘a matter of law,’ it was not going to consider [the creditor’s] motivation or rationale for offering to purchase only a subset of claims.” Fagerdala. at 853.
The Ninth Circuit reversed the bankruptcy court’s designation of the lender’s purchased claim and confirmation of the debtor’s plan. In doing so, it stated that the bankruptcy court erred in making a finding of bad faith without evidence of an ulterior motive, and when it failed to make actual findings of the creditor’s particular motivation for purchasing the claims.
Thus, this case reminds us that in California, and every other location within the Ninth Circuit, creditors may purchase claims to protect and defend their economic interests in bankruptcy proceedings. Fagerdala also makes it clear to third-party non-creditors or investors looking to purchase claims offensively to gain some benefit or advantage over a Chapter 11 debtor that such conduct will result in the designation or disqualification of their claims.
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