Buying Unsecured Claims in Good Faith

Good-faith efforts can create good outcomes. A can cause B. The absence of B, however, does not necessarily mean that A was absent: Bad results can occur even with good-faith efforts. The Ninth Circuit recently followed this logic to decide an issue of good faith under § 1126(e).[1] A finding of bad faith requires evidence of a bad motive — not merely a bad outcome.[2]

Good Faith Under § 1126(e)

A bankruptcy court may cast aside the votes of any entity whose acceptance or rejection of a plan of reorganization was not in good faith.[3] Section 1126(e) uses the term “designate,” but it means “disqualify from voting.”[4] The Bankruptcy Code fails, however, to define “good faith.” Instead, case law provides the standard for courts to apply.

Figter provides an example of a creditor who acted in good faith. In that case, the debtor owned an apartment complex in Los Angeles.[5] The debtor filed for bankruptcy under chapter 11, and it had only one secured creditor.[6] After the debtor proposed its plan, the secured creditor bought 21 of the 34 unsecured claims in one of the classes.[7] It had offered to buy every claim in the class, but some claimholders rejected the offer.[8] Because the secured creditor bought the 21 claims, no impaired and consenting class of claims remained,[9] so the plan would fail to work. Yet the secured creditor was deemed to have acted in good faith.[10]

Examples of bad faith exist, too: One company purchased a claim to block an action against it when it was not a preexisting creditor; to destroy a debtor’s business, creditors associated with a competing business rejected a plan; and an insider purchased claims that a debtor had against itself so that it could block the debtor’s plan.[11] Courts will need to see more than worse conditions for other creditors to find that a party acted in bad faith when buying claims.[12] What is not enough for a finding of bad faith is protecting your claim to its fullest extent.[13]

Secured Creditor Pacific Western’s Purchase of Unsecured Claims

The Ninth Circuit recently decided an issue of good faith under § 1126(e). The debtor, Fagerdala, filed for chapter 11 bankruptcy.[14] It owned real property worth about $6 million.[15] The senior secured creditor, Pacific Western, held a claim on that real property in excess of $3.95 million.[16] And this creditor wanted to block the debtor’s proposed plan.[17]

To confirm its plan, Fagerdala needed at least one class of impaired claims to accept the plan.[18] That required class could only accept the plan if creditors that held at least two-thirds in amount and more than one-half in number of the claims in the class voted to accept the plan.[19] Here, the general unsecured claims in class 4 were impaired.[20] So if the creditors in that class met the § 1126(c) requirement, the court could approve the plan.[21]

To block the plan, Pacific Western bought more than half of the claims in class 4.[22] Even though it bought only about 10 percen of the value of all claims in class 4, Pacific Western bought enough in number to block Fagerdala’s plan.[23] If the remaining holders of claims in class 4 voted to accept the plan, they would fail to provide enough votes under § 1126(c) to allow the court to confirm the plan.[24] After Fagerdala filed its second amended plan, Pacific Western voted its claims to block it.[25] Because of the perceived highly prejudicial effect of Pacific Western’s purchase on the creditors who held most of the unsecured debt, the bankruptcy court removed the purchased claims from voting,[26] upon which the claimholders in class 4 could vote to accept.[27] With approval of an impaired class under § 1126(c), the bankruptcy court later confirmed Fagerdala’s fourth amended plan,[28] and the district court affirmed the bankruptcy court’s decision.[29]

More Room for Good Faith

The Ninth Circuit concluded, however, that no court could find that Pacific Western acted in bad faith under § 1126(e) based on the available evidence.[30] It reversed the district court and vacated the bankruptcy court’s order.[31] First, the bankruptcy court erred by only considering how Pacific Western’s purchase affected other creditors.[32] Second, the bankruptcy court erred by failing to rely on evidence of Pacific Western’s motivations.[33] Purchasing claims to protect your interest in a bankrupt corporation alone can be an act of good faith — even if the act hurts other creditors.[34] Creditors have a right to protect themselves.[35]

The Ninth Circuit’s decision in Fagerdala expands the meaning of good faith under § 1126(e). Before, a creditor could act in good faith by purchasing claims if it offered to buy all claims in a class. But a creditor would act in bad faith if, for example, it purchased claims to destroy a competitor’s business. The facts of Fagerdala fall in the middle, yet the court found that the evidence failed to prove that the creditor in that case acted in bad faith. Now, a creditor who wants to block a plan by purchasing claims in an impaired class need not offer to buy all claims in the class. A creditor can block a plan in good faith to protect its lawful interest by offering to buy only half of the claims in the class.