Those seeking to purchase assets or a business out of a Chapter 11 case employing a “loan to own” strategy may well have received a boost from a recent decision of the U.S. Court of Appeals for the Ninth Circuit.
In In re Fagerdala,1 the Ninth Circuit Court of Appeals held that, for a creditor’s vote on a purchased claim in a Chapter 11 case to be disqualified by a bankruptcy court on the basis of bad faith, the creditor must be intending to obtain for itself some unfair advantage over other creditors for an improper motive unrelated to protecting another claim it owns in the case. “[P]urchas[ing] . . . claims for the very purpose of blocking confirmation of . . . [a] proposed plan . . . is not to be condemned.”2
The rationale of this decision generally would support the purchase by a creditor of claims belonging to one or more classes in a Chapter 11 case, even if certain of such claims are acquired by it with a view toward voting them against the perceived interests of the class to which they belong, so long as the creditor, in doing so, is acting to further its interests as a creditor with respect to, or otherwise protecting, another claim it owns in the case. This could prove helpful to creditors in a variety of related contexts, such as where a creditor may have, for example, acquired secured debt of a chapter 11 debtor at a discount in anticipation of potentially credit-bidding the secured debt at an auction of the collateral. Such a creditor may wish to acquire and vote other classes of debt in the Chapter 11 case in order to block competing reorganization proposals that do not call for auctions of the debtor’s assets at which the creditor could advantageously credit-bid, as it may desire to do.
Background
Fagerdala involved an oversecured senior mortgage lender that held a mortgage loan bearing interest at a below-market rate. The debtor in the Chapter 11 case, wanting to continue to benefit from the advantageous mortgage interest rate, sought to confirm a plan of reorganization that would reinstate the mortgage loan on its existing terms. The mortgage lender, instead, wanted its loan repaid and thus desired to block confirmation of the debtor’s plan that would reinstate its loan. Confirmation of the plan over the mortgage lender’s objection would have required the approval of at least one impaired class. The unsecured vendor class was the only other creditor class. Approval would require two-thirds in amount and over one-half of the 11 creditors comprising such creditor class voting in favor of the plan.
The strategy adopted by the mortgage lender to derail confirmation of the plan was to acquire (at some discount from par) six of the eleven unsecured claims, thereby making it impossible for the plan to achieve “numerosity” for that class. The principal amount of the acquired claims totaled about US$13,000, approximately one tenth of the aggregate principal amount of all of the unsecured claims in the class. The debtor asserted that the mortgage lender’s acquiring those unsecured claims and voting them against plan confirmation was an act of bad faith, and that its votes of such unsecured claims should be “designated“ and thus disqualified.
The bankruptcy court agreed with the debtor, and disqualified the mortgage lender’s votes of the purchased unsecured claims. The court held that purchasing only some of the available unsecured claims unfairly prejudiced the other unsecured claimholders whose claims were not purchased, and also pointed to the adverse impact of such vote on the unsecured vendor class as a whole, noting that the largest unsecured claims in the class, in terms of dollar amount, were not purchased and were left outstanding. Further, given the negative impact that such voting of the purchased unsecured claims would have on the class, the bankruptcy court ruled that the intentions of the mortgage lender, its actual motives in purchasing and voting the unsecured claims, were not relevant. The district court then upheld the bankruptcy court decision on appeal.
Appeal to the Ninth Circuit
On appeal from the district court, the Ninth Circuit Court of Appeals reversed, holding that an analysis of the actual motivations of the purchasing creditor is fundamental to any determination that the creditor acted in “bad faith” and that its vote be “designated,” or disqualified.
The circuit court ruled that a creditor’s vote will be disqualified only if it is pursuing some “ulterior motive“ by virtue of its acquisition and voting of other claims, seeking some “untoward advantage“ over other creditors in pursuing its ulterior motive, something unrelated to its interest as a creditor. Examples given by the court of improper ulterior motives warranting disqualification of voting rights included a creditor who is also a competitor of the debtor and wants to destroy the debtor’s business in order to reduce competition, or a creditor whose motivation is to block a plan of reorganization under which it would be sued by the debtor. Either of those would involve a motivation to vote the acquired claims which has little or no relation to one’s interest as a creditor. On the other hand, where the creditor’s motivation is to maximize recovery on its claim, such as was the case with the mortgage lender in the case at hand, bad faith is lacking and disqualification of its right to vote the claims it had purchased was improper. The court appeared to recognize that the interests of a creditor properly include its broader economic interests in striving to fashion as high a return as it can on its investment.
The mortgage lender in Fagerdala had purchased the unsecured claims with the intention of blocking a plan of reorganization that would have forced it to reinstate its mortgage loan at a disadvantageous rate of interest. Blocking the plan was the way in which the lender sought to enhance its recovery as a creditor, and its vote of the unsecured claims it had bought was in furtherance of this objective and thus not improper. The way it had voted the unsecured claims served its larger objective of protecting and enhancing the recovery on its secured mortgage claim, although it may have worked to the disadvantage of the class of which its purchased unsecured claims were a part. The finding was presumably buttressed by the fact that the mortgage lender was a pre-existing creditor, not a competitor of the debtor, and interested only in getting its loan repaid.
Notably, in listing examples of improper motivations for a creditor’s voting of purchased claims in a Chapter 11 case, the Ninth Circuit failed to include the purchase of secured claims in connection with a “loan to own” or similar strategy. This is particularly noteworthy in light of the court’s citing of the earlier Second Circuit Court of Appeals decision in In re DBSD, Inc.,4 in which that circuit court had disqualified the vote of a creditor that had purchased other claims during the course of a Chapter 11 case of a competitor that owned strategic assets the creditor was interested in acquiring. In that case, evidence was adduced demonstrating that the creditor viewed its own involvement in the case as an opportunity to exert control over a bankruptcy case involving assets strategic to its own business. Such motivations were found by the Second Circuit to be unrelated to such party’s interests as a creditor and thus an improper ulterior motive, and ruled that the creditor was not entitled to vote its purchased claims in furtherance of that strategy. The court in that decision appeared to view a creditor’s interests narrowly, as including its right to recover principal and interest on its claims but as not necessarily extending to other potential economic returns on its investment, such as acquiring strategic assets for its business through the reorganization process by being allowed to fully exercise its creditor rights under such claims.
Split Between the Circuits?
The Fagerdala decision therefore sets up a potential split between circuit courts. The Second Circuit decision in DBSD may be viewed as limiting voting rights of creditors in “loan to own” scenarios where (i) the creditor is a competitor (or owns a competitor) of the bankruptcy debtor in question and seeks to acquire strategic assets through the bankruptcy process, (ii) it purchases claims during the course of the bankruptcy case, and (iii) it seeks to exert control over the bankruptcy process by voting the purchased claims. In contrast, the Fagerdala decision, although not addressing loan-to-own scenarios directly (inasmuch as the facts in that case did not present such a scenario), would appear generally to lean away from characterizing as improper the motivations of a secured creditor in trying to steer a bankruptcy process towards a foreclosure sale on its strategic collateral for which it would be entitled to credit-bid — at least in cases not involving “competitors purchasing claims ‘to destroy the debtor’s business in order to further their own’”.5 The Fagerdala court’s discussion seems to leave ample room for viewing a secured creditor’s motivation to credit-bid for its collateral as reasonably designed to maximize its recovery in pursuing rights to which it is entitled as a secured creditor, and thus as proper.
There may of course be significant areas of overlap between the rationales of the two circuit court cases, such as where a competitor seeks to destroy a debtor’s business and the related competition. Yet there also seem to be significant areas of possible divergence, such as where there is no competition between creditor and debtor, but the creditor has purchased claims across different classes during the course of the bankruptcy process, intending to vote them to steer the bankruptcy process towards an auction at which it would credit-bid secured claims it holds in order to acquire assets it had strategically targeted for acquisition. In such a case, DBSD seems to lean towards disqualification, while Fagerdala does not.
This divergence should not appear where a creditor seeks the liquidation of its competitor through the exercise of creditor rights in a reorganization case, in which situation an “improper ulterior motive” presumably would be easy to find. Rather, the divergence may appear where certain assets of the debtor or where the business of the debtor is sought to be integrated in some way into an existing business of the creditor through the reorganization process. A court that effectively limits the proper scope of a creditor’s interests to the recovery of principal and interest would likely frown on a creditor’s attempted use of the reorganization process to achieve a strategic integration of debtor assets into its own business, potentially subjecting the creditor to exacting scrutiny and disqualification of its voting rights. On the other hand, a court with a broader view and that is somewhat more attuned to developments in the market could potentially recognize any number of economic benefits and value enhancements as being within the proper scope of a creditor’s interests, so long as each represents an element of real incremental return to the creditor, and regardless of how denominated. Such a court should be far less inclined to disqualify a creditor from fully exercising the voting rights on its claims in such circumstances.
What this Means for Sponsors and Other Claim Buyers
For equity sponsors, debt investors and other claim buyers interested in loan-to-own opportunities, it would appear advisable to follow certain guidelines in order to reduce the risk of potential disqualification by a court of the right to vote acquired claims. First, not controlling a direct competitor of the debtor would seem significant in this regard. Second, to avoid the entanglements of DBSD, all efforts should be made to acquire the relevant claims prior to the commencement of the bankruptcy case. Third, each of its relevant filings and other interactions with the bankruptcy court should be expressly linked, to the extent practicable, to its objective of enhancing its recovery on its primary claim in the case. These steps should help to reduce the risk of disqualification.
We look forward to keeping you apprised of additional developments in our next issue.
