Ninth Circuit Holds Protecting A Claim To Its Fullest Extent Is Not Evidence Of Bad Faith

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The Ninth Circuit Court of Appeals recently held that a secured creditor’s purchase of general unsecured claims to block confirmation of a Chapter 11 plan did not in itself constitute bad faith. In In re Fagerdala USA, the debtor owned real property on which Pacific Western Bank held the senior secured claim. The debtor’s plan of reorganization sought to impair Pacific Western’s claim by using an interest rate lower than the penalty interest rate for its loan, and modifying the length of the term and other loan provisions. Under section 1129(a)(10) of the Bankruptcy Code, in order to approve a plan over the objections of impaired creditors, a debtor is required to obtain the consent of at least one impaired class. In order to ensure that this debtor would not receive such consent, Pacific Western attempted to strategically buy up a sufficient amount of general unsecured claims—the only other impaired class—to block the plan. While Pacific Western did not seek to buy every general unsecured claim, it was able to purchase “one-half in number” of the general unsecured class, and was thus able to block the approval of the plan.

After the plan vote, the debtor moved to designate the votes Pacific Western cast on behalf of its general unsecured claims, arguing that Pacific Western purchased those claims in bad faith. To “designate” means the votes for the claims will not be counted in voting to accept or reject the plan. The bankruptcy court granted the debtor’s motion, concluding that “designation is appropriate in this case because [Pacific Western] will have an unfair advantage over the unsecured creditors who did not receive a purchase offer and who hold the largest percentage of claims…in terms of amount.” The district court affirmed this ruling, but the Ninth Circuit reversed it and remanded the case to the bankruptcy court.

The Ninth Circuit reasoned that “merely protecting a claim to its fullest extent cannot be evidence of bad faith. There must be some evidence beyond negative impact on other creditors.” Looking to case law, the court enumerated several clear examples of bad faith such as where a competitor purchases claims to destroy the debtor’s business or further its own or a non-preexisting creditor purchasing claims only to block the plan and then stated “[d]oing something allowed by the Bankruptcy Code and case law, without evidence of ulterior motive, cannot be bad faith. Not offering to purchase all the claims in a class (to later use those claims to block a plan) is not—alone—sufficient to evidence the bad faith necessary to designate votes under § 1126(e).”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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