Weil Summer Associate David Rybak contributed to this post
A creditor’s control of votes in a class of claims can be a powerful means of influencing the outcome of a debtor’s chapter 11 plan confirmation process.  The Ninth Circuit Court of Appeals’ recent decision in In re Fagerdala, 891 F.3d 848 (9th Cir. 2018) has sharpened a weapon in the arsenal of aggrieved creditors, holding that claims purchases by creditors aimed at acquiring a blocking position in a class of claims to influence the outcome of a chapter 11 plan process is not a per se act of bad faith.  Instead, a finding of bad faith requires evidence that a party acted with an “ulterior motive” beyond merely pursuing its enlightened self-interest to protect its economic interests.  Fagerdala expressly leaves the door open for such creditors to buy blocking positions against such plans, and to do so efficiently, so long as their motives do not cross the line.


Fagerdala USA – Lompoc, Inc. (“Fagerdala”), the debtor, was a California corporation that owned real estate worth approximately $6 million.  Pacific Western Bank held a senior secured claim worth approximately $4 million, secured on Fagerdala’s real estate.
Fagerdala filed for chapter 11 on August 14, 2014, and filed a proposed chapter 11 plan of reorganization on April 27, 2015. Pacific Western Bank was not satisfied with the proposed treatment its secured claim under the proposed plan.  As we’ve discussed previously on this blog, a debtor can confirm a chapter 11 plan over the objection of a non-consenting class of claims, so long as, among other things, at least one class of claims that is impaired has voted to accept the plan.
Because Pacific Western Bank would not vote to accept the debtor’s plan, the plan could not be confirmed without an affirmative vote from the general unsecured claims class.  See 11 U.S.C. § 1129(a)(10).   The debtor sought to “cram up” its secured lender, Pacific Western Bank, by using the general unsecured claims class to achieve its requirement to have an impaired accepting class vote in favor of the plan.
As a defensive measure, Pacific Western Bank took steps to block Fagerdala’s plan by offering to purchase some, but not all, of the general unsecured claims against the debtor.  This effort was successful, resulting Pacific Western Bank acquiring 50% in number of the allowed general unsecured claims.  These claims represented less than 10% in value of all allowed general unsecured claims against the debtor (the “Purchased Claims”).  Pacific Western Bank then voted all of its claims – both secured and unsecured – against Fagerdala’s chapter 11 plan.1  In response, Fagerdala moved to designate the votes of the Purchased Claims under 11 U.S.C. § 1126(e), arguing that the Pacific Western Bank had not purchased them in good faith.

Primer on Vote Designation and Good Faith

Section 1126(e) of the Bankruptcy Code provides that “on request of a party in interest, and after notice and a hearing, the court may designate any entity whose acceptance or rejection of such plan was not in good faith, or was not solicited or procured in good faith or in accordance with the provisions of this title.”  When a claim is “designated,” the vote of the claim is no longer considered when determining whether a class of claims has voted in favor of a plan of reorganization.
Good faith is not defined in the Bankruptcy Code, and its interpretation has been left to the courts to develop.  Historically, however, courts have looked toward parties’ subjective motives, and the Ninth Circuit has previously held that section 1126(e) designation applies to those who “were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled. . . . An entity acts in bad faith when it seeks to secure some untoward advantage over other creditors for some ulterior purpose.”2

The Bankruptcy Court and District Court Holdings

The bankruptcy court granted Fagerdala’s designation motion, stating as a matter of law it was not going to consider Pacific Western Bank’s subjective motivation for not offering to purchase all general unsecured claims.  Rather, the bankruptcy court rested its decision solely on (i) the objective fact that Pacific Western Bank did not offer to purchase all general unsecured claims, and (ii) its finding that failing to designate the Purchased Claims’ votes would be highly prejudicial to the remaining creditors in the general unsecured claims class.  Perhaps deciding with equitable principles in mind, the bankruptcy court highlighted the fact that the general unsecured claims would certainly not be paid in any liquidation that might have followed the plan not being confirmed, but would be paid in full within 60 days of confirmation of the debtor’s proposed plan.  On appeal, the district court affirmed the bankruptcy court’s designation order.

The Ninth Circuit’s Holding

The Ninth Circuit reversed the judgment and vacated the bankruptcy court’s designation order.  Reviewing the bankruptcy court’s finding of bad faith—a question of fact—the Ninth Circuit applied a “clear error” standard of review.  The Ninth Circuit first reiterated that a finding of bad faith is appropriate where an entity has acted with some ulterior purpose.  In other words, a finding of bad faith must be grounded in that entity’s subjective motives.
Consequently, the Ninth Circuit found that the bankruptcy court committed clear error in its bad faith determination by ignoring Pacific Western Bank’s underlying motivations.  Pacific Western Bank’s selectivity in offering to purchase only a subset of general unsecured claims was not, in isolation, dispositive of an ulterior motive.  Nor was the “highly prejudicial” effect of Pacific Western Bank’s actions vis-à-vis other creditors sufficient to demonstrate that Pacific Western Bank acted with an improper ulterior motive.  Rather, a creditor may rightfully protect its claims to the fullest extent and if it “acted out of enlightened self-interest, it is not to be condemned simply because it frustrated the debtor’s desires.”3

The Upshot

The Ninth Circuit took a macro-approach in evaluating a “creditor’s self-interest” by looking to a party’s interests in the case as a whole rather than conducting separate analyses with respect to claims held in different classes.  This approach reflects the practical realities of creditors looking to maximize their overall position in chapter 11 proceedings, instead of forcing creditors to wear different hats and pursue their self interest within different, competing classes of claims.
In keeping with this practical approach, the Ninth Circuit gave several examples of an outside or ulterior benefit, which if sought, would support a finding of bad faith.  Such examples include (i) a non-preexisting creditor purchasing a claim for the purpose of blocking an action against it, (ii) competitors purchasing claims to destroy the debtor’s business in order to further their own, and (iii) a debtor arranging to have an insider purchase claims.
Fagerdala serves as a reminder that, at least in the Ninth Circuit, bad faith determinations under 11 U.S.C. § 1126(e) must tie into a party’s improper, subjective motivations. Conceptually, the Ninth Circuit reiterated the distinction between “a motive which is ulterior to the purpose of protecting a creditor’s interest” – a token of bad faith – and “a creditor’s self interest as a creditor” – a permissible motivation under the Bankruptcy Code.4  The decision supports the ability of creditors to purchase claims as a defensive maneuver to protect their economic interests, so long as their motives are not otherwise tainted by an ulterior benefit.