The right of an impaired creditor to vote to accept or reject a plan of reorganization is one of the most “sacred entitlements that a creditor has in a chapter 11 case.”1 The Bankruptcy Code, however, balances that vital right by granting a court with authority to strip that creditor of its vote (i.e., designate the vote) as a consequence of certain actions taken by, or behavior exhibited by, that creditor. Given the severe implications of such extraordinary relief, courts have almost universally recognized that depriving these creditors of the right to vote on a plan is a drastic remedy.
A recent ruling by the U.S. Bankruptcy Court for the District of Nevada in the Chapter 11 cases of Circus & Eldorado Joint Venture,2 is just the latest in a series of decisions in which a court found that, given the facts and circumstances it was confronted with, designation was nevertheless warranted.3 As the Circus & Eldorado decision illustrates, the key question for the court remains relatively simple: Are a creditor’s actions sufficiently “ulterior” and/or inequitable enough to be deemed one of the so-called “badges of bad faith”?4
Courts have long sought to discourage “bad faith” behavior, and their ability to designate the vote of a creditor, which is now codified in Bankruptcy Code §1126(e), has a deep-rooted history in bankruptcy law. The relief was derived from §203 of Chapter X of the Bankruptcy Act of 1898 (as amended by the Chandler Act of 1938) and former Bankruptcy Rule 10-305.5 Both the Bankruptcy Act and the former Bankruptcy Rule empowered the court to direct a claim to be disqualified in connection with determining the requisite majority for acceptance of a plan, if the creditor’s acceptance of (or failure to accept) a plan was not exercised in good faith.6 Similarly, §1126(e) allows a court, on request of a party in interest, to “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 [the Bankruptcy Code].”7 The Bankruptcy Code, however, is silent as to what constitutes “good faith” and, more importantly, what actions in connection with voting can a court conclude to have been made in bad faith.8
Typically, vote designation is aimed at preventing wrongful behavior by a creditor, such as the situation in which a creditor attempts to extract an undue or inequitable advantage for itself.9 The Supreme Court, in analyzing the history of Bankruptcy Act §203, determined that the provision was intended to apply to those creditors “whose selfish purpose was to obstruct a fair and feasible reorganization in the hope that someone would pay them more than the ratable equivalent of their proportionate part of the bankrupt assets.”10 Likewise, the Second Circuit has noted that the relief afforded by §1126(e) is implicated when parties “venture beyond mere self-interested promotion of their claims.”11
Accordingly, §1126(e) addresses two general types of bad faith cases: (1) instances where the creditor attempts to extract or extort a personal advantage or benefit unavailable to others in its class; and (2) instances where the creditor has an “ulterior motive” or otherwise attempts to secure some advantage that does not relate to its claim or protection of its self-interest as a creditor.12 In applying §1126(e), courts have therefore considered certain behavioral “badges of bad faith” to determine situations in which the motives of a creditor are unquestionably ulterior and almost certainly designed to result in an unfair benefit for such creditor.13 These situations arise where a creditor attempts to (a) block a plan in order to acquire, take over or otherwise assume control of the debtor for an inequitable strategic purpose, (b) put the debtor out of business, injure the debtor’s business or otherwise gain a competitive advantage, (c) destroy the debtor out of pure malice, (d) prevent litigation against the creditor or (e) obtain benefits available under a private agreement between the creditor and a third party that depends on the debtor’s failure to reorganize.14 In addition, one court found that the legislative history of §1126(e) indicates that a creditor who has a conflict of interest with the class in which it votes may be subject to vote designation.15
Importantly, however, the existence of an “ulterior motive” does not necessarily mean that a creditor’s behavior will support a finding of bad faith. Instead, courts recognize that most creditors have interests beyond just their claim, and those other interests will invariably affect how they vote their claim.16 Likewise, a creditor’s selfishness, without more, should not subject a creditor to vote designation because a creditor need not “approach reorganization plan votes with a high degree of altruism and with the desire to help the debtor and their fellow creditors.”17 To find otherwise might result in situations in which few, if any, votes would be upheld by a court in the face of a designation challenge.
Courts must therefore differentiate between situations where a creditor’s actions do not rise to the level of bad faith behavior that Congress empowered courts to prevent, and those situations—for example, purchasing a blocking position in a voting class with an improper motive or through impermissible means—where a creditor crosses the line and demonstrates the behavior that necessitates vote designation.
‘Allegheny’ and ‘DBSD’
For example, in In re Allegheny Int’l, an investor purchased certain subordinated debentures of the debtor immediately prior to filing a plan of reorganization that would have given it control of the debtor.18 Thereafter, in order to defeat the debtor’s competing plan, the investor strategically purchased a blocking position in the two highest impaired classes (thereby ensuring that the debtor could not confirm its plan of reorganization). In granting the debtor’s motion to designate and disqualify the votes of the investor, the Allegheny court imputed bad faith to the investor’s intent by finding, among other things, that the investor had filed its plan of reorganization at the eleventh hour, purchased significant claims only after the voting period on the debtor’s own plan began, purchased a clear blocking position, paid prices close to par for the claims and purchased almost exactly the amount required to block the debtor’s plan.19
Equally disconcerting to the Allegheny court was the fact that the investor was able to defeat any plan of reorganization and thereby obstruct a “fair and feasible reorganization.”20 The investor was clearly interested in taking over and controlling the debtor, and the Allegheny court was convinced that the investor had “engaged in a pervasive pattern of bad faith designed to control the debtor and manipulate the bankruptcy process.”21 The Allegheny court also determined that the investor’s actions were a clear violation of the purposes of Chapter 11 that provided the court “with ample grounds to impose restraints and sanctions.”22 Nevertheless, subsequent to the Allegheny decision, courts were generally not inclined to designate the votes of a creditor who had obtained a blocking position, absent a greater showing of a bad faith motive.23
However, the Second Circuit in DBSD brought the Allegheny decision back into the spotlight when it affirmed the decision of the bankruptcy court to designate the votes of DISH Network Corporation after the bankruptcy court (in relying on the Allegheny and Waco decisions) determined that DISH, an indirect competitor of the debtors and a part-owner of a direct competitor of the debtors, acted in bad faith. Specifically, the bad faith imputed to DISH, who was not a pre-existing creditor of the debtors, revolved around its purchase of an entire class of claims after the debtors had proposed their plan. The Second Circuit agreed with the bankruptcy court’s factual finding that rather than maximizing its recovery on the debt, DISH’s ulterior motive was evinced by its position as a competitor to the debtors, its willingness to overpay for the claims it bought,24 its attempt to propose its own competing plan and (especially) by its internal communications that showed a desire to “obtain a blocking position” and “control the bankruptcy process for this potentially strategic asset.”25
Interestingly, the Second Circuit emphasized that its opinion imposed “no categorical prohibition on purchasing claims with acquisitive or other strategic intentions.”26 Moreover, the court also noted that it was not addressing the situation where a pre-existing creditor votes with strategic intentions.27
‘Circus & Eldorado’
If one thing is clear from the decisions related to vote designation, it is that the concept of bad faith is a fluid one that requires an examination of the totality of the circumstances, and not just a single set of factors.28 This is further illustrated by the very recent Circus & Eldorado cases. There, the U.S. Bankruptcy Court for the District of Nevada designated the plan votes of a noteholder of the debtors, and imposed sanctions against it, after finding that the noteholder acted in bad faith when it improperly attempted to induce other creditors to vote against the debtors’ plan by filing a motion to terminate exclusivity. The motion described the purported failings of the debtors’ plan of reorganization and described, in detail, the noteholder’s alternative plan structure.29 The court had not previously been presented with this information and the noteholder did not obtain approval to disseminate the information.
Most troubling to the court was that the creditor filed its motion seeking to terminate exclusivity during the debtors’ exclusive solicitation period and while the debtors were in the process of soliciting votes on their approved disclosure statement and plan.30 Additionally, and as further evidence of the noteholder’s bad faith, the court was equally troubled and perplexed by the failure to set or notice a hearing date for the court to hear the exclusivity motion.31 Accordingly, the court concluded that while the noteholder was perfectly entitled to act in its own self-interest and to try maximize the return on its claim, the noteholder’s true purpose was to acquire operating ownership of the debtors.32 The court’s analysis of the creditor’s conduct, therefore, falls squarely within the “badges of bad faith” that justify vote designation.
Although courts will likely continue to grapple with what constitutes bad faith under §1126(e) of the Bankruptcy Code for purposes of vote designation, a few key axioms do emerge when examining the relevant case law and legislative history of the provision and its legislative predecessors. Most important among them is that selflessness is not a necessary precondition to avoid designation, but a creditor is nevertheless restricted from wrongfully using the voting process for an “ulterior” purpose. Moreover, while a court’s inquiry is, and will remain, highly fact-intensive and require a close examination of the surrounding circumstances and motivations, creditors and strategic investors alike must be at all times wary of the timing, nature and extent of their actions.
Jayme T. Goldstein and Kenneth Pasquale are partners, and Jonathan Canfield is an associate, at Stroock & Stroock & Lavan, where they practice in the financial restructuring group.
1. See In re Adelphia Commc’ns, 359 B.R. 54, 56 (Bankr. S.D.N.Y. 2006).
2. No. 12-51156 (Bankr. D. Nev. 2012).
3. Recent decisions in which a court either (i) designated the vote of a creditor, or (ii) upheld a lower court decision to designate such vote include DISH Network v. DBSD N. Am. (In re DBSD N. Am.), 634 F.3d 79 (2d Cir. 2011) (discussed in detail herein), In re Derby Dev., No. 10-50259, 2012 WL 2501064 (Bankr. D. Conn. June 27, 2012) (bankruptcy court designated a creditor’s vote after it determined that the creditor was formed as a sham to advance the debtor’s interest in obtaining plan confirmation over the objection of a secured creditor) and In re RLD, No. 11-14071, 2012 WL 3638009 (Bankr. N.D. Cal. Aug. 22, 2012) (bankruptcy court found that a secured creditor acted in bad faith by voting to reject a plan of reorganization in order to correct a mistake made by that creditor).
4. Although not the focus of this article, §1126(e) of the Bankruptcy Code also leaves open the possibility that a court may, in very specific circumstances, designate the votes of a creditor as a result of a “technical violation” of the Bankruptcy Code (i.e., a vote that was “not solicited or procured…in accordance with the provisions of [the Bankruptcy Code]“). See, e.g., In re Stations Holdings Co., Case No. 02-10882 (Bankr. D. Del.); In re NII Holdings, Case No. 02-11505 (Bankr. D. Del.).
5. See In re Dune Deck Owners, 175 B.R. 839, 843 (Bankr. S.D.N.Y. 1995).
6. As discussed in various cases dealing with vote designation, §203 of the Bankruptcy Act of 1898 (as amended) provided, in relevant part, that “[i]f the acceptance or failure to accept a plan by the holder of any claim or stock is not in good faith, in the light of or irrespective of the time of acquisition thereof, the judge may, after hearing upon notice, direct that such claim or stock be disqualified for the purpose of determining the requisite majority for the acceptance of a plan.” 11 U.S.C. §603 (repealed 1978). Bankruptcy Rule 10-305(d) contained language that was substantially similar. See In re Dune Deck Owners, 175 B.R. at 843 n.8.
7. 11 U.S.C. §1126(e) (2012).
8. See Figter v. Teachers Ins. & Annuity Ass’n of Am. (In re Figter), 118 F.3d 635, 638 (9th Cir. 1997).
9. See Young v. Higbee, 324 U.S. 204, 211, 211 n.10 (1945); In re Dune Deck Owners, 175 B.R. at 844.
10. See Young, 324 U.S. at 211.
11. See In re DBSD N. Am., 634 F.3d at 102.
12. See, e.g., In re Dune Deck Owners, 175 B.R. at 844. The type of “ulterior motive” that §1126(e) is intended to target is illustrated in the Fifth Circuit’s decision in Texas Hotel Sec. v. Waco Dev., 87 F.2d 395 (5th Cir. 1936). The Waco decision necessitated the creation of the “good faith” rule, and the facts of the case are described in detail in the Second Circuit’s DBSD decision. See In re DBSD N. Am., 634 F.3d at 102-03.
13. See generally In re Dune Deck Owners, 175 B.R. at 844; In re Adelphia Commc’ns, 359 B.R. at 61.
14. See In re Dune Deck Owners, 175 B.R. at 844-45 (citations omitted).
15. The court In re Dune Deck Owners, 175 B.R. at 845 n.13, noted that, although not embodied in the Bankruptcy Code as enacted, the original House bill included a provision that expressly authorized a court to designate the vote of an “entity that has, with respect to such class, a conflict of interest that is of such a nature as would justify exclusion of such entity’s claim or interest.” According to the Dune Deck court, the House drafters “intended to insure that a creditor who held conflicting claims in two classes could be excluded from voting in one—though not necessarily both—of those classes.” Id. However, the Dune Deck discussion is at least somewhat at odds with the Adelphia decision, in which the court discussed that a creditor who may hold a conflict of interest by owning bonds of multiple debtors in a single Chapter 11 case, or holding bonds in “different, antagonistic, classes of a particular debtor in a single chapter 11 case” as a result of its motive to hedge, does not necessarily lead to a finding of bad faith. See In re Adelphia Commc’ns, 359 B.R. at 63.
16. As briefly discussed by the Second Circuit in the DBSD decision, external factors must be evaluated in determining what considerations may have informed a creditor’s vote since not every ulterior motive constitutes the sort of improper motive that will support a finding of bad faith. For example, trade creditors who regularly conduct business with a debtor may vote in the way most likely to assure future business with that debtor post-reorganization, or a secured creditor may seek liquidation of a debtor (in lieu of reorganization) as interest rates improve to permit funds loaned to the debtor to be recovered immediately and reinvested more wisely. See In re DBSD N. Am., 634 F.3d at 102 (citations omitted). These types of behaviors, while ulterior, should not be held to so taint a vote as to require designation. See In re The Landing Assocs., 157 B.R. at 807.
17. See In re Figter, 118 F.3d at 639.
18. In re Allegheny Int’l, 118 B.R. 282, 286-87 (Bankr. W.D. Pa. 1990). The investor was neither a previous creditor nor equity owner of the debtor, and only purchased the debt in order to qualify as a party in interest authorized to file a plan pursuant to §1121 of the Bankruptcy Code.
19. Id. at 289-99.
20. Id. at 289.
21. See Id. at 299.
22. See Id.
23. See, e.g., In re Figter, 118 F.3d at 639.
24. Although the bankruptcy court put a lot of weight on the fact that DISH purchased certain of the debt at par, the Second Circuit was not equally troubled by the price paid and noted that price was simply circumstantial evidence of DISH’s intent. In re DBSD N. Am., 634 F.3d at 104 n.13.
25. Id. at 104-05.
26. Id. at 105.
28. See In re Figter, 118 F.3d at 639.
29. In re Circus & Eldorado Joint Venture, No. 12-51156, Hr’g Tr. at 5, ECF No. 607 (Bankr. D. Nev. Sept. 20, 2012).
30. See id. The sequence of events in the Circus & Eldorado cases was, therefore, markedly different from other recent Chapter 11 cases, including those of Trump Entertainment Resorts and Pliant. See In re TCI 2 Holdings, No. 09-13654 (Bankr. D.N.J); In re Pliant, No. 09-10443 (Bankr. D. Del.). In TCI 2, a bondholder group moved to terminate exclusivity and filed a competing plan under seal (so as to not violate the solicitation requirements of the Bankruptcy Code and the general solicitation rules of the Securities Exchange Commission) prior to commencement of the debtor’s exclusive solicitation period. Likewise, in the Chapter 11 cases of Pliant, a noteholder, together with the official committee of unsecured creditors, moved to terminate exclusivity, and subsequently filed a competing plan of reorganization. The plan and related documents were filed under seal in order to avoid any appearance of interfering with the debtor’s exclusive period.
31. In re Circus & Eldorado Joint Venture, No. 12-51156, Hr’g Tr. at 8, ECF No. 607.
32. Id. at 9-10.