A recent Ninth Circuit Court of Appeals decision provides insight into “bad faith” claims-buying activity; specifically whether a creditor’s purchase of claims for the express purpose of blocking plan confirmation is permissible. In In re Fagerdala USA-Lompoc, Inc., the Court found it was—the secured creditor did not act in bad faith when it purchased a subset of all general unsecured claims and voted those claims against confirmation because it was acting to further its own economic interest as a creditor, without some extrinsic ulterior motive.

The facts are as follows. The debtor owned real property valued at $6 million. The bank held a claim of approximately $4 million, secured by the real property. All classes of claims were impaired (incredibly, unsecured creditors were set to receive payment in full plus interest within 60 days after confirmation) under the plan, and therefore, the debtor needed the unsecured creditor class to accept the plan to allow the debtor to “cramdown” the plan over the anticipated objection by the bank.

Understanding that it was vulnerable to a cramdown confirmation, the bank purchased certain unsecured claims to “acquire . . . a blocking position in the unsecured class.” The bank’s sole motivation for purchasing the claims and blocking confirmation was “to do what was best for [the bank] economically.” As such, the bank acquired more than half of the claims but such claims were only about 10% of the value of all unsecured claims.

For a class of claims to accept a plan, more than 2/3 in amount and at least 1/2 in number must vote in favor of a plan. Because the bank acquired more than 1/2 of the number of claims in the unsecured class, its votes were sufficient to block confirmation.

The debtor moved to designate (disallow) the bank’s unsecured claims vote, arguing that the bank had not purchased the claims in good faith. The Bankruptcy Court decided, as a matter of law, that it would not consider the bank’s motivation or rationale for purchasing only a subset of all of the claims. Rather, the Court found that the bank “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 this class.” The Court noted that a creditor purchasing claims for a blocking position is not per se bad faith; however, votes should be designated if a creditor’s conduct in furthering its own interests results in an unfair disadvantage to other creditors.

The Ninth Circuit disagreed. First, it noted that the Bankruptcy Code does not define good faith; rather, it is a fluid concept. Yet, the Court recognized that bad faith does not include “enlightened self interest, even if it appears selfish to those who do not benefit from it.” Moreover, “[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 of 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.” Instead, bad faith is evidenced when one is not looking to further its own proper interests, but is attempting to gain an advantage to which it is not entitled. The Court noted some examples of bad faith in this context: when a non-preexisting creditor buys claims to influence litigation against it, when a competitor of the debtor buys claims to destroy the debtor’s business (thus eliminating a competitor), or when a debtor has insiders purchase claims.

Thus, a creditor that purchases and uses claims to further its own economic interest as a creditor, and without some extrinsic ulterior motive, should be able to vote the claims to block confirmation even if the result is harmful to other creditors. The negative impact on the other creditors does not mean the claims buyer is acting in bad faith.