Disqualifying Votes on Chapter 11 Plans

by

David S. Kupetz

333 S. Hope Street, 35th FloorLos Angeles, CA 90071

(213) 617-5217dkupetz@sulmeyerlaw.com

2405501.1

David S. Kupetz specializes in troubled transactions, crisis avoidance consultation, workouts, restructurings, reorganizations, bankruptcies, receiverships, assignments for the benefit of creditors and other non‑bankruptcy insolvency proceedings. He represents debtors (in restructurings and workouts and in chapter 11 reorganization cases), secured creditors, unsecured creditors' committees, assignees for the benefit of creditors, buyers/sellers of businesses/assets in distressed circumstances and other entities in insolvency and bankruptcy situations.

A sampling of clients represented by Mr. Kupetz includes: Care Enterprises, Inc. (debtor in possession); Ocean Pacific Sunwear, Ltd. (debtor in possession); County of Los Angeles (creditor); General Electric Capital Corporation (secured lender); Litton Industries, Inc. (creditor); Boston West, LLC (Boston Markets) (debtor in possession); ExxonMobil Corporation (creditor); Honda Trading Co. (creditor); CKE Restaurants (creditor); San Diego Television, Inc. (debtor in possession); South Bay Pizza, Inc. (debtor in possession); Transgo Corp. (unsecured creditors’ committees); Aura Systems, Inc. (out-of-court unsecured creditors’ committee); Snow Valley, LLC (debtor in possession); Gardenburger, Inc. (debtor in possession); eStyle, Inc. (debtor in possession); American Home (debtor in possession); No Fear Retail Stores, Inc. (debtor in possession); and Ventura Port District (chapter 9 debtor).

His many articles on bankruptcy‑related subjects have been published in The Business Lawyer, Commercial Law Journal, IDEA: The Journal of Law and Technology, Journal of Bankruptcy Law and Practice, The Annual Survey of Bankruptcy Law, The Urban Lawyer, The Banking Law Journal, Los Angeles Lawyer, California Lawyer, Commercial Law Bulletin, Los Angeles Daily Journal, The Secured Lender, The Journal of Private Equity, The Journal of Corporate Renewal, Public Law Journal, Federal Lawyer and many other publications. Mr. Kupetz served as the author of Collier Commercial Bankruptcy Forms for many years and currently is the author of the Collier Handbook for Creditors' Committees.

Mr. Kupetz is a frequent lecturer on reorganization and other insolvency topics.

David S. Kupetz

Direct Line: 213.617.5274dkupetz@sulmeyerlaw.com www.sulmeyerlaw.com

Los Angeles Office333 South Hope StreetThirty-Fifth FloorLos Angeles, CA 90071Voice: 213.626.2311 Fax: 213.629.4520

Introduction

The ultimate goal of a case under chapter 11 of the Bankruptcy Code is confirmation of a plan of reorganization.

Voting on a plan can be a pivotal part of the confirmation process.

The Bankruptcy Code provides the court with the power, under specified, but undefined circumstances, to disqualify votes on a chapter 11 plan.

Bataa/KierlandIn In re Bataa/Kierland, LLC, 476 B.R. 538 (Bankr. D. Ariz.

2012), the United States Bankruptcy Court for the District of Arizona, exhaustively examines the development of the law governing the scope of the court's power to disqualify votes on a chapter 11 plan.

In Bataa, a secured creditor filed a motion to disqualify another secured creditor's vote in favor of the debtor's plan of reorganization.

The motion was brought pursuant to Bankruptcy Code section 1126(e) and asserted that the vote in favor of the plan was not in good faith.

Section 1126(e) and the Power to Disqualify

Section 1126(e) provides that "[o]n 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.“

The meaning of "good faith," as used in section 1126(e), is not defined in the Bankruptcy Code.

The courts have significant discretion in determining whether there is a lack of good faith connected with voting on a plan.

Section 1126(e) and the Power to Disqualify

The court, in Bataa, explained that to obtain a designation (disqualification) of a vote, the party seeking disqualification had a heavy burden of proof because designation is a narrow exception to the ordinary democratic process and because bad faith is akin to fraud, which is never presumed.

Based on Ninth Circuit precedent binding on the Bataa court, as set forth in In re Figter, 118 F.3d 635 (9th Cir. 1997), actions taken in the creditor’s self interest that didn't constitute malice, blackmail, competitive motive or attempt to obtain more than the creditor was entitled to receive on his claim would not lead to disqualification of the creditor’s vote.

Gerrymandering, Artificial Impairment, and Section 1129(a)(10)

Bankruptcy Code section 1129(a)(10) sets forth the plan confirmation requirement that if a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.

The purpose of section 1129(a)(10) is to require some indicia of creditor support for a plan under which rights are being altered.

The Modern View of “Ulterior” Motives

In Figter, a secured creditor purchased twenty-one unsecured claims and voted those claims against the debtor's plan, even though the plan provided for full payment of the secured creditor's oversecured claim.

This rendered the debtor's plan unconfirmable because it did not satisfy section 1129(a)(10).

On appeal, the Ninth Circuit upheld the bankruptcy court's finding of good faith because the creditor acted in a good faith attempt to protect its interests and not with some “ulterior” motive when it bought up most of the Class 3 claims in an effort to protect its own Class 2 claim.

The Modern View of “Ulterior” Motives

The Figter opinion derived the "ulterior motive" definition of bad faith from the history of the origins, drafting, and application of the predecessor of § 1126(e).

As long as a creditor acts to preserve what he reasonably perceives as his fair share of the debtor's estate, bad faith will not be attributed to his purchase of claims to control a class vote.

The Ninth Circuit indicated that the determination of good faith under section 1126(e) is to be made on a case-by-case basis.

The Modern View of “Ulterior” Motives – Cont.

The Figter opinion cited a number of cases where creditors acted out of self interest without constituting an ulterior motive, including:

purchasing claims for blocking confirmation of a plan; voting against the plan of a debtor who has a pending lawsuit

against the creditor; choosing to benefit the creditor's interest as a creditor as a

opposed to some unrelated interest; and purchasing additional claims for the purpose of protecting the

creditor's own preexisting claim.

The Modern View of “Ulterior” Motives – Cont.

The Ninth Circuit also cited examples where a bad faith ulterior motive was indicated, including:

where a party that was not a preexisting creditor purchased a claim for the purpose of blocking an action against it;

creditors with a competing business seeking to destroy the debtor's business in order to further their own; and

a debtor arranging for claims against itself to be purchased by an insider or affiliate for the purpose of blocking or fostering a plan.

The Modern View of “Ulterior” Motives – Cont. In DISH Network Corp. v. DBSD N. Am., Inc. (In re DBSD N. Am.,

Inc.), the Second Circuit follows the Figter approach, stating that the question “centers on what sort of ‘ulterior motives’ may trigger designation under § 1126(e).” 634 F.3d at 79 (2nd Cir. 2011).

The Second Circuit affirmed the bankruptcy court’s designation of the competitor’s vote because the competitor’s motive went beyond the traditional creditor seeking to maximize such return on the pre-petition debt it held.

In DBSD, a competitor of the debtor (DISH) who was not a creditor of DBSD before the chapter 11 case acquired claims with the goal of obtaining control over a strategic asset (the debtor's spectrum rights). DISH then voted the acquired claims against the debtor's plan.

The Modern View of “Ulterior” Motives – Cont.

The Bataa court found that it is not an ulterior motive for creditor to be “friendly” to the reorganization because it wants the reorganization to succeed so that it can continue to do business with the reorganized debtor.

Moreover, if a creditor can purchase and vote a claim in another class solely because the creditor wants the plan to fail, as in Figter, then certainly a creditor can vote its own claim in its own class solely because it wants the plan to succeed.

The court then turned to the Lender’s argument that creation of the creditor’s claim constituted a basis for disqualification under section 1126(e).

The Modern View of “Ulterior” Motives – Cont.

§ 1126(e) does not specifically refer to a bad faith creation of a claim as a basis to designate. It only applies to bad faith in solicitation or procurement of the vote, not to the creation of the claim in which the vote is cast.

Virtually all of the case law, including Figter, addressing section 1126(e) considers creditors’ motives and not the motives of debtors or other plan proponents.

The Bataa court declared that with respect to a debtor/plan proponent the disqualifying “ulterior” motive has to be a motive that is beyond the role or capacity of the party in the bankruptcy case.

If the purpose for creating a debt was to create a class that would likely satisfy § 1129(a)(10) and therefore render the plan confirmable, such a motive is not at all ulterior to that of a debtor who is a plan proponent.

Good Faith Under Section 1129(a)(3)Bankruptcy Code section 1129(a)(3) sets forth the

requirement for confirmation of a chapter 11 plan that “[t]he plan has been proposed in good faith and not by any means forbidden by law.

The Ninth Circuit’s definition of good faith for purposes of section 1129(a)(3) provides that a plan is proposed in “good faith” when it “achieves a result consistent with the objectives and purposes of the Code.”

The Bataa court observes that the adoption of the section 1129(a)(3) definition of good faith for purposes of section 1126(e) might have generated a different result for the secured creditor in the Figter, but would not have altered the results in Bataa.

Historical AnalysisThe Bataa court notes that the Ninth Circuit’s analysis of the history

and origins of the section 1126(e) in the Figter opinion was extremely truncated.

Unlike the Figter opinion, the Bataa opinion examines the history underlying section 1126(e) at length, including who (SEC Commissioner William O. Douglas) drafted the predecessor of section 1126(e), what facts generated the perceived need for the provisions ("capricious minorities" exercising veto power or extorting tribute), and how that predecessor provision (section 203) functioned under the prior Bankruptcy Act.

The Bataa court explains that section 203 of the Bankruptcy Act, the predecessor to section 1126(e), was intended to provide courts with authority to reverse the results of Texas Hotel Securities v. Waco Development.

Historical Analysis In Waco, a competitor and former lessee of the debtor (controlled by

Conrad Hilton) acquired claims against the debtor for the sole purpose of voting against the debtor’s plan and preventing the debtor’s reorganization so that it could obtain control of the debtor’s hotel.

The district court refused to count Hilton's vote.

The Fifth Circuit reversed this ruling since it was unable to identify any authority in the Bankruptcy Act for examining the motives of creditors voting against a plan.

The Bataa opinion discusses that section 203 of the Bankruptcy Act was drafted in the wake of Waco in order to prevent “capricious minorities” from exercising a veto power that they could use to prevent their competitor from reorganizing, or to extort payments from other creditors and stockholders for their assent to a plan.

Historical Analysis The test was not whether the motive was ulterior to the creditor’s self-

interest, but rather it was ulterior to the interests of the other members of class whose vote was being dominated.

A secured creditor who purchases unsecured claims, when that secured creditor has no unsecured claim of its own because it is oversecured, clearly has an ulterior motive. Its motive, as recognized by the Figter opinion, was to dominate the unsecured creditor class vote solely in order to protect its interest as a secured creditor – an interest not shared or common to the other members of the unsecured creditor class. Justice Douglas would have had no problem identifying that as an ulterior motive that equates with bad faith.

As passed, section 1126(e) included new language regarding vote solicitation, but it still retained the core function of its predecessors by allowing courts to designate votes cast in support of a motive ulterior to the interests of the other members of the class.

The analysis of the Bataa court demonstrates that the good faith test under section 1126(e) for disqualifying votes on a plan has developed in a manner that likely would not have been predicted at the time the Bankruptcy Code was enacted.

The Bataa court concludes that Ninth Circuit's approach is a result of viewing the section 1129(a)(10) requirement that a plan that impairs claims must have at least one impaired class that votes in favor of the plan as a purely technical requirement that neither protects no confers any substantive rights.

While the pursuit of an "ulterior motive" is the commonly stated basis for vote disqualification, the narrow, technical application of section 1129(a)(10) results in the approach adopted by the Ninth Circuit where the Court will not inquire into the motives for the alleged manipulation of the votes so long as they are consistent with the party's proper role and capacity in the case.

Conclusion

Under this approach, a preexisting creditor can acquire claims of creditors in another class, as was the case in Figter, in order to control to the vote of the other class and defeat confirmation of a plan to protect its own interests.

The Bataa opinion convincingly explains that this is contrary to the intent underlying section 1126(e).

Accordingly, although Figter may have been incorrectly decided, it is the law in the Ninth Circuit and embodies the modern approach that has been followed by other courts.

Conclusion – Cont.

The Bataa court reasons that "so long as there is no fraud, no injury to anyone's rights or interests, and no attempt to extort more than either … [the] accepting creditor or the debtor/plan proponent would be entitled to under the other confirmation requirements", just as a creditor may prevent confirmation of a plan by buying and voting claims of creditors whose interests it does not share, a plan proponent may manufacture a class to provide the necessary acceptance of a plan under section 1129(a)(10).

However, if the test for "good faith" voting on a plan was understood and applied in the same way as it was prior to and at the time of enactment of the Bankruptcy Code, the acquisition of claims by a creditor in another class for the purpose of voting against and defeating a plan would likely result in section 1126(e) being applied to disqualify the purchased votes.

Conclusion – Cont.

Nonetheless, with an active market in the acquisition of claims having developed since the Bankruptcy Code was enacted, it seems unlikely that the clock will be rolled back to a time where section 1126(e) is applied more liberally to protect the interests of creditors who decline to sell their claims and/or a plan proponent who loses the support of preexisting creditors upon the sale of their claims to a creditor in a different class.

Conclusion – Cont.