Contributed by Sunny Singh
On February 7, 2011, the Second Circuit issued its written decision in the DBSD, N.A., Inc. bankruptcy case addressing a number of important bankruptcy issues, such as the validity of the “gifting” doctrine, the designation of votes of a creditor under section 1126(e) of the Bankruptcy Code, and the standing of an “out of the money” creditor to object to a chapter 11 plan. This entry discusses the Second Circuit’s affirmance of the bankruptcy court’s designation of the vote of DISH Network Inc. on the DBSD debtors’ plan. For a more detailed description of the general background facts of the DBSD case, please see our prior entry on the Second Circuit’s analysis of the standing issue.
The facts surrounding the designation dispute between the DBSD debtors and DISH are fairly straightforward and are described in the bankruptcy court’s decision on the DBSD debtors’ motion to designate DISH’s vote. DBSD and its affiliated debtors are a development stage enterprise formed in 2004 to develop a services network that can deliver wireless satellite communications services to mass-market consumers. DISH is a provider of satellite television. DISH is also a significant investor in TerreStar Corporation, a competitor of the debtors, which is engaged in the same business as the debtors of designing and developing a wireless satellite communications services. DISH was not a prepetition creditor of the debtors. About two weeks after the debtors filed their chapter 11 plan, however, DISH purchased all of the first lien debt. Because the first lien debt was separately classified under the debtors’ plan, DISH’s purchase meant that it was the sole creditor voting in that class. DISH also purchased portions of the second lien debt, but only from those creditors who were not bound by plan support agreements with the debtors. Throughout this period, DISH was also pursuing a strategic transaction with the debtors.
DISH voted against the plan and asserted multiple objections to confirmation, including that the new secured notes that the debtor proposed to issue to DISH for the full amount of the first lien debt did not provide DISH the “indubitable equivalent” of its first lien debt. In response, the DBSD debtors moved to designate DISH’s vote and confirm the plan over DISH’s objection. The bankruptcy court granted the debtors’ motion to “designate” DISH’s vote under section 1126(e) of the Bankruptcy Code because it was not exercised in “good faith.” Notably, as discussed below, the bankruptcy court did not simply disregard DISH’s vote (which still would have meant that the class of first lien debt had not accepted the plan). The district court and Second Circuit both affirmed.
Section 1126(e) permits the court to designate a vote on a plan that was not in “good faith.” “Good faith,” however, is not defined in the Bankruptcy Code, and the determination of whether to designate the vote of a creditor is left to the discretion of the bankruptcy court. In reviewing the bankruptcy court’s decision to designate DISH’s vote against the plan, the Second Circuit outlined some general principles. First, designation is the exception, not the rule. Second, “merely purchasing the claims in bankruptcy for the purpose of securing the approval of rejection of a plan does not itself amount to ‘bad faith.’” And, third, “selfishness alone [does not] defeat a creditor’s good faith; the Code presumes that parties will act in their own self interest and allows them to do so.” Rather, designation aims to punish a very specific wrong: attempting to obtain some benefit to which a creditor is not entitled; also referred to as voting with an “ulterior motive” or with “an interest other than an interest as a creditor.” The Second Circuit noted that not every ulterior motive is an improper one that requires designation, and, in many cases, creditors may have more than one motive in voting on a plan. For example, trade creditors may be motivated not just by the treatment of their claims, but also on their ability to continue to do business with the debtor.
In affirming the bankruptcy court’s decision to designate DISH’s vote, among other things, the Second Circuit reviewed the legislative history of section 1126(e) and Texas Hotel Securities Corp. v. Waco Development, Co., the case that motivated the good faith exception for section 1126(e)’s predecessor, which was carried over to the Bankruptcy Code by section 1126(e). In the Waco case, Conrad Hilton purchased claims of a debtor to block confirmation of a plan that would have transferred a lease on the debtor’s property that was once held by Hilton to a third-party. By buying and voting claims, Hilton and his partners sought to force a plan that would achieve their ultimate goals of regaining the operation of a hotel on the debtor’s property or otherwise reestablishing an interest in the property. The district court refused to count Hilton’s vote, but the Fifth Circuit reversed, holding that the court had no authority to look to the motives of a creditor in voting against a plan. Two years later, Congress enacted the “good faith” requirement to voting of claims. According to the Second Circuit, Hilton’s conduct of buying a blocking position against the confirmation of a plan for selfish purposes was the wrong that section 1126(e) was intended to prohibit.
Naturally, a party’s motive and whether it exercised good faith in voting is a highly fact specific inquiry. The bankruptcy court was convinced by the totality of the evidence that DISH had not voted against the plan in good faith and, therefore, its vote should be disregarded. First, DISH was an indirect competitor of DBSD and part-owner of a direct competitor. As the Second Circuit noted, “[c]ourts have been especially wary of the good-faith of parties who purchase claims against their competitors.” Second, DISH bought the entire class of first lien debt after the plan had been proposed and at par. Although DISH stood to collect some interest on the first lien debt, DISH’s decision to purchase the debt at par strongly suggested to the bankruptcy court that DISH had other motivations. DISH also bought second lien debt but only from creditors that were not already subject to a plan support agreement with the debtors. Third, and perhaps worst of all, DISH’s internal communications and documents explicitly stated that DISH saw a “strategic opportunity to obtain a blocking position … and control the bankruptcy process for this potentially strategic asset.” 421 B.R. at 136. And finally, after pleading to the bankruptcy court that it was a “model citizen” because, among other things, it had not sought to terminate the debtor’s exclusivity or propose a competing plan, on the eve of the confirmation hearing, DISH did exactly that by moving to terminate the debtor’s exclusivity and filing a competing chapter 11 plan (which it later withdrew).
Based upon these facts and circumstances, it was clear to the Bankruptcy Court that DISH had voted with an ulterior motive and not in good faith. The Second Circuit agreed. Indeed, the Second Circuit found that DISH’s conduct mirrored Hilton’s in Waco. In both cases, the purchasers were competitors of the debtor that bought claims against the debtor to further another business objective, not to maximize their return on claims.
DISH also appealed the bankruptcy court’s decision to disregard DISH’s vote not just for purposes of calculating whether its class had accepted a plan, but also for purposes of section 1129(a)(8), which requires that every class either accept a plan or the cram-down standards under section 1129(b) be satisfied for a plan to be confirmed. Because DISH had purchased all of the first lien debt in the class, after the bankruptcy court designated DISH’s vote, it was effectively left with a class that had no other claims capable of accepting or rejecting the plan. The bankruptcy court rejected DISH’s argument that section 1129(a)(8) still must be satisfied with respect to its first lien claims notwithstanding that its vote had been designated. If DISH was still entitled to the protections of section 1129(a)(8), the designation ruling would have no effect because the plan could then only be confirmed if either DISH consented to the plan or could be crammed down. That level of control over the debtors’ plan was exactly the reason DISH purchased the claims and why its vote was designated. The Second Circuit affirmed, but noted that it took no position on whether a similar result is appropriate for other tests imposed by section 1129(a) for confirmation of a plan, such as the “best interests” test under section 1129(a)(7) or the requirement for at least one impaired class of non-insiders accept the plan under section 1129(a)(10).
The decision is a stern reminder that bankruptcy courts have the power to monitor and punish creditor overreaching in the plan process. But how the decision will affect chapter 11 practice is not as clear as other aspects of the opinion, such as the invalidation of the “gifting doctrine” in the Second Circuit. The facts of DBSD fit very neatly into case law precedent and legislative history. Indeed, the Second Circuit stated that DISH’s conduct “echoed” the Waco case. DISH was a competitor of the debtor that purchased debt postpetition to obtain a strategic advantage for a business or assets that it was interested in acquiring. And the evidence of its motive was overwhelming. It is difficult to predict how a court would rule in a situation where a creditor employs a strategy to buy enough claims in its class to obtain a blocking position because it does not support the debtor’s plan or its treatment or recovery thereunder – a common strategy in chapter 11 cases. It is arguable in that situation that the creditor’s ultimate motive is to maximize its recovery and not some other “ulterior motive.” It is also difficult to predict how a court may apply DBSD to the more common “loan to own” situations, in which creditors purchase significant debt positions for the ultimate purpose of acquiring the equity in the reorganized debtor. Recognizing that this could open a “can of worms,” the Second Circuit made clear that it was not deciding whether designation is appropriate if a preexisting creditor votes with strategic intentions. What is clear, however, is that DBSD has not created a bright line rule for designation, and each case will be evaluated on its independent facts with the bankruptcy court having significant discretion in such evaluation. DBSD should at least make a claims purchaser, particularly a competitor of the debtor that has no prepetition stake in the game, think twice before employing a strategy to buy a blocking position to gain a strategic edge.
In our previous posting on DBSD, we noted that the Bankruptcy Court had scheduled a hearing for February 15 to consider the DBSD debtors’ motion for authority to enter into an investment agreement with DISH and that the FCC’s deadline for DBSD’s transfer of the FCC licenses was March 28, 2011. Last week, the hearing on the investment agreement was adjourned to March 1, and the FCC deadline was extended to July 28, 2011.