Bankruptcy Voting and the Designation Power

Chapter 11 of the Bankruptcy Code is the only form of bankruptcy that requires winning the consent of the creditor body. Creditors are given the right to vote based on an underlying assumption that they will cast their votes to maximize recovery on their claims. When creditors collectively vote to further these distributional goals, then the estate in turn should realize the maximum value for its assets. Value maximization is one of the fundamental goals of chapter 11, and voting in bankruptcy is an important way of achieving that goal. The problem with these assumptions is that creditors sometimes vote for reasons other than their distributional goals. For example, if a creditor owns a competing business, it may be less concerned with maximizing recovery on its claim and more concerned with putting the debtor out of business no matter what terms the debtor offers. When creditors cast their votes for reasons other than their distributional goals, then the collective vote may no longer reflect the value-maximization goal of chapter 11. The Bankruptcy Code provides the courts with a mechanism to guard against the exercise of voting power based on these non-distributional motivations. Section 1126(e) allows a court to designate or disqualify a vote that was not cast in good faith, or was not solicited or procured in good faith or in accordance with the provisions of this title. The Code does not define the phrase in good faith, leaving courts to fill this breach on a case-by-case basis. Broadly speaking, courts have held that a vote should be disqualified when it is cast for a reason other than the creditor\u27s desire to maximize its recovery on its claim. In many areas, the courts have faithfully fulfilled this duty to screen outside influences that creep into the voting process. In the last two decades, however, the proliferation of claims trading in bankruptcy cases has increased the prevalence of voting based on outside influences, and the effectiveness of creditors who seek to influence the bankruptcy process for non-distributional ends. There is nothing new in a creditor buying other claims to influence the vote on a plan, but the amount of claims trading and the motivations behind it have dramatically changed over time. Some of these motivations are not known to the debtor, let alone the court, making it more difficult to regulate the voting process. This is especially true in cases of credit swaps, total return swaps, and other derivative agreements that are becoming more and more commonplace in large bankruptcy cases. Another significant change in practice is the frequency with which chapter 11 is used as a means of acquiring assets rather than its more historical use of reorganizing a business. With these changing dynamics, courts need to reevaluate the use of their designation power. Part I of this article begins with an identification of the underlying purpose that creditor voting is intended to fulfill. Part II explores the courts\u27 traditional use of designation powers to uphold this purpose. In Part III, this article identifies three major areas in which the courts should expand the use of designation powers to ensure that voting is serving its intended purpose, especially in light of modern day practices. It also recognizes one area in which some courts\u27 current application of this power may be contrary to the value-maximization goal of chapter 11