Are Corporate Family Chapter 11 Filings Governed by a Different Good - - PDF document

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Are Corporate Family Chapter 11 Filings Governed by a Different Good Faith Standard? March/April 2005 Mark G. Douglas The distinction between recourse to chapter 11 protection as a legitimate means to maximize the value of a company's assets and/or to restructure its financially-troubled yet otherwise viable

• perations, on the one hand, and clear bankruptcy abuse, on the other, is sometimes murky. A

court called upon to make such a distinction is obliged to "get into the debtor's head" and investigate the board's motives for commencing a bankruptcy case and, in some cases, to decide whether the debtor's otherwise permissible use of the powerful provisions of federal bankruptcy law is impermissible because the debtor's motives are antithetical to the basic purposes of bankruptcy. The Bankruptcy Code contains a variety of mechanisms that abridge, alter or delay creditor rights and remedies. Among these are the automatic stay, discharge of debts, avoidance of preferential transfers, rejection of unfavorable contracts and limitations on the amount of certain employee and landlord claims. However, it is generally recognized that a debtor can avail itself

• f these mechanisms only if its decision to seek chapter 11 protection in the first place comports

with lawmakers' intentions in 1978 in enacting the Bankruptcy Code. At the heart of this analysis lurks chapter 11's "good faith" filing requirement. The "good faith" standard is an integral part of the balancing process between debtor and creditor interests that is manifest in

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many provisions of the Bankruptcy Code. Unfortunately, caselaw guidance on the concept of "good faith" is highly fact-specific, and as a consequence, abstruse and sometimes contradictory. A ruling recently handed down by the Texas bankruptcy court overseeing the chapter 11 cases filed by energy supplier and marketing giant Mirant Corporation and its affiliates suggests that the good faith filing standard may be applied differently in cases involving a company that is part

• f a corporate "family" of chapter 11 debtors.

Chapter 11's Good Faith Filing Requirement Chapter 11 of the Bankruptcy Code has been interpreted to create two separate good faith requirements in connection with a debtor's authority to avail itself of and use the protections of the Bankruptcy Code. First, section 1129(a)(3) expressly provides that every plan of reorganization be "proposed in good faith and not by any means forbidden by law." This provision has been construed to require that a plan be proposed with "honesty and good intentions" and with "a basis for expecting that a reorganization can be effected." In keeping with that mantra, bankruptcy courts are required to determine whether a chapter 11 plan, viewed in light of the “totality of the circumstances,” fairly achieves a result consistent with the purposes

• f the Bankruptcy Code.

However, a bankruptcy court may be called upon to make a good faith ruling well before confirmation of a chapter 11 plan. Bankruptcy Code section 1112 delineates a catalogue of abuses or failures, including continuing loss to or diminution of the estate, the inability to effectuate a plan, or unreasonable delay by the debtor, that can lead to the outright dismissal of a

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chapter 11 case or its conversion to a liquidation. Courts have consistently found that the prosecution of a chapter 11 case in "bad faith" — although not listed as one of the examples — also constitutes "cause" for dismissal or conversion under section 1112(b). The good faith filing requirement is designed "to ensure that the hardships imposed on creditors are justified by fulfillment of the statutory objectives." Bad faith generally refers to a chapter 11 filing with the purpose of abusing the judicial process. For instance, a chapter 11 filing for the sole purpose of fending off litigation (e.g., foreclosure) if the debtor has no real prospect of reorganizing its business is often found to qualify as the kind of abuse that rises to the level of bad faith. Similarly, a filing by a solvent debtor merely to obtain a tactical litigation advantage has also been found to be abusive. When challenged, the debtor bears the burden of demonstrating that its bankruptcy petition was filed in good faith. The courts must make that determination on a case-by-case basis, undertaking an examination of the totality of the circumstances to decide where "a petition falls along the spectrum ranging from the clearly acceptable to the patently abusive." The basic thrust of the good faith inquiry has traditionally been whether the debtor needs chapter 11 relief. "Need" is informed by the Supreme Court's identification of two of the basic purposes

• f chapter 11 protection as "preserving going concerns" and "maximizing property available to

satisfy creditors." Thus, where a chapter 11 filing is motivated by something other than a desire to rehabilitate a financially-distressed yet viable entity or to preserve or maximize asset values for the creditor-beneficiaries of an orderly liquidation, a court will dismiss the case as having been filed in bad faith. The debtor's solvency may be relevant to the analysis, but it does not end

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the inquiry ― the Bankruptcy Code does not establish insolvency as a prerequisite to filing for chapter 11 (or any form of bankruptcy relief). If the debtor is insolvent, a "good faith" ruling is fairly assured because the filing "implements Congress' scheme of debt priorities and the policy

• f equal distribution among creditors with the same priority."

The analysis becomes more difficult if the debtor is solvent or otherwise financially healthy. Here, many courts find that the only bankruptcy policy implicated is avoidance of piecemeal liquidation that destroys going concern value. Absent circumstances surrounding the filing that pose this risk, these courts rule that a chapter 11 petition was not filed in good faith. The Mirant Corporate Family Chapter 11 Filings Mirant Mid-Atlantic, LLC ("MRMA") was formed in 2000 as part of a sale by Potomac Electric Power Company ("Pepco") of its power generation assets to Mirant Corporation ("Mirant") for nearly $3 billion under an asset sale and purchase agreement (the "sale agreement"). To finance the acquisition, Mirant caused MRMA to enter into a complex series of sale leaseback transactions involving two Maryland power plants. By means of these transactions, the lessors provided approximately $300 million of the purchase price directly and borrowed an additional $1.2 billion from public noteholders. The sale leaseback transactions were memorialized in a facility lease agreement, a participation agreement and a pass-through trust agreement (collectively referred to as the "leaseback agreements"). As part of the sale agreement, two other Mirant subsidiaries acquired power plants from Pepco with financing provided in part by MRMA. Mirant was obligated under a capital contribution

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agreement to contribute to MRMA's capital the cash flow produced by those power plants. Failure to do so was an event of default under the leaseback agreements. MRMA had contractual relationships with various other Mirant subsidiaries that enabled it to operate, purchase fuel and market power. Although the assets purchased from Pepco remained profitable, Mirant and its affiliates encountered other problems. Mirant's efforts to restructure bank loans and bond debt in early 2003 failed. As a consequence, Mirant and 74 of its affiliates, including MRMA, sought chapter 11 protection in July of that year. The filings triggered defaults under the sale agreement, the leaseback agreements and the capital contribution agreement. At the time that it filed for bankruptcy, MRMA was solvent and, subject to the potential consequences of cross-defaults under various agreements, had no difficulties meeting its obligations as they matured. MRMA and various other Mirant affiliates sued in the bankruptcy court for a determination that the sale leaseback transactions should be recharacterized as loans. The lessors and the indenture trustee for the public bonds responded by seeking dismissal of MRMA's chapter 11 case under section 1112(b) as having been filed in bad faith. The Texas bankruptcy court denied the motion. At the outset, the court observed that it is "appropriate to provide a different standard from that applied to good faith dismissal in a single debtor case to that of a key operating affiliate placed in chapter 11 in conjunction with necessary filings by its family of affiliates." According to the court, MRMA's solvency and ability to pay its obligations as they matured did not warrant a finding of bad faith.

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MRMA was one of the largest pieces of Mirant's enterprise. Had it not filed for chapter 11 relief, the court emphasized, MRMA would almost certainly have been forced into bankruptcy by creditors concerned about leaving so large a part of the parent company's business and assets beyond court supervision. Noting that MRMA would have been subject to repercussions from the filings of its affiliates, the court concluded that "[w]here, as here, the need for rehabilitation

• f the corporate family enterprise is obvious, it is clearly a valid use of chapter 11 to address that

need." Even so, the court ruled that dismissal of MRMA's case also was not warranted under the good faith test applied in stand-alone chapter 11 cases. It elected to make that determination by examining whether MRMA's chapter 11 served a "valid bankruptcy purpose." The court characterized as "justifiable" management's decision to file for bankruptcy because of potential contractual defaults under the leaseback and sale agreements, and concerns about MRMA's ability to operate outside of chapter 11: In sum, in mid-July of 2003, [MRMA] faced defaults in various contracts, complications in its interaction with chapter 11 debtor affiliates and other potential consequences from the filings of those affiliates. [MRMA's] Board of Managers determined it was more prudent to place [MRMA] in chapter 11 than face these risks out of court. Their purpose was valid: to protect [MRMA's] ability to continue as a going concern as part of the corporate family enterprise. Perhaps [MRMA] could have taken alternative precautions, could have protected itself through negotiated agreements with its contract parties. That is not the

• issue. . . . The question is whether [MRMA's] Board of Managers could properly

conclude that chapter 11 was an appropriate way to address possible tough times ahead. Finally, the court held that MRMA's chapter 11 filing was not tactical or intended for a "nefarious" purpose. It rejected the contention that MRMA filed for chapter 11 to gain an

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advantage in seeking to have the leaseback transactions recharacterized as loans. According to the court, the evidence clearly showed that MRMA first began exploring the possibility of recharacterizing the transactions six months after it filed for bankruptcy. Moreover, it explained, the company did not need to file for chapter 11 to seek a remedy that could have been granted by a non-bankruptcy court. Where Do We Go from Here? Chapter 11 is an invaluable tool for companies attempting to find a workable solution to a wide range of financial, operational and market problems. Still, a company must be suffering from financial distress that can be remedied by a bankruptcy filing before it can rely on the safe haven

• f chapter 11 and all of its attendant benefits. In the absence of financial distress, a chapter 11

debtor will be hard-pressed to withstand a motion to dismiss the case on bad faith grounds, even if the debtor would clearly benefit from the substantive entitlements created under federal bankruptcy law, such as the ability to reject burdensome contracts, to limit claims for damages flowing from rejection, or to sell assets without having to pay certain transfer taxes normally levied on such transactions. In a very real sense, the good faith test acts as the gatekeeper to chapter 11. In Mirant, the Texas bankruptcy court suggests that the good faith of a "corporate family" chapter 11 filing should be judged according to a different standard than that by which stand- alone cases are gauged ― but query whether it really is different. Notwithstanding the court's reliance on other decisions characterizing as "irrelevant" a corporate family member's ability to demonstrate good faith on a stand-alone basis, the court's good faith finding was clearly based on

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the potential ramifications of the corporate family filing on the financial well-being of any member that might not otherwise have filed for chapter 11. Most courts examine the totality of the circumstances surrounding a chapter 11 filing to ascertain whether a company's recourse to chapter 11 is legitimate under the good faith test. That is precisely what the court did in Mirant. Had there not been cross-default provisions in key agreements giving rise to potential exposure, MRMA's decision to file for chapter 11 would probably not have passed muster under the good faith standard, whether or not the company was part of a corporate family. If Mirant can be said to articulate a caveat to the good faith rule in the context of corporate family filings, it should be that members of a corporate family may be subject to different kinds of financial distress than stand-alone businesses by reason of their affiliations with other companies. ____________________________________________ In re Mirant Corporation, No. 03-46590 (Bankr. N.D. Tex. Jan. 26, 2005) (unpublished memorandum opinion and order).