Making the Case for a "Good Faith" Chapter 11 Filing - - PDF document

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Making the Case for a "Good Faith" Chapter 11 Filing December 2004 Paul D. Leake 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, including 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 many provisions of the Bankruptcy Code. Unfortunately, caselaw guidance on the concept of "good faith" is often abstruse, offering little concrete guidance, and sometimes contradictory.

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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(b)(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 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

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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." In the courts, 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

• f the basic purposes of 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 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 of 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. Recent Ruling on Good Faith Filing Requirement

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A decision recently handed down by the Third Circuit Court of Appeals in In re Integrated Telecom Express, Inc. confirms that courts will strictly scrutinize the circumstances surrounding a chapter 11 filing. Integrated, a software and equipment supplier to the broadband communications industry, entered into a commercial real property lease in 2001. After suffering net losses of over $36 million that year and stymied in its efforts to locate a potential purchaser, the company resolved to dissolve under state law. At the time, Integrated and certain of its

• fficers, directors and underwriters were defendants in a securities class action seeking over $90

million in damages. Integrated later decided to sell its intellectual property assets to a company newly formed by certain of Integrated’s officers and directors for $1.5 million. Recognizing that resolution of the lease issue could complicate the sale, the company attempted to negotiate with its landlord to reduce it lease exposure. During the course of the negotiations, Integrated’s lawyers sent the landlord a letter indicating that the company “was prepared to avail itself of various provisions in the Bankruptcy Code, including the cap on landlord’s claims . . . [and that] even if [Integrated] were to file bankruptcy solely to cap the Lessor’s claim using Bankruptcy Code § 502(b)(6), a use for which this Code section is intended, [Integrated] would not violate the good faith filing doctrine.” Integrated's board of directors even went so far as to adopt a resolution with similar

• language. Integrated and the landlord never settled.

Integrated filed a chapter 11 petition in 2002, scheduling over $105 million in cash on hand and other assets, and listing miscellaneous liabilities of approximately $430,000. The landlord submitted a proof of claim in which it denominated Integrated’s lease obligations (including future rent) at $26 million. Integrated immediately sought court authority to sell its intellectual property assets at auction and to reject its lease. The bankruptcy court ultimately

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approved the sale of Integrated's intellectual property assets for $2.5 million in two separate transactions. The landlord responded to the lease rejection motion by seeking dismissal of Integrated's chapter 11 petition as having been filed in bad faith. After conducting an evidentiary hearing, the bankruptcy court noted that Integrated "was experiencing a dramatic downward spiral" and that "the Board had an obligation . . . to give the investors their money back." Addressing Integrated's efforts to limit the landlord's claim for future rent, the court observed that "even assuming or accepting the landlord's position . . . that the principal reason for the Chapter 11 case was to cap the damage claim for the landlord, I conclude that as a matter of law, that is not a debilitating fact." The court then explained that caselaw supports the proposition that a solvent debtor can avail itself of the section 502(b)(6) cap, stating that the landlord elected to "ride with the bulls" when it decided to enter into a lease with Integrated, and "must suffer the consequences" of its instincts being wrong. The court confirmed a liquidating chapter 11 plan that limited the landlord's future rent claim in accordance with section 502(b)(6) and set aside a reserve of $5 million to supplement $20 million in insurance proceeds available to pay any judgment against Integrated in the pending securities litigation. The landlord appealed the confirmation order to the district court, which affirmed. Among other things, the district court found that the bankruptcy court soundly interpreted relevant caselaw and did not abuse its discretion in ruling that a chapter 11 filing for the principal purpose of limiting a landlord's claim does not amount to bad faith. The landlord fared better on appeal to the Third Circuit. Initially, the Court explained that in the realm of "good faith," cases have focused on two inquiries: (1) whether the petition serves a valid bankruptcy purpose, e.g., by preserving a going concern or maximizing the value

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• f the estate; and (2) whether the case is filed merely to obtain a tactical litigation advantage.

Because Integrated had gone out of business and was being liquidated, the Court observed, there was no going concern value to preserve, and it need only determine whether the company's chapter 11 petition might reasonably have maximized the value of its estate. The Third Circuit concluded that it would not have. At the outset, the Court emphasized that "[t]o say that liquidation under Chapter 11 maximizes the value of an entity is to say that there is some value that otherwise would be lost outside of bankruptcy." As such, the Third Circuit reasoned, good faith necessarily requires that the debtor be in some kind of financial distress that the bankruptcy case can address, although it need not be in extremis before resorting to bankruptcy, or even insolvent. Turning to the facts, the Court concluded that the lower courts' determination that Integrated faced financial distress because it "was losing a lot of money" and "experiencing a dramatic downward spiral" was not an adequate basis for finding good faith because a chapter 11 filing could not remedy these problems, which had "no relation to any debt

• wed by Integrated." Accordingly, the Third Circuit ruled that "[b]ecause Integrated's 'dramatic

downward spiral' did not establish that Integrated was suffering from financial distress, it does not, standing alone, establish that Integrated's petition was filed in good faith." The Court of Appeals rejected Integrated's contention that the chapter 11 petition served a valid bankruptcy purpose because the case provided a framework for resolving the securities

• litigation. Faulting the courts below for failing to make specific findings on this point, the Third

Circuit reasoned that the litigation itself did not place Integrated in financial distress regardless

• f the damages sought given the available insurance proceeds and Integrated's own assessment

that the action could be settled within the policy limits. The fact that the plaintiffs voted in favor

• f a plan that effectively limited their maximum recovery to $25 million, the Court emphasized,

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• nly reinforced the idea that Integrated was aware that its potential exposure was manageable

when it filed for bankruptcy. Instead, the Court remarked, the circumstances suggested "that Integrated filed for Chapter 11 in part to gain a litigation advantage over the securities class, a use of Chapter 11 that we emphatically reject[]." The Third Circuit rejected Integrated's remaining arguments as well. Turning to the claim that chapter 11 provided an efficient procedure to dissolve Integrated and distribute its assets, the Court explained that dissolution of a corporation is not an objective that can be attained in bankruptcy, "[n]or is 'distribution,' standing alone, a valid bankruptcy purpose." Next, the Third Circuit addressed Integrated's contention that chapter 11 provided court oversight to the proposed sale of its intellectual property as well as certain other protections not available

• utside of bankruptcy. According to the Court, any increase in value obtained for those assets

after Integrated filed for chapter 11 was due not to the bankruptcy filing itself, but Integrated's failure to adequately market the assets outside of bankruptcy to potential bidders other than corporate insiders and objections by Integrated's equity committee to the inadequacy of the

• riginal deal. Given the absence of any evidence that "inchoate claims" against Integrated were

lurking in the wings, the Court also discounted the debtor's argument that chapter 11 enabled it to establish a bar date "and define the universe of claims against it to ensure that any distributions to its creditors and stockholders account" for any such claims. Finally, the Third Circuit directed its attention to the proposition that Integrated's desire to take advantage of the section 502(b)(6) cap established good faith in and of itself. The Court rejected this idea, specifically holding that it does not. According to the Third Circuit, "[t]he question of good faith is . . . antecedent to the operation of § 502(b)(6)." The Court of Appeals summarized its ruling on this issue as follows:

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To be filed in good faith, a petition must do more than merely invoke some distributional mechanism in the Bankruptcy Code. It must seek to create or preserve some value that would otherwise be lost ― not merely distributed to a different stakeholder ― outside of bankruptcy. This threshold inquiry is particularly sensitive where, as here, the petition seeks to distribute value directly from a creditor to a company's shareholders. Where Do We Go from Here? The threat of a bankruptcy filing has long been part of a distressed company's negotiating tactics when attempting to resolve certain types of exposure, particularly when it involves litigation and

• nerous contracts and leases. The Third Circuit's decision in Integrated Telecom and other

decisions like it, including a California bankruptcy court's ruling in In re Liberate Technologies, send a clear message that busting leases and gaining a tactical litigation advantage cannot act as the sole basis for a chapter 11 filing. Instead, bankruptcy courts, as courts of equity, will apply a "good faith" standard to determine whether a debtor's commencement of a chapter 11 case is legitimately within the permissible purposes underlying the Bankruptcy Code. The court in Integrated Telecom makes clear that, to pass muster, a chapter 11 case must be commenced by a debtor that is in financial distress, which distress can be addressed in some manner by the bankruptcy case. The question, then, becomes what exactly qualifies as "financial distress." Integrated Telecom indicates that minimizing exposure under a commercial lease and managing litigation do not, at least when the debtor is clearly solvent and the real stakeholders in any chapter 11 case are the company's shareholders. Query what these courts would have done if presented with a good faith challenge under the circumstances present in the chapter 11 cases filed by Texaco and its affiliates in 1987 to deal with a $10 billion judgment awarded to Pennzoil?

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In Integrated Technologies, the Third Circuit was faced with a debtor that had ceased doing business, had no intention of reorganizing as a going concern, had no reasonable expectation that the chapter 11 case would maximize the value of its estate, and sought chapter 11 protection solely to take advantage of the provision of the Bankruptcy Code that caps landlord

• damages. The Court even had the benefit of a "smoking gun" ― the board resolution ― that

confirmed the motive for the filing. All these appeared to make the Court's call on the question whether the case had been filed in good faith relatively easy. (Of course, in a clear indicator of how uncertain this area of the law can be, notwithstanding all of those facts, both courts below had still reached the opposite conclusion.) At the other end of the spectrum, distressed scenarios

• ften involve a combination of many different elements that make a showing of good faith less

difficult for a debtor, including overleveraged balanced sheets, poor earnings, significant litigation exposure that diverts management resources and impediments to divestiture of assets due to lurking liabilities or successor liability concerns. In between these extremes is everything else that may be a much closer call. ____________________________________________ In re Integrated Telecom Express, Inc., 384 F.3d 108 (3rd Cir. 2004). In re Liberate Technologies, 314 B.R. 206 (Bankr. N.D. Cal. 2004). This article originally appeared in the November edition of the Bankruptcy Strategist. It has been reprinted here with permission.