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

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 operations, 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 of 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. NYI-2173499v1 GoodfaithfilingDecember 2004 BRR JP003318 079983 - 041016

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 of 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 NYI-2173499v1 GoodfaithfilingDecember 2004 BRR JP003318 079983 - 041016

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 of 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 NYI-2173499v1 GoodfaithfilingDecember 2004 BRR JP003318 079983 - 041016

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 officers, 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 NYI-2173499v1 GoodfaithfilingDecember 2004 BRR JP003318 079983 - 041016