In the Third Circuit, Good Faith Means Something

In recent years, there has been a seeming trend of financially solvent companies filing chapter 11 in order to limit their liability to one or more particular creditors and, thereby, maximize the distribution to shareholders. See, e.g., Solow v. PPI Enterprises (U.S.), Inc., (In re PPI Enterprises (U.S.), Inc.), 228 B.R. 339 (3d Cir. 2003) (hereafter, PPI Enterprises); In re Sylmar Plaza, L.P., 314 F.3d 1070 (9th Cir. 2002) (hereafter, Sylmar Plaza); In re Chameleon Systems, Inc., 306 B.R. 666 (Bankr. N.D. Cal. 2004); see also In re Central Jersey Airport Services, LLC, 282 B.R. 176 (Bankr. D.N.J. 2002). On August 3, 2004, the Court of Appeals for the Third Circuit issued a decision in an appeal arising out of the Integrated Telecom Express, Inc. chapter 11 case that appears to put the brakes on this trend.[1] In re Integrated Telecom Express, Inc., 384 F.3d 108 (3rd Cir. 2004) (hereafter, Integrated).

In Integrated, the Third Circuit held that the chapter 11 liquidation case of a cash-rich debtor that was filed primarily to use section 502(b)(6) of the Bankruptcy Code to limit the debtor’s liability to its landlord must be dismissed as having been filed in bad faith. As the Integrated court explained, a chapter 11 petition must “do more than merely invoke some distributional mechanism in the Bankruptcy Code” to meet the requirement of good faith. Rather, the case must be filed in order to preserve value for creditors, not shareholders, that otherwise would be lost outside of bankruptcy. Integrated, 384 F.3d at 129.

In the Integrated decision, the Third Circuit cites with favor a recent decision by the Bankruptcy Court for the Northern District of California in In re Liberate Technologies, 314 B.R. 206 (Bankr. N.D. Cal. 2004) (hereafter, Liberate Technologies), which likewise dismissed the chapter 11 case of a solvent debtor that was filed to take advantage of section 502(b)(6). In rendering its decision, the Integrated Court distinguished its decision in PPI Enterprises, a case with very similar facts, as well as the Ninth Circuit Court of Appeals’ decision in Sylmar Plaza, both of which were relied upon by the lower courts in reaching their decisions.[2]

The Third Circuit’s decision in Integrated, which reversed both the Bankruptcy and District Courts for the District of Delaware, revives and further extends a line of cases, including the Third Court’s decision in In re SGL Carbon Corp., 200 F.3d 154 (3d Cir. 1999) (hereafter, SGL Carbon), in which courts decried the use of chapter 11 as a sword, rather than a shield, and dismissed petitions that were filed solely to take advantage of the powers of chapter 11 rather than to use those powers to serve the larger purpose of maximizing creditor recoveries. See, e.g., Dunes Hotel Associates v. Hyatt Corp., 245 B.R. 492 (D.S.C. 2000) (solvent debtor not permitted to use chapter 11 strong arm powers to create a windfall for its shareholder at the expense of sole remaining creditor) (citing cases). As a result of the Integrated decision, solvent companies seeking to use chapter 11 in the Third Circuit as a means of resolving problems with landlords or other specific creditor bodies may expect to face a much tougher evidentiary burden in demonstrating that they have filed their bankruptcy petitions in good faith.

The Good Faith Filing Requirement

Section 1112(b) of the Bankruptcy Code provides that, upon request of a party in interest or the U.S. Trustee and after notice and a hearing, a bankruptcy court may dismiss a chapter 11 case or convert it to one under chapter 7 “for cause.” 11 U.S.C. § 1112(b). Although not specifically enumerated in that section, when considering the issue most courts, including the Third Circuit in SGL Carbon, have found that cause for dismissal or conversion exists when a chapter 11 petition is not filed in good faith. The burden of proving that a chapter 11 petition has been filed in good faith rests with the debtor. See Integrated, 384 F.3d at 118-20 (collecting cases). A bankruptcy court’s decision to grant or deny a motion pursuant to section 1112(b) is reviewed for abuse of discretion, id., a very tough standard of review.

The Integrated Chapter 11 Case

Integrated Telecom commenced its chapter 11 case on October 8, 2002, under somewhat unusual circumstances. Within 18 months of completing a successful IPO, the market for many of the company’s products had deteriorated markedly, resulting in substantial net losses. Rather than expend all of its remaining cash, in about December 2001, the company commenced efforts to develop an alternative business model or to locate a third party buyer or merger partner. When, by April 2002, those efforts had failed, Integrated Telecom’s board of directors approved a plan to liquidate the company’s assets and dissolve the company under state law, so as to maximize that portion of its more than $100 million in remaining cash that could be distributed to shareholders.

Before it could do so, however, Integrated Telecom had to dispose of its intellectual property and its continuing support and/or warranty obligations thereunder, resolve securities litigation arising out of its IPO, and dispose of its obligations under a long term office lease. Integrated Telecom’s board quickly arranged a sale of the company’s intellectual property and the buyer’s assumption of the company’s support and warranty obligations for $1.5 million. Integrated Telecom also had insurance to cover at least a portion of any liability associated with the securities litigation.

Integrated Telecom’s office lease was for a term of 10 years with monthly rent of $200,000, increasing 5 percent annually. When the Integrated Telecom board approved its plan of dissolution in April 2002, there were nearly nine years remaining on the lease. Apparently unwilling to spend so much of its remaining cash to pay the tens of millions of dollars due to the landlord for the remainder of the lease term, Integrated Telecom sought to settle with the landlord for a payment of up to $8 million. The Integrated Telecom board also authorized the commencement of a chapter 11 case in the event that negotiations with the landlord proved unsuccessful. To that end, the company’s board authorized a letter to the landlord in which Integrated Telecom threatened to file chapter 11 and avail itself of the cap on lease claims provided for under section 502(b)(6)[3] of the Bankruptcy Code in the event that the landlord refused to limit its claim to $8 million.

When the landlord refused to settle on the offered terms, Integrated Telecom filed its chapter 11 case and promptly moved to reject the lease. According to its schedules, Integrated Telecom had $105.4 million in cash, $20 million of insurance to cover potential securities liability and other assets valued at $1.5 million on the petition date. On the liability side, the landlord filed a proof of claim asserting that the present value of Integrated Telecom’s remaining obligations under the lease (without applying the 502(b)(6) cap) was approximately $26 million, while Integrated Telecom’s bankruptcy schedules listed other liabilities totaling approximately $430,000. The class action plaintiffs in the securities litigation sought a total of $93.24 million in damages, which claims and damage amounts Integrated Telecom disputed.[4]

Under the circumstances and even assuming that the claims of the shareholder class and the landlord were taken at face value, Integrated Telecom was “highly solvent and cash rich” on the petition date, and had sufficient cash to pay all of its liabilities in full. Integrated, 384 F.3d at 123-24. Nevertheless, by employing the section 502(b)(6) cap to the landlord’s $26 million claim, Integrated Telecom was able to reduce its liability to the landlord to $4.3 million, thereby redistributing nearly $22 million to the company’s shareholders that would otherwise have been payable to the landlord under state law.

The Good Faith Standard Applied

The landlord objected to Integrated Telecom’s lease rejection motion and also moved to dismiss the chapter 11 case pursuant to section 1112(b) as having been filed in bad faith. The landlord likewise objected to confirmation of Integrated Telecom’s liquidating plan. The Bankruptcy Court denied the motion/objection, finding that there was no insolvency requirement under chapter 11, that because the debtor was “losing a lot of money” and “experiencing a downward spiral” it was in “financial distress,” and thus, its petition and plan were filed in good faith. The District Court affirmed, finding that the Bankruptcy Court’s decision was based on a sound interpretation and application of the relevant case law.

The Third Circuit agreed with the lower courts that there is no solvency requirement for filing chapter 11. That being said, the Integrated Court found that the lack of an insolvency requirement does not mean that financially solvent companies should have “unfettered access” to chapter 11. Integrated, 384 F.3d at 121-22. Rather, the Third Circuit reiterated its SGL Carbon holding: “if a petitioner has no need to rehabilitate or reorganize, its petition cannot serve the rehabilitative purpose for which chapter 11 was designed.” Id. To demonstrate good faith, the solvent debtor must demonstrate that it faces some “financial distress.” Id. at 122. Similarly, the Bankruptcy Court in Liberate Technologies held that “where the debtor is solvent, ... the only bankruptcy policy implicated is the avoidance of piecemeal liquidation that destroys the going concern value of an enterprise.” Liberate Technologies, 314 B.R. at 212.

The Third Circuit also found that a desire to “take advantage” of a provision of the Bankruptcy Code, such as section 502(b)(6), while not necessarily indicative of “bad faith,” does not, standing alone, demonstrate “good faith.” Integrated, 384 F.3d at 127-28. As the Third Circuit explained, “although the Bankruptcy Code contains many provisions that have the effect of redistributing value from one interest group to another, these redistributions are not the Code’s purpose. Instead, the purposes of the Code are to preserve going concerns and to maximize the value of the debtor’s estate.” Id. at 128-29. Under the circumstances, to satisfy the good faith requirement, a debtor 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 ... the petition seeks to distribute value directly from a creditor to a company’s shareholders.” Id. at 129.

Applying these principles, the Third Circuit easily determined that Integrated Telecom’s petition had not been filed in good faith. Among other things, the Integrated Court disagreed with the Bankruptcy and District Courts’ conflation of Integrated’s business problems with “financial distress,” finding that chapter 11 could not offer the debtor “any relief from this sort of distress, which has no relation to any debt owed by Integrated.” Integrated, 384 F.3d at 122. To the contrary, the company’s assets were not threatened by foreclosure or other creditor action outside of bankruptcy, for which chapter 11 could provide a remedy. Indeed, Integrated Telecom had no significant debt other than the landlord’s claim, and it certainly had sufficient cash on hand to pay that claim as well as its other miscellaneous debts in full.

On appeal, Integrated Telecom argued that the pending securities action did threaten its assets. As the Third Circuit pointed out, however, even if the shareholder plaintiffs recovered all of the damages sought, the debtor still had sufficient cash to pay all of its debts if the insurance was included. Moreover, Integrated Telecom had repeatedly represented that the litigation was meritless and predicted that the matter would be settled within the limits of its insurance policy, which prediction ultimately came true when the class voted to accept the $25 million cap on its claims (of which $5 million would come from the estate and $20 million from the debtor’s insurance) proposed in the chapter 11 plan. Thus, rather than establishing good faith, the Third Circuit inferred from these facts that the debtor had sought to gain a litigation advantage over the class action plaintiffs with its bankruptcy filing, a use of chapter 11 that the Court specifically rejected in SGL Carbon. Integrated, 384 F.3d at 118-20.

Moreover, the mere fact that Integrated Telecom used the chapter 11 process to effect an orderly liquidation of its assets likewise did not establish that the petition had been filed in good faith. Rather, the Third Circuit found that the debtor had not demonstrated any evidence that it had realized efficiencies or increased the value of its assets by liquidating under chapter 11 that would not otherwise have been available to it under state law – except, of course – that distribution under the aegis of a chapter 11 plan allowed the debtor to use section 502(b)(6) to reallocate $22 million of value from a creditor (the landlord) to shareholders, Integrated, 384 F.3d at 126-28, something that appears to have been particularly troubling to the Court.

In its decision, the Delaware Bankruptcy Court relied on PPI Enterprises, which likewise involved a debtor that filed chapter 11, at least in part, to utilize the section 502(b)(6) cap, and on Sylmar Plaza, in which a solvent debtor filed a chapter 11 plan that enabled the debtor to avoid paying post-petition interest at the default rate to its secured creditor. The Third Circuit distinguished PPI Enterprises and Sylmar Plaza on their facts. For example, in PPI Enterprises, the debtor claimed to be insolvent and, in any event, had used chapter 11 to maximize the value of its sole remaining asset by a substantial factor, which increase inured to the benefit of creditors, not shareholders. In contrast, although Integrated Telecom sold certain assets during the chapter 11 case for $1 million more than it had agreed pre-petition, the Third Circuit found that the increase was due entirely to additional post-petition marketing efforts that easily could have been undertaken outside of bankruptcy and not due to any protections available under the Bankruptcy Code.[5] Integrated, 384 F.3d at 123-24, 126-27.

Likewise, the Third Circuit found that the Sylmar Plaza debtor was able to use the bankruptcy process to maximize the value of its sole asset and that the debtor’s ultimate solvency was not a foregone conclusion at the outset of the case. By contrast, Integrated Telecom, like the debtors in SGL Carbon and Liberate Technologies, clearly was solvent from the outset, even assuming that all of its liabilities were treated at face value, and was not facing “the chaotic mix of self help repossession and judicial execution available at state law to which the Bankruptcy Code provides an alternative.” Integrated, 384 F.3d at 122 (citation omitted).

Conclusion

It is not difficult to distinguish the Third Circuit’s opinion in Integrated based on the rather unique set of facts presented. Indeed, the Third Circuit clearly was troubled by the idea that a solvent debtor sought to use chapter 11 to reallocate millions of dollars from a creditor to shareholders. That being said, however, the opinion may be read more broadly, as an indication that, at least in the Third Circuit, satisfying the good faith standard means something more than demonstrating a desire to use the chapter 11 process. Rather, a debtor must be prepared to present evidence that the petition was filed to serve one of the overriding purposes of chapter 11, rehabilitation, preservation of a going concern and/or maximizing estate values. While the Third Circuit specifically found that “it is a truism that it is not bad faith to avail oneself of a particular Code provision,” it likewise found that a debtor’s desire to use the Bankruptcy Code, standing alone, cannot establish good faith.

1.On November 23, 2004, the Third Circuit denied appellees’ petitions for rehearing by the panel that decided the case and for a rehearing en banc. See In re Integrated Telecom Express, Inc., No. 04-2411, 2004 WL 2675858 (3d Cir. Nov. 23, 2004).

2. Although not mentioned in its opinion, the Third Circuit’s decision appears to undercut the holding of In re Chameleon Systems, Inc., 306 B.R. 666 (Bankr. N.D. Cal. 2004), in which another California bankruptcy court denied a landlord’s motion to dismiss on bad faith grounds the chapter 11 petition of a solvent debtor that filed to use section 502(b)(6) to cap a landlord’s claim. Chameleon Systems had relied heavily on the now reversed district court opinion in Integrated as well as PPI Enterprises, and was decided only a few months before Liberate Technologies.

3. Section 502(b)(6) limits the claim of a lessor arising out of the rejection of a real estate lease to the greater of one year’s rent under the lease or 15 percent of the rent due for the remainder of the lease term, not to exceed three years, following the earlier of (a) the petition date or (b) the date on which the lessor repossessed, or the lessee surrendered, the property, plus any unpaid rent due under the lease, without acceleration, on the earlier of such dates. 11 U.S.C. § 502(b)(6).

4. Notably, while the claims were not resolved during the chapter 11 case, Integrated Telecom’s liquidating plan – which was accepted by the class of securities claimants – provided that its liability to that class would be capped at $25 million – of which a maximum of $5 million would be payable by the estate with the remainder to be paid out of the proceeds of the debtor’s insurance.

5.The million dollar increase also was not significant as a percentage of the debtor’s total assets available for distribution, in contrast to the situation in PPI Enterprises.