Faith Hope and Clarity In re Integrated Telecam Express Inc. and In re NuCentrix Broadband Networks Inc. et al.

Journal Issue

Nov 2004

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As loyal followers of the ABI Journal
and this column know, three of the favorite topics reviewed by our
authors are good faith in the filing of bankruptcy cases,<a href="#1" id="1a">1</a> non-contractual fee
enhancements<a href="#2" name="2a">2</a> and
making sure you are properly retained as a professional in a bankruptcy
proceeding.<a href="#3" name="3a">3</a>
Continuing with this trend, this issue's offering discusses the recent
decision of In re Integrated Telecom Express Inc.,<a href="#4" name="4a">4</a> addressing good-faith filings in
chapter 11 proceedings, and In re
NuCentrix Broadband,<a href="#5" name="5a">5</a> which addresses
awards of noncontractual fee enhancements as well as the potential
downside to having your fee structure approved under 11 U.S.C. §328
as part of your employment application.

<h4>High-stakes California Hold 'em: In re Integrated Telecom
Express</h4>

The Integrated case is unusual in that it involves a solvent
high-tech company. The key issue addressed in the case was whether using
a chapter 11 to reduce state law damages under a lease of real property
under the 11 U.S.C. §502(b)(6) cap would constitute a good-faith
filing. Although 11 U.S.C. §502(b)(6) as a good-faith issue is a
fairly narrow issue, it has been considered by at least one other Third
Circuit Court of Appeals decision.<a href="#6" name="6a">6</a>

In Integrated, the debtor was a software company in the
broadband communications industry. In 2000, prior to its bankruptcy
filing, the debtor negotiated a lease in Silicon Valley for rent of
$200,000 per month plus a 5 percent annual increase in rent (Silicon
Valley lease). In 2001, as everyone knows, the broadband bubble
"popped." After several attempts to reorganize or sell its business, the
debtor ultimately prepared an out-of-bankruptcy liquidation plan and
dissolution. However, three problems arose in this process.

First, in November 2001, a securities class action was filed against
the debtor and certain of its officers concerning the debtor's IPO. The
class action sought $93 million in damages from the debtor and other
defendants in the class action. The debtor had $20 million in insurance
coverage for this lawsuit.

Second, in winding up its business, the debtor needed to terminate
its Silicon Valley lease. Under the terms of the Silicon Valley lease,
it owed the Silicon Valley landlord more than $26 million during the
remaining term of lease. The debtor attempted to settle the Silicon
Valley lease claim by returning the premises and making a payment of $8
million, but this offer was rejected.

Finally, the debtor needed to sell its remaining intellectual
property assets. Prior to its chapter 11 filing, certain officers and
directors agreed to purchase the debtor's IP assets for $1.5 million.
This sale was not consummated prior to the chapter 11 filing.

Ultimately, the debtor determined that the best way to resolve the
Silicon Valley lease problem would be to file a chapter 11
petition<a href="#7" name="7a">7</a> in order
to take advantage of the limitations of 11 U.S.C. §502(b)(6)
relating to the Silicon Valley lease claim. At the time the debtor filed
its chapter 11 bankruptcy, it had $105.4 million in cash and $1.5
million in other assets. The landlord's claim and the unliquidated class
action claim were the only claims in the bankruptcy case.

During the bankruptcy, the debtor moved to reject the landlord's
lease, and the landlord moved to dismiss the debtor's case on the
grounds of bad faith. The bankruptcy court granted the debtor's motion
to reject the Silicon Valley lease and capped the landlord's claim at
$4.3 million. The court also denied the landlord's motion to dismiss,
finding that the debtor had filed its chapter 11 case in good faith.
During the course of its chapter 11, the debtor sold its remaining
assets for $2.5 million and obtained approval of a plan that capped
liability in the class action at $20 million in insurance coverage and
$5 million from the debtor's estate. This $25 million reserve for the
securities litigation claims was approved by the securities class in the
debtor's case.

The landlord timely appealed and posted a bond to prevent the
distributions from being made under the plan. The district court
affirmed the bankruptcy court in a slip opinion (2004 WL 1136547 (D. Del
2004)) primarily on the ground that the bankruptcy court's finding that
the debtor's plan was filed in good faith was not an abuse of
discretion<a href="#8" name="8a">8</a> and
that the determination was supported by the Third Circuit's earlier
decision of In re PPI Enters. (U.S.) Inc.<a href="#9" name="9a">9</a> Undeterred, the landlord appealed to the
Third Circuit.

In a strongly worded opinion, the Third Circuit reversed the lower
courts' findings that the Integrated chapter 11 was filed in good
faith. The Third Circuit in Integrated initially restated the
"good-faith standards" established in their In re SGL Carbon
Corp.<a href="#10" name="10a">10</a>

decision, noting that the debtor has the burden of proof in establishing
that the debtor-in-chapter 11's petition was filed in
good faith. The court also held that the determination of whether the
good-faith filing requirement was met was a fact-intensive inquiry.

However, notwithstanding the lower court's extensive factual findings
and the abuse of discretion standard of review, the Third Circuit found
that in this case both the bankruptcy and district courts had made a
"legal error" in concluding that Integrated filed in good faith,
stating:

<blockquote>
We conclude that the collapse of Integrated's business model does not
support a finding of good faith. Integrated was not suffering financial
distress when it filed its petition, and the rulings of the bankruptcy
court and the district court to the contrary constitute legal error. The
failure of Integrated's business did not subject the company to any
pressure on the value of its assets that could be reduced or avoided in
an orderly liquidation under chapter 11. Because Integrated's economic
difficulties do not establish that Integrated was suffering from
financial distress, they do not, standing alone, establish that
Integrated's petition was filed in good faith.<a href="#11" name="11a">11</a>
</blockquote>

In making this ruling, the Third Circuit distinguished its previous
ruling of In re PPI Enterps. (U.S.) Inc., 324 F.3d 197 (3rd Cir.
2003),<a href="#12" name="12a">12</a> by
noting that the debtor in PPI was arguably insolvent when it
filed its chapter 11, while in this case the debtor clearly was
solvent.<a href="#13" name="13a">13</a> The
circuit court also ejected three additional arguments advanced by the
debtor that its filing was in good faith: (1) that the chapter 11
provided an efficient procedure for the distribution of the debtor's
assets; (2) that oversight of the sale of the debtor's assets by the
court was beneficial; and (3) that the establishment of a bar date was
beneficial to eliminate inchoate claims. The Third Circuit found that
there was no factual merit to the debtor's second and third arguments
and held that facilitating a dissolution and distribution of assets
favorable to a
debtor's equity holders, as opposed to creditors in general, was not a
valid purpose of a chapter 11 filing. Based on these findings, the Third
Circuit remanded the case for dismissal.

<h4>Flopping a Royal Flush: What Do I Win?</h4>

Continuing with the theme, the debtors in
NuCentrix,<a href="#14" name="14a">14</a> like the Integrated debtor, were
in the telecommunications industry. However, at the time of its chapter
11 filing in September 2003, unlike Integrated the debtors
appeared to be hopelessly insolvent, as the only offer they had for
their assets was $15
million, which would have provided the debtors' unsecured creditors with
only a 12-cent-on-the-dollar distribution. Based in part on this
somewhat financial picture, the debtors' counsel was employed on an
hourly basis at 93 percent of its normal rates. The debtors' financial
adviser and investment banker were employed under 11 U.S.C.
§§327 and 328 for a flat fee of $800,000 for their
services.

Fortunately for nearly all concerned, the sale of the debtors' assets
was a spectacular success, as the auction of the debtors' assets
resulted in a sale price of $51 million in cash plus the assumption of
an additional $5 million in liabilities. This sale resulted in a full
distribution to all creditors and a substantial return to the debtors'
equity-holders. Based on this success, both counsel and the investment
banker requested enhancements of their fees.

Initially in the Nucentrix opinion, the court reviewed the
fee-enhancement request of the debtors' counsel. Reviewing the request
under the standards set forth in Transamerica Natural Gas
Corp v. Zapata Partnership Ltd., 257 B.R 809 (Bankr. W.D. Tex.
2000), and In re El Paso Refinery L.P., 247 B.R. 509 (Bankr. W.D.
Tex. 2000),<a href="#15" name="15a">15</a> the
court found that counsel should be awarded a fee-enhancement of an
increase in its hourly fees to 100 percent of their standard rates plus
a 10 percent bonus over
and above these rates to compensate counsel for the rare and exceptional
result they obtained for the debtors in this case.

Unfortunately, the investment banker did not fare as well. As noted
above, the investment banker's employment was approved at a flat fee of
$800,000 under 11 U.S.C. §328, which limits courts from awarding
compensation different from what was provided for in the employment
application only "if such terms and conditions prove to have been
improvident in light of developments not capable of being anticipated at
the time of the fixing of such terms and conditions." In this case, the
Nucentrix court found that while the results were surprising and
unforeseen, they were in fact capable of being anticipated at the time
the investment banker sought retention. Indeed, as noted by the
Nucentrix court, the successful auction "was exactly what the
parties anticipated."

The court also found that, in light of the its approval of employment
of the investment bankers under 11 U.S.C. §328, the fee-enhancement
analysis of 11 U.S.C. §330 employed by the court in relation to the
counsel's fee-enhancement request could not be applied to the investment
banker's fee-enhancement request.

<h4>The River and Conclusion</h4>

The lessons that can be taken from these decisions are both
straightforward and important to bankruptcy practitioners.

First, the Integrated decision and two similar decisions from
the California bankruptcy courts<a href="#16" name="16a">16</a> seem to establish that companies that
are clearly solvent may not in good faith file chapter 11 cases to
attempt to limit damages arising from a lease unless the potential
debtor has other significant financial problems that would demonstrate a
need for chapter 11 protection.

Second, Integrated stands for the somewhat unremarkable
proposition that filing a chapter 11 to benefit equity-holders at the
expense of creditors will rarely be found to be an exercise of good
faith.

Third, the Nucentrix decision shows that a debtor's
professionals, including its attorneys, still have a chance to get a fee
enhancement if they achieve truly exceptional results, generally
including payment of all creditors in full, in a chapter 11 case. This
decision stands in contrast to some recent decisions that have either
refused to award or sharply limited noncontractual fee enhancement
requests by professionals.

Fourth, Nucentrix shows the care with which a party must draft
its retention agreement with the debtor in a bankruptcy proceeding.
While it is generally true that being employed under 11 U.S.C. §328
protects professionals from having their fees being second-guessed at a
final hearing on fees,17 11 U.S.C. §328 also requires professionals
to carefully craft their employment agreements if they wish to seek
enhancements of their fees.

With these lessons in mind, hopefully your bankruptcy practice will
be filled with solvent debtors so that you can worry about these issues
and will not have to endure another round of poker puns by a Straight
& Narrow author.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Crabbe, Deborah, "Does
the Constitution Require a Debtor to be Insolvent to File for
Bankruptcy?," 22 Am. Bankr. Inst. J. 34 (November 2003). <a href="#1a">Return to article</a>

<a name="2">2</a> Protopapas, Lydia T.,
"Fee Enhancements: How Do You Get One? Part I," 20 Am. Bankr. Inst. J 7
(June 2001). Protopapas, Lydia T., "Fee Enhancements: How Do You Get
One? Part II", 20 Am. Bankr. Inst. J 12 (July/August 2001). <a href="#2a">Return to article</a>

<a name="3">3</a> Bowles, C.R., "Ethical
Trilogy: Something Old, Something New, Something Borrowed," 22 Am.
Bankr. Inst. J 18 (June 2003); Protopapas, Lydia T., "Fee Enhancements:
How Do You Get One? Part II," 20 Am. Bankr. Inst. J 12 (July/August
2001). <a href="#3a">Return to article</a>

<a name="4">4</a> 2004 WL 2086058 (3rd Cir.
Sept. 20, 2004); Protopapas, Lydia T., "Fee Enhancements: How Do You Get
One? Part II," 20 Am. Bankr. Inst. J 12 (July/August 2001). <a href="#4a">Return to article</a>

<a name="5">5</a> Case No. 03-39123 (Bankr.
N.D. Tex. Sept. 20, 2004). <a href="#5a">Return to article</a>

<a name="6">6</a> In Re PPI Enterps.
(U.S.) Inc., 324 F.3d 197 (3rd Cir. 2003). <a href="#6a">Return to
article</a>

<a name="7">7</a> In a memorable display of
candor and honesty, the debtor counsel included a statement in both the
debtor's board minutes and in a letter to the landlord and a statement
that the principal, if not sole reason, for the debtor's bankruptcy
filing was to limit the landlord's claim. <a href="#7a">Return to
article</a>

<a name="8">8</a> It is well-settled that a
bankruptcy court's determination of whether a chapter 11 case is filed
in good faith is reviewed under an abuse-of-discretion standard. In
re PPI Enters. (U.S.) Inc., 324 F.3d 197, 211 (3rd Cir.
2003). <a href="#8a">Return to article</a>

<a name="9">9</a> Id. at 197. <a href="#9a">Return to article</a>

<a name="10">10</a> 200 F.3d 154 (3rd Cir.
1999). <a href="#10a">Return to article</a>

<a name="11">11</a> 2004 WL 2086 058 at *.
<a href="#11a">Return to article</a>

<a name="12">12</a> The Third Circuit also
distinguished the Ninth Circuit's decision in In re Sylmer Plaza
L.P., 34 F.3d 1070 (9th Cir. 2002), noting that in that case, the
bankruptcy was used to maximize the return for creditors as a whole
rather than limit the claim of a creditor for the benefit of
equity-holders. <a href="#12a">Return to article</a>

<a name="13">13</a> Id. at *, 11. <a href="#13a">Return to article</a>

<a name="14">14</a> In re NuCentrix
Broadband Networks Inc., et al., Case No. 03-39123 (Bankr. N.D. Tex.
Sept. 30, 2004). <a href="#14a">Return to article</a>

<a name="15">15</a> For a full discussion
of the best way to sell noncontractual fee enhancements, see
Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part I," 20
Am. Bankr. Inst. J 7 (June 2001); Protopapas, Lydia T., "Fee
Enhancements: How Do You Get One? Part II," 20 Am. Bankr. Inst. J 12
(July/August 2001). <a href="#15a">Return to article</a>

<a name="16">16</a> See In re Liberate
Technologies, 2004 WL 200 8956 (Bankr. N.D. Cal. Sept. 8, 2004);
In re Chameleon Systems Inc., 306 B.R 666 (Bankr. N.D. Cal.
2003). <a href="#16a">Return to article</a>

<a name="17">17</a> See In re
Barron, 325 F.3d 690 (5th Cir. 2003). <a href="#17a">Return to
article</a>

Journal Authors

C. R. Bowles

Journal Date

Monday, November 1, 2004 - 12:00

Bankruptcy Rule

2004