Solvent Debtors and Myths of Good Faith and Fiduciary Duty

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Dec/Jan 2004

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Congress did not expressly
limit chapter 11 protection to debtors who are insolvent or who suffer any
other particular form of financial distress.<a href="#2" name="2a">2</a> Solvent debtors are capable
of filing plans in "good faith" and, thus, confirming plans of
reorganization.<a href="#3" name="3a">3</a> Courts applying the "good-faith filing"
doctrine are also uniform in stating that insolvency is not a prerequisite
to seeking chapter 11 relief and that solvency alone will not result in
dismissal for an absence of good faith.<a href="#4" name="4a">4</a> Some of the most notable chapter
11 cases in history—such as Manville and Texaco—involved solvent debtors.

Solvent debtors—just like the more typical
insolvent debtor—may find advantages in restructuring or liquidating
under chapter 11 of the Bankruptcy Code. The Code provides for the
limitation of certain types of claims, such as landlord or certain
employment claims.<a href="#5" name="5a">5</a> Claims arising from the sale of securities may be
subordinated.<a href="#6" name="6a">6</a> Cramdown power, even in full payment plans, may be necessary
to bind recalcitrant creditor classes.<a href="#7" name="7a">7</a> A sale free and clear of
liens, claims and other interests under §363(f) of the Code may create
value in excess of what is otherwise obtainable, particularly when there
are issues of successor liability or similar concerns. Using chapter 11 to
"cap" or reduce claims, or otherwise increase the net
distributable assets, has the potential to maximize the return to holders
of equity interests (such as shareholders of a corporation) in the
liquidation of a solvent concern. Indeed, one could argue that the
fiduciary duty owed by the board of directors to the shareholders would
require liquidating through chapter 11 where doing so would markedly
increase the distribution to the shareholders.

However, the recent opinions in Liberate Technologies<a href="#8" name="8a">8</a> and Integrated Telecom Express<a href="#9" name="9a">9</a>
continue a trend, among some courts, toward limiting access to chapter 11
for solvent debtors through use of the good-faith filing requirement. These
two decisions appear to establish an "eligibility test" for
solvent debtors—the "present need to file" standards
suggest that, if not insolvency, " imminent illiquidity" or
similar financial distress is required in order to file in good faith and
maintain in good standing a chapter 11 case. These opinions suggest that
filing a chapter 11 case to take advantage of provisions that increase
shareholder distributions at the expense of any creditor may constitute a
"bad-faith" filing, notwithstanding the duty to maximize
returns to shareholders.<a href="#10" name="10a">10</a> These recent decisions, and others like them,
may also leave corporate boards—and counsel—wondering when
solvent debtors can file in "good faith" and what they can (or
must) do to discharge their fiduciary duties to creditors and shareholders.

<h4>The Requirement to File in "Good Faith"</h4>

The majority of courts considering the issue
recognize the requirement that a chapter 11 case must be filed in good
faith.<a href="#11" name="11a">11</a> Filing with an absence of good faith may lead to immediate
dismissal of the case. The application of the doctrine to cases filed under
the Code arose primarily from the distaste of some
courts—particularly the Fifth Circuit Court of Appeals—for
single-asset cases. Use of the doctrine, however, has not been limited to
real estate cases.<a href="#12" name="12a">12</a>

Defining what "good faith" means, with
any precision, has been difficult, and the doctrine has many formulations.
According to the Ninth Circuit, in the Marsch case, the "test is whether a debtor is attempting to
unreasonably deter and harass creditors or attempting to effect a speedy,
efficient reorganization on a feasible basis."<a href="#13" name="13a">13</a> The same Ninth
Circuit panel noted that the good-faith filing requirement
"encompasses several distinct, equitable limitations that courts have
placed on chapter 11 filings... Courts have implied such limitations to
deter filings that seek to achieve objectives outside the legitimate scope
of the bankruptcy laws."<a href="#14" name="14a">14</a> Building on Marsch, the Third Circuit reasoned in SGL
Carbon that the doctrine requires a chapter 11
filing to have a "valid reorganizational purpose."<a href="#15" name="15a">15</a>
Application of the doctrine, and a determination of "valid
reorganizational purpose," is a "fact-intensive inquiry"
that requires determining where a particular chapter 11 petition
"falls along the spectrum ranging from the clearly acceptable to the
patently abusive."<a href="#16" name="16a">16</a> The cases have developed a variety of checklists
of factors indicating the absence or presence of good faith. One court,
trying to synthesize the standards, has said that "the good faith
inquiry is essentially directed to two questions: (1) whether the debtor is
trying to abuse the bankruptcy process and invoke the automatic stay for
improper purposes, and (2) whether the debtor is really in need of
reorganization."<a href="#17" name="17a">17</a> As noted below, the second inquiry—the
"need" for reorganization—is often triggered when a
solvent debtor seeks chapter 11 relief.

Of course, none of these tests is exactly
self-effectuating, and courts emphasize that all facts and circumstances of
each filing must be examined.<a href="#18" name="18a">18</a> Whether or not a filing is found to have a
"valid reorganizational purpose" may depend heavily on what a
particular court views the Code's purposes to be. By focusing on the
"reorganizational purpose" of chapter 11, the tests also supply
little or no guidance about what constitutes good faith when a debtor files
a liquidating chapter 11. However, filing a chapter 11 to conduct an
orderly liquidation or going-concern sale of the debtor's assets is
not improper.<a href="#19" name="19a">19</a> The Code explicitly contemplates liquidating plans.<a href="#20" name="20a">20</a>

Some courts have criticized the good-faith filing
doctrine and its supposed underpinnings. One decision held that the
doctrine was in conflict with the language of §1112(b) of the Code,
the legislative history of §1112(b) and the Supreme Court's
decision in Toibb v. Radloff.<a href="#21" name="21a">21</a> The most strident criticism, however, attacks the
doctrine's imprecision. As Bankruptcy Judge Queenan wrote: "A
rule of law should be susceptible to clear statement, so that the result of
its application to particular facts can be predicted with reasonable
certainty. The good-faith filing doctrine fails this test miserably."<a href="#22" name="22a">22</a>
Still another court noted that the doctrine is unable to help counsel and
litigants to understand what they should and should not do.<a href="#23" name="23a">23</a> Judge Queenan
noted that the doctrine is really an "eligibility rule"<a href="#24" name="24a">24</a> and,
more critically, "an amorphous gestalt, devoid of reasoning and
impenetrable to understanding."<a href="#25" name="25a">25</a> While the doctrine may be here
to stay, as detailed below, the criticism about the doctrine's lack
of guidance may be most appropriate to its application to cases filed by
allegedly solvent debtors.

<h4>The Debtor's and DIP's Fiduciary Duty to Shareholders</h4>

Before examining the application of the good-faith
filing doctrine to solvent debtors, which may often be seen as filings
designed in part to preserve or enhance shareholder value, one should
detour to consider the duty of the debtor or debtor-in-possession (DIP), as
well as its management, to the holders of equity interests (in the case of
a corporate debtor, the shareholders) before and after a case is filed. Of
course, outside of bankruptcy, management of an entity has a duty to
preserve and maximize the value of the enterprise for the benefit of the
holders of equity interests. When the entity becomes insolvent, this duty
also extends to creditors. Similar principles apply in bankruptcy.

Unquestionably, the fiduciary duty of the corporate
DIP runs to the shareholders as well as the creditors.<a href="#26" name="26a">26</a> While the
interests of the shareholders may in most cases be subordinate to those of
creditors, the interests of shareholders cannot be ignored.<a href="#27" name="27a">27</a> The DIP must
treat all claimants and interest-holders "fairly, equally and in accordance with
the priority of their claims under law."<a href="#28" name="28a">28</a>

In the discharge of its duty, where the debtor is
solvent and proposing a 100 percent plan, the debtor may attempt to
"harmonize the interests of all of the estate's constituent
elements, including creditors and interest holders."<a href="#29" name="29a">29</a> As Bankruptcy
Judge James B. Haines Jr. has stated that "such attempts are consistent with the
debtor's fiduciary obligations, which extend to the entire community
of interests affected by reorganization, including investors."<a href="#30" name="30a">30</a> A
solvent DIP may pursue a reorganization strategy "that, while providing for creditors in a fashion consistent with
chapter 11's priorities, [seeks] to
adjust the rights and relations of parties-in-interest so that the
interests of equity interest-holders could be preserved."<a href="#31" name="31a">31</a> In
finding the DIP's pursuit of a competing plan permissible, the court
noted that the DIP did not aim to benefit equity interest holders "at the expense of the creditor
body."<a href="#32" name="32a">32</a>

One court has noted that because the DIP's
fiduciary duty runs to all classes of claimants and interest-holders,
management for the DIP is in a "conflict-ridden position."<a href="#33" name="33a">33</a> In
an attempt to reconcile such conflicts, Judge Queenan has held that the DIP
is not a fiduciary when it comes to negotiating and seeking confirmation of
its plan.<a href="#34" name="34a">34</a> Noting distinct differences in the Code's
terminology in this context, the judge wrote that:

<blockquote>
A DIP is therefore permitted to place its own
interests above those of the unsecured creditors with respect to what it
proposes to pay under its plan... As to its proposed plan dividend, a DIP
is not a fiduciary of the unsecured creditors owing them a duty of loyalty.
Its bargaining and cramdown rights necessarily exclude such a fiduciary
obligation.<a href="#35" name="35a">35</a>
</blockquote>

While few courts would go this far, the DIP's
continuing fiduciary duties to shareholders and its freedom to propose
cramdown plans where the creditor body as a whole is enjoying a 100 percent
plan suggest that there is nothing obviously untoward about using the Code
to maximize the return to shareholders, even though a particular creditor may see his
state law or contractual rights diminished by the operation of the
Code's provisions. However, as detailed below, some courts have
dismissed, as filed in bad faith, chapter 11 cases where the debtor was
solvent because holders of equity interests, not creditors, benefited.
These cases, as we will discuss below, often fail to consider what, if any,
duty management owed to holders of equity interests in this context.

<h4>Marsch, SGL Carbon and the "Litigation Advantage" Cases</h4>

The first notable foray into the arena of solvent
debtors and the good-faith filing doctrine was the Ninth Circuit's
opinion in Marsch.<a href="#36" name="36a">36</a>
In Marsch, an
individual debtor had suffered an adverse state court judgment and filed a
chapter 11 case while pursuing her appeal. The bankruptcy court dismissed
her case due to an absence of good faith, but the Bankruptcy Appellate
Panel (BAP) reversed. On further appeal, the Ninth Circuit reversed the
BAP. Noting that some courts allowed the filing of a petition to avoid
posting an appeal bond, the Ninth Circuit held that a "petition filed
for this purpose doesn't comport with the objectives of the
bankruptcy laws...if the debtor can satisfy the judgment with non-business
assets."<a href="#37" name="37a">37</a> The court noted that the debtor had the financial means to
pay the judgment. Since the debtor was not involved in a business venture,
the judgment didn't pose any danger of disrupting business interests.<a href="#38" name="38a">38</a> Accordingly,
the circuit court held that the bankruptcy court was correct in finding an
absence of good faith and dismissing the petition.

The Third Circuit's opinion in SGL Carbon<a href="#39" name="39a">39</a> built upon the base
constructed by Marsch. In SGL Carbon, the circuit court phrased the issue as "whether, on the
facts of this case, a chapter 11 petition filed by a financially healthy
company in the face of potentially significant civil antitrust liability
complies with the requirements of the Bankruptcy Code."<a href="#40" name="40a">40</a> Reversing
the lower courts, the court answered this question in the negative.

The circuit court first emphasized that the
good-faith filing doctrine was good law in the Third Circuit.<a href="#41" name="41a">41</a> The
bankruptcy court had refused to dismiss on bad-faith grounds, finding that
the antitrust litigation was distracting management and that the
litigation, if lost, was potentially ruinous and could put the debtor out
of business. The circuit court found no evidence to support these findings
and found them clearly erroneous. In the eyes of this circuit panel, the
debtor's filing was "premature" and for an improper
purpose: The filing was solely to gain an advantage vis-a-vis the
plaintiffs in the antitrust cases. On the first ground, the court noted
that "[w]hether or not SGL Carbon faces a potentially crippling antitrust judgment, it is
incorrect to conclude it had to file when it did."<a href="#42" name="42a">42</a> Noting that the
litigation was not complete, the court stated that the debtor "has
offered no evidence it could not effectively use [chapter 11's]
protections as the prospect of a judgment became imminent."<a href="#43" name="43a">43</a> The
court emphasized that chapter 11 debtors need not be insolvent, and that
the Code encourages early filing of petitions to allow debtors to
reorganize before their situation becomes hopeless. However, these
principles did not allow for a "premature filing" or the filing
of a bankruptcy petition that lacks a "valid reorganizational
purpose."<a href="#44" name="44a">44</a> Companies need not, in all cases, wait for a judgment to
be entered if, as in Texaco or Manville, the pendency of the litigation was creating financial stress, or
the debtor has other financial or management issues. But the "mere
possibility of a future need to file, without more, does not establish that
a petition was filed in 'good faith.'"<a href="#45" name="45a">45</a>

The SGL Carbon court also found that filing a chapter 11 petition merely
to obtain tactical litigation advantages is not within the legitimate scope
of the bankruptcy laws. Given the debtor's overall financial health
and the statements of its management, the court found such a purpose
evident in the case.<a href="#46" name="46a">46</a> In concluding, the court found the case "a
significant departure from the use of chapter 11 to validly reorganize
financially troubled businesses."<a href="#47" name="47a">47</a>

Subsequent courts have been all over the map in
applying the "teachings" of Marsch and SGL Carbon. A district court in the Third Circuit upheld a refusal to
dismiss a chapter 11 case of a solvent debtor faced with adverse litigation
where there was evidence that the filing also accomplished preventing the
termination of a valuable leasehold. The court held that "a valid
reorganizational purpose existed because of the threat to terminate
the...sublease."<a href="#48" name="48a">48</a>

A California bankruptcy court refused to dismiss the
case of a solvent debtor where the case had been filed to avoid posting a
bond on appeal, finding that the debtor could not afford the posting of the
bond and that the debtor was solvent only because the creditor protagonist
had failed to file a proof of claim and had its claim disallowed. The court
there emphasized the absence of an insolvency requirement for filing a
chapter 11 case: "Insolvency is not a requirement for a chapter 11
filing. Insolvency is not even a requirement for plan confirmation under
the explicit 'good faith' requirement of
§1129(a)(3)."<a href="#49" name="49a">49</a>

<h4>PPI Enterprises</h4>

The Third Circuit revisited this area in PPI Enterprises.<a href="#50" name="50a">50</a> In this case,
the debtor had filed its chapter 11 case to take advantage of
§502(b)(6) of the Code to cap a potentially large claim of a landlord.
The case was a liquidating chapter 11 case. By so limiting the claim, the
debtor proposed to pay 100 cents on the dollar to unsecured claims,
including the landlord claim as reduced. The landlord moved to dismiss the
case as lacking good faith. The bankruptcy court denied the motion, finding
that filing to use §502(b)(6) was not evidence of bad faith and that
the Code contemplated liquidating plans. The circuit court eventually
affirmed, finding no abuse of discretion by the bankruptcy court in making
those findings.<a href="#51" name="51a">51</a>

<h4>Liberate Technologies</h4>

Against the backdrop of these
"principles," the U.S. Bankruptcy Court for the Northern
District of California decided Liberate
Technologies.<a href="#52" name="52a">52</a> In Liberate
Technologies, the court, applying the
good-faith filing doctrine, dismissed the liquidating chapter 11 case
because the debtor had cash in excess of its liabilities and did "not
need bankruptcy protection to avoid wasteful liquidation of its business
assets."<a href="#53" name="53a">53</a>

Liberate Technologies's business had not been
successful; in fact, its revenues had declined, and the debtor had incurred
substantial operating losses. Prior to the filing date, the debtor
reasonably expected to continue suffering substantial losses. The debtor
was the defendant in several securities lawsuits, was under SEC
investigation and was also defending a critical patent infringement case.
Prior to the filing, the debtor abandoned the office space it had used for
its headquarters to save money. The debtor attempted to surrender the space
to its landlord and to negotiate a reduced claim for the breach of the
lease; the landlord refused. The possible future liability on the lease was
$45 million. When the landlord refused the surrender, the debtor filed its
chapter 11 petition. The debtor intended to sell its assets and cease
operating. Chapter 11 would, among other things, permit the debtor to use
§502(b)(6) to cap the landlord's claim and to obtain leverage to
settle with the securities plaintiffs. The court admitted that the debtor
was seemingly a candidate for chapter 11 on these facts, but then pointed
to "another side to the story."<a href="#54" name="54a">54</a>

At the filing date, the debtor had cash well in
excess of its liabilities. The debtor had $212 million in unrestricted
cash, and liabilities of $59 million to $167 million depending on the
outcome of the patent litigation. In short, the debtor could pay the
landlord claim in full, even if not reduced by the §502(b)(6) cap,
although doing so would markedly reduce the amount distributed to
shareholders. The debtor also contended that it could only sell the
business while in chapter 11, as most of its prospective purchasers had
insisted on a §363 sale. The court noted, however, that one of the
potential purchasers was not insisting upon a sale in chapter 11. (Although
a value-maximizing auction might not occur outside chapter 11).

Examining the good-faith filing doctrine as
articulated by Marsch and SGL Carbon, the court noted that the "most conspicuous element of the
good-faith requirement is that the debtor need chapter 11 relief."<a href="#55" name="55a">55</a>
Reviewing those decisions, the court held that "if a petitioner has
no need to rehabilitate or reorganize, its petition cannot serve the
rehabilitative purpose for which chapter 11 was designed."<a href="#56" name="56a">56</a> When a
solvent debtor seeks chapter 11 relief, the only bankruptcy policy
implicated is the avoidance of piecemeal liquidation that destroys the
going-concern value of an enterprise, as in cases such as Manville. In the case at bar,
the debtor's "litigation problems are no more compelling than
the circumstances found insufficient in Marsch and SGL Carbon.<a href="#57" name="57a">57</a> There was no flood of litigation, like the mass-tort
cases. Moreover, even if the litigation it faced might be a problem, the
filing was "premature" as the debtor might win, settle or lose
for less than its maximum possible liability.<a href="#58" name="58a">58</a> The "pending
litigation does not create a present need for bankruptcy relief because the pendency of the
lawsuits does not threaten the continuation of the debtor's business,
because the debtor may never incur significant liabilities from the
lawsuits and because [the] debtor can pay any judgments without liquidating
business assets."<a href="#59" name="59a">59</a> Because the debtor had no present need to file to avoid
immediate liquidation of business assets, given both balance-sheet solvency
and near-term liquidation, the filing lacked good faith.

Good faith was not established by the debtor's
historic losses or the potential for more of the same because it was
"wholly uncertain whether [the] debtor will be left with debts that
it cannot pay without liquidating business assets."<a href="#60" name="60a">60</a> If the
debtor was successful in selling its business as a going concern, its
losses would cease and it would receive millions for its assets. Given its
condition, the fact that the debtor was trying to seek to reduce the
payment to the landlord permanently and unconditionally (through access to
§502(b)(6)) and to limit the remedies of the litigation plaintiffs was
indicative of a lack of good faith.

While use of §502(b)(6) was not in itself
evidence of bad faith, its possible use also did not establish good faith.<a href="#61" name="61a">61</a>
The court found objectionable the use of the section to enhance shareholder
value. That section was intended by Congress for use by debtors with a
"real need for bankruptcy relief," not to increase the amount
realized by shareholders at the expense of lessors.<a href="#62" name="62a">62</a> Similarly, the desire
to conduct a sale under §363 also did not establish good faith, even
if its use might generate a higher sale price. "A company that is
able to sell its business as a going concern outside of bankruptcy and can
clearly pay all creditors in full does not have a need for bankruptcy
relief merely because it might be able to sell on better terms if it could
use §363(f) to sell the business free and clear of liens and
claims."<a href="#63" name="63a">63</a> Driving the point home, the court noted that these
"concerns go only to how much [the] debtor can return to its
equity-holders, and do not affect whether debtor can pay its creditors or
whether debtor can sell its assets as a going concern."<a href="#64" name="64a">64</a> The court
summarized the teachings of the Marsch and SGL Carbon cases to be that "present
need for bankruptcy relief is a central element
of good faith" and that a solvent entity has need for, and access to,
bankruptcy relief only to avoid liquidation of its business assets, not to
maximize return to equity-holders.<a href="#65" name="65a">65</a> In short, allowing liquidation in
a manner designed to maximize equity value was not a purpose for which
chapter 11 was intended.

<h4>Integrated Telecom</h4>

The next "nail" was provided by a
now-familiar source, the Third Circuit Court of Appeals, in Integrated Telecom Express.<a href="#66" name="66a">66</a>
The facts were strikingly similar to those in Liberate
Technologies. The company possessed at
filing substantial cash reserves. The debtor intended to liquidate through
a sale of all of its assets; its board had voted to dissolve. The filing
was primarily to take advantage of §502(b)(6) to cap a
landlord's claim after the landlord refused to settle pre-filing.
While there was a securities class action pending at the time of the
filing, the maximum liability anticipated in that case would still,
according to the court, leave the debtor solvent.

Following the filing, the debtor conducted a
§363 sale of its IP assets at an increase over the pre-filing bid for
the same assets. The debtor also moved to reject the lease, an action
opposed by the landlord, which also filed a motion to dismiss. Following an
evidentiary hearing, the bankruptcy court denied the motion to dismiss. The
bankruptcy court found that the debtor had suffered dramatic losses and was
losing a lot of money prior to the filing. The court found that the
debtor's board "had an obligation, and appropriately exercised
its obligation, to give the investors their money back."<a href="#67" name="67a">67</a> The
bankruptcy court found that the debtor's solvency, the fact that
shareholders would receive a distribution and the fact that the
debtor's use of §502(b)(6) would only serve to increase that
distribution did not amount to a lack of good faith.

The bankruptcy court confirmed the debtor's
plan, which capped the securities liability at $25 million, $20 million of
which was funded by insurance coverage; securities claimants voted in favor of the plan. The
landlord's claim was reduced pursuant to the Code. The landlord
appealed, and the bankruptcy court, in an opinion related to the
landlord's motion for stay, again noted that the debtor's
resorting to §§502(b)(6) and 510(b) was not improper.<a href="#68" name="68a">68</a> Indeed,
the court noted that the board would have breached its fiduciary duty to
the debtor's investors had it not pursued the course taken.<a href="#69" name="69a">69</a> The
district court affirmed, refusing to disturb the bankruptcy court's
findings that the debtor was in financial distress when it filed and that
the board properly pursued liquidation in chapter 11 in order to fulfill
its obligations to its investors.<a href="#70" name="70a">70</a>

The Third Circuit rather emphatically reversed. With
reference to SGL Carbon and (in passing) PPI, the court stated that at "its most fundamental level,
the good-faith requirement ensures that the Bankruptcy Code's careful
balancing of interests is not undermined by petitioners whose aims are
antithetical to the basic purposes of bankruptcy."<a href="#71" name="71a">71</a> The court then
"reasoned" that the Supreme Court had identified two of the
basic purposes of chapter 11 as (1) preserving going concerns and (2)
maximizing property available to satisfy creditors, citing the Supreme Court's decision in 203 N. LaSalle.<a href="#72" name="72a">72</a> As if they
were the only purposes of the Code, the court then noted that "each
of these purposes informs our application of the good-faith
requirement."<a href="#73" name="73a">73</a> Summarizing the import of prior Third Circuit
precedent on the good-faith filing requirement, the court stated that those
cases focused on two inquires: (1) whether the petition serves a valid
bankruptcy purpose by preserving a going
concern or maximizing the value of the debtor's estate, and (2) whether the petition is filed merely to obtain a
tactical advantage in litigation.<a href="#74" name="74a">74</a>

Since Integrated was out of business and liquidating, the court found no
going-concern value to preserve in chapter 11 through reorganization or
liquidation. The question then was whether the filing was justified by a
desire to maximize the value of the estate. The court then defined the
inquiry to focus entirely on the asset side of the bankruptcy balance sheet
rather than the net "value" that reducing claims might create:
"To 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."<a href="#75" name="75a">75</a> Moreover, while a debtor need not be
insolvent to file, some degree of financial distress is required.<a href="#76" name="76a">76</a> The
absence of an insolvency requirement "does not mean that all solvent
firms should have unfettered access to chapter 11."<a href="#77" name="77a">77</a> Bankruptcy must
offer some relief related to the form of distress suffered by the debtor.
The court could identify no value for Integrated's assets that was
threatened outside of bankruptcy that would be preserved or maximized by
resorting to chapter 11, as opposed to dissolution proceedings in state
law.<a href="#78" name="78a">78</a> The court found the findings with respect to the debtor's
financial distress to be clearly erroneous. The court also found that the
consensual plan treatment of the securities claimants evidenced the lack of
distress, refusing to credit the fact that the claims may have been
voluntarily reduced due to the leverage
created by the chapter 11 filing and the
debtor's access to §510(b). The court equally discounted the
fact that §363 had generated additional value.<a href="#79" name="79a">79</a>

The court also found that the benefits obtained by
access to §502(b)(6) did not establish good faith. The fact that
access to that provision increased the amount distributed to investors was
not maximizing the estate in this court's definition and therefore
not consistent with the Code's purposes:

<blockquote>
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 from a creditor to a
company's shareholders.<a href="#80" name="80a">80</a>
</blockquote>

Citing LaSalle again, the court noted that the purpose of chapter 11 was
to maximize the property available to creditors, not shareholders.<a href="#81" name="81a">81</a> The court noted that liquidation plans
were permissible, but such plans must also serve a valid bankruptcy
purpose, either by preserving some going-concern value, liquidating a
company as a whole or in such a way as to preserve some goodwill, or
maximizing the value of the debtor's estate (as opposed to simply
redistributing that value to interests).<a href="#82" name="82a">82</a> Thus, use of chapter 11 by a
solvent debtor to increase the amount distributed to shareholders at the
expense of any creditor,
by resorting to the claims-limiting or claims-subordinating provisions of
the Code, was not a "valid bankruptcy purpose" and therefore
not a good-faith filing. The Third Circuit failed to address, in any way,
the finding of the lower courts that the board's fiduciary duty to
shareholders required the action taken.

<h4>When Can a Solvent Debtor File in "Good Faith"?</h4>

Both Liberate
Technologies and Integrated
Telecom evidence the wisdom of Judge
Queenan's fundamental criticism of the good-faith filing doctrine.
The opinions, along with SGL Carbon, simply leave boards of directors and counsel wondering what
does and does not constitute a good-faith filing when a debtor is
balance-sheet solvent. A debtor need not be insolvent, but some degree of
"financial distress" (perhaps bordering on "imminent
illiquidity") may be required. A debtor need not wait until a
judgment is entered, but one cannot file too early in the litigation:
"Early" filing is encouraged, but "premature"
filing lacks good faith. Filing just to use one of the Code's
claim-limiting provisions is not bad faith per
se, but doing so is also not good faith and may
suggest a lack of good faith if the only beneficiaries of the claim limit
are holders of equity interests (and there is no other valid purpose for
the filing).

By requiring a lack of liquidity, both decisions may
also encourage debtors to file late in their downward spiral, when they are
less able to withstand the filing or must borrow to survive the chapter 11
case or even to complete a liquidation. By kicking cases out of a chapter
11 as "premature," the courts suggest it may be better to be a
little late than a little early, even if to do so is otherwise bad chapter
11 planning.

Like the good-faith filing doctrine in general, an
eligibility test based on illiquidity violates a "plain
meaning" approach to the Code. As Judge Queenan noted, Congress knew
how to write eligibility requirements when it wanted to. Expanding the
good-faith filing doctrine to make all solvent debtors, if not ineligible,
a "suspect class" of debtors, is also sure to increase
satellite litigation at the outset of these cases, which may have the
effect of increasing the costs of administration and risking the return to
all interests of the estate. Aggressive creditors will be sure to litigate
issues of "premature" filing in an effort to obtain early
leverage in the case.

Unlike the lower courts in Integrated Telecom, both opinions
failed to address critical issues of fiduciary duty. If liquidation in
chapter 11 of a failed but balance-sheet solvent entity would maximize the
return to interest-holders by limiting the amount of, or subordinating,
claims, doesn't the debtor's management have a duty to those
share-holders to pursue a liquidating chapter 11? Once in chapter 11, that
same duty would require management to maximize the use of such provisions.
While no management has a duty to file a case in bad faith, since the
good-faith inquiry is so fact-intensive, few boards will know in advance if
resorting to chapter 11 will run afoul of these cases or be required by
their fiduciary obligations to shareholders.

Lastly, the cases seem premised on a misreading of
Supreme Court precedent about the purposes of chapter 11, reading that
precedent to limit use of chapter 11 to maximize creditor returns rather
than preservation or maximization of the value of equity interests. But Weintraub is to the contrary,
and the Code contains many provisions directed to the protection of equity
interests.<a href="#83" name="83a">83</a> Chapter 11 is also about, and has always been about, the
protection of shareholder value as well as creditors' rights.

<h4>Conclusion</h4>

Liberate Technologies and Integrated Telecom seem to be a part of a backlash against the use of chapter
11 as a "business planning tool" or "litigation
device," rather than as a means of rehabilitating troubled
businesses. Abuses of this nature can undoubtedly occur. However, by trying
to create a set of principles to justify what is, in essence, a
"smell test," these courts may simply provoke unnecessary
litigation due to the fundamental vagueness of the resulting standards.
Such courts also suggest—wrongly—that chapter 11 is "not
for shareholders anymore." At best, they leave management in a
quandary over what is permissible and what fiduciary duty may require.
Utilization of the good-faith filing doctrine must be saved for the most
egregious cases. These cases do not seem to fit that bill.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Board
Certified in Business Bankruptcy Law by the American Board of
Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> Compare 11 U.S.C. §109(d)
with 11 U.S.C. §109(e)(3). See, e.g., In
re SGL Carbon Corp., 200 F. 3d 154, 163 (3d
Cir. 1999); In re Marshall, 298 B.R. 670, 676 (Bankr. C.D. Cal. 2003). <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., Marshall, 298 B.R. at 676. <a href="#3a">Return to article</a>

<a name="4">4</a> SGL Carbon, 200 F.3d at
163 ("It is well established that a debtor need not be insolvent
before filing a bankruptcy petition."). <a href="#4a">Return to article</a>

<a name="5">5</a> 11
U.S.C. §502(b)(6) (capping claims arising from rejection of leases); 11
U.S.C. §502(b)(7) (same, as to claims arising from the rejection of
employment agreements). <a href="#5a">Return to article</a>

<a name="6">6</a> 11
U.S.C. §510(b). <a href="#6a">Return to article</a>

<a name="7">7</a> 11
U.S.C. §1129(b)(2)(B)(i). <a href="#7a">Return to article</a>

<a name="8">8</a> In re Liberate Technologies, 314
B.R. 206 (Bankr. N.D. Cal. 2004). <a href="#8a">Return to article</a>

<a name="9">9</a> In re Integrated Telecom Express Inc., 384 F.3d 108, 2004 WL 2086058 (3d Cir. 2004). <a href="#9a">Return to article</a>

<a name="10">10</a> This
article will often use the term "shareholders" to refer to
holders of equity interests. The same analysis would apply generally to any
form of entity other than a corporation and to the holders of interests in
such an entity. <a href="#10a">Return to article</a>

<a name="11">11</a> SGL Carbon, 200 F.3d at
160 (collecting cases). <a href="#11a">Return to article</a>

<a name="12">12</a> For an
excellent, and critical, history of the doctrine's development, see In re Victory Ltd. Partnership, 187 B.R. 54 (Bankr. D. Mass. 1995). <a href="#12a">Return to article</a>

<a name="13">13</a> In re Marsch, 36 F.3d
825, 828 (9th Cir. 1994). <a href="#13a">Return to article</a>

<a name="14">14</a> Id. <a href="#14a">Return to article</a>

<a name="15">15</a> SGL Carbon, 200 F.3d at
165. <a href="#15a">Return to article</a>

<a name="16">16</a> Id. at 162. <a href="#16a">Return to article</a>

<a name="17">17</a> In re Marshall, 298 B.R.
670, 681 (Bankr. C.D. Cal. 2003). <a href="#17a">Return to article</a>

<a name="18">18</a> Id. ("The analysis
is based on the totality of the circumstances and not a bright line
rule.") <a href="#18a">Return to article</a>

<a name="19">19</a> In re PPI Enters. (U.S.) Inc., 324
F.3d 197, 211 (3d Cir. 2003). <a href="#19a">Return to article</a>

<a name="20">20</a> Id.; 11 U.S.C.
§1123(b)(4). <a href="#20a">Return to article</a>

<a name="21">21</a> Victoria Ltd. Partnership, supra n.11. Toibb v. Radloff, 501 U.S. 157, 111 S.Ct. 2197, 115 L. Ed. 2d 145
(1991), held that individuals not engaged in business are eligible to file
for relief under chapter 11. The case reasoned that chapter 11 did not have
any eligibility requirements not specifically enumerated in the Code. <a href="#21a">Return to article</a>

<a name="22">22</a> Victoria Ltd. Partnership, 187
B.R. at 61-62. <a href="#22a">Return to article</a>

<a name="23">23</a> In re Victory Constr. Co., 42
B.R. 145, 148-49 (Bankr. C.D. Cal. 1984). <a href="#23a">Return to article</a>

<a name="24">24</a> 187 B.R.
at 61. <a href="#24a">Return to article</a>

<a name="25">25</a> Id. at 62. <a href="#25a">Return to article</a>

<a name="26">26</a> Commodity Futures Trading Corp. v. Weintraub, 471 U.S. 343, 354-56 (1985). See,
also, Gower v. FHA (In re Davis), 899
F.2d 1136, 1143 n.15 (11th Cir. 1990). <a href="#26a">Return to article</a>

<a name="27">27</a> Bergquist v. Felland (In re O-Jay Foods Inc.), 1991 WL 378164 (D. Minn.) at *16. <a href="#27a">Return to article</a>

<a name="28">28</a> Id. <a href="#28a">Return to article</a>

<a name="29">29</a> In re DN Assocs., 144 B.R.
195, 200 (Bankr. D. Me. 1992), aff'd., 160 B.R. 20 (D. Me. 1993), aff'd., 3 F.3d 512 (1st Cir. 1993). <a href="#29a">Return to article</a>

<a name="30">30</a> Id. <a href="#30a">Return to article</a>

<a name="31">31</a> Id. (emphasis added). <a href="#31a">Return to article</a>

<a name="32">32</a> Id. (emphasis in
original). <a href="#32a">Return to article</a>

<a name="33">33</a> Hansen,
Jones & Leta, P.C. v. Segal, 220 B.R. 434, 459 (D. Utah 1998). <a href="#33a">Return to article</a>

<a name="34">34</a> In re Water's Edge L.P., 251
B.R. 1, 7 (Bankr. D. Mass. 2000). <a href="#34a">Return to article</a>

<a name="35">35</a> Id. at 8. <a href="#35a">Return to article</a>

<a name="36">36</a> In re Marsch, 36 F.3d 825
(9th Cir. 1994). <a href="#36a">Return to article</a>

<a name="37">37</a> Id. at 828. <a href="#37a">Return to article</a>

<a name="38">38</a> Id. at 829. This portion of
the court's rationale seems clearly at odds with Toibb v. Randloff, supra. n. 20, by
suggesting that a filing to preserve business assets is permissible when a
filing to preserve non-business assets is not permissible. <a href="#38a">Return to article</a>

<a name="39">39</a> SGL Carbon, supra n. 1. <a href="#39a">Return to article</a>

<a name="40">40</a> Id. at 156. <a href="#40a">Return to article</a>

<a name="41">41</a> Id. at 159-62. <a href="#41a">Return to article</a>

<a name="42">42</a> Id. at 163. <a href="#42a">Return to article</a>

<a name="43">43</a> Id. <a href="#43a">Return to article</a>

<a name="44">44</a> Id. <a href="#44a">Return to article</a>

<a name="45">45</a> Id. <a href="#45a">Return to article</a>

<a name="46">46</a> Id. at 165-166. Indeed, SGL Carbon may be the
"poster child" for unfortunate statements by a debtor's
management contributing to a finding of bad faith. <a href="#46a">Return to article</a>

<a name="47">47</a> Id. at 169. <a href="#47a">Return to article</a>

<a name="48">48</a> In re RBGSC Inv. Corp., 253
B.R. 352, 367 (E.D. Pa. 2000). <a href="#48a">Return to article</a>

<a name="49">49</a> Marshall, 298 B.R. at 681-83. But, see In re Fraternal Composite Serv. Inc., 2003 WL 23833178 (Bankr. N.D.N.Y.) (dismissing
chapter 11 case of solvent debtor as premature where state court judgment
not yet entered). <a href="#49a">Return to article</a>

<a name="50">50</a> P.P.I. Ent., supra n. 18. <a href="#50a">Return to article</a>

<a name="51">51</a> Id. at 212. There is some
suggestion that, absent the reduction of claim, the debtor could not have
proposed a 100 percent plan, although this is unclear from the opinion. <a href="#51a">Return to article</a>

<a name="52">52</a> Liberate Technologies, supra n.
7. <a href="#52a">Return to article</a>

<a name="53">53</a> Id. at 208. <a href="#53a">Return to article</a>

<a name="54">54</a> Id. at 209. <a href="#54a">Return to article</a>

<a name="55">55</a> Id. at 211. <a href="#55a">Return to article</a>

<a name="56">56</a> Id. <a href="#56a">Return to article</a>

<a name="57">57</a> Id. at 213. <a href="#57a">Return to article</a>

<a name="58">58</a> Id. at 213-14. <a href="#58a">Return to article</a>

<a name="59">59</a> Id. at 214. <a href="#59a">Return to article</a>

<a name="60">60</a> Id. <a href="#60a">Return to article</a>

<a name="61">61</a> Id. at 215. <a href="#61a">Return to article</a>

<a name="62">62</a> Id. <a href="#62a">Return to article</a>

<a name="63">63</a> Id. at 217. <a href="#63a">Return to article</a>

<a name="64">64</a> Id. <a href="#64a">Return to article</a>

<a name="65">65</a> Id. at 218 (emphasis
applied). <a href="#65a">Return to article</a>

<a name="66">66</a> Integrated Telecom Express, supra n. 8. <a href="#66a">Return to article</a>

<a name="67">67</a> Id., slip op. at p. 5.
This "obligation" was presumably a reference to the
board's fiduciary duty. <a href="#67a">Return to article</a>

<a name="68">68</a> Id. at 7. <a href="#68a">Return to article</a>

<a name="69">69</a> Id. <a href="#69a">Return to article</a>

<a name="70">70</a> Id. <a href="#70a">Return to article</a>

<a name="71">71</a> Id. <a href="#71a">Return to article</a>

<a name="72">72</a> Id. See Bank of Am. Nat'l. Trust & Sav.
Ass'n. v. 203 N. LaSalle St. P'ship., 526 U.S. 434, 453, 119 S.Ct. 1411, 143 L.Ed.2d. 60 (1999). 203 N. LaSalle, of
course, was about the conditions under which old equity could purchase new
equity in an insolvent chapter 11 debtor; its use in this context is
ironic, at best. <a href="#72a">Return to article</a>

<a name="73">73</a> Id. <a href="#73a">Return to article</a>

<a name="74">74</a> Id. <a href="#74a">Return to article</a>

<a name="75">75</a> Id. at 8-9. <a href="#75a">Return to article</a>

<a name="76">76</a> Id. at 9. <a href="#76a">Return to article</a>

<a name="77">77</a> Id. <a href="#77a">Return to article</a>

<a name="78">78</a> Id. <a href="#78a">Return to article</a>

<a name="79">79</a> Id. at 12-13. <a href="#79a">Return to article</a>

<a name="80">80</a> Id. at 14. <a href="#80a">Return to article</a>

<a name="81">81</a> Id. <a href="#81a">Return to article</a>

<a name="82">82</a> Id. at 9, n. 4. <a href="#82a">Return to article</a>

<a name="83">83</a> See, e.g., 11 U.S.C.
§1102 (appointment of equity security-holders committee);
§1129(b)(2)(c) (definition of fair and equitable plan as to class of
interests); §1129(a)(8) (requirement of acceptance by impaired class
of interests); §1123(a)(4) (prevention of discrimination among
interests); §1123(a)(7) (protection of interests of equity
security-holders). <a href="#83a">Return to article</a>

<hr>

Journal Authors

Robert J. Keach

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004