In the Third Circuit, Good Faith Means Something

By Barbra Rachel Parlin (New York)

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...