Suppose that your borrower or customer files a chapter 11 case.[i] You do not like this because you’ll almost certainly not collect the full amount owed to you and to get anything you’ll have to get involved with a bankruptcy case and hire attorneys. Your discontent becomes fury when you determine that your borrower or customer is not even broke. You’ve never heard of a solvent debtor. Can you get this case dismissed? Doesn’t a company have to be insolvent in order to file bankruptcy?
[Editor’s Note: For more on what a creditor should know, please see What Every Secured Creditor (And Its Lawyer) Should Know About Chapter 11.]
Let’s look at the situation through the debtor’s (that is, your borrower’s or customer’s) eyes: it is experiencing financial distress and all signs are that things will get worse. In due course, the debtor is reasonably sure it will run out of money and will not be able to keep current with suppliers.
Under these circumstances, a chapter 11 case may permit the debtor to sell its assets as a going concern to a stronger company, or restructure financially and operationally (i.e., become leaner and meaner) and avoid liquidation. Should it have to wait until it hits the iceberg to change direction?
There are a number of grounds on which creditors can have a bankruptcy case dismissed. Solvency, however, alone, will not suffice: there simply is no requirement that a company (or a person) be insolvent to file bankruptcy. The question, rather, is whether the filing serves a legitimate reorganization purpose.
[Editor’s note: For more on distressed companies, please see The Lifecycle of a Distressed Company.]
Bankruptcy Code §101(32) defines “insolvency” (for entities other than municipalities and partnerships) as the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation.”[ii] But the Code’s §109(d), which sets forth eligibility requirements for an entity to file for chapter 11 relief, neither requires nor is premised upon a requirement that the entity be insolvent.[iii]Bankruptcy Code §1112 provides that a creditor or other party in interest may move to dismiss the chapter 11 case for “cause”[iv] and provides a long list of cause examples of “cause.”[v] The solvency of the debtor is not on the list.
In the Johns-Manville bankruptcy case, an Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York[vi] reviewed the Bankruptcy Code and the policy behind it to conclude that, “[t]he reorganization provisions of the Code were drafted with the aim of liquidation avoidance by great access to Chapter 11.”[vii] “Liquidation avoidance” logically requires corporate restructuring well in advance of the reading of last rites.
There are numerous examples of clearly solvent debtors filing bankruptcy and not being tossed out.
In Fields Station LLC v. Capital Food Corp. of Fields Corner (In re Capital Foods Corp. of Fields Corner), the eventual debtor, Capital Food, was lessee (at below market rates) of commercial premises upon which it operated a grocery store.[viii] Capital Food stopped doing business and subleased the place to another store operator, which failed and departed, causing a default under the Capital Foods’ lease.[ix] Capital Foods decided to have another go at running a food store itself in the space and had nearly everything in place (except for city permits) by the deadline for cure set by the lessor’s notice of default.[x]
In order to forestall forfeiture of its favorable leasehold, Capital Foods filed a chapter 11 case. The lessor moved for dismissal, relying upon Capital Foods’ representation that it was solvent at the time it filed the chapter 11 petition (indeed, with the lease in place, it had adequate cash flow to pay its past and ongoing debts), could pay its unsecured debts without liquidating its assets, and thus had no present need for bankruptcy protection.[xi] The court denied the motion, observing that imminent catastrophic events, like the prospect of Capital Food losing its lease or the hypothetical example of a threatened foreclosure on real property essential to a successful reorganization, provided ample justification for filing, since the filing would serve two primary purposes of chapter 11 relief: the preservation of businesses as going concerns and the maximization of assets recoverable to satisfy unsecured claims.[xii]
A more recent case involving solvent debtors fending off dismissal was In re General Growth Properties, Inc. the debtor owned a large number of retail malls. It found itself unable to refinance a courtesy, at least in part, to the great financial crisis.[xiii] Unable to obtain the refinancings on which the debtors routinely relied, the debtors’ parent began to draw down its operating cash flow to meet regular expenses and financial obligations, leaving its development and redevelopment commitments to go begging.[xiv] Crucially, notwithstanding a “stable and generally positive cash flow,” the group of debtors faced a massive amount of debt that would be maturing over the next several years The debtors justified their filing on those coming maturities and the court agreed.[xv]
In sum, solvent debtors can survive motions to dismiss the chapter 11 cases where they face an existing and worsening litigation crisis of massive dimensions (Johns-Manville), an imminent undoing of an essential support for their ongoing businesses (Capital Food), or a portentous wave of debt maturities under conditions of severe credit uncertainty (General Growth Properties).
In order to survive a motion to dismiss, the solvent debtor must have filed their petition in good faith. The burden falls to the debtor to show that their filing was in good faith. [xvi] The court will do an intensive fact review of the totality of the case to determine if the filing is acceptable or in bad faith. [xvii] A good faith determination is essential to ensure “that the Bankruptcy Code’s careful balancing of interests is not undermined by petitioners whose aims are antithetical to the basic purposes of bankruptcy.” [xviii]
Investigated by the U.S. Department of Justice for alleged price-fixing, then subjected to a class action antitrust lawsuit by steel producers, SGL Carbon Corporation – a leading producer of graphite electrodes in steel production – filed a chapter 11 case.[xix] The debtor was solvent and denied that it had any serious insolvency or credit problems to be addressed in chapter 11.[xx] In a press release, the debtor announced that it filed bankruptcy “’to protect itself against excessive demands made by plaintiffs in civil antitrust litigation and in order to achieve an expeditious resolution of the claims against it.’”[xxi]
The Third Circuit determined that there was no evidence that possible antitrust judgments could force debtor out of business and that the debtor’s filing of a chapter 11 case solely to gain a tactical advantage in litigation was not a valid reorganizational purpose.[xxii] The court granted the creditor committee’s motion to dismiss.
A creditor might well succeed in moving to dismiss a chapter 11 case filed solely to secure a litigation advantage in the absence of financial distress. In the Johns-Manville case, Judge Lifland identified abuses that could implicate “bad faith” on the part of the debtor, justifying dismissal of the chapter 11 case, including the following:
In General Growth Properties, the court quoted bad faith factors from a Second Circuit case:
(1) the debtor has only one asset; (2) the debtor has few unsecured creditors whose claims are small in relation to those of the secured creditors; (3) the debtor’s one asset is the subject of a foreclosure action as a result of arrearages or default on the debt; (4) the debtor’s financial condition is, in essence, a two-party dispute between the debtor and secured creditors which can be resolved in the pending state foreclosure action; (5) the timing of the debtor’s filing evidences an intent to delay or frustrate the legitimate efforts of the debtor’s secured creditors to enforce their rights; (6) the debtor has little or no cash flow; (7) the debtor can’t meet current expenses including the payment of personal property and real estate taxes; and (8) the debtor has no employees.[xxiv]
[Editor’s Note: For more information on bankruptcy litigation, please see Bankruptcy Battle Royale – Common Litigation Scenarios.]
In short: insolvency is not required to file a chapter 11 petition, but a valid reorganization purpose with respect to the property of the debtor appears to be. And a valid reorganizational purpose implies reasonably imminent serious financial difficulties for the debtor as a whole that can be addressed in a chapter 11 case.
[Editor’s Note: This article is an update of an article originally published in February 2014.]
Renee is a writer with a history in bankruptcy law and finance. She previously served as a law clerk for the Hon. James E. Shapiro for the Eastern District of Wisconsin. She practiced bankruptcy law and litigation prior to transitioning into finance. She now writes full time.
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