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A financially healthy company that is going out of business cannot file for bankruptcy for the sole purpose of taking advantage of a provision of the Bankruptcy Code that sharply limits the amount a landlord may recover for termination of a long-term lease, the 3rd U.S. Circuit Court of Appeals has ruled. In its 26-page opinion in In re Integrated Telecom Express Inc., a unanimous three-judge panel found that the Delaware Bankruptcy Court had erred by rejecting the landlord’s motion to dismiss the debtor’s Chapter 11 filing on the grounds that it could not have been filed in good faith since the company had plenty of cash. The ruling reverses decisions by both the bankruptcy court and the Delaware U.S. District Court that said Integrated had the right to pursue a Chapter 11 filing because it “was losing a lot of money” and “was experiencing a dramatic downward spiral” in September 2001 and, as a result, had gone “out of business.” Those findings were not enough to show that the debtor was in “financial distress,” the 3rd Circuit found, because Integrated “was highly solvent and cash rich at the time of the bankruptcy filing.” Third Circuit Judge D. Brooks Smith found that the Bankruptcy Code does not allow for the filing of a Chapter 11 petition “by a financially healthy debtor, with no intention of reorganizing or liquidating as a going concern.” Smith, who was joined by Senior 3rd Circuit Judges Edward R. Becker and Morton I. Greenberg, found that Integrated had “no reasonable expectation” that its Chapter 11 proceedings would “maximize the value of the debtor’s estate for creditors.” Instead, Smith said, the evidence showed that Integrated filed the petition “solely to take advantage of a provision in the Bankruptcy Code” that limits claims on long-term leases. “We conclude that such a petition is not filed in good faith,” Smith wrote. The ruling is a victory for the landlord and its lawyers, Seth P. Waxman and Craig Goldblatt of Wilmer Cutler Pickering Hale & Dorr in Washington, D.C. Waxman, who served as U.S. solicitor general during the second Clinton administration, was supported in the appeal by an amicus brief filed by a trio of law professors who teach bankruptcy law — David A. Skeel Jr. of the University of Pennsylvania Law School; Robert K. Rasmussen of the Vanderbilt Law School; and G. Marcus Cole of the Stanford Law School. In their amicus brief, the professors argued that Integrated failed to satisfy one of the key prerequisites for seeking protection in bankruptcy court since it was unable to show that it was in “financial distress.” “At the time it sought to invoke the powers of Chapter 11, the debtor had sufficient cash on hand to pay all of its creditors in full. Moreover, this cash was not necessary to fund ongoing operations of the debtor, because the debtor had ceased all operations,” the professors wrote. “This case is neither a reorganization nor a liquidation; it is a redistribution. As such, it does not belong in Chapter 11,” they wrote. According to court papers, Integrated was a supplier of software and equipment to the broadband communications industry. In 2000, Integrated negotiated a 10-year lease for office space in Silicon Valley with a monthly base rent of $200,000, increasing 5 percent annually. But 2001 proved to be a difficult year for Integrated as the market for many of its products deteriorated, leading to net losses of $36.2 million. When an investment bank was unable to assist Integrated in negotiating a merger, Integrated’s board prepared a liquidation plan. In the meantime, Integrated was hit with a class action securities suit brought by investors who claimed the company’s stock price was overvalued in its initial public offering. In May 2002, Integrated’s board approved the sale of all its intellectual property and related assets to Real Com, a corporation formed by some of Integrated’s officers and directors. The only issue left to be resolved in the liquidation was Integrated’s long-term lease. The board voted in August 2002 to authorize a Chapter 11 filing if the landlord would not accept $8 million as satisfaction of Integrated’s obligations under the lease. In a letter to the landlord, Integrated’s bankruptcy counsel said that if the landlord was unwilling to settle, Integrated was prepared to file a Chapter 11 bankruptcy petition in order to invoke �(b)(6) of the Bankruptcy Code, which imposes a cap on landlords’ claims. When the landlord refused to settle, Integrated filed its bankruptcy petition, including schedules that showed it had $105.4 million in cash and $1.5 million in other assets. The landlord filed a proof of claim listing the present discounted value of Integrated’s lease obligations at approximately $26 million. Lawyers for the landlord then moved to dismiss the petition on the grounds that it was not filed in good faith since its sole purpose was to cap the landlord’s claim. But the Bankruptcy Court disagreed, finding that Integrated “offered a number of reasons for the filing of the bankruptcy case,” noting that the company’s financial losses were “dramatic.” The Bankruptcy Court also found that even if Integrated’s reasons for filing the petition were not “particularly persuasive,” its desire to take advantage of the �(b)(6) cap on landlords’ claims was not enough to support to motion to dismiss the petition. The court later confirmed Integrated’s plan and, applying the cap, reducing the landlord’s claim from $26 million to $4.3 million. Although the plan did not resolve the securities class action, it reserved $5 million of Integrated’s estate, which, along with $20 million in insurance coverage, effectively limited any potential judgment to $25 million. The securities class voted in favor of the plan. Although the Delaware U.S. District Court upheld the bankruptcy court’s ruling, the 3rd Circuit found that both courts had erred in their analyses of the “good faith” requirement. The appellate court found that despite its financial woes, Integrated was still solvent and had plenty of cash at the time of the filing. “We do not see how bankruptcy offers Integrated any relief from this sort of distress, which has no relation to any debt owed by Integrated,” Smith wrote. “That is, we can identify no value for Integrated’s assets that was threatened outside of bankruptcy by the collapse of Integrated’s business model, but that could be preserved or maximized in an orderly liquidation under Chapter 11,” Smith wrote. Smith found that despite Integrated’s “dramatic downward spiral,” it was unable to show that it was “suffering from financial distress” since its cash on hand was sufficient to meet all of its debts. To be filed in good faith, Smith said, a bankruptcy 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.” Lawyers for Integrated’s official committee of equity security holders argued that Integrated’s desire to take advantage of the cap on landlord claims established good faith in and of itself. Integrated’s lawyers made a similar argument, saying that its petition properly sought “a favorable forum for the consideration and resolution of other disputed claims, including the landlord’s claim.” Smith disagreed, saying, “Taken to its logical conclusion, the … argument is that any entity willing to undergo Chapter 11 proceedings may cap the claims of its landlord. Nothing in the Bankruptcy Code or its legislative history suggests that �(b)(6) was meant to allow tenants to avoid their leases whenever the landlord’s state law remedy exceeds the cap … by an amount greater than the cost of proceeding through a Chapter 11 reorganization or liquidation.” Such a rule, Smith said, “would not only obviate the need for a good faith requirement, but would be antithetical to the structure and purposes of the Bankruptcy Code.”

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