United States: Chapter 11 Filing to Delay Litigation and Subordinate Employee Claims Does Not Constitute Bad Faith

A financially troubled company embroiled in or confronting the prospect of onerous litigation that has the potential to compromise its ability to continue operating or restructure operations may consider filing for bankruptcy as part of its overall reorganization strategy. Whether recourse to bankruptcy as a means of warding off or managing the consequences of litigation is a legitimate invocation of federal bankruptcy laws has been the subject of some controversy. At the heart of the dispute are the Bankruptcy Code’s good faith filing and chapter 11 plan proposal requirements. A Delaware bankruptcy court recently discussed these requirements in In re Alta+Cast, LLC., ruling that a company did not file for chapter 11 in bad faith merely because it was involved in litigation with a former employee whose claims were ultimately subordinated in the company’s plan of reorganization.

Chapter 11 of the Bankruptcy Code has been interpreted to create two separate good faith requirements. The first is not expressly contained in the statute, but has been created by the courts over the course of many years. Bankruptcy Code section 1112 delineates a catalogue of abuses or failures, including continuing loss to or diminution of the estate, the inability to effectuate a plan or unreasonable delay by the debtor, that can lead to the outright dismissal of a chapter 11 case or its conversion to a liquidation. Courts have consistently found that the prosecution of a chapter 11 case in "bad faith" — although it is not one of the listed examples — also constitutes "cause" for dismissal or conversion under section 1112(b).

A bad faith filing generally refers to filing with the purpose of abusing the judicial process. In some instances, the filing is deemed improper because, despite the best intentions of the company, it appears improbable that the benefits of reorganization will be achieved at a reasonable cost or within a reasonable time period. In other cases, courts have found that the insiders of the company have attempted to abuse the judicial process and protections afforded by chapter 11. For instance, a chapter 11 filing for the sole purpose of fending off litigation if the debtor has no real prospect of reorganizing its business is often found to qualify as the kind of abuse that rises to the level of bad faith. Similarly, a filing by a solvent debtor merely to obtain a tactical litigation advantage has also been found to be abusive.

In addition to the good faith filing requirement, chapter 11 presents a litany of conditions that a plan of reorganization must satisfy before it can be confirmed by the court. Among those is the express mandate in Bankruptcy Code section 1129(a)(3) that every plan be "proposed in good faith and not by any means forbidden by law." This good faith requirement, which is derived from a long history pre-dating the enactment of the Bankruptcy Code in 1978, is designed to ensure that a bankruptcy court has the discretion to prevent confirmation of reorganization schemes that arguably comply with the technical strictures of the statute, but are somehow at odds with the fundamental objectives and purposes of federal bankruptcy law. Thus, Bankruptcy Code section 1129(a)(3) has been construed to require that a plan be proposed with "honesty and good intentions" and with "a basis for expecting that a reorganization can be effected." In keeping with that mantra, bankruptcy courts are required to determine whether a chapter 11 plan, viewed in light of the "totality of the circumstances," fairly achieves a result consistent with the Bankruptcy Code. The scope of the court's discretion in making that determination is considerable.

At the time that healthcare information technology provider Alta+Cast, LLC filed for bankruptcy in October of 2002, it was embroiled in litigation with former employee Mark Hays concerning the terms of his employment agreement, which contained both a stock repurchase obligation and a contractual subordination provision. Hays alleged that he was owed over $12 million for breach of the agreement. The bankruptcy court lifted the automatic stay to allow Hays to continue with the litigation and Hays ultimately obtained a judgment against Alta+Cast for over $2.25 million.

Alta+Cast moved to subordinate Hays' claim under sections 510(a) and (b) of the Bankruptcy Code, which provide for the enforcement of contractual subordination clauses in bankruptcy and the subordination of claims for damages arising from the purchase or sale of a debtor's securities. The bankruptcy court ruled in Alta+Cast's favor. It accordingly subordinated Hays' claim to the claims of all general unsecured creditors so that it was given the same priority as other ownership interests in the debtor.

Alta+Cast then sought to confirm a chapter 11 plan of reorganization under which stock and cash were to be distributed to secured and unsecured creditors, but equity interests (including Hays' subordinated interest) would receive nothing. Only Hays objected, opposing confirmation and moving to dismiss or convert the case or to appoint a chapter 11 trustee. He contended that subordination of his claim was improper and that both the bankruptcy petition and the chapter 11 plan were filed in bad faith because, among other things, the underlying purpose of both was to eliminate his claim.

The bankruptcy court overruled Hays' objections. Hays' claim, it observed, was properly subordinated under sections 510(a) and (b), the subject of a prior ruling that Hays could not properly contest in the context of a confirmation hearing. Next, the court noted that Alta+Cast, which had never been profitable since it was founded 1996, filed for chapter 11 only after it was confronted with the inability to raise additional capital. Given its dire financial condition, the fact that Alta+Cast was involved in litigation with Hays at the time it filed for bankruptcy did not undermine the good faith nature of the filing. In fact, the court emphasized, the litigation interfered with Alta+Cast's ability to raise capital and to operate its business because it diverted the attention of senior management. It accordingly ruled that neither Alta+Cast's chapter 11 filing nor its plan ran afoul of the Bankruptcy Code's good faith requirements.

Alta+Cast highlights the good faith filing and plan proposal requirements and serves important policy goals. As a general rule, those requirements are deemed to be satisfied as long as the actions taken by the debtor with respect to the treatment of creditor claims are permissible under the Bankruptcy Code. To be sure, dilatory tactics designed for no other reason than to thwart legitimate creditor rights and expectations by invoking bankruptcy will be deemed to fall outside the realm of good faith. A bankruptcy filing solely as a litigation tactic may be beyond the pale. Still, Alta+Cast illustrates that a bankruptcy court will look carefully at all of the circumstances surrounding a bankruptcy filing to determine whether a debtor's invocation of chapter 11 bankruptcy protection is legitimate and in keeping with Congress' views regarding the permissible purposes of reorganization.

In re Alta+Cast, LLC, 2004 WL 484881 (Bankr. D. Del. Mar. 2, 2004).

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