Is Insolvency a Prerequisite To Filing a Chapter 11 Case?

Conventional wisdom suggests there is no requirement that a debtor be “insolvent” to file a case under Chapter 11 or any other chapter of the Bankruptcy Code. No Code provision explicitly imposes such a requirement. Yet in 2023, several courts addressed the issue, and two courts directed the dismissal of massive Chapter 11 cases imposing what may fairly be characterized as an insolvency requirement. One of those courts, In re LTL Mgmt., LLC (LTL 1), stated there must be “financial distress,” and the other court, In re Aearo Techs. LLC, indicated there must be a “need” for reorganization. In a factually similar situation, a third court, In re Bestwall LLC, declined to reverse a bankruptcy court which had issued a preliminary injunction supporting a prospective reorganization. This report will describe the rulings in LTL 1, Aearo, and Bestwall and will provide updates on the status of those cases. All three are mass tort cases, which are significant in terms of the dollar amounts at issue and the claims involved, and in their cutting-edge issues.

In LTL 1, the most famous of the three cases, a Third Circuit panel ordered the dismissal of the Chapter 11 case of LTL Management LLC, an entity created through a “divisional merger” or “Texas Two-Step.” The decision received heightened attention because the author was the Honorable Thomas Ambro, a highly respected bankruptcy lawyer in Delaware before his appointment to the circuit court bench. After facing numerous talc lawsuits, Johnson & Johnson Consumer Inc., a wholly owned subsidiary of Johnson & Johnson, split into two new entities. One of those entities was LTL Management LLC, or the “bad company,” which held the liabilities relating to talc litigation and a funding support agreement from its corporate parents. Prospective costs and liabilities measured in the billions of dollars. The other entity, or the “good company,” held the business assets previously held by Johnson & Johnson Consumer Inc. Just a couple days after LTL Management LLC’s corporate inception, it filed a Chapter 11 case. Talc claimants filed motions to dismiss the bankruptcy case for “cause” under § 1112(b) asserting the case was not filed in good faith. The bankruptcy court denied the motions to dismiss, reasoning in part that LTL Management LLC had a valid bankruptcy purpose as the funding support agreement would fund a trust under § 524(g) of the Code for victims of asbestos diseases attributed to the exposure to talc. In ruling that “[o]nly a putative debtor in financial distress” can meet the intended purposes of the Code, the Third Circuit reversed and remanded with instructions to dismiss the case.

On remand, the bankruptcy judge dutifully, but we sense not cheerfully, dismissed the case. Negotiations continued, changes were made to a plan, the pot was sweetened, and more talc claimants joined in support. Two hours after the dismissal of LTL 1, a new Chapter 11 case was filed (LTL 2). The bankruptcy judge faced additional motions to dismiss the bankruptcy case for “cause” under § 1112(b). He concluded LTL 2 was not different enough to escape the dictates of the Third Circuit in LTL 1, and therefore, dismissed the case. The dismissal of LTL 2 is now on appeal and in the briefing stage.

Just a few weeks after the LTL 1 decision, several interested parties filed motions to dismiss the Aearo case for “cause” under § 1112(b) asserting a lack of good faith. Aearo Technologies LLC developed and sold devices meant to protect the hearing of users from loud noises such as those encountered in war. 3M purchased and continued the business. Thousands of tort claims followed; 336,000 at the high point, such that they constituted 30% of all the cases in the federal court system. The cases were consolidated into a multi-district litigation (MDL) case. Unlike in LTL 1, there was no divisional merger, but the structure was similar. On July 26, 2022, Aearo Technologies LLC filed a Chapter 11 case. 3M did not file, but it did enter into an uncapped funding agreement for Aearo Technologies LLC’s bankruptcy case. On June 9, 2023, a bankruptcy court in the Seventh Circuit ordered the dismissal of the case, relying heavily on the just published LTL 1 decision. While recognizing that “a debtor need not be insolvent to seek Chapter 11 protection,” the bankruptcy court nonetheless concluded that “a debtor’s ‘need’ for relief under the Chapter 11 is central to” the inquiry of good faith and whether the case serves a “valid reorganizational purpose.” After the Chapter 11 case was dismissed, 3M agreed to provide $6 billion to settle the claims in the MDL process providing that 98% of the claimants did not opt-out. While Aearo was appealed to the Seventh Circuit, the appeal has been stayed pending implementation of the settlement.

The third case, the Bestwall case, which was decided just a few weeks before Aearo, involved a divisional merger by Georgia-Pacific LLC. Georgia-Pacific LLC had sold joint compounds and plaster that contained asbestos. This led to numerous tort cases. Georgia-Pacific LLC then split into two new entities. Bestwall, the “bad company” with asbestos assets and liabilities, filed a Chapter 11 case with a funding support agreement from Georgia-Pacific Holdings LLC. The bankruptcy court issued preliminary injunctions protecting third parties, including the “good company,” Georgia-Pacific LLC, against pending cases. That decision was first appealed to the district court, which affirmed the bankruptcy court, and then was appealed to the Fourth Circuit. The Fourth Circuit panel affirmed. However, the Fourth Circuit panel was divided. One of the judges, Judge King, filed a dissent in part expressing vehement opposition to divisional mergers. While the fact pattern was similar to LTL 1 and Aearo, the legal issue was different. The Bestwall decision addresses the authority of the bankruptcy court to issue a preliminary injunction protecting third parties. One might speculate that a motion to dismiss would have been based on § 1112(b) and the absence of good faith if the LTL 1 decision had been issued prior. A petition for a writ of certiorari has now been filed with the United States Supreme Court.

As indicated above, § 1112(b) of the Code provides for the dismissal of bankruptcy cases for “cause.” But “cause” is not defined. § 1112(b)(4) does provide a non-exclusive list of circumstances that constitute “cause,” though none of those 16 circumstances are based on the insolvency or lack of insolvency of the debtor. As compared to other countries, such as Mexico, Germany, and many others that require insolvency as a precondition for a bankruptcy-type process, it has long been taught that the United States does not require insolvency to file bankruptcy and does not mandate a filing upon insolvency. The flexibility is presented as an advantage of our system. (One of the authors has long taught an International Bankruptcy course as an adjunct professor at the University of Minnesota Law School, a course designed and primarily presented by the American College of Bankruptcy.)

Earlier cases have been dismissed under § 1112(b) as “bad faith” filings, or stated in the opposite way, as not “good faith” filings. However, they did not focus primarily on the solvency issue. Moreover, just as a requirement of a form of insolvency was read into the statute in LTL 1 and Aearo, the concept of “good faith” is nowhere in the statute. But a body of law has developed around this concept. Some courts have found there is no basis under the Code for dismissal for lack of good faith, but most courts have found that it is implied in the Code and that § 105(a) authorizes courts to make “any determination” needed to prevent an “abuse of process.” The body of law surrounding this topic lacks cohesion, and some say lacks an underlying rationale at all. It is hard to resist, as an aside, noting the Aearo bankruptcy judge’s reference in a footnote to the statement of Bankruptcy Judge Queenan in declining to read a good faith standard into § 1112(b). Judge Queenan described the good faith standard as “an amorphous gestalt, devoid of reasoning and impenetrable to understanding.”

A number of courts have approached the problem of what constitutes lack of good faith by presenting a long list of factors that a court should take into consideration. For example, the court in In re Tekena USA, LLC, lists 14 factors. That approach may be criticized as presenting an unhelpful unweighted multifactor test; but in any event, such lists have generally not included as a ground for dismissal that the debtor is not insolvent. Which is not to say there is no precedent at all for LTL 1 and Aearo.

Although the bankruptcy court was the finder of fact, in LTL 1 the Third Circuit panel utilized de novo review applying an “ultimate fact” standard to overrule the fact finding of the bankruptcy court. It cited its own decisions finding a lack of good faith to be “cause” under § 1112(b). The court wrote, “Because the Code’s text neither sets nor bars explicitly a good-faith requirement, we have grounded it in the ‘equitable nature of bankruptcy’ and the ‘purposes underlying Chapter 11.’” Two particularly relevant inquiries are: “(1) whether the petition serves a valid bankruptcy purpose; and (2) whether it is filed merely to obtain a tactical litigation advantage.” In Integrated Telecom Express, Inc., an earlier circuit case, the Third Circuit determined that a valid bankruptcy purpose “assumes a debtor in financial distress.” In addition to relying on Integrated Telecom Express, Inc., the Third Circuit in LTL 1 also relied on its decision in In re SGL Carbon Corp. These are two decisions where the case seemed to have more to do with protection from on-going litigation than with financial restructuring. Finding the bankruptcy court had abused its discretion, the LTL 1 court held, “What counts to access the Bankruptcy Code’s safe harbor is to meet its intended purposes. Only a putative debtor in financial distress can do so. LTL was not. Thus, we dismiss its petition.”

In Aearo, the court looked to the then recent LTL 1 decision, the Third Circuit precedents described above, and other cases in stating, “Courts have consistently dismissed Chapter 11 petitions filed by financially healthy companies with no need to reorganize under the protection of Chapter 11.” In referencing LTL 1, the Aearo court concluded:

The Court ultimately finds this logic persuasive. While the Court would rather frame the issue in terms of a debtor’s “need” rather than “financial distress,” (lest “financial distress” be interpreted too literally and ignore the Code’s lack of an insolvency requirement), the inquiry will often be the same: are the problems the debtor is facing within the range of difficulties envisioned by Congress when it crafted Chapter 11?

It may be argued that earlier cases that had mentioned absence of insolvency did so in conjunction with the lack of a valid reorganizational purpose. That is, the situations expressly or impliedly involved an improper purpose. LTL 1 and Aearo, however, highlighted no improper purpose. The companies sought to reorganize due to the existence of massive financial liabilities and costs due to pending tort claims. One thing that differs from most cases is that the claims remain unliquidated. What these courts have done now is deny access to the bankruptcy court, even in the absence of an apparent improper purpose. This adds a requirement of a measure of severity and immediacy of insolvency standing by itself. That can also be garnered from the statements in the cases as to the need to let more time pass, for the tort process to continue longer, in order to enable the court to determine a degree of financial distress before the gates of the bankruptcy system may be opened.

It may be relevant to understanding how these decisions came to be to note that the context of these cases includes other boundary pushing issues not yet resolved by the courts, including the divisional mergers (which beg a fraudulent transfer analysis), third-party releases (which is an issue before the Supreme Court now), and sometimes venue manipulation, even though they are not given as reasons in the decisions here discussed. It may be that these courts are really saying, “This is just too much.”  But now that this form of separate solvency requirement is clearly and strongly expressed, it will be interesting to see how far this doctrine spreads. For instance, In re Aldrich Pump LLC, the bankruptcy court declined to apply the LTL 1 “financial distress” standard, finding that the Fourth Circuit standard was narrower. In In re Bootjack Dairy M&D, LLC, the bankruptcy court dismissed a Chapter 12 case for lack of good faith and relied on the traditional factors, including financial distress, though not giving it special weight as the Ninth Circuit had not adopted the LTL 1 standard.

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The decisions in LTL 1 and Aearo run contrary to the conventional understanding that a debtor need not be insolvent to file bankruptcy. Both cases acknowledge the lack of an insolvency requirement in the Code but then impose a standard that is functionally equivalent, a particular form of insolvency. Perhaps the law of LTL 1 and Aearo is best understood as adding another factor to the list pertinent to the good faith inquiry: “Debtor is not (or may not be) currently insolvent, and any prospective future insolvency is too speculative to support the current use of the bankruptcy system.” 

  • James L. Baillie

    He has counseled and represented thousands of businesses in challenging financial circumstances in over five decades of practice and is adept at developing creative solutions to difficult problems. He was lead attorney for a ...

  • Katherine A. Nixon

    Katherine’s practice focuses on corporate restructuring and bankruptcy. She works diligently to understand clients’ specific financial concerns and to strategize the most effective and efficient way to resolve those ...

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