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| 2 minutes read

Impending Financial Distress Is Critical Fact In Good Faith Finding For Chapter 11

Within In re LTL Management, LLC, No. 22-2003 (3d Cir. Jan. 30, 2023), the United States Court of Appeals for the Third Circuit issued its decision on the J&J “Texas –Two Step” bankruptcy saga. The Court’s decision complimented the parties and the lower court for their thorough analysis of the issues, but refocused practitioners on a basic bankruptcy principle: 

[A bankruptcy filing] gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.

Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). While the principle was espoused in a consumer case, even a corporate debtor must proceed in its chapter 11 case in “good faith.” After a 5 days evidentiary trial, the bankrupt court held that LTL Management LLC’s bankruptcy case was filed in “good faith.” The Official Tort Claimants Committee and several independent plaintiffs’ firms appealed. 

Texas-Two Step Defined

This “en vogue” corporate transaction involves the use of the Texas “Divisive Merger” statute which allows a corporate entity to create two (2) “newcos” – one of which is allocated a series of historic liabilities and one of which is allocated all the other operative assets and operating liabilities. Once the division occurs, the “liability” company seeks bankruptcy protection – usually with its main or only asset a “funding” mechanism from the “healthy” operative sister company to fund the amount of liabilities ultimate agreed or determined. 

Third Circuit Explains Required Good Faith

The case turned whether it should be dismissed under § 1112 (b) of the Bankruptcy Code.  The Court reiterated the principle that cases should not dismissed unless they are not filed in “good faith”. The burden to prove “good faith” is on the debtor.

When analyzing “good faith,” the Court focuses on whether the petition serves a “valid bankruptcy purpose”, and whether it was filed merely to obtain a tactical litigation advantage. The Court highlighted that valid bankruptcy purpose assumes that the Debtor is in some form of “financial distress”.

Court Required Finding Of Financial Distress

Financial distress does not necessarily require insolvency. Rather, financial distress is focused on whether a debtor faces the kinds of problems that justify Chapter 11 relief. Chapter 11 focuses on a system that ensures a collection of assets to ensure ratable distribution because “there is a risk that there won’t be enough to go around”. Financial distress must be apparent and sufficiently immediate to justify filing. A court must always analyze the temporal connection between threatened litigation and ultimate adverse results and take into account whether the debtor has the capacity to address adverse results.  The “potential” for future distress is not sufficient because a debtor can always “file later.” 

The Court’s analysis boiled down to a singular theme: “absent financial distress, there is no reason for Chapter 11, and no valid bankruptcy purpose.”

The Court gave full effect to the state law, divisive merger transaction for purposes of assigning liability, and focused exclusively on that “new entity’s” assets and financial distress for bankruptcy purposes. The Court focused exclusively on the financial picture related to the debtor here – LTL Management LLC. The “history” of the predecessor entities are not relevant for the analysis. LTL’s major asset is the Funding Agreement payable to LTL, which appeared to provide more than sufficient funding to satisfy 100% of its allocated liabilities.

The Court noted the apparent irony: the bigger a backstop a parent company provides to its subsidiary, the less likely the subsidiary will have financial distress to justify its bankruptcy filing. However, a debtor’s financial distress – and the need to address it – is the hallmark of good faith needed to pursue a bankruptcy case. 

A petition for rehearing en banc has been briefed and is pending.


bankruptcy, insolvency, chapter 11, restructuring & insolvency