Measuring Credit and Bankruptcy Risk
By Scott Blakeley

A fundamental responsibility for the credit executive is assessing a customer's credit risk. Based on the risk assessment, a credit professional concludes the length and amount of credit terms, if any, including whether a credit enhancement, such as a personal or corporate guarantee, letter of credit or deposit, may be required. Key to this risk assessment is the credit professional's determination of insolvency risk, and, therefore, the prospects of a customer's bankruptcy filing. Indeed, Dr. Altman's Zscore theory has been used for years as a predictor of a company's probability of filing bankruptcy. A sophisticated credit professional is well aware of the downside with a customer's bankruptcy filing where credit has been extended on an unsecured basis: nominal recovery. Given this, the credit professional is vigilant in looking for red flags that may indicate a customer's bankruptcy may be in the offing, especially where a large order is placed by the customer and credit is requested.

But what if there are no red flags that a customer's bankruptcy is imminent. Rather, what if a customer elects to use a Chapter 11 filing as a business tool to limit creditors' claims, for example, even though the customer is otherwise solvent. May a debtor seek Chapter 11 protection, even though it is balance-sheet solvent, or can generally meet its debts when due? The Third Circuit Court of Appeals, in In re Integrated Telecom¹ recently considered the situation where a debtor filed Chapter 11 and was balance sheet solvent by several million dollars. The Third Circuit concluded that it was 'bad faith' for the solvent debtor to file Chapter 11, and refused to confirm the Debtor's plan of liquidation. The court's opinion is considered below, as well as the impact on the credit professional attempting to measure credit and bankruptcy risk in such an environment.

Chapter 11 As A Business Tool

Over the last decade, Chapter 11 has lost its stigma at the upper levels of management. In considering alternatives when faced with a difficult operating environment, or financial challenges, management is more inclined to consider Chapter 11 as a tool to achieve a business solution. In recent years, management has used Chapter 11 to deal with, for example, future asbestos claims, an extraordinary judgment or environmental claims. Chapter 11 allows management to continue in control of the debtor as it attempts to achieve its solution management appears to view Chapter 11 as an alternative that customers, lenders and vendors are more understanding of.

Eligibility To File Chapter 11: Must A Debtor Be Insolvent?

Management's view that there may no longer be a stigma attached to filing Chapter 11 (or at least greatly weakened) may be answered by looking to the Bankruptcy Code. The Bankruptcy Code does not impose a threshold financial standard for a debtor to file Chapter 11, such as liabilities exceeding assets or the debtor's inability to meet its debts when due (But the filing of an involuntary bankruptcy petition and the legal standard a petitioning creditor must establish, is that the debtor generally is not paying its debts when due). However, a benchmark for a Chapter 11 filing is traditionally a creditor chasing the debtor for payment. Indeed, often a debtor seeks Chapter 11 refuge to obtain the protection of the automatic stay, which enjoins creditors from seizing its assets. Notwithstanding that there is no financial standard for a voluntary Chapter 11 filing, a creditor, or creditor group, may challenge a debtor's Chapter 11 filing by raising whether the Chapter 11 was filed in 'bad faith'. A bankruptcy court may dismiss a Chapter 11 case upon a showing that the petition was filed in 'bad faith'. What is the criteria for a court to determine that a bankruptcy petition is filed in 'bad faith'?

In In re Integrated Telecom, the Third Circuit, which includes the states Delaware, New Jersey, Pennsylvania and the Virgin Islands, held that a financially healthy debtor was ineligible to file Chapter 11. The Circuit Court noted the Debtor had ceased doing business and had no intention of reorganizing or liquidating as a going concern, and had no reasonable expectation that the Chapter 11 proceedings would maximize value for creditors. The court also found the Debtor filed bankruptcy solely to take advantage of provision of the Bankruptcy Code that capped the creditor's damage claim, and thus the bankruptcy petition was not filed in 'good faith', and should be dismissed.

The Third Circuit Considers A Debtor's Financial Condition

In In re Integrated Telecom, the Debtor was a supplier of software and equipment to the broadband communications industry. The market for the Debtor's products deteriorated, causing it to suffer multi-million dollar losses. The Debtor elected to liquidate its assets outside of bankruptcy and dissolve under state law. The Debtor sold its assets. The Debtor had $105.4 million in cash and $1.5 million in other assets. The Debtor was solvent, with its assets exceeding its liabilities by several million dollars. As all of its assets had been sold, the Debtor had to deal with its former landlord. Based on its lease agreement, the landlord claimed it was entitled to a breach of contract damage claim, of $26 million. The Debtor demanded the landlord to settle its claim for $8 million, or the Debtor would file for bankruptcy so as to take advantage of the Bankruptcy Code's cap on a landlord's rejection damage claim.

The parties did not agree and the Debtor filed Chapter 11 and requested the Bankruptcy Court authorize rejection of the landlord's lease, thereby capping the landlord's damage claim. The creditor opposed the rejection of the lease on the grounds that the bankruptcy petition was not filed in 'good faith'. The Bankruptcy Court disagreed and confirmed the Debtor's plan of liquidation. The creditor appealed to the District Court, which affirmed the Bankruptcy Court's ruling. The creditor appealed to the Circuit Court of Appeals.

The Circuit Court reversed the lower court's ruling, finding the Debtor had filed the bankruptcy petition in 'bad faith'. Key to the Circuit Court's ruling was that the Debtor was not in financial distress and was not leveraged. The Court noted that a significant distribution was going to shareholders even though the Chapter 11 was filed. Further, two of the basic purposes of Chapter 11 would not be furthered with the bankruptcy filing, that of preserving going concern values and maximizing property available to satisfy creditors. The Court also questioned whether the bankruptcy petition was filed merely to obtain a litigation advantage.

The Court observed that the Debtor was out of business and therefore had no going concern value to preserve in Chapter 11 through reorganization or liquidation. The Court questioned whether the petition might maximize the value of the bankruptcy estate.

The Court observed that a 'good faith' Chapter 11 filing requires a debtor be in financial distress. The Court pointed to the legislative history of the Bankruptcy Code communicawhich talks about a debtor in some form of financial difficulty. Absent that financial distress, a debtor has no need to rehabilitate or reorganize, its petition could not serve the reorganization purpose of Chapter 11. The Court noted:

'Chapter 11 vests petitioners with considerable powers-the automatic stay, the exclusive right to propose a reorganization plan, the discharge of debts, etc.-that can impose significant hardship on particular creditors. When financially troubled petitioners seek a chance to remain in business, the exercise of those powers is justified. But this is not so when a petitioner's amis lie outside those of the Bankruptcy Code.

[T]he drafters of the Bankruptcy Code understood the need for early access to bankruptcy relief to allow a debtor to rehabilitate its business before it is faced with a hopeless situation. Such encouragement, however, does not open the door to premature filing, nor does it allow for the filing of a bankruptcy petition that lacks a valid reorganizational purpose.²'

Both the Bankruptcy Court and District Court concluded that the Debtor faced distress because it was losing money and was experiencing a downward spiral, and, as a result, had gone out of business. The Court of Appeals did not see how Chapter 11 offered the Debtor any relief from this sort of distress, which had no relation to any debt owed by the Debtor. There is no value for the Debtor's assets by the collapse of the Debtor.

The Court of Appeals concluded that the collapse of the Debtor's business model did not support a finding of 'good faith'. The Debtor was not suffering financial distress and the Bankruptcy Court and District Court's finding otherwise was in error. The failure of the Debtor's business did not subject the company to any pressure on the value of its assets that could be reduced or avoided in an orderly liquidation under Chapter 11.

The Lesson for Credit Executives

The Integrated Telecom circuit court ruling is encouraging for the credit professional attempting to measure a customer's bankruptcy risk. The Third Circuit rejects a solvent debtor's attempt to use bankruptcy as a litigation tool to limit a creditor's right to full payment on their claim. The Integrated Telecom decision may force debtors to rethink a strategy of a bankruptcy filing to cap payment on a creditor's claim.

1. In re Integrated Telecom Express, Inc., 2004 WL 2086058 C.A.(Del.), 2004.

2. Integrated Telecom at 2086059-60.