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
'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.),
2. Integrated Telecom at 2086059-60.