As loyal followers of the ABI Journal and this column know, three of the favorite topics reviewed by our authors are good faith in the filing of bankruptcy cases,¹ non-contractual fee enhancements² and making sure you are properly retained as a professional in a bankruptcy proceeding.³ Continuing with this trend, this issue's offering discusses the recent decision of In re Integrated Telecom Express Inc.,⁴ addressing good-faith filings in chapter 11 proceedings, and In re NuCentrix Broadband,⁵ which addresses awards of noncontractual fee enhancements as well as the potential downside to having your fee structure approved under 11 U.S.C. §328 as part of your employment application.

High-stakes California Hold 'em: In re Integrated Telecom Express

The Integrated case is unusual in that it involves a solvent high-tech company. The key issue addressed in the case was whether using a chapter 11 to reduce state law damages under a lease of real property under the 11 U.S.C. §502(b)(6) cap would constitute a good-faith filing. Although 11 U.S.C. §502(b)(6) as a good-faith issue is a fairly narrow issue, it has been considered by at least one other Third Circuit Court of Appeals decision.⁶

In Integrated, the debtor was a software company in the broadband communications industry. In 2000, prior to its bankruptcy filing, the debtor negotiated a lease in Silicon Valley for rent of $200,000 per month plus a 5 percent annual increase in rent (Silicon Valley lease). In 2001, as everyone knows, the broadband bubble "popped." After several attempts to reorganize or sell its business, the debtor ultimately prepared an out-of-bankruptcy liquidation plan and dissolution. However, three problems arose in this process.

First, in November 2001, a securities class action was filed against the debtor and certain of its officers concerning the debtor's IPO. The class action sought $93 million in damages from the debtor and other defendants in the class action. The debtor had $20 million in insurance coverage for this lawsuit.

Second, in winding up its business, the debtor needed to terminate its Silicon Valley lease. Under the terms of the Silicon Valley lease, it owed the Silicon Valley landlord more than $26 million during the remaining term of lease. The debtor attempted to settle the Silicon Valley lease claim by returning the premises and making a payment of $8 million, but this offer was rejected.

Finally, the debtor needed to sell its remaining intellectual property assets. Prior to its chapter 11 filing, certain officers and directors agreed to purchase the debtor's IP assets for $1.5 million. This sale was not consummated prior to the chapter 11 filing.

Ultimately, the debtor determined that the best way to resolve the Silicon Valley lease problem would be to file a chapter 11 petition⁷ in order to take advantage of the limitations of 11 U.S.C. §502(b)(6) relating to the Silicon Valley lease claim. At the time the debtor filed its chapter 11 bankruptcy, it had $105.4 million in cash and $1.5 million in other assets. The landlord's claim and the unliquidated class action claim were the only claims in the bankruptcy case.

During the bankruptcy, the debtor moved to reject the landlord's lease, and the landlord moved to dismiss the debtor's case on the grounds of bad faith. The bankruptcy court granted the debtor's motion to reject the Silicon Valley lease and capped the landlord's claim at $4.3 million. The court also denied the landlord's motion to dismiss, finding that the debtor had filed its chapter 11 case in good faith. During the course of its chapter 11, the debtor sold its remaining assets for $2.5 million and obtained approval of a plan that capped liability in the class action at $20 million in insurance coverage and $5 million from the debtor's estate. This $25 million reserve for the securities litigation claims was approved by the securities class in the debtor's case.

The landlord timely appealed and posted a bond to prevent the distributions from being made under the plan. The district court affirmed the bankruptcy court in a slip opinion (2004 WL 1136547 (D. Del 2004)) primarily on the ground that the bankruptcy court's finding that the debtor's plan was filed in good faith was not an abuse of discretion⁸ and that the determination was supported by the Third Circuit's earlier decision of In re PPI Enters. (U.S.) Inc.⁹ Undeterred, the landlord appealed to the Third Circuit.

In a strongly worded opinion, the Third Circuit reversed the lower courts' findings that the Integrated chapter 11 was filed in good faith. The Third Circuit in Integrated initially restated the "good-faith standards" established in their In re SGL Carbon Corp.¹⁰ decision, noting that the debtor has the burden of proof in establishing that the debtor-in-chapter 11's petition was filed in good faith. The court also held that the determination of whether the good-faith filing requirement was met was a fact-intensive inquiry.

However, notwithstanding the lower court's extensive factual findings and the abuse of discretion standard of review, the Third Circuit found that in this case both the bankruptcy and district courts had made a "legal error" in concluding that Integrated filed in good faith, stating:

We conclude that the collapse of Integrated's business model does not support a finding of good faith. Integrated was not suffering financial distress when it filed its petition, and the rulings of the bankruptcy court and the district court to the contrary constitute legal error. The failure of Integrated'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. Because Integrated's economic difficulties do not establish that Integrated was suffering from financial distress, they do not, standing alone, establish that Integrated's petition was filed in good faith.¹¹

In making this ruling, the Third Circuit distinguished its previous ruling of In re PPI Enterps. (U.S.) Inc., 324 F.3d 197 (3rd Cir. 2003),¹² by noting that the debtor in PPI was arguably insolvent when it filed its chapter 11, while in this case the debtor clearly was solvent.¹³ The circuit court also ejected three additional arguments advanced by the debtor that its filing was in good faith: (1) that the chapter 11 provided an efficient procedure for the distribution of the debtor's assets; (2) that oversight of the sale of the debtor's assets by the court was beneficial; and (3) that the establishment of a bar date was beneficial to eliminate inchoate claims. The Third Circuit found that there was no factual merit to the debtor's second and third arguments and held that facilitating a dissolution and distribution of assets favorable to a debtor's equity holders, as opposed to creditors in general, was not a valid purpose of a chapter 11 filing. Based on these findings, the Third Circuit remanded the case for dismissal.

Flopping a Royal Flush: What Do I Win?

Continuing with the theme, the debtors in NuCentrix,¹⁴ like the Integrated debtor, were in the telecommunications industry. However, at the time of its chapter 11 filing in September 2003, unlike Integrated the debtors appeared to be hopelessly insolvent, as the only offer they had for their assets was $15 million, which would have provided the debtors' unsecured creditors with only a 12-cent-on-the-dollar distribution. Based in part on this somewhat financial picture, the debtors' counsel was employed on an hourly basis at 93 percent of its normal rates. The debtors' financial adviser and investment banker were employed under 11 U.S.C. §§327 and 328 for a flat fee of $800,000 for their services.

Fortunately for nearly all concerned, the sale of the debtors' assets was a spectacular success, as the auction of the debtors' assets resulted in a sale price of $51 million in cash plus the assumption of an additional $5 million in liabilities. This sale resulted in a full distribution to all creditors and a substantial return to the debtors' equity-holders. Based on this success, both counsel and the investment banker requested enhancements of their fees.

Initially in the Nucentrix opinion, the court reviewed the fee-enhancement request of the debtors' counsel. Reviewing the request under the standards set forth in Transamerica Natural Gas Corp v. Zapata Partnership Ltd., 257 B.R 809 (Bankr. W.D. Tex. 2000), and In re El Paso Refinery L.P., 247 B.R. 509 (Bankr. W.D. Tex. 2000),¹⁵ the court found that counsel should be awarded a fee-enhancement of an increase in its hourly fees to 100 percent of their standard rates plus a 10 percent bonus over and above these rates to compensate counsel for the rare and exceptional result they obtained for the debtors in this case.

Unfortunately, the investment banker did not fare as well. As noted above, the investment banker's employment was approved at a flat fee of $800,000 under 11 U.S.C. §328, which limits courts from awarding compensation different from what was provided for in the employment application only "if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions." In this case, the Nucentrix court found that while the results were surprising and unforeseen, they were in fact capable of being anticipated at the time the investment banker sought retention. Indeed, as noted by the Nucentrix court, the successful auction "was exactly what the parties anticipated."

The court also found that, in light of the its approval of employment of the investment bankers under 11 U.S.C. §328, the fee-enhancement analysis of 11 U.S.C. §330 employed by the court in relation to the counsel's fee-enhancement request could not be applied to the investment banker's fee-enhancement request.

The River and Conclusion

The lessons that can be taken from these decisions are both straightforward and important to bankruptcy practitioners.

First, the Integrated decision and two similar decisions from the California bankruptcy courts¹⁶ seem to establish that companies that are clearly solvent may not in good faith file chapter 11 cases to attempt to limit damages arising from a lease unless the potential debtor has other significant financial problems that would demonstrate a need for chapter 11 protection.

Second, Integrated stands for the somewhat unremarkable proposition that filing a chapter 11 to benefit equity-holders at the expense of creditors will rarely be found to be an exercise of good faith.

Third, the Nucentrix decision shows that a debtor's professionals, including its attorneys, still have a chance to get a fee enhancement if they achieve truly exceptional results, generally including payment of all creditors in full, in a chapter 11 case. This decision stands in contrast to some recent decisions that have either refused to award or sharply limited noncontractual fee enhancement requests by professionals.

Fourth, Nucentrix shows the care with which a party must draft its retention agreement with the debtor in a bankruptcy proceeding. While it is generally true that being employed under 11 U.S.C. §328 protects professionals from having their fees being second-guessed at a final hearing on fees,17 11 U.S.C. §328 also requires professionals to carefully craft their employment agreements if they wish to seek enhancements of their fees.

With these lessons in mind, hopefully your bankruptcy practice will be filled with solvent debtors so that you can worry about these issues and will not have to endure another round of poker puns by a Straight & Narrow author.

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Footnotes

¹ Crabbe, Deborah, "Does the Constitution Require a Debtor to be Insolvent to File for Bankruptcy?," 22 Am. Bankr. Inst. J. 34 (November 2003). Return to article

² Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part I," 20 Am. Bankr. Inst. J 7 (June 2001). Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part II", 20 Am. Bankr. Inst. J 12 (July/August 2001). Return to article

³ Bowles, C.R., "Ethical Trilogy: Something Old, Something New, Something Borrowed," 22 Am. Bankr. Inst. J 18 (June 2003); Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part II," 20 Am. Bankr. Inst. J 12 (July/August 2001). Return to article

⁴ 2004 WL 2086058 (3rd Cir. Sept. 20, 2004); Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part II," 20 Am. Bankr. Inst. J 12 (July/August 2001). Return to article

⁵ Case No. 03-39123 (Bankr. N.D. Tex. Sept. 20, 2004). Return to article

⁶ In Re PPI Enterps. (U.S.) Inc., 324 F.3d 197 (3rd Cir. 2003). Return to article

⁷ In a memorable display of candor and honesty, the debtor counsel included a statement in both the debtor's board minutes and in a letter to the landlord and a statement that the principal, if not sole reason, for the debtor's bankruptcy filing was to limit the landlord's claim. Return to article

⁸ It is well-settled that a bankruptcy court's determination of whether a chapter 11 case is filed in good faith is reviewed under an abuse-of-discretion standard. In re PPI Enters. (U.S.) Inc., 324 F.3d 197, 211 (3rd Cir. 2003). Return to article

⁹ Id. at 197. Return to article

¹⁰ 200 F.3d 154 (3rd Cir. 1999). Return to article

¹¹ 2004 WL 2086 058 at *. Return to article

¹² The Third Circuit also distinguished the Ninth Circuit's decision in In re Sylmer Plaza L.P., 34 F.3d 1070 (9th Cir. 2002), noting that in that case, the bankruptcy was used to maximize the return for creditors as a whole rather than limit the claim of a creditor for the benefit of equity-holders. Return to article

¹³ Id. at *, 11. Return to article

¹⁴ In re NuCentrix Broadband Networks Inc., et al., Case No. 03-39123 (Bankr. N.D. Tex. Sept. 30, 2004). Return to article

¹⁵ For a full discussion of the best way to sell noncontractual fee enhancements, see Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part I," 20 Am. Bankr. Inst. J 7 (June 2001); Protopapas, Lydia T., "Fee Enhancements: How Do You Get One? Part II," 20 Am. Bankr. Inst. J 12 (July/August 2001). Return to article

¹⁶ See In re Liberate Technologies, 2004 WL 200 8956 (Bankr. N.D. Cal. Sept. 8, 2004); In re Chameleon Systems Inc., 306 B.R 666 (Bankr. N.D. Cal. 2003). Return to article

¹⁷ See In re Barron, 325 F.3d 690 (5th Cir. 2003). Return to article