The U.S. Court of Appeals for the Third Circuit recently held that a company with assets of $107 million cannot use the protection of the Bankruptcy Code to avoid its long-term lease obligations.

The underlying bankruptcy petition filed in In re Integrated Telecom Express Inc., 384 F.3d 108 (3d Cir. 2004) did not seek to further the objectives of rehabilitation and reorganization, the appeals court noted. Integrated failed to prove it filed its petition in good faith, the court concluded, and remanded the case to the bankruptcy court with instructions to dismiss the case.

In early 2001, Integrated Telecom, which supplied software and equipment to the broadband communications industry, signed a 10-year lease for space in Silicon Valley. Shortly thereafter, the company experienced a downturn in business, and suffered a net operating loss for that year of $36.2 million. The company’s financial picture worsened at the end of 2001, when it was named as a defendant in a $93 million securities lawsuit.

After unsuccessfully seeking a buyer or merger partner, the company decided to liquidate its assets, which primarily consisted of intellectual property worth an estimated $1.5 million (but later sold for $2 million), and $105.4 million in cash.

The company sought to reduce its $26 million lease obligation, offering the landlord $8 million to settle claims. When the landlord refused, the company filed a petition under Chapter 11, seeking the protection of Bankruptcy Code Section 502(b)(6), which limits a landlord’s claim for damages for termination of a lease of real property to the greater of one year’s rent or 15 percent of the balance due on the lease.

In seeking bankruptcy protection, Integrated argued it was a “financially distressed” company. However, the court noted the company was in the black by approximately $75 million. By its own estimate, Integrated believed the securities action would settle for $25 million. With liability insurance coverage of $20 million, the company’s exposure to securities claims was only approximately $5 million.

The court noted the two basic purposes of Chapter 11 are to (1) preserve going concerns and (2) maximize property available to satisfy creditors. In determining whether a bankruptcy petition is filed in good faith, courts should focus on whether the petition serves a valid bankruptcy purpose, or whether it is filed merely to obtain a tactical litigation advantage, the court found.

The court then examined the company’s value inside and outside of bankruptcy—whether any assets were threatened outside of bankruptcy that could be preserved or maximized in an orderly liquidation under Chapter 11. In the case at hand, the company’s shareholders, rather than the creditors, stood to benefit from a reduction in lease liability. The financial problems that led to the closure of the business had no relation to the debts the company owed creditors. Hence, the Third Circuit concluded there was no proof that Integrated’s assets were threatened outside of bankruptcy but could be preserved by a bankruptcy filing.

This ruling provides support for creditors to argue that merely going out of business and losing money are not reasons enough for companies to seek bankruptcy protection. Companies must show such protection is required to preserve value for creditors that would be lost outside of bankruptcy.