Under Section 1112(b)(1) of the Bankruptcy Code (the code), a bankruptcy court may convert or dismiss a Chapter 11 case for “cause,” including, for example, when a debtor files a bankruptcy petition in bad faith. In a recent decision, In re HONX, No 22-90035 (Bankr. S.D. Tex. Dec. 28, 2022), the U.S. Bankruptcy Court for the Southern District of Texas (the court) addressed whether a debtor that has no independent assets or ongoing business operations can reorganize under Chapter 11 in good faith.

Background

From 1965 to 1998, HONX, Inc.—a wholly owned subsidiary of the Hess Corp.—operated a petroleum refinery on the island of St. Croix, U.S. Virgin Islands. Since the 1980s, more than 1,500 plaintiffs filed personal injury suits against HONX and its predecessors alleging that they were exposed to asbestos at HONX’s refinery.

In April 2022, in response to an influx of asbestos-related lawsuits, HONX filed a voluntary petition for bankruptcy relief under Chapter 11. Although HONX (the debtor) has yet to file a proposed plan of reorganization, it indicated that it is going to file a plan and, as part of the plan, seek to resolve its asbestos liabilities through the establishment of a Section 524(g) trust. The proposed trust, which would be wholly funded by the debtor’s parent company, would be used to pay present and future asbestos claimants.

Following the filing, the debtor’s Official Committee of Unsecured Creditors (the committee) moved to dismiss the debtor’s Chapter 11 case, or alternatively, to convert the case to a Chapter 7. In moving to dismiss, the committee’s main argument was that the bankruptcy filing was a bad faith filing and that the debtor was improperly using the bankruptcy process solely to cap its parent company’s asbestos liabilities. In support of this argument, the committee asserted that the bankruptcy case should be dismissed or converted as: the debtor filed its petition in bad faith, the debtor had no reasonable likelihood of rehabilitation, and the debtor failed to maintain adequate insurance coverage.

The Court’s Opinion

The committee’s first argument—that the debtor filed its petition in bad faith—was largely premised on the committee’s view that the debtor did not seek bankruptcy protection for its own benefit. Since the debtor had no ongoing business or assets, the committee reasoned that the debtor’s parent company, Hess, was really the “true target” of the plaintiffs’ asbestos exposure claims. As such, the debtor’s only possible motive for seeking bankruptcy protection was to solely (and unfairly) benefit Hess by delaying the ongoing asbestos litigation and, ultimately, by limiting Hess’s exposure through a Section 524(g) channeling injunction or third-party release.

In response, the debtor argued that its bankruptcy case was a “a textbook example of why Section 524(g) exists,” and that it was not bad faith for the debtor to utilize the mechanism that Congress designed to help debtors manage their asbestos liabilities nor was it grounds for dismissal. The debtor argued that it has an independent motive to file for bankruptcy because of its own independent asbestos liability that it sought to resolve through bankruptcy. Further, the debtor argued that its bankruptcy filing would also ultimately benefit creditors by allowing more efficient and timely resolution of their claims than would otherwise be possible if the claims were litigated piecemeal in the U.S. Virgin Islands.

The court agreed with the debtor and found no evidence of bad faith. The court found that the committee had not put forth any evidence to refute the debtor’s assertion that “its purpose in filing for bankruptcy was to fairly and efficiently deal with its asbestos liability,” which the court expressly noted was not a bad faith motive. In making its bad faith argument, the committee drew a comparison to divisive-merger bankruptcies—a bankruptcy strategy known as the “Texas two-step”—in which a subsidiary is created solely for the purpose of “absorbing their parents’ liabilities.” The court wholly rejected this analogy because, unlike divisive-merger bankruptcies, HONX was not created for the purpose of inheriting Hess’ liabilities, which the court stated “existed separate and apart from those of HONX.”

Alternatively, the committee argued that cause exists to dismiss or convert the debtor’s Chapter 11 case because the debtor had no hope of “rehabilitation.” Under Section 1112(b)(4)(A) of the code, one possible basis for dismissal is “substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation.” The committee argued that, since the debtor had no ongoing operations or income, there was no business to rehabilitate.

As part of its opposition to the motion to dismiss, the debtor argued that the plain language of the code does not require an ongoing business to reorganize and cited other examples of entities with no continuing operations who have reorganized under Chapter 11.

The court agreed with the debtor that the code does not require a “going concern.” The court made a distinction between “rehabilitation”—as used in Section 1112(b)(4)(A)—and “reorganization,” as used elsewhere in the code. According to the court, rehabilitation is “better read as encompassing a debtor’s intention to use the bankruptcy process to prevent a complete and total loss of value. HONX has met this standard by pointing out that, in bankruptcy, it is able to secure funding from its parent with which it may be able to pay the asbestos claimants.”

The court likewise rejected the argument that the debtor’s failure to carry adequate insurance provided grounds for dismissal. Pursuant to Section 1112(b)(4)(C), a bankruptcy court may dismiss a case for cause if the debtor fails to “maintain appropriate insurance that poses a risk to the estate or to the public.” In rejecting this argument, the court found that a company with “no operations beyond defense of the asbestos claims” could not pose a risk to the public or to the estate by not maintaining insurance.

Conclusion and Commentary

For the forgoing reasons, the court denied the committee’s motion to dismiss and allowed the debtor’s bankruptcy case to proceed. The court also touched on, but dismissed as premature, other concerns raised by the committee about HONX’s overall approach to its bankruptcy. The committee’s motion to dismiss alleged that Hess would seek to minimize its own exposure by agreeing to fund the debtor’s bankruptcy case only if it is released from future asbestos liability. The committee also expressed doubts that the $10 million funding commitment made by Hess would be sufficient to pay asbestos claimants. The court dismissed these concerns as premature because the debtor had yet to file a plan of reorganization. Furthermore and contrary to the committee’s assertions, the court found that Hess acknowledged that it would fully fund the debtor’s bankruptcy case. The committee has appealed the court’s ruling, so this may not be the final resolution of this matter, and the more controversial issues surrounding a possible release of Hess’s liabilities may become a contested issue in the future.

Lawrence J. Kotler is a partner and co-chair of the bankruptcy and fiduciary representations division of the business reorganization and financial restructuring practice group at Duane Morris.

Roxanne J. Indelicato is an associate at the firm and practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.