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What’s Insolvency Got to Do With it Anyway? Assessing “Bad Faith” Bankruptcy Filings Following In Re Aearo

Bankruptcy courts possess broad discretion to dismiss chapter 11 bankruptcy cases for “cause” under Section 1112(b) of the Bankruptcy Code. While the Bankruptcy Code enumerates a long (though non-exhaustive) list of instances when a case may clearly be dismissed for cause, courts generally agree that cases may also be dismissed under Section 1112(b) for the classic catch-all reason—if they are filed in “bad faith.”

Courts adopt different approaches to assess bad faith. Though some remain skeptical of the premise entirely [1], most circuits have found that evidence that a Debtor presently lacks the cash necessary to operate its business is consistent with a finding that the case was filed in good faith. Still, the Bankruptcy Code permits individuals or firms to file for bankruptcy even when they are not insolvent.

The facts of In Re Aearo Technologies LLC raised the question on everyone’s minds: how close to insolvency must a debtor be (if at all) to be acting in good faith?

Reviewing the case law of other circuits, the Aearo court reasoned that while some of the cases assessing Section 1112(b) make passing references to debtor’s economic reality or financial distress, the issue was more appropriately framed in terms of a debtor’s need.  As such, Aero determined that the key question in assessing bad faith was whether the debtor was able to create a valid reorganization plan designed with the purpose to preserve or create value to satisfy creditor claims in full. If the plan served this purpose, then the debtor acted in good faith. If not, the petition was likely filed only to delay and harass creditors.

Aero was acquired by 3M Corporation—an A-rated, Fortune-500 company famous for post-it notes—in 2008. But Aero’s bankruptcy petition was a prophylactic measure: in 2018, it became a defendant in the largest multidistrict litigation in American history. Aearo previously manufactured hearing protection devices designed to afford military personnel and civilians the ability to hear while blocking or reducing loud sounds such as gunfire. These products allegedly caused injuries, such as hearing loss and tinnitus, leading to a surge of lawsuits. While some of the initial “bellwether” cases were dismissed before trial or resulted in favor of 3M and Aero, ten of the initial verdicts held 3M and Aero jointly and severally liable for damages ranging from $1.7 million to $77.5 million. At one point, Aero faced 336,000 pending actions.

When Aero filed for bankruptcy in July 2022, it was financially healthy. Aero reported no cash flow problems, and its sales had increased over the years. While the Court acknowledged that the multi-district litigation represented great potential for financial distress or insolvency, this harm was not immediate enough to justify filing. As part of their decision to file for bankruptcy, 3M agreed to pay Aearo’s Chapter 11 administrative expenses and indemnification obligations. Although the Funding Agreement required Aearo to exhaust most of its own assets as a precondition for 3M’s financial support, the Court found that Aero was not presently in any financial need. Nor was their reorganization plan aimed at creating or preserving value for creditors.

The Court left open the possibility for Aero to refile should their financial circumstances drastically change. However, absent congressional intervention clarifying under what circumstances a debtor facing mass tort litigation may file for bankruptcy, the Court determined that allowing a financially healthy debtor remain in bankruptcy exceeded the boundaries of its jurisdiction.

Debtors are entitled to use the protections afforded by the Bankruptcy Code to their advantage. But squandering the bankruptcy system’s resources, and needlessly interfering with other court systems when an entity is financially sound is, according to the Court, apparently a bridge too far. Debtors like Aero are simply not what Congress had in mind when it crafted Chapter 11 protections.

[1] In In re Victoria Limited Partnership, 187 B.R. 54 (Bankr. D. Mass. 1995), Judge Queenan described the good faith standard as “an amorphous gestalt, devoid of reasoning and impenetrable to understanding.”

Categories: Chapter 11