Court Holds that a Financially Healthy Debtor Cannot File Chapter 11 Bankruptcy in Good Faith

Daniella Sesto

St. John’s University School of Law

American Bankruptcy Institute Law Review Staff

            Section 1112(b) of title 11 of the United States Code (the “Bankruptcy Code”) provides that a chapter 11 case may only be dismissed for cause.[1] Though courts have held that failure to file in good faith permits dismissal for cause, there is no universally accepted definition for “good faith.” In In re Aearo Technologies, the United States Bankruptcy Court for the Southern District of Indiana (the “Bankruptcy Court”) held that a financially healthy debtor may not file for chapter 11 bankruptcy in good faith and, therefore, the case is subject to dismissal under section 1112(b).[2]

In the late 1990’s, Aearo,[3] which became a wholly owned subsidiary of 3M in 2008, designed earplugs that allowed the wearer to hear voices but blocked loud noises, such as gunfire.[4] Aearo sold these earplugs to the United States Military. Tort claims derived from hearing damage emerged throughout the country and were consolidated into the biggest multidistrict legislation (“MDL”) in history, with over 330,000 total cases, representing 30% of all cases pending in federal district court.[5] Most of the claims seek to hold 3M and Aearo jointly and severally liable.[6] 3M has exclusively borne all defense costs relating to the MDL, totaling approximately $350 million.[7] Beginning in 2022, 3M began exploring alternatives to the MDL, including a chapter 11 bankruptcy for Aearo. Independent Directors negotiated the terms under which 3M would fund a chapter 11 bankruptcy by Aero pursuant to a funding agreement. Under the funding agreement, 3M committed to satisfy all of Aearo’s liabilities, such that Aearo would have assets greater than liabilities, and therefore the financial capacity to satisfy obligations. 3M established an initial $1 billion trust to fund claims against the earplugs and respirators, and a $240 million fund for administration of the chapter 11 cases.[8]

            The Bankruptcy Court analyzed theories for defining “good faith,” ultimately finding that chapter 11 cases that do not serve valid reorganization purposes are filed in bad faith.[9] The Bankruptcy Court noted that truly unnecessary chapter 11 cases impose improper burdens on both the creditors and the bankruptcy system. According to the Bankruptcy Court, in unnecessary chapter 11 cases, the creditors are arbitrarily required to accept certain treatment in the bankruptcy in place of their property rights under non-bankruptcy law, and the bankruptcy system is required to waste resources.[10] The U.S. Court of Appeals for the Seventh Circuit, where this case was pending, has not yet expressly articulated whether it is bad faith for a financially healthy debtor to seek chapter 11 relief, so the Bankruptcy Court closely considered the U.S. Court of Appeals for the Third Circuit’s holding in LTL Management.[11] In LTL Management, the Third Circuit held that a debtor seeking relief in chapter 11 must state a valid bankruptcy purpose, which assumes that the debtor is in financial distress. In LTL Management, Johnson and Johnson had agreed to fund the tort claims arising from LTL Management’s talc products and because Johnson and Johnson was solvent and able to fund those claims in full, the Third Circuit found that the bankruptcy filing was in bad faith.[12]

Consistent with the Third Circuit in LTL Management, the Bankruptcy Court found that, because 3M agreed to fund both the tort suits and the chapter 11 claims pursuant to the funding agreement, Aearo’s chapter 11 filing was in bad faith.[13] In LTL Management, the Third Circuit held “financial distress” is a determining factor for good faith.[14]The Bankruptcy Court distinguished the test applied in LTL Management, finding that a debtor’s “need” for chapter 11 reorganization is more compelling than financial distress due to the ambiguity of the terms.[15] According to the Bankruptcy Court in Aearo, whether a debtor is in “need” of chapter 11 protection depends on whether the problem that the debtor is facing falls within the range of difficulties envisioned by Congress when it created chapter 11.[16] The Bankruptcy Court held that there was no imminent threat to Aearo’s existence, and the amount of claims asserted against it did not exceed the value of available assets as a result of the funding agreement.[17] It was relevant to the Bankruptcy Court that notwithstanding the MDL, Aearo’s sales increased, it had no cash flow problems, and it met its obligations. In fact, Aearo had not faced any execution of judgment because 3M solely bore all costs relating to the MDL.[18]

            The Bankruptcy Court noted that its decision is consistent with accepted theories of good faith filings, and the high profile LTL Management decision from the Third Circuit. The Bankruptcy Court’s holding asks courts to determine whether the debtor’s need is consistent with Congress’s purpose in passing chapter 11, and whether the chapter 11 filing serves a valid reorganization purpose.[19] If both tests are met, the filing is in good faith. Because the Banrkuptcy Court found that neither 3M nor Aearo had faced execution of judgment at the time of the decision, the Bankruptcy Court held that both companies were financially healthy and not in need of chapter 11 protection.[20] The Bankruptcy Court noted that the financial status of 3M and Aearo might change in the future once they face execution of judgments and they could require chapter 11 protection in the future, perhaps supporting a good faith filing.