Cash Flow vs. Balance Sheet Insolvency in Chapter 11: Who Cares? Insolvency Is Not a Prerequisite to a Voluntary Chapter 11 Filing in the Ninth Circuit

Contributed by Cristine Pirro
In yet another case in the series of Marshall cases, the United States Court of Appeals for the Ninth Circuit, adopting the bankruptcy court’s opinion, recently confirmed in In re Marshall III, No. 09-55573, 2013 WL 3242478 (9th Cir. June 28, 2013) that Congress validly exercised its bankruptcy powers under the Constitution to authorize solvent debtors to file for chapter 11 protection.
The background is all too familiar to bankruptcy practitioners:  J. Howard Marshall dies, leaving nearly all of his assets to his son Pierce, but excluding his wife Vickie Lynn Marshall (more famously known as Anna Nicole Smith) and his other son Howard from participating in his fortune.  The ensuing controversy has, in the words of the Ninth Circuit, “survived almost all of its original players.”  As a reminder to those who may not be caught up on our Stern Files, Vickie and Howard unsuccessfully challenged J. Howard Marshall’s will in Texas probate court.  During that dispute, Pierce successfully counterclaimed against Howard on the basis of fraud, causing Howard to suffer a multimillion dollar judgment that eventually forced Howard and his wife Ilene into bankruptcy.
Among other motions and objections to Howard and Ilene’s plan, Pierce moved to dismiss the case as outside of the bankruptcy court’s jurisdiction because the debtors were solvent under a “balance sheet” test.  Pierce looked to the debtors’ assets as of the date of filing and, noting that the assets exceeded the debtors’ liabilities, contended that the debtors were balance sheet solvent as of the petition date and thus unable to file.  Pierce argued in support of this proposition that the Bankruptcy Clause of the Constitution only granted authority to Congress to regulate the affairs of debtors that are insolvent.
In considering this contention, the bankruptcy court first addressed the meaning of “insolvency.”  Pierce urged the court to look to section 101(32)(A) of the Bankruptcy Code for the definition of insolvency.  Section 101(32)(A) provides, in relevant part, that “insolvent means . . . with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation,” excluding certain property.  While there are differences between this section of the Bankruptcy Code and the typical balance sheet test, section 101(32)(A) generally adopts the balance sheet test as the definition of insolvency.
The word “insolvency,” however, only arises a handful of times in the Bankruptcy Code.  One such instance is in section 109(c)(3), which requires a municipality to be insolvent prior to filing for bankruptcy protection.  The meaning of “insolvency” in this section is governed by section 101(32)(C) of the Bankruptcy Code, which uses a cash flow test for solvency rather than the balance sheet test.  The cash flow test – not the balance sheet test – is thus the only solvency test that has ever played a role in qualifying an entity (and solely a municipality under chapter 9) to be a debtor under bankruptcy law.  Therefore, Pierce’s argument that a balance sheet test should be applied was accordingly rejected by the bankruptcy court (and, by extension, the Ninth Circuit through its adoption of the bankruptcy court’s opinion).
Even from a policy perspective, the court went on to note that if insolvency were a prerequisite to a chapter 11 filing, the cash flow test would be the more appropriate test.  The Bankruptcy Code, it reasoned, is designed to provide relief to creditors that have cash flow difficulties, even if they are balance sheet solvent.  The prospects for reorganizing a debtor that is still solvent are greater than when that debtor is already insolvent; if a debtor were forced to wait until becoming insolvent to commence reorganization, substantial economic value could be lost.  The court looked to other countries that require balance sheet insolvency as a prerequisite to admission into the bankruptcy system and found that in those countries, businesses are “generally not reorganizable and substantial economic values are lost.”  Accordingly, the court found that even if a solvency test were required, the balance sheet test would not be the appropriate test to apply in determining insolvency.
Finally, the bankruptcy court reviewed the history of the bankruptcy laws and found that constitutional history did not support the argument that bankruptcy relief be limited to insolvent debtors, or that this meaning was included in the Bankruptcy Clause.  An analysis of the history of the bankruptcy laws in the United States and England revealed that the Bankruptcy Clause was never tied to balance sheet insolvency.   To the contrary, of the five United States bankruptcy laws and its three primary English predecessors, only two acts required a debtor to plead cash flow insolvency for voluntary filings, and under those acts courts still lacked the authority to inquire into whether the debtor was actually insolvent.  For involuntary cases, insolvency did not become the chief basis for a petition until the adoption of the Bankruptcy Code in 1978.  Even now, an involuntary filing requires a showing of cash flow insolvency by virtue of section 303(h)(1), which authorizes an involuntary case where the debtor “is generally not paying such debtor’s debts as they become due,” and balance sheet insolvency is irrelevant.
The bankruptcy court thus confirmed that Congress validly exercised the Bankruptcy Powers under the Constitution to authorize a debtor who is solvent, whether in the balance-sheet or cash-flow sense, to file a voluntary chapter 11 case and to confirm a plan of reorganization.  The Ninth Circuit agreed, affirming the bankruptcy court’s denial of the motion to dismiss and adopting the bankruptcy court’s opinion on the constitutional issues without issuing its own opinion on the issue.