REORGANIZING HIGH-TECH BUSINESSES - USC Gould School …



OVERVIEW

1. High-Tech Companies are Different From You and Me -- They Have No Cash Flow. (Apologies to Ernest Hemingway).

2. Watch Your Back, Watch the Door and Cover your Assets.

3. Assignment of Licenses in Bankruptcy: Have License, Can’t Travel.

4. Money Does Not Grow on Trees and Chapter 11 Does Not Manufacture Cash.

5. Selling a High-Tech Company: “As Is – Where Is - It Is What It Is.”

6. Top Ten List (Attached).

7. Article: Reorganizing High-Tech Businesses – “I Need Help, Find Me Some Lawyers Who Wear Suits” (Attached).

1. Key Concepts. Most bankruptcy cases are filed under Chapter 11 (reorganizations). Debtor in possession concept is the norm. Trustees are appointed in Chapter 7 (liquidation) cases and may be appointed in Chapter 11 cases. Commencement of a bankruptcy case creates an “estate.” Executory contracts can be assumed (honored) or rejected (breached) by the debtor. Claims are generally classified as “general unsecured” or “administrative expenses.” The former are paid pro rata, the latter are usually paid in full.

2. Get Organized. Pull your license agreements and contracts, check outstanding A/R, prepare a Notice of Appearance for filing in the Chapter 11 case and alert your credit, consulting, maintenance and & support organizations. Key to payment is vigilance in the case.

3. Analyze Contract. Only executory contracts present a debtor with the choice of assumption or rejection. Common test for executoriness is whether each party has material, unperformed obligations under the contract. If so, contract may be executory. If not, the contract would be an asset or liability of the debtor. In re Robert L. Helms Constr., 9th Cir. 1997 (“If performance is due to the debtor, the contract is an asset, which becomes estate property. If performance is due by the debtor, it is a liability of the estate and the nondebtor is an unsecured creditor.”). IP license agreements are typically considered executory because licensor has ongoing indemnity and warranty obligations (and license itself is merely a covenant not to sue) and licensee usually has ongoing payment, noncompetition, quality control and confidentiality obligations.

4. Payment & Performance Rights and Duties. General rule is that commencement of bankruptcy case stays collection and litigation efforts on pre-bankruptcy charges. Need to check the debtor’s bankruptcy schedules and prepare a Proof of Claim by the bar date. Generally speaking, pending assumption or rejection of contract, nondebtor party must continue to perform. Nondebtor party, however, can seek payment for post-petition charges, which may require pro-ration across the petition date

5. Know Catapult. Ninth Circuit Court of Appeals has held that a debtor may not even assume contracts that are not assignable under applicable non-bankruptcy law (namely, nonexclusive patent licenses, probably nonexclusive copyright licenses). This means that nondebtor can request relief from the automatic stay to terminate the license. See Catapult Entertainment, 165 F.3d 747 (9th Cir. 1999); CFLC, Inc., 89 F.3d 673 (9th Cir. 1996); Harris v. Emus Records, 734 F.2d 1329 (9th Cir. 1984); Access Beyond Tech., 237 BR 32 (Bankr. Del. 1999); Patient Education Media, 210 BR 237 (Bankr. SDNY 1997).

6. Draft License to Protect Rights & Maximize Leverage. Make sure license agreements contain (a) a bankruptcy termination clause (Section 365(e)(2)), (b) a change of control termination clause (Institut Pasteur risk), (c) an anti-assignment clause (with minimal dilution) (Catapult issue).

7. Debtor as Licensor Issues. Section 365(n) of the Bankruptcy Code grants special protection to licensees. Trademarks are not included in definition of “intellectual property” so there is a risk that rejection may deprive licensee of ability to use marks even though it is able to distribute copyrighted works. But, Section 365(n) permits continued rights under “supplementary” agreements. The principle of Section 365(n) (preventing harm to ongoing business through deprivation of licensed rights) may apply to new technologies – wholesaler of internet addresses granted use rights to nondebtor ISP.

8. Development Contracts – “Works Made for Hire”. Development work that is done under “work for hire” contracts should emphasize the personal services aspect of the agreement to protect employer in the event contractor files a bankruptcy and employer wishes to terminate contract.

9. Assumption, Rejection & Cure of Defaults. If a debtor decides to assume a contract, it must cure defaults, compensate for damages and provide assurances of future performance. Assumption provides opportunity to obtain repayment of pre-petition claims and, possibly, ancillary claims for consulting services. Breach of an assumed contract gives rise to an administrative expense. In rejection scenarios, consider execution of termination letter to recover software & documentation.

10. Watch for Preference Exposure. Preferential transfers made by a debtor within 90 days prior to the commencement of the case may be avoided and recovered. Although there are many defenses, there are also many opportunities to settle this possible exposure.

8. REORGANIZING HIGH-TECH BUSINESSES --

“I NEED HELP, FIND ME SOME LAWYERS WHO WEAR SUITS”

William P. Weintraub

Pachulski, Stang, Ziehl, Young & Jones PC

Three Embarcadero Center, Suite 1020

San Francisco, CA 94111

(415) 263-7000

(415) 263-7010

wweintraub@

TABLE OF CONTENTS

I. Introduction 1

II. Cultural Differences Between High-Tech Companies and Other Companies 1

III. Perfecting and Protecting Rights in Intellectual Assets 3

1. Perfecting Security Interests in Intellectual Property. 3

a. General Intangibles. 3

b. Trademarks. 3

c. Copyrights. 4

d. Patents. 6

e. Inventory and Receivables Based on Copyrights. 6

2. High-Tech Licenses. 7

a. Escrow Arrangements For Licensed Intellectual Property. 8

b. Assignment of Licenses After CFLC and Catapult. 8

IV. Human Resources Issues 11

a. Retention Bonuses. 11

b. The WARN Act. 12

V. Financing High-Tech Companies 14

1. Cash Collateral and Post-petition Financing. 14

2. Valuation of Collateral. 16

VI. Confidentiality Issues, Tire-Kickers and Shopping a High-Tech Company 16

1. Asset Sales. 16

2. Bidding Protection. 18

VII. Conclusion 19

Introduction

Reorganizing a “high-tech” company presents several challenging issues for turnaround managers and insolvency professionals. Many high-tech companies are start-up companies with inadequate accounting and information systems, poor document control, and high turnover, especially in the accounting and finance departments.

In addition, the culture of high-tech companies (stock options and IPOs) inevitably leads to several problems that, while not unique to high-tech companies, are often exacerbated when the high-tech company finally accepts the reality of its financial situation. Oftentimes, the high-tech company has gone through several rounds of financing involving multiple issues of preferred stock and convertible subordinated debt. Senior management, as well as most or all of the employees, hold stock options. There may or may not be a traditional lender in place, or the basis of the institutional debt might not be a working capital asset based loan, but instead a series of loans to acquire related businesses (all now failing as well) with the result that the lender is undersecured.

The high-tech case presents all of the “usual” issues that are presented in any Chapter 11 situation (such as first day orders, debtor in possession financing, use of cash collateral, identification of executory contracts, employee benefits issues, customer relation issues, trade vendor problems, and ultimately, reorganizability). But the high-tech case also may involve culture shock (buttoned down turnaround professionals versus problem solving entrepreneurs who are not tied to following the “rules”), as well as unique issues presented by emerging case law in the areas of intellectual property protection and licensing and the undeniable fact that, more than in any other industry, the assets go home each night and hopefully return to work in the morning.

The purpose of this outline is to provide a framework for discussing some of these issues.

Cultural Differences Between High-Tech Companies and Other Companies

High-tech companies have a unique culture. Many of the employees are young, well-educated and not particularly interested in accounting or legal issues that “get in the way” of their goals.

Many high-tech companies are financed by venture capitalists or angels who initially do not put many operational restrictions on the use of cash. Oftentimes the answer to a cash shortage is another round of equity financing to raise more cash.

When the angel or venture capitalist becomes disaffected, or the bank becomes nervous, the first reaction of management is not to react at all or to cling to the belief it can work its way out of the problem without outside assistance. And the natural inclination of many of the financiers of start-up companies that falter is to move on to the next start-up.

Turnaround professionals and insolvency counsel are just about the last people high-tech companies want to look to for assistance. There is the widely held view that high-tech companies are not reorganizable. Perhaps the better view is that high-tech companies are reorganizable if the correct remedial steps are taken early in the process.

In this regard, high-tech companies are not different from other financially distressed companies who wait too long to seek assistance. If the company is out of cash, it cannot be operated for purposes of either selling its assets or trying to locate a new source of equity or debt financing. Indeed, if the company waits too long, it will not have the resources to hire the professionals that it needs.

Another potential area of conflict can arise when the entrepreneurs running the high-tech company are confronted with the basic rules of insolvency, including the well established proposition that an insolvent company has a fiduciary duty to its creditors. This proposition conflicts with the high-tech company’s instinct to protect its employees at all costs. For example, payment of employee benefits at the expense of other creditors may also cause potential conflicts between management and the turnaround and insolvency professionals.

Entrepreneurs may wish to also protect the investors and angels who have funded the troubled company. Management will not want to offend these players as they may wish to seek financing for future start-ups from the same entities.

Conflicts might arise if the company wants to compromise with its distributors and retailers over “disputes” and treat those compromises as “ordinary course of business” transactions. The demands of distributors and retailers to over reserve for warranty claims and returns will impact upon the collectability of receivables. Management’s efforts may be geared toward accommodating distributors and retailers beyond what may be necessary if a more confrontational approach is used.

On the positive side, entrepreneurs often have a more informal hands-on, open door approach to issues. They can be quite willing to embrace creative approaches to a work-out. they often have close relationships with the various constituencies in the case -- the employees, the investors, the critical suppliers and general creditors.

Open communication with the various parties is sometimes easier with a high-tech company used to frequent and open meetings with investors on new developments within the company. Investors in high-tech start-ups can be traditional sources of equity, but may also be key customers of the company. Key customers have been known to step in and assist a high-tech company in financial crisis.

In sum, the culture of high-tech companies is both good and bad. The mind set of some high-tech companies is that the trade creditors who have suffered the most, and who by their actions and inactions have supported the debtor’s lifestyle for months, are the last people to be considered or paid. Taking constituencies for granted and expecting undying support from creditors and others after months of dodging telephone calls from persons asking for payment or updated financial information is a common mistake. Clear and open communication with the various parties is essential for high-tech turnarounds in particular.

Perfecting and Protecting Rights in Intellectual Assets

1. Perfecting Security Interests in Intellectual Property.

Next to the cultural considerations, one of the most important considerations to a high-tech company involves its intellectual property and the grant and perfection of liens against these assets. The following section will outline the statutory and case law framework governing the perfection of security interests in the various intellectual property assets of a typical high-tech company.

a. General Intangibles.

Section 9-106 of the Uniform Commercial Code defines “general intangible” to mean any personal property (including things in action) other than goods, accounts, chattel paper, documents, instruments, and money. Consequently, patents, copyrights, and trademarks fall within the catch-all definition of general intangibles. The Official Comment to section 9-106 confirms this: “Other examples [of general intangibles] are copyrights, trademarks, and patents, except to the extent that they may be excluded by section 9-104(a).”

In turn, section 9-104 of the Commercial Code provides, in subsection (a), that Article 9 does not apply to a security interest subject to any statute of the United States, to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property.

Therefore, it is generally accepted that federal filings are not required to perfect a security interest in patents or trademarks from avoidance by a bankruptcy trustee. See In re Transportation Design & Technology, Inc., 48 B.R. 635 (Bankr. S.D. Cal. 1985) and City Bank and Trust Co. v Otto Fabric, Inc., 83 B.R. 780 (D. Kan. 1988). This view as to patents was recently affirmed by the Bankruptcy Appellate Panel for the Ninth Circuit in In re Cybernetic Services, Inc., 239 B.R. 917 (BAP 9th Cir. 1999) (the Patent Act deals with title and true assignments, not security interests, so a properly filed UCC-1 will perfect a security interest in a patent). Nonetheless, the conventional wisdom is that “double filings” are prudent -- a UCC-1 filing with the Secretary of State as a general intangible under Article 9, and a filing with the United States Patent and Trademark Office (“PTO”). And, as discussed below, because of the existence of an indexing system at the Copyright Office and conflicting case law, copyrights present special problems for secured creditors.

b. Trademarks.

Trademarks also present their own unique set of problems. Ordinarily, a trademark cannot be sold or assigned separately from the goodwill associated with it, and therefore, an assignment of a trademark without the sale of the associated goodwill is considered deceptive and ineffective as an “assignment in gross.” The Assignment of Trademarks and Tradenames, 30 Mich. L. Rev. 489-503 (1932). The Lanham Act (governing trademarks) requires the assignment of a trademark to be recorded with the PTO. A secured party who takes an “assignment” of a trademark without the transfer of goodwill might find that it has an unenforceable security interest, although some older cases suggest there is a meaningful distinction between the assignment of a trademark and the grant of a security interest in a trademark, effectively side-stepping the assignment in gross issue and recognizing that a security interest is not the kind of assignment that triggers Lanham Act problems.

Recent cases have followed the older cases and hold that a lender may take a security interest in a trademark without recording the “assignment” with the PTO. See In re TR-3 Industries, 41 B.R. 128 (Bankr. C.D. Cal. 1984); and In re Roman Cleanser Co., 43 B.R. 940 (Bankr. E.D. Mi. 1984). Both courts found a distinction between an outright assignment of the mark and a conditional assignment for purposes of security and held that filing a UCC-1 is sufficient to perfect a security interest in trademarks.

The Roman Cleanser court examined the issue of assignments in gross and held that a reference to general intangibles in the UCC-1 financing statement would automatically pick up the company’s goodwill, meaning that the trademark will continue to be connected with the same products with which it has been associated in the past. The court also held that no particular tangible assets had to be transferred with the mark in order to avoid being an assignment in gross and that granting rights in the customer lists and formulas alone was sufficient. 43 B.R. at 947-48 (citations omitted). Roman Cleanser was affirmed on the assignment in gross issues by the Sixth Circuit at 802 F.2d 207 (6th Cir. 1986). The issue of perfection through a UCC state filing was not appealed, but it appears that the majority opinion assumed the correctness of that portion of the case. In the concurring opinion, however, one of the justices hinted that it is not clear whether a federal registration of the security interest alone will protect the lender’s ability to realize upon its collateral in bankruptcy, and suggested that the only safe harbor is to file a UCC-1 financing statement with the Secretary of State.

c. Copyrights.

Copyrights are treated differently from both patents and trademarks. In re Peregrine Entertainment, Ltd., 116 B.R. 194 (Bankr. C.D. Cal. 1990), holds that a financing statement is insufficient to perfect a security interest in copyrights. Even though the Copyright Act does not seem to have a comprehensive and indexed method of recording and locating security interests in copyrights, Judge Koziniski (a justice of the Ninth Circuit Court of Appeals sitting as a district judge) held that the Copyright Act occupied the field of filing with respect to copyright collateral and that the financing statement filed by the creditor in that case was a nullity.

...[T]he comprehensive scope of the federal Copyright Act’s recording provisions, along with the unique federal interest they implicate, support the view that federal law preempts state methods of perfecting security interests in copyrights and related accounts receivable.

***

Recording in the U.S. Copyright Office rather than filing a financing statement under Article Nine, is the proper method for perfecting a security interest in a copyright.

116 B.R. at 199, 203.

In light of Peregrine, a lender that relies on a UCC financing statement will have a problem. In order to be absolutely certain as to perfection, the lender must file notice of its security interest in the United States Copyright Office. Further, it should be noted that filings are not currently indexed in a manner that would permit easy search for competing security interests. For example, registrations are not organized by the name of the debtor, but instead on the basis of title and registration number. Accordingly, a “floating lien” that attaches to after-acquired copyrights might not be effective. This will require the secured lender to effect multiple filings as new copyrights are registered with the Copyright Office.

In re AEG Acquisition Corp., 161 B.R. 50 (9th Cir. BAP 1993), follows Peregrine. AEG is important because it provides that two steps must be taken to perfect a security interest in a motion picture: (1) the film must be registered with the Copyright Office, and (2) the security interest must be recorded in the same office. This suggests that if the item in which the creditor seeks to assert a security interest is an unrecorded copyright, there might not be a mechanism for perfection until the copyright is registered. Indeed, that is the result in In re Avalon Software, Inc., 209 B.R. 517 (Bankr. D. Ariz. 1997), where the bankruptcy court held as follows:

Imperial Bank argues that if Avalon failed to register any of its copyrightable material or software, that it (or its Trustee) is not entitled to the “other central registry” exception of the UCC. The bank then maintains that, because of the failure to actually register a product which is capable of registration, it then becomes something else - perhaps a general intangible - which was perfected and which only could be perfected by filing with Arizona’s Secretary of State.

This court holds that a product to which a copyright attaches, such as computer software, acquires its character as “copyrightable” when the intellectual work is created. 17 U.S.C. §§ 101, 201(a). Importantly, registration “is not a condition of copyright protection.” 17 U.S.C. § 408(a). Thus, a product which is entitled to be registered at the U.S. Copyright Office, but is not, does not carry different “label” or become something different solely because it was not registered at the U.S. Copyright Office. [Citations omitted]. In other words, a security interest in such an item is unperfected if filed or recorded anywhere other than at the U.S. Copyright Office. Attempting to call such a product a “trade secret” does not change the requirement for security-interest filing at the Copyright Office. The burden to perfect properly is entirely on the secured creditor in such an instance. It is immaterial whether the debtor has registered its material. Perfection and constructive notice to the world is accomplished by the creditor’s satisfaction of two requirements: (1) documenting the security interest with the U.S. Office of Copyright, and (2) insuring that a registration of the copyrighted product has also been made at the U.S. Copyright Office.

Therefore, as to all Avalon property which the bank is required to perfect at the U.S. Copyright Office, but which it did not, Imperial Bank is unperfected, and it is an unsecured creditor to the extent of that property interest and any sale proceeds.

209 B.R. at 521-22.

But in a more recent case, Aerocon Engineering Inc. v. Silicon Valley Bank (In re Auxillary Power Company), 244 B.R. 149 (Bankr. N.D. Cal. 1999), the bankruptcy court reached a different conclusion holding that an unregistered copyright is a general intangible and that a secured creditor can perfect its interest in the unregistered copyright by filing a UCC-1 financing statement with the appropriate secretary of state. The underpinnings of the court’s rationale appears to be two-fold: first, the Copyright Act does not permit perfection of a security interest in an unregistered copyright, so federal law does not preempt state methods of perfection with respect to unregistered copyrights; and, second, since a hypothetical lien creditor (i.e., a trustee in bankruptcy) cannot record a lien against an unregistered copyright in a way that trumps a prior unrecorded security interest, , the state filing system is the only way to deal with this problem.

This issue remains perilously unresolved, so good practice suggests that a creditor who is truly relying on copyrighted collateral should insist that the debtor/borrower register its copyrights.

d. Patents.

It is also worth noting that some commentators believe that Peregrine calls into question the underpinnings of patent cases such as Transportation Design and Technology and Otto Fabric, supra. See Peregrine, supra, 116 B.R. at 203-204 (“In reaching this conclusion, the court rejects Citibank & Trust Co. v. Auto Fabric, Inc., 83 B.R. 780 (D. Can. 1988), and In re Transportation Design & Technology Inc., 48 B.R. 635 (Bankr. S.D. Cal. 1995), insofar as they are germane to the issues presented here. ***These cases misconstrue the plain language of UCC section 9-104, which provides for the voluntary step back of Article Nine’s provisions “to the extent [federal law] governs the rights of [the] parties.”*** Thus, when a federal statute provides for a national system of recordation or specifies a place of filing different from that in Article Nine, the method of perfection specifies in Article Nine are supplanted by that national system; compliance with a national system of recordation is equivalent to the filing a financing statement under Article Nine. ***Whether the federal statute also provides a priority scheme different from that in Article Nine is a separate issue, addressed below. ***Compliance with a national registration scheme is necessary for perfection regardless of whether federal law governs priorities.”).

In light of the uncertainty Peregrine throws into the patent area, double filings (state and federal) would be well advised with respect to patent collateral as well.

e. Inventory and Receivables Based on Copyrights.

Peregrine may also call into question whether or not a foreclosing lender may dispose of inventory subject to a copyright. In particular, the precise holding of Peregrine was that the secured creditor’s financing statement was inadequate to perfect the creditor’s purported security interest in copyrights and the receivables generated there from. 116 B.R. at 204.

Prior to Peregrine, it was fairly well-settled that the “first sale” doctrine applied to a foreclosing secured lender. This doctrine allowed a secured creditor with a security interest in inventory could dispose of that inventory, through foreclosure, without violating any copyright of the debtor in such inventory. This is because the “involuntary” sale through foreclosure was tantamount to the “first sale” that terminated the copyright owner’s exclusive right to sell patented or copyrighted objects. Once the “first sale” has been done, a buyer (here, the foreclosing creditor), can sell the patented or copyrighted objects without violating the copyright owner’s exclusive rights. See Platt & Munk Co. v. Republic Graphics, Inc., 315 F.2d 847 (2d Cir. 1963).

Inasmuch as Peregrine suggests that a secured creditor with a security interest in “copyrights and the receivables generated therefrom” must record its security interest with the Copyright Office in order to perfect its security interest, the viability of Platt & Munk and its progeny may be open to question where the secured creditor has not recorded its security interest in copyrighted inventory with the Copyright Office. Although the text of Avalon, supra, is a little unclear, that opinion suggests that the secured creditor in that case did not have an enforceable security interest in copyrighted inventory because it had failed to record its security interest in the Copyright Office. (The debtor in that case was in the business of selling shrink-wrapped software). Once again in light of the foregoing, a secured creditor is well advised to record its inventory security interest with the Copyright Office if the debtor’s inventory consists of or embodies copyrighted material.

2. High-Tech Licenses.

Much of the value of a high-tech company may reside within its licensing arrangements with third parties. These may include “licenses in,” where technology is licensed by the debtor as licensee, as well as “licenses out,” where the debtor acts as a licensor and licenses its technology to third parties.

Bankruptcy Code section 365(n) was enacted in 1998 (Intellectual Property Licenses in Bankruptcy Act, P.L. No. 100-506, 1988 U.S. Code Cong. & Admin. News (102 stat.) 2538) in order to protect non-debtor licensees from the rejection of their license with a debtor licensor.

It is well-settled that a technology or software license constitutes an executory contract under Bankruptcy Code section 365. See In re Select-A-Seat Corp., 625 F.2d 290 (9th Cir. 1980). Accord In re CFLC, Inc., 89 F.3d 673 (9th Cir. 1996). In the now infamous case of Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), cert. denied, 106 S. Ct. 1285 (1986), the debtor licensor’s bankruptcy trustee rejected a license of the debtor with the result that the non-debtor licensee, whose business was dependant upon use of the licensed technology, was effectively put out of business.

In order to protect other non-debtor licensees from a similar fate, Congress enacted Bankruptcy Code § 365(n) to enable a non-debtor licensee to preserve its rights under the license following rejection, so long as the licensee continues to make royalty payments under the contract.

a. Escrow Arrangements For Licensed Intellectual Property.

One common means for a licensee to try to protect its license with a faltering licensor is to require the licensor to put the intellectual property and all upgrades and modifications (oftentimes source code or diagrams and drawings) into an escrow that may be accessed by the licensee under enumerated circumstances. Generally speaking, technology escrows are enforceable in bankruptcy (subject to ipso facto restrictions and the automatic stay) and are considered to be “supplementary agreements” within the meaning of Bankruptcy Code section 365(n).

While the automatic stay under the Bankruptcy Code prohibits actions against the debtor or the debtor’s property and might prevent immediate access to intellectual property put into an escrow, the licensor should not agree to instructions that permit the licensee to have access to the escrowed materials upon the licensor’s bankruptcy or insolvency. Nor should the licensor waive the benefits of the automatic stay in the escrowed documents. Instead, the licensor should insist that the escrowed materials may only be accessed by the licensee if the licensor stops supporting its products for a specified period of time or ceases business operations altogether. Because the licensor might eventually sell the business, the escrow agreement should prohibit the licensee from accessing the escrowed materials if a buyer or successor to the licensor continues to support the licensee in the same manner as the original licensor. The last thing the debtor wants to do is permit the non-debtor licensee to have access to some of the debtor’s most valuable information simply because the debtor has commenced a bankruptcy case. So long as the debtor is still operating its business, or there is a successor to the licensor, there is no justification for the non-debtor to have access to the intellectual property in the escrow.

The party relying on ultimately finding the most recent version of the intellectual property in the escrow must monitor the other party closely. May transactions are set up properly, only to fail in the practical details of properly updating the escrowed materials.

b. Assignment of Licenses After CFLC and Catapult.

Two recent cases from the Ninth Circuit have created shockwaves for high-tech debtors. These cases are In re CFLC, Inc., 89 F.3d 673 (9th Cir. 1996); and In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999).

Both CFLC and Catapult involved the debtor’s attempt to assign a patent license to a third party in connection with the sale of the debtor’s business. In both cases, the debtor was the licensee, and the license itself was either expressly non-assignable or silent as to assignability.

Bankruptcy Code section 365(c) prohibits a trustee (or debtor in possession) from assuming or assigning an executory contract if “applicable law” excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor. This is true whether or not the contract prohibits or restricts assignment of rights or delegation of duties.

CFLC involved the sale of substantially all of the debtor’s assets to a third party. In conjunction with the sale, the debtor sought authority to assume and assign certain in-bound licenses over the objection of a licensor. The court was faced with the issue of whether established federal common law declaring patent licenses to be non-assignable without the licensor’s consent constituted “applicable law” under section 365(c) thereby prohibiting the proposed assignment. The Ninth Circuit said yes.

According to the Ninth Circuit,

Federal law holds a non-exclusive patent license to be personal and nonassignable and therefore would excuse [the licensor] from accepting performance from, or rendering it to, anyone other than [the debtor]. “It is will settled that a non-exclusive licensee of a patent has only a personal and not a property interest in the patent and that this personal right cannot be assigned unless the patent owner authorizes the assignment or the license itself permits assignment.” [Citations omitted]. The only decision cited to the contrary as Justice Trainor’s decision in Dopplmaier. While that opinion raises not insignificant questions about the actual holdings, relevance and continued vitality of the nineteenth century Supreme Court decisions which are cited for the origins of the federal rule, [citations omitted], those questions are not so significant as to compel departure from uniform rule of modern federal decisions reading those precedents as defining non-exclusive patent licenses as personal and non-assignable.

89 F.3d at 679-80.

The peculiar construct of the prefatory language to Bankruptcy Code section 365(c) provides that the trustee or debtor in possession “may not assume or assign any executory contract unexpired lease . . . .” Given that language, it was not long until another decision came along and focused upon the fact that not only could the debtor not assign a non-assignable patent license to a buyer, but the debtor could not even assume its own non-assignable patent license, even in the absence of a pending assignment. This is the gist of the unfortunate holding in Catapult.

Catapult involved a prepackaged plan of reorganization that implemented a reverse triangular merger. One of the licenses to be assumed as part of the transaction was a patent license. The licensor opposed the transaction and one of the issues was whether the license was even being assigned, given the structure of the transaction. The debtor in that case became a wholly-owned subsidiary of the acquirer by merging into a wholly-owned subsidiary of the acquirer. The Ninth Circuit found the structure of the transaction (merger versus sale) was a distinction from CFLC without a difference and held that the patent license could not be assumed by the reorganized debtor a part of the plan of reorganization. Although Catapult arose within the context of an obvious transfer of assets, Catapult is a very troubling decision because it appears to prevent the debtor from assuming its own patent licenses separate and apart from whether the licenses would ever be assignable to a third party as part of a sale transaction. Catapult, if strictly enforced, can put a debtor out of business.

The linchpin of Catapult is application of the so-called “hypothetical test,” where the debtor’s assumption of its own contract will be prohibited if the assignment of the license to a third party could be barred. The “hypothetical” aspect of the test is that the debtor is prohibited from assuming its own license if it could be prevented from assigning the license to a hypothetical third party, even where the debtor has no intention of assigning the contract in question to any such third party. In so holding, the Ninth Circuit has sided with In re James Cable Partners, L.P. 27 F.3d 534 (11th Cir. 1994); and In re West Elec., Inc., 852 F.2d 79 (3rd Cir. 1988). Catapult has been followed by at least one bankruptcy court. See In re Access Beyond Technologies, Inc., 237 B.R. 32 (Bankr. Del. 1999). For a contrary analysis, see Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997), cert. denied, 117 S. Ct 2511 (1997). A petition for a writ of certiorari was filed with the U.S. Supreme Court in the Catapult case, but the case settled.

In both the CFLC and Catapult cases, the non-debtor/patent licensor was able to argue that the subject patent licenses were inherently non-assignable as a matter of federal common law because either the license expressly prohibited assignment without the consent of the licensor or the license was silent as to whether it was assignable and therefore the licensor could argue that under federal common law the “personal” nature of a patent license prevented assignment without the licensor’s express consent. While there are cogent reasons why CFLC and Catapult cases are incorrect, they are the law for the time being.

But what if the license permits assignment? It would appear that in those circumstances, the debtor may both assume the license and/or assign it to a third party. The prefatory language, which qualifies all of subsection (c) of Bankruptcy Code section 365(c), uses the phrase “whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties...”. That phrase only creates an exception to the otherwise free assignability under Bankruptcy Code section 365(f)(1) where the contract in question (such as a patent license) is of a type that is non-assignable under applicable law and the language of the contract expressly prohibits assignment or is silent as to assignment. (A contract that is silent as to assignability does not prohibit or restrict assignments and is arguably picked up by the “whether or not” language; but a contract whose provisions expressly permit assignment would not fall within the ambit of the prefatory phrase “whether or not such contract...prohibits...assignment.”). The prefatory language to section 365(c) does not state that the proposed assignment may be blocked “notwithstanding the express assignability of the contract.” If Congress wanted to override the ordinary state law contract principles that would permit assignment when the contract itself permits assignment, it knew how to do so.

Second, section 365(c)(1)(B) only prevents assignment where the non-debtor party does not consent to the assignment. If the non-debtor party has already consented to assignment by agreeing to the assignability of the license when the contract was originally made, it cannot rewrite its contract postpetition and withdraw its consent. The licensor may only prevent assignment under these circumstance by arguing that the proposed assignee cannot demonstrate adequate assurance of future performance as required under Bankruptcy Code section 365(f)(2).

Unfortunately, the limited exception to Catapult where the license is expressly assignable does not help the high-tech debtor who is dependent upon its non-assignable patent licenses.

It is unclear what, if anything, the debtor can do in these circumstances. One solution might be to make sure that the debtor is current on all of its payment (i.e., royalty) obligations under its patent licenses prior to the commencement of the bankruptcy case, and that the debtor continues to make payments as they arise after the commencement of the case. In theory, the debtor could argue that it should be permitted to continue to use the patent license so long it pays any royalties, regardless of whether the license has been “assumed” by the debtor. At the conclusion of the case, the debtor would not seek to assume the license, but merely have it “ride-through” the case upon plan confirmation. Although the licensor might seek to accelerate the debtor’s time to assume or reject the license, or request relief from the automatic stay in order to terminate the license because the debtor cannot assume the license, the bankruptcy court could and should permit the debtor to continue to use the license throughout the case, so long as it is not in default.

Another interesting seeming disconnect in the law after Catapult is the inconsistency between how the Bankruptcy Code treats the same license depending upon the identity of the debtor. Under Catapult, a debtor/licensee cannot assume its own license, thereby suggesting that the license must be rejected and the licensee deprived of its use. However, if you reverse the roles of the parties to the same license and the licensor is now the debtor, the debtor/licensor cannot deprive the non-debtor/licensee of the right to continue to use the license. See Bankruptcy Code section 365 (n). So, on the one hand, the debtor/licensee can be “put out of business” by the non-debtor licensor, but if the tables are turned, and the licensor is the debtor, the licensor cannot put the licensee out of business by rejecting the license and preventing the licensee’s ongoing use of the license. This hardly makes sense.

Human Resources Issues

As suggested above, oftentimes the most valuable assets of the high-tech company are its employees. These are the people who understand the technology and make it work. These are the people who are going to push the company ahead with research and development. These are the people who understand how the source code actually works and who can make it work. Unfortunately, these are also the people who can transfer to another company in a “hot” market when the ship begins to founder.

a. Retention Bonuses.

The challenge in a high-tech case is to incentivize key employees to stay with the company during the workout or attempted reorganization. In a distressed environment, additional stock options are meaningless. The usual incentive for keeping employees is cash in the form of a bonus that is either paid up front, or earned over a period of time, or some combination of the foregoing.

A customary “paid-to-stay” plan would provide for a future right to receive cash payments. The right will accrue over some period of time, and the bonus will be paid, so long as the employee is still employed by the company at the end of the applicable period. Resignation by the employee or termination for cause will ordinarily disqualify the employee from receiving the bonus, but termination without cause (such as a result of further downsizing) should not result in the denial of the bonus, at least with respect to the period prior to termination of employment.

b. The WARN Act.

Another employment question presented in a troubled company situation is the applicability of the so-called WARN statute -- Worker Adjustment and Retraining Notification, 29 U.S.C. § 2101 et seq. WARN imposes certain notice requirements on “covered” employers who are going through reductions in force. This outline is not intended to be a comprehensive discussion of WARN, but a few issues are worth highlighting.

First, generally speaking, WARN does not apply to businesses that employ fewer than 100 full-time employees. Sec. 2101(a)(1). Part-time employees are not counted for most purposes under the statute. Part-time employees include employees who have worked at the company for less than six months before layoff. Sec. 2101(a)(8).

Second, WARN requires covered employers to provide 60 days written notice of a potential “plant closing” or “mass layoff” if such plant closing or mass layoff would result in a “employment loss” at a “single site of employment” (1) during any 30-day period for 50 or more full-time employees in the case of a plant closing, or (2) during any 30-day period for either at least 33% of the full-time employees and at least 50 full time employees or at least 500 full-time employees in the case of a mass layoff. Secs. 2101(a)(2) and (a)(3). Written notice (with appropriate specificity) must be given to each affected employee as well as any state dislocated worker unit and the chief elected official of the unit of local government within which the closing or layoff is to occur. Sec. 2102. With respect to plant closings, the employment loss does not have to involve the entire plant, so to speak. It can involve the permanent or temporary shutdown of one or more facilities within a single site of employment (such as where a “single site” is a series of geographically connected sites or buildings) or one or more operating units within the single site of employment (such as the elimination of a sub-group, line, or department). Sec. 2101(a)(2).

Third, the penalty for failing to provide written notice to affected employees within the 60-day period, or such shorter period as is permitted under certain limited exceptions (discussed below), is the obligation to pay “each aggrieved employee” who suffers an employment loss as a result of such closing or layoff back pay for each day of violation plus certain benefits under employee benefit plans such as medical expenses incurred during the employment loss which would have been covered under an employee benefit plan if the employment loss had not occurred. Sec. 2104(a)(1). The maximum liability is for 60 days, less any wages paid by the employer to the employee for the period of the violation, any voluntary and unconditional payment by the employer to the employee that is not required by any legal obligation, and any payment by the employer to a third party or trustee (such as premiums for health benefits or payments for defined contribution pension plan) on behalf of and attributable to the employee for the period of the violation. Secs. 2104(a)(1) and (a)(2). There is also a civil penalty of not more than $500 for each day of the violation payable to a unit of local government that should have received the WARN notice along with the employees. Sec. 2104(a)(3). An employer has a good faith defense if it has reasonable grounds to believe that its act or omission was not a violation of the Act. Sec. 2104(a)(4). There is also a prevailing party attorneys’ fees provision in the statute for persons who seek to enforce liability for noncompliance with the statute. Sec. 2104(a)(6).

Fourth, one the intricacies of the statute involves “rolling” counting periods that are designed to prevent an employer from doing a series of layoffs that are designed to avoid tripping the notification requirements. The rolling periods will also affect whether the employer has 100 or more full-time employees, depending upon when layoffs occur that put the employer below the 100 employee threshold. To this end, the statute has a series of embedded counting provisions. The definitions of the terms “plant closing” and “mass layoff” each contain a 30-day period for looking at the effects of layoffs at the single site of employment for purposes of a plant closing and aggregate layoffs at the single site of employment for purposes of determining a mass layoff. Secs. 2101(a)(2) and (a)(3). In addition, the statute also provides that, in determining whether a plant closing or mass layoff has occurred or will occur, employment losses for two or more groups at a single site of employment, each of which is less than the minimum number of employees as specified in the definitions, but which in the aggregate exceeds the minimum numbers, and which occur within in any 90-day period, shall be considered to be a plant closing or mass layoff unless the employer demonstrates that the employment losses are the result of separate and distinct actions and causes and are not an attempt by the employer to evade the requirements of the statute. Sec. 2102(d).

Fifth, if the business is sold, the seller is responsible for giving notice until the sale occurs, and thereafter, it is the buyer’s responsibility. Sec. 2101(b)(1). This can have the effect of shifting liability to the buyer, depending upon how and when the plant closing or mass layoff will occur in connection with the sale, so the buyer should insist upon the notice being given in advance of the sale. The same provision of the statute also provides that if employees are transferred from the buyer to the seller, there is not an “employment loss” for purposes of the statute. Id.

Sixth, there are two somewhat arcane “exceptions” that permit a shutdown with respect to a plant closing, or a plant closing or mass layoff, without compliance with the 60-day notice period. In the first instance, if the employer was actively seeking capital or business which, if obtained, would have enabled the employer to avoid or postpone the shutdown, and the employer reasonably and in good faith believed that giving the notice required would have precluded the employer from obtaining the needed capital or business, the employer may be permitted to give less than 60-days notice. Sec. 2102(b)(1). This exception would seem to require both active and ongoing efforts by the employer to locate new capital (which presumably means seeking new loans or an equity investment) or new business (which presumably means seeking new customers) to save the business and a reasonable belief that if the employer gave the notice, either the employees would begin to leave, thereby threatening the viability of the enterprise, or the potential source of capital or business would simply panic and terminate discussions. In the second instance, which is applicable to either a plant closings or a mass layoff, the employer must demonstrate that the plant closing or mass layoff was caused by business circumstances that were not reasonably foreseeable at the time the notice would have been required. Sec. 2102(b)(2)(A). In other words, the employer can provide less than 60-days notice if it did not see the problem coming within the 60-day period in which notice would otherwise have been required. This exception should not ordinarily apply to troubled companies. Financial unraveling is usually foreseeable. In re Riker Indus., Inc., 151 B.R. 823 (Bankr. N.D. Ohio 1993). Truly unforeseeable events would include a wildcat strike, the unexpected bankruptcy of a major customer or supplier, or the unexpected loss of a key contract. Layoffs due to natural disasters that negatively affects the business do not require notice. Sec. 2102(b)(2)(B). Even if an exception applies under Sections 2102(b)(1) or (b)(2), the employer must give as much notice as is practicable. Sec. 2102(b)(3).

Seventh, in determining whether and when to give the WARN notice to employees, counsel should be sensitive to the fact that if the layoff occurs postpetition, there may be an argument that the 60-day penalty for failure to give the notice constitutes an expense of administration under Bankruptcy Code section 507(a)(1). In re Hanlin Group, Inc., 176 B.R. 329 (Bankr. D.N.J. 1995). Therefore, good practice would suggest that layoffs should occur immediately before the filing of the bankruptcy case, rather than immediately after. In addition, at least two cases have held that a portion of the pre-bankruptcy liability for failure to provide the notice would qualify as a priority claim under Bankruptcy Code section 507(a)(3), as wages “earned” within 90 days of the commencement of the case, subject to the statutory cap. In re Riker Indus., Inc., 151 B.R. 823 (Bankr. N.D. Ohio 1993); and In re Cargo, Inc., 138 B.R. 923 (Bankr. N.D. Iowa 1992). As between $4,300 per employee as a priority claim or two (2) month’s wages as an expense of administration, the former is preferable to the latter if the debtor wants to minimize claims.

Eighth, in a recent case, In re Bluffton Casting Corp., 186 F. 3d 857 (7th Cir 1999), the Seventh Circuit held that the remedies (i.e. damages contained within the WARN Act) are the exclusive remedies (Sec. 2104) for violation of its provisions and that state law remedies, such as superpriority liens, are not available to employees to “securitize” what are otherwise unsecured WARN Act claims for sixty days of wages. In that case, terminated employees tried to bootstrap their sixty day wage claims into secured claims using Indiana’s wage lien statute. The Seventh Circuit did not permit the employees to enhance their WARN Act claims by making the claims secured claims under Indiana law. Even though Sec. 2105 provides WARN Act rights are in addition to, and not in lieu of state law rights, the Court declined to let the employees use the state lien law as a vehicle to obtain a lien where the WARN Act did not provide for a lien.

And lastly, the Regulations for WARN found in the Code of Federal Regulations 20 CFR § 639.1 et seq. are invaluable for parsing through intricacies of the WARN statute.

Financing High-Tech Companies

If a high-tech company resorts to the protection of Chapter 11 to effect a reorganization attempt, unique issues arise regarding the company’s post-petition cash requirements.

1. Cash Collateral and Post-petition Financing.

Use of cash collateral and approval of debtor in possession financing has become somewhat routine in Chapter 11 cases. Assuming a cooperative lender, the real issues concern adequate notice to creditors, observance of local guidelines that limit the so-called “lender incentives” (priming and replacement liens, superpriority claims, waiver of surcharge rights, etc.) that are customarily extracted by the lender as part of the price for consensual use of cash collateral or the advance of new funds, and negotiation of a budget that delineates approved disbursements of cash collateral or loan proceeds.

Problems will arise if the secured creditor or lender does not believe that the value of its collateral supports either use of cash collateral or new advances that will result in more debt.

Oftentimes the high-tech company, especially if it is a start up, will not have sufficient cash to meet its ongoing obligations (principally payroll, rent and critical supplies), even if it is granted use of cash collateral. In other words, the amount of readily collectable accounts receivable may be insufficient to run the company, even assuming timely collection. In these circumstances, postpetition advances from the prepetition lender will be critical to the debtor.

This is two-edged sword. On the one hand, if the secured creditor believes that it might throwing good money after bad, it might be unwilling to lend new money to the debtor; but on the other hand, if funding does not occur, the piecemeal liquidation of the lender’s collateral may result in a large deficiency.

In these circumstances, it is critical for the debtor’s professionals to convince the secured creditor that it must advance new funds on some basis to permit the enterprise to optimally maximize its chances for either a reorganization , a viable exit strategy, or an orderly liquidation. Whether the parties are trying to find new equity, a buyer, or generate a stand- alone reorganization, unless the debtor is able to meet its payroll obligations, the people assets will leave. Therefore, one of the critical aspects of the financing will be the inclusion of arrangements to either honor prepetition pay-to-stay bonus arrangements, or the development of a postpetition pay-to-stay bonus.

As with any early case dispute over lifting the stay or using cash collateral, the bankruptcy court will be inclined to side with the debtor, because lifting the stay or denying use of cash collateral will be the death-knell for the debtor. In re Shockley Forrest Indus., Inc., 5. B.R. 160 (Bankr. N.D. Ga. 1980). Because one of the prime purposes of reorganization is to facilitate the rehabilitation of the business, the case law in this area strongly supports giving the debtor the benefit of the doubt on issues such as asset values, adequate protection, and the necessity for use of cash collateral. See In re Heatron, Inc. 6 B.R. 493 (Bankr. W.D. Mo. 1980); and In re Prime, Inc., 15 B.R. 216 (Bankr. W.D. Mo. 1981). Of course, the debtor must be sure that it meets its burden of proof in its opposition to the lift stay motion or its request to use cash collateral by using competent and credible evidence to support its assertions. Merely reciting that it must use cash collateral or that use of cash collateral is necessary to avoid irreparable harm, without supporting evidence, will not be sufficient. See In re Robert E. Derecktor, Inc., 137 B.R. 95 (Bankr. D. R.I. 1992); and In re O.P. Held, Inc., 74 B.R. 777 (Bankr. N.D.N.Y. 1987).

Use of cash collateral and postpetition financing should always be pursued on a consensual basis. If the high-tech company is in denial or waits too long to retain crisis management or insolvency counsel, the debtor will be deprived of its most useful tools -- representation by professionals who understand the concerns of secured creditors and who can both address and play to their fears. There is nothing worse than contacting the secured creditor after the filing and asking for use of cash collateral and perhaps additional funding without any prior warning. The amount of time that it will take to prepare financial projections and budgets to the secured creditor’s satisfaction, is time that the debtor might not have. In addition, if the debtor has lost its key accounting and finance personnel, it might not be able to generate profit and loss statements and cashflows in a form that is acceptable to the secured creditor.

2. Valuation of Collateral.

Another important issue in the financing area will be the value of the secured creditor’s collateral. The tension will be between the secured creditor who will want to attach liquidation values to the debtor’s assets and unknown values to the intellectual property portfolio (such as patents, trademarks, and copyrights), and the debtor’s inclination to use going concern values that may reflect an intangible premium over a multiple of the presently deteriorating cash flow of the company.

Indeed, valuation of high-tech assets or high-tech companies can be tricky. The usual valuation problems are typically present: lack of comparables; absence of “normalized” revenues; deteriorating sales; and selection of appropriate methodology (multiple of earnings, discounted cash flow). In addition, the high-tech company is oftentimes a basket of intangible assets, partially developed products and failed products. Experts must be retained to value such esoteric assets as the overall value of patent portfolio or the value of proprietary software. In this regard, the strength of the company might hinge on such matters as the strength of patent claims, the scope of assignments and licensing, and royalty agreements. Valuations may be more complex since intellectual property assets may have more value to a party to be held as a defensive asset to be used in potential future litigation, rather than the value of the product to be used in a manufacturing concern.

Apart from the uncertainties involved in valuing intangible assets, case law suggests that valuations are done within the context of the particular proceeding. See Associates Commercial Corp v. Rash, 117 S. Ct. 1879 (1997) (fair market value or replacement value is appropriate where the purposes does not involve a liquidation). If the secured creditor has moved to lift the automatic stay, it will argue that liquidation values are appropriate, inasmuch as the creditor is asking for permission to liquidate its collateral. If, however, the context of the valuation is the debtor’s desire to use cash collateral, the debtor will focus upon going concern value, inasmuch as the purpose of using cash collateral is to continue the operation of the enterprise. Indeed, most businesses are valued as an integrated whole and not as separate items for liquidation. In re Kim, 130 F. 3d 833 (9th Cir. 1997) cert. denied 523 u.s. 1103. For good discussion of various valuation techniques, see In re Southmark Storage Associates, Ltd. Partnership, 130 B.R. 9 (Bankr. D. Conn. 1991); and In re American Kitchen Foods, Inc., 9 C.B.C. 537 (Bankr. D. Me. 1976). See also In re Sutton, 904 F2d 327 (5th Cir. 1990) (valuation done on case-by-case basis).

Confidentiality Issues, Tire-Kickers and Shopping a High-Tech Company

1. Asset Sales.

Because many high-tech companies are start-ups with little infrastructure and represent upside potential as opposed to balance sheet wealth, one of the common strategies employed in a turnaround or restructuring is to seek a buyer or investor who will acquire the people and the assets in a sale transaction.

If the professionals expect that the sale will be consummated in a bankruptcy proceeding or that the sale will be followed by a bankruptcy proceeding, it is important that the debtor be able to demonstrate that it took appropriate efforts to locate a buyer. This means that the company has to be “shopped” through an organized process by either using the resources and contacts of existing management and board members or the turnaround professionals, or engaging a business broker or investment banker.

As with any other kind of company, shopping a high-tech company will require the preparation of a confidential offering memorandum or some other sale document that explains the history of the company, its current financial condition and the upside potential for an acquirer. The debtor should also accumulate its financial information and key contracts and assemble those documents in a format that makes it easy for interested parties to review the information.

Before information is provided to the potential acquirer, the acquirer must enter into a confidentiality agreement with the debtor which provides that the information that will be given to the potential acquirer will be kept confidential and will not be used for any purpose other than evaluating a proposed transaction. The confidentiality agreement should also contain a provision that prohibits the potential acquirer from directly or indirectly soliciting the debtor’s employees for a specified period of time, usually one (1) year from the date of the agreement.

The company should also consider establishing certain benchmark criteria for the creditworthiness or financial wherewithal of potential buyers or investors before it provides information to everyone who is willing to sign a confidentiality agreement. Due diligence can be expensive and time consuming for a financially distressed company and oftentimes a competitor will sign the confidentiality agreement just to find out what information it can, without really being a serious contender for the assets. Sometimes information will be received and the informed potential buyer will wait for a distress sale or Chapter 7 sale to minimize the purchase costs.

If the debtor finds a buyer or investor, it is likely that the buyer or investor will insist upon consummating the transaction within the confines of a Chapter 11 case to obtain an order from the court that the sale is free of all liens and to provide for an orderly notice of the terms of the sale. The sale can be accomplished fairly quickly under Bankruptcy Code sections 363(b) and (f). These provisions permit a sale of substantially all of the assets of the debtor, outside the ordinary course of business, free and clear of liens, claims, and interests, so long as there is a legitimate business justification for the sale. See In re Lionel Corp., 722 F.2d 1063 (2nd Cir. 1983). The Lionel case has been widely followed and is well-established as the law in almost every jurisdiction.

Alternatively, the transaction may be effected through a prenegotiated or prepackaged plan of reorganization.

Sales outside of a plan are a quicker, less expensive, and objections can be overruled by the bankruptcy court at the sale hearing. In contrast, confirmation of a sale under a plan takes longer due to both statutory time periods and the need to coordinate with the various creditor constituencies, is ordinarily more expensive because of the documentation involved, and is subject to either creditor acceptance by class or cramdown. Nonetheless, there might be certain advantages to using a plan of reorganization: For example, there are certain securities law exemptions applicable to equity securities issued by the debtor under a plan, and a plan may be used to compromise claims or bind dissident creditors.

2. Bidding Protection.

Most buyers will request some form of “bidding protection” from the debtor because any unconsummated agreement for the sale of the debtor’s assets is not enforceable against the debtor until such time the bankruptcy court approves the transaction. Because the debtor is required to obtain the highest and best price for the assets, competitive bidding is possible and often required. The first bidder in the case will generally spend significant sums of money in due diligence costs and legal fees. The lead buyer will not want to act as a “stalking horse” for other bidders who can piggy-back on the lead buyer’s due diligence and simply bid up the price and win the assets.

Bidding protections ordinarily include a minimum upset price or minimum overbid that will require competing bidders to bid a predetermined amount in excess of the lead bidder’s offer, provisions for reimbursement of reasonable attorneys’ fees and costs in the event the lead bidder is out bid, and “break-up” or “topping” fees. Generally speaking, a break-up fee is payable if the debtor breaches the terms and conditions of the contract and the transaction does not close; and a topping fee is payable in the event the lead bidder is out bid by a third party. The former can be viewed as liquidated damages, and the debtor should negotiate hard a break-up fee that is styled as liquidated damages. Buyers routinely ask for fees that range from one percent to seven percent of the sale price. Indeed, the fees can get quite high, and the higher the fee, the more difficult it is for competing bidders to enter the fray. Any minimum overbid should be calculated to cover the cost of the topping fee that must be paid.

The lead bidder will often condition it willingness to move ahead with the transaction upon the bankruptcy court’s preapproval of the bidding procedures, including the break-up and topping fees, in order to know, ahead of time, whether it has its “remedies” in place if the debtor breaches the sale agreement or it is overbid by a third party. The remedies are ineffective without bankruptcy court approval, and if approved, will constitute an expense of administration in the case. A prudent buyer will not want the uncertainty of not knowing whether it will be compensated if the events occur that should trigger its right to payment of the fees. Most buyers do not want to continue with due diligence and other expense items in the dark, only to find out at the sale hearing whether the break-up and topping fee protections will be approved. Early disapproval enables the lead bidder to decide whether it wants to continue to incur expense for which it will not be compensated. Experience shows that most buyers do not “walk away” if the fees are denied or adjusted by the court. Nonetheless, buyers routinely demand expedited court approval of the foregoing protections, well in advance of the actual sale hearing.

There are two lines of cases that discuss the propriety of break-up fees and topping fees. The first line of cases follows the approach taken in In re Integrated Resources, Inc., 147 B.R. 650 (S.D.N.Y. 1992). That case views the debtor’s business judgment as the guiding factor. Of course, the debtor’s business judgment is circumscribed by certain parameters that must be followed. For example, the court will examine whether the relationship of the parties that negotiated the break-up fee was tainted by self dealing or manipulation; whether the fee would hamper, rather than encourage, bidding; and whether the amount of the fee is unreasonable relative to the proposed purchase price. Under the rule established in Integrated Resources, the bankruptcy court should approve the break-up fee if it is not excessive in amount and was not tainted by self-dealing and was the product of arms-length negotiations.

The second approach in analyzing break-up fees is illustrated by the bankruptcy court’s decision In re America West Airlines, Inc., 166 B.R. 908 (Bankr. D. Ariz 1994). In that case, the bankruptcy court concluded that the standard is not whether the break-up fee is within the business judgment of the debtor, but instead, whether the transaction will “further the diverse interests of the debtor, creditors and equity security holders alike.” 166 B.R. at 912. Therefore, the bankruptcy court held that it had an independent responsibility to determine if the break-up fee made economic sense for all concerned parties. Large break up fees that could chill the bidding or overcompensate lead bidders, who presumably factor their anticipated attorneys’ fees into their initial offer, are often whittled down by courts and creditors’ committees.

There is some current controversy over the propriety of break-up fees and topping fees in bankruptcy cases. The emerging trend seems to limit break-up fees and topping fees to reimbursing the lead bidder for its reasonable out of pocket attorneys’ fees and costs in the event the debtor breaches the sale agreement or the lead bidder is out bid by another party. Some courts will not approve payment of a break-up fee if the sale transaction itself is independently disapproved by the bankruptcy court, or if the lead buyer simply decides not to move ahead with the sale. Many courts are considering adopting local guidelines for bidding procedures and break-up fees, similar to the local guidelines that control cash collateral stipulations and debtor in possession financing agreements.

Conclusion

As is plain to see, reorganizing a high-tech company presents several challenging issues to reorganization professionals. A turnaround manager familiar with the special issues raised in connection with a high-tech work-out will have the ability to address the pertinent issues early on to give the company a fighting chance at reorganization or a viable exit strategy.

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Top Ten List

Program - USC, 20th Annual Institute for Corporate Counsel

March 7, 2001

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