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Business Bankruptcy Issues Recent Developments

The “Ride Through” Doctrine Rides Again: Ninth Circuit BAP Lets A License Agreement Ride Through Chapter 11

In a June 18, 2007 decision in In re J.Z. L.L.C. (available here), the Bankruptcy Appellate Panel (BAP) of the U.S. Court of Appeals for the Ninth Circuit faced an interesting question: Did the so-called "ride through" doctrine from the old Bankruptcy Act of 1898 survive enactment of the Bankruptcy Code in 1978? The BAP’s introduction to the decision sums up its answer:

We confront the puzzle of the status of an executory contract that was neither assumed nor rejected during a chapter 11 case in which there was a confirmed plan that did not involve transfers of property of the estate or creation of new entities. We conclude that the “ride through” doctrine developed under the former Bankruptcy Act retains vitality in chapter 11 cases when the debtor continues operating and does not change form.

After a chapter 11 case was closed, the reorganized debtor sued in state court to enforce a license that it had granted prepetition regarding the use of its manufacturing technology. The state court declined to act without a bankruptcy court ruling that the license, which had been neither assumed nor rejected during the chapter 11 case, remained in effect. The bankruptcy court ruled that the license contract survives under the “ride through” doctrine, that the debtor has standing to enforce the contract because all property of the estate vested in the debtor on confirmation, and that the reorganized debtor should not be judicially estopped. We AFFIRM.

Executory Contracts And Bankruptcy. I have previously discussed the importance of executory contracts in bankruptcy, and specifically how licenses of intellectual property are treated. Both of those posts were premised on the bankruptcy court being asked to decide whether an intellectual property license could be assumed, assumed and assigned, or rejected during the bankruptcy. This case, however, presented a very different situation in which the Chapter 11 debtor did not take any action during the Chapter 11 case to assume or reject the executory contract (here a license agreement permitting the non-debtor party to manufacture, promote, and sell a horizontal grinder on an exclusive basis for five years). In addition, although aware of the bankruptcy case, the non-debtor party to the contract also did not seek to force a decision on assumption or rejection pursuant to Section 365(d)(2).

The BAP’s Reasoning. The BAP’s 28-page decision carefully analyzes the issues raised in the case and makes a number of interesting conclusions.

  • First, not only did the debtor neither assume nor reject the license agreement, it also failed to list it on its bankruptcy schedules (specifically Schedule G). Nevertheless, the BAP held that the non-debtor licensee’s failure to disclose it to the Bankruptcy Court or creditors left it "in the grandstand and not on the playing field" on its argument that the debtor should lose the right to enforce the agreement.
  • Second, even though the license agreement was unscheduled, once the debtor’s Chapter 11 plan was confirmed, all property of the estate — including this unscheduled asset — revested in the reorganized debtor under Section 1141(b) of the Bankruptcy Code.
  • Third, while judicial estoppel can sometimes apply to limit the debtor’s ability to sue on an unscheduled asset,  the BAP decided against applying judicial estoppel here, noting that when creditors could be harmed by such limits one "should not become so angry at a debtor that a creditor is taken out and shot." The BAP did acknowledge that the state court hearing the debtor’s lawsuit against the licensee could reach a different conclusion.
  • Fourth, under the language and structure of the Bankruptcy Code, an "executory contract that is not assumed in a chapter 11 case is not ‘deemed rejected.’ As a matter of straightforward statutory construction, it follows that some other alternative, i.e., ‘ride through,’ must be available."
  • Fifth, the "ride through" or "pass through" doctrine was well established under the Bankruptcy Act of 1898 and nothing in the Bankruptcy Code of 1978 requires a conclusion that Congress intended to disturb that existing doctrine. In addition, the lack of clarity over which contracts are executory and which are non-executory (and thus not subject to assumption or rejection) bolsters the view that a "ride through" alternative exists for contracts.

For more background on the Bankruptcy Court’s decision below (available here), affirmed by the BAP, be sure to read Warren Agin’s December 2006 post on his Tech Bankruptcy Blog, which gives his always insightful perspective on these IP and bankruptcy issues. 

Significance Of A BAP Decision. It’s worth noting that unlike a U.S. Court of Appeals, the BAP is made up of bankruptcy judges only, not federal circuit judges. Given a BAP’s place in the judicial system’s hierarchy, its decisions are not given the same precedential weigh as U.S. Court of Appeals decisions. This means that it’s possible that the U.S. Court of Appeals for the Ninth Circuit could reach a different, and overruling, conclusion. However, the BAP’s decision in this case is well-reasoned and three other circuits (the First, Second, and Fifth) have also ruled that the ride through doctrine still applies today. This makes the BAP’s decision of special interest.

A Strategic Use Of The "Ride Through" Doctrine? As discussed in an earlier post on assumption of IP licenses, in several circuits a debtor cannot even assume many in-licenses of intellectual property without the licensor’s consent.

  • In those circuits, a debtor may consider whether it could retain licenses simply by choosing to have them "ride through" the Chapter 11 case, neither moving to assume the license nor (the debtor hopes) having the licensors move to compel rejection. This scenario makes the old "ride through" doctrine of particular interest, especially if the debtor licensee has not defaulted under the agreement and is seeking only to keep the license agreement after reorganizing in Chapter 11.
  • While it’s true that the occasional executory contract may slip through without a formal decision to assume or reject, it’s the prospect of a debtor being able to use the doctrine as alternative way of preserving valuable intellectual property licenses that has bankruptcy lawyers giving the "ride through" doctrine a closer look.

Stay tuned, but the BAP’s decision in In re JZ L.L.C. may encourage more such efforts in the future.

Business Bankruptcy Issues Recent Developments

Florida Bankruptcy Court Considers The Supreme Court’s Travelers Decision And Refuses To Allow Post-Petition Attorney’s Fees To An Unsecured Creditor

In March 2007, the U.S. Supreme Court overruled the so-called Fobian rule in the Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. decision. (Click here for a copy of the decision.) That rule, named for the decision by the United States Court of Appeals for the Ninth Circuit in a case called In re Fobian, 951 F.2d 1149 (9th Cir. 1991), had barred unsecured creditors from recovering as part of their unsecured claim attorney’s fees incurred post-petition litigating bankruptcy issues. 

The Open Question. As discussed in an earlier post, although the Supreme Court dispatched the Fobian rule, in Travelers it did not decide whether an unsecured creditor could actually recover its attorney’s fees. Among other issues, it left for another day the issue of whether Section 506(b) of the Bankruptcy Code, which expressly allows attorney’s fees to oversecured creditors, precludes recovery of post-petition attorney’s fees as part of an unsecured claim.

A New Decision From Florida. Jordan Bublick has an interesting post on his Miami Florida Bankruptcy Law blog about a July 6, 2007 decision in the In re Electric Machinery Enterprises, Inc. Chapter 11 case. In the decision, the court held that an unsecured creditor is not permitted to add post-petition attorney’s fees and costs to its unsecured claim. A copy of the decision, by Judge Michael G. Williamson of the the U.S. Bankruptcy Court for the Middle District of Florida, is available here. As Jordan points out, the Florida bankruptcy court held that the pre-Travelers majority rule denying unsecured creditors post-petition attorney’s fees was still good law. Among the reasons the court cited:

  • Section 506(b)’s language permits only oversecured creditors to receive interest and fees, and this effectively excludes recovery by unsecured creditors.
  • The reasoning of the Supreme Court’s decision in United Savings Ass’n v. Timbers, 484 U.S. 365 (1988), that post-petition interest can only be paid to secured creditors with the benefit of an equity cushion, applies to attorney’s fees as well.
  • Section 502(b) requires the amount of a claim to be determined "as of the date of the filing of the petition," before post-petition fees have accrued.
  • Allowing fees to contract creditors would be inequitable because tort and many trade creditors, who lack the ability to recover attorney’s fees, would have their relative recovery diminished.

Judge Williamson called out another reason for his decision:

Furthermore, the Court is particularly mindful of the practical impact a contrary ruling would have on the administration of a bankruptcy case. There would be no finality to the claims process as bankruptcy courts would constantly have to revisit the issue of the amount of claims to include ever-accruing attorneys’ fees. The ‘cash registers’ would ring on a daily basis, as attorneys for unsecured creditors that were active in the case would continually be filing new claims or seeking to reconsider previously allowed claims in order to add post-petition attorneys’ fees and costs. Essentially, there could be no finality to the claims resolution process if the ever-accruing fees and costs attendant to the representation of unsecured creditors were allowed as part of an unsecured claim.

An Earlier California Bankruptcy Court Decision. Interestingly, the Florida bankruptcy court did not cite to the In re Qmect, Inc. decision, issued by the U.S. Bankruptcy Court for the Northern District of California in May 2007 and discussed in this earlier post. In that decision, the California bankruptcy court took the opposite view. It held that an unsecured creditor could recover, as part of its unsecured claim, post-petition attorney’s fees if its contract with the debtor provided for recovery of such fees. Adopting a different view of the bankruptcy policies at issue, that court held:

The strongest rationale for implying a prohibition on the inclusion of post-petition attorneys’ fees in a unsecured creditor’s pre-petition claim is that, unless the debtor is solvent, the unsecured creditor’s augmented claim will diminish the dividend to other unsecured creditors. However, a similar effect flows from allowing secured creditors to include their post-petition attorneys’ fees in their secured claims. While equality of distribution is one of the basic tenets of bankruptcy law, another important policy in bankruptcy is the preservation of nonbankruptcy legal rights except to the extent necessary to facilitate the purpose of the bankruptcy proceeding. Absent a clear provision of the Bankruptcy Code modifying a creditor’s nonbankruptcy legal rights, the Court concludes that those rights should be deemed to be left intact.

More Decisions To Follow. Bankruptcy courts are now beginning to address whether unsecured creditors can recover post-petition attorney’s fees in the wake of the Travelers decision. These two early decisions have reached completely different conclusions. More decisions will undoubtedly follow as creditors with attorney’s fees provisions in their contracts seek to include post-petition fees in their unsecured claims. With the issue far from settled, be sure to stay tuned.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Signs Of A Turn In The Private Equity Buyout Market?

Last week saw what may prove to be early signs of a turn in the robust market for the debt that finances private equity buyouts. In just a week’s time, The New York Times reported on a possible cooldown in the buyout market, and the Financial Times published a commentary on signs of a possible "bondholder revolt" against issuer-favorable debt terms (including low debt coverage ratios mentioned in an earlier post) that have prevailed for the past several years. In addition, the DealBook Blog‘s post entitled "Buyout Boom Could Slow As Investors Push Back" discussed how several buyout debt offerings were recently curtailed or modified, a first in this previously strong debt market.

Then, in a separate but interesting move, the former co-head of investment banking at UBS, Jeff McDermott, left last week to start a new private equity firm, Stony Lane Partners. Stony Lane’s focus? Buying and turning around distressed businesses. When asked by the Financial News why he’s making the move, McDermott answered:

I think a credit crunch will play out over time, and it will be like a slow rolling wave. It’s won’t be a one-day cataclysmic event. I think there will be double leverage in the system. I think CDOs are buying margin leverage and are buying corporate credits, which are priced like there’s no end to economic growth in the future. Of course, there are economic cycles.

If he’s right, a rise in defaults, restructurings, and Chapter 11 bankruptcy filings may be coming down the road.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Case Addresses Whether A Security Interest In A Patent Can Be Perfected With Just A PTO Filing

When a debtor grants a security interest in a patent issued by the U.S. Patent and Trademark Office (PTO), the creditor must take steps to perfect that security interest. Given that the PTO issues patents but the Uniform Commercial Code (UCC) generally governs perfection of security interests, creditors have often filed both a UCC-1 financing statement and made a filing in the PTO to cover all the bases.

Perfection By UCC Filing. In 2001, the Ninth Circuit held that a creditor who filed a UCC-1 financing statement properly perfected a security interest in a patent even if it did not also make a filing with the PTO. The decision in the In re Cybernetic Services, Inc. case, officially Moldo v. Matsco, Inc., 252 F.3d 1039 (9th Cir. 2001), rested on the Ninth Circuit’s determination that the federal Patent Act does not cover liens on patents and does not preempt the UCC with respect to perfection of security interests. This seemed to settle the question of whether a UCC filing alone was enough to perfect a security interest in a patent, at least in the Ninth Circuit.

Does A PTO Filing Alone Perfect? Judge William C. Hillman of the U.S. Bankruptcy Court for the District of Massachusetts faced the opposite question in the In re Coldwave Systems, LLC case. There the creditor sought to rely on a PTO filing alone to perfect its security interest in a patent because the Bankruptcy Court avoided as a preference a tardy UCC filing made long after the security interest was granted but within 90 days of the bankruptcy petition. The creditor’s much earlier PTO filing of a Recordation Form Cover Sheet, recording the conveyance of the security agreement between the debtor and the creditor, was not subject to avoidance as a preference. The creditor argued that the PTO filing was sufficient to perfect its security interest, even in the absence of a UCC filing.

UCC Perfection Or Bust. In his 14-page decision issued on May 15, 2007, Judge Hillman held that the PTO filing was insufficient to perfect the creditor’s security interest because the Patent Act (specifically Section 261 of Title 35), did not create a system for the perfection of security interests in patents. After first concluding that "[t]he Federal statute does not protect holders of security interests," Judge Hillman held as follows:

There is nothing in §261 that addresses in any way the conflict between one who is not a holder of an interest by way of assignment, grant, or conveyance and a bankruptcy trustee. We must look to other law for the answer. 

That other law was the UCC. Holding that a patent is a general intangible, the Court ruled that nothing in the UCC excepts general intangibles from the rule requiring perfection by a UCC filing. Since no valid UCC filing perfected the creditor’s security interest, it was unperfected and the Chapter 7 trustee prevailed.

The Bottom Line. The Coldwave Systems decision is consistent with the Ninth Circuit’s earlier Cybernetic Services ruling. Together they teach creditors that the only way to perfect a security interest in a patent is by an unavoidable and proper UCC filing. Any creditor relying on a PTO filing alone will end up unperfected and unsecured. While there may be other reasons for a creditor to make a PTO filing, such as potentially protecting against an improper assignment of the patent, perfection of a security interest is not one of them.

Want More? For more on the Coldwave Systems and Cybernetic Services decisions, be sure to read Warren Agin’s excellent post on the Tech Bankruptcy blog, entitled "An Expert Builds On Cybernetic Services." Warren also gets special thanks for first posting on Judge Hillman’s interesting decision.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Third Circuit Holds Contemporaneous Exchange Defense To Preference Claim Is Available Even For Credit Transactions

On June 7, 2007, the U.S. Court of Appeals for the Third Circuit issued a decision in the In re Hechinger Investment Company case holding that the "contemporaneous exchange for new value" defense to preference claims can apply even if the payments were made in the context of a credit arrangement. The key is whether the parties intended the payments involved to be contemporaneous exchanges for new value, the linchpin of this particular preference defense. A copy of the Third Circuit’s decision is available here.

Bankruptcy Preferences. As a reminder, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

The Contemporaneous Exchange Defense. This defense, found in Section 547(c)(1) of the Bankruptcy Code, is short and to the point:

(c) The trustee may not avoid under this section a transfer–

(1) to the extent that such transfer was–

(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

In interpreting this language, the Bankruptcy Court held that a "credit relationship is inconsistent with the intent required in order to sustain" the defense. Essentially, under its view the defense would presumably be limited to situations in which no credit was allowed to remain outstanding but instead a C.O.D. purchase or other similarly immediate "goods for cash" swap was involved.

The Third Circuit’s Focus On Intent. The Third Circuit reversed the Bankruptcy Court’s ruling, explaining its reasoning as follows:

The Bankruptcy Court found that the disputed transfers were not intended by the parties to be contemporaneous exchanges because the transfers were credit transactions. In reaching this result, the Court relied upon several factually distinguishable cases, none of which stand for the proposition that parties can never intend credit transactions to be contemporaneous exchanges under § 547(c)(1)(A). We disagree with the Bankruptcy Court’s conclusion. Indeed, it would appear that § 547(c)(1) covers little other than credit transactions. The § 547(c)(1) defense applies only to transfers that the debtor has shown are payments on an “antecedent debt” under § 547(b). See 11 U.S.C. § 547(b)(2) (definition of avoidable transfers). If there is no delay between when the debt arises and payment of the obligation, then the transfer is outside the scope of § 547(b), and § 547(c)(1) is not implicated. The existence of a delay between the creation of a debt and its payment is a hallmark of a credit relationship, which is, by definition, a relationship in which the creditor entrusts the debtor with goods without present payment. OXFORD ENGLISH DICTIONARY (2d ed. 1989) (defining “credit” as “[t]rust or confidence in a buyer’s ability and intention to pay at some future time, exhibited by entrusting him with goods, etc. without present payment.”).

We do not think that the District Court’s interpretation of the Bankruptcy Court’s order – namely, as concluding that the parties intended to have a credit relationship – necessarily resolves the question. The inquiry still remains: even if a credit relationship was intended, was it nonetheless their intent that the ongoing payments would be contemporaneous exchanges for new value? A court may find the parties intended a contemporaneous exchange for new value even when the transaction is styled as a “credit” transaction. See In re Payless Cashways, Inc., 306 B.R. 243 (8th Cir. BAP 2004), aff’d, 394 F.3d 1082 (8th Cir. 2005). The question is one of intent, and although a delay between the incurrence of the debt and its payment can evidence that the exchange was not intended to be contemporaneous, the passage of time does not necessarily negate intent.

(Footnotes omitted.)

The Bottom Line. Under this decision, a contemporaneous exchange defense to a preference is available even if the defendant has extended credit to the debtor. Nevertheless, to prevail the defendant will have to prove that it and the debtor actually intended the payments to be contemporaneous exchanges for new value and they were, in fact, substantially contemporaneous with the exchange of goods or services.

A Final Note. The Third Circuit decision covered other issues as well, including the ordinary course of business defense and whether prejudgment interest is available for preference claims. For more on those issues, plus a copy of the Bankruptcy Court’s decision below, be sure to read the detailed post on the case by the Delaware Business Bankruptcy Report.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Who Gets The Benefit Of A D&O Policy’s Proceeds, The Directors And Officers Or A Bankruptcy Trustee?

On June 8, 2007, Delaware Bankruptcy Judge Kevin Gross issued a decision in the World Health Alternatives, Inc. bankruptcy case that corporate directors, officers, attorneys, and bankruptcy professionals alike will find of interest. A copy of the Court’s 13-page decision and short order is available here.

The Three-Sided D&O Policy. The issue in the case was whether a Chapter 7 bankruptcy trustee could get an injunction to prevent directors and officers from using the proceeds of a Director and Officer (D&O) liability policy to settle a shareholder lawsuit pending in another court (known as the Consolidated Action). The underlying question centered on who owns the proceeds of a D&O policy when the policy provides:

  • Side A coverage for directors and officers;
  • Side B coverage for the corporation’s expenses in indemnifying directors and officers; and
  • Side C coverage for the corporation’s own exposure for securities litigation claims.  

As is true with many D&O policies, the policy involved in this case also had a "Priority of Payments" endorsement that gave payments under the Side A coverage for the directors and officers priority over both the Side B and Side C coverages.

Does The Automatic Stay Stop Use Of A D&O Policy’s Proceeds? The Chapter 7 trustee sought to block the use of the D&O policy’s limited proceeds to settle the shareholder lawsuit, arguing that they were property of the bankruptcy estate and that the effort to use them to settle this Consolidated Action violated the automatic stay of bankruptcy.  The Chapter 7 trustee had his own lawsuit pending against the directors and officers and he wanted to keep the "wasting" D&O policy (called "wasting" because the policy proceeds also had to cover defense costs) available to cover his claims. The debtor corporation had been dismissed from the shareholder litigation so no Side C coverage was implicated, and because no indemnification had been or was likely to be paid, the Side B coverage had not been triggered.

In denying the Chapter 7 trustee an injunction, the Delaware Bankruptcy Court held that although the policy was property of the bankruptcy estate since the debtor corporation had purchased it, the policy’s proceeds were not. Although acknowledging that some other courts had ruled differently, Judge Gross followed an earlier Delaware Bankruptcy Court decision in In re Allied Digital Technologies Corp., 306 B.R. 505 (Bankr. D.Del. 2004), and held as follows:

Applying the rulings in the cases cited above to the case at hand, it appears that the proceeds of the Debtor’s insurance policy are not property of the estate. The Court arrives at this conclusion from its review of the ‘language and scope of the [P]olicy at issue.’ Allied Digital, 306 B.R. at 509. The Policy proceeds which are being used to fund the Settlement and are being held in escrow by Lead Counsel are from the Policy’s Coverage A. World Health, and now the Trustee as successor, has no right to any Coverage A proceeds, which insures only World Health’s officers and directors. World Health must look to Coverage B which insures it for indemnification claims. There are no such claims against World Health. If the Trustee is seeking to recover for the wrongs of the defendants in the Trustee’s Action pending in this Court, it is not entitled to preference over the settlement of the Consolidated Action. As the Court held in Allied Digital:

The Trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from The D&O Policy rather than as a potential defendant seeking to be protected by the D&O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.

Id. at 512.

Judge Gross ruled that the automatic stay did not apply to the policy proceeds at issue and, as a result, the Chapter 7 trustee was not entitled to an injunction to stop them from being used to settle the other litigation. 

The Take-Aways. When D&O policy proceeds are being used by insured directors and officers to fund a defense or settlement of a covered claim, a bankruptcy trustee generally will not be able to interfere if none of the other coverages — specifically the Side B and C coverages — has been invoked.

  • If claims have been made against the Side B or Side C coverages, the outcome could very well be different.
  • A Priority of Payments endorsement, which gives priority to the Side A coverage for directors and officers, is one tool to consider to help ensure that the D&O policy is available for directors and officers first. However, the law is not clear whether that endorsement would trump the automatic stay if the other coverages were invoked.
  • These issues are complicated and those with a stake in these questions should be sure to get legal advice on both the bankruptcy and insurance coverage issues involved.

For more discussion of the decision and the insurance issues raised, be sure to read Kevin M. LaCroix’s excellent post at The D&O Diary. Special thanks to Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog for highlighting Kevin’s post.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Article Examines What Might Happen To Private Equity Buyouts In A Downturn

The Globe And Mail has a story on its Report On Business.com site entitled "Private equity’s high-wire act: Can leveraged buyout artists build firm foundations on soft money?" The article discusses the current low default rate on the debt that has been financing private equity buyouts and considers who will get hurt when the default rate rises.

The article makes a number of interesting observations about the risks in the current buyout market, including the following:

  • Banks hold a smaller percentage of leveraged debt, having sold off debt to hedge funds and others though pooling vehicles such as collateralized loan obligations, known as CLOs.
  • This trend has put some banks in something of a loan broker role, making the initial acquisition loan but later selling the position.
  • The free cash flow to interest expense ratios are now in the 1.7 range, a noticeable reduction from the 2.6 average three years ago.
  • Toggle bonds, which allow borrowers to issue new bonds, often at higher rates, to finance interest costs on the existing bonds, have become more common.

The article concludes with a discussion of what might bring this private equity cycle to an end, a question on many people’s minds these days. For more on this issue, you may find interesting three past posts on the general subject, available here, here, and here.