Business Bankruptcy Issues

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Business Bankruptcy Issues

Selling A Bankruptcy Claim: Opportunity And Risk

At one time or another just about every creditor in a large corporate Chapter 11 bankruptcy case will receive an offer to purchase the creditor’s claim.  These offers typically come from professional claims traders, most of which are in the business of buying claims at a discount to what they believe will be the claims’ ultimate value.  Some claims buyers, including hedge funds and other distressed debt investors, may buy claims with the strategic objective of controlling the direction of the Chapter 11 case by owing a substantial percentage of one or more classes of creditors. 

How do claims buyers find out about your claim? Within the first few weeks after a bankruptcy is filed, the debtor must file schedules of its assets and liabilities.  Creditors holding secured claims are listed on Schedule D and those with unsecured claims are listed on Schedule F.  These schedules show the amount the debtor believes it owes each creditor and whether it thinks the claim is disputed, contingent, or unliquidated.  Claims buyers will often first contact creditors with claims listed as being undisputed, not contingent, and liquidated because those claims are less likely to be subject to litigation later in the bankruptcy case. 

If you express interest in selling your claim, you may be sent a "confirmation" document with key terms such the percentage on the dollar to be paid and the amount of the claim to be purchased.  The actual document that transfers the claim, however, is usually a separate "claim assignment agreement."  You should carefully review all of the documentation, including the claim assignment agreement, before committing to sell your claim.

Selling a claim can sometimes be beneficial, but there are also risks.  When evaluating whether to sell your claim, here are some of the key points to keep in mind:

  • Liquidity.  The main advantage of selling your claim is getting some cash for it now.  Although creditors often believe that selling their claim will also eliminate any further risk of loss, for the reasons discussed below claim assignment agreements usually keep you at risk even after you sell your claim.  If you’re willing to accept those risks, you can get immediate liquidity by selling your claim instead of having to wait months or years to receive whatever payment — which sometimes is in the form of stock or debt instead of cash — the bankruptcy estate ultimately distributes.
  • Price.  Given the claims buyer’s usual objective of buying at a discount, coupled with the time value of money, the price you are offered could end up being lower than the value you could recover if you held your claim and waited for distributions to be made later in the case. The price offered for claims can also rise or fall over time as more information about creditors’ likely recovery becomes available.  
  • Read the fine print.  Occasionally, claims buyers add detailed provisions and representations to the claim assignment agreement that operate to give the buyer an option to "put" or sell all, or the disputed part, of the claim back to you upon the mere filing of an objection or other challenge to the claim — even if the objection is ultimately defeated. Why? Well, if the price paid for your claim later turns out to have been too high, the claims buyer might use the filing of a claim challenge to get its money back, plus interest. Since commonplace events such as claim objections and preference actions may be classified as triggering "challenges," it’s important to watch out for these provisions.
  • Defending the claim.  Often the claims buyer will put a provision in the claim assignment agreement requiring you to defend the claim against any objection at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed.  If a portion of your claim is disputed, however, you may well want the right to defend the claim so you can keep what you’ve been paid. Either way, you may incur costs in the bankruptcy case after you sell your claim.
  • Setoff or other special claims.  Claim assignment agreements may also include provisions limiting your right to assert a setoff or recoupment against the debtor (concepts discussed in an earlier post) or requiring you to pay back all or a portion of the purchase price if you do.  If you have significant setoff rights, be careful to preserve those rights if you sell your claim. Likewise, if you have an administrative claim or reclamation claim (which could be paid at 100 cents on the dollar), be sure it’s clear how those valuable rights will be treated.
  • Creditors’ committee.  If you’re serving on the official committee of unsecured creditors in a Chapter 11 case, you should get legal advice on whether, or under what conditions, you may sell your claim.  You likely will have received confidential information about the debtor while on the creditors’ committee, and this could restrict your ability to sell your claim.  Generally, you will also have to resign from the committee if you sell your claim.  
  • Court-ordered restrictions.  In some cases, bankruptcy courts may restrict creditors — especially those with very large claims — from selling their claims.  This is done to preserve the tax benefits of a debtor’s net operating losses or NOLs, which can be lost if ownership of a large amount of claims or equity interests changes.  As this example shows, these orders can be very complicated and you may want to consult with a bankruptcy attorney to determine whether any restrictions apply to you.

If you sell your claim, you will often be required to sign an additional document with a name such as "Evidence of Transfer of Claim," which does not mention the price paid and which will be filed with the bankruptcy court.  Thereafter, you may receive a notice from the bankruptcy court that the claims buyer has filed the Evidence of Transfer of Claim document and giving you 20 days to object to the transfer.  This notice is designed to prevent unscrupulous individuals from fraudulently assigning claims to themselves and is only a formality in a legitimate claims sale.

Claims buyers can provide creditors with a ready market for their claims, generating liquidity months or years before creditors otherwise would receive a distribution from the bankruptcy estate.  Selling a claim is not risk free, however, so be sure to consult with a bankruptcy attorney for specific advice on how best to protect your rights if you do choose to sell.

Business Bankruptcy Issues

Intellectual Property Licenses: What Happens In Bankruptcy?

The major role intellectual property, or "IP," plays in our economy makes intellectual property licenses an especially significant type of executory contract.  Whether you are a licensor or licensee, it’s important to know what can happen to IP licenses when a bankruptcy is filed.

Licensor in bankruptcy.  A licensor in bankruptcy (or its bankruptcy trustee) has the option of assuming or rejecting a license. Generally, a debtor licensor can assume a license if it meets the same tests (cures defaults and provides adequate assurance of future performance) required to assume other executory contracts.  Many licensees will not have a problem with assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is the fear of losing their rights to the licensed IP, which often can be mission critical technology, if the license is rejected.

  • Special protections. Recognizing this concern, the Bankruptcy Code, in Section 365(n), provides licensees with special protections.  If the debtor or trustee rejects a license, under Section 365(n) a licensee can elect to retain its rights to the licensed intellectual property, including even a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payments. The licensee also can retain rights under any agreement supplementary to the license, which includes source code or other forms of technology escrow agreements.  Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • Watch out for trademarks. While many people would expect intellectual property to include trademarks, the Bankruptcy Code has its own limited definition of "intellectual property." The bankruptcy definition includes trade secrets, patents and patent applications, copyrights, and mask works.  Importantly, however, it does not include trademarks. This distinction means that trademark licensees enjoy none of Section 365(n)’s special protections and those licensees are at risk of losing their trademark rights in a bankruptcy.

Licensee in bankruptcy.  The law is different when an IP licensee files bankruptcy.  The Bankruptcy Code, in Section 365(c)(1), contains an exception to the general rule that executory contracts can be assumed and assigned to third parties if defaults are cured and adequate assurance of future performance is demonstrated. The exception kicks in when "applicable law" precludes such an assignment absent consent of the nondebtor party. 

  • Restrictions on assignment. Case law from several United States Courts of Appeals holds that "applicable law" — here patent and copyright law (and perhaps trademark law) — in fact precludes an assignment of rights under an intellectual property license unless the IP owner has consented.  These courts have ruled that non-exclusive patent and copyright licenses are personal and nonassignable. As a result, a patent or copyright holder can prevent a debtor licensee from assuming and assigning a non-exclusive license to a third party without the licensor’s consent. 
  • License at risk. In the Ninth Circuit, which includes California, a licensor not only can stop a debtor from assigning the license to a third party, it can even prevent a debtor from keeping the license for itself.  Although the reason is technical, stemming from how the Ninth Circuit has interpreted Section 365(c)(1) of the Bankruptcy Code, the impact can be very real. For those interested, the landmark Ninth Circuit decision on this point is In re Catapult Entertainment, Inc.,165 F.3d 747 (9th Cir. 1999). 

Get advice. The interplay between bankruptcy and intellectual property law is complex.  Whether you are a licensor or licensee, you should get legal advice about your specific license agreement and the ways you may be able to protect your rights if a bankruptcy is filed.  Likewise, companies that anticipate having to file bankruptcy should pay careful attention to their IP licenses before they file.

Business Bankruptcy Issues The Financially Troubled Company

Setoffs And Bankruptcy

Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side’s debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank’s right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

  • If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
  • Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed — also known as a "post-petition" setoff — is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies. 

 

Business Bankruptcy Issues Recent Developments

Texas District Court Holds Part Of New Bankruptcy Law Unconstitutional

In a decision on Wednesday, July 26, 2006, the United States District Court in Dallas ruled that a portion of the new bankruptcy law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (also known as BAPCPA), unconstitutionally restricts attorneys when they provide legal advice to their clients. 

These provisions were part of BAPCPA’s focus on consumers and the restrictions were aimed at preventing attorneys — who are apparently included within the term "debt relief agency" under BAPCPA — from advising individuals, among other things, to take on more debt if they are contemplating bankruptcy.  The court also held that other related provisions were constitutional, specifically one requiring disclosure of certain specific information to individuals who are considering filing for bankruptcy.

While the decision does not affect businesses directly, it’s important to know when a court holds part of the bankruptcy law unconstitutional.  For those interested in learning more about the decision and the consumer-related provisions involved, I recommend that you read David Rosendorf’s excellent post on the American Bankruptcy Institute’s BAPCPA blog and Steve Jakubowski’s equally informative post on his Bankruptcy Litigation blog.

Business Bankruptcy Issues

Claims Against Individuals In Bankruptcy: Is Every Debt Discharged?

Usually, businesses have claims against other businesses.  Still, you may occasionally have a claim against an individual and it’s good to know what can happen in that situation. 

The "no asset" case. Unfortunately, most individuals who file bankruptcy, especially those who file the more common Chapter 7 liquidation case, do not have any significant assets that can be sold to pay creditors.  What’s more, the assets they do have — such as IRAs, 401(k) accounts, etc. — are usually exempt from creditors’ claims.  Cases in which no non-exempt assets are available to pay creditors are known as "no asset" cases.  (Bankruptcy lawyers love imaginative names.)  In a no asset case, the bankruptcy court’s notice will actually instruct you not to file a proof of claim unless later notified to do so. 

The "asset" case.  Sometimes there are enough non-exempt assets to produce at least some distribution to unsecured creditors.  While not very common in Chapter 7 cases, it could be that the individual has filed a Chapter 13 "wage-earner" case or a Chapter 11 personal reorganization case and expects to pay creditors some amount over time.  If so, a claims filing deadline known as a "bar date" will be set.  If you file a proof of claim form by the bar date, you may eventually receive a check, although typically this will be months or even years after the bankruptcy was filed.  In most cases involving individuals, the distribution to unsecured creditors is painfully small.

The bankruptcy discharge. In general, when individuals file bankruptcy, they will get discharged, or excused, from their pre-filing debts.  This is especially true in Chapter 7 and 11 cases and also in Chapter 13 cases if the individual debtor makes all of the payments required under his or her plan.  The discharge is part of what is often referred to as the "fresh start" that bankruptcy offers. 

Nondischargeable debts. Although recent changes to the bankruptcy laws have made it harder for individuals to file bankruptcy and get a discharge, many people are still able to do so.  That said, the law does call out certain kinds of debts and makes them "nondischargeable," meaning that they can be excluded from the scope of the bankruptcy discharge. These include debts arising from the debtor’s fraud or other intentional bad acts, including when he or she obtained credit, and also to obligations for alimony, child support, student loans, and many taxes.  (So it’s clear, the concept of a debt being nondischargeable applies only to individuals, not to corporations or other business entities.) 

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Business Bankruptcy Issues Recent Developments

Chapter 11 Cases: Using The Internet To Keep Track Of Case Developments

A fairly recent phenomenon, especially in large Chapter 11 bankruptcy cases, is the special website designed to help creditors and others keep track of developments in a particular reorganization case.  Among active cases right now, for example, you can follow the latest activity in the Delphi Chapter 11 case, the Refco bankruptcy, and the Delta Airlines case.  These websites generally have information about the attorneys representing the company and the creditors’ committee, an electronic docket of pleadings filed in the case, access to a proof of claim form, and announcements about major events in the case.  

Many companies in Chapter 11 reserve a section of their corporate website for updates on their reorganization efforts, and they often make pleadings and other documents available there.  Adelphia is just one example.

Regardless of whether a special website has been created, you or your attorney can also obtain access to the pleadings and other documents filed in a Chapter 11 case (and any other type of bankruptcy case) through the relevant bankruptcy court’s PACER system.  Another system, called Case Management/Electronic Case Files or CM/ECF, typically is open only to attorneys and other bankruptcy professionals with a need to file pleadings in a bankruptcy case.  Both services require pre-registration and payment of downloading or other fees where applicable.

Business Bankruptcy Issues

Executory Contracts — What Are They And Why Do They Matter In Bankruptcy?

If you start talking to a bankruptcy lawyer, before long you’ll probably hear them use the term “executory contract.” Often they’ll act as though people use the term everyday.  The truth is that bankruptcy lawyers are just about the only lawyers – much less business people — who ever talk about executory contracts.  (I confess I do it too, but there’s a really good reason.)

So what is an executory contract? The concept is fairly simple. It’s a contract between a debtor and another party under which both sides still have important performance remaining.  Put another way, if either side stopped performing the contract it would be an actual breach of contract. 

Examples of executory contracts (and some common reasons why they might be executory) include:

  • Real estate leases (tenant has to pay rent/landlord has to provide space)
  • Equipment leases (lessee has to pay rent/lessor has to provide equipment)
  • Development contracts (development work required/payment required on milestones), and
  • Licenses to intellectual property (licensee can use only within scope of license/licensor must refrain from suing for licensed uses).

Having cleared up the definition, the next question is why executory contracts seem to matter so much in bankruptcy.  (The debtor even has to list them separately in its bankruptcy schedules.)

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