Recent Developments

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Recent Developments

A New Bankruptcy Blog: The Delaware Business Bankruptcy Report

This week, Morris James LLP, a Delaware law firm, launched the Delaware Business Bankruptcy Report with the goal of "providing access to current decisions, news and commentary regarding commercial bankruptcy cases in Delaware." From the posts already up on the blog, they are certainly off to an excellent start. Thanks to Carl (Chuck) Kunz at Morris James for alerting me to the launch of the new blog.

The Delaware Business Bankruptcy Report joins a number of excellent bankruptcy law blogs out there, including the Bankruptcy Litigation Blog and the Georgia Bankruptcy Law Blog. You can find even more at the American Bankruptcy Institute’s very handy new Bankruptcy Blog Exchange site, which collects feeds from twenty different bankruptcy blogs all in one place.

I think you’ll find the Delaware Business Bankruptcy Report and the ABI’s Bankruptcy Blog Exchange well worth a look.

 

Business Bankruptcy Issues Recent Developments

Assumption Of Intellectual Property Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?

Executory contracts present a host of interesting issues in bankruptcy cases. This is especially true when the executory contract involves a license of intellectual property (or "IP"). In the past I’ve devoted several posts to the topic, including how IP licenses are treated in bankruptcy and the unique issues presented when a trademark licensee or trademark licensor files bankruptcy. 

In this post, I’ll drill down a bit deeper into the question of how courts have analyzed whether a Chapter 11 debtor can assume or assign an IP license to a third party over the IP licensor’s objection. If you’re new to the topic, be forewarned: the courts are all over the map on the issue. For those who’d like a scorecard, you’ll find a link to a circuit-by-circuit chart in the "Where Does Your Court Stand?" section toward the end of this post.

Assumption And Assignment. In bankruptcy parlance, assumption means that the debtor gets to keep the license. Usually, debtors are allowed to exercise their business judgment when deciding whether to assume or reject (read: breach and stop performing) an executory contract, as well as to assume and assign one to a third party. However, Section 365(c)(1) of the Bankruptcy Code puts a limit on a debtor’s ability to assign executory contracts, and perhaps even to assume them, when "applicable law" gives the non-debtor party to the contract the right to refuse to deal with someone else.

The Key Bankruptcy Code Section. Since Section 365(c)(1) is so important to this debate, it bears careful review. Here’s what it says:

(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment.

What’s "Applicable Law?" Collectively, a number of courts have interpreted the phrase "applicable law" to mean patent, copyright, and trademark law, holding that these federal intellectual property laws excuse a non-debtor party to an IP license from accepting performance from or rendering performance to an entity other than the debtor in bankruptcy. As a result, these courts have held that an IP licensor who does not consent can successfully block a debtor from assigning a patent, copyright, or trademark license to a third party during a bankruptcy case. This rule applies with greatest force to non-exclusive IP licenses but may also apply to certain exclusive licenses too. For more on this subject, read Professor Menell’s article on the bankruptcy treatment of IP assets, which I discussed last month.

What Constitutes Consent? Consent to assumption or assignment of an IP license can come in three ways. First, the licensor can affirmatively consent in writing after a bankruptcy case has been filed. Second, a licensor that fails to object after a motion has been filed seeking to assume, or to assume and assign, a license agreement will likely be deemed to have consented. Third, a number of license agreements expressly permit assignment under certain circumstances and many, but not all, courts will treat such provisions as providing the consent required under Section 365(c)(1)(B). A provision sometimes found in license agreements allows assignment in conjunction with a sale of all or substantially all of the assets of the licensee. Warren Agin of the Tech Bankruptcy blog wrote about a recent Massachusetts case (in which I represented the buyer) enforcing a similar provision.

Hypothetical Versus Actual Test. If a debtor cannot assign an IP license without consent of the licensor, can it at least assume the license? That question has led courts to examine ever so closely the first seven words of Section 365(c): "The trustee may not assume or assign…" 

  • When the statute says that the trustee may not assume or assign an IP license, does the word "or" really mean "and" too?
  • Put differently, what happens when a debtor is only trying to assume (keep) an IP license and is not actually trying to assign it? Does the Bankruptcy Code language mean that it can neither assume nor assign the license or does it only mean that the debtor cannot assign the license?
  • That, in a nutshell, is the difference between the so-called "hypothetical test" (which reads Section 365(c)(1)’s language as asking whether the debtor hypothetically could assign the license even if it’s only proposing to assume it) and the "actual test" (which interprets the statute’s language as asking only what the debtor is actually proposing to do).
  • The U.S. Courts of Appeals for three circuits have adopted the hypothetical test. The Ninth Circuit (covering California, Arizona, and a number of other Western states), the Third Circuit (which includes Delaware, the venue of many Chapter 11 cases), and the Fourth Circuit (covering Virginia, West Virginia, Maryland, and North and South Carolina), have held that Section 365(c)(1) gives most IP licensors a veto right over proposals by a Chapter 11 debtor to assign — and even to assume — IP licenses.
  • The leading hypothetical test decision is from the Ninth Circuit in In re Catapult Entertainment, Inc.,165 F.3d 747 (9th Cir. 1999). In Catapult, the court built on an earlier decision holding that a non-exclusive patent license could not be assigned without the patent holder’s consent and, adopting the hypothetical test, held that such a patent license also could not be assumed over the patent holder’s objection.
  • Leading the charge for the actual test is the First Circuit’s decision in Institut Pasteur, et al. v. Cambridge Biotech Corporation, 104 F.3d 489 (1st Cir. 1997). That circuit includes Massachusetts, among other states.

A Third Test From New York. Despite this predominantly licensor-favorable backdrop, in several recent decisions courts have sided with Chapter 11 debtors. This emerging trend is noteworthy because two of those decisions come from the Southern District of New York. That’s where many of the largest Chapter 11 bankruptcy cases tend to be filed, such as Enron, WorldCom, Delphi Corporation, Dana Corporation, Northwest Airlines, and Delta Airlines, to name a few, making it perhaps the most important bankruptcy court in the country.

The New York Cases: Footstar And Adelphia. In a 2005 decision in In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005), the Bankruptcy Court for the Southern District of New York broke new ground. Although it did not involve intellectual property licenses, the case put Section 365(c)(1)’s language front and center and came up with a third way of analyzing this critical section. Judge Adlai Hardin adopted a new "literal" reading of section 365(c)(1), one that he found was "entirely harmonious with both the objective sought to be obtained in Section 365(c)(1) and the overall objectives of the Bankruptcy Code, without construing ‘or’ to mean ‘and.’" His approach? Section 365(c)(1)’s use of the word "trustee" does not (as other courts had taken for granted) include the debtor or debtor in possession. As such, the right of the non-debtor party to object to assignment does not by itself affect the right of the debtor in possession (as opposed to a trustee) to assume an executory contract.

In January 2007, Judge Robert Gerber, also of the Bankruptcy Court for the Southern District of New York, faced the same issue in the Adelphia Communications Chapter 11 case. In his decision on the Section 365(c)(1) issue, Judge Gerber expressly rejected the cases following the "hypothetical" test as "incorrectly decided," and instead embraced Judge Hardin’s Footstar decision, describing it as "consistent in outcome with the decisions of" those courts following the "actual" theory. In a footnote, Judge Gerber stated: "[W]here there is no Second Circuit authority, [the Bankruptcy Court for the Southern District of New York] follows the decisions of other bankruptcy judges in this district in the absence of clear error. But to say that the Footstar decisions should be followed under that standard would be faint praise here. In this Court’s view, Judge Hardin’s analysis in those decisions was plainly correct." This suggests that other judges in the Southern District of New York may follow suit, at least unless the Second Circuit were to rule otherwise.

For a detailed analysis of the Footstar decision, be sure to read the article by Cooley Godward Kronish partners Jay Indyke and Richard Kanowitz, and associate Brent Weisenberg, who were directly involved in the case, which appears in the April 2007 issue of the Journal of Bankruptcy Law and Practice. It’s called “Ending the Hypothetical’ vs.‘Actual’ Test Debate: A New Way to Read Section 365(c)(1),” 16 J. BANKR. L. & PRAC. 2 Art. 2 (2007).

Another Circuit Follows The Actual Test. The Fifth Circuit (covering Texas, Louisiana, and Mississippi) also jumped into the fray, albeit interpreting a different but related section, Section 365(e), with its February 2006 decision in Bonneville Power Administration v. Mirant Corp., 440 F.3d 238 (5th Cir. 2006). Upon the Chapter 11 bankruptcy of Mirant Corporation, the Bonneville Power Administration (BPA) attempted to terminate its executory contract with Mirant based on an ipso facto clause, a provision that makes a bankruptcy filing a breach of contract. While these provisions generally are not enforced, the BPA relied on Section 365(e)(2)(A), which closely mirrors the language of Section 365(c)(1)(A), and argued that it could terminate the contract because applicable law — the federal Anti-Assignment Act, 41 U.S.C. Section 15 — excused it from accepting performance from or rendering performance to an entity other than the debtor or debtor in possession. After a lengthy analysis, the Fifth Circuit joined the First Circuit (rejecting the position of the Third, Fourth and Ninth Circuits) and expressly adopted the "actual" test. The Fifth Circuit held that the ipso facto clause was null and void under Section 365(e)(1) because Mirant, the debtor in possession, was not actually planning to assign the contract. For a more detailed discussion of the case, be sure to check out Steve Jakubowski’s excellent post over at the Bankruptcy Litigation Blog.

Where Does Your Court Stand? With courts coming out on different sides of the hypothetical versus actual test issue, and with the Footstar and Adelphia courts advancing yet another view of Section 365(c)(1), you might be looking for a chart to keep up with all the decisions. Well, as part of a presentation I made last month to the Commercial Law and Bankruptcy Section of the Bar Association of San Francisco (and with a big assist from Brian Byun, an associate in the Bankruptcy & Restructuring Group at my firm who also contributed to this blog post), we put together just such a circuit-by-circuit chart of the various decisions. You may find this circuit map useful when reviewing the chart. 

How Often Does This Come Up? The answer is frequently. Most corporate debtors have critical in-licenses of intellectual property and either need to assume them or, as part of a Section 363 asset sale, assume and assign them to the buyer. IP licensors are understandably protective of their intellectual property. Still, even when they have the right to object to assumption or assignments, in my experience many IP licensors will agree to allow debtors to assume, and sometimes even to assign to a buyer, important licenses. There may be an added cost, either in the form of a fee or the imposition of conditions to protect the licensor’s rights. That said, not all licensors will consent to assumption or assignment. In hypothetical test jurisdictions, debtor licensees may end up losing their license rights.

Location, Location, Location. This phrase is most often associated with real estate, but it could just as well apply to the venue of a bankruptcy case when assumption of an IP license is at issue. A debtor’s ability to assume an IP license over the objection of the licensor can be radically different depending upon where the bankruptcy case is pending. Perhaps the developing circuit split over Section 365(c)(1) will lead the U.S. Supreme Court to agree to take up the issue. Until that happens, or Congress amends the law, what a debtor can do with its IP licenses will continue to depend, in no small part, on where it files bankruptcy. 

Business Bankruptcy Issues Recent Developments

Proof Of Claim And Other Bankruptcy Forms Revised To Reflect April 1, 2007 Dollar Amount Adjustments

As reported in this post last month, certain dollar amounts in the Bankruptcy Code were increased effective April 1, 2007. The dollar amount changes meant that some of the official bankruptcy forms, most notably the proof of claim form and the voluntary petition, had to be revised as well.

After I put up that post, the Administrative Office of the United States Courts (known in the trade as "the AO") made the revised forms available and released a formal notice of the dollar amount adjustments. Copies of the revised forms — with handy arrows pointing out each place where they were revised — are attached to the notice.

Of course, you’ll need to get the forms in blank to use in bankruptcy cases. If you don’t have special bankruptcy form software, a number of the official bankruptcy forms have been designed to allow you to type in information or select choices from drop-down menus before printing the form. Printing is the only way to go because the form won’t let you save your changes. 

If you follow the links above you’ll be able to access blank copies of the revised forms from the AO’s website. That way, you’ll be sure to have the most up-to-date versions.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Defending A Preference: Ninth Circuit Holds That Even First Time Transactions Can Be In The “Ordinary Course”

In a decision issued on April 3, 2007 in the In re: Ahaza Systems, Inc. case, the Ninth Circuit held that even first time transactions can qualify for the "ordinary course of business" defense to preferences. A copy of the Court of Appeal’s decision is available here.

The Bankruptcy Preference. As a quick refresher, 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.

Pre-BAPCPA Statute. The ordinary course of business defense, designed to protect parties who engage in normal transactions with a financially troubled business, is one of the most common defenses available to preference recipients. The Ninth Circuit examined it under the version of the preference statute, Section 547 of the Bankruptcy Code, as it existed before the 2005 amendments made in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). This pre-BAPCPA statute, specifically Section 547(c)(2), provided that a trustee could not avoid a transfer as a preference

to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and

(C) made according to ordinary business terms.

The Court’s focus was on subsection (A), the "debt" issue. Usually, parties have a series of contracts or purchase orders, as well as a payment history, that gives context to the ordinary course of business between them. In this case, however, the transaction that led to the allegedly preferential payments was their first one. The Court faced the question of whether a debt can be considered as having been incurred in the ordinary course of business of the debtor and the preference defendant when there had been no other past transactions to which it could be compared.

Court Looks To Past Practices With Other Similar Parties. The Court’s answer was yes, holding that a preference defendant can indeed assert the ordinary course of business defense involving a debt created by the first contract or transaction between the parties. However, the Ninth Circuit articulated a special rule when a "first time" debt is involved:

[W]hen we have no past debt between the parties with which to compare the challenged one, the instant debt should be compared to the debt agreements into which we would expect the debtor and creditor to enter as part of their ordinary business operations. Consistent with Food Catering [971 F.2d 396 (9th Cir. 1982)], however, this analysis should be as specific to the actual parties as possible. Thus, we hold that to fulfill § 547(c)(2)(A), a first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties. Only if a party has never engaged in similar transactions would we consider more generally whether the debt is similar to what we would expect of similarly situated parties, where the debtor is not sliding into bankruptcy.

Both Original And Restructured Agreements Are Relevant. On a related point, since the first transaction here was an agreement that was later restructured to give the debtor more time to pay, the Ninth Circuit also held that both the original and revised agreement should be evaluated for ordinariness.

Ruling Still Important Under BAPCPA. BAPCPA revised the ordinary course of business defense so that Section 547(c)(2) now provides that a payment or other transfer cannot be avoided

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

Although different, the current statute still makes the issue decided in the In re: Ahaza Systems case, whether the debt was incurred in the ordinary course of business, a requirement. The major change is that the statute now allows the defense to be established by additionally showing that payments were made either (A) in the ordinary course of business of the parties or (B) according to ordinary business terms, rather than both as under the pre-BAPCPA version.

How Hard To Meet? Having established the new test, the Court then reversed the granting of summary judgment to the defendant because it found the proof presented was inadequate. This suggests that although the Ninth Circuit will permit preference defendants to assert the ordinary course of business defense on first time transactions, some defendants may face a challenge in meeting that standard.

Recent Developments The Financially Troubled Company

Report On The Delaware Supreme Court’s Recent Oral Argument In The Trenwick America Deepening Insolvency Case

One of the most important recent decisions by the Delaware Court of Chancery in the insolvency area was the August 10, 2006 opinion in the Trenwick America Litigation Trust case. As discussed at length in an earlier post, the Trenwick America decision by Vice Chancellor Strine (available here) squarely held that there was no cause of action for "deepening insolvency" under Delaware law. The Chancery Court’s opinion rejected it as a cause of action in no uncertain terms:

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, ‘deepening insolvency’ is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Delaware Supreme Court Hears Appeal. The significance of the Chancery Court decision makes it particularly interesting to follow the appeal in the case, now before the Delaware Supreme Court. The oral argument on the appeal, held on March 14, 2007 at the Widener University School of Law campus in Wilmington, may shed some light on how the Delaware Supreme Court will ultimately rule. Frank Reynolds of Andrews Publications prepared this news story on the oral argument, and the law school’s website also has an article, complete with slideshow, on the oral argument in Trenwick America and in a second case that day. To hear the Trenwick America oral argument for yourself, follow this link and download the audio recording from the Delaware Supreme Court’s website.

Focus At Oral Argument. Having listened to the recording (an entertaining addition to my iPod), it’s interesting to note that the deepening insolvency issue received only a few mentions during oral argument. Those came mainly during a discussion of the business judgment rule and whether existing contractual and statutory remedies sufficiently protect creditors. Instead, the parties and the Justices focused on the following issues during oral argument:

  • Whether the complaint sufficiently pled that the corporation was insolvent or in the zone of insolvency;
  • Whether the business judgment rule protected the directors in permitting the subsidiary corporation to incur guaranty and other obligations;
  • What fiduciary duty was owed and how it was allegedly breached;
  • Whether the zone of insolvency issue was critical to the plaintiff’s case; and
  • Whether the directors breached any fiduciary duties when following the parent corporation’s business plan for the subsidiary and the corporate group.

Reading The Tea Leaves. With the range of issues discussed at oral argument, it’s possible that the Delaware Supreme Court will render its decision in the Trenwick America case without considering the Chancery’s Court’s ruling that deepening insolvency does not exist as a cause of action under Delaware law. Plaintiff’s counsel argued that the Delaware Supreme Court could rule for his client without reaching the issue. Likewise, counsel for the defendants urged affirmance based on what Vice Chancellor Strine found to be insufficient pleading of insolvency, a lack of any fiduciary duty owed given the complaint’s allegations, and the application of the business judgment rule. Although not directly involving deepening insolvency, in response to a specific question from one of the Justices, defense counsel also argued that the Delaware Supreme Court should consider holding that directors do not owe fiduciary duties to creditors upon insolvency, leaving creditors to the existing protections and remedies otherwise available to them.

After an interesting oral argument, stay tuned.

Business Bankruptcy Issues Recent Developments

New Article On How Distressed Debt Investors Are Preparing For The Next Economic Downturn

The DealBook blog from the New York Times has an interesting post entitled "Stocking Up For A Storm." It describes how certain investment banks have been expanding their distressed debt businesses, believing that the length of the current "good times" period may actually lead to an increase in the level of distress when the economy finally turns. 

The DealBook post points readers to a new article in The Economist on so-called vulture investors. Entitled "The Vultures Take Wing," the article discusses the view of many investors and insolvency professionals that, after a drought of restructurings, a new wave of bankruptcies and defaults may not be too far off. When the problems come, they will likely be even more complex than in past cycles. Not only have very active hedge funds taken a much greater role in recent years, but many companies now have an additional tranche of secured debt in the form of the increasingly popular second lien loans.

While corporate restructurings and Chapter 11 bankruptcy cases have always been complex, when the next surge in defaults hits these trends are likely to present even more challenges — and perhaps opportunities — for both debtors and creditors.

Business Bankruptcy Issues Recent Developments

Northwest Airlines Ad Hoc Committee Files Second Appeal On Disclosure Of Trading Details

As reported last week, the Ad Hoc Committee of Equity Security Holders in the Northwest Airlines case, a group made up chiefly of hedge funds, recently complied with the Bankruptcy Court’s earlier orders and filed a Rule 2019 statement disclosing details of their trades. Having made the filing, it wasn’t clear whether the Ad Hoc Committee would continue to appeal from the Bankruptcy Court’s decisions compelling the disclosure. An answer to that question came late in the day on Monday, March 26.

New Appeal Filed. Late Monday, the remaining membership of the Ad Hoc Committee of Equity Security Holders filed a second notice of appeal, this time from the Bankruptcy Court’s original February 26, 2007 decision requiring the detailed statement to be filed. A copy of the new notice of appeal is available here. An earlier notice of appeal was filed from the Bankruptcy Court’s March 9, 2007 order denying a motion to file the Rule 2019 statement under seal. It appears that the earlier appeal will be pursued as well.

No Stay Pending Appeal. As previously reported, at a March 15, 2007 hearing the Bankruptcy Court also denied the Ad Hoc Committee’s motion for a stay pending appeal. However, the Ad Hoc Committee got until March 25, 2007 to seek a stay from the United States District Court for the Southern District of New York. (Here’s the Bankruptcy Court’s order on the stay issue, which was filed only last Friday.) Despite the temporary reprieve, the Ad Hoc Committee apparently decided against seeking a stay pending appeal and instead went ahead and filed the updated Rule 2019 statement and then a new appeal.

The Disclosure Issue Moves To Another Court. With the new appeal filed Monday, this issue should be headed to the District Court for briefing and argument in the coming months. It’ll be interesting to see whether the District Court, sitting as an appellate court, has any different reaction to the disclosure issue. Stay tuned for future developments.