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The Financially Troubled Company

Leading Venture Capitalists Reflect On Business Failure

David Feinlieb of Mohr Davidow Ventures has an interesting post on his Tech, Startups, Capital, Ideas blog entitled "Why Startups Fail." David highlights four main reasons around his general theme of "they run out of money":

  • They spend too much on sales and marketing before they’re ready.
  • The market outpaces the startup’s ability to execute.
  • There is no entrepreneur.
  • The market takes too long to develop.

David’s explanations behind each of these headlines are incisive and thought-provoking, and they underscore the challenging road startups must travel. I would add to the list the impact an industry or general economic slowdown can have on a particular startup, including when it comes to raising additional capital. (For more on the topic, you may find interesting an earlier post discussing the views of another VC on why early stage businesses fail and another one examining how a recession may affect investment decisions of VCs.)

On a similar theme is a post by Brad Feld of Foundry Ventures entitled "Do VCs Fund Entrepreneurs Who Have Failed At Previous Ventures?" over at the Ask The VC blog. Thanks to Brad as well for first blogging on David Feinlieb’s post on startups, where Brad observes that "we are heading for another wave of failure as companies run out of gas after their Series B / Series C rounds and their investors lose patience with them."

Brad sums up his views this way on the topic of funding entrepreneurs with a prior failed business:

My favorite entrepreneurs to fund are those that have had at least one success and one failure.  While it is a cliche, failure teaches the big lessons.  Most importantly, entrepreneurs that have some failure under their belt have humility and perspective that I think is deeply useful in the creation of the company.

Startups are inherently risky, even in a strong economic climate. As the potentially recessionary economy produces more failed startups, it’s especially valuable to have insights and perspectives like these from experienced VCs.

Business Bankruptcy Issues Recent Developments

Latest Edition Of Bankruptcy Resource Now Available

The Spring 2008 edition of the Absolute Priority newsletter, published by the Cooley Godward Kronish LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter give updates on current developments in bankruptcies and workouts with the goal of keeping you "ahead of the curve" on these issues. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions.

The latest edition covers a range of cutting edge topics, including:

  • The ability of unsecured creditors to recover post-petition attorney’s fees;
  • Key issues when selling claims in bankruptcy;
  • Jury trials and proofs of claim;
  • Assignments for the benefit of creditors; and
  • The impact of post-petition performance on executory contracts.

We have also included information on some of our recent representations of official committees of unsecured creditors in Chapter 11 bankruptcy cases, and unofficial committees in out-of-court workouts, involving major retailers. These include Sharper Image, Lillian Vernon, CompUSA, Wickes Furniture, and The Bombay Company, among others. In addition, a note from my partner Adam Rogoff, the editor of Absolute Priority, discusses the increasing number of bankruptcy filings nationwide and our representation of Bayonne Medical Center in its Chapter 11 reorganization.

I hope you find this latest edition of Absolute Priority to be a helpful resource.

Business Bankruptcy Issues Recent Developments

New Article Examines Whether Wire Transfers Can Immunize Payments To Shareholders In LBOs

Leveraged buyouts, known as LBOs, have frequently been the subject of fraudulent transfer challenges when the target company later files bankruptcy. As its name implies, the classic LBO involves the use of leverage — debt — to finance the acquisition of the target company’s stock. Often that new debt is secured by the assets of the target company. This post highlights a new article that addresses one of the hot issues in LBO fraudulent transfer litigation, but before doing that it may help to give some context to the discussion.

What Is A Fraudulent Transfer? There are two types of fraudulent transfers. The first is a transfer made with an actual intent to hinder, defraud, or delay creditors. However, transfers may be considered fraudulent, even in the absence of actual fraud, if the transfer has a similar effect on creditors. This second type of fraudulent transfer involves what is known as "constructive fraud." A court may find that a transfer involves constructive fraud if a company, at a time when it is already financially impaired or is made so by the transaction itself, does not receive "reasonably equivalent value" in return for the transfer in question. Section 548, the Bankruptcy Code’s fraudulent transfer statute, and state fraudulent transfer laws, cover both actual and constructive fraudulent transfers.

The LBO Fraudulent Transfer Lawsuit. When an LBO is followed sometime later by a bankruptcy, a fraudulent transfer lawsuit may be filed to challenge the LBO itself. Although actual fraud may be asserted, more often the case involves a constructive fraud claim.

  • The argument usually made is that the use of the target company’s assets to secure loans (the leverage), the proceeds of which were then paid to selling shareholders (the buyout), rendered the company insolvent, made it otherwise unable to pay its debts when they became due, or left it with an unreasonably small capital with which to conduct its business. Since the target company does not receive anything in exchange for the payment to the selling shareholders, the lack of reasonably equivalent value element is usually present.
  • The plaintiff in a fraudulent transfer lawsuit may be the company itself as Chapter 11 debtor in possession, the official committee of unsecured creditors, or a bankruptcy trustee or post-confirmation plan trustee.
  • The defendants may include the new shareholders, the lenders who obtained security interests in the target company’s assets, and the shareholders who sold their stock for cash to the acquirer.

The Settlement Payment Defense. When selling shareholders are sued, they often assert a defense based on the "settlement payment" exception to certain fraudulent transfer claims found in Section 546(e) of the Bankruptcy Code. This exception was added to the Bankruptcy Code to prevent disruptions to the functioning of capital markets that might occur if long-settled trades were able to be unraveled by a fraudulent transfer action years down the road. Some courts, interpreting the term "settlement payment" to include payments made from a financial institution, have held that payments to selling shareholders, made by means of wire transfers using a bank or other financial institution, qualify as just such a "settlement payment" protected from avoidance as a fraudulent transfer under Section 546(e). Those courts, in effect, hold that the fact that a bank made wire transfers rendered an otherwise potentially fraudulent transfer immune from challenge.

Two Recent Articles Tackle This Issue. Two articles, including one published last week, take a look at how courts have been addressing the reach of the Section 546(e) defense in the context of these wire transfer payments.

How Far Does The Defense Go? The new article discusses case law from outside of the Third Circuit. In particular, it examines a recent decision from a New York bankruptcy court that rejected the Section 546(e) defense in a situation involving an LBO of a private, rather than publicly traded, target company. The article sums up the differences this way:

The application of the settlement payment defense in the context of an LBO has been far from uniform. While courts in the 3d Circuit have utilized Section 546(e) to shield virtually all LBO payments from avoidance, even in the context of private transactions, a significant number of courts have limited the scope of this safe harbor provision.           

Accordingly, the extent to which wire transfers may insulate LBO payments from attack under fraudulent transfer laws will likely be determined as much by the venue of the bankruptcy proceedings as much as the facts of the transaction at issue.

Worth Reading. Anyone involved in LBOs, including acquirers, target company directors or management, selling shareholders, and of course their professionals, will find these articles very interesting reading.

Business Bankruptcy Issues Recent Developments

Free Bankruptcy Research Tool Available Online

Bankruptcy professionals and the public rarely get a chance to read a judge’s own research binder. Fortunately, however, Chief Judge Randall J. Newsome of the United States Bankruptcy Court for the Northern District of California has made his very helpful 348-page research binder available on the Court’s website. Follow the links in this sentence to access the entire binder in pdf format and this HTML version organized by topic. I’ve found the binder to be an excellent way to identify leading cases on a particular topic quickly. The pdf version can also be searched using a key word or phrase. 

Updated as of February 8, 2008, and covering cases through Volume 378 of Bankruptcy Reports, the research binder collects a vast range of cases on business bankruptcy and other topics under the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. Chief Judge Newsome presides in the Northern District of California so the primary focus of the research binder is on Ninth Circuit law, but some out-of-circuit law is listed as well.

Chief Judge Newsome’s disclaimer puts this helpful tool’s function in perspective:

The following list of cases and supplemental information is presented for informational and educational purposes only. Though it represents the aggregation of 19 years of research, the Court makes no claims as to its current level of accuracy. Some of the cases set forth may very well have been superseded, reversed, or otherwise may no longer be good law. The Court has posted it with the intention to educate and assist those who may find it helpful. Accordingly, users should consider it a first, but by no means final, research tool, and should cite check all cases listed herein for continued viability prior to relying on such cases in practice.

With those caveats in mind, it can be a great place to start when researching bankruptcy law issues in Ninth Circuit.

Business Bankruptcy Issues Recent Developments

Northern District of California Bankruptcy Court Local Rule Amendments Take Effect May 1, 2008

As previously reported, in August 2007 the Bankruptcy Court for the Northern District of California proposed amendments to the Bankruptcy Local Rules designed to implement the changes made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). After taking comments, the final amendments are scheduled to take effect on May 1, 2008.

  • Follow the links for a clean set of the final amended Bankruptcy Local Rules and a redline version showing changes from the current local rules.

Business Bankruptcy Changes. Certain of the amended local rules will affect Chapter 11 corporate bankruptcy cases. These include changes to the rules governing the investment of estate funds, the replacement of a "responsible individual" for a Chapter 11 debtor or debtor in possession, entry of a final decree closing a case, the procedures for bankruptcy appeals, and the general electronic case filing (ECF) procedures. A number of the other revisions are aimed primarily at consumer bankruptcy cases.

Jury Trial Rule Amended. In addition, however, the Bankruptcy Court took this opportunity to modify Bankruptcy Local Rule 9015-2(b), governing jury trials, which the U.S. Court of Appeals for the Ninth Circuit struck down in its September 2007 decision in the In re HealthCentral.com case. An earlier post entitled "Ordinary Course Preference Case Takes Extraordinary Turn: Ninth Circuit Strikes Down Local Bankruptcy Rule On Jury Trials" gives more details on the decision and its impact.

Conclusion. The changes to the Northern District of California Bankruptcy Local Rules may not be as significant for Chapter 11 cases as those recently proposed in the Southern District of New York or adopted in Delaware, but attorneys practicing in the Northern District of California, and businesses with cases or adversary proceedings pending in that court, should be sure to follow them when they take effect on May 1, 2008.

Business Bankruptcy Issues Recent Developments

What Happened At The Supreme Court Oral Argument In The Section 1146(a) Bankruptcy Transfer Tax Exemption Case?

On Wednesday, March 26, 2008, the United States Supreme Court heard oral argument in the case of Florida Dept. of Revenue v. Piccadilly Cafeterias, Inc. A link to the transcript of the oral argument can be found below. The case presents the following question:

Whether section 1146(a) of the Bankruptcy Code, which exempts from stamp or similar taxes any asset transfer “under a plan confirmed under section 1129 of the Code,” applies to transfers of assets occurring prior to the actual confirmation of such a plan?

With so many asset transfers in Chapter 11 cases taking place through Section 363 asset sales before plan confirmation, rather than when plans are consummated after confirmation, how the Supreme Court answers the question presented will have a significant impact on the extent to which debtors end up paying stamp and other transfer taxes as a practical matter.

The Eleventh Circuit’s Decision And Aftermath. The Supreme Court case results from a decision by the U.S. Court of Appeals for the Eleventh Circuit holding that pre-confirmation sales can be subject to the exemption under Section 1146(a) if followed by plan confirmation later in the case. Use the link in this sentence to read the Eleventh Circuit’s decision in Piccadilly.

The Language of Section 1146(a). The one-sentence section, Section 1146(a), was previously numbered Section 1146(c) but its language has not changed. (Many court orders and opinions still use the old designation.) The statute provides as follows:

The issuance, transfer, or exchange of a security, or the making or delivery of an instrument of transfer under a plan confirmed under section 1129 of this title, may not be taxed under any law imposing a stamp tax or similar tax.

As discussed below, much of the dispute over the scope of this exemption is based on interpretation of the phrase "under a plan confirmed."

Section 363 Sales And Transfer Taxes. As bankruptcy professionals know, Section 363 asset sales often precede confirmation of a plan by months. When confirmed, the plan may simply distribute the cash generated from prior sales of the debtor’s assets or may enable a reorganized but smaller debtor to emerge from bankruptcy. Courts around the country have taken very different views on whether Section 1146(a)’s exemption should apply to these pre-confirmation transfers.

Some courts will include findings in Section 363 sale orders that the sale, even though prior to plan confirmation, is exempt from stamp and similar taxes. This sale order from the Southern District of New York illustrates that approach:

The sale of the Purchased Assets . . . is a prerequisite to the Debtors’ ability to confirm and consummate a plan or plans. The Sale Transaction is therefore an integral part of a plan or plans to be confirmed in the Debtors’ cases and, thereby, constitutes a transfer pursuant to section 1146(c) of the Bankruptcy Code, which shall not be taxed under any law imposing a transfer tax, a stamp tax or any similar tax.

Cases filed in Delaware will likely receive a very different response. In 2003, the Third Circuit in In re Hechinger Inv. Co. of Del., Inc., 335 F.3d 243 (3d Cir. 2003) — unlike the Eleventh Circuit in Piccadilly — held that the Section 1146(a) exemption does not apply to pre-confirmation transfers. (The Third Circuit’s opinion was authored by then Circuit Judge, and now Associate Justice, Samuel Alito.) Delaware’s new local rule governing Section 363 sales requires sale motions to make express disclosure of an effort to obtain such a provision in a sale order:

Tax Exemption. The Sale Motion must highlight any provision seeking to have the sale declared exempt from taxes under section 1146(a) of the Bankruptcy Code, the type of tax (e.g., recording tax, stamp tax, use tax, capital gains tax) for which the exemption is sought. It is not sufficient to refer simply to "transfer" taxes and the state or states in which the affected property is located.

Other courts have taken a similar view. The Section 363 sale guidelines adopted by the Bankruptcy Court for the Northern District of California call out various provisions that the Bankruptcy Court generally will not approve in a sale order, including the following:

Any provision that purports to exempt the transaction from transfer taxes under section 1146(c). By its own terms, that section applies only to a sale pursuant to a plan of reorganization, not a sale outside of a plan under section 363(b).

The Supreme Court Oral Argument And Transcript. Against this background, the Supreme Court heard oral argument in the Piccadilly case on March 26, 2008. A copy of the transcript of the oral argument is available by clicking on the link in this sentence.

It’s difficult to tell how the decision will come out based on the questions asked by the various Justices, but the questions are themselves quite interesting. Some focused on why Congress would want to exempt post-confirmation but not pre-confirmation transfers. Others implied that the plain language of the statute limited the reach of the exemption only to transfers made, literally, "under" a confirmed Chapter 11 plan of reorganization. Still others inquired about the administrative impact on states if pre-confirmation transfers were initially exempt but subsequently could be taxed in the event that no plan was ever confirmed. An additional topic raised was whether, if the statute were held to exempt pre-confirmation transfers, the exemption should cover only those transfers "necessary" for a later plan confirmation or also transfers merely "instrumental" to a later plan confirmation. 

The State’s Arguments. During the argument, the State of Florida contended that the statute was unambiguous and that the word "under" meant a transfer made at or following confirmation of plan. Arguing for this bright-line rule, the State asserted that if pre-confirmation transfers could also be exempt taxing authorities would not know, at the time a transfer was recorded, whether a Chapter 11 plan would in fact later be confirmed to validate the exemption. From a policy perspective, the State argued that tax exemptions should be narrowly construed, that stamp and other transfer taxes generate millions of dollars in revenues, and that it would be an administrative burden to require states to monitor Chapter 11 cases to see if plans were later confirmed to validate exemptions claimed on earlier asset transfers.

The Debtor’s Arguments. The debtor made both policy and statutory interpretation arguments. On the policy side, Piccadilly argued that a debtor cannot get a Chapter 11 plan confirmed without cash, debtors often make Section 363 asset sales to preserve value and raise funds needed to confirm a Chapter 11 plan later in the case, the exemption was designed to save cash for the benefit of creditors, and these pre-confirmation sales should receive the same benefit from the exemption. The debtor also asserted that the key phrase in Section 1146(a), "under a plan confirmed" appears in Section 365(g)(1). Section 365 was interpreted by the Supreme Court in N.L.R.B. v. Bildisco &. Bildisco, 465 U.S. 513 (1984), to require pre-confirmation, not post-confirmation, decisions on executory contracts. The debtor contended that because the phrase "under a plan confirmed" means before confirmation when used in Section 365(g)(1), it must mean before confirmation in Section 1146(a) as well. In contrast, the debtor argued, Congress used the different phrase "confirmed plan" in Sections 1142(b) or 511(b) when it intended to refer to a point after plan confirmation.

Conclusion. Whether Section 1146(a)’s exemption from transfer taxes applies to pre-confirmation transfers has split circuit and bankruptcy courts alike over the years. The questions asked during the Supreme Court’s oral argument in the Piccadilly case suggest a similar split among the Justices over how the statute should be interpreted. With the Supreme Court’s term ending in the next few months, however, debtors, creditors, and taxing authorities should not have to wait much longer for a definitive answer to this open issue.  

Business Bankruptcy Issues Recent Developments

Trademark Licenses In Bankruptcy: New Developments In The N.C.P. Marketing Case

Last November I reported on the status of the Ninth Circuit appeal in In re: N.C.P. Marketing Group, Inc., a case addressing whether a debtor can assume a trademark license over the trademark owner’s objection. Back in 2005 the U.S. District Court for the District of Nevada issued its first of a kind decision, In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), holding that trademark licenses are personal and nonassignable in bankruptcy absent a provision in the trademark license to the contrary. Click here for a copy of the N.C.P Marketing Group decision and here to read an earlier post on the case.

The N.C.P. Marketing Court’s Analysis. In reaching its conclusion, the District Court held that under the Lanham Act, the federal trademark statute, a trademark owner has a right and duty to control the quality of goods sold under the mark:

Because the owner of the trademark has an interest in the party to whom the trademark is assigned so that it can maintain the good will, quality, and value of its products and thereby its trademark, trademark rights are personal to the assignee and not freely assignable to a third party.  

The trademark owner in that case, Billy Blanks of the Billy Blanks® Tae Bo® fitness program, successfully moved the court to compel rejection of the trademark license because under the "hypothetical test" analysis of Section 365(c)(1) of the Bankruptcy Code adopted by the U.S. Court of Appeals for the Ninth Circuit, contracts that cannot be assigned by the debtor without the nondebtor party’s consent cannot be assumed by the debtor either. (For a full discussion of these issues, take a look at this earlier post entitled "Assumption of Intellectual Property Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?")  

The Ninth Circuit Appeal. N.C.P. Marketing appealed the decision to the Ninth Circuit, the appeal was fully briefed, and oral argument had been scheduled for November 5, 2007. Prior to the oral argument, the Chapter 7 trustee for N.C.P. Marketing reached a settlement in the case. At the trustee’s request, the Ninth Circuit took the oral argument off calendar and directed the parties to move to dismiss the appeal if the settlement was approved by the Bankruptcy Court. At the time, I commented that it appeared that no Ninth Circuit decision would be issued in the case due to the settlement.

The Settlement Is Rejected. Back in the Bankruptcy Court, the Chapter 7 trustee filed a motion for approval of the settlement, but N.C.P. Marketing and certain other parties filed an objection and offered a competing bid for the appeal rights. In something of a surprise, on February 28, 2008, the Bankruptcy Court issued a brief order denying the trustee’s motion for approval of the settlement and instead approved a sale of the appeal rights and certain other assets to the objecting parties. The objecting parties thereafter posted the undertaking required by the Bankruptcy Court’s order.

Appeal May Go Forward. As a result, the Ninth Circuit appeal may be revived, although no new oral argument has been scheduled yet. Barring further developments, trademark licensors and licensees may end up seeing a Ninth Circuit decision after all on the important issue of whether trademark licenses can be assumed in bankruptcy. Stay tuned.