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The Financially Troubled Company

When Startups Shut Down: A Venture Capitalist Reflects On Why Early Stage Businesses Fail

Fred Wilson, a managing director at New York-based venture capital firm Union Square Ventures, has an insightful post entitled "Why Early Stage Venture Investments Fail." It’s a rare opportunity to get a venture capital investor’s perspective on the reasons startup companies go bust. Fred cites two main reasons:

1) It was a dumb idea and we realized it early on and killed the investment. I’ve only been involved in one investment in this category personally although I’ve lived through a bunch like this over the years in the partnerships I’ve been in.
2) It was a decent idea but directionally incorrect, it was hugely overfunded, the burn rate was taken to levels way beyond reason, and it became impossible to adapt the business in a financially viable manner.

He notes that it’s the second reason — a failure to adapt the business in a way that makes financial sense — that predominates. Fred highlights the danger caused by allowing companies to run with high burn rates, something my own experience teaches is a common affliction of distressed companies, particularly those in the early, developmental stages before they have substantial revenues to offset the burn.

This post followed another in which Fred discussed his overall early stage failure rate. Both make for interesting reading for anyone looking to understand why businesses fail — and how to help them succeed.

(Hat tip to Erick Schonfeld for his post on the subject at TechCrunch.)

Business Bankruptcy Issues Recent Developments

Don’t Miss The Important Business Bankruptcy Rule Amendments That Just Took Effect

On December 1st of almost every year, amendments to the Federal Rules of Bankruptcy Procedure — the ones that govern how bankruptcy cases are managed — take effect to address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others. Often the changes are relatively minor and of interest only to bankruptcy practitioners, but this year’s set has made some significant changes that will directly impact debtors, creditors and other stakeholders.

A Look At The Amendments. You may find it interesting to see the entire group of amendments together, so I have included two links. The first is to the full "clean" set of the amended rules. The second is to a redline showing the changes made by these amendments to the existing rules, together with the Advisory Committee’s comments.

The Omnibus Objection Problem. One of the most significant amendments will make changes to the popular practice of filing omnibus objections. In large cases the debtor or other estate representative has so many claims to address that they have combined objections to dozens — sometimes hundreds — of different claims in one single motion. The objection may have a name such as “Debtors’ Fourteenth Omnibus Objections To Claims (Substantive)” or some similarly titled document. Click here for one example. In a post last year called "Objections To Claims: Ignore Them At Your Peril," I discussed how it can be hard to tell which claims an omnibus objection is targeting.

  • The format has often meant that the only reference to an individual creditor is buried within the objection’s many pages of text and exhibits, typically in an attached list or chart.
  • If the creditor doesn’t respond to the objection timely, its claim will likely be disallowed and it will recover absolutely nothing from the bankruptcy estate.

The Amended Rule 3007: An "Anti-Gotcha" Solution. The new rules restrict the use of omnibus objections to certain limited circumstances and impose formatting standards. Otherwise, each claim will require its own separate claim objection unless the combined objection covers claims filed by the same person or entity. What grounds for objection can be made by an omnibus objection under the newly revised Rule 3007?

  • Duplicate claims;
  • Claims filed in the wrong case;
  • Original claims that were amended by later claims;
  • Claims that were not timely filed;
  • Claims that have already been paid or released;
  • Claims filed in a form that does not comply with applicable rules;
  • Claims that are really asserting an equity interest in the debtor; and
  • Priority claims that assert an amount in excess of the maximum amount in the Bankruptcy Code.

In short, if the claim is being challenged on substantive grounds, rather than more technical or procedural ones, then the objection will have to be filed one claimant at a time.

When an omnibus objection does make the permitted objections, it will now have to list claimants in alphabetical order, cross-reference claim numbers, give the ground for the objection and cross-reference that to the text of the objection, describe the objector and the reason for the objection in the document’s title, and combine no more than 100 claims in a single objection. This is all designed to make it easier for the creditor to figure out whether its claim is included and the basis for the objection.

Amended Rule 4001: The Clearer Disclosure Rules. Changes have been made to the rule that governs motions and stipulations for use of cash collateral and obtaining debtor in possession (DIP) financing. The amended rules now require that more details about the key provisions of cash collateral and DIP financing terms and conditions be stated in the motion, that proposed forms of order be filed with the motion, and that cross-references be made in the motion to where in the cash collateral or DIP financing agreements and proposed orders the key provisions are reflected. Since some financing agreements can run hundreds of pages long, with complex formulas and provisions, this rule change is designed to make it easier for the court and the parties to understand their material features without wading through the entire document.

New Rule 6003: Putting The Breaks On Some "First Day" Orders. Another major change is the addition of Rule 6003. This new rule provides that "except and to the extent that relief is necessary to avoid immediate and irreparable harm, the court shall not, within 20 days after the filing of the petition, grant relief" regarding three key areas:

  • The employment of professionals;
  • A motion to pay any prepetition claims (read: critical vendors) or to use, sell, lease (Section 363 sales), or incur an obligation for property of the estate, other than cash collateral or DIP financing motions; or
  • Assumption or assignment of any executory contract or unexpired lease (including commercial real estate leases).

As drafted, unless there is an emergency, and then only to the extent it’s really necessary, the bankruptcy court should defer these decisions until after the 20th day following the filing of the Chapter 11 bankruptcy petition (although technically these apply under the other chapters of bankruptcy). One reason for the rule is to give time for a creditors committee to be appointed and retain counsel before important decisions are made. That said, the exceptions for cash collateral and DIP financing, as well as for rejection of leases and other executory contracts, means a lot can still be done during the early part of a case. When Section 363 sale or critical vendor motions come up on an emergency basis, it’ll be interesting to see how often courts, in applying this new rule, find the existence of irreparable harm.

Amended Rule 6006: Assumption, Assignment, And Rejection Of Executory Contracts. Similar to Rule 3007, Rule 6006 has been changed to put limits on when omnibus motions can be used to deal with executory contracts and leases. Under new Rule 6006(e), absent special court authorization, omnibus motions may be used for multiple executory contracts or leases only when all of the executory contracts to be assumed or assigned are (1) between the same parties, or (2) being assigned to the same assignee. This latter provision likely covers most Section 363 asset sales, so non-debtor contracting parties should continue to carefully review those motions, as discussed in this earlier post. An omnibus motion may also be used when a debtor or trustee seeks to assume, but not assign to more than one assignee, real property leases. In addition, omnibus motions may be used to request rejection of multiple executory contracts or leases.

New Rule 6006(f) provides that, when allowed, these omnibus motions can list no more than 100 executory contracts or leases in any one motion (unlike the chart on this fairly typical pre-amendment motion), and multiple motions will need to be numbered consecutively. The new rule also requires that permitted omnibus motions provide a variety of new information, including:

  • An alphabetical listing by party name;
  • The terms of the assumption or assignment, including for curing defaults; and
  • The identity of the assignee and the adequate assurance of future performance to be provided.

A Few Other Changes. The other amendments this year (1) permit a court to consider a change of venue, (2) clarify when corporate ownership disclosure needs to be made, (3) address constitutional challenges to statutes, and (4) specify procedures for protecting social security numbers and other private information in court filings. Check the clean or redline sets linked above to read these additional rule amendments.

Conclusion. This year’s amendments to the Federal Rules of Bankruptcy Procedure have more than their share of real changes and they will have an impact on business bankruptcy cases. The omnibus motion changes should help creditors from missing when their claim is the target of an objection and contract parties from failing to see that their executory contract or lease is part of a motion to assume and assign. Although cash collateral and DIP financing motions are not affected, the new irreparable harm standard for certain relief in the first 20 days of a case may prove interesting when emergency Section 363 sales are attempted. Stay tuned.

Recent Developments

How The Credit Crunch May Affect Corporate Debt Refinancings And Bank Lending

The Economist has two new articles on how the current troubles in the credit markets may impact the broader economy. The first is on the topic of "Business and the Credit Crunch." After discussing how several private equity buyout deals have unraveled, it offers an interesting observation:

What happens to private equity may be a leading indicator of how the crisis in the financial system will affect the rest of the business world, both because private-equity deals are so dependent on large amounts of debt, and because many of the shrewdest judges of corporate value work for private-equity funds. The number of new private-equity deals has plunged with the financial crisis, and nobody expects activity to pick up again soon. The collapse of deals suggests that the business climate has changed sharply.

While the article stops short of forecasting a recession in the United States, it notes that $160 billion of leveraged loans will come due in 2008 and "refinancing them may be a struggle in today’s financial markets." As one analyst commented, a severe recession — if it were to happen — could push the default rate on corporate bonds as high as 20%.

A second article focuses on the capital needs of commercial and investment banks as a result of recent and predicted write-downs. The open question is what impact these reductions in capital will have on future lending, in particular if banks seek to maintain capital ratios in the 10% range often seen. One prediction: write-downs through next year could reduce lending by as much as $2 trillion.

What does all this mean for business bankruptcy? A lot will depend on how long the credit crunch lasts and how widespread its impact extends.

  • It’s been almost five months since early signs first emerged of a turn in the buyout debt market that presaged the credit crunch and few are ready to predict when it will end.
  • Many insolvency professionals believe a significant increase in Chapter 11 bankruptcy filings is coming, even without a recession.
  • If the economy falls into an actual recession, the number of defaults on corporate bond issuances and other debt would rise dramatically.

With most economists still predicting that the U.S. economy will slow but not dip into recession, the most interesting question may be what would the default picture look like in such a low growth economy. These Economist articles suggest it may not be a pretty sight. 

Business Bankruptcy Issues Recent Developments

Assumption Of Trademark Licenses In Bankruptcy: An Update On The N.C.P. Marketing Case

Over a year ago, I posted on a first of its kind decision in In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), in which the U.S. District Court for the District of Nevada held that trademark licenses are personal and nonassignable 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 the 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. In December 2005, the parties appealed this decision to the Ninth Circuit. The appeal was fully briefed and had been scheduled for oral argument on November 5, 2007.

  • In July 2007, however, the N.C.P. Marketing Chapter 11 case was converted to Chapter 7. 
  • On October 24, 2007, the Chapter 7 trustee asked the Ninth Circuit to reschedule the oral argument because of a pending settlement in the case.
  • In response, the Ninth Circuit took the oral argument off calendar and directed the parties to move to dismiss the appeal if the settlement is approved by the Bankruptcy Court.

Still No Court Of Appeals Decision. If the settlement is approved, no Ninth Circuit decision will be issued. Instead, this case seems to be headed to an ending similar to that in In re Wellington Vision, Inc. (see this earlier post on the Wellington Vision case for more details), perhaps the only other bankruptcy decision to date to address this trademark issue. There, conversion of the case to Chapter 7 also led to a settlement without an appellate decision. With these recent developments in the In re N.C.P. Marketing case, trademark licensors and licensees will have to wait longer still for an appeals court decision on this important issue at the intersection of trademark and bankruptcy law.

Recent Developments

Merrill Lynch Comments On The Current U.S. Economy’s Striking Similarities To The Late 1980s

Merrill Lynch economists David Rosenberg and Neil Dutta have prepared a fascinating analysis comparing a number of current economic indicators with those from the late 1980s. (Hat tip to Brad Feld and Seth Levine.) You can view the report, entitled 1980s Redux?, by clicking on its title in this sentence.

Here are a few of their observations, which when combined with their startling side-by-side charts comparing the two cycles, make their point:

  • Inverted Yield Curve. "At the peak of the tightening cycle in the late 1980s, the Fed inverted the yield curve. It did the very same thing this time around. The yield curve leads by 5-6 quarters and was flashing economic stress signals a year-ago just as it did in the late 1980s."

  • Increase In Unemployment. "This expansion and the one in the late 1980s witness a dramatic tightening in labor markets and chronic shortages of skilled labor. [O]nce the unemployment rate hooks up from its low, a recession was not far behind."

  • Housing Market Deflation. "This cycle is also hauntingly similar to the 1980s because of what happened to the housing market. Years of massive credit extension, overbuilding and "new paradigm" thinking of housing as an asset class ultimately morphed into a massive excess inventory overhang, eroding credit quality and house price deflation. We are reliving that today, except the deflation is much broader and the credit issues far more complex and global in nature."

They also point out further similarities between the two periods, including that both had an LBO-financed M&A boom, a falling dollar, and a strong Asian stock market (then Japan, now China). These observations take on even more force when looking at their charts.

For companies, credit managers, and bankruptcy professionals trying to determine where the economy is headed, a look back to the economy of the late 1980s — which was followed by the recession of the early 1990s and a spike in Chapter 11 filings — might be a good starting point.

Business Bankruptcy Issues Recent Developments

A Fly In The Ointment: Sale Of Property May Cut Off Landlord’s Section 502(b)(6) Lease Rejection Claim For Future Rent

Here’s a scenario frequently seen in Chapter 11 cases. A tenant files bankruptcy and rejects a commercial real estate lease. The landlord files an unsecured lease rejection claim seeking to recover the lost future rent under the rejected lease. The claim amount is capped by Bankruptcy Code Section 502(b)(6) but may still be one of the larger unsecured claims in the case. Now let’s add a small, but relatively common, twist. Sometime later, but before distributions are made on the claim, the landlord sells the real estate that the debtor had occupied under the rejected lease.

The FLYi Chapter 11 Case. That, complete with the twist, was the situation in the In re FLYi, Inc. Chapter 11 case pending in the Delaware Bankruptcy Court. After the landlord sold the property, the liquidation trust established under the debtor’s Chapter 11 plan of reorganization objected to the landlord’s claim, arguing that after the sale of the property the debtor had no further obligations under the lease. Virginia law applied because the property was located in Dulles, Virginia. As described by the Bankruptcy Court, the landlord had three options under Virginia law:

[D]o nothing and sue for the rent remaining under the Lease; reenter the Premises for the sole purpose of re-letting it without terminating the Lease; or re-enter the Premises and exercise full dominion over the premises thereby terminating the Lease and eliminating FLYi’s obligation to pay any future rent.

The landlord argued that this interpretation of the law was wrong but asserted that provisions in the lease protected the landlord’s claim anyway. The Bankruptcy Court rejected those arguments and held that the landlord’s sale of the property terminated both the lease and the landlord’s right to future rent after the date of the sale. A copy of the Bankruptcy Court’s decision is available here.

Be sure to read the Delaware Business Bankruptcy Report’s interesting discussion for more details on the decision, including the arguments advanced and the Bankruptcy Court’s treatment of them.

What Does This Mean For Landlords? A landlord contemplating a sale of the real property will have to consider what impact that sale might have on its lease rejection claim.

  • In states like Virginia where, according to the Bankruptcy Court in the FLYi case, termination of a lease cuts off a landlord’s claim for future rent, landlords will have to be prepared to lose all or a portion of a lease rejection claim if they sell the real property. 
  • The outcome may be different in other states. Section 1951.2 of the California Civil Code, for example, expressly permits a landlord, upon termination of a lease, to recover the present value of the difference between the unpaid future rent under the lease and the amount of rent that could reasonably be avoided through mitigation efforts. This may permit a landlord to sell the property and still retain a lease rejection claim.
  • When state law allows it, landlords may seek to include provisions in a lease to preserve contractually the right to a post-sale lease damages claim.

What Does This Mean For Bankruptcy Estates? Debtors, liquidation trusts, and other estate representatives may have an incentive to determine whether the landlord still owns the property. In states where a post-rejection sale of the property operates to cut off the landlord’s future rent claim, this fact could provide a new ground for an objection to the landlord’s Section 502(b)(6) claim.

Conclusion. Time will tell how frequently this scenario will play out in future cases, but landlords should expect to see the "did you sell the property" question asked more often going forward.

Business Bankruptcy Issues Recent Developments

New Article Tackles Whether Unsecured Creditors Should Be Able To Recover Post-Petition Attorney’s Fees, The Question Left Open By The Travelers Decision

When the U.S. Supreme Court overruled the Ninth Circuit’s so-called Fobian rule in the Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. decision (available here) in March 2007, it left for another day the question of whether unsecured creditors could recover, as part of their unsecured claims, post-petition attorney’s fees incurred during the course of the bankruptcy case.

Early Decisions Take Different Views. Since the Travelers decision, two bankruptcy courts have issued decisions but have come to different conclusions on that question. 

  • In May 2007, in the In re Qmect, Inc. decision (available here), the U.S. Bankruptcy Court for the Northern District of California held that unsecured creditors could recover post-petition attorney’s fees. For more on that decision, see this earlier post on the case and its analysis. 
  • In July 2007, in the In re Electric Machinery Enterprises, Inc. case (available here), the U.S. Bankruptcy Court for the Middle District of Florida came to the opposite conclusion, following a majority of courts that had addressed this issue unrestrained by the Ninth Circuit’s Fobian decision. See this previous post for more on the Florida decision.

New Article Sides With Majority View. A new article to be published in the Winter 2007 issue of the American Bankruptcy Institute Law Review, gives context for these differing views and argues that the majority position is the correct one. The article, entitled "Interpreting Bankruptcy Code Sections 502 and 506: Post-Petition Attorneys’ Fees in a Post-Travelers World," was written by Professor Mark S. Scarberry, Professor of Law at the Pepperdine University School of Law. Professor Scarberry is the current Robert M. Zinman Scholar in Residence at the American Bankruptcy Institute. A copy of the article is available for download from the Social Science Research Network website by following this link.

A Textual Argument. The centerpiece of the article is Professor Scarberry’s interesting analysis of the interplay between Sections 502(b) and 506 of the Bankruptcy Code and the textual argument he advances to support the majority view.

  • A key building block of this argument is his conclusion that the language in Section 502(b), which provides that a claim is to be allowed in an amount "as of the date of the filing of the petition," precludes inclusion of post-petition amounts as part of the Section 502(b) claim allowance. 
  • He then argues that Section 506(b)’s function is to add post-petition interest and "reasonable fees, costs, and charges" to this Section 502(b) allowed amount but only for secured claims (determined under Section 506(a)) and only when the value of a secured creditor’s collateral exceeds the allowed amount of the claim, determined under Section 506(a).
  • He contends that Section 506(b)’s use of the phrase "there shall be allowed" demonstrates that its purpose is to allow amounts not otherwise allowable under Section 502(b).

The Debate Continues. Professor Scarberry’s article is an excellent resource for those seeking to understand the history and background of this issue. It also provides debtors, creditors committees, and their attorneys with arguments to oppose an unsecured creditor’s attempt to recover post-petition attorney’s fees. The issue, however, remains far from settled in the courts. 

  • The majority view, now bolstered by the arguments in Professor Scarberry’s article, will probably prevail in many cases.
  • Still, the In re Qmect decision shows that at least some courts may allow these fees.

Until this issue is resolved by the Supreme Court, or at least by more Courts of Appeals, unsecured creditors with a contractual or nonbankruptcy statutory right to attorney’s fees may try their luck and seek allowance of post-petition attorney’s fees in bankruptcy cases as part of their unsecured claims.