Latest Articles

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

S&P Warns A Big Increase In Debt Defaults Is Coming

In an article entitled "Defaults wave to hit corporate US," the Financial Times reports that Standard & Poor’s is predicting that $35 billion in corporate debt will go into default by the end of 2008. This is similar to the view taken by Moody’s, reported in a recent post.

According to the Financial Times, S&P believes that the slowing economy, together with liquidity issues caused by credit market problems, puts approximately 75 issuers of junk debt at a high risk of default. These companies are primarily in the media, healthcare, and consumer products industries. Not surprisingly, S&P believes that the default rate could go up significantly if the economy were to decline more than currently predicted.

Struggling companies that took on substantial debt during the recent favorable credit environment “are highly reliant on financial market access to support operational cash needs, but the plentiful liquidity for high-yield borrowers is almost surely a thing of the past,” according to S&P.

Of course, debt defaults frequently lead to Chapter 11 bankruptcy filings. With S&P joining Moody’s in predicting a rise in defaults, the ride could get bumpy from here.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

A UK Perspective On The Turmoil In The Credit Markets

On his Insolvency Blog, Chris Laughton, a recovery and insolvency partner at the UK’s Mercer & Hole firm of chartered accountants, gives a UK and European perspective on the recent gyrations in the credit markets. His new post is entitled "The boom-bust cycle: where are we now?" and it chronicles the progression of the credit crunch from the United States to the UK and beyond. 

After providing links to a number of recent articles from the UK press on the subject, Chris sums up his views:

So what does all this mean? Yes the capital markets are in turmoil, banks are lending much more cautiously and some high risk investment vehicles are failing, but essentially this is only a liquidity problem. Its effect though is that stressed businesses will no longer be able to borrow their way out of trouble as they have become hard-wired to do over the last 3 years.

Crisis cash management and operational and corporate restructuring will come back into vogue as refinancing becomes passé. Only if stressed businesses fail to seek appropriate and timely assistance will the business insolvency statistics really start to rise.

His informative post, and the UK articles highlighted, underscores the interconnected nature of today’s global credit markets. It makes for interesting reading — wherever you are.

Business Bankruptcy Issues The Financially Troubled Company

Are “Termination On Bankruptcy” Contract Clauses Enforceable?

Practically every contract has a provision that makes the bankruptcy or insolvency of one contracting party a trigger for the other party to terminate the contract. These are standard fare and rarely negotiated unless they also include a provision for the reversion back of ownership of property, often intellectual property, upon bankruptcy or insolvency. This post takes a look at these provisions and examines whether they are enforceable.

The Typical Ipso Facto Clause. Termination on bankruptcy provisions are often known as ipso facto clauses (the Latin phrase meaning "by the fact itself") because the language provides that the fact of bankruptcy itself is enough to trigger the termination of the agreement. Here’s a common provision:

This Agreement shall terminate, without notice, (i) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of either party’s debts, (ii) upon either party making an assignment for the benefit of creditors, or (iii) upon either party’s dissolution or ceasing to do business.

Variants of this language are found in many types of contracts, including licenses, leases, and development agreements. Some provide that termination is automatic and others first require notice. Termination triggers may include:

  • Filing a voluntary bankruptcy;
  • Having an involuntary bankruptcy filed against a party;
  • Becoming insolvent (frequently the term is left undefined in the contract);
  • Admitting in writing that the party is insolvent;
  • Making a general assignment for the benefit of creditors (a liquidation alternative recognized under the laws of many states); or
  • Tripping a financial condition covenant.

The bankruptcy or insolvency of either party is frequently a termination trigger. However, when the financial condition of only one contracting party is in doubt, the more financially stable party may insist on a one-sided provision allowing it to get out of the agreement upon the weaker party’s insolvency or bankruptcy. 

Notso Fasto: The Bankruptcy Code Stops The Clause In Its Tracks. These termination provisions may be common, but are they enforceable? The short answer, which may be surprising to some, is generally "no." Two key provisions of the Bankruptcy Code lead to this result. First, Section 541(c) of the Bankruptcy Code provides that an interest of the debtor (the bankrupt company or person) in property becomes "property of the estate," meaning that the debtor does not lose the property or contract right, despite a provision in an agreement:

that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.

11 U.S.C. §541(c). Translated from bankruptcy-ese, this statute means that a clause that terminates a contract because of the "insolvency" or "financial condition" of the debtor, or due to the filing of a bankruptcy case, will be unenforceable once a bankruptcy case has been filed.

A second Bankruptcy Code provision, Section 365(e)(1), governs ipso facto clauses in executory contracts, which are agreements under which both sides still have important performance remaining (discussed in more detail in this earlier post). Section 365(e)(1) provides:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
11 U.S.C. §365(e)(1). This statute generally makes ipso facto provisions in executory contracts and leases unenforceable.

Why Put Ipso Facto Clauses In Contracts In The First Place? If these termination provisions are generally unenforceable, why do parties seem to include them in almost every contract? There are three main reasons.

Force Of Habit. One reason is that under the old Bankruptcy Act of 1898, replaced by the Bankruptcy Code in 1979, these ipso facto clauses were enforceable. Over the years, lawyers and businesses got used to including them in their contract forms and they have continued to write them into many agreements. Since it’s always possible that the Bankruptcy Code could be changed to reinstate the old rule, lawyers often see little reason to take them out.

It Takes An Actual Bankruptcy. Another and perhaps more important reason is that the rule applies only if a bankruptcy is actually filed. If an ipso facto provision provides that the agreement terminates upon a party’s insolvency, and no bankruptcy case is ever filed, it’s possible that the solvent party could terminate the agreement using the ipso facto provision. But be forewarned: if a bankruptcy case is later filed, an insolvency-based termination made before the bankruptcy filing may not be enforced in the bankruptcy case. This means that the debtor may still have a chance to retain the rights under the contract, including assuming or assigning an executory contract during the bankruptcy case.

A Limited Exception In Bankruptcy. A third reason is that an important, albeit limited, exception to the rule applies even after a bankruptcy is filed. The exception stems less from the ipso facto clause itself and more from the rules governing assumption of certain types of executory contracts, including intellectual property licenses (at least in some circuits).

  • Section 365(e)(2) of the Bankruptcy Code, in conjunction with Section 365(c)(1), provides that an ipso facto clause can be enforceable if the debtor or trustee is not permitted by "applicable law" to assume or assign the executory contract. Simply put, if applicable law provides that an IP license or another executory contract cannot be assumed by the debtor or trustee without the other party’s consent, then the non-debtor contracting party can force rejection of the license or seek relief from the automatic stay to terminate the agreement based on the ipso facto clause.
  • Although an analysis of the law governing assumption and assignment of IP licenses and related agreements is beyond the scope of this post, you can find a detailed discussion in an earlier one entitled "Assumption of IP Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" 

A Word To The Wise. Parties include "termination on bankruptcy" provisions in contracts all the time, despite the general rule making them unenforceable in bankruptcy. Unfortunately, some do so without realizing that the provision may be ineffective, and that can lead to trouble. If enforcing an ipso facto clause is important to one of your agreements, especially if you also seek the highly problematic reversion of intellectual property or other rights upon such a termination, be sure to get specific legal advice on your situation, including whether alternative approaches may exist to help achieve your objectives.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Is The Default Rate On High-Yield Debt About To Double?

According to Moody’s, the credit rating and investor service firm, the default rate on high-yield or junk bond debt is likely to increase substantially from the current level of 1.4%. Moody’s predicts that the default rate will rise to 4.1% by August 2008 and then to 5.1% by August 2009. 

  • As reported by Credit, Moody’s director of corporate default research believes that "higher spreads and diminished liquidity" have increased the default risk for distressed issuers.
  • Unless the U.S. economy falls into a recession, however, the default rate is predicted to stay below its long-term average of 5.0%, at least until 2009. Any real downturn in the economy could push the default rate higher.

The New York Times DealBook Blog has a similar story, pointing out that Moody’s predicted in another report that the U.S. industries likely to have the highest default rate are packaging, construction, consumer durables, and automotive. Also, companies that need new financing will be more at risk than firms that already obtained financing on the favorable terms available in the credit markets until recently.

As The DealBook Blog points out, a rising default rate will likely lead to an increase in Chapter 11 bankruptcy filings. Stay tuned. 

Business Bankruptcy Issues Recent Developments

Another Court Follows The Footstar Decision On Assumption Of IP Licenses In Bankruptcy

Intellectual property licenses continue to be significant to companies across a wide range of industries. This fact makes their treatment in business bankruptcy cases a topic of keen interest. 

Can A Debtor Licensee Retain IP License Rights? When the debtor in possession is a licensee under a patent, copyright, or trademark license, a key question arises: Can the license be assumed (bankruptcy-speak for kept) or will the bankruptcy filing put the licensor in a position to force rejection of the license — resulting in the ultimate termination of the debtor’s right to use the licensed IP?  A new case, discussed below, recently sided with the debtor in possession.

One Statute, Three Tests. This issue has led to a significant split of authority among bankruptcy courts and courts of appeal around the country, stemming from different interpretations of the language in Section 365(c)(1) of the Bankruptcy Code. That section provides as follows:

(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.

Some courts, including the U.S. Court of Appeals for the Ninth Circuit, have sided with the licensor and interpret Section 365(c)(1) to prohibit both assignment and assumption. Other courts, including the First Circuit, have permitted such licenses to be assumed.

  • Despite the split, most courts agree that Section 365(c)(1) prohibits assignment of executory contracts without the non-debtor contracting party’s consent if "applicable law" requires such consent because that would require the non-debtor party to accept performance from a new party. 
  • A number of courts have held that when the "applicable law" is federal patent, copyright, or trademark law, such consent is required.
  • Courts diverge, however, on whether the statute’s language should be read to prohibit a debtor in possession from assuming such executory contracts or only from assigning them.

Rather than cover that ground here, if this topic is new to you I suggest reading an earlier post entitled "Assumption Of Intellectual Property Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" It discusses in detail how different courts have interpreted Section 365(c)(1), leading to the licensor-favorable "hypothetical test," the debtor-favorable "actual test," and the newer, debtor-favorable Footstar analysis. 

A Word On Footstar. Before moving on to the new decision, a brief word about the Footstar case may be helpful. In In re Footstar, Inc,, 323 B.R. 566 (Bankr. S.D.N.Y. 2005), Judge Adlai Hardin of the U.S. Bankruptcy Court for the Southern District of New York took a somewhat different approach in analyzing the statute. He concluded that 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 when assumption is sought because assumption does not require the non-debtor party to accept performance from a new party other than the debtor or debtor in possession. A trustee is a new party and the statute logically provides that a trustee may not "assume or assign" such an executory contract.

A Common Scenario. How does this issue come up in Chapter 11 cases? Well, here’s a typical situation. The debtor is the licensee under a prepetition patent license. The patent licensor files a motion to compel the debtor in possession to reject the patent license agreement or alternatively to have the automatic stay lifted to permit the licensor to cancel the agreement. The licensor argues that under the "hypothetical test" interpretation of Section 365(c)(1), the debtor in possession cannot assign the license and, as a result, cannot assume the license either. With neither option open, the licensor argues, the debtor in possession should be compelled to reject the license.

The Aerobox Decision. This was the situation that recently played out in the In re Aerobox Composite Structures, LLC Chapter 11 bankruptcy case. Ruling on just such a motion by a patent licensor, on July 27, 2007, Judge Mark B. McFeeley of the U.S. Bankruptcy Court for the District of New Mexico issued an 11-page decision holding that the actual test, and Judge Hardin’s analysis in Footstar, was the correct interpretation of Section 365(c)(1). As such, he denied the licensor’s motion and held that the debtor in possession was not barred by Section 365(c)(1) of the Bankruptcy Code from assuming the prepetition patent license at issue in that case. The Bankruptcy Court summed up its holding as follows:

Similarly, the bankruptcy court in Footstar reasons that it makes perfect sense for the statute, which uses the term, “trustee,” to prohibit the trustee from assuming or assigning a contract, because the trustee is an “entity other than the debtor in possession” but it makes no sense to read “trustee” to mean “debtor in possession.” Footstar, 323 B.R. at 573. Doing so

would render the provision a virtual oxymoron, since mere assumption [by the debtor in possession] (without assignment) would not compel the counterparty to accept performance from or render it to “an entity other than” the debtor.

Id.

This Court agrees.

Thus, where the debtor-in-possession seeks to assume, or, as is the situation in the instant case, where the debtor-in-possession has neither sought to assume nor reject the executory contract but simply continues to operate post-petition under its terms, 11 U.S.C. § 365(c)(1) does not prohibit assumption of the contract by the debtor-in-possession and cannot operate to allow the non-debtor party to the executory contract to compel the Debtor to reject the contract. In reaching this conclusion, the Court finds that the “actual test” articulated in Cambridge Biotech, and the reasoning of the court in Footstar, is the better approach to § 365(c)(1) when determining whether a debtor-in-possession is precluded from assuming an executory contract.

Venue Still Matters. The decision is interesting because it represents another bankruptcy court, this time outside of the Southern District of New York, endorsing the analysis in the Footstar decision. That said, Judge McFeeley wrote on something of a clean slate because the Tenth Circuit has not yet taken a view on whether the hypothetical test, the actual test, or the Footstar analysis controls. As this circuit-by-circuit chart of Section 365(c)(1) decisions shows (last updated in March 2007), many other circuits have staked out a position on the issue. Absent a Supreme Court decision or new legislation resolving the circuit split, where a debtor files bankruptcy will continue to make a big difference in the relative rights of licensors and debtors over intellectual property licenses in Chapter 11 cases.

Business Bankruptcy Issues Recent Developments

Northern District Of California Bankruptcy Court Proposes Amendments To Local Rules

As bankruptcy lawyers know, complying with local rules is an essential part of appearing before a particular court. In response to the changes made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA), as well as the implementation of the electronic case filing system (called ECF), the Bankruptcy Judges for the Northern District of California have proposed a set of amendments to the Court’s local bankruptcy rules.

  • You can find a clean version and a redline version of the proposed amended local rules by clicking on the appropriate link in this sentence.
  • Attorneys or others wishing to comment on the local rules may do so by going to this website form or by sending those comments to the address indicated on that page. The deadline is September 27, 2007.

Among the amendments affecting Chapter 11 corporate bankruptcy cases are those governing  replacement of a "responsible individual" for a Chapter 11 debtor or debtor in possession, entry of a final decree closing a case, and the general electronic case filing procedures. A number of other revisions are aimed at consumer bankruptcy cases.

Although the changes do not appear to be dramatic, attorneys who practice before the Northern District of California, and businesses with cases or adversary proceedings pending in that court, will want to stay up to date on these local rule amendments.

Business Bankruptcy Issues Recent Developments

Lack Of Recognition: New Case Shows That Chapter 15 International Bankruptcy Protection Isn’t Automatic

On August 30, 2007, in twin decisions in recent cases involving two Bear Stearns hedge funds (available here and here), Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York made clear that recognizing a foreign insolvency proceeding in a Chapter 15 cross-border bankruptcy case is not to be "rubber stamped by the courts."  The decision is of particular interest because Judge Lifland was one of the authors of Chapter 15 and the Model Law on Cross-Border Insolvency on which it is based.

The Bankruptcy Court’s Ruling. In a nutshell, the Bankruptcy Court held that although the two hedge funds were organized under the laws of the Cayman Islands, their business operations were in New York and not in the Cayman Islands. As such, the Bankruptcy Court would not recognize the Cayman Islands insolvency proceeding as either a "foreign main proceeding" or a "foreign nonmain proceeding." If you’re unfamiliar with this terminology, keep reading for an overview of Chapter 15 and more details on the decision.

A Chapter 15 Refresher. On October 17, 2005, as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (known as BAPCPA), a new Chapter 15 of the Bankruptcy Code went into effect governing ancillary and other cross-border cases. (For those already familiar with ancillary proceedings, Section 304 of the Bankruptcy Code, which previously governed those proceedings, was repealed although many of its concepts were retained in Chapter 15.)

  • The main purpose of enacting Chapter 15 was to incorporate the Model Law on Cross-Border Insolvency as part of the Bankruptcy Code. 11 U.S.C. § 1501(a). My partner Adam Rogoff, who has significant experience with international insolvency matters, has prepared a very helpful chart comparing Chapter 15 and the Model Law’s provisions.
  • Chapter 15 is used principally by representatives of, or creditors in, foreign insolvency proceedings to obtain assistance in the United States, by a debtor or others seeking to obtain assistance in a foreign country regarding a bankruptcy case in the United States, or when both a foreign proceeding and a bankruptcy case in the United States are pending with respect to the same debtor. 11 U.S.C. § 1501(b). 

Several important terms involving the different types of foreign insolvency proceedings are key to understanding the scope of Chapter 15 and Judge Lifland’s ruling. 

  • A “foreign proceeding” means “a collective judicial or administrative proceeding in a foreign country, including an interim proceeding, under a law relating to insolvency or adjustment of debts in which proceeding the assets and affairs of the debtor are subject to control or supervision by a foreign court, for the purpose of reorganization or liquidation.” 11 U.S.C. § 101(23). 
  • For purposes of Chapter 15, “debtor” means “an entity that is the subject of a foreign proceeding.” 11 U.S.C. § 1502(1). 
  • A "foreign main proceeding" means a foreign proceeding pending in the country where the debtor has the center of its main interests which, in the absence of contrary evidence, is presumed to be the location of the debtor’s registered office. 11 U.S.C. §§ 1502(4) and 1516(c). 
  • A "foreign nonmain proceeding" means a foreign proceeding, other than a foreign main proceeding, pending in a country in which the debtor has an “establishment,” defined as a place of operations where the debtor carries out a nontransitory economic activity. 11 U.S.C. §§ 1502(2) and (4). 

Chapter 15’s basic procedure is straightforward. A case is commenced when a foreign representative, often a liquidator or provisional liquidator, files a petition for recognition of a foreign proceeding. 11 U.S.C. §§ 1504 and 1515(a). If properly filed, the bankruptcy court is entitled to presume that the facts stated in the petition are correct and the attached documents are authentic. 11 U.S.C. §§ 1516(a) and (b). As long as recognition would not be manifestly contrary to the public policy of the United States, the court must enter an order recognizing the foreign proceeding (here’s an example order). 11 U.S.C. §§ 1506 and 1517(a). 

Evidence Trumps Presumptions. With all this in mind, Judge Lifland held that the Cayman Islands proceeding could not be considered either a "foreign main" or a "foreign nonmain" proceeding. Despite Chapter 15’s presumption that the registered office or place of incorporation, here the Cayman Islands, would be a debtor’s "center of main interests" (known in the trade as the "COMI"), other evidence showed that the actual center of their activity was in New York. This, Judge Lifland held, precluded recognition of the Cayman Island proceeding as a foreign main proceeding. Also, without a true business presence there, the Bankruptcy Court could not conclude that the Cayman Islands was a place where the funds had "nontransitory economic activity," precluding foreign nonmain recognition. Judge Lifland held that even in the absence of objection, Chapter 15 places the burden of proof on these issues on the foreign representatives. Here, the facts in the petition and related papers showed that New York, and not the Cayman Islands, was the COMI for the funds.

Is Non-Recognition The End Of The Road? One of the most interesting aspects of Judge Lifland’s decision is the door he left open to the foreign representatives. Although the two hedge funds could not get protection under Chapter 15 of the Bankruptcy Code based on their filing in the Cayman Islands, they have the option of filing an involuntary Chapter 7 or Chapter 11 bankruptcy case in the United States.

  • Although Section 304 of the Bankruptcy Code, the old "ancillary proceedings" section, was repealed when Chapter 15 was enacted, Section 303 — and the ability of foreign representatives to file an involuntary Chapter 7 or Chapter 11 bankruptcy case — was not repealed.
  • Judge Lifland noted that Section 303(b)(4) of the Bankruptcy Code allows a foreign representative, such as the provisional liquidators appointed by the Cayman Islands court, to file an involuntary bankruptcy petition against the hedge funds and obtain bankruptcy protection in this manner.

Additional Reading In The Blogs. For more on the case, be sure to read Jordan Bublick’s informative post on his Miami Florida Bankruptcy Law blog and Chris Laughton’s commentary on his Insolvency Blog out of the UK. For the hedge fund industry’s perspective, you may find this post on the Hedgefunds Weblog of interest.

A Few Observations. With many offshore investment funds operating in the United States, Chapter 15 filings may become even more commonplace in the future, especially if we continue to encounter the kind of turbulence recently seen in the financial markets. Although the enactment of Chapter 15 made it easier for foreign representatives to get bankruptcy protection in the United States, the process is not automatic. As Judge Lifland’s decision shows, bankruptcy courts will scrutinize the facts — even in essentially unopposed cases — before agreeing to formally recognize a foreign proceeding. Without such recognition, foreign representatives will have to fall back on the more cumbersome involuntary bankruptcy process or find themselves with no U.S. bankruptcy protection at all.