Business Bankruptcy Issues

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Business Bankruptcy Issues Recent Developments

Winter 2014 Edition Of Bankruptcy Resource Now Available

I hope you had a wonderful holiday season and Happy New Year everyone.

To start the new year off, the Winter 2014 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. 

This edition of Absolute Priority covers a range of cutting edge topics, including:

  • An Eleventh Circuit ruling that indirect benefits from a Subchapter S election can constitute reasonably equivalent value for fraudulent transfer purposes;
  • The Ninth Circuit’s decision permitting recharacterization claims; and
  • A recent Seventh Circuit decision on the validity of a cross-collateralized real estate lien.

It also reports on some of our recent representations, including for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others, and our work for Chapter 11 debtors. Recent committee cases include Mervyn’s Holdings, Appleseed’s Intermediate Holdings, and Underground Energy, among others. Recent debtor representations include Cylex (now Immunology Partners), IntraOp Medical (now MC Liquidation), and Nirvanix.

I hope you find the latest edition of Absolute Priority to be of interest. Please note that this will be the final issue in newsletter format, as soon our group will be providing future insights through a new Absolute Priority blog, in addition to this In The (Red) blog. Stay tuned for more details. 

Business Bankruptcy Issues Recent Developments

Innovation Act, Passed By The House, Would Make Major Changes To Section 365(n)’s IP Licensee Protections

It isn’t law yet, but on December 5, 2013, the U.S. House of Representatives passed a significant patent reform bill known as the "Innovation Act." Although the focus of the legislation is on patent infringement litigation and other patent law revisions, the Innovation Act, H.R. 3309, would also make major changes to Section 365(n) of the Bankruptcy Code. Follow the link in the prior sentence for a copy of the Innovation Act in the form passed by the House and received in the Senate last week. It would also address the interplay between Section 365(n) and Chapter 15 cross-border bankruptcy cases, the subject of my last post, on the Qimonda AG decision from the U.S. Court of Appeals for the Fourth Circuit.

Licensee Protections Under The Current Version Of Section 365(n). Section 365(n) was added to the Bankruptcy Code in 1988 to protect licensees of intellectual property in the event the licensor files bankruptcy.

  • Under Section 365(n) as it now exists, if a debtor or trustee rejects a license, the licensee can elect to retain its rights to the licensed intellectual property, including a right to enforce an exclusivity provision.
  • In return, the licensee must continue to make any required royalty payments.
  • The licensee also can retain rights under any agreement supplementary to the license, which should include source code or other forms of technology escrow agreements.
  • Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • To read more about the current version of Section 365(n)’s benefits and its protections, follow the link in this sentence.

Limits Of The Current Section 365(n). These existing protections have several significant limitations. First, the Bankruptcy Code’s special definition of "intellectual property" excludes trademarks from the scope of Section 365(n)’s protections (although a recent Seventh Circuit decision may have opened an alternative path for trademark licensees to retain their rights). Another is that Section 365(n) is in the U.S. Bankruptcy Code and applies only in a U.S. bankruptcy case. Most other countries do not have protections similar to Section 365(n).

Proposed Changes In The House-Passed Innovation Act. The Innovation Act would make four major changes to Section 365(n)’s protections for licensees.

  • First, it would extend Section 365(n)’s protections, including through an amendment to Section 101(35A) of the Bankruptcy Code’s definition of intellectual property, to licenses of trademarks, service marks, and trade names.
  • Second, rejection of a trademark, service mark, or trade name license would not relieve the trustee (or presumably a debtor in possession in a Chapter 11 case) of the debtor’s contractual obligations to monitor and control the quality of a licensed product or service.
  • Third, it would expand the payments that a licensee would have to continue to make to the estate, if it elected to retain its license rights, to include not only "royalty" payments but also "other" payments under the license.
  • Fourth, it would amend Section 1522 of the Bankruptcy Code to make Section 365(n) directly applicable to Chapter 15 cases, providing that if a foreign representative rejects or repudiates an IP license, the licensee would be entitled to elect to retain its IP rights under Section 365(n).

If enacted and signed by the President, the Innovation Act’s revisions would apply as of the date of enactment to pending and future cases.

Will The Innovation Act Become Law? I’m a bankruptcy lawyer, not a political analyst, but it’s fair to say we shouldn’t get too excited about these potential legislative changes just yet. The Innovation Act has passed only the House and has been referred to the Senate Committee on the Judiciary, where the bill meets an uncertain fate. Even if the Innovation Act passes the Senate, the Section 365(n) provisions could be amended or the legislation could otherwise stall. However, the Innovation Act is not a one-party bill: it passed the House with a large bipartisan majority on a 325-91 vote. That suggests it has the potential for support in the Senate.

Potential Impact Of Innovation Act’s Changes To Section 365(n). If the changes to Section 365(n) do become law, they would be the most significant revisions since its enactment in 1988.

  • The biggest changes would be the extension of Section 365(n)’s protections to trademarks, service marks, and trade names, together with the monitoring obligations on a trustee. In the 25 years since Section 365(n) was enacted, trademark licensees have lived under the specter of losing trademark license rights in bankruptcy. These revisions would be a sea change in the trademark area.
  • In addition, the Innovation Act provides that the trustee or debtor in possession would not be relieved of a contractual obligation to continue to monitor the quality of goods or services using a mark, in effect limiting the benefits of rejection to an estate for the protection of consumers. However, it’s unclear how a trustee would be able to meet such an obligation, particularly if an estate had no assets, and how a trustee could meet a long-term obligation to monitor quality given that the Chapter 7 case would eventually be closed. These were some of the difficult issues that led Congress to leave trademarks out of Section 365(n) originally.
  • Another significant change is the requirement that a licensee that elects to retain its IP rights under Section 365(n) essentially continue to make all payments under the license agreement and not simply those determined to be "royalty" payments. If this provision becomes law, drafters of license agreements will need to consider how rejection and the non-performance of the licensor’s obligations would impact payments otherwise required under the license agreement.
  • As a timely anticipation of the Fourth Circuit’s Qimonda AG decision, the Innovation Act would apply Section 365(n) in all Chapter 15 cases through an amendment to Section 1522. The language used — applying when a foreign representative rejects or "repudiates" a license agreement — suggests that the House intended this to cover not only rejection under Section 365 of the Bankruptcy Code but also equivalent foreign law powers to repudiate or disclaim contracts. By placing the Section 365(n) reference in a new, separate subsection of Section 1522 governing protection of creditors and other interested persons, it seems that Section 365(n) would apply in all Chapter 15 cases, regardless of whether the foreign representative sought preliminary or discretionary relief under Sections 1519 or 1521.

Conclusion. If it becomes law in its current form, the Innovation Act would bring the most sweeping changes to Section 365(n) since its enactment in 1988. Although there’s a long way to go before that actually happens, the breadth of the proposed changes and their impact on bankruptcy and IP law makes this piece of legislation one to watch. Stay tuned.

Business Bankruptcy Issues Recent Developments

When Worlds Collide, The Sequel: Fourth Circuit Rules On Section 365(n)’s IP Licensee Protections In Chapter 15 Cross-Border Bankruptcy

My how time flies in protracted bankruptcy litigation. More than four years ago, as I reported back at the time, the Bankruptcy Court in the Chapter 15 cross-border bankruptcy case of Qimonda AG issued its first decision on the application of Section 365(n) in that case. After an initial appeal, a four-day trial on remand, and another appeal, last week the U.S. Court of Appeals for the Fourth Circuit issued a major decision that may bring the litigation to a close.

Even if you are not a Chapter 15 bankruptcy aficionado, this decision has important implications for licensees of intellectual property, especially when the IP owner is a foreign entity.

Before diving into the Fourth Circuit’s decision and examining where the decision leaves licensees, let’s first take a look at Section 365(n), Chapter 15, and the long and winding road that led to the Fourth Circuit’s decision. Or, if so inclined, you can just jump to the discussion of the Fourth Circuit’s decision and where it leaves licensees, found toward the end of this post.

Section 365(n) And Licensee Rights. Section 365(n) was added to the Bankruptcy Code to protect licensees of intellectual property in the event the licensor files bankruptcy.

  • Under Section 365(n), if the debtor or trustee rejects a license, a licensee can elect to retain its rights to the licensed intellectual property, including a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payments.
  • The licensee also can retain rights under any agreement supplementary to the license, which should include source code or other forms of technology escrow agreements.
  • Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • For more on Section 365(n)’s benefits and protections, follow the link in this sentence.

Limits Of Section 365(n). These protections, however, have their limits. One is that the Bankruptcy Code’s special definition of “intellectual property” excludes trademarks from the scope of Section 365(n)’s protections (although at least one recent decision may have opened an alternative path for trademark licensees to retain their rights). Another is that Section 365(n) is in the U.S. Bankruptcy Code and applies only in a U.S. bankruptcy case. Most other countries do not have protections similar to Section 365(n).

Chapter 15 Bankruptcy. Chapter 15 allows a foreign entity’s official representative to obtain U.S. bankruptcy protection for assets and interests in the United States, ancillary to the insolvency proceedings in the entity’s home country. It was was added to the Bankruptcy Code to implement certain cross-border insolvency procedures when corporations or others have assets and interests in more than one country. To read more on Chapter 15 bankruptcy, follow the link in this sentence.

Does Section 365(n) Apply In Chapter 15 Cases? An open question has been what would happen if a foreign licensor were the subject of a cross-border case under Chapter 15 of the U.S. Bankruptcy Code. Would Section 365(n) apply to protect licensees in a Chapter 15 proceeding?

  • In the Qimonda case, the two worlds collided — Chapter 15’s cross-border bankruptcy procedures and Section 365(n)’s protections for IP licensees.
  • The first bombshell came in November 2009. Judge Robert G. Mayer of the U.S. Bankruptcy Court for the Eastern District of Virginia issued an initial decision, holding that Section 365(n)’s protections did not apply in the Chapter 15 case, starting the four-year journey to the Fourth Circuit’s decision.

The Qimonda Chapter 15 Case. Qimonda, a German company that manufactured semiconductor devices, was in an insolvency proceeding in Germany. The principal assets of Qimonda’s estate were approximately 10,000 patents, of which roughly 4,000 were U.S. patents. It had issued licenses of rights under those U.S. patents to third party licensees. Qimonda’s German insolvency administrator had filed the Chapter 15 case to seek recognition by the Bankruptcy Court of the pending German insolvency proceeding as a “foreign main proceeding.” The Bankruptcy Court granted recognition and, at the request of the administrator, granted him discretionary relief under Section 1521(a)(5) of the Bankruptcy Code, entrusting to him the administration of all of Qimonda’s assets within the United States, primarily the 4,000 U.S. patents. In its supplemental order granting relief under Section 1521, the Bankruptcy Court on its own provided that, among other things, Section 365 of the U.S. Bankruptcy Code would apply to the Chapter 15 case (it does not apply automatically in Chapter 15 cases).

U.S. Licensees Invoke Section 365(n). Following the Bankruptcy Court’s supplemental order, certain U.S. licensees asserted Section 365(n) rights in an attempt to retain their rights to the intellectual property that Qimonda had licensed them.

The Bankruptcy Court’s Decision. In November 2009, Judge Mayer issued the first decision on the issue, agreeing with Qimonda’s administrator and modifying the prior supplemental order to exclude the effect of Section 365(n). Judge Mayer provided that Section 365(n) would apply only if the administrator “rejects an executory contract pursuant to Section 365 (rather than simply exercising the rights granted to the Foreign Representative pursuant to the German Insolvency Code).”

Appeal To The District Court. The licensees appealed to the District Court, which remanded the case back to the Bankruptcy Court.

  • The District Court ordered the Bankruptcy Court to consider the requirement under Section 1522(a) of the U.S. Bankruptcy Code to ensure that “the interests of the creditors and other interested entities, including the debtor, [were] sufficiently protected.” The District Court held that the Bankruptcy Court had to balance the relief granted to the German insolvency administrator as foreign representative with the interests of those affected by that relief.
  • As a separate basis for remand, the District Court directed the Bankruptcy Court to consider whether Section 365(n) is a fundamental U.S. public policy such that, under Section 1506 of the U.S. Bankruptcy Code, subordinating it to Section 103 of the German Insolvency Code would be “manifestly contrary to the public policy of the United States.”

The Bankruptcy Court On Remand. On remand, another Bankruptcy Judge, Stephen S. Mitchell, held a four-day evidentiary hearing, with testimony on the likely impact of applying, or not applying, Section 365(n) to licenses under Qimonda’s U.S. patents. At the outset, the administrator had committed to re-license the licensees under a “reasonable and nondiscriminatory” royalty license (known as RAND), but the licensees pressed to keep their existing license rights without having to negotiate and pay a new royalty. At stake for the Qimonda estate was approximately $47 million in estimated re-licensing fees. The licensees argued the stakes were far higher on their side. They contended that a failure to apply Section 365(n) would destablize the system of licensing and cross-licensing in place to address the “thicket” of multiple patents held by different parties in the semiconductor industry, and in turn that would reduce investment and innovation.

Ultimately, the Bankruptcy Court issued its decision and, under Section 1522(a), balanced the interests of Qimonda and the licensees in favor of requiring that Section 365(n) apply to the administration of Qimonda’s U.S. patents. Taking up the other issue raised by the District Court, the Bankruptcy Court independently held that “deferring to German law, to the extent it allows cancellation of the U.S. patent licenses, would be manifestly contrary to U.S. public policy.” Under Section 1506, the Bankruptcy Court concluded that U.S. public policy required that Section 365(n)’s protections apply to Qimonda’s U.S. patents.

The Fourth Circuit’s Decision. After procedural hurdles were cleared, a direct appeal to the Fourth Circuit followed. On December 3, 2013, the Fourth Circuit issued its 45 page opinion affirming the Bankruptcy Court’s decision to apply Section 365(n). After first examining the history, purpose, and structure of Chapter 15, the Fourth Circuit turned to the three arguments the German administrator had advanced on appeal.

  • No request for Section 365(n) to apply. The administrator argued that in seeking discretionary relief under Section 1521, he had never asked for either Section 365 or 365(n) to apply; since relief under Section 1521 has to be requested by the foreign representative, he asserted that his decision not to request it should resolve the question. The Fourth Circuit rejected the argument, holding his view of the relationship between Sections 1521(a) and 1522(a) “too myopic.” Instead, it held that if any discretionary relief is granted under Section 1521(a), the interests of creditors and the debtor must be “sufficiently protected” under Section 1522(a).
  • Erroneous test under Section 1522(a). The administrator next argued that the “sufficiently protected” standard is designed only to make sure that all creditors can participate in the foreign proceeding on an equal footing, not to change the substantive outcome in that foreign proceeding. Reviewing the Guide to Enactment of the Model Law on which Chapter 15 is based, the Fourth Circuit also rejected this argument. It held that Section 1522(a) requires a balancing of interests before discretionary relief is granted, and anticipates a particularized analysis of the impacts on creditors and the debtor from the relief sought.
  • Faulty balancing analysis. Finally, the administrator argued that the Bankruptcy Court abused its discretion in balancing the interests involved. Specifically, he asserted that the lower court overstated the risk to the licensees’ investments made in reliance on the licenses that Qimonda had granted, especially given the administrator’s RAND license offer. The Fourth Circuit rejected this argument as well, agreeing with the Bankruptcy Court’s assessment of the risks. These included the risks to investments already made and the threat of infringement litigation contrary to the Qimonda licenses. The Fourth Circuit also held that although the RAND proposal would reduce the licensees’ risks, it would not sufficiently protect them. The outcome of those negotiations were uncertain, there were significant hold-up risks in the RAND license negotiations. Moreover, it was unclear whether even new RAND licenses would survive if the administrator sold the patents in the German proceeding — and the purchaser later filed an insolvency proceeding under German law.

In the final section of the decision (Part IV), the Fourth Circuit returned to the purposes of Chapter 15 and Section 365(n). It stated that in affirming the Bankruptcy Court’s decision based on Section 1522(a), it was also indirectly furthering the public policy behind Section 365(n). However, the Fourth Circuit did not reach Section 1506. Unlike the Bankruptcy Court, the Fourth Circuit did not hold that subordinating Section 365(n) to Section 103 of the German Insolvency Code would be “manifestly contrary to the public policy of the United States.” Interestingly, Part IV of the opinion only got two votes. Circuit Judge Wynn concurred in the judgment and in the first three parts of the decision, but not in Part IV, which he found to be “unnecessary dictum.”

Where Does The Decision Leave Licensees? While plainly good news for the Qimonda licensees, who can now use Section 365(n) to retain their pre-existing IP rights, the Fourth Circuit’s decision leaves a number of unanswered questions for future cases.

  • Is a decision allowing a foreign representative to reject licenses without applying Section 365(n) protection “manifestly contrary to the public policy of the United States” under Section 1506? The Bankruptcy Court thought it was, but the Fourth Circuit carefully chose not to reach the issue. It remains an open question even in the Fourth Circuit, much less in Chapter 15 cases filed in the rest of the country. Section 1506, quoted below, is so important because it’s Chapter 15’s local law trump card:

Nothing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.

By declining to reach the Section 1506 question, the Fourth Circuit kept the Section 1506 trump card in the deck. That leaves licensees with continued uncertainty about whether Section 365(n) will in fact be applied in the next Chapter 15 case.

  • Must courts apply Section 365(n) every time a foreign representative requests any discretionary relief under Section 1521? The Fourth Circuit’s decision required courts to balance the particular interests of creditors and the debtor under Section 1522(a), not just their access to the foreign court. To coin a phrase, this means “substantive sufficient protection” instead of just “procedural sufficient protection.” The Qimonda decision should help licensees tip the balance in their favor, especially when a foreign representative is asking to administer U.S. patents. However, the Fourth Circuit holding was that the Bankruptcy Court’s exercise of discretion was reasonable. It did not hold that no other decision was possible. That makes it a little less clear whether the Fourth Circuit would allow this particularlized balancing to go the other way — a refusal to apply Section 365(n) — in another case.
  • What if the foreign representative doesn’t seek any discretionary relief? Remember, the Fourth Circuit affirmed the Bankruptcy Court only under Section 1522(a), which in turn applies only when a foreign representative requests discretionary relief under Section 1521 (or relief under Section 1519 before recognition).  Most foreign representatives will seek discretionary relief, and specifically seek to have U.S. assets entrusted to them. That is what Qimonda’s German administrator did. However, if a foreign representative decided not to request any such relief, the balancing of interests called for by the Fourth Circuit would not be triggered. That could leave licensees with only Section 1506’s public policy trump card, which the Fourth Circuit did not invoke.
  • What if the foreign representative doesn’t file a Chapter 15 case at all? This one is pretty easy. If the foreign representative chooses not file a Chapter 15 case in the first place (or of course a Chapter 11 or Chapter 7 case), then there would be no U.S. bankruptcy case in which to try to invoke Section 365(n). That’s one of Section 365(n)’s major limitations, and one licensees — and the attorneys who draft their licenses — should remember.

Conclusion. The Fourth Circuit’s Qimonda decision is important for licensees of intellectual property owned by a foreign entity. It signals that U.S. courts will incline to protect licensees by applying Section 365(n) when an insolvent foreign entity’s administrator or other representative asks for assistance from the U.S. bankruptcy courts. However, the Fourth Circuit did not go as far as some licensees would have liked, stopping short of declaring that an attempt to reject licenses without applying Section 365(n) would be “manifestly contrary” to U.S. public policy. That makes the Qimonda decision a helpful, but perhaps not decisive, tool for IP licensees. It of course remains to be seen whether other courts will follow the Qimonda decision or chart a different path.

Business Bankruptcy Issues Recent Developments

Amendments To The Federal Bankruptcy Rules, Plus A New “Free And Clear” Sale Motion Filing Fee, To Take Effect December 1, 2013

Almost every year, changes are made to the set of rules that govern how bankruptcy cases are managed — the Federal Rules of Bankruptcy Procedure. The changes address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others.

Rule Amendments. This year the rule amendments mainly affect bankruptcy cases filed by individuals. There are also some revisions to Rules 9006, 9013, and 9014, which govern motions in individual and business bankruptcy cases, but they are minor and not too exciting this time. So you can keep up-to-date, a copy of the amendments, in both clean and redline, is available by following the link in this sentence. The new amendments will take effect on December 1, 2013, barring unlikely action by Congress.

"Free And Clear" Motion Filing Fee. Also taking effect on December 1, 2013, is a new, $176 filing fee each time a motion is filed under Section 363(f) of the Bankruptcy Code to sell assets "free and clear" of liens, interests and other encumbrances. Given the frequent use of Section 363 asset sales in Chapter 11 bankruptcy cases, this new fee may well generate some much needed revenue for the courts.

Business Bankruptcy Issues The Financially Troubled Company

DIP Financing: How Chapter 11’s Bankruptcy Loan Rules Can Be Used To Help A Business Access Liquidity

Cash Is King. An army may march on its stomach, but for companies, it’s liquidity that keeps the business going. For many companies, typical sources of liquidity, beyond cash flow from sales or other revenue, are (1) financing from banks or other secured lenders, (2) credit from vendors that can reduce immediate liquidity needs, and (3) when needed, loans from owners, investors, or other insiders.

When A Liquidity Crisis Hits. Companies in financial distress often find that their need for liquidity goes up just as the availability of traditional financing goes down. The borrowing base may shrink, the ability to get further advances may be cut off, and loans may go into default. Worse, new lenders may be unwilling to make loans given the distress. For many distressed businesses, revenues may also be declining and insufficient to cover expenses without additional financing. A liquidity crunch can quickly snowball into a liquidity crisis.

Insider Loans. Even if an owner, investor, or other insider might be open to making a loan, the company’s distress may raise a red flag because of the extra scrutiny often given to insider loans to a distressed company. Insiders may be concerned that if they make the loan, creditors or a bankruptcy trustee could later challenge it (and any security interest granted) in an attempt to recharacterize the loan as an equity contribution or have the debt equitably subordinated — and therefore never repaid — in a bankruptcy. 

A Potential Solution: DIP Financing. A company in financial distress is probably already looking at a workout, restructuring, or sale of the business. Out-of-court workouts should be considered and may succeed. However, in the right situation a Chapter 11 bankruptcy can provide powerful options, including the ability to facilitate financing. If a company needs a loan but a potential lender is unwilling to make it, including because of concern about a legal challenge, the Bankruptcy Code offers a way to give the lender comfort that the loan will not be challenged, even if the lender is an insider or a potential purchaser.

  • To explore this further, we first need to review a little bankruptcy terminology. When a company files a Chapter 11 bankruptcy, the company’s management and board of directors remain in possession of its business (unless a trustee is later appointed). For that reason, the company in Chapter 11 is called a "debtor in possession" or a "DIP" for short. The special Chapter 11 bankruptcy financing is known by this acronym: DIP financing.
  • When the debtor company has lined up a lender, it files a motion seeking Bankruptcy Court approval of the DIP financing. Typical DIP financing terms include a first priority security interest, a market or even premium interest rate, an approved budget, and other lender protections. Creditors have a right to object to the DIP loan, and may do so if the proposed lender is an insider, and the Bankruptcy Court will ultimately decide whether to approve it.
  • If the company already has secured debt, to borrow funds secured by a lien equal or senior to the existing lender (often called "priming" the existing lender), the company either will need the existing lender to consent or will have to convince the Bankruptcy Court that the existing lender’s lien position will be "adequately protected" (essentially meaning that the existing lender will not be worse off if the DIP loan is approved).
  • An existing lender itself may be willing to make a DIP loan, even if it has refused to make further advances outside of bankruptcy. In fact, when DIP loans are made they often come from a company’s existing lender. That lender may have its own reasons to use the DIP financing process, for instance, to finance a sale process on specific timelines or otherwise to enhance its position.
  • Unlike a loan outside of bankruptcy, if the Bankruptcy Court gives final approval to a DIP loan and finds that the loan was made in good faith, the new DIP loan will no longer be subject to legal challenge. Put differently, with that approval in hand, a loan that could have been challenged outside of bankruptcy will not be subject to challenge inside of bankruptcy. That’s true even if the lender is an insider or a "stalking horse purchaser" seeking to buy the company’s assets. 
  • The takeaway is that while it isn’t easy, in the right case a distressed company may be able to use Chapter 11 bankruptcy’s DIP financing procedures to get the liquidity it needs, to run a sale process or finance a formal Chapter 11 restructuring, even if it could not get a new loan outside of bankruptcy.

Why Chapter 11? One of the key reasons companies file for Chapter 11 bankruptcy is because of the special legal protections it provides. For the company, those include the automatic stay and, in the right case, the ability to restructure its debts through a Chapter 11 plan of reorganization. Chapter 11’s protections for purchasers of assets can sometimes allow the seller to achieve through Chapter 11 a sale price that it never could have realized without bankruptcy. Likewise, Chapter 11’s DIP financing process for lenders may help the company generate liquidity — including from an existing lender, investor, or stalking horse purchaser — even if it could not do so outside of bankruptcy. 

Conclusion.  A company facing a liquidity crisis should get legal advice from an experienced restructuring and bankruptcy attorney to make sure it considers all options. A workout or other out-of-court restructuring may be able to solve the problem and get the business back on track. However, there are times when a Chapter 11 bankruptcy filing, despite its costs and disruptions, is the best tool in the toolkit. That’s especially true if Chapter 11’s DIP financing rules help a business access liquidity that it could not get outside of bankruptcy.

Business Bankruptcy Issues The Financially Troubled Company

The Privilege Is All Mine: What Happens To A Corporation’s Attorney-Client Privilege In Bankruptcy?

It’s well-established that a corporation has an attorney-client privilege and can assert it to keep communications between the corporation and its attorneys confidential. When a corporation is solvent, its officers and directors maintain the right to assert — or waive — the attorney-client privilege on behalf of the corporation, and control who has access to privileged communications.

The Attorney-Client Privilege In Bankruptcy. This raises a question: what happens if the corporation files bankruptcy? The answer depends on the type of bankruptcy filed and whether a bankruptcy trustee is appointed.

  • Chapter 11 Case. In a Chapter 11 reorganization bankruptcy, the corporation generally remains as a "debtor in possession," unless a trustee is appointed. As a debtor in possession, the corporation’s board of directors and management remain in control — literally "in possession" — of the company’s assets. Courts have held that this control extends to the continued right to assert, or waive, the corporation’s attorney-client privilege.
  • Chapter 7 Bankruptcy. In a Chapter 7 liquidation bankruptcy, a Chapter 7 trustee is appointed and the debtor corporation’s board and management is removed from control. The U.S. Supreme Court held in CFTC v. Weintraub, 471 U.S. 373 (1985), that it’s the Chapter 7 trustee alone who controls the ability to assert, or waive, the corporation’s attorney-client privilege. This means that the Chapter 7 trustee is given access to all of the corporation’s attorney-client privileged communications prior to bankruptcy.
  • Chapter 11 Trustee. The answer is less clear in the relatively few Chapter 11 cases in which the court appoints a Chapter 11 trustee. Several courts, however, have extended the Supreme Court’s decision in Weintraub and held that the appointed Chapter 11 trustee, like a Chapter 7 trustee, takes control of the debtor’s assets and therefore has authority to assert or waive the corporation’s attorney-client privilege and to access privileged communications.

Access To Attorney-Client Privileged Communications. It’s important for officers, directors, and attorneys for corporations to remember that the attorney-client privilege belongs to the corporation. Anyone who later gains control of the corporation will have access to its attorney-client privileged communications.

  • While nothing new, for solvent companies this means that, for example, future officers and directors will have access to attorney-client communications that took place in the past between corporate counsel and former officers and directors. The same is true when a corporation is acquired through a merger; the new ownership and management takes control of the corporation — and also of its past and present attorney-client privileged communications.
  • Likewise, when a corporation files bankruptcy, a bankruptcy trustee, certainly a Chapter 7  trustee and probably a Chapter 11 trustee, will be given similar access to the corporation’s attorney-client communications. This is true even if the trustee wants access to use previously privileged communications, as they sometimes will do, to bring causes of action against former officers and directors or others.

Conclusion. The attorney-client privilege is an essential part of the attorney-client relationship, fostering the ability of a corporation to get the full benefit of its counsel’s legal advice. While not always obvious, the privilege is held by the corporation, not specific officers or directors. Companies that file Chapter 11 bankruptcy and remain as a debtor in possession generally do not turn over the corporation’s attorney-client privilege to a third party. However, if the corporation files or ends up in a Chapter 7 bankruptcy, or perhaps has a Chapter 11 trustee appointed, control of the corporation, and its attorney-client privileged communications, may well end up in the hands of the bankruptcy trustee. 

Business Bankruptcy Issues Recent Developments

Video Of Testimony Before ABI Commission To Study Reform Of Chapter 11

As mentioned in a recent blog post, the American Bankruptcy Institute has established a Commission to Study the Reform of Chapter 11. A video of testimony before the Commission’s June 4, 2013 field hearing in New York is available below.

  • At that hearing, I testified on the second panel, discussing intellectual property licenses, their treatment in bankruptcy cases, and potential reforms to address several key issues. My testimony begins at the 01:14:14 mark.
  • Lawrence Gottlieb, my colleague at Cooley LLP in our Corporate Restructuring and Bankruptcy group, testified as part of the first panel, focusing on real property lease issues, how they impact Chapter 11 cases (especially those involving retailers), and suggested reforms. His testimony begins at the 00:08:12 mark.

More information on the Commission and its work, together with access to the video and written testimony of all panelists at the Commission’s hearings, is available at the Commission’s website.