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Business Bankruptcy Issues Recent Developments

Patent Law Collides With Bankruptcy: Federal Circuit Denies Bankruptcy Liquidation Trust Standing To Sue For Patent Infringement

The United States Court of Appeals for the Federal Circuit has jurisdiction over, among other areas, patent appeals, so it’s not every day that a Federal Circuit decision appears on this business bankruptcy blog. (Actually, it’s been about a year since this post discussing another Federal Circuit decision.) However, a September 19, 2007 opinion (available here) of the Federal Circuit rested largely on the intersection of patent law and the terms of a Chapter 11 plan of reorganization. Since the decision denied a trust created under the plan standing to bring the debtor’s patent infringement claims, it’s a significant one for debtors and creditors alike. After discussing the court’s decision I’ll conclude with my suggested take-away from the case.

The At Home Corporation Plan And Liquidation Trusts. The litigation arose in the At Home Corporation Chapter 11 bankruptcy case, which was filed in September 2001. As part of the confirmed plan of liquidation, a general unsecured creditor liquidation trust (called GUCLT) was created to pursue various claims for the benefit of creditors, including certain patent infringement claims against Microsoft Corporation. A separate liquidation trust (called AHLT) received ownership of the At Home patent at issue in the litigation, among other assets. GUCLT was not granted a license to the patent.

The Patent Litigation And Federal Circuit Decision. The patent litigation reached the Federal Circuit in 2006. Although the plan and related documents granted GUCLT the express right to pursue the patent litigation claims at issue, the Federal Circuit found that to be insufficient to confer standing. It held that the patent statutes provide protection to the party with a right to exclude, not the party with a right to sue. Because the right to exclude others from practicing the patent (part of AHLT’s rights) had been separated from the right to sue for infringement (GUCLT’s rights), GUCLT was not protected under the patent statutes. The Federal Circuit summed up the situation this way:

The problem for GUCLT and AHLT is that the exclusionary rights have been separated from the right to sue for infringement. The liquidation plan contractually separated the right to sue from the underlying legally protected interests created by the patent statutes—the right to exclude. For any suit that GUCLT brings, its grievance is that the exclusionary interests held by AHLT are being violated. GUCLT is not the party to which the statutes grant judicial relief. See Warth, 422 U.S. at 500. GUCLT suffers no legal injury in fact to the patent’s exclusionary rights. As the Supreme Court stated in Independent Wireless, the right to bring an infringement suit is “to obtain damages for the injury to his exclusive right by an infringer.” 269 U.S. at 469; see also Sicom, 222 F.3d at 1381 (“Standing to sue for infringement depends entirely on the putative plaintiff’s proprietary interest in the patent, not on any contractual arrangements among the parties regarding who may sue…”); Ortho, 52 F.3d at 1034 (“[A] right to sue clause cannot negate the requirement that, for co-plaintiff standing, a licensee must have beneficial ownership of some of the patentee’s proprietary rights.”).

Since GUCLT had the right to sue but not the right to exclude others from practicing the patent, and since AHLT had the right to exclude others but not the right to sue for infringement, neither liquidating trust could sue for the infringement alleged in the GUCLT’s underlying lawsuit. The Federal Circuit ruled that the problem could not be solved by the typical practice of joining the legal title holder, here AHLT, to the patent litigation as a party. Although such joinder solves prudential standing requirements, the court held that it does not solve the constitutional standing requirement of actual legal injury. GUCLT did not suffer legal injury because it had no right to exclude others from practicing the patent.

The Federal Circuit’s majority opinion prompted an interesting dissent, which ended with the following:

While I do not read any precedent as directly governing the peculiar circumstances of this case, I also do not read any as precluding co-plaintiff standing for GUCLT. I believe that, in denying all possibility for enforcing the patent, the majority opinion extends limitations on co-plaintiff standing without a reasoned basis. Accordingly, while neither GUCLT nor AHLT individually may pursue infringement litigation, I would not deprive the patent of all value. Because I would allow GUCLT and AHLT, as co-plaintiffs, standing to sue Microsoft, I respectfully dissent.

The View From IP Bloggers. Dennis Crouch of the Patently-O patent law blog has an interesting post on the case, and he gets special thanks for first reporting on the decision. For another view, you may find this post from the Patry Copyright Blog published by William Patry, Google’s Senior Copyright Counsel, of interest.

Important Lessons. On his patent law blog, Dennis Crouch gives the practice pointer that he believes patent lawyers should learn from the decision: "A non-title-holder must be granted an exclusive license as well as full litigation rights in order to have standing to sue for patent infringement." That is helpful advice for patent lawyers, but I have a suggestion of my own.

  • When intellectual property such as patents, copyrights, or trademarks is involved in a bankruptcy case, get expert advice from IP counsel, in addition to bankruptcy advice. The problem may be separating exclusionary rights from the right to sue for patent infringement one day and transferring a trademark without its goodwill the next.
  • This suggestion applies when dealing with, for example, the transfer of IP in a bankruptcy case, whether by liquidation trusts, Section 363 asset sales, or something else, or assessing the risk of continuing patent infringement when purchasing IP assets.
  • As the Federal Circuit’s decision shows, the interplay between IP issues and bankruptcy cases can be complex and the possible outcomes surprising. Getting expert advice can help you avoid these and other traps for the unwary.
Business Bankruptcy Issues The Financially Troubled Company

Section 363 Sales: Interesting Article Takes A Further Look

David Powlen, Managing Director and Partner at Western Reserve Partners LLC, has an interesting article on the Turnaround Management Association website entitled "Bargains Await Buyers Skilled At Navigating Section 363 Minefields." It gives a good overview of the range of issues that arise in the context of a sale under Bankruptcy Code Section 363. Among the article’s observations:

  • Unlike traditional private company M&A deals, Section 363 sales take place in the "fishbowl" of a bankruptcy proceeding;
  • Although the bankruptcy process generally leads the debtor to seek an auction, some typical M&A bidders may not participate in a bankruptcy sale, potentially reducing the competition to a stalking horse bidder;
  • Compensating for the usual lack of representations and warranties in an asset purchase agreement with a bankrupt company is the court’s sale approval order, which generally approves a sale free and clear of liens, claims, and interests; and
  • A Section 363 sale may not be free of every claim or interest, however, as certain environmental and product liability claims may nevertheless pass to the buyer. 

The article also includes a helpful chart giving a graphic presentation of the relative risks and benefits of an out-of-court sale, a Section 363 sale, and the less common sale through a Chapter 11 plan of reorganization. For more on these issues, you may also be interested in this earlier post and linked article on buying assets from a financially distressed company.

Business Bankruptcy Issues Recent Developments

Third Circuit Shoots Down Plan Confirmation, Finding Improper Gerrymandering

In an interesting decision issued last month in a case called In re Machne Manachem, Inc., the Third Circuit upheld a district court’s decision to reverse confirmation of a Chapter 11 plan of reorganization. The decision stemmed from steps taken to obtain votes required for approval of the plan. Before discussing the details, a bit of background on bankruptcy plans and the rules governing voting is in order.

Classes And Plans Of Reorganization. Bankruptcy plans must classify creditors and equity holders into various classes, usually based on the type of debt or equity security they hold or on other characteristics of their claims or interests. Each secured creditor is typically put in a separate class or subclass, bondholders may be put in a separate class based on the bond issue involved, general unsecured creditors may be grouped together in one class, and the claims held by insiders are occasionally put in a separate class.

Voting Requirements For Plans. The Bankruptcy Code spells out the voting rules for Chapter 11 plans of reorganization.

  • Under Section 1129(a)(10) of the Bankruptcy Code, at least one "impaired" class must vote to accept a plan. In the bankruptcy world, "impaired" means that under the plan the holder of the claim or interest will receive treatment that is different (usually worse) than what it would get outside of bankruptcy. This may involve stretching out repayment terms over time, paying less than 100 cents on the dollar, or canceling all shares of prepetition stock.
  • To accept a plan, the tally of votes from the impaired class must meet or exceed two thresholds. Two-thirds in dollar amount and a majority in number of those creditors voting must accept the plan.
  • If these tests are satisfied, as happened in the Third Circuit case, and if other requirements are met, the debtor may be able to "cram down" the plan on the rest of the creditor body, even if other creditors voted to reject the plan. 

A Case Of Gerrymandering. In this case, the plan got the required votes from the impaired class. So what prompted the Court of Appeals to throw out the plan? In short, the Court found that by purchasing a select set of impaired claims, an insider of the debtor gerrymandered the vote in favor of the debtor’s plan. The Court ruled that the insider’s purchase of four claims in the only impaired class that accepted the plan was done to win the vote of that class. Once they were purchased, those claims were shifted out of the key class and into another class where their votes would not matter. This conduct, the Court held, was improper and "undermined the critical confirmation requirements of the bankruptcy code."

  • Although there was little evidence either way, the Court seem concerned that the vote in that one critical accepting class — 7 claims accepting and 4 claims rejecting — could have ended up as 7 claims accepting and 8 claims rejecting if the four purchased claims had stayed in the original class.
  • The Court also found troubling that the purchased claims received less than 100 cents on the dollar, which was the treatment the proposed plan provided for the rest of the creditors in the key class.

Conclusion. Classifying claims into classes for Chapter 11 plans and the voting process are critical aspects of the reorganization process in a business bankruptcy case.  From time to time objecting creditors may accuse the debtor or other plan proponent of gerrymandering those classes to win confirmation, but when the Third Circuit issues a decision finding that improper gerrymandering actually took place, it’s a case worth reading.  Special thanks to the Delaware Business Bankruptcy Report for first posting on the case.

Business Bankruptcy Issues Recent Developments

Second Liens and Intercreditor Agreements: Are Those Bankruptcy Voting Provisions Really Enforceable?

In this post I look at the second lien phenomenon and then discuss an interesting new case addressing whether a fairly common intercreditor agreement provision — giving a senior lender the right to vote a second lien lender’s claim in bankruptcy — will actually be enforced.

Senior Debt And Mezzanine Financing. When a company borrows from a bank, it typically grants the bank a first priority, blanket security interest in all of its assets to secure this senior debt. In the past, when a company needed additional capital, whether to grow the business or to fund an acquisition, it often turned to unsecured "mezzanine" financing, so named to reflect its middle position between senior debt and equity. This type of unsecured debt typically is subject to complete payment subordination in favor of the senior lender and is considerably more expensive than bank debt. 

The Second Lien Market. One of the biggest financing trends in recent years has been the move away from unsecured mezzanine credit to debt secured by a second priority security interest on all of the company’s assets. Much of this "second lien" debt is coming from hedge funds and other private equity funds, although more traditional lenders have also become active in the market. According to CFO.com, the second lien market has grown dramatically over the past several years, from $570 million in 2002 to more than $16 billion in 2005. Some reports suggest it approached $30 billion in 2006. 

Why the attraction to second lien financing? The main reasons are price, terms, and availability. Healthy companies generally find the pricing on second lien credit to be lower than unsecured mezzanine debt (although a bit more expensive than on senior debt) and often comes with few covenants. For distressed companies, if they can obtain additional credit at all, many times it’s as part of a restructuring in which a new lender requires a second lien to protect it from an increased risk of default. 

Subordination and Intercreditor Agreements. Most second liens are blanket security interests and cover the same collateral against which the senior lender has a first lien. Traditionally, senior lenders include provisions in their loan documents prohibiting borrowers from granting security interests or liens to any other lender without the consent of the senior lender. When a lender proposes to make a second lien (also known as a "junior" or "tranche B" loan), it must negotiate not only with the borrower but also with the senior or "tranche A" lender. As the size of the second lien market suggests, senior lenders have been willing to consent to second lien loans, often to help the borrower make an acquisition or to bring in additional liquidity.

  • The negotiations between the first and second lien lenders usually address their respective rights to the collateral and various provisions regarding repayment of their loans. Sometimes the second lien debt will be subordinated to repayment of the senior debt, as with traditional mezzanine financing, but more often only the security interest in the common collateral will be subordinated to that of the senior lender.
  • The senior lender generally insists that the junior lender be a "silent second" and waive rights to object to actions taken by the senior lender in a default or bankruptcy. The junior lender instead wants to have the ability to protect its own interests. The end result often comes out somewhere in between, but restrictions on the second lien lender are common.
  • The arrangements between the senior and second lien lenders are documented in a separate agreement, usually called an intercreditor agreement or a subordination agreement.

Key Intercreditor Agreement Provisions. If everything goes well and the borrower repays its loans on time, the provisions of the intercreditor agreement won’t be all that important. However, if the borrower defaults on the loans, or files for bankruptcy, the terms of the agreement can become critical.

  • With bankruptcy in mind, key provisions negotiated in intercreditor agreements often include waivers or consents by the second lien lender relating to debtor in possession (DIP) financing, use of cash collateral, rights to adequate protection, conduct of a Section 363 sale of the debtor’s assets (i.e., the lenders’ collateral), and the extent to which the senior lender will have the right to vote the second lien lender’s claim on any Chapter 11 bankruptcy plan of reorganization.
  • Section 510(a) of the Bankruptcy Code provides that a "subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." Bankruptcy courts routinely enforce payment subordination provisions in which the junior lender agrees not to receive any payments (or to turn over any that it does receive) until the senior lender is paid in full.

Bankruptcy Voting Provisions. Bankruptcy voting provisions, however, have not always been enforced. Most notably, the court in In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), held that Section 1126(a) of the Bankruptcy Code, which provides that the "holder of a claim or interest allowed under section 502 of this title may accept or reject a plan," means that only the actual holder of the claim may vote and that an agreement giving that right to the senior lender is not enforceable. Other courts have been more willing to enforce voting provisions in subordination agreements. Still, the issue has not come up very often. Voting provisions have been the subject of reported decisions in only a handful of cases over the past 25 years.

The Aerosol Packaging Decision.  That dearth of authority makes the decision in In re Aerosol Packaging, LLC, issued by a bankruptcy court in Atlanta in late December 2006, of keen interest. (Thanks go to Scott Riddle of the Georgia Bankruptcy Law Blog for first posting on the decision.) In that case, Wachovia Bank was the senior lender under a subordination agreement entered into with Blue Ridge Investors, II, L.P., a second lien lender to the debtor, Aerosol Packaging. In its Chapter 11 bankruptcy, the debtor filed a plan of reorganization acceptable to Wachovia. When votes were solicited, both Wachovia and Blue Ridge submitted competing ballots voting Blue Ridge’s claim, with Wachovia’s ballot accepting the plan’s primary treatment of Blue Ridge’s claim and Blue Ridge’s ballot rejecting that proposed treatment.

  • Blue Ridge then filed a motion seeking a determination of its voting rights and allowance of its ballot instead of the one Wachovia submitted. (For reference, the subordination agreement attached as an exhibit to that motion designates Blue Ridge as the "Subordinated Creditor" and Wachovia, as successor to SouthTrust Bank, as the "Lender.")
  • Wachovia opposed the motion, relying on a section in the subordination agreement that made it, as the Lender, "irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor)" to "take such other action (including without limitation voting the Subordinated Debt. . . " as it "deemed necessary or advisable." Wachovia also argued that the In re 203 North LaSalle Street Partnership case, relied on by Blue Ridge, was wrongly decided and that the bankruptcy rules allowed agents to vote another party’s claim. 
  • To complete the picture, the debtor itself also filed a response supporting Wachovia’s position.

In siding with Wachovia, the bankruptcy court held that Wachovia was the agent of Blue Ridge, that under the subordination agreement Blue Ridge assigned its right to vote to Wachovia, and that Section 1126(a) of the Bankruptcy Code does not prohibit the enforcement of such provisions. The court therefore accepted Wachovia’s ballot and rejected the one submitted by Blue Ridge. The court also pointed out that Blue Ridge is not without a remedy: it "may free itself from the ongoing effect of the Subordination Agreement by paying the Wachovia claim in full in cash." Blue Ridge has appealed the decision, so a higher court may have a chance to rule on the issue.

Uncertainty Remains. As only one bankruptcy court ruling, the Aerosol Packaging decision does not settle the issue of whether bankruptcy voting provisions will be enforced. Still, it’s interesting that the court considered and rejected the reasoning of the In re 203 North LaSalle Street Partnership decision. Given that this subordination agreement involved both lien and payment subordination, it’s unclear whether the voting provision would have been enforced if the lenders’ agreement had involved only lien and not payment subordination, which is the more typical second lien arrangement. The answer to that question will have to wait for the next case.