The Financially Troubled Company

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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.

The Financially Troubled Company

An Entrepreneur’s Take On Managing Layoffs

Almost every financially troubled company will face a layoff at some point. Knowing how to implement one with sensitivity to all employees (including those not part of the layoff) and with the needs of the business squarely in mind can best preserve the ability for future success.

Will Herman, an entrepreneur and former CEO of several successful companies, has a very interesting post on his 2-Speed blog entitled "How To Manage A Layoff."  In it, Will offers up nine key guidelines for effectively managing a layoff. Among his well-put suggestions:

  • Do it quickly — Nothing will drain the life out of an organization faster than mass fear of job loss.
  • Do it once — Not completing a layoff in one pass will kill the productivity of those who remain.  
  • Plan ahead — Decide how you’re going to handle the termination details – have any severance, benefits, insurance, outplacement service offerings or reference policy well documented ahead of time (can you afford any of these?). 
  • Communicate — Make it clear to everyone (those being laid off and those remaining) why it happened and what has been done or is being done to make sure it doesn’t t happen again.  Emphasize that the layoff as just witnessed is OVER and that no one else will be laid off because of the current situation (new situations may, of course, come up). 

Getting a layoff right can be a make-or-break event in a successful turnaround. Will’s range of business experience makes his post essential reading for anyone interested in this important, if unpleasant, topic.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Signs Of A Turn In The Private Equity Buyout Market?

Last week saw what may prove to be early signs of a turn in the robust market for the debt that finances private equity buyouts. In just a week’s time, The New York Times reported on a possible cooldown in the buyout market, and the Financial Times published a commentary on signs of a possible "bondholder revolt" against issuer-favorable debt terms (including low debt coverage ratios mentioned in an earlier post) that have prevailed for the past several years. In addition, the DealBook Blog‘s post entitled "Buyout Boom Could Slow As Investors Push Back" discussed how several buyout debt offerings were recently curtailed or modified, a first in this previously strong debt market.

Then, in a separate but interesting move, the former co-head of investment banking at UBS, Jeff McDermott, left last week to start a new private equity firm, Stony Lane Partners. Stony Lane’s focus? Buying and turning around distressed businesses. When asked by the Financial News why he’s making the move, McDermott answered:

I think a credit crunch will play out over time, and it will be like a slow rolling wave. It’s won’t be a one-day cataclysmic event. I think there will be double leverage in the system. I think CDOs are buying margin leverage and are buying corporate credits, which are priced like there’s no end to economic growth in the future. Of course, there are economic cycles.

If he’s right, a rise in defaults, restructurings, and Chapter 11 bankruptcy filings may be coming down the road.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Case Addresses Whether A Security Interest In A Patent Can Be Perfected With Just A PTO Filing

When a debtor grants a security interest in a patent issued by the U.S. Patent and Trademark Office (PTO), the creditor must take steps to perfect that security interest. Given that the PTO issues patents but the Uniform Commercial Code (UCC) generally governs perfection of security interests, creditors have often filed both a UCC-1 financing statement and made a filing in the PTO to cover all the bases.

Perfection By UCC Filing. In 2001, the Ninth Circuit held that a creditor who filed a UCC-1 financing statement properly perfected a security interest in a patent even if it did not also make a filing with the PTO. The decision in the In re Cybernetic Services, Inc. case, officially Moldo v. Matsco, Inc., 252 F.3d 1039 (9th Cir. 2001), rested on the Ninth Circuit’s determination that the federal Patent Act does not cover liens on patents and does not preempt the UCC with respect to perfection of security interests. This seemed to settle the question of whether a UCC filing alone was enough to perfect a security interest in a patent, at least in the Ninth Circuit.

Does A PTO Filing Alone Perfect? Judge William C. Hillman of the U.S. Bankruptcy Court for the District of Massachusetts faced the opposite question in the In re Coldwave Systems, LLC case. There the creditor sought to rely on a PTO filing alone to perfect its security interest in a patent because the Bankruptcy Court avoided as a preference a tardy UCC filing made long after the security interest was granted but within 90 days of the bankruptcy petition. The creditor’s much earlier PTO filing of a Recordation Form Cover Sheet, recording the conveyance of the security agreement between the debtor and the creditor, was not subject to avoidance as a preference. The creditor argued that the PTO filing was sufficient to perfect its security interest, even in the absence of a UCC filing.

UCC Perfection Or Bust. In his 14-page decision issued on May 15, 2007, Judge Hillman held that the PTO filing was insufficient to perfect the creditor’s security interest because the Patent Act (specifically Section 261 of Title 35), did not create a system for the perfection of security interests in patents. After first concluding that "[t]he Federal statute does not protect holders of security interests," Judge Hillman held as follows:

There is nothing in §261 that addresses in any way the conflict between one who is not a holder of an interest by way of assignment, grant, or conveyance and a bankruptcy trustee. We must look to other law for the answer. 

That other law was the UCC. Holding that a patent is a general intangible, the Court ruled that nothing in the UCC excepts general intangibles from the rule requiring perfection by a UCC filing. Since no valid UCC filing perfected the creditor’s security interest, it was unperfected and the Chapter 7 trustee prevailed.

The Bottom Line. The Coldwave Systems decision is consistent with the Ninth Circuit’s earlier Cybernetic Services ruling. Together they teach creditors that the only way to perfect a security interest in a patent is by an unavoidable and proper UCC filing. Any creditor relying on a PTO filing alone will end up unperfected and unsecured. While there may be other reasons for a creditor to make a PTO filing, such as potentially protecting against an improper assignment of the patent, perfection of a security interest is not one of them.

Want More? For more on the Coldwave Systems and Cybernetic Services decisions, be sure to read Warren Agin’s excellent post on the Tech Bankruptcy blog, entitled "An Expert Builds On Cybernetic Services." Warren also gets special thanks for first posting on Judge Hillman’s interesting decision.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Third Circuit Holds Contemporaneous Exchange Defense To Preference Claim Is Available Even For Credit Transactions

On June 7, 2007, the U.S. Court of Appeals for the Third Circuit issued a decision in the In re Hechinger Investment Company case holding that the "contemporaneous exchange for new value" defense to preference claims can apply even if the payments were made in the context of a credit arrangement. The key is whether the parties intended the payments involved to be contemporaneous exchanges for new value, the linchpin of this particular preference defense. A copy of the Third Circuit’s decision is available here.

Bankruptcy Preferences. As a reminder, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

The Contemporaneous Exchange Defense. This defense, found in Section 547(c)(1) of the Bankruptcy Code, is short and to the point:

(c) The trustee may not avoid under this section a transfer–

(1) to the extent that such transfer was–

(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

In interpreting this language, the Bankruptcy Court held that a "credit relationship is inconsistent with the intent required in order to sustain" the defense. Essentially, under its view the defense would presumably be limited to situations in which no credit was allowed to remain outstanding but instead a C.O.D. purchase or other similarly immediate "goods for cash" swap was involved.

The Third Circuit’s Focus On Intent. The Third Circuit reversed the Bankruptcy Court’s ruling, explaining its reasoning as follows:

The Bankruptcy Court found that the disputed transfers were not intended by the parties to be contemporaneous exchanges because the transfers were credit transactions. In reaching this result, the Court relied upon several factually distinguishable cases, none of which stand for the proposition that parties can never intend credit transactions to be contemporaneous exchanges under § 547(c)(1)(A). We disagree with the Bankruptcy Court’s conclusion. Indeed, it would appear that § 547(c)(1) covers little other than credit transactions. The § 547(c)(1) defense applies only to transfers that the debtor has shown are payments on an “antecedent debt” under § 547(b). See 11 U.S.C. § 547(b)(2) (definition of avoidable transfers). If there is no delay between when the debt arises and payment of the obligation, then the transfer is outside the scope of § 547(b), and § 547(c)(1) is not implicated. The existence of a delay between the creation of a debt and its payment is a hallmark of a credit relationship, which is, by definition, a relationship in which the creditor entrusts the debtor with goods without present payment. OXFORD ENGLISH DICTIONARY (2d ed. 1989) (defining “credit” as “[t]rust or confidence in a buyer’s ability and intention to pay at some future time, exhibited by entrusting him with goods, etc. without present payment.”).

We do not think that the District Court’s interpretation of the Bankruptcy Court’s order – namely, as concluding that the parties intended to have a credit relationship – necessarily resolves the question. The inquiry still remains: even if a credit relationship was intended, was it nonetheless their intent that the ongoing payments would be contemporaneous exchanges for new value? A court may find the parties intended a contemporaneous exchange for new value even when the transaction is styled as a “credit” transaction. See In re Payless Cashways, Inc., 306 B.R. 243 (8th Cir. BAP 2004), aff’d, 394 F.3d 1082 (8th Cir. 2005). The question is one of intent, and although a delay between the incurrence of the debt and its payment can evidence that the exchange was not intended to be contemporaneous, the passage of time does not necessarily negate intent.

(Footnotes omitted.)

The Bottom Line. Under this decision, a contemporaneous exchange defense to a preference is available even if the defendant has extended credit to the debtor. Nevertheless, to prevail the defendant will have to prove that it and the debtor actually intended the payments to be contemporaneous exchanges for new value and they were, in fact, substantially contemporaneous with the exchange of goods or services.

A Final Note. The Third Circuit decision covered other issues as well, including the ordinary course of business defense and whether prejudgment interest is available for preference claims. For more on those issues, plus a copy of the Bankruptcy Court’s decision below, be sure to read the detailed post on the case by the Delaware Business Bankruptcy Report.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Who Gets The Benefit Of A D&O Policy’s Proceeds, The Directors And Officers Or A Bankruptcy Trustee?

On June 8, 2007, Delaware Bankruptcy Judge Kevin Gross issued a decision in the World Health Alternatives, Inc. bankruptcy case that corporate directors, officers, attorneys, and bankruptcy professionals alike will find of interest. A copy of the Court’s 13-page decision and short order is available here.

The Three-Sided D&O Policy. The issue in the case was whether a Chapter 7 bankruptcy trustee could get an injunction to prevent directors and officers from using the proceeds of a Director and Officer (D&O) liability policy to settle a shareholder lawsuit pending in another court (known as the Consolidated Action). The underlying question centered on who owns the proceeds of a D&O policy when the policy provides:

  • Side A coverage for directors and officers;
  • Side B coverage for the corporation’s expenses in indemnifying directors and officers; and
  • Side C coverage for the corporation’s own exposure for securities litigation claims.  

As is true with many D&O policies, the policy involved in this case also had a "Priority of Payments" endorsement that gave payments under the Side A coverage for the directors and officers priority over both the Side B and Side C coverages.

Does The Automatic Stay Stop Use Of A D&O Policy’s Proceeds? The Chapter 7 trustee sought to block the use of the D&O policy’s limited proceeds to settle the shareholder lawsuit, arguing that they were property of the bankruptcy estate and that the effort to use them to settle this Consolidated Action violated the automatic stay of bankruptcy.  The Chapter 7 trustee had his own lawsuit pending against the directors and officers and he wanted to keep the "wasting" D&O policy (called "wasting" because the policy proceeds also had to cover defense costs) available to cover his claims. The debtor corporation had been dismissed from the shareholder litigation so no Side C coverage was implicated, and because no indemnification had been or was likely to be paid, the Side B coverage had not been triggered.

In denying the Chapter 7 trustee an injunction, the Delaware Bankruptcy Court held that although the policy was property of the bankruptcy estate since the debtor corporation had purchased it, the policy’s proceeds were not. Although acknowledging that some other courts had ruled differently, Judge Gross followed an earlier Delaware Bankruptcy Court decision in In re Allied Digital Technologies Corp., 306 B.R. 505 (Bankr. D.Del. 2004), and held as follows:

Applying the rulings in the cases cited above to the case at hand, it appears that the proceeds of the Debtor’s insurance policy are not property of the estate. The Court arrives at this conclusion from its review of the ‘language and scope of the [P]olicy at issue.’ Allied Digital, 306 B.R. at 509. The Policy proceeds which are being used to fund the Settlement and are being held in escrow by Lead Counsel are from the Policy’s Coverage A. World Health, and now the Trustee as successor, has no right to any Coverage A proceeds, which insures only World Health’s officers and directors. World Health must look to Coverage B which insures it for indemnification claims. There are no such claims against World Health. If the Trustee is seeking to recover for the wrongs of the defendants in the Trustee’s Action pending in this Court, it is not entitled to preference over the settlement of the Consolidated Action. As the Court held in Allied Digital:

The Trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from The D&O Policy rather than as a potential defendant seeking to be protected by the D&O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.

Id. at 512.

Judge Gross ruled that the automatic stay did not apply to the policy proceeds at issue and, as a result, the Chapter 7 trustee was not entitled to an injunction to stop them from being used to settle the other litigation. 

The Take-Aways. When D&O policy proceeds are being used by insured directors and officers to fund a defense or settlement of a covered claim, a bankruptcy trustee generally will not be able to interfere if none of the other coverages — specifically the Side B and C coverages — has been invoked.

  • If claims have been made against the Side B or Side C coverages, the outcome could very well be different.
  • A Priority of Payments endorsement, which gives priority to the Side A coverage for directors and officers, is one tool to consider to help ensure that the D&O policy is available for directors and officers first. However, the law is not clear whether that endorsement would trump the automatic stay if the other coverages were invoked.
  • These issues are complicated and those with a stake in these questions should be sure to get legal advice on both the bankruptcy and insurance coverage issues involved.

For more discussion of the decision and the insurance issues raised, be sure to read Kevin M. LaCroix’s excellent post at The D&O Diary. Special thanks to Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog for highlighting Kevin’s post.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Article Examines What Might Happen To Private Equity Buyouts In A Downturn

The Globe And Mail has a story on its Report On Business.com site entitled "Private equity’s high-wire act: Can leveraged buyout artists build firm foundations on soft money?" The article discusses the current low default rate on the debt that has been financing private equity buyouts and considers who will get hurt when the default rate rises.

The article makes a number of interesting observations about the risks in the current buyout market, including the following:

  • Banks hold a smaller percentage of leveraged debt, having sold off debt to hedge funds and others though pooling vehicles such as collateralized loan obligations, known as CLOs.
  • This trend has put some banks in something of a loan broker role, making the initial acquisition loan but later selling the position.
  • The free cash flow to interest expense ratios are now in the 1.7 range, a noticeable reduction from the 2.6 average three years ago.
  • Toggle bonds, which allow borrowers to issue new bonds, often at higher rates, to finance interest costs on the existing bonds, have become more common.

The article concludes with a discussion of what might bring this private equity cycle to an end, a question on many people’s minds these days. For more on this issue, you may find interesting three past posts on the general subject, available here, here, and here.