OVERVIEW

  1. High-Tech Companies are Different From You and Me -- They Have No Cash Flow. (Apologies to Ernest Hemingway).
  2. Watch Your Back, Watch the Door and Cover your Assets.
  3. Assignment of Licenses in Bankruptcy: Have License, Can’t Travel.
  4. Money Does Not Grow on Trees and Chapter 11 Does Not Manufacture Cash.
  5. Selling a High-Tech Company: “As Is – Where Is - It Is What It Is.”
  6. Top Ten List (Attached).
  7. Article: Reorganizing High-Tech Businesses – “I Need Help, Find Me Some Lawyers Who Wear Suits” (Attached).

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  1. Key Concepts. Most bankruptcy cases are filed under Chapter 11 (reorganizations). Debtor in possession concept is the norm. Trustees are appointed in Chapter 7 (liquidation) cases and may be appointed in Chapter 11 cases. Commencement of a bankruptcy case creates an “estate.” Executory contracts can be assumed (honored) or rejected (breached) by the debtor. Claims are generally classified as “general unsecured” or “administrative expenses.” The former are paid pro rata, the latter are usually paid in full.
  2. Get Organized. Pull your license agreements and contracts, check outstanding A/R, prepare a Notice of Appearance for filing in the Chapter 11 case and alert your credit, consulting, maintenance and & support organizations. Key to payment is vigilance in the case.
  3. Analyze Contract. Only executory contracts present a debtor with the choice of assumption or rejection. Common test for executoriness is whether each party has material, unperformed obligations under the contract. If so, contract may be executory. If not, the contract would be an asset or liability of the debtor. In re Robert L. Helms Constr., 9th Cir. 1997 (“If performance is due to the debtor, the contract is an asset, which becomes estate property. If performance is due by the debtor, it is a liability of the estate and the nondebtor is an unsecured creditor.”). IP license agreements are typically considered executory because licensor has ongoing indemnity and warranty obligations (and license itself is merely a covenant not to sue) and licensee usually has ongoing payment, noncompetition, quality control and confidentiality obligations.
  4. Payment & Performance Rights and Duties. General rule is that commencement of bankruptcy case stays collection and litigation efforts on pre-bankruptcy charges. Need to check the debtor’s bankruptcy schedules and prepare a Proof of Claim by the bar date. Generally speaking, pending assumption or rejection of contract, nondebtor party must continue to perform. Nondebtor party, however, can seek payment for post-petition charges, which may require pro-ration across the petition date
  5. Know Catapult. Ninth Circuit Court of Appeals has held that a debtor may not even assume contracts that are not assignable under applicable non-bankruptcy law (namely, nonexclusive patent licenses, probably nonexclusive copyright licenses). This means that nondebtor can request relief from the automatic stay to terminate the license. SeeCatapult Entertainment, 165 F.3d 747 (9th Cir. 1999); CFLC, Inc., 89 F.3d 673 (9th Cir. 1996); Harris v. Emus Records, 734 F.2d 1329 (9th Cir. 1984); Access Beyond Tech., 237 BR 32 (Bankr. Del. 1999); Patient Education Media, 210 BR 237 (Bankr. SDNY 1997).
  6. Draft License to Protect Rights & Maximize Leverage. Make sure license agreements contain (a) a bankruptcy termination clause (Section 365(e)(2)), (b) a change of control termination clause (Institut Pasteur risk), (c) an anti-assignment clause (with minimal dilution) (Catapult issue).
  7. Debtor as Licensor Issues. Section 365(n) of the Bankruptcy Code grants special protection to licensees. Trademarks are not included in definition of “intellectual property” so there is a risk that rejection may deprive licensee of ability to use marks even though it is able to distribute copyrighted works. But, Section 365(n) permits continued rights under “supplementary” agreements. The principle of Section 365(n) (preventing harm to ongoing business through deprivation of licensed rights) may apply to new technologies – wholesaler of internet addresses granted use rights to nondebtor ISP.
  8. Development Contracts – “Works Made for Hire”. Development work that is done under “work for hire” contracts should emphasize the personal services aspect of the agreement to protect employer in the event contractor files a bankruptcy and employer wishes to terminate contract.
  9. Assumption, Rejection & Cure of Defaults. If a debtor decides to assume a contract, it must cure defaults, compensate for damages and provide assurances of future performance. Assumption provides opportunity to obtain repayment of pre-petition claims and, possibly, ancillary claims for consulting services. Breach of an assumed contract gives rise to an administrative expense. In rejection scenarios, consider execution of termination letter to recover software & documentation.
  10. Watch for Preference Exposure. Preferential transfers made by a debtor within 90 days prior to the commencement of the case may be avoided and recovered. Although there are many defenses, there are also many opportunities to settle this possible exposure.

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REORGANIZING HIGH-TECH BUSINESSES --

“I NEED HELP, FIND ME SOME LAWYERS WHO WEAR SUITS”

William P. Weintraub

Pachulski, Stang, Ziehl, Young & Jones PC
Three Embarcadero Center, Suite 1020
San Francisco, CA 94111
(415) 263-7000

(415) 263-7010

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TABLE OF CONTENTS

I.Introduction...... 1

II.Cultural Differences Between High-Tech Companies and Other Companies...... 1

III.Perfecting and Protecting Rights in Intellectual Assets...... 3

1.Perfecting Security Interests in Intellectual Property...... 3

a.General Intangibles...... 3

b.Trademarks...... 3

c.Copyrights...... 4

d.Patents...... 6

e.Inventory and Receivables Based on Copyrights...... 6

2.High-Tech Licenses...... 7

a.Escrow Arrangements For Licensed Intellectual Property...... 8

b.Assignment of Licenses After CFLC and Catapult...... 8

IV.Human Resources Issues...... 11

a.Retention Bonuses...... 11

b.The WARN Act...... 12

V.Financing High-Tech Companies...... 14

1.Cash Collateral and Post-petition Financing...... 14

2.Valuation of Collateral...... 16

VI.Confidentiality Issues, Tire-Kickers and Shopping a High-Tech Company...... 16

1.Asset Sales...... 16

2.Bidding Protection...... 18

VII.Conclusion...... 19

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I.Introduction

Reorganizing a “high-tech” company presents several challenging issues for turnaround managers and insolvency professionals. Many high-tech companies are start-up companies with inadequate accounting and information systems, poor document control, and high turnover, especially in the accounting and finance departments.

In addition, the culture of high-tech companies (stock options and IPOs) inevitably leads to several problems that, while not unique to high-tech companies, are often exacerbated when the high-tech company finally accepts the reality of its financial situation. Oftentimes, the high-tech company has gone through several rounds of financing involving multiple issues of preferred stock and convertible subordinated debt. Senior management, as well as most or all of the employees, hold stock options. There may or may not be a traditional lender in place, or the basis of the institutional debt might not be a working capital asset based loan, but instead a series of loans to acquire related businesses (all now failing as well) with the result that the lender is undersecured.

The high-tech case presents all of the “usual” issues that are presented in any Chapter 11 situation (such as first day orders, debtor in possession financing, use of cash collateral, identification of executory contracts, employee benefits issues, customer relation issues, trade vendor problems, and ultimately, reorganizability). But the high-tech case also may involve culture shock (buttoned down turnaround professionals versus problem solving entrepreneurs who are not tied to following the “rules”), as well as unique issues presented by emerging case law in the areas of intellectual property protection and licensing and the undeniable fact that, more than in any other industry, the assets go home each night and hopefully return to work in the morning.

The purpose of this outline is to provide a framework for discussing some of these issues.

II.Cultural Differences Between High-Tech Companies and Other Companies

High-tech companies have a unique culture. Many of the employees are young, well-educated and not particularly interested in accounting or legal issues that “get in the way” of their goals.

Many high-tech companies are financed by venture capitalists or angels who initially do not put many operational restrictions on the use of cash. Oftentimes the answer to a cash shortage is another round of equity financing to raise more cash.

When the angel or venture capitalist becomes disaffected, or the bank becomes nervous, the first reaction of management is not to react at all or to cling to the belief it can work its way out of the problem without outside assistance. And the natural inclination of many of the financiers of start-up companies that falter is to move on to the next start-up.

Turnaround professionals and insolvency counsel are just about the last people high-tech companies want to look to for assistance. There is the widely held view that high-tech companies are not reorganizable. Perhaps the better view is that high-tech companies are reorganizable if the correct remedial steps are taken early in the process.

In this regard, high-tech companies are not different from other financially distressed companies who wait too long to seek assistance. If the company is out of cash, it cannot be operated for purposes of either selling its assets or trying to locate a new source of equity or debt financing. Indeed, if the company waits too long, it will not have the resources to hire the professionals that it needs.

Another potential area of conflict can arise when the entrepreneurs running the high-tech company are confronted with the basic rules of insolvency, including the well established proposition that an insolvent company has a fiduciary duty to its creditors. This proposition conflicts with the high-tech company’s instinct to protect its employees at all costs. For example, payment of employee benefits at the expense of other creditors may also cause potential conflicts between management and the turnaround and insolvency professionals.

Entrepreneurs may wish to also protect the investors and angels who have funded the troubled company. Management will not want to offend these players as they may wish to seek financing for future start-ups from the same entities.

Conflicts might arise if the company wants to compromise with its distributors and retailers over “disputes” and treat those compromises as “ordinary course of business” transactions. The demands of distributors and retailers to over reserve for warranty claims and returns will impact upon the collectability of receivables. Management’s efforts may be geared toward accommodating distributors and retailers beyond what may be necessary if a more confrontational approach is used.

On the positive side, entrepreneurs often have a more informal hands-on, open door approach to issues. They can be quite willing to embrace creative approaches to a work-out. they often have close relationships with the various constituencies in the case -- the employees, the investors, the critical suppliers and general creditors.

Open communication with the various parties is sometimes easier with a high-tech company used to frequent and open meetings with investors on new developments within the company. Investors in high-tech start-ups can be traditional sources of equity, but may also be key customers of the company. Key customers have been known to step in and assist a high-tech company in financial crisis.

In sum, the culture of high-tech companies is both good and bad. The mind set of some high-tech companies is that the trade creditors who have suffered the most, and who by their actions and inactions have supported the debtor’s lifestyle for months, are the last people to be considered or paid. Taking constituencies for granted and expecting undying support from creditors and others after months of dodging telephone calls from persons asking for payment or updated financial information is a common mistake. Clear and open communication with the various parties is essential for high-tech turnarounds in particular.

III.Perfecting and Protecting Rights in Intellectual Assets

1.Perfecting Security Interests in Intellectual Property.

Next to the cultural considerations, one of the most important considerations to a high-tech company involves its intellectual property and the grant and perfection of liens against these assets. The following section will outline the statutory and case law framework governing the perfection of security interests in the various intellectual property assets of a typical high-tech company.

a.General Intangibles.

Section 9-106 of the Uniform Commercial Code defines “general intangible” to mean any personal property (including things in action) other than goods, accounts, chattel paper, documents, instruments, and money. Consequently, patents, copyrights, and trademarks fall within the catch-all definition of general intangibles. The Official Comment to section 9-106 confirms this: “Other examples [of general intangibles] are copyrights, trademarks, and patents, except to the extent that they may be excluded by section 9-104(a).”

In turn, section 9-104 of the Commercial Code provides, in subsection (a), that Article 9 does not apply to a security interest subject to any statute of the United States, to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property.

Therefore, it is generally accepted that federal filings are not required to perfect a security interest in patents or trademarks from avoidance by a bankruptcy trustee. SeeIn re Transportation Design & Technology, Inc., 48 B.R. 635 (Bankr. S.D. Cal. 1985) and City Bank and Trust Co. v Otto Fabric, Inc., 83 B.R. 780 (D. Kan. 1988). This view as to patents was recently affirmed by the Bankruptcy Appellate Panel for the Ninth Circuit in In re Cybernetic Services, Inc., 239 B.R. 917 (BAP 9th Cir. 1999) (the Patent Act deals with title and true assignments, not security interests, so a properly filed UCC-1 will perfect a security interest in a patent). Nonetheless, the conventional wisdom is that “double filings” are prudent -- a UCC-1 filing with the Secretary of State as a general intangible under Article 9, and a filing with the United States Patent and Trademark Office (“PTO”). And, as discussed below, because of the existence of an indexing system at the Copyright Office and conflicting case law, copyrights present special problems for secured creditors.

b.Trademarks.

Trademarks also present their own unique set of problems. Ordinarily, a trademark cannot be sold or assigned separately from the goodwill associated with it, and therefore, an assignment of a trademark without the sale of the associated goodwill is considered deceptive and ineffective as an “assignment in gross.” The Assignment of Trademarks and Tradenames, 30 Mich. L. Rev. 489-503 (1932). The Lanham Act (governing trademarks) requires the assignment of a trademark to be recorded with the PTO. A secured party who takes an “assignment” of a trademark without the transfer of goodwill might find that it has an unenforceable security interest, although some older cases suggest there is a meaningful distinction between the assignment of a trademark and the grant of a security interest in a trademark, effectively side-stepping the assignment in gross issue and recognizing that a security interest is not the kind of assignment that triggers Lanham Act problems.

Recent cases have followed the older cases and hold that a lender may take a security interest in a trademark without recording the “assignment” with the PTO. SeeIn re TR-3 Industries, 41 B.R. 128 (Bankr. C.D. Cal. 1984); and In re Roman Cleanser Co., 43 B.R. 940 (Bankr. E.D. Mi. 1984). Both courts found a distinction between an outright assignment of the mark and a conditional assignment for purposes of security and held that filing a UCC-1 is sufficient to perfect a security interest in trademarks.

The Roman Cleanser court examined the issue of assignments in gross and held that a reference to general intangibles in the UCC-1 financing statement would automatically pick up the company’s goodwill, meaning that the trademark will continue to be connected with the same products with which it has been associated in the past. The court also held that no particular tangible assets had to be transferred with the mark in order to avoid being an assignment in gross and that granting rights in the customer lists and formulas alone was sufficient. 43 B.R. at 947-48 (citations omitted). Roman Cleanser was affirmed on the assignment in gross issues by the Sixth Circuit at 802 F.2d 207 (6th Cir. 1986). The issue of perfection through a UCC state filing was not appealed, but it appears that the majority opinion assumed the correctness of that portion of the case. In the concurring opinion, however, one of the justices hinted that it is not clear whether a federal registration of the security interest alone will protect the lender’s ability to realize upon its collateral in bankruptcy, and suggested that the only safe harbor is to file a UCC-1 financing statement with the Secretary of State.

c.Copyrights.

Copyrights are treated differently from both patents and trademarks. In re Peregrine Entertainment, Ltd., 116 B.R. 194 (Bankr. C.D. Cal. 1990), holds that a financing statement is insufficient to perfect a security interest in copyrights. Even though the Copyright Act does not seem to have a comprehensive and indexed method of recording and locating security interests in copyrights, Judge Koziniski (a justice of the Ninth Circuit Court of Appeals sitting as a district judge) held that the Copyright Act occupied the field of filing with respect to copyright collateral and that the financing statement filed by the creditor in that case was a nullity.

...[T]he comprehensive scope of the federal Copyright Act’s recording provisions, along with the unique federal interest they implicate, support the view that federal law preempts state methods of perfecting security interests in copyrights and related accounts receivable.

***

Recording in the U.S. Copyright Office rather than filing a financing statement under Article Nine, is the proper method for perfecting a security interest in a copyright.

116 B.R. at 199, 203.

In light of Peregrine, a lender that relies on a UCC financing statement will have a problem. In order to be absolutely certain as to perfection, the lender must file notice of its security interest in the United States Copyright Office. Further, it should be noted that filings are not currently indexed in a manner that would permit easy search for competing security interests. For example, registrations are not organized by the name of the debtor, but instead on the basis of title and registration number. Accordingly, a “floating lien” that attaches to after-acquired copyrights might not be effective. This will require the secured lender to effect multiple filings as new copyrights are registered with the Copyright Office.