The advent of the information age has given rise to economies built not on steel, but on ideas.  It is therefore no surprise that intellectual property assets have assumed an increasingly important component of firm balance sheets – and firm value – throughout advanced economies worldwide.

And yet, though the value of intellectual property is universally recognized and the rights attaching to it increasingly protected, “knowledge assets” are not always treated in the same manner whenever – and wherever – the firm enters restructuring or liquidation.  The story of Qimonda AG is the story of what happens when one country’s rules governing the treatment of an insolvent firm’s intellectual property collide with those of another.

 As the following post suggests, that story is far from over.

Quimonda AG’s Insolvency.

Qimonda AG (Qimonda), a producer of Dynamic Random Access Memory (DRAM) chips, also holds a portfolio of approximately 12,000 patents.  A little more than one-third of this intellectual property originated in the US (i.e., it consists of US patents or pending applications); the balance is of German or other international origin.

Over a 13-year period, Qimonda entered into a series of joint venture and cross-licensing agreements with a number of semiconductor manufacturers.  Under those agreements, Qimonda and these manufacturers cross-licensed tens of thousands of patents.

During 2007 and 2008, prices for PC-based DRAM technology collapsed.  Despite efforts to restructure, Qimonda entered German insolvency proceedings in January 2009.  The Munich court overseeing the proceeding appointed Dr. Michael Jaffé as Qimonda’s insolvency administrator.

Subsequently, Dr. Jaffé sought and obtained recognition in the US for Qimonda’s German insolvency proceeding.  Dr. Jaffé also obtained concurrent, discretionary relief making certain sections of the US Bankruptcy Code applicable to Qimonda’s Chapter 15 proceeding.  These sections included Section 365, which governs executory contracts – including licensing agreements.

Both the German Insolvency Code and the US Bankruptcy Code address the administration of executory contracts.  However, US insolvency practitioners will be aware the US Bankruptcy Code – specifically, section 365(n) – protects the intellectual property licensees of a bankrupt licensor.  Under this subsection, the licensee – at its own option – may preserve its rights under an intellectual property license, despite the bankruptcy trustee’s efforts to reject the license.

The German Insolvency Code provides no such protection.  Instead, Section 103 of that statute simply provides that the court-appointed insolvency administrator may elect performance of contractual obligations or affirm that they remain unenforceable against the estate by electing non-performance.

Dr. Jaffé’s Proposed Treatment of Qimonda’s Cross-Licensing Agreements.

Sometime after obtaining recognition and discretionary relief in Virginia, Dr. Jaffé, acting pursuant to German law, provided notification to certain of Qimonda’s cross-licensing partners of his elected non-performance of Qimonda’s patent cross-licensing agreements.

Those partners, understandably, protested – and argued further that Section 365(n) (made applicable to Qimonda’s Chapter 15 proceeding at Dr. Jaffé’s own request) now prohibited Dr. Jaffé from electing non-performance.  In response, Dr. Jaffe sought the US Bankruptcy Court’s amendment of his previously-granted relief in order to clarify the basis for his non-performance of the cross-licensing agreements.  Specifically, Dr. Jaffé sought a modification of the prior order to provide that Section 365 (and, therefore, Section 365(n)) would be applicable only in such instances where he sought rejection of agreements pursuant to the US statute.

The Cross-Licensing Partners’ Appeal.

Following a hearing held 28 October 2009, US Bankruptcy Court Judge Robert Mayer issued a decision granting Dr. Jaffé’s further request, thereby clearing the way for him to elect non-performance of the cross-licensing agreements under German insolvency law.  Qimonda’s partners promptly appealed to the US District Court for Virginia’s Eastern District, arguing (i) that Section 365 – including Section 365(n) – applies automatically to foreign proceedings recognized under Chapter 15 (and, presumably, may therefore not be “modified” or otherwise trifled with by the Bankruptcy Court in the manner proposed by Dr. Jaffé); and, further (ii) that principles of comity applicable under US case law (and the provisions of Chapter 15) did not require the requested modification of the Bankruptcy Court’s prior order.

In an appellate decision issued 2 July 2010, US District Judge Thomas Selby (Tim) Ellis III remanded the matter back to Judge Mayer for further clarification of two issues – one factual, one legal.  Along the way, however, Judge Ellis offered several important observations regarding the construction of Sections 1521(a) (governing the provision of “any appropriate relief” to the representative of a recognized foreign proceeding) and 1509(c) (governing a recognized administrator’s requests for comity).

Section 1521(a).

A significant portion of Judge Ellis’ 36-page decision is devoted to the conclusion that Section 365 of the US Bankruptcy Code does not apply automatically upon recognition of a foreign “main proceeding.”  This seems unremarkable, given that a simple reading of Section 1520(a) makes only select provisions of the Bankruptcy Code applicable automatically in Chapter 15, and that Section 365 is not among them.  As a result, Section 365 – available to a foreign representative only through specific request pursuant to Section 1521(a) – is susceptible to selective or otherwise limited application by the US Bankruptcy Court.  Indeed, the Bankruptcy Court may determine it does not apply at all.

Far more interesting is Judge Ellis’ conclusion that Dr. Jaffe’s request had been granted without the requisite balancing test set forth in Section 1522.  That section requires that, upon a request for modification of relief previously granted through Section 1519 or 1521, the Court may so modify only after ensuring that “the interests of the creditors and other interested entities, including the debtor, are sufficiently protected.”  11 U.S.C. §1522(a).  Because the evidence relied upon by the Bankruptcy Court to balance creditors’ interests was “anemic,” Judge Ellis remanded the matter for a more full-bodied factual inquiry.

Specifically, Judge Ellis directed focus on two primary issues:

How the application of § 365(n) would unavoidably “splinter” or “shatter” the Qimonda patent portfolio “into many pieces that can never be reconstructed,” thereby diminishing its value and rendering the Qimonda patent portfolio essentially unsalable  (“Left unexplained, in particular, is why this is so, given that the continuation of appellants’ non-exclusive licenses for an unspecified percentage of the Qimonda patent portfolio would preclude neither the sale of the patents themselves nor the grant of additional, non-exclusive licenses.”).

The nature of the U.S. patents licensed to appellants, and whether cancellation of licenses for those patents would put at risk appellants’ investments in manufacturing or sales facilities in this country for products covered by the U.S. patents (“At best, the Bankruptcy Court stated (i) that the application of dissimilar bankruptcy laws to different portions of Qimonda’s patent portfolio ‘may well be detrimental to parties who are or wish to license patents,’ and (ii) that appellees’ demanding that appellants pay new licensing or royalty fees was an ‘unfortunate but an inevitable result’ of Qimonda’s insolvency . . . . It is not readily apparent why this is so.”).

Though leaving little doubt that Section 365’s applicability to a Chapter 15 proceeding was entirely within the Bankruptcy Court’s sound discretion, Judge Ellis nevertheless observed that “the Bankruptcy Code nonetheless ‘limits the opportunity for a completely unencumbered new beginning to the honest but unfortunate debtor,’ as ‘statutory provisions governing nondischargeability reflect a congressional decision to exclude from the general policy of discharge certain categories of debts.’”

Under Judge Ellis’s reading of Sections 1521 (and 1522), a Bankruptcy Court enjoys broad discretion – not only to provide “any appropriate relief” to a foreign representative, but to further amend, modify, or terminate the same relief – provided that the Court engage in the affirmative exercise of articulating why the interests of the debtors and the creditor are protected.

Section 1509(c).

Judge Ellis’ treatment of judicial discretion did not end with Section 1521.  On appeal, Qimonda’s cross-licensing partners also called into question the Bankruptcy Court’s decision to grant comity to Dr. Jaffé’s application of German insolvency law to the cross-licensing agreements.

By contrast to the broad discretionary application of “appropriate relief” under Section 1521, Judge Ellis found that a US Bankruptcy Court’s discretion regarding the comity to be afforded determinations rendered under foreign law and pursuant to Section 1509 is far more limited:

Section 1509 states, in mandatory terms, that “a court in the United States shall grant comity or cooperation to the foreign representative.” 11 U.S.C. § 1509(b)(3) (emphasis added).  . . .  [U]nder the plain terms of § 1509(b)(3), the Bankruptcy Court lacked general discretion to deny the Foreign Administrator’s request for comity; rather, the Bankruptcy Court could only have refused to defer to German Insolvency Code § 103 on the ground that applying German law, instead of § 365(n), would be “manifestly contrary to the public policy of the United States” under § 1506.  Put another way, §§ 1509(b)(3) and 1506, read in pari materia, provide that comity shall be granted following the U.S. recognition of a foreign proceeding under Chapter 15, subject to the caveat that comity shall not be granted when doing so would contravene fundamental U.S. public policy.

What sort of foreign relief would “contravene fundamental US public policy?”

Judge Ellis’ review of decisions addressing the “public policy” exception to Chapter 15’s comity mandate indicated that the focus of this exception is on (i) procedural inequity (e.g., a lack of “due process” as that term is commonly understood by US courts); and (ii) frustration of a US court’s ability to administer the Chapter 15 proceeding and/or severe impingement of a U.S. constitutional or statutory right, particularly if a party continues to enjoy the benefits of the Chapter 15 proceeding (e.g., frustration of the “automatic stay” made applicable upon recognition of Chapter 15).

However, Judge Ellis further found that – as with the “balancing test” required by Section 1522 – the Bankruptcy Court had not gone far enough in its analysis.

Congress enacted Section 365(n) in direct response to contrary case law and in order to protect the US-based licensees of intellectual property.  Yet the entire section is subject to modification or amendment in Chapter 15 upon the Bankruptcy Court’s discretion – or not applicable at all.

In light of these mixed judicial signals, is the protection of Section 365(n) therefore “fundamental?”  Or not?  In granting Dr. Jaffé’s request, the Bankruptcy Court had not explicitly decided this question, so Judge Ellis direct that it do so upon remand.

What Does It Mean?

Judge Ellis’ Qimonda decision is significant for its analysis of Sections 1509 and 1522 – it appears to endorse, at least in general terms, the flexibility required of an internationally-oriented recognition statute and the latitude potentially available to recognized foreign representatives.

However, Judge Ellis’ Qimonda analysis is perhaps most significant for what it doesn’t say.  It leaves unanswered what general factors courts might apply to the “balancing test” of creditors’ and debtors’ interests mandated by Sections 1521 and 1522.  And though it describes the outer bounds of “fundamental US public policy” such that otherwise-mandatory comity ought not to apply to the determinations of non-US tribunals, it does little to address the import (if any) to be derived from Congressional amendments specifically intended to protect the rights (or the interests) of general or special US economic interests.

As the economy lurches forward into an uncertain back half of 2010, the DIP lending market remains in flux.  In a short piece appearing in the Journal of Corporate Renewal last Wednesday, Imran Choudhury and Frank Merola – both of Jeffries & Co., Inc. - offer a concise overview of the factors affecting credit availability and expense over the last two years.

After a sharp contraction in 2008, Choudry and Merola show how DIP funding has increased – both in terms of deal size and in terms of new money . . .

and likewise, how spreads have eased during the same period . . . .

Their walk-away, in light of this data:

“The overall state of the DIP financing market has changed over the last couple of years as the broader credit markets have changed. Lower yields due to improvements in the overall credit markets have resulted in lower rates in the DIP loan market as well.

While it is difficult to say precisely what DIP yields will be over the next year or so, it seems very likely that the worst part of the credit cycle is over and DIP yields are not going to reach the same levels as they did in late 2008 and early 2009. Even though yields on DIP loans are not at their peak levels, the loans will still likely be used for . . . strategic reasons—protecting existing debt positions or controlling restructuring processes or acquiring assets through credit bids.”

In a globalized business environment, it should be no surprise that some of the more interesting – and better – economic reporting on the US economy now comes from offshore.

Last month, China’s Xinhua news agency reported that California leads the nation in small-business bankruptcies.  The report – based on data reported by Equifax – covers small business filings under all applicable chapters of the Bankruptcy Code (i.e., Chapters 7, 11, and 13).  The Xinhua report (it broke the story a day before the Orange County Register) is here.

Equifax’s reporting shows that California remains the most impacted state, with the Los Angeles and Riverside/San Bernardino MSA’s leading the nation in small business bankruptcy flings by a significant margin.  

The chart below provides a closer look at this trend.

                                                    # of
                 MSA         # of Bankruptcies Bankruptcies  % of Increase
                                    Q1 2009        Q1 2010
    Los Angeles-Long
     Beach-Glendale, CA                899          1035          15.13%
    Riverside-San
     Bernardino-Ontario,
     CA                                663           736          11.01%
    Sacramento-Arden-
     Arcade-Roseville,
     CA                                462           522          12.99%
    Houston-Sugar Land-
     Baytown, TX                       365           399           9.32%
    San Diego-Carlsbad-
     San Marcos, CA                    345           387          12.17%
    Portland-Vancouver-
     Beaverton, OR-WA                  276           386          39.86%
    Denver-Aurora, CO                  304           382          25.66%
    Santa Ana-Anaheim-
     Irvine, CA                        359           370           3.06%
    California -Rest of
     State                             233           335          43.78%
    Phoenix-Mesa-
     Scottsdale, AZ                    234           327          39.74%
    Dallas-Plano-
     Irving, TX                        348           323          -7.18%
    Chicago-Naperville-
     Joliet, IL                        395           314         -20.51%
    Atlanta-Sandy
     Springs-Marietta,
     GA                                336           304          -9.52%
    Oregon -Rest of
     State                             235           299          27.23%
    ---------------                    ---           ---          -----
    New York-White
     Plains-Wayne, NY-
     NJ                                335           272         -18.80%
    ------------------                 ---           ---         ------

Inc. Magazine picked up the story last week, commenting that “no area has been insulated from the recession and the economy clearly isn’t rebounding quickly enough.”

No kidding.

The Advisory Committee on Bankruptcy Rules of the Administrative Office of the U.S. Courts has pulled back from its earlier position on the disclosure required of hedge fund and other distressed debt investors participating as ad hoc committees or other, loosely organized creditor groups in Chapter 11 cases.

An earlier version of proposed amendments to Federal Rule of Bankruptcy Procedure 2019 would have required such investors to disclose the dates and prices paid for their purchases of distressed securities.  These changes were resisted by investor groups such as the Loan Syndications and Trading Association, and created some press coverage last year (an earlier post on the amendments is available here).

That said, investors will still be required to reveal the “disclosable economic interest” they each hold in a company, including debt and derivatives. This includes the identity of specific investors and the date such investors acquired their interests.

Morever, Committee notes to the proposed rule indicate that the previously-contested disclosures of pricing and purchase dates may be compelled through discovery or by the Court acting under its own authority outside the proposed rule.

A copy of the proposed rule, along with a summary of comments received on earlier versions and the Committee’s advisory notes, is available here.

Practitioners and business people who have toiled in and around US-based restructuring work are well-acquainted with one of the great strengths (and primary threats) of Chapter 11:  The ability of a debtor to restructure its secured obligations over the objection of a lender through the use of the “cram-down” procedures of Section 1129(b).

For those who may be less familiar, the concept of “cram-down” is not as difficult than the colorful term might suggest.  Essentially, a debtor may confirm a Chapter 11 plan and restructure its debts over the objection of secured creditors so long as the debtor’s plan offers those creditors the present value of their allowed secured claims, such that they receive an appropriate rate of interest which accurately maintains the present value of their concern.

Fighting over “cram-down,” therefore, really boils down to fighting over which interest rate ought to apply to the lender’s restructured loan.

In an era where real estate and other collateralized capital assets are under significant duress (and “risk-free” rates of interest are near all-time lows), the issue of “cram-down” is once again a matter of immediate relevance – and its resolution can often spell the difference between restructuring or foreclosure.

Because the notion of “cram-down” has been part of US insolvency jurisprudence for decades, US Courts have accumulated considerable collective sophistication in addressing the financially-oriented evidence and arguments that surround “cram-down fights.”

But sophistication does not mean consistency.

Last week, Ray Clark of Orange County-headquartered VALCOR Consulting, LLC released a succinct overview of some of the more notable case law surrounding “cram down” developed in the years since the US Supreme Court decided Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951 (2004).

Tracing several key cases issued by Circuit Courts of Appeal since Till, Ray – who has previously appeared on this blog as a guest – offers a very concise, readable summation of what it takes to win (or defeat) a “cram down” effort in Chapter 11.

One of Ray’s strengths is his ability to make the often unfamiliar and complex financial underpinnings of restructuring work accessible to the average, intelligent business person.  His summary is available here – and is well worth a read.

Questions?

Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

The esoteric world of credit default swaps and other derivative securities often appears far removed from the everyday practice of Chapter 11.  But the impact of this little-known (and often less-understood) corner of the securities market upon the bankruptcy world has recently garnered considerable academic interest – and is now attracting some legislators’ attention as well.

Several posts on this blog (beginning here) have summarized the intersection between credit default swaps and bankruptcy.  Some academics have explored the potential indirect effect of these securities upon out-of-court netogiations – focusing primariliy on the potential problems of “holdout” creditors and the ”empty creditor hypothesis.”  Others (here and here) have offered their preliminary thoughts on the continued usefulness of the Bankruptcy Code’s “securities safe harbors,” originally included to shield financial markets from the effects of large bankruptcy filings – but now perceived as distorting creditor priorities and possibly exacerbating the financial risk created by such events.

Some portions of this debate (such as the true impact of CDS’s on corporate insolvency) continue to play out in the realities of Chapter 11 economics.  Other portions (such as the continued viability of the Bankruptcy Code’s “safe harbor” rules) are beginning to work themselves – albeit slowly – into legislative proposals.

Within the last 30 days, Florida’s Sen. Bill Nelson has offered a brief, 2-page amendment to the proposed financial reform legislation now working its way through the US Senate.  In essence, the amendment would strip the “safe harbors” out of the Bankruptcy Code, ostensibly “leveling the playing field” for all creditors.

For its simplicity, the amendment – which has no co-sponsors – has provoked still further discussion amongst academics.  Seton Hall’s Steve Lubben commends it as a good “first step” toward amending the Bankruptcy Code, but believes further compromise is necessary (his proposed compromises are outlined here).  Harvard’s Mark Roe says, in an updated research paper, that the amendment deserves “central consideration” in connection with financial reform legislation.

A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11’s.  Perhaps more accurately, the post focuses on Chapter 11’s that could be – but aren’t – formally designated as “Small Business” Chapter 11’s.

Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.  Anecdotally, Prof. Lawless refers to one of the cases he surveyed:  a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.

So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?

The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:

- Congress’ 2005 amendments impose additional filing requirements.  Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.  One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.

- The “small business” deadlines are too compressed.  For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.  This period can, of course, be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”  But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.

- The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.

- Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.

- The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, but which were never really a good idea from a practical perspective.

With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11’s.

But are they always?

It may be that “small business” cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.  For example:

- Additional filing requirements.  There may be circumstances where the client’s non-compliance with income tax filing requirements preclude any “small business” self-designation.  But most businesses – even troubled ones – can generate a very rudimentary set of financial statements.  Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.  It’s worth noting that in California’s Central District, the additional “up-front” filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trustee’s Office.  In one “small business” Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one – though certainly not the only – reason a “small business” filing was recommended for the client.

- Compressed deadlines.  Part of South Bay Law Firm’s pre-petition planning involves a review of the client’s “exit strategy.”  The fundamental question is: What is the client’s perceived business objective for the contemplated Chapter 11?  If there isn’t one, the client has more fundamental issues to consider – and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.  If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy” are typically reduced to an informal “Plan Term Sheet” which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.  At South Bay Law Firm, our experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.  And with the “end game” relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.  This is a factor critical to the speed that is so important to an economically successful Chapter 11.

- More reasons for dismissal.  It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.  But more often, the real challenge isn’t Section 1112 – or the US Trustee’s Office.  Instead, it’s helping the “small business” Chapter 11 debtor focus on the administrative requirements of a Chapter 11 – and in California’s Central District, there are many.  To that end, the extra discipline required up-front for a “small business” Chapter 11 is, in fact, an important test of the debtor’s ability and willingness to get through the process with success.  If the debtor can’t even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.

- It’s all an impractical (though perhaps well-intended) judicial idea.  For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, bt very practical – at least in the larger scope of Chapter 11 economics.  But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner), their result - docket efficiency and speed of administration – are both great sources of judicial pleasure.  The judicial clerkship experience resident at South Bay Law Firm attests that there really is no better way to make friends with everyone behind the bench than making their job easier – even if the job is just a tad bit harder on counsel’s end.  We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a “jump ball” in front of the person wearing the black robe.

All of this may be very interesting, but how does it implicate the law firm business model?

Only this way: In an industry predominated by an “hourly fee” pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and “weeds out” many candidates unsuitable for Chapter 11 – “small business” or otherwise.  This, in turn, has the effect of making “small business” Chapter 11’s generally quicker and cheaper – and therefore potentially less profitable, at least from an “hourly fees” point of view.  It also tends, at least initially, to restrict or limit overall client “volume.”

However, it also has the effect of creating a relatively well-defined “product” which is potentially salable to a larger segment of troubled small businesses.  And a larger overall market segment means a larger absolute number of “small business” debtors who are possessed of the discipline and determination to reorganize their businesses successfully.

Many readers of this blog understand the importance of asset and enterprise valuation at a number of stages of the bankruptcy process.  Whether it be specific collateral (to address a secured creditor’s concerns) or enterprise value (to determine the viability of a Chapter 11 plan), or for purposes of a fraudulent transfer or an asset sale, the discipline and methodology of valuation forms a fundamental touchstone of business insolvency practice.

A recent Delaware Bankruptcy Court decision highlights the use of valuation in yet another context:  The appointment of equity committees.  In the Chapter 11 cases of Spansion, Inc. and its affiliates, Judge Kevin Carey reviewed the request of an ad hoc equity committee’s request for official sanction and appointment by the Office of the US Trustee.  To evaluate the committee’s request, Judge Carey turned to case law holding that the appointment of an equity committee depends upon:

- the substantial likelihood of a distribution to equity holders after all creditors are paid; and

- equity holders’ inability to represent themselves without such an official committee.

Central to Judge Carey’s decision was a detailed analysis of the anticipated distribution to equity holders.  Spansion’s disclosure statement, submitted with its proposed Chapter 11 plan, valued the debtors’ enterprise value at less than the amount of creditors’ claims and therefore left nothing for equity.  The ad hoc equity committee (not surprisingly) believed enterprise value after payment was sufficient that equity holders should have a collective voice with respect to the proposed plan.

Both sides submitted extensive evidence in support of their positions.  Unlike the debtors’ “full-blown” valuation, however, the ad hoc equity committee submitted a “sensitivity analysis” based on the debtors’ numbers and including an analysis of “precedent transactions,” comparable trading multiple analysis, and a discounted cash flow (DCF) analysis.

A substantial portion of Judge Carey’s 20-page decision denying the ad hoc equity committee’s request revolves around a careful weighing of the parties’ competing valuation evidence.  The ad hoc equity committee’s valuation evidence ultimately faltered on four points:

- The future of the debtors’ market:  For Judge Carey, the ad hoc equity committee’s analysis was not sensitive enough.  It inferred growth estimates based on the broader semiconductor and memory markets rather than for the debtors’ smaller (and much less healthy) specific memory market.

- The estimated DCF terminal value:  The ad hoc equity committee’s valuations assumed constant cash flow growth (a view not shared by the debtors), higher EBITDA multiples, and higher terminal values.  By contrast, the debtors’ valuation assumed flat to negative growth, and a lower terminal value.

- Valuation of specific assets:  The ad hoc equity committee claimed certain valuable assets – such as cash, litigiation claims held by the debtors, and net operating losses - were not accounted for in the debtors’ estimate of enterprise value.  While acknowledging that cash ought to be included in enterprise value, Judge Carey nevertheless found that the ad hoc equity committee offered no support for its valuation of the litigation claims at issue.  He found, further, that ambiguity surrounding the effect of the debtors’ net operating losses was not sufficiently resolved by the ad hoc equity committee to assign it any value for the committee’s analysis.

- Total amount of claims:  The ad hoc equity committee’s claimed equity stake derived at least in part from its estimate of claims.  However, Judge Carey found that the committee had neglected to include administrative claims and cash requirements necessary to exit from Chapter 11.  The committee also had neglected to estimate the value of claims from as-yet-to-be-rejected contracts.

In the end, Judge Carey found that “[t]he only thing certain . . . is the uncertainty of the valuations” – and that, as a result, the ad hoc equity committee’s “uncertain” estimate had not established the “substantial likelihood” of distribution required for official appointment.

Judge Carey’s valuation analysis is instructive.  Specifically, it highlights the evidentiary burden that can attend valuation fights in a bankruptcy case, as well as the thoroughness with which a court may investigate enterprise value.

Something to consider in a variety of bankruptcy contexts.

In light of the tumultuous economic events of 2008 and 2009, a number of proposals for significant bankruptcy reform have surfaced – many of which have been summarized on this blog.

One of last year’s posts focused on the ongoing debate over the impact of credit derivatives on failing companies, and on the continued usefulness of Bankruptcy Code provisions designed to insulate the financial markets from the bankruptcy process.

Last week, Harvard’s Mark Roe added to that discussion with a paper entitled “Bankruptcy’s Financial Crisis Accelerator: The Derivatives Players’ Priorities in Chapter 11”

The essence of Professor Roe’s proposal is set forth at p. 3:

Although several of [the Bankruptcy Code’s safe-harbor super-priorities for derivatives and repurchase agreements] are functional and ought to be kept, the full range is far too broad. Most are more likely to destabilize financial markets than to stabilize them and most need to be repealed.

Professor Roe’s thoughtful analysis is a worthwhile read.

JSC BTA Bank – A recent post appearing here discussed JSC BTA Bank (BTA)’s petition for recognition in the Southern District of New York’s U.S. Bankruptcy Court.  BTA, reportedly Khazakstan’s second-largest bank, sought recognition of its state-sponsored restructuring in Khazakstan as a “foreign main proceeding.”  On March 2, Judge James Peck in Manhattan granted the bank’s request.  A copy of Judge Peck’s ruling is available here.

White Birch Paper Co.  – The second-largest newsprint company in North America – Greenwich, Conn.’s White Birch Paper – followed the largest (Montreal’s AbitibiBowater Inc.), into bankruptcy in both Canada and the US on February 24.

White Birch and 10 affiliates, which together operate paper mills in Gatineau, Quebec; Riviere-du-Loup, Quebec; and Quebec City filed their request for protection under the Canadian Companies’ Creditors Arrangement Act in Montreal, and a concurrent request for recognition of 6 of those proceedings in Virginia’s Eastern District before Chief Bankruptcy Judge Douglas O. Tice, Jr.  They were joined by US affiliate Bear Island Paper Co. of Ashland, which sought protection under Chapter 11.

Pleadings filed in White Birch’s cases claim that the companies controlled approximately 12% of the North American newsprint market as of last December.  The filings were triggered by the continued shift from print to digital media and the attendant decline in revenues.  In addition, the widening spread between the Canadian and US currencies also hurt operations, as payables are frequently accepted in US dollars, while expenses are paid in Canadian dollars.  Finally, the companies’ operational woes were compounded by the burden of a January 2008 purchase of SP Newsprint Co. for approximately $350 million.

Cost-cutting efforts commenced in late 2009 were not sufficient to prevent White Birch’s default on first- and second-lien credit facilities.  Attempts to restructure the debt out of court were likewise unsuccessful.  Judge Tice’s Order granting recognition and entering a preliminary injunction was entered yesterday.

JSC Alliance Bank – Khazakstan’s sixth-largest bank followed BTA’s lead, seeking similar recognition in Manhattan’s Southern District less than 2 weeks after the larger Kazakh institution did so. 

Like BTA, Alliance sought relief from creditors and litigation in the US while it restructures itself out of debt defaults and liquidity problems arising, in part, from its need to foreclose on bad loans and its subsequent difficulty selling foreclosed assets.  In its papers, Alliance claims that last December, it obtained approval for a restructuring plan from creditors holding more than 94 percent of its claims.

Mega Brands Inc. – Toymaker Mega Brands has sought recognition in Delaware before Bankruptcy Judge Christopher Sontchi for its Canadian restructuring, commenced in mid-February before the Superior Court of Quebec in Montreal.

The global supplier of construction toys, stationery and other children’s toys and activity instruments plans to implement a global restructuring, which is reportedly supported by more than 70% of the company’s secured debt holders and all of its debenture holders – and on which lenders and shareholders will vote on March 16.  In pleadings submitted with the petition, the company blames its need to restructure on the downturn in global demand, resulting stagnation in the North American toy industry, and fluctuations in raw materials prices.

Japan Airlines – On January 19, Japan Airlines (JAL), Asia’s largest airline, sought Chapter 15 protection in New York in furtherance of its reorganization in the Tokyo District Court under Japan’s Corporate Reorganization Act.  Bankruptcy Judge James Peck – the same judge presiding over BTA Bank’s Chapter 15 proceeding (see above) – recognized the Japanese proceeding in mid-February.  According to JAL’s Court pleadings, US assets protected by the Chapter 15 recognition order include aircraft and real estate interests in New York and Los Angeles.  Judge Peck’s Order granting JAL’s recognition is here.