Until recently, the words bankruptcy and insolvency were almost never heard in connection with Internet companies. The computer sector was too energized, the stock market too hot, and equity, whether through angel investors, venture capitalists, or the public markets, too easy to obtain. The emerging .com company, finding itself in a cash flow crunch, would either raise additional capital or merge.
This is changing. Investors are starting to demand more of the .com companies, as shown by the recent stock market slide. Reduced stock valuations will mean limited options for start-ups that can not maintain cash flow. Absent a ready merger partner, running out of cash can mean shutting the doors. The alternative is trying to reorganize using the Chapter 11 bankruptcy process. For example, the Internet back-bone service provider Apex Global Information Services (AGIS) recently filed a Chapter 11 petition when free ISP NetZero Corporation either failed or refused to pay a $900,000 receivable.
How is Bankruptcy Relevant to the Internet Economy?
Traditional thinking is the bankruptcy process can not help Internet companies. Chapter 11 plans usually restructure hard assets such as equipment, inventory and real estate, which Internet companies lack. What's more, the traditional company usually only emerges from bankruptcy if it can establish positive cash flow during the bankruptcy case. The new economy plays by new rules. Traditional thinking can lead to the wrong conclusions.
Internet companies may not have inventory or even accounts receivable, but they have other valuable assets like intellectual property, patent rights, software and content licenses, and partner relationships. Bankruptcy provides special tools to restructure these assets. For example, a bankrupt company can keep profitable linking agreements, while canceling other partner agreements that proved, in hindsight, unwise. Internet companies may lack positive cash flow, but they have user flow, sometimes described as metrics. A business whose Web site attracts significant traffic or has many registered users has a valuable base on which to build a profitable business. Finally, traditional thinking says that Internet companies can't use the bankruptcy process because they are largely debt free. However, Internet companies' capital structures are primarily equity driven, and one of the most powerful tools in the bankruptcy process is the ability to restructure equity. The bankruptcy process can redefine equity holder rights, replace preferred stock positions with straight equity, eliminate equity positions outright, and rebuild the company's capital structure to make the company more attractive to new investors.
Dealing with a Bankrupt Company.
What do you do when a company you deal with files a bankruptcy petition? Initial questions include how the bankruptcy will affect your agreements and licenses with the company, whether your business can collect amounts owed which are outstanding at the time of the bankruptcy, and whether you should continue to provide goods and services to the company.
A business can file either a Chapter 7 or a Chapter 11 bankruptcy petition. A Chapter 7 bankruptcy is a liquidation and, except under unusual circumstances, the bankrupt business closes its doors before the date the petition is filed. In most cases, no assets are available for distribution. Thus, it is usually not possible to recover accounts receivable from a Chapter 7 bankruptcy. However, if the court notifies you of' a date by which claims against the bankruptcy estate must be filed, you should file a claim. Failure to file a timely claim bars payment even if funds are available. In Chapter 7 cases, licenses and other continuing agreements generally are rejected, or considered terminated, sixty days after the debtor files its bankruptcy petition. In some cases, a bankruptcy trustee will instead try to sell the debtor's rights under the agreement. In other cases, you might ask the court to force the debtor to reject the agreement before the sixty-day period ends.
A Chapter 11 petition is usually filed by a debtor who wishes to continue operations but wants to restructure its debts under the bankruptcy court's protection. Because the debtor will continue to operate during the Chapter 11 proceeding, it may request that your business continue to provide services and honor ongoing agreements.
There are a number of complex legal issues involved in continuing to do business with a company, during a Chapter 11 bankruptcy proceeding. Therefore, you should consult an attorney familiar both with the bankruptcy process and the particular type of business relationship. While it is not illegal or unusual for a business to continue to do business with a debtor in Chapter 11, you should consider requiring that the debtor pay cash in advance for any services. You should also be cautious about continued performance under ongoing agreements, such as licenses or linking agreements. If the business fails to pay, your only recourse will be to file an Application for Payment of an Administrative Expense with the bankruptcy court. Because few Chapter 11 bankruptcies are successfully concluded, this administrative claim might not be paid for a considerable amount of time, if at all.
Licenses and other ongoing contracts are called "executory contracts" in the bankruptcy forum, and a Chapter 11 debtor can terminate them, retain them, or try to sell its rights under them. Your rights during the bankruptcy process will be different from your rights outside of bankruptcy. For example, until the debtor makes a decision regarding a license, your business might be required to perform under the contract, even though the debtor is not paying you. On the other hand, some recent court cases limit the debtor's ability to sell, or even retain, rights under certain patent and copyright licenses.
Your options will depend on the type of agreement, and the facts of the particular bankruptcy case. For example, in some situations, you are better off letting the debtor continue to license technology or software during the case, rather than try to force the debtor to cancel the agreement. In other cases, early and aggressive action is required to force the debtor to make payments. You should be concerned with both obtaining payment from the debtor and controlling the relationship. This is another area where obtaining early advice from a bankruptcy attorney can help save, or even make, money in the end.
When a business goes bankrupt, the bankruptcy code and the bankruptcy court govern your future dealings. It is important to keep in mind that a new set of rules now applies to your relationship with that business, and that your rights and duties have been redefined.
Warren E. Agin, a Boston attorney and a member of Swiggart & Agin, LLC, is the author of Bankruptcy and Secured Lending in Cyberspace (Bowne & Co, 2000). He can be reached at (617) 742-0110 or wea@swiggartagin.com.