Inventory and Accounts Financing of Manufacturers

²Under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code"), an eligible debtor may obtain relief from creditors while attempting to confirm a plan of reorganization.

³The debtor in a Chapter 11 proceeding remains in possession of the property of the bankruptcy estate unless a trustee is appointed. See Sections 1104(a) and 1107(a) of the Bankruptcy Code. Under Section 1107(a) of the Bankruptcy Code, a debtor-in-possession has the rights and avoiding powers of a trustee, including the right under Section 544(a) of the Bankruptcy Code to avoid certain unperfected security interests.

⁴Throughout this article, references to "copyrightable" material are intended to encompass any works entitled to protection under the United States Copyright Act of 1976, as amended, 17 U.S.C. ' 101 et seq (the "Copyright Act"), without regard to whether the owner of the copyright has, or has not, registered the copyright. As Avalon (see note 9, infra) explains, the Copyright Act, and its preemptive effect, applies to copyrightable material even if the copyright is not registered with the Copyright Office. See also In re AEG Acquisition Corp. , 161 B.R. 50 (9th Cir. BAP 1993), where copyright preemption even was extended to foreign copyrights exempt from registration under the Copyright Act by the Berne Convention for the Protection of Literary and Artistic Works (an international convention pertaining to copyright protection which, as a treaty, has supremacy over the Copyright Act).

⁵In addition to copyrights protectable under the Copyright Act, Borrower almost certainly also will have trademarks entitled to protection under the Lanham Act, 15 U.S.C. ' 1051 et seq (the federal statute governing trademark registration). In the area of consumer product packaging, trademark and copyright law often overlap, but both have distinct application. To characterize the overlap in a somewhat oversimplified way, trademark law provides the principal protection for the name, logo, and goodwill of the product, while copyright law protects the right to copy and distribute tangible expressions of textual, pictorial, and graphical creative works pertaining to the product packaging and labeling. The reason this article focuses on the copyright aspect, rather than the trademark aspect, is that courts generally have construed the Lanham Act as not preempting the UCC with respect to perfection of security interests in trademarks. See, e.g., In re Joseph v. 1200 Valencia, Inc., 137 B.R. 778 (Bankr. C.D. Calif. 1992). The interplay between trademark and copyright law, and the relative valuation of those intangible aspects of the product, may become quite relevant to the allocational analysis discussed below. See notes 39-42, infra, and accompanying text.

⁶As a pure factual matter, Borrower may have a point. The wholesale price of a well-regarded brand name consumer product usually is much greater than the direct cost of making the product. Much of the wholesale price is calculated to recoup the investment previously made in researching, developing, marketing, advertising, and promoting the brand name and the product. A physically identical product sold as a "generic" product under an unknown name almost certainly would have a substantially lower wholesale price (e.g., 60" per bottle for generic shampoo with a direct manufacturing cost of 50" per bottle, as opposed to $2.00 per bottle for brand name merchandise). The differential in value can be argued to be attributable to intangible assets, including copyrights, trademarks, "trade dress," trade secrets, and goodwill. See notes 39-42, infra, and accompanying text, for allocational considerations.

⁷Product labeling takes different forms. Paper or plastic labels may be physically affixed to bottles or containers, as with adhesive labels attached to glass bottles, or they may be an integral part of the componentry, such as text or graphics indelibly printed or stamped on plastic containers or cardboard boxes. In the former case, removal may be merely impractical; in the latter case, it may be practically impossible without damaging the goods. For simplicity, this article will refer to "labels" as including product packaging on which the relevant text or graphics directly is imprinted.

⁸The bankruptcy court has the inherent equitable power to allocate value between non-avoidable secured claims and avoided secured claims. See generally Bankruptcy Code ' 105. Security interests avoided under Section 544(a) of the Bankruptcy Code due to non-perfection are automatically preserved for the benefit of the estate by Section 551 of the Bankruptcy Code. See also Section 552 of the Bankruptcy Code, which provides for allocation of value in other analogous contexts.

⁹In re Avalon Software Inc., 209 B.R. 517 (Bkrtcy. D. Ariz. 1997) ("Avalon").

¹⁰ Quality King Distributors, Inc. v. L'anza Research International, Inc., ___ U.S. ___, 1998 WL 96265 (March 9, 1998) ("Quality King").

¹¹209 B.R. at 521. Avalon is discussed at length in Turner and Bue, The Pitfalls of Financing Software Developers, 53 Secured Lender No. 6, pp. 14 et seq (November-December 1997) ("Pitfalls"), reprinted with permission in The Newsletter of the Commercial Law and Bankruptcy Section of the Los Angeles County Bar Association, Volume 5, No. 1, pp. 4 et seq (Fall 1997), and republished with permission, under the title Guidelines for Financing Software Developers.

¹²1998 WL 96265 at pp. *1 and *3. Even though the copyrights in Quality King were registered with the Copyright Office, that fact is irrelevant to the analysis in this article. As pointed out in note 4, supra, the Copyright Act applies to unregistered "copyrightable" works as well. If a registered label is covered by the Copyright Act, it is also covered even if it is not registered. Although the Supreme Court in Quality King did not engage in specific analysis of why the labels in that case were copyrightable, it is clear that labels may and often do contain copyrightable material. See, e.g., Nimmer on Copyrights, 6 2.08[G] at pp. 2-135 et seq (M. Bender). The threshold for "copyrightability" is extremely minimal (and is lower than comparable thresholds for trademark or patent protection) ; almost any original creative content will suffice; novelty or uniqueness is not required. Id. On the other hand, some labels (for example, those containing only the product name and list of ingredients, with no original creative content) may fall below the threshold. See, e.g., Copyright Office Rules ' 202.1. See also Copyright Act ' 102(b), which provides: "In no case does copyright protection for an original work of authorship extend to any idea, procedure, process, system, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied in such work." Most major consumer product manufacturers take the view that their labels are protected, at least to some extent, by the Copyright Act, and this article assumes that the labels involved have sufficient creative content to qualify for Copyright Act protection.

¹³See note 7, supra. See also notes 39-42, infra, and accompanying text.

¹⁴U. S. Const., Art. I, ' 8, cl. 8, the constitutional source for the power of Congress to enact the Copyright Act. Even though, as the Supreme Court noted in Quality King, the principal function of the Copyright Act is the protection of original works, rather than "ordinary commercial products that use copyrighted material as a marketing aid," nevertheless the Copyright Act does protect commercial marketing material with original content. 1998 WL 96265 at pp. *4 and *9. See also note 12, supra.

¹⁵"The Supremacy Clause of the U.S. Constitution permits a federal law to supersede or preempt a state law if the state law conflicts with the federal law or prevents the achievement of a federal objective. Where the scope of a federal statute or regulation comprehensively governs a particular area of the law, the federal statute or regulation will preempt conflicting state or local laws governing the same subject matter." Pitfalls at p.20, n. 4.

¹⁶As discussed below (see text accompanying and following note 43, infra), the copyright concerns are materially lessened after a "first sale" of the labeled inventory; therefore, this article focuses on inventory financing of manufacturers, before the "first sale" has occurred, and financing of the accounts resulting from the sale of such inventory; this article does not address the financing of inventory held by non-manufacturer distributors or retailers.

¹⁷In re Peregrine Entertainment Ltd., 116 B.R. 194 (C.D. Cal. 1990) ("Peregrine").

¹⁸209 B.R. at pp. 521-22.

¹⁹209 B.R. at pp. 521, 523.

²⁰See Pitfalls at pp. 16, 18.

²¹1998 WL 96265 at p. *3.

²²Id.

²³Id.

²⁴Id.

²⁵Id. at pp. *3 and *4.

²⁶Id.

²⁷Id. at p. *3.

²⁸Id. at pp. *3 and *4.

²⁹Id. at p. *4.

³⁰See 1998 WL 96265 at p. *6. The "first sale" exception is discussed below. See text accompanying and following note 43, infra.

³¹1998 WL 96265 at pp. *4-*9.

³²Id. at pp. *3-*4.

³³Copyright Act ' 106, 501, and 502.

³⁴See generally Boyle, Shamans, Software, and Spleens: Law and the Construction of the Information Society, pp. 1-12 (Harvard University Press 1996).

³⁵116 B.R. at pp. 198, 199, and 207 (n.20).

³⁶In Avalon, the "proceeds" at stake were the revenues arising under non-exclusive software license agreements. 209 B.R. at pp. 521-523. Arguably, the characterization of non-exclusive licensing revenues as proceeds was erroneous, because no "disposition" of the copyright occurred; the owner of the copyright could license distribution and use of specific copies of the work an unlimited number of times without "using up" the underlying work. See Pitfalls at pp. 14 and 20 (n.6). Analogously, when the sale occurs of a bottle of shampoo with a copyright-protected label affixed, no sale of the underlying copyright occurs, only the sale of a specific copy of the copyrightable material . the label on the specific bottle. The owner retains the right to sell an infinite number of additional bottles bearing identical labels. For purposes of this article, however, until either the courts get it right or Congress amends the Copyright Act to clarify and narrow its preemptive effect, a cautious lender must assume that the copyright preemption problem extends not only to the work itself and copies of the work, but also potentially to revenues derived from the sale or license of the copyrightable material, including accounts.

³⁷Indeed, as discussed below (see notes 48-52, infra, and accompanying text), Lender's potential dilemma with respect to the accounts may be less easily solvable, because, while a license from Borrower to Lender to distribute the copyrightable material in connection with a sale by Lender of the inventory may help protect Lender's right to the entire proceeds of a sale by Lender of the inventory, by contrast, the accounts in which Lender asserts a security interest presumably are the proceeds of sales by Borrower of inventory, and the existence of a license in favor of Lender may be irrelevant to the analysis.

³⁸See note 8, supra.

³⁹See, e.g., the numerous cases cited at 5 Collier on Bankruptcy 6 552.02[4][d], p. 552-13, n. 23 (15th Ed. M. Bender).

⁴⁰As a general rule, Sections 544(a)(1) and (2) of the Bankruptcy Code permit the trustee or debtor-in-possession to avoid unperfected security interests in personal property.

⁴¹Lender, of course, will argue that the overall value of the inventory is allocable, not only to the goods themselves and the related copyrightable material, but also to other intangible components in which a security interest may be perfected by the filing of a financing statement under the UCC, such as trademarks, "trade dress," trade secrets, and goodwill. Even assuming Lender is relatively successful in allocating value to the aspects of the product other than copyrightable material, however, the cost, and loss of value due to delay, could be considerable, and Lender will be subject to the "leverage" that Borrower can exact from Lender's potentially vulnerable position.

⁴²See notes 36-37, supra, and accompanying text.

⁴³Copyright Act ' 106, subject to the exceptions and limitations set forth in Sections 107 through 121 of the Copyright Act.

⁴⁴See Pitfalls at pp. 16-18.

⁴⁵Section 205(c) of the Copyright Act requires specificity in identification of copyrights in connection with transfers of interests therein, including security interests. "Blanket" references are not permitted.

⁴⁶Extensive materials regarding registration of copyrights and transfers of copyright interests, including security interests, freely are available on the Worldwide Web through the Library of Congress site.

⁴⁷See Sections 205(c)(1) and (2) of the Copyright Act.

⁴⁸Appendix A to this article is an example of a License Agreement that Lender could enter into with Borrower.

⁴⁹Bankruptcy Code ' 365(a).

⁵⁰Bankruptcy Code ' 365(n) provides in relevant part as follows: "(n)(1) If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect . . . (B) to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankruptcy law), as such rights existed immediately before the case commenced, for - (i) the duration of such contract; and (ii) any period for which such contract may be extended by the licensee as of right under applicable nonbankruptcy law. (2) If the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, under such contract - (A) the trustee shall allow the licensee to exercise such rights; (B) the licensee shall make all royalty payments due under such contract for the duration of such contract and for any period described in paragraph (1)(B) of this subsection for which the licensee extends such contract; and (C) the licensee shall be deemed to waive - (i) any right of setoff it may have with respect to such contract under this title or a applicable nonbankruptcy law; and (ii) any claim allowable under section 503(b) of this title arising from the performance of such contract. (3) If the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, then on the written request of the licensee the trustee shall - (A) to the extent provided in such contract, or any agreement supplementary to such contract, provide to the licensee any intellectual property (including such embodiment) held by the trustee; and (B) not interfere with the rights of the licensee as provided in such contract, or any agreement supplementary to such contract, to such intellectual property (including such embodiment) including any right to obtain such intellectual property (or such embodiment) from another entity. (4) Unless and until the trustee rejects such contract, on the written request of the licensee the trustee shall - (A) to the extent provided in such contract or any agreement supplementary to such contract - (i) perform such contract; or (ii) provide to the licensee such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankruptcy law) held by the trustee; and (B) not interfere with the rights of the licensee as provided in such contract, or any agreement supplementary to such contract, to such intellectual property (including such embodiment), including any right to obtain such intellectual property (or such embodiment) from another entity."

⁵¹It may be desirable for the license to be granted in a separate "contract" to minimize the impact of the setoff waiver provisions of Bankruptcy Code ' 365(n)(2)(c)(i) (quoted in note 50, supra).

⁵²There is, however, little applicable precedent on which Lender may rely.

⁵³Of course, if the lender wants the added protections of Copyright Act registration (protection against infringement and the rights of purchasers, for example), the lender is free to take that extra step.

⁵⁴See Pitfalls at p. 16.

⁵⁵Id.

⁵⁶See note 15, supra.

⁵⁷Courts have proven able to craft rules governing such interplay in the analogous contexts of patents and trademarks. See, e.g., the cases cited in Pitfalls at p. 164 (n. 13).

⁵⁸See note 1, supra.

⁵⁹See Pitfalls at p. 18.

⁶⁰Pitfalls at p. 18, 20.