Last year, the Bankruptcy Court in Boston, amid great fanfare, conducted its first online auction of assets of a bankrupt. This was a recent and important incidence of the Court’s increasing utilization of the Internet in the bankruptcy process. Court dockets and pleadings are now online, Web sites provide case information and the electronic filing of pleadings is accepted.
It would be a strange irony if this increasing application of the Internet by the court system utilized the engine of the dotcom revolution as an instrument for liquidation or reorganization of financially troubled Internet companies. There have been relatively few of these so far, but indications are that more will follow.
Obviously, it is presumptuous to predict a dotcom recession, particularly in the face of prosperity and the resilience of the dotcoms; however, conditions are ripe. In fact, with the increasing volatility of the stock market, there has been some skepticism about the “New Economics” expounded by e-commerce firms. With periodic interruptions of the flow of investment capital needed to sate the apparently voracious appetite of dotcoms for operations and for expansion, investors are becoming more conservative and are focusing more attention on short-term profitability and, failing that, their remedial rights, their recourse to the assets available to recover investments and the time and expense required to do so.
The shift in emphasis is palpable. Since an initial public offering or merger or takeover is no longer a certain exit strategy, early-stage investors and later-stage lenders both have begun to ask more insistently, in the vernacular of the Old Economy: “Where’s the beef?”
There is no easy answer, as the media has been quick to point out. Dotcoms in distress may have accounts receivable, but hard assets which lenders and investors traditionally are most comfortable valuing, such as real estate, inventory, equipment, fixtures and furnishings are like hens’ teeth. What may be left to fight over are more ephemeral items, such as patents, copyrights, trade names, software, licenses, domain names and Web sites – which are comprised of some of those items.
In the financially troubled enterprise, lenders and investors are, indeed, in competition for these assets. What lenders have “secured” is denied to general creditors and investors. Equity investors are at the bottom of the food chain and are in line to be paid only after creditors are paid in full, absent agreement by all parties to a different arrangement. If the interests of these constituencies cannot be reconciled consensually the issues may have to be adjudicated and the enterprise reorganized or liquidated in Bankruptcy Court.
There have been relatively few bankruptcies involving dotcoms and, as a consequence, the law is not well settled. Nevertheless, some bankruptcy implications can be anticipated. First, the automatic stay will freeze all existing, and enjoin prospective action by creditors and investors against the bankrupt or its property. In bankruptcy, a sale of assets of a bankrupt, even a going concern, can be made free and clear of liens and encumbrances – with certain exceptions. By the same token, a lender to a bankrupt may, with court authority, be granted a lien superior to existing liens and security interests. So a lender concerned about title to a dotcom’s assets and existing liens pre-bankruptcy, may be more amenable to post-bankruptcy financing. Additionally, the Bankruptcy Code provides special protections to licensees under executory contracts of intellectual property in the event the licensor goes bankrupt.
This is some comfort; however, realizing upon the “intangible” assets will be a challenge. Lenders must pay close attention to insure they have secured sufficient rights to utilize the asset in the event of a default and bankruptcy, and even then there are pitfalls. For example, trademarks are not among the examples of “intellectual property” within the meaning of the Bankruptcy Code and, thus, licensees are not entitled to the special protections of the Bankruptcy Code with respect to trademarks, which may be integral to intellectual property licenses. The licensee may have the right to continue to use software but not the trademark that validates it. In addition, recent court decisions have cast doubt on the proper procedures for perfecting security interests in copyrights. It also is not settled that a bankruptcy trustee may assign the rights of a bankrupt licensee in a non-exclusive license without the consent of a licensor.
The status of customer lists has been similarly unsettled and the subject of much speculation. In e-retail, conventional wisdom is that Internet sales are particularly price sensitive and success involves sacrificing margins and profit to grow sales and ultimately to broaden the product base. The returns are not all tabulated on the viability of that strategy. To the skeptics it resembles the sale of chocolate-covered Egyptian cotton by Milo in Catch 22. When the company does founder because financing to continue to fund operating losses or necessary expansion is unobtainable, or for other reasons, the core asset of the business may well be the demographics of customers obtained in the sales process. Such was the case of Toysmart.com, an online toy store funded by The Walt Disney Co., which ceased operation and filed for bankruptcy in Boston recently.
After the filing of its bankruptcy petition, Toysmart.com moved for authority to auction and sell its assets, including its lists of customer information. This generated a flurry of objections, first from the Federal Trade Commission, which sued to enjoin the proposed sale alleging that it would constitute “unfair or deceptive acts or practices in effecting commerce.” The FTC also alleged violation of the Children’s Online Privacy Protection Act in that Toysmart.com had collected personal information from customers it actually knew were under the age of 13.
Toysmart.com has attempted to settle the dispute by agreeing to limitations on the sale of customer information. Its tentative agreement with the FTC provides that the customer information could be sold only as part of the sale of Goodwill and only to a qualified buyer approved by the Bankruptcy Court. A “qualified buyer” must concentrate its business in the “family commerce market involving the area of education, toys, learning and/or home instruction,” and expressly agree to maintain and preserve the customer information subject to the privacy statement promulgated by Toysmart.com. Further, the “qualified buyer” may use the customer information only to fulfill customer orders and to personalize customers’ experience on the Toysmart.com Web site.
This compromise satisfied the FTC but apparently did not satisfy Attorneys General from 40 states which filed opposition to its approval by the Bankruptcy Court. The Attorneys General oppose any use of customer information without express consent of each customer affected. They even objected to the offer by Disney to pay $50,000 for the information in order to destroy it. At a recent hearing before the Bankruptcy Judge, the Judge expressed great concern over the issues raised by the Attorneys General, and Toysmart.com has, for the moment, withdrawn its application for approval of the settlement and sale of the customer information.
The ramifications of this case could be far-reaching. Of course, not every retailer uses the same privacy statement as Toysmart.com, and some statements are sure to change the final decision. In addition, the court has not addressed the conveyance of customer lists in differently structured transactions like the issuance of stock of a reorganized debtor. However, if the privacy issue is a serious concern to customers, and it seems to be, retailers will not be able, for competitive reasons, to dilute their promises substantially and at least one bill is pending in Congress to require consent to disclosure by each affected customer. Under the circumstances, the customer lists and customer information will have significantly less value to lenders and investors alike than previously anticipated.
Consequently, it would appear that if the competition is over the disembodied parts of the failed dotcom, recoveries to all constituencies are likely to suffer due to the uncertainties described above, and the flight of key personnel responsible for the maintenance and enhancement of the cyber assets. The presence of strategic buyers, or the reorganization of the dotcom on a going-concern basis, may generate incrementally better results on an item-by-item basis but equity investors, in particular, should not expect a safe haven in the bankruptcy process. t
Richard Hiersteiner is a partner at the Boston law firm of Palmer & Dodge LLP, and is chair of the Bankruptcy Group.