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Can an old dog learn new tricks? As the new economy continues to develop — and falter — many will be watching to see how the U.S. Bankruptcy Code, drafted when the Internet was barely a twinkle in anyone’s eye, functions in an e-commerce world. One of the central features of the Bankruptcy Reform Act of 1978 (the “Bankruptcy Code”) was its creation of a single reorganization chapter for all types of businesses. Chapter 11 was intended to encompass all businesses regardless of type, size, form or ownership structure. This “one size fits all” approach has, with certain exceptions, remained the guiding philosophy of business reorganizations under the Bankruptcy Code through the present day. [FOOTNOTE 1] But the rise and subsequent fall of numerous e-commerce and dot-com companies during the past five years raises a new, fundamental challenge to the idea that Chapter 11 is suited for all business types and models. The forecasted failure of Internet companies [FOOTNOTE 2] poses two interesting questions: whether Chapter 11 is a sensible option for the reorganization of troubled e-commerce and dot-com companies; and what types of e-commerce companies, if any, are best suited for Chapter 11 reorganization. [FOOTNOTE 3] The legislative history of the Bankruptcy Reform Act of 1978 states that “[t]he purpose of a business reorganization case, unlike a liquidation case, is to restructure a business’s finances so that it may continue to operate, provide its employees with jobs, pay its creditors, and produce a return for its stockholders.” [FOOTNOTE 4] Reorganization is more “economically efficient” than liquidation because it “preserves jobs and assets.” [FOOTNOTE 5] As indicated by the legislative history, the enactment of Chapter 11 was intended to achieve the important goal of preserving a business’s going-concern value. In essence, the premise underlying Chapter 11 is that the enterprise value of an operating business is greater than the value to be achieved by the liquidation of its assets. The difference between the enterprise value and the liquidation value of a business is often referred to as the “going concern premium.” Generally speaking, Chapter 11 provides a troubled company with the means to protect and maximize its going-concern premium. Chapter 11 achieves this by making certain tools and opportunities available to a troubled company. First, Chapter 11 provides a distressed business with the chance to implement a business and/or reorganization plan designed to return the business to a viable and sustainable operational state. This chance is made possible by, among other things, the automatic stay that is triggered upon the commencement of a Chapter 11 case. The automatic stay operates to enjoin substantially all judicial and administrative actions against a debtor or its property on account of claims against the debtor that arose before the commencement of the Chapter 11 case. [FOOTNOTE 6] In this respect, the stay gives a debtor a breathing spell from creditors by stopping all collection efforts and foreclosure actions and relieving the debtor of the immediate financial pressures that forced it to seek Chapter 11 protection in the first instance. CONTINUING IN POSSESSION Second, Chapter 11 provides a troubled business with the means of maintaining, and in some instances augmenting, its asset base. Chapter 11 permits a debtor to continue in possession of its property and to operate and manage virtually all aspects of its business in the ordinary course during the pendency of its Chapter 11 case. [FOOTNOTE 7] Consistent with the operation of its business, a Chapter 11 debtor may continue to employ and pay its workers, pay its creditors, perform under existing contracts and enter into new ones, and implement a long-term business plan. By offering a debtor the opportunity of doing “business as usual,” Chapter 11 generally serves to protect the debtor’s going-concern premium. Finally, Chapter 11 specifically affords a debtor the chance to obtain credit while in bankruptcy. [FOOTNOTE 8] Typically, such financing takes the form of secured indebtedness, senior in priority to virtually all other creditors. Chapter 11 debtors routinely borrow money while in bankruptcy in order to fund their continued business operations and reorganization efforts. As a general matter, Internet companies have not had much in common with the types of businesses that traditionally have used Chapter 11 successfully as a tool for reorganization. To date, most e-commerce companies earn little or no income and suffer annual operating losses. They possess little or no asset-based debt, relying on capital contributions and unsecured loans from corporate insiders, equity-based financing and, in certain situations, high-yield bond debt. Such a capital structure makes these dot-com companies almost completely dependent on the fortunes of the equity markets and the business decisions of venture capital firms for their survival. The asset bases of Internet companies are also different from those of “old economy” companies. The assets of many e-commerce companies consist almost entirely of intellectual property, such as technology licenses and agreements, that generally have a limited value outside the business itself, and thus lose value as the companies’ business operations deteriorate. For these companies, the possession of “hard assets” such as equipment, inventory and fixtures is purely incidental to the operation of their businesses. Moreover, even those e-commerce companies that produce tangible assets — for instance, personal computer manufacturers — are faced with challenges that old economy companies do not have. For example, according to Charles B. Rutstein, a research director specializing in e-business infrastructure at Cambridge, Mass.’s Forrester Research Inc., the value of inventory held by e-commerce companies is estimated to depreciate at a rate of one percent a week, on average. These special characteristics, among others, of e-commerce and dot-com companies suggest that, notwithstanding the “one size fits all” design of Chapter 11, it may not be a particularly well-suited restructuring option for the majority of troubled Internet companies. Consideration of the Chapter 11 policies and tools described above in the context of distressed e-commerce companies lends support to this conclusion. As an initial matter, few, if any, financially distressed e-commerce companies have attempted to reorganize their businesses as going-concern entities, either inside or outside of bankruptcy. Most troubled Internet companies have chosen either to shut down and liquidate their businesses outside the bankruptcy context or, less frequently, to use bankruptcy as a means to effectuate the sale of their assets. [FOOTNOTE 9] Notably, neither of these approaches involves an effort to implement business and/or restructuring plans to stabilize operations or to return the business to a viable and sustainable operational state. ASSETS DEMATERIALIZE Second, troubled Internet companies have had a difficult time maintaining their asset bases. Because of the primarily intangible nature of their assets — and the fact that the IP assets of e-commerce companies generally have little or no value outside the particular business purposes for which they were created — many Internet companies have substantially overvalued their assets and have failed in their efforts to market and sell their businesses and assets. [FOOTNOTE 10] Moreover, distressed dot-com companies have been at a particular disadvantage with respect to retaining one critical intangible asset: employees. Indeed, when the stock options that many dot-com companies used to recruit and retain employees lose their value because of business deterioration, there are few financial or other incentives for employees to stay. The loss of employees further depreciates the asset bases of these companies since many of these employees possess special knowledge and expertise related to intellectual property that cannot be easily replaced. Finally, there is little evidence to suggest that troubled Internet companies are likely candidates to borrow money through the Chapter 11 process. E-commerce businesses have few hard assets to back the asset-based loans that traditionally are obtained to support businesses during Chapter 11 cases. Typically, most financially distressed dot-com companies would have unsuccessfully sought additional unsecured and/or equity-based financing before filing a Chapter 11 case. Given these factors, Chapter 11 may not be the most sensible option for troubled Internet companies seeking to restructure their businesses. As described above, financially distressed Internet companies have not been favorable reorganization candidates and seem to possess an asset mix that does not lend itself to the Chapter 11 restructuring process. Moreover, troubled e-commerce companies are highly unlikely to be able to raise the financing necessary to fund continued business operations while they attempt to implement a restructuring. Simply stated, the going concern premiums of financially distressed e-commerce companies, if they exist, generally have not been protected, much less augmented, through the Chapter 11 process. IF NOT, THEN WHAT? Although Chapter 11 may not be well-suited for many troubled e-commerce companies, the question remains whether there are particular types of Internet companies that may be able to use the Chapter 11 process effectively as a means for reorganization. The likely answer is yes, although to date there are few precedents to consult on this question. Forrester Research’s Rutstein believes that so-called metro ethernet companies (e-commerce companies that provide communications and data connections between major companies located in different metropolitan areas), which use their equity financing to create hard assets, such as the networks necessary to operate their businesses and provide services to their customers, “are more similar to the Old Economy business model than most existing e-commerce companies.” This suggests that metro ethernet companies may be better equipped than other e-commerce companies to use the Chapter 11 process to reorganize their businesses as going concern entities and to raise asset-based financing, if necessary. The same conclusion may apply to certain e-marketplace providers. These companies create online product and commodities markets that allow companies to purchase direct and indirect materials used for production and manufacturing online, rather than through more traditional supply channels. During the past three years, e-marketplaces have arisen in such diverse industries as the construction, automotive, chemicals and utilities industries. To the extent that e-marketplace providers offer manufacturing (or other) companies meaningful savings in terms of transaction and supply costs, it is reasonable to anticipate that those companies will have a vested interest in supporting troubled e-marketplace providers through a Chapter 11 reorganization process. Indeed, depending on the cost savings achieved through e-marketplace providers, it is conceivable that manufacturers would step in with additional financing (asset-based or otherwise) to effectuate the restructuring of e-marketplace providers under Chapter 11. Notwithstanding the “one size fits all” flexibility of Chapter 11, the unique characteristics of e-commerce companies suggest that reorganization under Chapter 11 may not be a particularly well-suited option for many troubled dot-coms in their present form. Indeed, Chapter 11 simply may not be an effective means for maintaining the going concern premium of financially distressed Internet companies. Future shakeouts in the e-commerce world will demonstrate whether certain types of dot-coms — such as metro ethernet companies and e-marketplace providers — will be able to make effective use of Chapter 11 as a tool for reorganizing their businesses as going concern entities. Roger G. Schwartz is an associate, and Shelley C. Chapman a partner, in the corporate reorganization and bankruptcy department of the New York office of Sidley & Austin. ::::FOOTNOTES:::: FN1 Since the enactment of the Bankruptcy Code, Congress has passed special provisions related to small businesses using Chapter 11 and single-asset real estate cases. These provisions “reflect a perceived need to ‘tailor’ Chapter 11 to fit certain kinds of situations, a tacit acknowledgement that, after all, perhaps one size does not fit all.” Hon. Leif M. Clark, “Chapter 11 — Does One Size Fit All?” 4 Am. Bankr. Inst. L. Rev. 167, 175-76 (1996) (certain provisions of the Bankruptcy Reform Act of 1994 suggest the beginnings of a departure from the unitary approach to reorganization embodied in Chapter 11). FN2 See, e.g., Tamara Loomis, “ Dot-Com Deaths Leave Bankruptcy Lawyers Crying,” NYLJ, Dec. 7, 2000, at A2 (more than 80 dot-coms had shut down or filed for bankruptcy since the beginning of 2000, and analysts predicted that “the bloodbath is far from over”); Steven J. Kafka, “The eMarketplace Shakeout,” The Forrester Report, August 2000 (Forrester Research Inc., Cambridge, Mass.) (predicting a significant decline in business-to-business e-marketplace services during 2000 and 2001). FN3 This article focuses on the question of whether troubled Internet companies can use Chapter 11 effectively for reorganization. It does not directly address whether Chapter 11 is an advisable means for distressed Internet companies to liquidate or to maximize the value of any one particular asset, such as an undermarket lease. FN4 H.R. Rep. No. 595, 95th Cong., 1st Sess. (1977), reprinted in 1978 U.S.C.C.A.N. 5963. FN5 Id. FN6 11 U.S.C. 362(a). FN7 See 11 U.S.C. 1107, 1108. FN8 See 11 U.S.C. 364. FN9 For example, Mercata.com, an Internet co-op buying site backed by Microsoft co-founder Paul Allen, announced its intention to cease operations and to commence an orderly shutdown and liquidation of its assets. Similarly, shareholders of Pets.com, on online retailer for pet supplies, approved the company’s liquidation plan which included a strategic effort to sell the majority of the company’s assets. In the bankruptcy context, Furniture.com, an online furniture sales company, filed for Chapter 11 and is in the process of negotiations to sell all of its intellectual property assets. FN10 See, e.g., Robert S. Gebhard, “Dot-com Bankruptcies: A Preview from Silicon Valley?” 2000 ABI JNL LEXIS 68 (September 2000) (one dot-com Chapter 11 debtor initially valued its intellectual property at $20 million, but after conversion of the case to a Chapter 7 liquidation it sold the intellectual property, along with substantially all of the debtor’s remaining assets, for $275,000); Reuters, “Musicmaker.com to Liquidate,” Jan. 4, 2001, available at www.msnbc.com/news/511350.asp (describing online music company that decided on liquidation and was unable to find a partner or buyer willing to offer greater value than that expected to be derived from liquidation).

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