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The last few months have witnessed an implosion of the dot-com and e-commerce sector. [FOOTNOTE 1]As this trend accelerates, many of these companies will eventually fail as their cash runs out. [FOOTNOTE 2]In many instances, failed dot-com companies simply close their doors, or at most, liquidate under the Bankruptcy Code. [FOOTNOTE 3]If the economy declines, we may witness filings for reorganization under Chapter 11 of the U.S. Bankruptcy Code by more established e-commerce companies. These entities, while not yet profitable, often have more mature businesses with substantial revenues, as well as substantial debt. [FOOTNOTE 4]They are prime candidates for reorganization under Chapter 11. E-commerce sites catering to consumers typically state that information provided by a consumer will not be sold to third parties without the consumer’s permission. [FOOTNOTE 5]Bankruptcy cases, frequently involving the sale of assets, pose a potential for conflict, as illustrated in the Toysmart.com bankruptcy case, in which the debtor advertised its customer profiles database for sale, violating its own privacy policy. The Federal Trade Commission and the state attorneys general sued Toysmart.com in the U.S. District Court for the District of Massachusetts, alleging that such sale would violate fair-trade statutes. The Bankruptcy Court rejected a settlement on the ground that because no actual sale was up for approval, the matter was not yet ripe. The dispute was ultimately resolved when a subsidiary of the majority equity holder agreed to pay $50,000 to have Toysmart.com destroy the customer database. [FOOTNOTE 6] The privacy policies of many dot-coms contain language in which the dot-com business retains the right to modify the privacy policy at any time, making the enforceability of such privacy policies dubious. One consequence of the Toysmart.com litigation is that it may lead parties in future cases to favor a plan of reorganization as a way to preserve this value rather than an outright sale pursuant to Section 363(b) of the Bankruptcy Code. [FOOTNOTE 7]A plan could provide for a capital infusion by a third party, who would receive the equity of the reorganized debtor. [FOOTNOTE 8]As a practical matter, the third party would succeed to this customer information, but there would be no violation of the privacy policy, since most privacy policies do not address changes in the equity ownership of the e-commerce business. Indeed, a recent change in Amazon.com’s privacy policy specifically excludes a sale of substantially all of the company’s assets. [FOOTNOTE 9] LIEN ON ME Much of an e-commerce debtor’s value lies in the value of its intellectual-property assets. These assets could include copyrights in the debtor’s Web pages, as well as copyrights in any unique software developed and owned by the debtor. There is some uncertainty as to whether a security interest in an unregistered copyright can, indeed, be perfected. At least one case, In re Avalon Software Inc., [FOOTNOTE 10]has held that a security interest in a copyright may be perfected only by registering the copyright and filing with the federal Copyright Office. [FOOTNOTE 11]If, in fact, such a lien was not properly perfected, it can be avoided by the estate pursuant to Section 544(a) of the Bankruptcy Code. [FOOTNOTE 12] Even if such security interests were properly perfected and thus may not be avoided, they may prove to be of little value to the lender because of the changing nature of the collateral. Section 552(a) of the Bankruptcy Code provides the general rule that a pre-petition security interest does not extend to property of the estate acquired after the bankruptcy case was commenced. [FOOTNOTE 13]Section 552(b)(1) carves out an exception to this rule by providing that a pre-petition lien attaches to “proceeds, product, offspring, or profits” of the lender’s pre-petition collateral if applicable nonbankruptcy law permits and if provided for in the security agreement. [FOOTNOTE 14] Web pages are constantly modified and software changed. If a court concludes that this is new property, then the lender’s lien will attach to these intellectual-property assets only if they fit within the exceptions listed in Section 552(b)(1). New versions of Web pages and software would appear to be outside the scope of the definition of proceeds under Section 9-306 of the Uniform Commercial Code, which defines proceeds as including “whatever is received upon the sale, exchange, collection, or other disposition of collateral.” Since no disposition of the pre-petition collateral is occurring, the new versions of these assets would seem to fall outside this definition. Similarly, new Web pages and software versions do not fit neatly within concepts of “proceeds, product, offspring, or profits.” [FOOTNOTE 15] SECURED, UNSECURED Pursuant to Section 1129(b)(2)(A) of the Bankruptcy Code, a debtor that wishes to retain a lender’s collateral must, absent contrary agreement by the lender, pay the lender in cash the present value of the amount of its secured claim. [FOOTNOTE 16]If the claim is unsecured, then the debtor has far greater flexibility in how it may treat such a claim without the lender’s consent. For example, it may elect to pay only a portion of such a claim, in property other than cash (such as common stock of the reorganized debtor), provided that no junior classes receive any distribution. [FOOTNOTE 17]Moreover, the lender is entitled to post-petition interest only to the extent of the value of the collateral securing its claim. [FOOTNOTE 18]A determination that the lender is totally or partially unsecured will thus have the effect of stopping or reducing the accrual of post-petition interest. The issue of valuation arises under the Bankruptcy Code in a variety of contexts. For example, the debtor in possession may use “cash collateral” [FOOTNOTE 19]subject to a secured lender’s lien only if the secured lender consents or if the court approves the use of cash collateral. The court may approve the use of cash collateral only if it concludes that the secured lender is “adequately protected.” [FOOTNOTE 20]While adequate protection can take many forms, [FOOTNOTE 21]typically the courts find that a lender is adequately protected if it has an “equity cushion.” That is, the value of the lender’s collateral exceeds the amount of the loan secured by such collateral. [FOOTNOTE 22]The bankruptcy court will be required to value the collateral securing the lender’s loan if the parties are unable to reach an agreement regarding the use of cash collateral. In an e-commerce bankruptcy, it is likely that a substantial portion of such collateral will consist of intellectual property — copyrights in Web pages, patents on business methods, customer lists and so on. [FOOTNOTE 23] WHAT’S IT WORTH? At its most fundamental level, the question will arise as to how to value these new-economy businesses in the context of plan confirmation. A Chapter 11 plan may be confirmed only if all creditors and equity holders have accepted the plan, or if the court finds that each creditor or equity holder who has not accepted the plan will receive “property of a value” of at least as much as such creditor or equity holder would receive in a Chapter 7 liquidation. [FOOTNOTE 24]If creditors or equity holders are to receive securities under the plan, then these securities must be valued for purposes of this analysis. In addition, the court must make findings regarding the value of any property, including intellectual property, to be sold pursuant to a Chapter 7 liquidation. Similarly, the Bankruptcy Code provides that, absent the consent of senior classes of unsecured creditors and equity holders, junior unsecured creditors and equity holders may not receive any distributions with respect to their claims against and interests in the debtor unless such senior classes receive “property of a value” equal to their claims or equity interests. [FOOTNOTE 25]Moreover, as a corollary to this rule, senior classes may not receive more than the allowed amounts of their claims if junior classes are to be wiped out. [FOOTNOTE 26]If the plan is not completely consensual and creditors are to receive securities under the plan, then a valuation of these securities is required. GETTING THE CASH TO FLOW The current trend is for courts to apply a discounted cash flow analysis in valuing a business for plan purposes. [FOOTNOTE 27]Using this method, the present value of a series of cash flows plus a terminal value (i.e., the residual value remaining in the business at the end of the projection period) is used to estimate the overall value of the enterprise. [FOOTNOTE 28]This issue is magnified by the fact that many of these businesses have never had positive cash flows. [FOOTNOTE 29]In a contested confirmation battle, both the plan proponent and those opposing confirmation are likely to offer widely varying estimates of future cash flow. Indeed, the battle lines that are likely to be drawn on this issue will blur with those drawn on the highly related issue of “feasibility.” [FOOTNOTE 30] Another critical valuation issue will be arriving at the appropriate discount rate. The debtor and the equity committee in In re Zenith Electronics Corporation [FOOTNOTE 31]had radically different views on the proper valuation of technology relating to the transmission of digital television, a key asset of the debtor. [FOOTNOTE 32] Because this technology was “new and untried in the market,” [FOOTNOTE 33]the bankruptcy court concluded that the significantly higher discount rate urged by the debtor was more appropriate than the equity committee’s. [FOOTNOTE 34]The lesson is obvious: To the extent that the ability of the intellectual property to generate future cash flows is uncertain, a higher discount rate, and thus a lower valuation, is likely. The discounted cash flow valuation method is notably at odds with the various methodologies that, until relatively recently, were advocated by champions of the new economy. Web site hits, registered users and gross sales were used to justify often lofty stock market valuations of such companies. [FOOTNOTE 35]It is unlikely that these approaches will be accepted by a bankruptcy court in a contested confirmation battle. Indeed, given the radical devaluations of the perceived values of Internet companies by the stock market, it is hard to imagine the bankruptcy courts adopting such approaches. Lawrence P. Gottesman is a partner at New York’s Brown Raysman Millstein Felder & Steiner, where he heads the firm’s bankruptcy practice. Craig J. Conte, an associate at the firm, assisted in writing this article. ::::FOOTNOTES:::: FN1 SeeJayson Blair, “Glimpse at Profit Earns $30 Million for Kozmo,” New York Times, Dec. 30, 2000, at B3. FN2Some recent failures are Boo.com, BigWords.com, Pets.com and Urbanfetch.com. FN311 U.S.C. 101, et seq. FN4According to the 10-K of Amazon.com filed on Sept. 8, 2000, it had net sales of more than $1.6 billion, total assets of more than $2.4 billion for 1999, and long-term debt of more than $1.4 billion. FN5Toysmart.com’s privacy policy, as it formerly appeared on its Web site, read: “When you register with Toysmart.com, you can rest assured that your information will never be shared with a third party.” FN6 SeeComplaint, FTC v. Toysmart.com LLC, No. 00-CV-11341 (D. Mass. July 10, 2000). FN711 U.S.C. 363(b) (The debtor in possession may sell property of the estate outside the ordinary course of business after notice and a hearing). FN811 U.S.C. 1123(a)(5)(C) & (J). FN9“As we continue to develop our business, we might sell or buy stores or assets. In such transactions, customer information generally is one of the transferred business assets. Also, in the unlikely event that Amazon.com, Inc., or substantially all of its assets are acquired, customer information will of course be one of the transferred assets,” available at www.amazon.com/exec/ obidos/tg/browse. FN10209 B.R. 517 (Bankr. D. Ariz. 1997). FN11 Id.at 521. But see In re World Auxiliary Power Co., 244 B.R. 149, 154 (Bankr. N.D. Cal. 1999). FN1211 U.S.C. 544(a). FN1311 U.S.C. 552(a). FN1411 U.S.C. 552(b)(1). FN1511 U.S.C. 552 (b) (1). FN1611 U.S.C. 1129(b)(2)(A). FN1711 U.S.C. 1129(b)(2)(B)(ii). FN1811 U.S.C. 506(b). FN1911 U.S.C. 363(a). FN2011 U.S.C. 363(c)(2)(B). See, e.g., In re George Ruggiere Chrysler-Plymouth Inc., 727 F.2d 1017, 1019 (11th Cir. 1984). FN21 See11 U.S.C. 361. FN22 See, e.g., In re Dixie-Shamrock Oil & Gas Inc., 39 B.R. 115, 117 (Bankr. M.D. Tenn. 1984). FN23In determining how much of the lender’s claim is secured, the court will have to value the collateral. FN2411 U.S.C. 1129(a)(7)(A). FN2511 U.S.C. 1129(a)(8) & (b)(2)(B) & (C). FN26 See, e.g., 7 Collier on Bankruptcy 1129.06[2] at 1129-153 (15th ed. Rev. 2000). FN27 Id. FN28 See, e.g., In re Cellular Info. Sys., 171 B.R. 926, 935 (Bankr. S.D.N.Y. 1994). FN29 See, e.g., Carole Gould, “Mutual Funds Report: Winning Managers’ Strategy: Selling Short,” New York Times, Jan. 7, 2001, at 1. FN3011 U.S.C. 1129(a)(11). FN31241 B.R. 92 (Bankr. D. Del. 1999). FN32 Id.at 104. FN33 Id. FN34 Id. FN35Bill Whyman, “Net Businesses Need New Valuation Metrics,” June 14, 1999, at http://www.thestandard.com.

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