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When the Internet bubble burst, over 200 Internet companies filed for bankruptcy protection in the U.S., and over 500 more simply shut their doors. For many in-house counsel who had scarcely (if ever) had to deal with their client’s customers going bankrupt, this bankruptcy avalanche has forced us to learn the bankruptcy basics, fast. Beyond technical bankruptcy law, however, some vital “real world” lessons can be learned about how to proactively protect one’s client from such bankruptcies, and how to minimize the damage once your client is stuck with a bankrupt customer. WHY BANKRUPTCIES ARE SO BAD FOR YOUR CLIENT Bankruptcies can be costly for your client, beyond the obvious fact that when a customer goes out of business, your client loses a revenue stream. For one, bankruptcy law compels your client to continue to provide services to the bankrupt customer — even if the bankrupt customer isn’t paying its bills. That means that your client is barred from terminating the contract, and must keep expending money and resources to float this bankrupt customer. Suppose, for example, that your client is an electric utility, providing power to the bankrupt customer which owes your client over $1 million from invoices going back several months. Your client must — under threat of court sanctions and contempt — keep providing electric power to the bankrupt company, even though your client is not getting paid. Your only recourse is to file a motion for relief in court (asking that the bankrupt company come current on its bills, or that you be allowed to cease provision of services), which can be costly and time-consuming. To add insult to injury, your client may also be forced to repay amounts paid to it by the customer within 90 days prior to the customer’s bankruptcy filing (under “preferential” or “fraudulent” transfer doctrines), even if your client is owed millions of dollars from the bankrupt customer! Finally, you as in-house counsel will be forced to spend time and money reviewing the mass of bankruptcy documents (and you must read everything, because you never know which sentence may affect your client’s interests), responding to various motions as necessary and filing a Proof of Claim for the amount owed to your client, failure of which may cause your client to lose all sorts of rights pertaining to the customer contract and to monies it may be owed. Gleaned from exhaustive experience, here are some real-life lessons from the .Bomb catastrophe which may assist in-house counsel in protecting their client from the slings and arrows of bankrupt customers. TERMINATE ‘EM The best way to handle a bankrupt customer is to never have to deal with one. Thus, all of your customer contracts should have strong termination rights so that you can terminate a customer as soon as it’s clear they’re a sinking ship — before they file for bankruptcy protection. When a customer fails to pay its bills, or tells you they’ll pay up as soon as they obtain their next round of funding, it’s a pretty good indication that the customer is going down for the count. For example, suppose your client is an Internet co-location facility (a “co-lo” facility is an Internet hub, where companies gather to interconnect to one another and gain Internet transit). You want the contractual ability to terminate a delinquent customer as soon as possible after a payment deadline is missed, by sending a termination notice with an extremely tight cure period (such as 3 days). What you don’t want is something like a 30-day termination notice and cure period, because this will only give the delinquent customer time to file for bankruptcy — and then you’re stuck with them sitting in your space, while your client is legally compelled to continue providing services at your client’s expense, potentially for several months without getting paid a dime. Your client should also be advised not to continually drag out the relationship with a financially shaky delinquent customer by agreeing on short-term payment plans. While it seems like keeping up friendly relations by agreeing to float a customer that can’t pay its bills, or by accepting a fraction of the invoiced amount until the customer can get “caught up,” all you’re really doing is providing the delinquent customer with bargain-basement prices at your expense and giving them time to go file bankruptcy or otherwise shut their doors. While the swift termination of customers will no doubt meet with some resistance by the sales and business representatives at your company who will no doubt initially view you as an over-zealous lawyer hell-bent on hacking away the customer base, this reluctance can be overcome when you point out the cost-benefit analysis. Remind them that a bankrupt customer is not a revenue stream — it’s pure liability. Even more enticing, you can explain that by terminating the contract, your client will then have enormous leverage in renegotiating its terms, such as requiring pre-payment for the new term of contract (thus eradicating the risk in dealing with a financially-shaky customer). Gaining this leverage assumes, of course, that you have a service that the customer cannot afford to have terminated; nevertheless, your client is still better off with a terminated contract than with a bankrupt customer that isn’t paying its bills. Also point out that termination doesn’t mean eternal death of the client-customer relationship — because any contract can be easily revived by the parties, if desired. A Note about “Termination-for-Bankruptcy” Clauses.In most executory contracts, there is a standard contract clause which states that one party may terminate the contract if the other party files for bankruptcy. While these clauses are generally not enforceable (and you could be severely penalized by the court for trying to exercise such a clause), it is nonetheless always advisable to retain such clauses in the contract. For one, it may give certain advantages to your client in bankruptcy proceedings. Secondly, one never knows if the law may eventually change and make this type of clause enforceable in some way. TAKE THE CASH Your client should always grab whatever money a customer may send, both before and after the customer files bankruptcy. While the bankruptcy court (including the Trustee, the bankrupt customer’s attorneys, or a creditor’s committee) may later seek return of that money, it is always better to have cash in hand than not. Most likely, especially in the Internet business, your client will collect little to nothing from the bankruptcy estate, so you want to take what you can when you can. TAKE THEIR PROPERTY Your contract should also include a provision that allows your client to assume ownership of any customer property left on your client’s premises promptly after termination. This will at least offset some of the harm suffered by your client. Ideally, you will want to give notice of the fact that your client will be exercising its rights to retain all such property, and to provide a reasonable opportunity for the terminated customer to pick up their property. If you fail to give adequate notice, you may find yourself embroiled in equipment disputes with third parties who end up purchasing the equipment in future bankruptcy proceedings. Given the great powers of a bankruptcy court to seize and liquidate assets, this is not a dispute you’ll want to engage in. If the retained property is significant in value, your client’s accounting department should log the retained property as acquired assets on the company’s books, in order to evidence your client’s assertion of ownership. A NOTE ON PREFERENTIAL CLAIMS AGAINST YOUR CLIENT Although your client may have suffered millions in damages due to a bankrupt customer, you will nevertheless in all likelihood end up receiving a demand from a bankruptcy Trustee, Judge or Committee to return whatever amount of money that the customer paid to your client within 90 days prior to the bankruptcy filing date, on the grounds that the payment(s) was “preferential.” To familiarize yourself with the defenses to such an attack, review the U.S. Bankruptcy Code �� 547(c)(1), (2), and (4). The important thing to note is that you can successfully argue against most preferential claims (without having to make court motions or hiring outside counsel) by demonstrating to the demanding party either a “new value” defense (i.e., your client provided new services to the customer after the payment was received) or an “ordinary course of business” defense (e.g., the customer regularly paid on the 1st of each month). Sometimes, you can avoid having to return any money by agreeing to reduce the amount of your claim against the bankrupt company. OFFERS TO BUY YOUR CLIENT’S CLAIM Beware of companies that offer to buy your client’s claim in bankruptcy court. These companies often offer an enticing, lump-sum cash payment (e.g., 50 percent of what your claim is against the bankrupt company). The standard, non-negotiable agreement they put before you, however, has cleverly veiled language that states that your client guarantees the amount of the claim and its collectability. Your client could end up being sued for whatever amount the claim-buyer couldn’t recover in court! In addition, just because you sell your claim doesn’t mean you wash your hands of the bankruptcy — you still have to keep up with the bankruptcy papers, make the necessary motions in court, deal with the disposition of the contract, etc. ASSIGNMENT CLAUSES Your standard customer contract should also have a strong non-assignment provision. If you do allow the customer to liberally assign, then in any such event the customer should be expressly liable for the payment obligations thereunder. The reason? Some companies will look to assign a contract they no longer desire to a asset-dry shell affiliate whose only purpose for existence is to go bankrupt and thereby break undesirable contracts. These shell companies are a way for the asset-rich parent to pawn-off liability. In bankruptcy, all contracts must either be: (i) assumed by the bankrupt entity; (ii) assumed and assigned to third parties; or (iii) rejected (in bankruptcy jargon, “rejected” means the bankrupt company no longer desires the contract and it becomes officially terminated). The important item to note: in order for the bankrupt company to assume and assign away your client’s customer contract, your client is legally entitled to be paid all outstanding amounts due under the contract. Make sure your client gets paid before you allow such an assignment. Also note that there’s very little you can do to prevent the assignment of your contract, so don’t fight it unless it’s truly necessary. You would have to show some sort of special harm to prevent an assignment (e.g., assignment would divulge trade secrets to a competitor). A WORD ON NON-BANKRUPTCY DISSOLUTIONS In dealing with a customer that tells you they’re going out of business, try to quickly settle with them by terminating the contract and getting as much cash as you can before they dissolve and the principals disappear. Such companies will always offer a meager percentage of what’s actually owed (anywhere between 5 to 25 percent). You can often obtain a higher amount than they originally offer by asking to see their balance sheet of debts and assets, or by requesting a written statement from a senior officer (such as the CFO or President) confirming that what they’ve offered you represents an equitable pro rata percentage as compared to all other creditors. You don’t want to settle on receiving only 5 percent of your client’s debt when other creditors are getting 50 percent. Finally, if your client is owed a significant amount, or if you object to the amount being offered (perhaps you suspect that the principals are looting the company?), you can always attempt to force them into an involuntary bankruptcy where their finances will be deeply scrutinized. We have no doubt seen the worst of the Internet bankruptcy wave. The rate of Internet bankruptcies is half of what it was just a few months ago, and the surviving companies are more healthy in general or are being bought at severe discounts. Nonetheless, the above tips can be invaluable in your long-term strategy for protecting your client from the enormous expense in dealing with customer bankruptcies. Saving your client from even one customer bankruptcy can typically save your client tens or hundreds of thousands of dollars. Michael L. Baroni is in-house counsel for PAIX.net, Inc.an Internet infrastructure company in Palo Alto, Calif. Mr. Baroni has handled over 100 customer bankruptcies and may be reached at (650) 752-2862 or via e-mail at [email protected].

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