Intellectual Property Valuation for Bankruptcy Purposes

Part II: Nine Additional Reasons a Valuation Is Needed in Chapter 11

This second part of the article focuses on the remaining nine reasons a valuation of IP is necessary in a Chapter 11.

In the first part of this two-series article, the author summarized the various types of intellectual property that valuation analysts (“analysts”) may encounter within a commercial bankruptcy controversy,  listed the generally accepted intellectual property valuation approaches, and discussed three of the 12 reasons  why an analyst may be asked to value intellectual property within a commercial bankruptcy environment.  In this second part, the author reveals the remaining nine reasons why a valuation analyst may be asked to value intellectual property.

Reason 4: Entering Inbound and Outbound License Agreements (Section 363)
Section 363 covers the “use, sale, or lease of property” within a bankruptcy estate. The debtor company may enter into the bankruptcy encumbered by inbound or outbound intellectual property licenses. And, the DIP may wish to enter into new inbound or outbound intellectual property licenses during the bankruptcy proceeding.

The analyst may be asked to assess the reasonableness (from a financial perspective) of the royalty rates and other contractual terms of the debtor company intellectual property licenses. And, the analyst may be asked to assess the reasonableness of the royalty rates and other contractual terms of any new intellectual property licenses being considered by the DIP. 

Reason 5: Decrease in the Value of a Creditor’s Interest (Section 361)
After a 363 asset sale, or in other circumstances in which the secured creditor’s interest in the debtor’s property has been reduced, the secured creditor may retain an analyst to assess (1) the amount by which the secured creditor’s interest was reduced and (2) the value of the additional interest that the creditor should receive in order to obtain the “indubitable equivalent” of the value of the lost security interest.

The Bankruptcy Code provides protection for a creditor’s interest in the debtor’s property. Events may occur during the bankruptcy proceeding that reduce the creditor’s interest in the debtor’s property (such as a 363 asset sale of that collateral property). In such instances, Section 361 basically provides that the creditor should be made whole. The creditor could be made whole by receiving (1) cash from the trustee or (2) an additional lien on other debtor property. The relevant Section 361 subsections are presented below:

When adequate protection is required under section 362, 363, or 364 of this title of an interest of an entity in property, such adequate protection may be provided by—

(1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay under section 362 of this title, use, sale, or lease under section 363 of this title, or any grant of a lien under section 364 of this title results in a decrease in the value of such entity’s interest in such property;

(2) providing to such entity an additional or replacement lien to the extent that such stay, use, sale, lease, or grant results in a decrease in the value of such entity’s interest in such property; or

(3) granting such other relief, other than entitling such entity to compensation allowable under section 503 (b)(1) of this title as an administrative expense, as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.

In these instances, the relevant questions include: (1) by how much was the value of the creditor’s interest (in the debtor’s collateral property) reduced? and (2) what is the value of the additional interest that the creditor should receive in order to obtain the “indubitable equivalent” of the value of the lost security? These questions are important to the secured creditors, and these questions are typically answered by a valuation analysis.

Reason 6: Bankruptcy Rules Regarding a Secured Creditor’s Interest (Rules 3012 & 3018)
The recurring question of the value of the creditor’s security interest in the debtor’s property is often answered by a valuation analysis.

In a Chapter 11 bankruptcy, the value of a secured creditor’s security interest is important for a number of reasons. For example, the value of the creditor’s security affects the creditor’s influence with regard to the approval (or disapproval) of the proposed plan of reorganization. When there is a question about the value of a creditor’s security interest, the court may hold a valuation hearing and hear testimony from analysts.

The following are selected sections of two relevant Bankruptcy Rules regarding the value of a secured creditor’s interest:

Rule 3012 Valuation of Security
The court may determine the value of a claim secured by a lien on property in which the estate has an interest on motion of any party in interest and after a hearing on notice to the holder of the secured claim and any other entity as the court may direct.

Rule 3018 Acceptance or Rejection of Plan in a Chapter 9 Municipality or a Chapter 11 Reorganization Case
(a) Entities Entitled To Accept or Reject Plan; Time for Acceptance or Rejection. A plan may be accepted or rejected in accordance with §1126 of the Code within the time fixed by the court pursuant to Rule 3017.
(d) Acceptance or Rejection by Partially Secured Creditor. A creditor whose claim has been allowed in part as a secured claim and in part as an unsecured claim shall be entitled to accept or reject a plan in both capacities.

A creditor typically wants to prove that it is a secured (versus unsecured) creditor. In particular, a creditor wants to prove that it is a fully secured (and not a partially secured) creditor. Typically, the determination of the value of the creditor’s security interest in the debtor collateral property is the result of a valuation analysis.

Section 560:  Determination of a Secured Creditor’s Status (Section 1129)
Creditors are interested in determining whether their security interest in the debtor property is greater (or less) than the debtor’s liability to them. This relationship (between (1) the value of the creditor’s security and (2) the amount of the debtor’s liability) affects the secured creditor’s status throughout the bankruptcy proceeding.

The Bankruptcy Code Section 560 subsections related to a secured creditor’s status are presented below:

(a) (1) An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to set off is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.

(b) To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.

To the extent that the value of the creditor’s security interest exceeds the amount of the debtor’s liability, then the secured creditor can claim interest on that difference during the bankruptcy proceeding. The question of the value of the creditor’s security interest in the debtor’s property is typically answered by a valuation analysis.

Reason 7: Reorganization Plan Confirmation (Section 1129)
An analyst may be asked to review the proposed reorganization plan. The analyst may be asked to assess (and opine on) whether the proposed reorganization plan is “reasonable.” Also, the analyst may be asked to opine as to whether the proposed reorganization plan is “fair and equitable” to the various classes of creditors and to other stakeholders in the bankruptcy estate.

Analysts may be called on to assess and opine on the proposed plan of reorganization in a bankruptcy. The analyst can perform this reorganization plan analysis on behalf of the DIP or on behalf of any group of secured or unsecured creditors.

The relevant Section 1129 subsections are presented below:

(a)  The court shall confirm a plan only if all of the following requirements are met: . . .
(7) With respect to each impaired class of claims or interests—
(A) each holder of a claim or interest of such class—
(i) has accepted the plan; or
(ii) will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date;  . . .
(11) Confirmation of the plan is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan. . .
(16) All transfers of property of the plan shall be made in accordance with any applicable provisions of nonbankruptcy law that govern the transfer of property by a corporation or trust that is not a moneyed, business, or commercial corporation or trust.
(b)(1) Notwithstanding section 510(a) of this title, if all of the applicable requirements of subsection (a) of this section other than paragraph (8) are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan notwithstanding the requirements of such paragraph if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.
(2) For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a class includes the following requirements:
(A) With respect to a class of secured claims, the plan provides—
(i)(I) that the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims; and
(II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property;

Reason 8: Cram Down of the Reorganization Plan (Section 1129)
When the court seeks to confirm a proposed reorganization plan over the objection of creditors (called a “cram down”), an analyst may be asked to testify regarding the analysis of the reorganization plan and whether the reorganization plan is fair and equitable.

Ideally, all bankruptcy stakeholders will accept the proposed reorganization plan. However, this plan acceptance by all stakeholders does not always happen. Often, one or more of the creditor groups is not satisfied with the reorganization plan. However, the court can still confirm the reorganization plan over the creditors’ objections. Even if the reorganization plan impairs the interests of one or more of the creditor groups, the court may confirm the proposed plan if the plan is “fair and equitable” with regard to all groups of creditors that are impaired. An analyst may testify in such a bankruptcy hearing regarding the analyses of the reorganization plan and, particularly, regarding the opinion of whether the proposed plan is “fair and equitable” to all impaired creditor groups.

This judicial confirmation of such a reorganization plan is called a “cram down,” and such a cram down is allowed in Section 1129. The following discussion summarizes the Section 1129 provisions:

Another requirement for reorganization plan confirmation is that, with respect to each class of claims, (1) such class has accepted the plan, or (2) such class is not impaired under the plan. If all the requirements for plan confirmation are met except for this one, the plan can still be confirmed if the plan does not discriminate unfairly, and is fair and equitable with respect to each class of claims or interests that is impaired under, and has not accepted the plan. This is known as a cram down.

Reason 9: Secured Creditor Relief from the Automatic Stay (Section 362)
The analyst may be asked to testify when a secured creditor seeks relief under Section 362 from the automatic stay against collection efforts.

After a bankruptcy filing, there is an automatic stay with regard to the creditors’ ability to collect the debtor’s prepetition debts. This automatic stay can be lifted by the court in certain instances. Section 362 allows for a secured creditor to receive relief from this automatic stay of collection efforts if two conditions are met. First, related to the secured property, the debtor must have no equity in the property (i.e., the amount of the specific liability exceeds the value of the specific collateral asset). Second, the secured property must not be a necessary part of the debtor company’s core business.

The analyst may be called on to provide expert testimony related to both of these questions with regard to a Section 362 motion. The following are the relevant Section 362 subsections:

On request of a party in interest and after notice and a hearing, the court shall grant relief from the [automatic] stay…, such as by terminating, annulling, modifying, or conditioning such stay—
(1) for cause, including the lack of adequate protection of an interest in property of such party in interest;
(2) with respect to a stay of an act against property . . ., if—
(A) the debtor does not have an equity in such property; and
(B) such property is not necessary to an effective reorganization. . .

Reason 10: Collateral Valuation for DIP Financing
An analyst may be asked to value the debtor company’s proposed collateral property for DIP financing purposes. Frequently, that proposed collateral property is intellectual property.

A debtor company’s ability to borrow is limited during a Chapter 11 proceeding. Without the court’s authorization, the debtor company can only incur ordinary course of business trade debt that will be allowed as an administrative expense in the bankruptcy case.

However, the court can authorize the debtor to obtain of credit secured by a senior or equal lien on encumbered property of the bankruptcy estate. The court can authorize such debt only if (1) the debtor company is unable to obtain credit otherwise and (2) there is adequate protection of the interest of the holder of the lien on the property on which such senior or equal lien is proposed to be granted. This type of new debt is usually referred to as DIP financing.

In order to obtain DIP financing, the debtor company has to prove that the collateral property’s value is greater than the amount of the new DIP liability. An analyst may be asked to value the proposed collateral property and to opine that the property’s value is greater than the amount of the proposed financing.

The financially distressed DIP usually doesn’t have a lot of property available to pledge for DIP financing collateral. This is because the debtor company has already pledged all of its receivables, inventory, real estate, tangible personal property, and equity in subsidiaries and joint ventures. However, the debtor company may not have previously pledged its intellectual property as secured debt collateral. Therefore, the DIP financing may involve the pledge of the debtor company’s intellectual property assets as the DIP financing collateral.

Hence, the analyst may be asked to value the debtor company’s intellectual property for DIP financing collateral purposes.

Reason 11: The Zone of Insolvency and the Debtor Company Director Duties
Before a bankruptcy filing, an analyst may be asked to assess the financial condition of a financially distressed company. Before approving any major dividend, financing, capital expenditure, or other corporate decision, the distressed company directors may want the analyst to opine as to whether the debtor company is operating in (or near) the zone of insolvency.

The debtor company debtors typically owe a duty of loyalty, care, and good faith to the corporation and to its shareholders. But when a debtor company approaches the zone of insolvency, under the laws of most states, the directors also owe those duties to creditors. In such a case, creditors (and not just shareholders) have standing to assert breach of fiduciary duty claims on the company’s behalf.

Reason 12: Rejection of Intellectual Property Licenses (Section 365)
Section 365(n) allows the trustee to reject an executory contract in which the debtor is a licensor to a right to intellectual property. If such a contract rejection is made, the intellectual property licensee has certain rights specified in Section 365(n). First, the analyst may assist the trustee in an assessment of whether or not to reject the debtor’s outbound intellectual property license. Second, the analyst may assist the licensee(s) in the assessment of the licensee rights to the debtor intellectual property, as such rights are specified in Section 365(n).

Summary and Conclusion
Intellectual property valuation issues arise frequently in commercial bankruptcy proceedings. An analyst may be asked to assist the many bankruptcy stakeholders, including: the DIP and/or the trustee, the management or directors of the pre-filing debtor company, the secured creditors committee, the unsecured creditors committee, and other parties in interest to the proceeding (e.g., contract counterparties, unions, joint ventures, and so on).

Robert Reilly, CPA is the managing director of Willamette Management Associates’ Chicago Office. His practice includes business valuation, forensic analysis, and financial opinion services. Mr. Reilly can be reached at (773) 399-4318 or by e-mail at rfreilly@willamette.com.

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