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UPDATE: July 19, 2001

Since the time of Barbara Franklin's presentation, the Ninth Circuit has decided that a security interest in a patent can be perfected through an ordinary UCC filing, without the need to file with the Patent and Trademark Office. The decision is In re Cybernetic.

A PDF version of this opinion can be found by clicking here.

Barbara L. Franklin
Assistant United States Trustee
Office of the United States Trustee
605 West Fourth Avenue, Suite 258
Anchorage, AK 99501

May 18, 2001


Not so long ago, things were pretty rosy. See, Steidmann, Dr. Carl, "The Impact of E-Retailing," page 24, ABI Journal, April 2000. "Virtually all e-retail companies today are valued not on their tangible assets, but on the value of the idea and the people behind that idea."

  1. 46% of B2C (business to consumer) High-tech have failed by December 2000.
  2. 19% of B2B (business to business) High-tech failed in that same period.
  3. 98% of Dot.coms will fail in the next two years.
  4. News of failures on

2. Warning Signs:

  1. Abrupt changes in technological developments
  2. Delay in next generation product
  3. No new technology/product in the pipeline
  4. Increasing inventory levels
  5. High consumer returns of product
  6. Increasing terms or price guarantees to distributors
  7. Stretching vendor payments
  8. Failure to meet unit projections
  9. Loss of key technology
  10. Board and management resignations
  11. Increasing rebate discount programs
  12. Mismanagement of rapid growth

3. High-tech Culture vs. Button-down turnaround professionals:

1. In an industry where a company's assets go home at night and hopefully return the next day, the entrepreneurial spirit wants to invent new ways of doing things, not follow the "old rules." As inventors and engineers, they may not be interested in accounting or legal issues that "get in the way" of the "new rules." Remedial steps to achieve a sound footing may be discounted as out-dated, e.g. pay employees and their benefits before paying trade creditors. They may make concessions to distributors and retailers that will affect the collectibilty of receivables. Entrepreneurs may want to protect "angels" and investors whom they see as potential financing for future start-ups.

2. On the other hand, entrepreneurs may have a more open-door approach and willingness to embrace creative, "thinking outside the box" solutions to work-outs. They often have close relationships with constituencies as a result of frequent and open meetings. Investors may be key customers. By now the reality of the bust will make management and engineers more willing to consider work-outs before they are forced to close the doors.

3. Lawyers Job: Stressing managements' fiduciary duties to creditors when insolvent. See, Sheehan, Martin P., "Breach of Fiduciary Duty by Directors," NABTalk Vol. 17, No. 1, Spring 2001.

4. Perfecting Security Interests in Intellectual Property

1. Meyer, Lee G., "Intellectual Property in Today's Financing Market," page 20, ABI Journal, March 2000.

2. General intangibles may be perfected by filing in the proper agency, i.e., trademarks, patents and copyrights. See, Section 9-104(a) UCC.

3. Generally accepted that federal filings are not required to perfect a security interest in patents or trademarks from avoidance by a bankruptcy trustee. In re Cybernetic Services, Inc., 239 B.R. 917 (9th Cir. BAP 1999)(Patents)

4. Conventional wisdom: "double filing."

5. Trademarks. May a Lender take a security interest in a Trademark without triggering Landam Act problems and record the assignment in the U.S. Patent and Trademark Office? Recent cases followed older cases and hold that there is a distinction between an outright assignment of the mark and a conditional assignment for purposes of security and it has been held that filing UCC-1 is sufficient to perfect a security interest in a trademark. In re TR-3 Industries, 41 B.R. 128 (Bankr. C.D. Cal. 1984); and In re Roman Cleanser Co., 43 B.R. 940 (Bankr. E.D. Mich. 1984).

6. Copyrights. Notice of security interest must be filed with U.S. Copyright Office. A financing statement may be insufficient to perfect a security interest in copyrights. In re Peregrine Entertainment Ltd., 116 B.R. 194, 203(Bankr. C.D. Cal. 1990); In re AEG Acquisition Corp. 161 B.R. 50 (9th Cir. BAP 1993)(Movies); In re Avalon Software, Inc., 209 B.R. 517 (Bankr. D. Ariz. 1997); but see, Aeroncon Engineering Inc. v. Silicon Valley Bank, 244 B.R. 149 (Bankr. N.D. Cal. 1999). The lesson in this precariously unresolved area: insist on registration of copyrighted collateral.

7. Patents: In light of Judge Koziniski's decision in Peregrine, the uncertainty can best be resolved by both state and federal filings. Peregrine at 203-204.

8. Inventory and receivables based on copyrights. Peregrine has created an uncertainty regarding disposal of inventory subject to a copyright. The continued viability of older cases holding otherwise would caution secured creditors to record an interest in "copyrights and receivables generated therefrom" in the Copyright Office.

5. Conflict between Intellectual Property Law and Bankruptcy Code:

1. Hesse, Gregory G., "The Risk of an Offensive Use of Catapult," ABI Journal, April 2001, page 14.

2. Primoff, Madlyn Gleich, and Weinberger, Erica G., "E-Commerce and Dot-Com Bankruptcies: Assumption, Assignment and Rejection of Executory Contractors, Including Intellectual Property Agreements, and Related Issues Under Sections 365(c), 365(e) and 365(n) of the Bankruptcy Code," American Bankruptcy Institute Law Review, Vol. 8, No. 2, Winter 2000.

3. Cieri, Richard M., Olack, Neil P., Witalec, Joseph M., "Protecting Technology and Intellectual Property Rights When a Debtor Infringes on Those Rights," American Bankruptcy Institute Law Review, Winter 2000, Vol. 8, No. 2. page 349.

(1) Policies behind the two sets of federal law may be at odds: intellectual property law protect holders against unauthorized use and allow suits for damages or injunctive relief vs. bankruptcy law provides for a stay of actions to allow debtor or trustee to evaluate options.

(2) Jurisdiction may effect outcome in debtor-favored bankruptcy court vs. intellectual property holder-favored federal district court.

(3) Section 365 (n) added in 1988 to protect non-debtor licensees from the rejection of their license with a debtor-licensor. Licensee preserves its rights in the license provided that the licensee continues to make royalty payments under the contract to debtor.

(4) One common means for a licensee to try to protect its license with a faltering licensor is to require the licensor to put the intellectual property and all upgrades and modifications (i.e., source codes or diagrams and drawings) into an escrow that may be accessed by the licensee under enumerated circumstances. Generally speaking, technology escrows are enforceable in bankruptcy (subject to ipso facto restrictions and the automatic stay) and are considered to be "supplementary agreements" within the meaning of Section 365(n).

(5) Escrow agreements: A licensor would not want to agree, however, to give licensee access to the escrow merely because the licensor files a petition or becomes insolvent. A licensor may agree to access if the licensor stops supporting its product for a specified period of time or ceases business operations altogether, but should not agree to a lift of the bankruptcy stay in the agreement. A licensor may want to protect its ongoing ability to sell the business by not permitting access as long as its successor licensor continues to support the license in the same manner as the original licensor. The licensee will want to monitor the licensor to make sure the most recent versions are placed in escrow. Properly updated escrowed materials will assure that the intellectual property is there if access is allowed.

6. Regulatory Issues:

1. Privacy of customer lists in a bankruptcy sale - What happens to customer lists developed from a strongly worded privacy policy during the administration of a bankruptcy estate. In bankruptcy, the constitutional and contractual privacy rights outweigh the fundamental bankruptcy tenet of maximizing the distribution to creditors. Partially in response to Toysmart, has changed its privacy policy.

(1) Bankruptcy Reform Act of 2000: Sections 231 and 232 of S. 420 would protect "personally identifiable information" from sale without court approval, the appointment of a "privacy ombudsman." Section 231 of H. 333 would not require debtors to publicly disclose the names of their minor children.

2. Cleansing transaction by stock sale . In Toysmart, the Disney company eventually paid $50,000 to destroy the customer lists

7. Human Resources:

1. Most valuable assets and the first to leave at the sign of trouble.

(1) Retention Bonuses: Pay to Stay plans may be paid up front or over time conditioned on continued employment during difficult, but escape clauses for resignation or downsizing.

(2) Salaries may be disproportionate to the market if the market is flooded with like-experienced software engineers.

(3) WARN Act issues.

8. Creative Accounting:

1. The SEC, in December 1999, released new guidance on when the sales can be booked. Revenue generally is realized and earned when four criteria are met:

(1) Persuasive evidence of an arrangement exists

(2) Delivery has occurred or services have been rendered

(3) The seller's price is fixed and determinable, and

(4) Collectibilty is reasonable assured.

2. Examples of Creativity:

(1) Microstrategy is a company that sold software and services in complex multi-million dollar deals to major corporations. Typically it would book half of the deal in advance and half at mid-point of a multi-year contract. Due to pressures from the SEC, it restated its revenue for 1999 from what it originally reported as $205.3 million with $150 in profits to revenue of $12.6 million with a loss of $34 million.

(2) "Gross-up" revenues by reporting the entire sales price a customer pays at their on-line site when in fact the company keeps only a small percentage of that amount as a commission.

(3) Barter transactions happen when two internet companies enter into barter schemes in which no cash is actually exchanged or they send each other equal sums. The "revenue merry-go-round" does not reflect the "fair value" according to GAAP.

(4) Coupons, discounts, loss leaders, and marketing expenses. The company records the full revenue and takes the discount or coupon as a marketing expense instead of cost of sales, which inflates gross margin, but not the bottom line.

(5) When items are sold below cost, the company books the sale at full value then records a "loss leader" expense for the difference.

(6) AOL sent out free disks to the world (almost), then tried to hide the impact of this $350 million marketing expense by capitalizing the cost as an investment/deferred cost on the balance sheet. The amount was charged off to earnings over 24 months instead of in the period when the costs were incurred. AOL eventually when back to expensing subscriber-acquisition costs when they occurred.

(7), eToys, and 1-800-flowers played a shell game with "fulfillment costs," which are expenses of warehousing, packaging, and shipping products. Offline companies usually record these expenses on their income statement as cost of sales. The dot.coms classified fulfillment costs as a marketing expense thus overstating gross margins.

9. Valuing Domain Names.;;

Appraisals and bidding sites as a place to start.

10. Bibliography:

1. American Bankruptcy Institute Law Review, Vol. 8, No. 2, Winter 2000. This volume was dedicated to "E-Bankruptcy," including articles on identifying, securing, and liquidating of assets; assumption and rejection of executory contracts; and intellectual property rights.

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