The Role of Intangibles in Bankruptcy
Intangible assets are steadily becoming a dominant force in American business, and therefore, by extension, in bankruptcy cases. The appropriate valuation of those assets is consequently assuming a more vital role in bankruptcies as parties recognize the expanding influence of intangibles in today's business environment. However, just as insolvency professionals begin to understand various ways to value intangible assets, they must also understand the many situations where the accurate valuation of intangible assets can affect the course of a bankruptcy case. This article attempts to highlight a selection of situations where the appropriate valuation of intangibles can be of critical importance in bankruptcy actions.
Identify Intangible Assets
Valuation of intangibles is a financial, not legal, analysis. However, that valuation can be affected dramatically by legal strategies. Likewise, legal strategies can be directly impacted by that valuation.
In today's economy, the value of a business' intangible assets can easily exceed by two to three times the stated value of that business' tangible assets. The value of U.S. gross investment in intangibles has been estimated to be at least $1 trillion annually.1 Despite the increased importance of intangibles in today's business enterprise, they are often overlooked in the financial records of the company and, as a result, may not be appropriately considered by insolvency professionals. In one recent study, business leaders were asked if the value of their company's intangible assets was "on the books." Only 10.3 percent of those surveyed believed that their company officially recorded intangible assets, while 89.7 percent said that either they did not record intangible assets or were unsure whether their company did or did not.2
The lack of knowledge regarding the accounting for intangible assets is especially troubling when one considers the staggering variety and prevalence of intangible assets. Certainly, many lawyers and businessmen are familiar with the more "traditional" forms of intangible assets such as copyrights, patents and trademarks. However, there are many forms of intangible assets that are often neglected. These include franchise agreements, product names, mailing lists, customer lists, logos, jingles and music, concepts, and 1-800 numbers. Other intangible assets are products of the evolution and rise of technology in American business, including Internet URLs and computer operating systems. A person's name can even be considered to be an asset.3 While these assets are often overlooked, they can be some of the most valuable assets a business owns. As an example, in one of the most significant bankruptcy purchases from a failed dot-com company, K.B. Toys actively sought and purchased eToys' URL for $3.4 million when the company's assets were sold in bankruptcy in 2001. That compares favorably to the amount paid for the failed company's inventory.4
Increasing Counsel's Credibility
The professional valuation of these intangibles can be significant to a bankruptcy in many ways, not the least of which may be the credibility of the debtor's counsel with the court. The ability of counsel to describe and discuss the intangible assets of the debtor can demonstrate an understanding of the business and financial resources of the debtor and may help to establish a certain comfort level for the court. A court is much more likely to accept the positions taken by counsel throughout the course of the bankruptcy if the court can be confident that counsel understands the debtor's business and the role of intangible assets in that business.
It can also be important to understand the value of intangible assets and how that value is derived if counsel must seek the court's assistance in actively protecting that value. One of the most significant differences between tangible and intangible assets is that the value of intangible assets can be extremely volatile. This volatility may mean that bankruptcy itself presents a potentially serious threat to the value of the debtor's intangible assets. Many intangible assets, such as trade secrets, lose most, if not all, of their value in the event of disclosure. Therefore, counsel is well advised to seek the assistance of the court in protecting against disclosures that would devalue these assets. Moreover, many intangibles have a significantly higher value as part of an ongoing business concern than if separated from the debtor's business. Counsel must be able to understand how the value of these intangibles is derived when seeking the assistance of the court in protecting that value. This is one area where the court may be significantly more receptive to counsel's requests if he or she is able to demonstrate a true understanding of these assets and their role in the debtor's business.
List Intangible Assets in Schedules
One of the threshold tasks to be addressed as the debtor enters bankruptcy is the preparation of its Schedules. This duty is often delegated to the debtor's accounting staff who have little understanding of the process involved and its importance. As a result, the Schedule of Assets often is merely reflective of the debtor's balance sheet. As cited above, many debtors simply do not report their intangibles on their financial statements. Counsel should be diligent to include all intangibles, whether recorded or not. Valuation of the intangibles may be speculative and may later require adjustment after consultation with an expert, but identification and disclosure are vital first steps. If intangibles are not scheduled, counsel may find that the court is less receptive of an emergency motion to protect them. Creditors may view a failure to list them as an attempt to conceal their importance and potential value.
Best Use of Intangibles
The existence and value of intangibles may also impact the decision of whether the case proceeds as a reorganization or a liquidation. In a contested reorganization, counsel for objecting parties may assert that a liquidation is in the best interest of the creditors because a sale of the intangibles might provide a greater recovery than would the proposed reorganization. The resulting valuation contest will include evidence from experts on the assets' salability or portability and the probable economic recovery, but counsel must first identify the intangibles and determine any potential restrictions or impediments to their sale. When considering the sale of intangibles, their valuation can be much more complex than valuation of tangible assets. One characteristic of many intangible assets is that their value can be significantly different for purposes of a sale than if used in the reorganized business. A sale of intangibles can affect their value either positively or negatively. A competitor who wants to add a Web address or customer list to its existing business may pay a substantial amount for an asset that proved to be of little or no value to the original owner. On the other hand, many intangible assets have a significantly higher value when integrated with the owner's business than when liquidated and transferred to new ownership. Thus, counsel must be mindful of the method used by the debtor to value its intangibles if they are carried as assets on the financial statements. That value may have little relevance to the value that may be realized.
Where there are competing reorganization plans, knowledge of, and appropriate use of, the intangible assets may mean the difference between approval of the plan or failure. The ability to use the intangibles as additional collateral may be what is needed in order to convince the court that the plan is fair or in the best interest of a particular class of creditors. Even when there is no competing plan, demonstrating that intangible assets have been adequately taken into account can facilitate the expeditious approval of the debtor's plan.
Auction or Negotiated Sale
In a liquidation case, the valuation of intangibles has a significant role as well. The sale of intangible assets has become a widespread and profitable business in recent years, and the ability to identify and accurately value those assets is vital. Even knowing where and how intangibles can be sold is becoming more important daily as new markets and methods of sale grow. Intangibles continue to be sold in "traditional" negotiated, private transactions. However, auctions of intangible assets are becoming more prevalent and popular. In 2004, Commerce One's portfolio of intellectual property was sold at auction for $15.5 million to an intermediary for Novell Inc.5 That sale is dwarfed by the 2003 sale of Pillowtex Co. assets (primarily brand IP) for $121 million.6
Whether sold in a traditional manner, at auction or using some other method, the real value of an intangible may be far greater for a buyer than it was when the intangible was owned by the debtor. For example, in late 2001, Digimarc Corp. bought the photo-ID-card unit of Polaroid Corp. for $56.5 million out of the Polaroid bankruptcy. The combination of the significant customer contracts held by Polaroid with the patented digital watermarking technology of Digimarc helped Digimarc to increase sales at an annualized growth rate of 242 percent over five years.7
Intangibles as Collateral
The existence of valuable intangibles may be determinative of the outcome of a relief from stay motion. Clearly, the value of any intangibles that serve as collateral to the creditor will be vital in determining whether the debtor has equity in property pledged as collateral. Even if no equity exists in the collateral, the existence of intangibles in that collateral may provide the debtor with the basis for an argument that the property is necessary for an effective reorganization if those intangibles are vital to a continuation of the debtor's business.
Because intangible assets may take the form of executory contracts, early identification, valuation and planning may be essential to the management of a debtor's estate. If the intangibles exist as executory contracts, the debtor may face extremely short deadlines for the assumption or rejection of the intangible asset. With that decision comes the related obligations associated with either choice, and potential limitations on the debtor's ability to assume and assign agreements.
The existence and valuation of intangibles can play an important role in DIP or exit financing. Providers of these loans are increasingly willing to accept intangibles and their revenue streams as collateral. Recently, New Jersey-based Congress Financial provided Maidenform Inc. with financing to replace its bankruptcy exit loan of $60 million,8 partially relying upon the company's intangible assets as collateral. Understanding the value of intangibles and demonstrating that value to a potential lender may open new avenues to secure credit for the troubled company.
Impact of Privacy
The role of intangible assets in a bankruptcy case is often overlooked and underappreciated. Certainly in the large e-commerce cases, intangible assets become the central focus. However, the insolvency professional cannot afford to ignore the potential existence of intangible assets in any business case. Identifying and utilizing any intangibles could mean the difference between a successful reorganization and a liquidation or between a no-asset case and a distribution to creditors.
1 Jarboe, Kevan P., "Reporting Intangibles: A Hard Look at Improving Business Information in the United States (2005)," www.athenaalliance.org/papers/Reporting Intangibles.html.
2 "Patents: What Are They Worth?," Corporate Legal Times (May 2005).
3 The trustee in In re David Blatt, a/k/a Jay Black, Case No. 8-05-84851 E.D.N.Y. 2005), sued to prevent the debtor from using his name while performing.
4 "KB Toys Gets eToys Website," Wired News, May 17, 2001, www.wired.com/news/business 0,1367,43883,00.html.
5 Gilbert, Alorie, "Web Services Patents Fetch $15.5 Million," ZDNet News, Dec. 6, 2004, news.zdnet.com/2100_9588_22_5480341.
6 "Bankrupt Pillowtex Assets Sold at Auction," Cincinnati Enquirer, Business Digest, Oct. 4, 2003, www.enquirer.com/editions/ 2003/10/04/biz_bizdigest04.html.
7 "The 25 Fastest Growing Technology Companies," Forbes, Jan. 30, 2004, www.forbes.com/2004/01/30_cz_jy_0130fastesttechs04.html.