Investor enthusiasm for Internet start-up companies has waned, and a growing number of "dot-com" companies² reportedly are in financial trouble. With fewer prospects for equity funding or institutional financing to meet their working-capital needs, these companies are running out of cash, and they can no longer absorb operating losses for the sake of future growth or profits. To many observers, the dot-com casualties signal the beginning of a shakeout in various segments of the e-commerce market.³

For bankruptcy practitioners, the question is, "Will this 'digital Darwinism' result in more cases and more work?" If dot-com bankruptcies from Silicon Valley are any measure of the coming trend, the answer is "yes and no"—possibly more cases, but not necessarily more work.

For the past five years, business bankruptcy filings in the San Jose Division of the Northern District of California, which includes Silicon Valley, have been down. Indeed, chapter 11 filings in 1999 were at a 10-year low, and filings in 2000 are on pace to set a new low.⁴ This is no surprise, given the unprecedented growth and prosperity that Silicon Valley experienced during the last five years.

What may come as a surprise is that over the past four years, a handful of dot-com bankruptcies, primarily chapter 11 cases, have been filed in San Jose. It is too early to tell whether this trickle of cases will become the next wave of business filings or whether this small sample of cases is indicative of the types of e-business cases that will be filed. Nevertheless, the cases provide an initial glimpse into the "virtual" bankruptcy.

Debtor Profiles

Between 1997 and the first half of 2000, eight e-business cases were filed in San Jose—six under chapter 11 and two under chapter 7. Five of the eight companies were engaged in the business of providing Internet services to subscribers for little or no fee. Whether they provided dial-up Internet access, computer support, web hosting or web portals to community sites, bulletin boards or chat rooms, their revenues were to be derived principally from selling advertising and/or selling research data about their subscribers. Two companies were engaged in online sales: a software vendor that developed certain proprietary video technology for mass distribution over the Internet and an online auction service. The most recent case was filed by an Internet software developer. Notably, the group did not include any "e-tailers" engaged in selling goods to consumers over the Internet.

The companies suffered from similar business and financial problems. None of the chapter 11 debtors had ever earned any income, and three reported annual operating losses in excess of $1 million. The companies had financed their development and operating costs primarily from capital contributions and unsecured loans from individuals, shareholders or other corporate insiders. By and large, they had no institutional financing, no backing from traditional venture capital firms and no ready access to debt or equity markets to continue funding their operations. The most common reason given by the debtors for filing bankruptcy was that they were out of cash, although in some cases shareholders also appeared to be engaged in a power struggle over the future direction of the company.

The debtors were small corporations, newly formed and privately held, with less than two years of operating experience and stock ownership concentrated among a few individuals. Among the eight companies, total asset values ranged between $28,000 and $20.5 million, but there were few or no tangible assets. The companies leased their office space, furniture and equipment. Some purchased their own computers, which had little or no residual value. Five of the six chapter 11 debtors reported having less than $25,000 in cash at the time of the bankruptcy. The sixth debtor sold its primary asset, a wholly owned subsidiary, prior to filing bankruptcy and ceased business operation within two months after filing. The debtors' principal assets typically consisted of subscribers, key employees and intellectual property such as proprietary software or technology and domain name(s). Stated values for intellectual property varied wildly among the debtors from "unknown" to $100,000 to $20 million. Three companies also owned stock in other Internet companies.

From a balance-sheet standpoint, all of the companies were insolvent. Six companies reported liabilities in excess of assets at the time of filing bankruptcy, in some cases by multiples of 10. Two debtors appeared to be solvent at the time of the filing but their assets later proved to be worth substantially less than the assets' stated value and the debtors' pre-filing debts. For instance, one chapter 11 debtor initially valued its intellectual property at $20 million. After the case was converted to chapter 7, the trustee sold the intellectual property, along with substantially all of the debtor's remaining assets, for $275,000.

The debtors had few, if any, secured creditors. Their unsecured debts generally consisted of unpaid wages and payroll taxes, trade debt and unsecured loans from insiders and various other individual investors. No company reported pre-petition liabilities in excess of $4.9 million.

Speedy Case Disposition

Regardless of their ultimate disposition, the administration of these cases can best be described as "faster, cheaper, simpler." The average disposition time for the chapter 11 cases was 227 days (less than eight months) as compared to 340 days (almost one year) for the other business cases filed during the same period.⁵ These cases moved more quickly even though no case had a pre-packaged plan of reorganization, and only one case involved an immediate sale of assets, both of which regularly occur in other high-technology cases and result in quick case dispositions.

The cases did not generate substantial professional fees or costs of administration and, generally speaking, presented no unique or complex bankruptcy issues.⁶ The debtors' shareholders or other insiders continued to fund the businesses with equity infusions or simple loans, thereby obviating the need for lengthy cash-collateral hearings or sophisticated debtor-in-possession financing motions. The companies had few remaining employees and no significant operating issues. Apart from a few shareholder disputes that were quickly resolved and some garden-variety motions for relief from stay—primarily by equipment lessors—there were few, if any, contested motions, adversary proceedings or claim disputes.

There also was little, if any, creditor participation in these cases. In three of the six chapter 11 cases, the U.S. Trustee was able to appoint a creditors' committee, but only two committees actively participated. The quicker dispositions therefore were not the result of any direct action by creditors. The U.S. Trustee actively participated in the cases by conducting initial debtor interviews, scrutinizing the monthly operating reports and other pleadings filed by the debtors, and appearing at all status conferences and case dispositive hearings to make recommendations to the court as to how the cases should proceed.

Exit Strategies

Although two companies initially attempted to reorganize by growing their businesses with additional equity infusions or post-petition loans, the only exit strategy that proved successful was merger or acquisition. Two companies confirmed plans: one to disburse proceeds from a pre-confirmation asset sale, and the other to pursue a merger or acquisition outside of bankruptcy. In a third case, the debtor voluntarily dismissed its case in order to be acquired by an unrelated company via a stock swap. The only unsuccessful case involved an operating company that was liquidated in chapter 7 after the debtor sustained a post-petition operating loss of $2 million.

The two most recent cases were filed to effect asset sales in bankruptcy. One involved a pre-negotiated asset sale; the other involved an orderly liquidation of the company's assets, which largely consisted of shares of stock in a publicly traded Internet company that the debtor acquired in a pre-filing sale of its wholly owned subsidiary. The debtor companies ceased business operation prior to or within a few months after filing bankruptcy. It remains to be seen whether the cases will be successfully concluded.

Mergers or asset sales have been commonplace among other high-tech companies filing under chapter 11 in San Jose, particularly those with assets that primarily consist of intellectual property and key employees. Indeed, in response to the growing number of these cases, the bankruptcy court, with input from the U.S. Trustee, promulgated guidelines to facilitate the court's review and consideration of pre-packaged plans and motions to sell substantially all assets within the first 60 days of the case. The guidelines were promulgated in August 1999, but as of yet they are untested because no debtor company has attempted a sale or pre-pack within 60 days of the bankruptcy filing.

Perhaps the best description of the predicament that many dot-com companies will face in the near future is found in a debtor's disclosure statement filed in October 1999:

The Internet and those businesses that service it are dealing with many unknowns. Most companies that service it are operating at a negative cash flow to support both growth and to solidify a market position...The debtor is greatly influenced by the financial environment in which it is operating and is in no position to change the habits of the majority at this early stage...Because it is unclear to the debtor how to create an economic model that yields either profitability or positive cash flow in the short term, it is incumbent upon the debtor's management to aggressively pursue the strategy of being acquired or at a minimum establishing a partnership with a much stronger organization... Timing can be a huge risk in the sense that Internet stocks and investments are coming under more scrutiny. If the market were to completely turn against Internet companies or their stocks, it could become increasingly difficult to implement the strategy that has been outlined.

Future Dot-com Bankruptcies?

Are these Silicon Valley bankruptcies the precursor to a wave of e-business filings? A handful of dot-com bankruptcies already have been filed in other jurisdictions. However, because these companies typically lack earnings or hard assets, it is difficult to imagine that many would file for chapter 11 to reorganize their businesses once they lose their funding. They would have no means to continue operating in bankruptcy or to pay the costs of case administration.

Nevertheless, this small sample of Silicon Valley cases suggests that some dot-com companies will resort to chapter 11 to complete mergers and asset sales—as do many other high-tech companies—because the Bankruptcy Code can facilitate these transactions by affording the parties certain protections that would not otherwise be available. Time will tell whether more of these cases are filed as financially troubled companies struggle to survive and stronger companies look to increase or solidify their market position.

A market shakeout may result in far more chapter 7 liquidations or corporate dissolutions. With no funding, few or no hard assets, and no history of earnings, many dot-com companies will have no other choice because they will be unable to attract any merger partners or purchase offers, particularly if there is a glut of dot-com casualties. Rather than file under chapter 11, they will cease operating, their key employees and subscribers will move on, and their creditors will be left to pick over the scraps—inside or outside of bankruptcy.

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Footnotes

¹ The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, the U.S. Department of Justice or the U.S. Trustee Program. Return to article

² "Dot-com companies" are those primarily engaged in Internet commerce. Return to article

³ Farrell, Rita, "What'll You Bid for this Failed 'Dot-com'?" Reuters, June 7, 2000; Tessler, Joelle and Marshall, Matt, "Online Firms Short on Cash," San Jose Mercury News, April 1, 2000; Kaufman, Leslie, "New Species, Old Struggle," New York Times, March 29, 2000, at D1. Return to article

⁴ From 1990 to 1994, chapter 11 filings in the San Jose Division ranged from a low of 184 in 1990 to a high of 318 in 1992. Filings then dropped to 151 in 1995 and below 100 in 1996, where they have remained ever since, hitting a record low of 67 in 1999. For the first six months of 2000, there were only 19 new filings. Return to article

⁵ Disposition times were calculated for all cases filed between 1997 and 1999, a sample that included four e-business cases and 236 other cases. "Disposition" is defined as plan confirmation, dismissal or conversion. Two e-business cases were filed in 2000, but they, along with most of the other 17 newly filed cases, still await disposition. Return to article

⁶ The chapter 7 cases likewise appeared to be rather straightforward because, with the possible exception of potential preference actions, the trustees had few assets to liquidate other than intellectual property or domain names. Debtors' counsel were paid less than $5,000 apiece for filing these cases. Return to article