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After the Gold Rush

With IPO work dried up, Southern California lawyers are turning to litigation, bankruptcy

Logo - RecorderMarch 27, 2001 | The Recorder

By Mark Thompson

Though it was written just over two years ago, the Dec. 21, 1998, issue of Morrison & Foerster’s electronic newsletter touting its prowess in Internet work reads today like a relic from an ancient time capsule. “MoFo takes wings on high-flying Internet IPOs,” the headline proclaims. In a few frenetic weeks, the firm’s lawyers had helped close five dot-com megadeals, the most spectacular of which was the initial public offering of TheGlobe.com.

Shares in the company rocketed from an offering price of $9 to $63.50 on the first day of trading, a 606 percent one-day gain that’s a record — one that may stand, given the cautionary tale the online community company’s subsequent history tells. By the end of last month, TheGlobe.com’s shares were trading at 25 cents and it had just gotten word it was about to get delisted from the Nasdaq.

IPO business has crashed back to earth at just about every tech-centric law firm in Southern California, along with a lot of the new economy legal work that many lawyers were feasting on as recently as last fall. Dot-com lawyers are still in demand these days. But there aren’t as many billable hours to go around, and the nature of the available work has changed. Litigation related to the dot-com crash is one hot niche. Dot-com bankruptcy work is another.

The chill didn’t hit Stradling Yocca Carlson & Rauth, a 125-lawyer Newport Beach, Calif., firm with many emerging growth company clients, until just a few months ago. “We were going gangbusters through a good portion of last year,” says Michael Flynn, head of the firm’s 50-lawyer corporate department. But the year-long bear market for technology stocks has finally gotten the best of investors, venture capitalists and lenders; funding for high-tech ventures has dried up, and “the deal flow has definitely slowed down,” Flynn says. Stradling Yocca is “not rushing out and hiring as many lawyers as we can anymore.”

One section of the firm is an exception. “Our litigation department right now is as busy as it has been in recent history. Our litigators are on fire,” says Flynn. “They’re actually looking to hire laterally right now while the corporate folks are not.” Two areas, in particular, are generating an abundance of work: class action securities suits that have been filed against some of the firm’s clients and litigation stemming from deals gone bust.

But not all of the companies that Stradling Yocca helped usher into the world have lived long enough to litigate. “Several of our clients that were once well funded are now visiting bankruptcy lawyers,” says Flynn.

That trend hasn’t gone unnoticed at Levene, Neale, Bender & Rankin, an 11-attorney Century City-based bankruptcy boutique. “There is a ton of bankruptcy work related to failed dot-coms,” says partner David Neale. More than a fifth of the firm’s debtor clients in the past year have been dot-com related. The firm is handling Chapter 11 reorganizations for, among others, Castnet.com, an online casting service, and Stan Lee Media, an online animation site founded by Lee, the creator of Spiderman.

One of the peculiar challenges of a bankruptcy practice is that the typical client doesn’t usually generate repeat business, but even that fact hasn’t darkened the firm’s outlook. “I think there’s a lot more shaking out to do before this is all said and done,” Neale says of the still-unfolding dot-com train wreck.

A Wide Array of Litigation

Megan Gray, an associate at Baker & Hostetler who specializes in Internet law, scans court dockets every day in Los Angles to keep abreast of trends in Internet litigation. Formerly high-flying dot-com lawyers who now find themselves riding the bench might find some solace in the fact that Gray says she hasn’t spotted any legal malpractice claims.

Arguably, some of the companies that rushed to market with little more than a domain name and a grandiose business plan weren’t particularly well served by the lawyers who helped them along the way. But few of the entrepreneurs appear to be looking back. “In the fast and furious pace of Internet time, the mentality has been to keep speeding ahead as quickly as possible, understanding that you’re going to let some water under the bridge,” Gray surmises.

Legal action by the legions of employees who have been cut loose from foundering dot-coms in recent months has also been surprisingly scarce, she says. They, too, may be looking ahead for the next new thing, perhaps concerned that suing a former employer might brand them as “a bad egg.” At-will employees laid off by businesses that were inherently risky generally have no legal recourse anyway.

Failed Business Model Suits

At the heart of most of the dot-com crash litigation winding up in court, Gray says, is a badly flawed business model or the failure of one or more participants to discover or disclose the holes in the plan. Typical causes of action include breach of contract or a wrongful inducement to invest based on false depictions of the financial situation. Gray has also seen pre-emptive strikes by faltering dot-coms seeking a declaratory injunction holding that they were not in breach of contract.

Many of the IPOs launched and deals hashed out in the heyday of the dot-com boom were “based on assumptions about the business process that turned out to have no basis in reality or that have been fundamentally undermined by a shift in the way dot-com companies do business,” adds Adam Belsky, a San Francisco lawyer with many new economy clients.

For example, many companies paid exorbitant sums for cross-branding or cross-advertising agreements that no longer make any sense, given the sorry state of one or both partners. “That causes companies that would otherwise be viable to become unviable based on bad deals they made,” says Belsky. “They’re on the hook for millions of dollars that they may have to default on.”

Beverly Hills-based Checkout.com, an e-commerce site that set out to sell videos and other entertainment merchandise, is one such case in point. The company was sued in December by Launch Media, an online entertainment company owned by Hollywood powerbroker Michael Ovitz among others. The suit accused Checkout.com of paying only the first of four installments of a $375,000 amount owed under a “strategic alliance agreement.” No one was available at Checkout.com in early March to offer a response. As the company’s Web site puts it, “Checkout has … well, checked out.”

Intellectual Property Traps

In addition to the failure of many e-commerce ventures to generate the expected gusher of cash, another common misconception that has tripped up dot-coms was a failure to recognize that a seemingly brilliant business plan involved conduct that other parties would construe as a bald-faced breach of their intellectual property rights. Scour.com, a Los Angeles-based broadband entertainment portal featuring Napster-like file-sharing software that enabled users to swap digital video files, was a case in point.

Scour was sued last year by the Motion Picture Association of America and other entertainment industry heavyweights. The company’s lawyers thought they could beat the rap, but they would need millions to fund the legal battle. Facing huge attorneys’ fees, and far more staggering liability in the event of a loss in court, venture capital for Scour dried up and the company went bankrupt.

Marin County, Calif., lawyer Ira Rothken, who represented a company in a failed bid for Scour’s assets, says his practice is thriving, thanks to the “enormous growth” in similar, IP-related business model litigation. He is involved in one case over whether hyperlinks arising out of search engine results constitute contributory copyright infringement and another over whether a software-based VCR created by RecordTV is just as lawful as a hardware-based VCR.

While old-fashioned bankruptcy has proved to be an effective exit strategy for many “new economy” entrepreneurs whose business models never worked as advertised, it doesn’t always succeed, particularly for those entangled in an intellectual property dispute.

“Creditors are starting to get more aggressive about trying to pierce the corporate veil,” Belsky says. “They are going after the individual founders who are skating off into new ventures leaving their creditors on the hook.”

Traditional ways to do that include alleging that the failed entrepreneur didn’t follow corporate formalities in setting up the business, or improperly commingled personal and corporate assets, or was guilty of a fraudulent misrepresentation of some sort. It’s even easier to pursue a bankrupt company in a copyright infringement case.

“The corporate veil is much more fragile in copyright litigation than in any other kind of litigation,” notes Rothken. “You could just show that the directors or officers were directly involved in decisions that led to copyright infringement.” Some dot-com entrepreneurs therefore may find that even after a bankruptcy, they’ll still be on the hook.

There’s nothing new about the theories. But suits by jilted creditors against the principals of bankrupt dot-com companies may be more prevalent than in old-economy bankruptcies because of the gold rush mentality that prevailed during the early days of so many dot-coms, Belsky says.

“People were throwing money at dot-com companies without doing the necessary due diligence so maybe less scrupulous businesses were setting up these companies to take advantage of the cash that was out there,” he says. “Now that their business plan has failed and their company has gone under, they’re maybe more vulnerable because of the way they operated the company.”

Belsky is representing a client in a case, which he declines to name, involving allegations that a principal of a bankrupt dot-com remains personally liable for some of the company’s debts. “It remains to be seen whether we will be successful,” he says.

In many cases the so-called corporate veil was shabbily woven to begin with, adds Neale. “Perhaps a lot of the people who started venture-type companies did it on a shoestring,” he says. “Maybe they didn’t want to invest in following corporate formalities, didn’t hire corporate lawyers to set them up with an LLC or a corporation or whatever. They started out as ‘so and so doing business as’ a Web site.

“That was all well and good when stock prices were going through the roof and equity was easily had and investments were easily made,” Neale continues. Now that the prospect of new infusions of cash is a pipe dream, companies that run into financial difficulties are finding that such oversights can come back to haunt them. But that’s an old story as far as companies in bankruptcy are concerned.

The unique issues that once characterized dot-com bankruptcies have largely disappeared as dot-com bankruptcies have become more commonplace, says Neale. For example, in the early days of the dot-com boom, many creditors didn’t bother obtaining a security interest in the company’s domain name, notes Neale. Little did they know that in the end, the only asset with any value would be the Web address. It hasn’t taken long for creditors to catch on. These days, “in every security agreement that I review there’s a grant of security in the domain name, the Web address and things like that,” says Neale.

“Nowadays, unwinding the dot-coms is a lot more like a bankruptcy involving a brick-and-mortar-type business than you might imagine. Except in most instances with the dot-coms, there’s a lot less in the way of assets to play with.”

Mark Thompson is a free-lance writer based in Inglewood, Calif.