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What Happens to SCO Next? -- Some Possibilities
Sunday, August 02 2009 @ 05:48 PM EDT

A lot of you have been asking about what happens if SCO is sent into Chapter 7. I did some research for you and I'll show you what I found. But there are other possibilities on the table now, and I'll show you a bit about all of them. We'll try to find an answer to our question, what could happen to SCO now?

Some Context

This started with three motions to convert SCO to Chapter 7 from IBM, Novell and even the US Trustee's Office. As an urgent alternative, SCO said it wanted to sell some of its assets to unXis in a private sale, while retaining what it needs to continue the anti-Linux litigation, something it sprung on everyone as a last-minute surprise at the hearing on June 15.

The proposed sale agreement was followed by objections from IBM and Novell and then a hearing on July 27th to sort it all out. Reports from the hearing seem to confirm that there isn't money guaranteed by unXis or by any investors it may have found, nothing that compels them to come through, and a second possible buyer showed up, LNS Acquisitions, and it wants a chance to bid, and likely that's part of why SCO is now "agreeing" to an auction that appears inevitable, if any sale at all is allowed at this point, whether SCO agrees or not.

After the July 27th hearing, which didn't go very well from SCO's point of view, judging from reports, SCO sent the judge a letter suggesting "the appointment of an examiner to oversee the sale should the Court so direct. The Debtors agree to the involvement of an examiner under 11 U.S.C. 1104 to advise the Debtors' board and to report to the Court on the sale process and the outcome of any auction."

IBM and Novell opposed immediately in letters of their own, which you'll find on that same linked page for SCO's letter, on the grounds that this new suggestion needs to be filed as a motion, and there isn't one, not as a letter, and that the powers of an examiner as suggested by SCO would be too limited anyway, among other objections, although IBM had an alternative proposal, as I'll show you.

So what might happen to SCO? There are various possibilities, including converting its bankruptcy to Chapter 7, staying in Chapter 11 but having an examiner or trustee appointed, or SCO's new idea of appointing an examiner just for the sale, the auction.

What About Conversion to Chapter 7 and Appointment of a Trustee?

Let's get an overview of how bankruptcy is supposed to work first. I confess, at the get go, that I have no idea where SCO's proposed sale fits into the normal scheme of things. Either I'm failing to find the part of bankruptcy law that fits, or SCO is offering a tailored "solution" based on special circumstances or something I can't even figure out. But here's an explanation of how it's supposed to work if SCO's case is converted to Chapter 7.

The first thing that happens is the appointment of a Chapter 7 trustee to take over for SCO management. U.S. Courts has a basic explanation of what the trustee's role is, among other things, and I'l be referring to this page unless otherwise linked:

Role of the Case Trustee

When a chapter 7 petition is filed, the U.S. trustee ... appoints an impartial case trustee to administer the case and liquidate the debtor's nonexempt assets. 11 U.S.C. 701, 704....

Commencement of a bankruptcy case creates an "estate." The estate technically becomes the temporary legal owner of all the debtor's property. It consists of all legal or equitable interests of the debtor in property as of the commencement of the case, including property owned or held by another person if the debtor has an interest in the property. Generally speaking, the debtor's creditors are paid from nonexempt property of the estate.

The primary role of a chapter 7 trustee in an asset case is to liquidate the debtor's nonexempt assets in a manner that maximizes the return to the debtor's unsecured creditors. The trustee accomplishes this by selling the debtor's property if it is free and clear of liens (as long as the property is not exempt) or if it is worth more than any security interest or lien attached to the property and any exemption that the debtor holds in the property. The trustee may also attempt to recover money or property under the trustee's "avoiding powers." The trustee's avoiding powers include the power to: set aside preferential transfers made to creditors within 90 days before the petition; undo security interests and other prepetition transfers of property that were not properly perfected under nonbankruptcy law at the time of the petition; and pursue nonbankruptcy claims such as fraudulent conveyance and bulk transfer remedies available under state law. In addition, if the debtor is a business, the bankruptcy court may authorize the trustee to operate the business for a limited period of time, if such operation will benefit creditors and enhance the liquidation of the estate. 11 U.S.C. 721.

Section 726 of the Bankruptcy Code governs the distribution of the property of the estate. Under 726, there are six classes of claims; and each class must be paid in full before the next lower class is paid anything. The debtor is only paid if all other classes of claims have been paid in full. Accordingly, the debtor is not particularly interested in the trustee's disposition of the estate assets, except with respect to the payment of those debts which for some reason are not dischargeable in the bankruptcy case. The individual debtor's primary concerns in a chapter 7 case are to retain exempt property and to receive a discharge that covers as many debts as possible.

So you can see why SCO isn't enthusiastic about Chapter 7. It would be the end of the company as we know it. That would be fine with most of the world, but to SCO it's an appalling prospect. Management loses all control. SCO's hopes, if there are any, seem to involve hitting the litigation lottery, somehow undoing what happened in the Novell case, and in the end being determined to be the owners of the copyrights after all and then being able to prove actual infringement of any of them after that.

It's a hope no one seems to share but SCO management, and not even all of them, I gather. At the July 27th hearing there was testimony that at least some employees, even in management, don't share the dream any more. When we get the transcript, we'll find out if any of that testimony ended up on the record or not, but we heard about it at the hearing, and it's unforgettable.

My point is simply that it seems to me to be more like dreaming of hitting the lottery than a plan. Some people do win the lottery, after all, but you probably don't want to plan your budget around such a hope, do you? And Novell's argument is that in this situation, it's not OK to force creditors to fund your hope at their expense.

What was that part about "avoiding" earlier? I see that one thing an examiner or trustee can do is essentially to undo things the debtor did just before filing for bankruptcy, which makes sense in that if there is fraud or abuse, the creditors want that to be undone so they can get paid:

Avoidable Transfers

The debtor in possession or the trustee, as the case may be, has what are called "avoiding" powers. These powers may be used to undo a transfer of money or property made during a certain period of time before the filing of the bankruptcy petition. By avoiding a particular transfer of property, the debtor in possession can cancel the transaction and force the return or "disgorgement" of the payments or property, which then are available to pay all creditors. Generally, and subject to various defenses, the power to avoid transfers is effective against transfers made by the debtor within 90 days before filing the petition. But transfers to "insiders" (i.e., relatives, general partners, and directors or officers of the debtor) made up to a year before filing may be avoided. 11 U.S.C. 101(31), 101(54), 547, 548. In addition, under 11 U.S.C. 544, the trustee is authorized to avoid transfers under applicable state law, which often provides for longer time periods. Avoiding powers prevent unfair prepetition payments to one creditor at the expense of all other creditors.

SCO, as debtor in possession, technically could undo what it did. It has the power, but let's get real.

What About Chapter 11 With a Trustee Instead?

Chapter 7 is very different from Chapter 11, where this is the goal:

Chapter 11 is typically used to reorganize a business, which may be a corporation, sole proprietorship, or partnership.
Reorganization means the company gets time to breathe. It pays what it can, sloughs off the rest of its debts, and leaves bankruptcy a viable business, hopefully. The problem SCO has is that after two years in Chapter 11, there's no reorganization plan. Maybe no reorganization *hope*, even, particularly if it sells off its UNIX assets, which is what it proposes doing. So we have a proposed sale but no plan, and it's very, very late in the Chapter 11 process.

You can understand why at this point, Novell is just saying over and over to the judge, please send them to Chapter 7 and appoint someone rational and neutral to take over from these guys. It's our money being lost, and the whole point of special circumstances, meaning doing something a little differently than strictly by the book, is to help creditors like Novell, not management or customers or the board.

Up until now, SCO has been what's called a Debtor in Possession in Chapter 11, which means it has been in control of what it does, subject to court approval and oversight by the U.S. Trustee's Office, but subject also to certain obligations, like to be honest and transparent, which is currently at least subject to question by IBM at the hearing. Here's how the US Courts page explains what a debtor in possession is about:

Section 1107 of the Bankruptcy Code places the debtor in possession in the position of a fiduciary, with the rights and powers of a chapter 11 trustee, and it requires the debtor to perform of all but the investigative functions and duties of a trustee. These duties, set forth in the Bankruptcy Code and Federal Rules of Bankruptcy Procedure, include accounting for property, examining and objecting to claims, and filing informational reports as required by the court and the U.S. trustee or bankruptcy administrator (discussed below), such as monthly operating reports. 11 U.S.C. 1106, 1107; Fed. R. Bankr. P. 2015(a). The debtor in possession also has many of the other powers and duties of a trustee, including the right, with the court's approval, to employ attorneys, accountants, appraisers, auctioneers, or other professional persons to assist the debtor during its bankruptcy case. Other responsibilities include filing tax returns and reports which are either necessary or ordered by the court after confirmation, such as a final accounting. The U.S. trustee is responsible for monitoring the compliance of the debtor in possession with the reporting requirements.
As you can see, that means they get to run the show. But they have duties, some of which SCO is accused of not adequately fulfilling. Like filing timely MORs. And Novell has accused SCO of exhibiting a lack of sound business judgment.

IBM at the July 27th hearing noted even more serious issues, like a public company listing inaccurate (to hear SCO tell it at the hearing) information about who are its executives. You could call that the Hans Bayer boomerang. If he's only associated with SCO Germany, which apparently is what SCO argued at the hearing, claiming the website wording is a mistake, why is Bayer still listed on the website as being VP of International Sales for SCO *Group*? SCO can't win this one for losing, and IBM smoothly addressed it at the end of the hearing as if what SCO had claimed were true, the website had misinformation, in which case, IBM argued, SCO, a public company, has misinformation on its website. Like I say, SCO painted itself into a corner, and there's no good way out.

Note that a debtor in possession also gets to choose its lawyers and auctioneers. Ooh. Its auctioneers. That raises my interest level, as an auction is what SCO is now "agreeing" to. But if it gets to choose the auctioneer, then how safe do IBM and Novell and other bidders than unXis feel? It's certainly happened that an auctioneer has been accused of improper conduct at the auction.

After the devastating bankruptcy hearing on the 27th, where creditors IBM and Novell and the U.S. Trustee's Office argued for a neutral party to take over from SCO management totally, SCO sent the letter to the judge, trying to keep some control over its proposed auction, by suggesting an examiner take on a kind of advisory role with the Board still in control of decisions.

IBM and Novell didn't go for that idea, so let's look at the possibilities. What happens if the judge chooses to keep SCO in Chapter 11 instead of sending SCO to Chapter 7, but with a neutral party running the show? IBM wouldn't object to that, I gather. U.S. Courts explains again how that would work:

Although the appointment of a case trustee is a rarity in a chapter 11 case, a party in interest or the U.S. trustee can request the appointment of a case trustee or examiner at any time prior to confirmation in a chapter 11 case. The court, on motion by a party in interest or the U.S. trustee and after notice and hearing, shall order the appointment of a case trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement, or if such an appointment is in the interest of creditors, any equity security holders, and other interests of the estate. 11 U.S.C. 1104(a). Moreover, the U.S. trustee is required to move for appointment of a trustee if there are reasonable grounds to believe that any of the parties in control of the debtor "participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or the debtor's financial reporting." 11 U.S.C. 1104(e). The trustee is appointed by the U.S. trustee, after consultation with parties in interest and subject to the court's approval. Fed. R. Bankr. P. 2007.1. Alternatively, a trustee in a case may be elected if a party in interest requests the election of a trustee within 30 days after the court orders the appointment of a trustee. In that instance, the U.S. trustee convenes a meeting of creditors for the purpose of electing a person to serve as trustee in the case. 11 U.S.C. 1104(b).

The case trustee is responsible for management of the property of the estate, operation of the debtor's business, and, if appropriate, the filing of a plan of reorganization. Section 1106 of the Bankruptcy Code requires the trustee to file a plan "as soon as practicable" or, alternatively, to file a report explaining why a plan will not be filed or to recommend that the case be converted to another chapter or dismissed. 11 U.S.C. 1106(a)(5).

As you see, a Chapter 11 examiner or trustee runs the show, pretty much the way a Chapter 7 trustee would. And remember, when reading over that list, that the US Trustee's Office did feel it was time in this bankruptcy for someone to take over for management. What about SCO's latest counter proposal?

What About an Examiner Just for the Auction?

But let's imagine there is appointed an examiner only for the auction, as SCO proposes, although as I confess, I have no idea why SCO thinks it can do what it proposes. But here's one point I do notice:

Upon the request of a party in interest or the U.S. trustee, the court may terminate the trustee's appointment and restore the debtor in possession to management of bankruptcy estate at any time before confirmation.11 U.S.C. 1105.
So, at least it is possible to have a short-term trustee of some sort appointed, and I gather the judge can order the examiner also to do whatever jobs the judge thinks management shouldn't handle any longer, which is what IBM's letter proposes, while it also points out that there is no current motion filed that is pending. Here's the US Court's explanation of the role of an examiner in a Chapter 11 case:
The appointment of an examiner in a chapter 11 case is rare. The role of an examiner is generally more limited than that of a trustee. The examiner is authorized to perform the investigatory functions of the trustee and is required to file a statement of any investigation conducted. If ordered to do so by the court, however, an examiner may carry out any other duties of a trustee that the court orders the debtor in possession not to perform. 11 U.S.C. 1106. Each court has the authority to determine the duties of an examiner in each particular case. In some cases, the examiner may file a plan of reorganization, negotiate or help the parties negotiate, or review the debtor's schedules to determine whether some of the claims are improperly categorized. Sometimes, the examiner may be directed to determine if objections to any proofs of claim should be filed or whether causes of action have sufficient merit so that further legal action should be taken. The examiner may not subsequently serve as a trustee in the case. 11 U.S.C. 321.
That explains the IBM response to SCO's letter, where IBM asked, if the judge were inclined to grant SCO's request, that the order include precisely what the examiner was to do:
IBM's concern about the proposal to limit the examiner's role could be addressed by an order under the second half of 1106(b) ("any other duties of the trustee that the court orders the debtor in possession not to perform") expanding the role. As long as the Court's order made clear that the examiner would have all the rights, powers, functions and duties of a trustee with respect to the sale of any or all assets of the estates outside the ordinary course of business and with respect to the settlement of any litigation and that the debtors in possession were prohibited from participating in any aspect of any such sale or settlement except as specifically requested by the examiner, IBM would not object to the appointment of an examiner.
Now What?

So those are the various possibilities I see. Do you see any good ones, if you are SCO management? I don't see even one. If we are marking on a curve, SCO's suggestion in its letter is the least toxic, but none of the possibilities now are really ideal from SCO's point of view, and how realistic do you think it is as a suggestion at this late date, considering all that came out in discovery and at the hearing?

I think this may be the very first time in the entire SCO saga where SCO seems to have no really good options on the table that I can see.

And that's probably why after the hearing on the 27th, I was overwhelmed by the incandescent realization that we had just turned a real corner, one that changes everything, and that we're in end-game territory, at last.

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