UNITED STATES BANKRUPTCY COURT EASTERN DISTRICT OF VIRGINIA Richmond Division

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1 UNITED STATES BANKRUPTCY COURT EASTERN DISTRICT OF VIRGINIA Richmond Division IN RE: ) ) Bankruptcy Case MOVIE GALLERY, INC., et al., ) No DOT ) Chapter 11 Debtors. ) Jointly Administered OBJECTION OF BOARDS VIDEO COMPANY, LLC TO MOTION OF THE DEBTORS FOR AN ORDER AUTHORIZING THE DEBTORS TO REJECT A LICENSE AGREEMENT AND A PRODUCT AND SUPPORT AGREEMENT WITH BOARDS, INC. AND REQUIRING BOARDS, INC. TO CEASE USING LICENSED MARKS BOARDS VIDEO COMPANY, LLC ( Boards ) by counsel WILEY REIN LLP, H. Jason Gold, Valerie P. Morrison, and Dylan G. Trache files this objection (the Objection ) to Motion ( Rejection Motion ) of the Debtors for an Order authorizing the Debtors to reject a License Agreement and a Product and Support Agreement with Boards, Inc. and requiring Boards, Inc. to cease using certain licensed marks, respectfully stating to the Court as follows: I. Summary of Argument. The Boards Contracts (hereinafter defined) generate substantial revenues and are very profitable to the Debtors bankruptcy estates. Pursuant to the Boards Contracts, Boards owns and operates a profitable business enterprise comprised of 20 retail video stores which employs approximately 400 people and generates annual revenue of approximately $30 million. If the Rejection Motion is granted, Boards business will very likely be destroyed and its employees will lose their jobs. The Boards Contracts themselves are profit centers for the Debtors estates. The only potentially burdensome provision is a Put Option (hereinafter defined) which requires the H. Jason Gold, Va. Bar No Valerie P. Morrison, Va. Bar No Dylan G. Trache, Va. Bar No WILEY REIN LLP 7925 Jones Branch Drive, Suite 6200 McLean, Virginia (703) Counsel to Boards Video Company, LLC

2 Debtors to purchase the Boards stores and was the subject of a (now stayed) pre-petition arbitration proceeding. Boards understands the Debtors assertion that it is downsizing and therefore not in a position to acquire Boards stores. Accordingly, Boards is willing to waive the Put Option, dismiss the arbitration proceeding and forego the sale in the event the Boards Contracts are assumed. In order to succeed in its Rejection Motion, the Debtors must establish that rejection is an exercise of the Debtors sound business judgment. That burden cannot be met here. In the instant case, the estates will continue to derive substantial economic benefit from the Boards Contracts if they are assumed, and will suffer loss of a substantial revenue stream if they are rejected. These simple economic facts suggest an ulterior motive and lack of sound business judgment on the Debtors part, precisely the type of whim or caprice the Bankruptcy Code will not countenance as grounds for rejection of an executory contract. In addition, in enacting 365(n), Congress has directed bankruptcy courts to develop equitable treatment in handling the rejection of trademark licenses. See S. Rep , 1988 U.S.C.C.A.N. 3200, Clearly, it would not be equitable treatment to allow the Debtors to reject the profitable Boards Contracts without a sound business justification where the result will be the loss of so many livelihoods. Boards is entitled to take discovery concerning the issues presented above and requests a meaningful opportunity to do so. Accordingly, the hearing on the Rejection Motion should be postponed to permit such discovery to occur. Finally, the Debtors are not permitted to seek injunctive relief in a contested matter proceeding, and must refile their motion as an adversary proceeding if they wish to pursue such relief. 2

3 II. Background. 1. On January 25, 2001, Hollywood Entertainment Corporation ( Hollywood ), Hollywood Management Company ( HMC ) and Boards, Inc. entered into a License Agreement ( License Agreement ) pursuant to which Hollywood granted Boards, Inc. a non-exclusive license to use certain names, trademarks, characters, symbols, designs, likenesses and trade dress (collectively, Hollywood Marks ). On January 1, 2003, Boards, Inc. assigned the License Agreement to Boards with the consent of Hollywood. The License Agreement requires Boards to pay quarterly royalties of two percent (2%) to Hollywood. 2. In accordance with the License Agreement, Hollywood and Boards, Inc. entered into a Product and Support Agreement ( PSA and collectively, with the License Agreement, the Boards Contracts ) through which Hollywood supplies to Boards movies, games, accessories, concessions and other products and supplies customarily provided by Hollywood to its stores. Hollywood also provides certain operational support to Boards, as described in the PSA. Boards pays Hollywood certain product, distribution and warehouse fees in return for the services provided by Hollywood under the PSA. Boards, Inc. also assigned the PSA to Boards with the consent of Hollywood on or about January 1, Boards rents and sells digital video disks (DVDs), videocassettes, video games and other merchandise at 20 retail stores in seven states located west of Utah ( Boards Stores ). Pursuant to the License Agreement and the PSA, each of the Boards Stores is operated as a Hollywood Video store. 4. Boards has approximately 400 employees. 3

4 5. Boards has paid Hollywood over $900,000 per year in royalties under the License Agreement and distribution fees under the PSA in each of the last 3 years. The estimated fees for 2007 will total approximately $1,050, In 2005, Hollywood underwent a change in control as defined in the License Agreement. Pursuant to the License Agreement, upon a change in control, Boards was entitled to require Hollywood, HMC, or their successor to purchase the Boards Stores pursuant to a valuation procedure set forth in the License Agreement (the Put Option ). 7. Following Hollywood s change in control, Boards exercised the Put Option. When the parties were unable to agree upon a sale price for the Boards Stores, in accordance with the License Agreement, Boards made a demand for arbitration ( Put Option Arbitration ) in March Pursuant to 11 U.S.C. 362, the Put Option Arbitration is currently stayed. 8. On October 16, 2007, Hollywood and its related debtors (collectively, the Debtors ) each filed a voluntary petition for relief under chapter 11 of the United States Bankruptcy Code in this Court. 9. On November 28, 2007, the Debtors filed the Rejection Motion seeking to (i) reject the License Agreement; (ii) reject the PSA; and (iii) enjoin Boards from taking certain actions. A hearing on the Rejection Motion is currently scheduled for December 18, III. Argument. A. The Debtors Should Not Be Authorized to Reject the Boards Contracts. 1. Standard for Rejection of Executory Contracts. In this circuit, the business judgment rule governs a debtor s decision to assume or reject an executory contract or unexpired lease under 11 U.S.C See Lubrizol Enter., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, (4 th Cir. 1985) ( the bankrupt s 4

5 decision [to reject] is to be accorded the deference mandated by the sound business judgment rule as generally applied by courts to discretionary actions or decisions of corporate directors ). To determine whether a contract may be rejected under 365 a court s proper inquiry is first to determine whether the contract is executory and if so, whether its rejection would be advantageous to the estate. In re Lawson, 14 F.3d 595, 1993 WL at *3 (4 th Cir. 1993) (unpublished). 1 While this review of the debtor s proposal is highly deferential to debtor s wishes, the Court must also consider all of the circumstances surrounding any particular lease assumption or rejection. 2 In re Trak Auto Corp., No DHA, 2002 WL at *2 (Bankr. E.D. Va. Jan. 9, 2002). 3 The Court should evaluate the debtor s business judgment by considering the impact of the debtor s decision on a variety of parties as well as the impact on the debtor s estate; i.e. a judicial review of the totality of the circumstances surrounding the debtor s proposal relative to a particular lease. Id. In Trak Auto, Judge Adams adopted a four factor test for evaluating a debtor s business judgment with respect to the assumption or rejection of a contract or lease. These factors are: (1) the effect of the debtor s proposed assumption or rejection upon the debtor s estate; (2) how the lessor [or contract counter-party] is impacted by the assumption or rejection of its lease [or contract]; (3) whether any benefit or harm to the unsecured creditors arises from the assumption or rejection of [the subject lease or contract]; and (4) the significance of the lease [or contract] to debtor s overall reorganization efforts. Id. at *3. Other courts have considered similar factors in determining whether a debtor s decision to assume or reject a contract or lease satisfies the business judgment, including: (i) whether the contract burdens the estate financially; (ii) 1 A copy of this opinion is attached hereto as Exhibit A. Unpublished opinions of the Fourth Circuit are not binding but may provide helpful guidance to courts. In re Serra Builders, Inc., 970 F.2d 1309, 1311 (4 th Cir. 1992). 2 The standards for rejection of a lease as opposed to a contract are the same. 3 A copy of this opinion is attached hereto as Exhibit B. 5

6 whether rejection would result in a large claim against the estate; (iii) whether the debtor showed real economic benefit resulting from the rejection; and (iv) whether upon balancing the equities, rejection will do more harm to the other party to the contract than to the debtor if not rejected. In re G Survivor Corp., 171 B.R. 755, 758 (Bankr. S.D.N.Y. 1994) (and cases cited therein). 2. The Debtors Have Not Established Sound Business Judgment in Their Decision to Reject the License Agreement and the PSA. The Debtors advance essentially four arguments in favor of rejection: (i) that the Boards Contracts are burdensome and do not represent sources of potential value for the Debtors future operations and creditors ; (ii) that the Boards Contracts were not arm s-length transactions and are unduly burdensome ; (iii) that the Debtors are not interested in acquiring the Boards Stores and seek to eliminate the time and resources that they do not want to spend in the Put Option Arbitration; and (iv) that Boards continued operation of the Boards Stores may diminish the integrity of the Hollywood Marks. Rejection Motion at None of these arguments is supported by the evidence, nor do they satisfy any of the factors set forth in Trak Auto. 4 a. The Boards Contracts are Valuable to the Debtors Estates. Over the past three years, Boards has paid almost $600,000 per year to Hollywood in royalties as required by the License Agreement. In addition, during such time period, Boards has paid an average of approximately $385,000 annually to Hollywood for its product distribution services. Virtually all of Hollywood s costs associated with Boards contracts are passed through directly to Boards. Significantly, Hollywood does not provide services such as training, oversight and field services, and does not maintain on its payroll employees whose sole 4 As explained below, at the very least, Boards is entitled to discovery to challenge these bald assertions. 6

7 function is to administer the Boards Contracts. Accordingly, the operation of the Boards Stores results in a substantial profit for the Debtors at minimal cost. The Debtors have not explained how this profitable enterprise burdens the estates. Moreover, the unsecured creditors of the estates would suffer if rejection is allowed, not only by foregoing the profits associated with these contracts, but because Boards would have a substantial rejection claim (estimated in excess of $30 million) should the Boards Contracts be rejected. Therefore, far from being a burden on the estates, the Boards Contracts in fact provide substantial value to the estates. b. The License Agreement and PSA are Arm s-length Transactions. The Debtors argument that the contracts are not the result of historical arms-length negotiations is a red herring. Boards, Inc. was created and the Boards Contracts were entered into specifically to prevent the complete loss of new store locations that Hollywood was not able to acquire for itself at the time due to financial constraints. Since their inception, the Boards Contracts have not only been a profit center for Hollywood, but they allowed Hollywood (without spending a cent) to carry its name and brand into markets and locations that otherwise would have been lost had the parties not entered into the Boards Contracts, and to eliminate lease liability exposure for the stores Hollywood was not permitted to open. In April, 2005, Movie Gallery, Inc. acquired Hollywood and HMC with full knowledge of the history, benefits and burdens of the Boards Contracts. In short, the Boards Contracts are either beneficial to the estate or they are not. To argue (as the Debtors really do) that they would be even more profitable if they were renegotiated misses the point. c. Boards Will Waive the Put Option if the Boards Contracts are Assumed. The Debtors have asserted that they do not desire to purchase the Boards Stores. The Put Option Arbitration is now stayed and will continue to be stayed until confirmation of a plan, 7

8 unless Boards seeks and is granted relief from the automatic stay. Accordingly, during the pendency of these bankruptcy cases, the Debtors will not have to spend any time or resources devoted to the Put Option Arbitration. More importantly, Boards is willing to waive the Put Option in the event the Debtors ultimately assume the Boards Contracts. 5 Accordingly, the Put Option does not present a burden to the estate and is not a factor that supports rejection of the Boards Contracts. d. Boards Has Not and Will Not Tarnish the Hollywood Marks. Maintaining the value of the Hollywood Marks is as essential to Boards business as it is to the Debtors business. Boards operates profitable, competitive, well-run video retail stores in reliance upon and in accordance with the license. The Debtors have presented absolutely no evidence that Boards has somehow misused or tarnished the Hollywood Marks. Moreover, the Debtors have presented no evidence that they have historically incurred or will incur any expense in the future to ensure that the operation of those stores does not tarnish the integrity of the Licensed Marks. Rejection Motion at 18. Accordingly, the Debtors argument that Boards may tarnish the Hollywood Marks is pure speculation and should be disregarded. e. The Court Should Question Whether the Proposed Rejection is in Good Faith. The Debtors apparently desire to transfer control of their operations to Sopris Capital Advisors, LLC ( Sopris ). See Movie Gallery, Inc., et al. Proposed Restructuring Term Sheet; Rejection Motion of the Debtors for an Order (A) Authorizing the Debtors to Perform Under Restructuring Agreements, (B) Authorizing the Debtors to Pay Certain Associated Fees to and Reimbursement of Certain Expenses of the Backstop Party and (C) Granting Related Relief. It is 5 Boards is not willing to immediately waive the Put Option because in the event the Debtors are successful in rejecting the Boards Contracts, the presence of the Put Option will very substantially increase Boards rejection claim. 8

9 known in this case, that Boards President, Mark Wattles, the founder and former chief executive officer of Hollywood prior to its sale to the current owners, is a potential investor in connection with a possible competing reorganization plan. Given the timing of the Rejection Motion, and the profitability of the Boards Contracts, it appears that the motive for the filing of the Rejection Motion may be to disincentivize competitive bidding or as retribution, rather than a sober and sound exercise of Debtors (as opposed to someone else s) business judgment. 3. Equity Weighs Against Rejection of the Boards Contracts. In response to the Fourth Circuit s decision in Lubrizol, Congress enacted 365(n) of the Bankruptcy Code, which provides certain protections to holders of intellectual property licenses. While Congress excluded the holder of trademark licenses from these protections, Congress explained this decision as follows: Finally, the bill does not address the rejection of executory trademark, trade name or service mark licenses by debtor-licensors. While such rejection is of concern because of the interpretation of section 365 by the Lubrizol court and such others, see, e.g., In re Chipwich, Inc., 54 Bankr. Rep. 427 (Bankr. S.D.N.Y. 1985), such contracts raise issues beyond the scope of this legislation. In particular, trademark, trade name and service mark licensing relationships depend to a large extent on control of the quality of the products or services sold by the licensee. Since these matters could not be addressed without a more extensive study, it was determined to postpone congressional action in this area and to allow the development of equitable treatment of this situation by bankruptcy courts. S. Rep , 1988 U.S.C.C.A.N (emphasis added). Courts have the equitable discretion to deny rejection under circumstances such as these, where the rejection of the License Agreement and PSA produces no substantial benefit to the estates, but could effectively destroy a profitable business and cause the loss of almost 400 jobs. Specifically, rejection would cause Boards to (i) lose the goodwill associated with the Hollywood Marks; (ii) incur substantial re-branding expenses should Boards attempt to continue in business; (iii) require Boards to enter into individual agreements with major movie studios in 9

10 order to acquire product; and (iv) purchase new information technology and computer systems. The combination of these expenses will most likely make it impossible for Boards to remain in business. In the event of a failure of Boards business, Boards will face lease exposure of in excess of $19 million. 6 In In re Matusalem, the court refused to allow rejection of a franchise agreement, including a license to use trademarks and trade names where there was no economic benefit to the debtor in doing so, and where the proposed rejection would utterly destroy the business of [the licensee] and with it the livelihood of [the licensee s] principals and employees. In re Matusalem, 158 B.R. 514, 522 (Bankr. S.D. Fla. 1993). Here, like in Matusalem, rejection would likely result in the destruction of Boards business without any demonstrable benefit to the estates. Other courts have also refused to allow rejection where the harm to the counter-party to a contract is disproportionate to any benefit to the estate. For example, in In re The Monarch Tool & Mfg. Co., the debtor was not permitted to reject an exclusive distribution agreement after application of the business judgment test. In re The Monarch Tool & Mfg. Co., 114 B.R. 134, 137 (Bankr. S.D. Ohio 1990). In Monarch, as in this case, the contract party was established for the express purpose of operating under its agreements with the debtor. Similarly, in In re Midwest Polychem, Ltd., the court noted that [e]ven in the application of the so-called business judgment test courts have recognized that the relative equities must come into play and accordingly denied approval of a proposed rejection where the sole purpose of the rejection was to eliminate a non-compete agreement that would substantially damage the counter-party to the contract. In re Midwest Polychem, Ltd., 61 B.R. 559, (Bankr. N.D. Ill. 1986). The 6 Many of the leases are personally guaranteed by Boards principal, who personally faces approximately $12.5 million in lease guaranty exposure. 10

11 damage to Boards that would occur upon rejection, combined with the fact that the contracts are profitable for the Debtors, and the fact that rejection would harm the unsecured creditors by allowing a large rejection claim constitute more than sufficient grounds for denying rejection in this case. B. Boards is Entitled to Discovery Regarding the Debtors Alleged Good Business Judgment. The filing of this Objection will commence a contested matter under Federal Rule of Bankruptcy Procedure The hearing on the Rejection Motion is currently scheduled for December 18, Boards only recently engaged counsel with respect to the Rejection Motion. As explained above, the Debtors decision to reject the Boards Contracts raises serious issues regarding their business judgment. Boards requires discovery on issues core to the central question of the Debtors business judgment. Allowing discovery to proceed will not prejudice the Debtors in any way. To the contrary, if rejection is delayed, the Debtors will continue to be entitled to royalty and other payments under the Boards Contracts until such time as a rejection occurs. C. The Debtors Request for Injunctive Relief Requires an Adversary Proceeding. The Debtors request that Boards be required to cease use of the [Hollywood] Marks immediately upon the effectiveness of the rejection of the Boards Contracts. Rejection Motion at 13. The Rejection Motion is devoid of any support for this request for injunctive relief. Moreover, such relief must be requested by adversary proceeding rather than Rejection Motion. See In re Best Prod. Co., 203 B.R. 51, 54 (Bankr. E.D. Va. 1996) ( Fed. R. Bankr. P. 7001(7) plainly requires that any request for an injunction or other equitable relief must be sought in the context of an adversary proceeding ). The Debtors should be required to re-file any request for equitable or injunctive relief as an adversary proceeding. 11

12 WHEREFORE, based upon the foregoing, Boards Video Company, LLC respectfully requests entry of an Order by the Court: (i) sustaining the Objection; (ii) denying the Rejection Motion or alternatively, continuing the hearing and establishing a discovery schedule; (iii) requiring the Debtors to re-file any request for equitable or injunctive relief as an adversary proceeding; and (iv) granting such other and further relief as is just and proper. WILEY REIN LLP 7925 Jones Branch Drive, Suite 6200 McLean, Virginia Respectfully submitted, BOARDS VIDEO COMPANY, LLC By Counsel By: /s/ Dylan G. Trache H. Jason Gold, Va. Bar No Valerie P. Morrison, Va. Bar No Dylan G. Trache, Va. Bar No Counsel to Boards Video Company, LLC 12

IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF MARYLAND (Greenbelt Division)

IN THE UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF MARYLAND (Greenbelt Division In re: USGen New England, Inc., Case No. 03-30465 (PM Debtor. Chapter 11 MOTION FOR AUTHORITY TO REJECT POWER PURCHASE