Litigation In A High-Tech World

Wednesday, September 1, 2004 - 01:00

Lori E. Lesser
Barnes, Richardson & Colburn

This review represents excerpts from "Litigation In A High-Tech World," a chapter in a Practising Law Institute publication, Advising High-Tech Companies.

§ 14:9 Bankruptcy

High-tech companies often have myriad licensing agreements, which pose unique problems if a contracting party declares bankruptcy.

§ 14:9.1 Licenses as "Executory Contracts"

Intellectual property licenses are generally considered to be "executory contracts" under section 365 of the Bankruptcy Code. An executory contract is not defined in the Bankruptcy Code; the courts hold that it is a contract in which "the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other." If a contract is not executory, it has been fully performed, such as an outright sale of intellectual property, and Bankruptcy Code section 365 will not apply.

Intellectual property licenses generally qualify as executory contracts, because even in royalty-free licenses both sides have material ongoing duties. The licensor must (1) refrain from suing the licensee for infringement (the raison d'etre of a license) and (2) for a trademark license, exercise quality control. The licensor may also need to (3) refrain from using the property in any exclusive fields; (4) maintain and renew patents and registrations; (5) defend infringement suits; or (6) provide training, improvements, or support services. Meanwhile, the licensee must (1)use the property only within the specified field or territory, and (2) for a trademark license, maintain quality standards. The licensee may need to (3) mark legends and notices on products; (4) keep proper accounting of royalty payments; and (5) cooperate in enforcement actions by the licensor.

If a contract is deemed executory, the trustee or debtor-in-possession ("debtor") has broad powers to assume or reject it, subject to the cure of existing defaults and assurance of future performance thereunder. If the debtor rejects the license, this is deemed to be a pre-petition breach, for which the nondebtor will have a pre-petition claim for damages, which for unsecured claims usually recoups less than 100 cents on the dollar. If the licensee is the rejecting debtor, the nondebtor licensor still owns the licensed property, but will likely not recoup all outstanding royalties. If the licensor is the debtor, a rejection can be catastrophic for the nondebtor licensee, who can no longer use the licensed property, subject to any protection provided by Bankruptcy Code section 365(n).

§ 14:9.2 Debtor as Licensee - Assignment Issues

If the debtor does not wish to reject the executory contract, the debtor may assume it and assign it to a third party pursuant to Bankruptcy Code section 365(f), except for certain nonassignable contracts in Bankruptcy Code section 365(c), as discussed below. A nondebtor licensor may be quite eager to curtail the debtor-licensee's assignment power, particularly for a proposed assignment to a competitor. Yet, because the debtor has so much discretion in bankruptcy, parties generally cannot draft a license that avoids the issue. For example, even if the contract provides - as many intellectual property licenses do - that the license terminates upon a party's bankruptcy, Bankruptcy Code section 365(e) holds that such provisions are unenforceable. Similarly, even if the license prohibits assignments without the licensor's consent, Bankruptcy Code section 365(f) permits a debtor to assign the contract irrespective of such language.

The debtor's power under Bankruptcy Code section 365(f) is not absolute, however; it is subject to the exception in Bankruptcy Code section 365(c). Bankruptcy Code section 365(c) provides that, unless the nondebtor consents, the debtor may not assume or assign an executory contract (whether or not the contract prohibits assignment) if "applicable law" excuses the nondebtor from accepting performance from anyone else. The courts hold that this exception covers a narrow category of contracts: those for which non bankruptcy law prohibits their assignment and/or those for which the contracting parties' identity is material, due to the very nature of the agreement. Such contracts include contracts for personal services, government contracts, golf club memberships, and as the cases below indicate, intellectual property licenses.

[A] Nonexclusive Licenses

Many appellate courts hold that, pursuant to Bankruptcy Code section 365(c), the licensor's consent is required to transfer a nonexclusive patent license in bankruptcy. They have held that federal patent law - the "applicable law" under Bankruptcy Code section 365(c) - supports that a nonexclusive licensee has merely a personal privilege not to be sued by the licensor. The licensor may wish to grant this privilege to Company A, but not to an unspecified, future Company B. Therefore, the license is presumed nonassignable unless it expressly permits otherwise. Several courts have analogized copyrights to patents and support that a nonexclusive copyright license qualifies for Bankruptcy Code section 365(c) and cannot be assigned in bankruptcy without the licensor's consent. Two courts support that a nonexclusive trademark license may also qualify for Bankruptcy Code section 365(c), as well.

[B] Exclusive Licenses

Based on the few reported cases, the better argument is that exclusive intellectual property licenses fit within the Bankruptcy Code section 365(c) exception. The Ninth Circuit holds that an exclusive licensee is not a full copyright owner, and therefore does not enjoy all of the owner's substantive rights, such as the right to assign without consent. Meanwhile, three lower courts in other circuits hold that an exclusive copyright license is assignable without consent, because an exclusive licensee has some ownership rights, such as the right to restrict the licensor's use.

One case apiece holds that exclusive patent and trademark licenses require consent under Section 365(c) to assign in bankruptcy. Earlier cases had left the issue open, with respect to exclusive patent licenses.

§ 14:9.3 Debtor as Licensee - Assumption Issues

If the license is a type that needs consent to assign under Bankruptcy Code section 365(c), the next issue is whether the debtor may still assume such a license for its own continued use. The venue of the debtor's bankruptcy may be crucial, because the appellate courts are split on whether the debtor's assumption of a license requires the nondebtor's consent under Bankruptcy Code section 365(c). The Third, Fourth, Ninth, and Eleventh Circuits hold that Bankruptcy Code section 365(c) requires the licensor's consent for either assignment or assumption of a qualifying license. These courts' analysis, set forth In re Catapult Entertainment, Inc., has been called the "hypothetical test," which holds that the debtor may not even assume a qualifying license, even if he or she has no intention of assigning it, if applicable law would hypothetically prevent the debtor from assigning the license to a third party. The Ninth Circuit noted that the plain language of Bankruptcy Code section 365(c) treats assumption and assignment as two distinct events, each of which requires the nondebtor's separate consent. Similarly, the Third Circuit has stated that Bankruptcy Code section 365(c) reflected Congress's judgment that "a solvent contractor and an insolvent debtor in possession going through bankruptcy are materially distinct entities."

In contrast, the First Circuit held that a bankrupt licensee may assume a qualifying Bankruptcy Code section 365(c) license without the licensor's consent, because the bankrupt licensee is still the same essential entity. This analysis, set forth in Institut Pasteur v. Cambridge Biotech Corp., is called the "actual test," which focuses on "the performance actually to be rendered by the debtor-in-possession," which the court should not presume is "materially distinct from the pre-petition debtor." The First Circuit allowed CBC to assume a patent license from Pasteur, even though Pasteur's direct competitor had bought all of CBC's stock. The court noted that the license (1)restricted outright assignments but not transfers via a "change of control" scenario, such as a stock sale; (2)allowed CBC to assign to affiliates; and (3)expressly restricted CBC's rights to sublicense to a company other than its new owner. Therefore, the court held that Pasteur could have covered the instant scenario in the license's nonassignment clause, but did not do so.

§ 14:9.4 Debtor as Licensor - Section 365(n)

The Bankruptcy Code provides certain protections for nondebtor licensees of intellectual property. In Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., the court upheld a technology licensor's rejection of a license as properly following the law, despite the "serious burden" it caused to the licensee. In reaction to Lubrizol, and to protect all similarly situated licensees, Congress enacted the Intellectual Property Bankruptcy Protection Act of 1988 to add Section 365(n) to the Bankruptcy Code.

Bankruptcy Code section 365(n) provides that if a licensor of "intellectual property" declares bankruptcy and rejects the license, the licensee may either (1)treat the contract as terminated, if the rejection amounts to such a breach as would render the contract terminated by virtue of its own terms, applicable nonbankruptcy law, or an agreement made by the licensee with another entity or (2)retain its rights (including any exclusivity rights, but excluding other rights of specific performance) under the agreement and "any agreement supplementary" thereto as such rights existed immediately prior to bankruptcy. Under option (1), if the licensee does not wish to continue the arrangement, it can terminate and sue for pre-petition damages. Under option (2), the licensee may override the licensor's rejection and keep the license - with certain limitations - provided that it pays all royalties due and waives any right of setoff.

Bankruptcy Code section 365(n) may help many licensees avoid a Lubrizol encore; yet, it does not provide full protection, for several reasons, including:

1.No trademarks. Bankruptcy Code section 365(n) protects licensees of "intellectual property" as defined in Bankruptcy Code section 101(35A): trade secrets, patents, patent applications, plant varieties, works of authorship protected under the Copyright Act, and mask works, but not trademarks, trade dress, domain names, and related rights. This is not intuitive, since trademarks certainly fit a plain English definition of "intellectual property."

2.No future rights. Bankruptcy Code section 365(n) allows the licensee to retain its rights "as such rights existed immediately before the case commenced" and does not allow for future specific performance, except for honoring an exclusivity provision. Therefore, if the license covers a continuing stream of intellectual property (for example, real-time content for a website or database), future improvements or enhancements (for example, a software license), or future services (for example, support, maintenance and training), Bankruptcy Code section 365(n) does not apply. Meanwhile, this unprotected matter can represent most of the license's value. For example, for a license to real-time national news footage, section 365(n) allows the licensee to keep its pre-existing content, which would quickly become stale, and the licensee would receive no future news footage after the licensor's bankruptcy date.

3.No future license. The license agreement must be valid and effective prior to the licensor's bankruptcy to merit Bankruptcy Code section 365(n) protection. In In re Storm Technology Inc. , the court held that a "springing" patent license - it was to "spring" into effect if the licensor did not repay a corporate note on time - was not covered by Bankruptcy Code section 365(n). The licensor had declared bankruptcy before the note's maturity date, and therefore the licensee had only a contingent right to a license, not an actual license, at that time.

4."Supplementary" agreements required. Bankruptcy Code section 365(n) protects the main intellectual property license and agreements "supplementary to" it. For example, a source code escrow agreement should be deemed supplementary to a software license, because it allows the licensee to retrieve the code under certain conditions specified in the main license. It is unclear what agreements will be deemed sufficiently "supplementary" by a bankruptcy court to merit Section 365(n) protection.