Bankruptcy: What Happens to the Royalty Payments?

The Bankruptcy Court approved the sale of CellNet's assets to Schlumberger, free and clear of all liens, except that the court recognized BCN's right to continue to use the licensed intellectual property under '365(n) of the Bankruptcy Code for the term of the licenses, so long as BCN paid royalties. Bechtel, the other venture partner of BCN, then acquired the assets and liabilities of BCN from CellNet and made a $2.25 million lump sum payment for the future royalties, which the parties placed in escrow to await the resolution of the royalty ownership issue.

Schlumberger argued that its exclusion of the licenses from the asset purchase agreement did not constitute a technical separation of the right to receive royalties from Schlumberger's underlying ownership of the licensed intellectual property. Schlumberger also contended that CellNet's rejection of the executory license under '365(a) of the Bankruptcy Code gave Schlumberger superior rights to the royalties, as CellNet was no longer a party to the licenses. Both the Bankruptcy Court and the U.S. District Court for the District of Delaware disagreed and awarded the royalties to CellNet's bankruptcy estate.

The Appeals Court affirmed those decisions, rejecting both of Schlumberger's arguments. The court concluded that the asset purchase agreement (drafted by Schlumberger) was not ambiguous and provided the “express reservation” required by case law to separate the ownership of the intellectual property from the right to receive royalties from licenses of that intellectual property. The court disagreed with Schlumberger that, in this case, the right to receive the royalties was inherent in the ownership of the intellectual property and that the language used in the agreement excluding the licenses from the purchased assets was insufficient to separate the right to receive royalties from the ownership of the intellectual property.

The court also rejected Schlumberger's claim that the agreement language was ambiguous. Under the applicable New York law, ambiguity does not exist “simply because the parties urge different interpretations.” Hugo Boss Fashions v. Federal Insurance Co., 252 F3d 608, 616 (2d Cir. 2001). Schlumberger's election in the agreement to exclude all proceeds from the BCN licenses constituted a proper “express reservation” to separate the royalties from the intellectual property purchased from CellNet. Moreover, the court found that CellNet had excluded from the “bundle of rights” sold to Schlumberger the exclusive right to use the intellectual property outside the United States.

Although rejecting an executory contract under '365(a) normally ends all obligations between the parties and makes the nonbreaching party an unsecured creditor for any damages caused by the rejection, licensees of intellectual property are placed in a better position under the Bankruptcy Code. Section 365(n) allows such licensees to elect to retain their rights after the debtor's rejection of a license by paying the royalties for the duration of the license and any extended period provided as of right.

Because BCN elected to retain its rights under the licenses and tendered the royalty payments, CellNet was entitled to receive the royalties despite its rejection of the licenses. Although CellNet was technically no longer a party to the licenses, the royalties were still its property despite the transfer of the underlying intellectual property assets to Schlumberger.

The court determined that the licenses were the property of the bankruptcy estate after Schlumberger excluded them from the asset purchase agreement and before CellNet rejected them. CellNet's rejection of the licenses under '365(a) did not extinguish the rights of those contracts after BCN made its election to retain its rights under '365(n).

The plain language of '365(n), the court noted, contemplates that the licensee and the bankruptcy trustee will have a continuing relationship, including the trustee's right to receive royalties. In this case, as debtor-in-possession, CellNet stood in place of the trustee.

In a decision interpreting for the first time certain provisions in the Bankruptcy Code, the Third Circuit Court of Appeals concluded that royalty payments belonged to the estate of the bankrupt debtor/licensor rather than to the new owner by assignment of the underlying intellectual property covered by the licenses. In re CellNet Data Systems, Inc., 327 F.3d 242 (3d Cir. 2003). The Third Circuit held that the debtor/licensor was permitted to sever the right to receive the remaining royalty payments due on the license from the transfer of the underlying intellectual property rights.

CellNet Data Systems and Bechtel Enterprises, Inc. formed a joint venture called BCN Data Systems LLC. CellNet granted BCN exclusive licenses to use CellNet's intellectual property outside the United States and promised technological support to BCN.

When CellNet later became insolvent, it entered into an asset purchase proposal with Schlumberger Resource Management Services, Inc., under which CellNet was to transfer all or substantially all of its assets and business operation to Schlumberger, including the intellectual property licensed to BCN. However, in the proposal Schlumberger reserved the right to exclude certain later-defined assets from the asset purchase agreement to be negotiated. That agreement was signed shortly after CellNet filed for bankruptcy. Schlumberger specifically excluded the BCN licenses from the assets purchased from CellNet. However, CellNet and Schlumberger disagreed about who would receive the royalties from the BCN licenses. They provided in their agreement that the Bankruptcy Court would resolve the dispute. CellNet agreed that it would reject the licenses in the bankruptcy as executory contracts that it could not fulfill, under '365(a) of the Bankruptcy Code.

The Bankruptcy Court approved the sale of CellNet's assets to Schlumberger, free and clear of all liens, except that the court recognized BCN's right to continue to use the licensed intellectual property under '365(n) of the Bankruptcy Code for the term of the licenses, so long as BCN paid royalties. Bechtel, the other venture partner of BCN, then acquired the assets and liabilities of BCN from CellNet and made a $2.25 million lump sum payment for the future royalties, which the parties placed in escrow to await the resolution of the royalty ownership issue.

Schlumberger argued that its exclusion of the licenses from the asset purchase agreement did not constitute a technical separation of the right to receive royalties from Schlumberger's underlying ownership of the licensed intellectual property. Schlumberger also contended that CellNet's rejection of the executory license under '365(a) of the Bankruptcy Code gave Schlumberger superior rights to the royalties, as CellNet was no longer a party to the licenses. Both the Bankruptcy Court and the U.S. District Court for the District of Delaware disagreed and awarded the royalties to CellNet's bankruptcy estate.

The Appeals Court affirmed those decisions, rejecting both of Schlumberger's arguments. The court concluded that the asset purchase agreement (drafted by Schlumberger) was not ambiguous and provided the “express reservation” required by case law to separate the ownership of the intellectual property from the right to receive royalties from licenses of that intellectual property. The court disagreed with Schlumberger that, in this case, the right to receive the royalties was inherent in the ownership of the intellectual property and that the language used in the agreement excluding the licenses from the purchased assets was insufficient to separate the right to receive royalties from the ownership of the intellectual property.

The court also rejected Schlumberger's claim that the agreement language was ambiguous. Under the applicable New York law, ambiguity does not exist “simply because the parties urge different interpretations.” Hugo Boss Fashions v. Federal Insurance Co. , 252 F3d 608, 616 (2d Cir. 2001). Schlumberger's election in the agreement to exclude all proceeds from the BCN licenses constituted a proper “express reservation” to separate the royalties from the intellectual property purchased from CellNet. Moreover, the court found that CellNet had excluded from the “bundle of rights” sold to Schlumberger the exclusive right to use the intellectual property outside the United States.

Although rejecting an executory contract under '365(a) normally ends all obligations between the parties and makes the nonbreaching party an unsecured creditor for any damages caused by the rejection, licensees of intellectual property are placed in a better position under the Bankruptcy Code. Section 365(n) allows such licensees to elect to retain their rights after the debtor's rejection of a license by paying the royalties for the duration of the license and any extended period provided as of right.

Because BCN elected to retain its rights under the licenses and tendered the royalty payments, CellNet was entitled to receive the royalties despite its rejection of the licenses. Although CellNet was technically no longer a party to the licenses, the royalties were still its property despite the transfer of the underlying intellectual property assets to Schlumberger.

The court determined that the licenses were the property of the bankruptcy estate after Schlumberger excluded them from the asset purchase agreement and before CellNet rejected them. CellNet's rejection of the licenses under '365(a) did not extinguish the rights of those contracts after BCN made its election to retain its rights under '365(n).

The plain language of '365(n), the court noted, contemplates that the licensee and the bankruptcy trustee will have a continuing relationship, including the trustee's right to receive royalties. In this case, as debtor-in-possession, CellNet stood in place of the trustee.