Opinion Casts Doubt on Licensees' Ability to Protect Licenses

Ever since '365(n) was added to the U.S. Bankruptcy Code in 1988, a party with a license to use intellectual property ' defined to include patents and copyrights but not trademarks ' could rest assured that a bankruptcy filing by the licensor would not divest them of their right to use the property. Section 365(n) expressly provides that the rejection of an intellectual property license allows the licensee to retain its rights under the license, including the right to enforce any exclusivity provision. But a 2003 decision by the Seventh U.S. Circuit Court of Appeals, Precision Industries Inc. v. Qualitech Steel SBQ, LLC, casts serious doubt on the ability of licensees to protect their licenses under '365(n).

Section 365(n) was Congress' response to an earlier decision, Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc. (In re Richmond Metal Finishers Inc.), decided by the Fourth U.S. Circuit Court of Appeals in 1985. In Lubrizol, the Fourth Circuit allowed a debtor to reject a metal coating technology license as an executory contract that was burdensome to the estate.

The motivation for the debtor's rejection of the license agreement was to 'facilitate sale or licensing of the technology unhindered by restrictive covenants in the ' agreement,' according to the court's opinion in Lubrizol. Congress responded with the Intellectual Property Bankruptcy Protection Act of 1988. Through the enactment of '365(n), Congress intended 'to make clear that the rights of an intellectual-property licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license pursuant to '365 in the event of the licensor's bankruptcy.'

Section 365(n) does not prohibit a bankrupt licensor from rejecting an intellectual property license. Instead, '365(n) specifies the licensee's rights if the license agreement is rejected by the licensor. If the license agreement is rejected, the licensee has two choices. Under most circumstances, it can treat the license as terminated and assert a claim for damages against the debtor. Or it can elect to retain its rights under the agreement for the duration of the license including any option periods.

If the licensee elects to retain its rights, it must make royalty payments to the debtor (or trustee) for the duration of the license and is deemed to waive all setoff rights and administrative claims. This allows the licensee to continue using the intellectual property while relieving the licensor of burdensome obligations under the license, such as maintenance and support.

But the Seventh Circuit's decision in Precision Industries calls this protective scheme into question. In Precision Industries, the issue was '365(h), which provides that a tenant under a real-property lease may elect to retain its possessory rights if the debtor-landlord rejects the lease in bankruptcy, much like '365(n) does with intellectual property licenses.

According to the opinion, the debtor, Qualitech Steel, leased a portion of its real property to Precision Industries, which constructed a warehouse under an unrecorded ground lease. After filing for bankruptcy, Qualitech sought to sell its interest in the real property under '363(f), which allows a debtor to sell property 'free and clear of any interest in such property.' The tenant, Precision Industries, did not object to the sale. The bankruptcy court approved the sale 'free and clear of all liens, claims, encumbrances and interests.'

Following the sale, the new owner barred Precision Industries from the property, the opinion noted. Precision Industries sued, alleging trespass, breach of contract, conversion and wrongful eviction. The bankruptcy court held that the sale under '363(f) was free and clear of all interests, including Precision Industries' possessory interest as a tenant. The district court reversed, holding that the sale did not terminate Precision Industries' interest given the express language of '365(h).

Reversal of Fortune

The Seventh Circuit reversed the district court's decision for a variety of reasons. The Seventh Circuit noted in its opinion that the term 'interests' in '363(f) must be broadly construed to include a tenant's possessory interest under a real-property lease. The court also noted that '365(h) provides protection to tenants only if the lease is 'rejected,' as opposed to being sold.

Finally, the court observed that the rules of statutory construction require statutory provisions to be construed so that one does not supersede the other, and the only way to do that is to construe '365(h) narrowly.

The holding in Precision Industries easily could extend to '365(n). If a licensor seeks to sell intellectual property free and clear of interests under '363(f), the licensee's interest would be repudiated under the Seventh Circuit's logic, despite the protections supposedly afforded by '365(n). This appears to be at odds with Congress' intent in enacting '365(n), especially considering that the debtor's motivation in Lubrizol was to facilitate a sale of the underlying technology 'unhindered by restrictive covenants.'

Barring further amendment by Congress or reversal by the U.S. Supreme Court, Precision Industries jeopardizes a licensee's ability to retain its rights under a license agreement if the underlying property is sold under '363(f).

As with much of the law, the ultimate resolution of this issue will have to be left to the courts, unless Congress clarifies this conflict through further amendment of the Bankruptcy Code. But for now, licensees should be wary. Section 365(n) may provide little or no protection to their intellectual-property licenses.

This article originally appeared in the Texas Lawyer, an American Lawyer Media publication.

William B. Finkelstein and James H. Billingsley are partners in Dallas' Hughes & Luce. They both practice bankruptcy, insolvency and creditors' rights law. Mr. Finkelstein is the chairman of the firm's bankruptcy and business reorganization section.

Ever since '365(n) was added to the U.S. Bankruptcy Code in 1988, a party with a license to use intellectual property ' defined to include patents and copyrights but not trademarks ' could rest assured that a bankruptcy filing by the licensor would not divest them of their right to use the property. Section 365(n) expressly provides that the rejection of an intellectual property license allows the licensee to retain its rights under the license, including the right to enforce any exclusivity provision. But a 2003 decision by the Seventh U.S. Circuit Court of Appeals, Precision Industries Inc. v. Qualitech Steel SBQ, LLC, casts serious doubt on the ability of licensees to protect their licenses under '365(n).

Section 365(n) was Congress' response to an earlier decision, Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc. (In re Richmond Metal Finishers Inc.), decided by the Fourth U.S. Circuit Court of Appeals in 1985. In Lubrizol, the Fourth Circuit allowed a debtor to reject a metal coating technology license as an executory contract that was burdensome to the estate.

The motivation for the debtor's rejection of the license agreement was to 'facilitate sale or licensing of the technology unhindered by restrictive covenants in the ' agreement,' according to the court's opinion in Lubrizol. Congress responded with the Intellectual Property Bankruptcy Protection Act of 1988. Through the enactment of '365(n), Congress intended 'to make clear that the rights of an intellectual-property licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license pursuant to '365 in the event of the licensor's bankruptcy.'

Section 365(n) does not prohibit a bankrupt licensor from rejecting an intellectual property license. Instead, '365(n) specifies the licensee's rights if the license agreement is rejected by the licensor. If the license agreement is rejected, the licensee has two choices. Under most circumstances, it can treat the license as terminated and assert a claim for damages against the debtor. Or it can elect to retain its rights under the agreement for the duration of the license including any option periods.

If the licensee elects to retain its rights, it must make royalty payments to the debtor (or trustee) for the duration of the license and is deemed to waive all setoff rights and administrative claims. This allows the licensee to continue using the intellectual property while relieving the licensor of burdensome obligations under the license, such as maintenance and support.

But the Seventh Circuit's decision in Precision Industries calls this protective scheme into question. In Precision Industries, the issue was '365(h), which provides that a tenant under a real-property lease may elect to retain its possessory rights if the debtor-landlord rejects the lease in bankruptcy, much like '365(n) does with intellectual property licenses.

According to the opinion, the debtor, Qualitech Steel, leased a portion of its real property to Precision Industries, which constructed a warehouse under an unrecorded ground lease. After filing for bankruptcy, Qualitech sought to sell its interest in the real property under '363(f), which allows a debtor to sell property 'free and clear of any interest in such property.' The tenant, Precision Industries, did not object to the sale. The bankruptcy court approved the sale 'free and clear of all liens, claims, encumbrances and interests.'

Following the sale, the new owner barred Precision Industries from the property, the opinion noted. Precision Industries sued, alleging trespass, breach of contract, conversion and wrongful eviction. The bankruptcy court held that the sale under '363(f) was free and clear of all interests, including Precision Industries' possessory interest as a tenant. The district court reversed, holding that the sale did not terminate Precision Industries' interest given the express language of '365(h).

Reversal of Fortune

The Seventh Circuit reversed the district court's decision for a variety of reasons. The Seventh Circuit noted in its opinion that the term 'interests' in '363(f) must be broadly construed to include a tenant's possessory interest under a real-property lease. The court also noted that '365(h) provides protection to tenants only if the lease is 'rejected,' as opposed to being sold.

Finally, the court observed that the rules of statutory construction require statutory provisions to be construed so that one does not supersede the other, and the only way to do that is to construe '365(h) narrowly.

The holding in Precision Industries easily could extend to '365(n). If a licensor seeks to sell intellectual property free and clear of interests under '363(f), the licensee's interest would be repudiated under the Seventh Circuit's logic, despite the protections supposedly afforded by '365(n). This appears to be at odds with Congress' intent in enacting '365(n), especially considering that the debtor's motivation in Lubrizol was to facilitate a sale of the underlying technology 'unhindered by restrictive covenants.'

Barring further amendment by Congress or reversal by the U.S. Supreme Court, Precision Industries jeopardizes a licensee's ability to retain its rights under a license agreement if the underlying property is sold under '363(f).

As with much of the law, the ultimate resolution of this issue will have to be left to the courts, unless Congress clarifies this conflict through further amendment of the Bankruptcy Code. But for now, licensees should be wary. Section 365(n) may provide little or no protection to their intellectual-property licenses.

This article originally appeared in the Texas Lawyer, an American Lawyer Media publication.

William B. Finkelstein and James H. Billingsley are partners in Dallas' Hughes & Luce. They both practice bankruptcy, insolvency and creditors' rights law. Mr. Finkelstein is the chairman of the firm's bankruptcy and business reorganization section.