Protecting Interests If Another Company Files for Bankruptcy

As the Boy Scouts say: “Be Prepared.” And in today's economic climate, that means prepare in advance ' when a contract is entered into ' to protect yourself in case the other entertainment-industry party declares bankruptcy. This requires a basic understanding of the extraordinary protections and rights that are afforded to debtors in a bankruptcy, particularly the right to void unperfected security interests (see the first installment of this article in the December 2008 issue of Entertainment Law & Finance) and to terminate executory contracts. So forewarned is forearmed.

Executory Contracts

Section 365 of the Bankruptcy Code sets forth special rules, discussed below, that apply to “executory contracts” (as defined therein), including rules that: a) permit the debtor to elect to either “assume” or “reject” such contracts; b) permit executory contracts to be sold by the debtor to third parties notwithstanding any non-assignment provisions in the contract (unless the contract is non-assignable by law); and c) permit a non-debtor/licensee to retain certain rights under an executory license granted by a debtor/licensor.

Definition

A threshold question for all of the issues mentioned above is whether or not the contract is “executory” within the meaning of the Bankruptcy Code. Most courts purport to apply the “Countryman test,” which was proposed by Professor Countryman in a law review article. V. Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439 (1973). Under this test, a contract is executory if a breach of the remaining obligations by both parties would constitute a material breach, such that failure to perform such obligations by one party would permit the other party to terminate the contract (a “Termination Right”). At least that's the theory. In practice, the courts don't actually follow through applying that analysis at all, the cases are hopelessly muddled and the majority of courts simply treat all licenses as “executory” without applying any logical analysis.

Consequence if Executory Contract

If a contract is deemed to be executory, generally the debtor can elect to “assume” or “reject” the contract. The debtor cannot pick and choose provisions to assume or reject within one contract but must assume or reject the entire contract. See, e.g., In re Rovine Corp., 6 B.R. 661 (Bankr. W.D. Tenn. 1980); In re Klaber Bros. Inc., 173 F.Supp. 83 (S.D.N.Y. 1959).

Assumption

If the debtor assumes the contract, it must cure all past defaults and must prove its ability to comply with its future obligations under the contract. Importantly, the debtor is prohibited from assuming the contract unless the contract could be assigned to a third party outside of bankruptcy (ignoring any anti-assignment language in the contract). See, Bankruptcy Code Section 365(c)(1); In re Sunterra Corporation, 361 F.3d 257 (4th Cir. 2004). But see, In re James Cable Partners L.P., 148 B.R. 59 (Bkrtcy. M.D. Ga. 1992).

Some cases have held that a license (even if exclusive) of rights to a U.S. Copyright is not assignable unless the license expressly permits assignment (see, Gardner v. Nike Inc., 279 F.3d 774 (9th Cir. 2002); Harris v. Emus Records Corp., 734 F.2d 1329 (9th Cir. 1984)), and literal application of these cases would prevent a debtor from assuming such licenses (see, In re Sunterra Corporation, 361 F.3d 257 (4th Cir. 2004) (indeed, this case held that the contract had to expressly permit assumption in a bankruptcy to permit such assumption)). Similar rules apply to trademarks. See, Tap Publications Inc. v. Chinese Yellow Pages (New York) Inc., 924 F.Supp. 212, 218 (S.D.N.Y. 1996); In Re Travelot Co., 286 B.R. 447, 455 (S.D.G.A. 2002); Raufast S.A. v. Kicker's Pizzazz Ltd., 208 U.S.P.Q. 699 (E.D.N.Y. 1980); Miller and CMJ Worldwide Inc. v. Glenn Miller Productions, 318 F.Supp.2d 923 (C.D. Cal. 2004).

Where one party has a special skill, ability, knowledge or other personal quality that was a material inducement to the contract, the law implies that that party may not assign the contract unless the contract expressly permits assignment. See, Knipe v. Barkdull, 35 Cal.Rptr. 283 (Cal. Ct. App. 1963); Coykendall v. Jackson, 62 P.2d 746 (Cal. Ct. App. 1936) (a contract which grants an exclusive right to purchase and distribute the entire output of a factory to a party who agrees to devote his entire time and attention to advertising and selling such products, cannot be assigned so as to substitute another to perform those undertakings). Under this line of cases, a contract retaining the services of the debtor as a sales agent should be non-assignable and, therefore, non-assumable by the debtor.

Licenses often provide that the licensee assumes the obligation to pay participations owed to talent or residuals to guilds. If a debtor/licensee assumes the license, talent may argue that the licensee must therefore assume the obligation to pay talent if provided for in the license. In In re Gardinier Inc.,
831 F.2d 974 (11th Cir. 1987), cert. denied, 488 U.S. 853 (1988), the court held that a debtor could assume an executory contract to sell property to a third party, without assuming a contractual obligation to pay a broker, even if provided for in the sale agreement. The court held that the obligation to pay the broker was separate from the obligation to sell the property and that the debtor could assume one without the other. By direct analogy, a licensee should be able to assume an executory license without assuming the obligation to pay participations owed to talent or residuals to guilds.

Rejection

Rejection of an executory contract is treated as a breach of the contract retroactive to the moment before the bankruptcy filing. Because the breach is deemed to occur immediately before the bankruptcy filing date, any damages arising from the breach are treated in the same manner as all other pre-petition unsecured claims against the debtor.

• By Licensee. A rejection of an executory license by a debtor/licensee is no more than an election by the debtor/licensee to breach the license. Technically, this breach should not, in and of itself, rescind or terminate the license with a reversion of the licensed rights to the licensor. However, most bankruptcy cases equate rejection with termination and treat a “rejected” license as terminated.
• By Licensor. Section 365(n) of the Bankruptcy Code deals with the effect of the rejection by a debtor/licensor of an executory license of “intellectual property.” Section 101(56)(E) of the Bankruptcy Code defines “intellectual property” as including a “work of authorship protected under Title 17 [of the Copyright Act].” Applying the plain meaning of the statute, this provision does not apply to Foreign Copyrights, but the courts have overlooked this detail and are likely to continue to do so. In re EI International, 123 B.R. 64 (B.K. D. Idaho 1991) (applying Sec. 365(n) to Foreign Copyright without analysis).

If a debtor/licensor rejects an executory license, the licensee may elect under Section 365(n) to retain its rights under the license for the duration of the license. Section 365(n) is based on the assumption that, but for its provisions, rejection of an executory license by a debtor/licensor results in an automatic reversion of the licensed rights to the licensor. This assumption is technically incorrect (since rejection is just a deemed breach, not a rescission), but most courts adopt this assumption. Section 365(n) does not apply to non-executory licenses on the assumption that the debtor could not terminate such licenses, and this assumption is also incorrect. However, it would be anomalous for non-executory licenses to be given less protection than executory licenses, so it is likely that the courts will either hold that the debtor cannot terminate a non-executory license or will apply Section 365(n) even to non-executory licenses.

A licensee can elect to retain its rights under a license under Section 365(n) only “as such rights existed immediately before the case commenced.” Section 365(n)(1)(B). Thus, any rights granted a licensee for films completed post-petition would not be subject to the provisions of Section 365(n). This means that the debtor/licensor's rejection of the license would deprive the licensee of any rights to films not completed as of the bankruptcy filing date.

Consequence if Not Executory Contract

A finding that a contract is not executory can have a significant practical impact to the licensee, because the prohibition on the assumption of an executory contract won't apply. In addition, if the debtor breaches a non-executory contract while the bankruptcy proceeding is pending, the other party may be entitled to specific performance and any damages may be entitled to administrative priority status.

If the license is not executory, and if the debtor/licensee breaches the license, the licensor's rights depend on the terms of the license. Licenses generally have three different standard approaches for dealing with a payment default by a licensee:

1. Sometimes the license expressly states that it may not be terminated by the licensor for any reason, including payment default by the licensee, and that the licensor's sole remedy is to bring a damage action against the licensee. This type of provision should end the inquiry, as the licensor would have no right to terminate the license.
2. Sometimes the license expressly states that the licensor has a Termination Right upon a payment default by the licensee, perhaps after a notice-and-cure period. This type of provision would permit the licensor to terminate the license.
3. If the contract is silent on the issue of termination for breach by the licensee, then under the default rules of most states, the licensor has a Termination Right if either: a) a required advance minimum guarantee is not paid; or b) there is no required advance minimum guarantee under the license and there is a complete failure to pay royalties. See, Nolan v. Sam Fox Publishing Co., 499 F.2d 1394 (2d Cir. 1974) (failure to pay 74% of royalties due was not a material breach); Septembertide Publishing B.V. v. Stein and Day Inc., 884 F.2d 675 (2d Cir. 1989) (failure to pay 33% of royalties due was not a material breach); Fain v. Irving Trust Co. (In re Waterson, Berlin & Snyder Co.), 48 F.2d 704 (2d Cir. 1931); Lucerne Prods. Inc. v. Skil Corp., 489 F.Supp. 1128 (N.D. Ohio 1980); Crane Co. v. Aeroquip Corp., 356 F.Supp. 733 (N.D. Ill. 1973); In re Amica Inc., 135 B.R. 534 (Bankr. N.D. Ill. 1992) (failure to pay royalties, when there was only a $5,000 advance, was substantial and fundamental breach, terminating license); Peterson v. Highland Music, 140 F.3d 1313 (9th Cir. 1998) (failure to pay contingent royalties, when there was no advance, permitted rescission); Hustlers Inc. v. Thomasson, 307 F.Supp.2d 1375 (N.D. Ga. 2004) (failure to pay any further royalties permitted termination, even though royalties had been paid for prior 25 years). On the other hand, if the license requires an advance minimum guarantee and it has been paid, then the default rule of most states is that the licensor does not have a Termination Right for any other breaches by the licensee, including a failure to pay royalties.

As long as the licensor has a valid termination right, it should be able to enforce that right against the licensee, although it will generally require court approval to do so unless the contract terminates automatically without the requirement of even giving notice to the licensee. If the licensor prevails over the debtor/licensee and the licensed rights revert to the licensor, then the debtor/licensee must pay the licensor an amount equal to the benefit to the debtor/licensee from the use of the licensed rights for the period commencing from the date of the bankruptcy filing through the date of the actual reversion of the rights to the licensor. Bankruptcy Code Sec. 503(b)(1)(A). This obligation is an administrative priority that is paid before the payment of any unsecured claims. The amount of the benefit to the debtor/licensee is usually, but not necessarily, determined under the license.

Protective Security Interests

Because of the risk to each party to a license of a termination or breach of the license in a bankruptcy of the other party, both parties may want to obtain a protective security interest in the other party's interest in the license and the licensed rights. The courts have held that a security interest is not “executory,” and thus cannot be rejected, even if it is contained within an otherwise executory contract. See, Jenson v. Continental Financing Corp., 591 F.2d 477 (8th Cir. 1979); Leasing Service Corp. v. First Tennessee Bank Nat'l Ass'n, 826 F.2d 434 (6th Cir. 1987); In re Middleton, 3 B.R. 610 (Bankr. E.D. Pa. 1980); Weil v. Lansburgh (In re Garfinkle), 577 F.2d 901 (5th Cir. 1978). A more precise analysis, which reaches the same result, is that even if a security interest is “executory,” rejection of an executory contract does not in itself affect property rights, such as a security interest.

Summary of Protection for Licensors and Licensees

Licensors

To protect themselves against a potential bankruptcy of a licensee, licensors should consider adopting all or some of the following protective strategies:

• Instead of making the third party a licensee and entering into a license, attempt to appoint the third party as a sales agent performing services for a commission and have the licenses run directly from the licensor to the next level in the distribution chain. Have revenues placed in a segregated trust account, with the sales agent taking a commission, and the balance remitted to the licensor.
• Put an express Termination Right in the license.
• If a short-form assignment is recorded, make sure it references the license itself in order to incorporate the Termination Right.
• Structure the transaction as a license for a limited term and not as a “sale” in perpetuity.
• Obtain a protective security interest in the licensed rights and in the licensee's interest in the license.

Licensees

To protect themselves against a potential bankruptcy of a licensor, licensees should consider adopting all or some of the following protective strategies:

• Do not accept appointment as a sales agent; insist on receiving a grant of rights.
• Make sure that the license expressly states that it is exclusive and assignable.
• Do not permit the license to contain a Termination Right, and have the license expressly state that it will not terminate for any reason.
• Record the license (or a short-form assignment that refers to the license) in the U.S. Copyright Office and in the major foreign countries that have a recording system.
• Structure the transaction as a “sale” of the rights in perpetuity, instead of as a license for a limited term.

Automatic Stay

The moment a debtor declares bankruptcy, it is protected by an invisible force field called the “automatic stay,” which halts all further actions against the debtor, such as foreclosures, court litigation and arbitrations. It halts third parties from taking any actions that interfere with, or attempt to collect from, the debtor, including giving advance notice of termination of a license to the debtor if the license has an advance notice and cure period. For this reason, it is preferable for licensors to provide for automatic termination of a license ' without notice having to be given to the licensee ' upon specified breaches by the licensee.

Ipso Facto Clauses

The Bankruptcy Act voids any clauses that purport to terminate a contract upon the bankruptcy or insolvency of the debtor, although a contract may accelerate any remaining payment obligations upon the occurrence of such events. One way to potentially reach the same result is to have a key-man clause, since key personnel often leave in a bankruptcy.

Voidable Preferences

Under Bankruptcy Code Section 547(b), the debtor can rescind a prior “transfer” (subject to certain exceptions) if: a) the transfer is made to or for the benefit of a creditor on account of an “antecedent” debt; b) the transfer is made while the debtor was insolvent; c) the transfer is made within the 90-day period before the bankruptcy filing (or within one year if the creditor is an “insider”); and d) the creditor receives more than it would otherwise receive in the bankruptcy.

The term “transfer” includes not only the payment of cash, but also the perfection of a security interest in the debtor's assets. Therefore, the perfection of a security interest in a film is a “transfer” that may be voided if the other conditions are met. A security interest is treated as a “transfer” on the date of its creation as long as it is perfected within the relevant grace period. Under the Copyright Act, perfection within one month of grant of the security interest is treated as occurring at the time of grant. See, Copyright Act Sec. 205(d); Bankruptcy Code Sec. 547(e)(1)(B). The Bankruptcy Code, however, provides for only a 10-day grace period (Sec. 547(e)(2)), and the court in In re AEG Acquisition Corp., 127 B.R. 34 (Bankr. C.D. Cal. 1991), aff'd, 161 B.R. 50 (9th Cir. BAP 1993), held that the Bankruptcy Code 10-day grace period governed a security interest in a film copyright without discussing the specific Copyright Act 30-day grace period.

In the case of U.S. Copyrights, perfection requires, depending on which cases govern, either: a) a Uniform Commercial Code (UCC) filing, if the work is not registered in the Copyright Office; or b) recording of the security interest and registration of the work in the Copyright Office. (See the discussion in Part One of this article.)

When perfection is made to secure a revolving line of credit that has been fully used up, such as when the debtor continues to produce or acquire new films, the lender will perfect by recording its security interest against those films, but this perfection is for an antecedent debt and the lender is not extending new value in the way of additional loans. Thus, as long as the other requirements are met, the perfection of the security interest would be voidable.

Fraudulent Conveyance

The debtor may also rescind any transfers that occur generally within four years (depending on state law) prior to the bankruptcy if one of the following two conditions is met:

1. The transfer was made for less than adequate consideration at a time when the debtor was insolvent; or
2. The transfer was made with the intent to hinder or delay creditors.

These transfers are referred to as “fraudulent transfers.” The intent of this provision is to protect the debtor from selling assets at a fire-sale price due to financial pressures.

Post-Petition Property

In General

Section 552(a) of the Bankruptcy Code provides that, except as limited by subsection (b), “property acquired by the estate after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.” Section 552(b) permits security agreements to remain effective as to after-acquired property that is “proceeds, product, offspring, rents or profits” of pre-petition collateral.

Royalties

If post-petition royalties are received pursuant to licenses in place on the date of the bankruptcy filing and the creditor has a security interest in the licenses, the future royalties probably are “proceeds.” See, J. Catton Farms Inc. v. First Nat'l Bank of Chicago, 779 F.2d 1242 (7th Cir. 1985) (payments to farmer under U.S. payment-in-kind contract were “proceeds”); United Virginia Bank v. Slab Fork Coal Co., 784 F.2d 1188 (4th Cir. 1985), cert. denied, 477 U.S. 905 (1986) (payments under contract to sell coal were “proceeds”); In re James Cable Partners L.P., (Bankr. M.D. Ga. 1992) CCH 74,667 (payments under pre-petition cable subscriber contracts were “proceeds,” while payments under contracts entered into post-petition were not).

On the other hand, if the royalties are generated from contracts entered into after the bankruptcy filing or the creditor does not have a security interest in the contracts, the royalties should not constitute “proceeds.” See, Northview, 130 B.R. at 546 (hotel revenues were not “proceeds” of hotel); In re S & J Holding Corp., 42 B.R. 249 (Bankr. S.D. Fla. 1984) (revenues from video games used by the public were not “proceeds” of the video games).

As the Boy Scouts say: “Be Prepared.” And in today's economic climate, that means prepare in advance ' when a contract is entered into ' to protect yourself in case the other entertainment-industry party declares bankruptcy. This requires a basic understanding of the extraordinary protections and rights that are afforded to debtors in a bankruptcy, particularly the right to void unperfected security interests (see the first installment of this article in the December 2008 issue of Entertainment Law & Finance) and to terminate executory contracts. So forewarned is forearmed.

Executory Contracts

Section 365 of the Bankruptcy Code sets forth special rules, discussed below, that apply to “executory contracts” (as defined therein), including rules that: a) permit the debtor to elect to either “assume” or “reject” such contracts; b) permit executory contracts to be sold by the debtor to third parties notwithstanding any non-assignment provisions in the contract (unless the contract is non-assignable by law); and c) permit a non-debtor/licensee to retain certain rights under an executory license granted by a debtor/licensor.

Definition

A threshold question for all of the issues mentioned above is whether or not the contract is “executory” within the meaning of the Bankruptcy Code. Most courts purport to apply the “Countryman test,” which was proposed by Professor Countryman in a law review article. V. Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439 (1973). Under this test, a contract is executory if a breach of the remaining obligations by both parties would constitute a material breach, such that failure to perform such obligations by one party would permit the other party to terminate the contract (a “Termination Right”). At least that's the theory. In practice, the courts don't actually follow through applying that analysis at all, the cases are hopelessly muddled and the majority of courts simply treat all licenses as “executory” without applying any logical analysis.

Consequence if Executory Contract

If a contract is deemed to be executory, generally the debtor can elect to “assume” or “reject” the contract. The debtor cannot pick and choose provisions to assume or reject within one contract but must assume or reject the entire contract. See, e.g., In re Rovine Corp., 6 B.R. 661 (Bankr. W.D. Tenn. 1980); In re Klaber Bros. Inc., 173 F.Supp. 83 (S.D.N.Y. 1959).

Assumption

If the debtor assumes the contract, it must cure all past defaults and must prove its ability to comply with its future obligations under the contract. Importantly, the debtor is prohibited from assuming the contract unless the contract could be assigned to a third party outside of bankruptcy (ignoring any anti-assignment language in the contract). See, Bankruptcy Code Section 365(c)(1); In re Sunterra Corporation, 361 F.3d 257 (4th Cir. 2004). But see, In re James Cable Partners L.P., 148 B.R. 59 (Bkrtcy. M.D. Ga. 1992).

Some cases have held that a license (even if exclusive) of rights to a U.S. Copyright is not assignable unless the license expressly permits assignment ( see , Gardner v. Nike Inc. , 279 F.3d 774 (9th Cir. 2002); Harris v. Emus Records Corp. , 734 F.2d 1329 (9th Cir. 1984)), and literal application of these cases would prevent a debtor from assuming such licenses ( see , In re Sunterra Corporation , 361 F.3d 257 (4th Cir. 2004) (indeed, this case held that the contract had to expressly permit assumption in a bankruptcy to permit such assumption)). Similar rules apply to trademarks. See , Tap Publications Inc. v. Chinese Yellow Pages (New York) Inc. , 924 F.Supp. 212, 218 (S.D.N.Y. 1996); In Re Travelot Co., 286 B.R. 447, 455 (S.D.G.A. 2002); Raufast S.A. v. Kicker's Pizzazz Ltd. , 208 U.S.P.Q. 699 (E.D.N.Y. 1980); Miller and CMJ Worldwide Inc. v. Glenn Miller Productions , 318 F.Supp.2d 923 (C.D. Cal. 2004).

Where one party has a special skill, ability, knowledge or other personal quality that was a material inducement to the contract, the law implies that that party may not assign the contract unless the contract expressly permits assignment. See , Knipe v. Barkdull , 35 Cal.Rptr. 283 (Cal. Ct. App. 1963); Coykendall v. Jackson , 62 P.2d 746 (Cal. Ct. App. 1936) (a contract which grants an exclusive right to purchase and distribute the entire output of a factory to a party who agrees to devote his entire time and attention to advertising and selling such products, cannot be assigned so as to substitute another to perform those undertakings). Under this line of cases, a contract retaining the services of the debtor as a sales agent should be non-assignable and, therefore, non-assumable by the debtor.

Licenses often provide that the licensee assumes the obligation to pay participations owed to talent or residuals to guilds. If a debtor/licensee assumes the license, talent may argue that the licensee must therefore assume the obligation to pay talent if provided for in the license. In In re Gardinier Inc.,
831 F.2d 974 (11th Cir. 1987), cert. denied , 488 U.S. 853 (1988), the court held that a debtor could assume an executory contract to sell property to a third party, without assuming a contractual obligation to pay a broker, even if provided for in the sale agreement. The court held that the obligation to pay the broker was separate from the obligation to sell the property and that the debtor could assume one without the other. By direct analogy, a licensee should be able to assume an executory license without assuming the obligation to pay participations owed to talent or residuals to guilds.

Rejection

Rejection of an executory contract is treated as a breach of the contract retroactive to the moment before the bankruptcy filing. Because the breach is deemed to occur immediately before the bankruptcy filing date, any damages arising from the breach are treated in the same manner as all other pre-petition unsecured claims against the debtor.

• By Licensee. A rejection of an executory license by a debtor/licensee is no more than an election by the debtor/licensee to breach the license. Technically, this breach should not, in and of itself, rescind or terminate the license with a reversion of the licensed rights to the licensor. However, most bankruptcy cases equate rejection with termination and treat a “rejected” license as terminated.
• By Licensor. Section 365(n) of the Bankruptcy Code deals with the effect of the rejection by a debtor/licensor of an executory license of “intellectual property.” Section 101(56)(E) of the Bankruptcy Code defines “intellectual property” as including a “work of authorship protected under Title 17 [of the Copyright Act].” Applying the plain meaning of the statute, this provision does not apply to Foreign Copyrights, but the courts have overlooked this detail and are likely to continue to do so. In re EI International, 123 B.R. 64 (B.K. D. Idaho 1991) (applying Sec. 365(n) to Foreign Copyright without analysis).

If a debtor/licensor rejects an executory license, the licensee may elect under Section 365(n) to retain its rights under the license for the duration of the license. Section 365(n) is based on the assumption that, but for its provisions, rejection of an executory license by a debtor/licensor results in an automatic reversion of the licensed rights to the licensor. This assumption is technically incorrect (since rejection is just a deemed breach, not a rescission), but most courts adopt this assumption. Section 365(n) does not apply to non-executory licenses on the assumption that the debtor could not terminate such licenses, and this assumption is also incorrect. However, it would be anomalous for non-executory licenses to be given less protection than executory licenses, so it is likely that the courts will either hold that the debtor cannot terminate a non-executory license or will apply Section 365(n) even to non-executory licenses.

A licensee can elect to retain its rights under a license under Section 365(n) only “as such rights existed immediately before the case commenced.” Section 365(n)(1)(B). Thus, any rights granted a licensee for films completed post-petition would not be subject to the provisions of Section 365(n). This means that the debtor/licensor's rejection of the license would deprive the licensee of any rights to films not completed as of the bankruptcy filing date.

Consequence if Not Executory Contract

A finding that a contract is not executory can have a significant practical impact to the licensee, because the prohibition on the assumption of an executory contract won't apply. In addition, if the debtor breaches a non-executory contract while the bankruptcy proceeding is pending, the other party may be entitled to specific performance and any damages may be entitled to administrative priority status.

If the license is not executory, and if the debtor/licensee breaches the license, the licensor's rights depend on the terms of the license. Licenses generally have three different standard approaches for dealing with a payment default by a licensee:

1. Sometimes the license expressly states that it may not be terminated by the licensor for any reason, including payment default by the licensee, and that the licensor's sole remedy is to bring a damage action against the licensee. This type of provision should end the inquiry, as the licensor would have no right to terminate the license.
2. Sometimes the license expressly states that the licensor has a Termination Right upon a payment default by the licensee, perhaps after a notice-and-cure period. This type of provision would permit the licensor to terminate the license.
3. If the contract is silent on the issue of termination for breach by the licensee, then under the default rules of most states, the licensor has a Termination Right if either: a) a required advance minimum guarantee is not paid; or b) there is no required advance minimum guarantee under the license and there is a complete failure to pay royalties. See , Nolan v. Sam Fox Publishing Co. , 499 F.2d 1394 (2d Cir. 1974) (failure to pay 74% of royalties due was not a material breach); Septembertide Publishing B.V. v. Stein and Day Inc. , 884 F.2d 675 (2d Cir. 1989) (failure to pay 33% of royalties due was not a material breach); Fain v. Irving Trust Co. (In re Waterson, Berlin & Snyder Co.), 48 F.2d 704 (2d Cir. 1931); Lucerne Prods. Inc. v. Skil Corp. , 489 F.Supp. 1128 (N.D. Ohio 1980); Crane Co. v. Aeroquip Corp. , 356 F.Supp. 733 (N.D. Ill. 1973); In re Amica Inc., 135 B.R. 534 (Bankr. N.D. Ill. 1992) (failure to pay royalties, when there was only a $5,000 advance, was substantial and fundamental breach, terminating license); Peterson v. Highland Music , 140 F.3d 1313 (9th Cir. 1998) (failure to pay contingent royalties, when there was no advance, permitted rescission); Hustlers Inc. v. Thomasson , 307 F.Supp.2d 1375 (N.D. Ga. 2004) (failure to pay any further royalties permitted termination, even though royalties had been paid for prior 25 years). On the other hand, if the license requires an advance minimum guarantee and it has been paid, then the default rule of most states is that the licensor does not have a Termination Right for any other breaches by the licensee, including a failure to pay royalties.

As long as the licensor has a valid termination right, it should be able to enforce that right against the licensee, although it will generally require court approval to do so unless the contract terminates automatically without the requirement of even giving notice to the licensee. If the licensor prevails over the debtor/licensee and the licensed rights revert to the licensor, then the debtor/licensee must pay the licensor an amount equal to the benefit to the debtor/licensee from the use of the licensed rights for the period commencing from the date of the bankruptcy filing through the date of the actual reversion of the rights to the licensor. Bankruptcy Code Sec. 503(b)(1)(A). This obligation is an administrative priority that is paid before the payment of any unsecured claims. The amount of the benefit to the debtor/licensee is usually, but not necessarily, determined under the license.

Protective Security Interests

Because of the risk to each party to a license of a termination or breach of the license in a bankruptcy of the other party, both parties may want to obtain a protective security interest in the other party's interest in the license and the licensed rights. The courts have held that a security interest is not “executory,” and thus cannot be rejected, even if it is contained within an otherwise executory contract. See , Jenson v. Continental Financing Corp. , 591 F.2d 477 (8th Cir. 1979); Leasing Service Corp. v. First Tennessee Bank Nat'l Ass'n , 826 F.2d 434 (6th Cir. 1987); In re Middleton, 3 B.R. 610 (Bankr. E.D. Pa. 1980); Weil v. Lansburgh (In re Garfinkle), 577 F.2d 901 (5th Cir. 1978). A more precise analysis, which reaches the same result, is that even if a security interest is “executory,” rejection of an executory contract does not in itself affect property rights, such as a security interest.

Summary of Protection for Licensors and Licensees

Licensors

To protect themselves against a potential bankruptcy of a licensee, licensors should consider adopting all or some of the following protective strategies:

• Instead of making the third party a licensee and entering into a license, attempt to appoint the third party as a sales agent performing services for a commission and have the licenses run directly from the licensor to the next level in the distribution chain. Have revenues placed in a segregated trust account, with the sales agent taking a commission, and the balance remitted to the licensor.
• Put an express Termination Right in the license.
• If a short-form assignment is recorded, make sure it references the license itself in order to incorporate the Termination Right.
• Structure the transaction as a license for a limited term and not as a “sale” in perpetuity.
• Obtain a protective security interest in the licensed rights and in the licensee's interest in the license.

Licensees

To protect themselves against a potential bankruptcy of a licensor, licensees should consider adopting all or some of the following protective strategies:

• Do not accept appointment as a sales agent; insist on receiving a grant of rights.
• Make sure that the license expressly states that it is exclusive and assignable.
• Do not permit the license to contain a Termination Right, and have the license expressly state that it will not terminate for any reason.
• Record the license (or a short-form assignment that refers to the license) in the U.S. Copyright Office and in the major foreign countries that have a recording system.
• Structure the transaction as a “sale” of the rights in perpetuity, instead of as a license for a limited term.

Automatic Stay

The moment a debtor declares bankruptcy, it is protected by an invisible force field called the “automatic stay,” which halts all further actions against the debtor, such as foreclosures, court litigation and arbitrations. It halts third parties from taking any actions that interfere with, or attempt to collect from, the debtor, including giving advance notice of termination of a license to the debtor if the license has an advance notice and cure period. For this reason, it is preferable for licensors to provide for automatic termination of a license ' without notice having to be given to the licensee ' upon specified breaches by the licensee.

Ipso Facto Clauses

The Bankruptcy Act voids any clauses that purport to terminate a contract upon the bankruptcy or insolvency of the debtor, although a contract may accelerate any remaining payment obligations upon the occurrence of such events. One way to potentially reach the same result is to have a key-man clause, since key personnel often leave in a bankruptcy.

Voidable Preferences

Under Bankruptcy Code Section 547(b), the debtor can rescind a prior “transfer” (subject to certain exceptions) if: a) the transfer is made to or for the benefit of a creditor on account of an “antecedent” debt; b) the transfer is made while the debtor was insolvent; c) the transfer is made within the 90-day period before the bankruptcy filing (or within one year if the creditor is an “insider”); and d) the creditor receives more than it would otherwise receive in the bankruptcy.

The term “transfer” includes not only the payment of cash, but also the perfection of a security interest in the debtor's assets. Therefore, the perfection of a security interest in a film is a “transfer” that may be voided if the other conditions are met. A security interest is treated as a “transfer” on the date of its creation as long as it is perfected within the relevant grace period. Under the Copyright Act, perfection within one month of grant of the security interest is treated as occurring at the time of grant. See, Copyright Act Sec. 205(d); Bankruptcy Code Sec. 547(e)(1)(B). The Bankruptcy Code, however, provides for only a 10-day grace period (Sec. 547(e)(2)), and the court in In re AEG Acquisition Corp., 127 B.R. 34 (Bankr. C.D. Cal. 1991), aff'd , 161 B.R. 50 (9th Cir. BAP 1993), held that the Bankruptcy Code 10-day grace period governed a security interest in a film copyright without discussing the specific Copyright Act 30-day grace period.

In the case of U.S. Copyrights, perfection requires, depending on which cases govern, either: a) a Uniform Commercial Code (UCC) filing, if the work is not registered in the Copyright Office; or b) recording of the security interest and registration of the work in the Copyright Office. (See the discussion in Part One of this article.)

When perfection is made to secure a revolving line of credit that has been fully used up, such as when the debtor continues to produce or acquire new films, the lender will perfect by recording its security interest against those films, but this perfection is for an antecedent debt and the lender is not extending new value in the way of additional loans. Thus, as long as the other requirements are met, the perfection of the security interest would be voidable.

Fraudulent Conveyance

The debtor may also rescind any transfers that occur generally within four years (depending on state law) prior to the bankruptcy if one of the following two conditions is met:

1. The transfer was made for less than adequate consideration at a time when the debtor was insolvent; or
2. The transfer was made with the intent to hinder or delay creditors.

These transfers are referred to as “fraudulent transfers.” The intent of this provision is to protect the debtor from selling assets at a fire-sale price due to financial pressures.

Post-Petition Property

In General

Section 552(a) of the Bankruptcy Code provides that, except as limited by subsection (b), “property acquired by the estate after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.” Section 552(b) permits security agreements to remain effective as to after-acquired property that is “proceeds, product, offspring, rents or profits” of pre-petition collateral.

Royalties

If post-petition royalties are received pursuant to licenses in place on the date of the bankruptcy filing and the creditor has a security interest in the licenses, the future royalties probably are “proceeds.” See , J. Catton Farms Inc. v. First Nat'l Bank of Chicago , 779 F.2d 1242 (7th Cir. 1985) (payments to farmer under U.S. payment-in-kind contract were “proceeds”); United Virginia Bank v. Slab Fork Coal Co. , 784 F.2d 1188 (4th Cir. 1985), cert. denied , 477 U.S. 905 (1986) (payments under contract to sell coal were “proceeds”); In re James Cable Partners L.P., (Bankr. M.D. Ga. 1992) CCH 74,667 (payments under pre-petition cable subscriber contracts were “proceeds,” while payments under contracts entered into post-petition were not).

On the other hand, if the royalties are generated from contracts entered into after the bankruptcy filing or the creditor does not have a security interest in the contracts, the royalties should not constitute “proceeds.” See, Northview, 130 B.R. at 546 (hotel revenues were not “proceeds” of hotel); In re S & J Holding Corp., 42 B.R. 249 (Bankr. S.D. Fla. 1984) (revenues from video games used by the public were not “proceeds” of the video games).