The Application of 365(n) to Cross-License Agreements

Part One of this Article discusses the effect of applying section 365(n) to cross-license agreements in greater detail. Part Two next month will discuss the problems that section 365(n) presents to debtors who are party to cross-license agreements creates for debtors.

The Problem with Applying 365(n) to Patent Cross-License Agreements

Patent cross-license agreements are generally not assignable in bankruptcy without the counterparty's consent. See In re Access Beyond Techs., Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999) (holding that “[w]here the provisions of a patent license are silent on the question of assignability, the license is nontransferable”) (citing Walter A. Wood Harvester Co. v. Minneapolis-Esterly Harvester Co., 61 F. 256, 258 (C.C.D. Minn. 1894)). This means that in “hypothetical” test jurisdictions such as the Third Circuit, patent license agreements may not be assumed without the counterparty's consent. See Cinicola v. Sharffenberger, 248 F.3d 110, 126'27 (3d Cir. 2001). See also In re Access Beyond Techs., Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999) (holding that the debtor could not sell a patent cross-license because the agreement could not be assumed without the counterpary's consent).

However, 365(n) prevents a debtor from terminating the licensee rights of the counterparty. This creates a rather odd result when applied to a cross-license agreement. A debtor may not assume the cross-license without the counterparty's consent, effectively forcing the debtor to reject the agreement unless it obtains consent. On the other hand, upon rejection, the non-debtor counterparty may nonetheless choose to retain its rights as licensee pursuant to section 365(n). This means that a non-debtor counterparty may strip a debtor of its rights as licensee under a cross-license agreement, while the counterparty retains its rights under the reciprocal license granted to it by the debtor.

Conditions

There are, of course, conditions placed on a counterparty's exercise of its 365(n) rights; however, these conditions fail to adequately protect the debtor's interest in the case of a cross-license agreement. Section 365(n) permits a licensee of intellectual property to elect to retain its rights as licensee, subject to certain conditions:

(n)(1) If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect '

(A) to treat such contract as terminated by such rejection if such rejection by the trustee amounts to such a breach as would entitle the licensee to treat such contract as terminated by virtue of its own terms, applicable nonbankruptcy law, or an agreement made by the licensee with another entity; or

(B) to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankruptcy law), as such rights existed immediately before the case commenced, for '

(i) the duration of such contract; and

(ii) any period for which such contract may be extended by the licensee as of right under applicable nonbankruptcy law.

(2) If the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, under such contract '

(A) the trustee shall allow the licensee to exercise such rights;

(B) the licensee shall make all royalty payments due under such contract for the duration of such contract and for any period described in paragraph (1)(B) of this subsection for which the licensee extends such contract; and'

(C) the licensee shall be deemed to waive '

'(i) any right of setoff it may have with respect to such contract under this title or applicable nonbankruptcy law; and

'(ii) any claim allowable under section 503(b) of this title arising from the performance of such contract.

11 U.S.C. ' 365(n)(1)-(2)

Thus, the principal bargain struck by 365(n)(2) is that the non-debtor licensee may retain its rights only if it continues to pay royalties. This strikes a fair balance where the debtor is licensing intellectual property to obtain licensing fees, but does not work where the only consideration received by the debtor is a reciprocal license.

In re Access Beyond Technologies, Inc.

In the matter of In re Access Beyond Technologies, Inc., the United States Bankruptcy Court for the District of Delaware held that a perpetual, royalty-free patent cross-license agreement was an executory contract that the debtor could not assume without the counterparty's consent. See In re Access Beyond Technologies, Inc., 237 B.R. 32, 43. In reaching this conclusion, the court held that the cross-license agreement was “not an assignment, but a mere naked license” because the rights it conferred on the debtor were not exclusive. Id. Thus, despite the fact that the cross-license agreement at issue in Access Beyond was “irrevocable and royalty free,” it was still subject to section 365 of the Bankruptcy Code. Id. at 44.

If we apply 365(n) to the patent cross-license agreement at issue in Access Beyond, the debtor could not assume the agreement without the counterparty's consent; however, if forced to reject the agreement, the counterparty would be able to retain its licensing rights in perpetuity without providing any ongoing consideration to the debtor. In such a circumstance, the counterparty has no incentive to assent to the debtor's assumption of the agreement because it may retain its license free of cost under 365(n). Effectively, this would give rise to the sort of hold-up problem contemplated in the Jaffe case.

In next month's issue, we discuss the problems that section 365(n) presents to debtors who are party to cross-license agreements creates for debtors.

Jeff J. Marwil is a partner with the firm of Proskauer Rose LLP (“Proskauer”) and the U.S. co-head of Proskauer's Business Solutions, Governance, Restructuring & Bankruptcy Group (“BSGR&B Group”). Jeremy T. Stillings and Brandon W. Levitan are associates with Proskauer and members of its BSGR&B Group.

In high-tech industries such as semiconductor manufacturing, the practice of engaging in broad patent cross-license agreements with competitors has become common. This practice has arisen from the recognition that the complex web of patent rights in such industries is so thick that participants may not be able to avoid infringing on existing patents, or even definitively determine whether a new product infringes on existing patents prior to bringing it to market.

Moreover, once industry participants have engaged in patent cross-licenses, they may make substantial investments in reliance on the enforceability of those cross-license agreements. For example, the costs of creating a state-of-the-art semiconductor fabrication facility exceed $1 billion. See Heck, Kaza, and Pinner, Creating Value in the Semiconductor Industry at 9, McKinsey on Semiconductors (Autumn 2011) (“The cost of building leading-edge fabs continues to increase as well; for example, the average 8-inch fab costs $1.6 billion to build, while a state-of-the-art 12-inch fab costs $3 billion to $4 billion.”); Brief for the Semiconductor Industry Association, Chamber of Commerce of the United States of America, National Association of Manufacturers, and Business Software Alliance as Amici Curiae in Support of Appellees at 11, Jaffe v. Samsung Electronics Co., Ltd. , 737 F.3d 14 (4th Cir. 2013) (No. 12-1802), ECF 42-1 (“The average semiconductor fabrication facility costs $4 to $5 billion dollars to construct”).

The Fourth Circuit Court of Appeals's recent decision in Jaffe v. Samsung Electronics Co. , Ltd., 737 F.3d 14 (4th Cir. 2013) has drawn attention to the integral role section 365(n) of the Bankruptcy Code plays in protecting the rights of non-debtor counterparties to patent cross-license agreements. Designed to protect non-debtor counterparties from opportunistic debtors, section 365(n) may leave debtors vulnerable to opportunistic behavior of cross-licensees. Depending on the jurisdiction, debtors may be prohibited from assuming, let alone assigning, their patent cross license agreements, but compelled to honor the rights of their counterparties as licensee. In effect, section 365(n) provides for the division of reciprocal licenses that the parties never intended to be separate.

Part One of this Article discusses the effect of applying section 365(n) to cross-license agreements in greater detail. Part Two next month will discuss the problems that section 365(n) presents to debtors who are party to cross-license agreements creates for debtors.

The Problem with Applying 365(n) to Patent Cross-License Agreements

Patent cross-license agreements are generally not assignable in bankruptcy without the counterparty's consent. See In re Access Beyond Techs., Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999) (holding that “[w]here the provisions of a patent license are silent on the question of assignability, the license is nontransferable”) (citing Walter A. Wood Harvester Co. v. Minneapolis-Esterly Harvester Co. , 61 F. 256, 258 (C.C.D. Minn. 1894)). This means that in “hypothetical” test jurisdictions such as the Third Circuit, patent license agreements may not be assumed without the counterparty's consent. See Cinicola v. Sharffenberger , 248 F.3d 110, 126'27 (3d Cir. 2001). See also In re Access Beyond Techs., Inc., 237 B.R. 32, 43 (Bankr. D. Del. 1999) (holding that the debtor could not sell a patent cross-license because the agreement could not be assumed without the counterpary's consent).

However, 365(n) prevents a debtor from terminating the licensee rights of the counterparty. This creates a rather odd result when applied to a cross-license agreement. A debtor may not assume the cross-license without the counterparty's consent, effectively forcing the debtor to reject the agreement unless it obtains consent. On the other hand, upon rejection, the non-debtor counterparty may nonetheless choose to retain its rights as licensee pursuant to section 365(n). This means that a non-debtor counterparty may strip a debtor of its rights as licensee under a cross-license agreement, while the counterparty retains its rights under the reciprocal license granted to it by the debtor.

Conditions

There are, of course, conditions placed on a counterparty's exercise of its 365(n) rights; however, these conditions fail to adequately protect the debtor's interest in the case of a cross-license agreement. Section 365(n) permits a licensee of intellectual property to elect to retain its rights as licensee, subject to certain conditions:

(n)(1) If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect '

(A) to treat such contract as terminated by such rejection if such rejection by the trustee amounts to such a breach as would entitle the licensee to treat such contract as terminated by virtue of its own terms, applicable nonbankruptcy law, or an agreement made by the licensee with another entity; or

(B) to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankruptcy law), as such rights existed immediately before the case commenced, for '

(i) the duration of such contract; and

(ii) any period for which such contract may be extended by the licensee as of right under applicable nonbankruptcy law.

(2) If the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, under such contract '

(A) the trustee shall allow the licensee to exercise such rights;

(B) the licensee shall make all royalty payments due under such contract for the duration of such contract and for any period described in paragraph (1)(B) of this subsection for which the licensee extends such contract; and'

(C) the licensee shall be deemed to waive '

'(i) any right of setoff it may have with respect to such contract under this title or applicable nonbankruptcy law; and

'(ii) any claim allowable under section 503(b) of this title arising from the performance of such contract.

11 U.S.C. ' 365(n)(1)-(2)

Thus, the principal bargain struck by 365(n)(2) is that the non-debtor licensee may retain its rights only if it continues to pay royalties. This strikes a fair balance where the debtor is licensing intellectual property to obtain licensing fees, but does not work where the only consideration received by the debtor is a reciprocal license.

In re Access Beyond Technologies, Inc.

In the matter of In re Access Beyond Technologies, Inc., the United States Bankruptcy Court for the District of Delaware held that a perpetual, royalty-free patent cross-license agreement was an executory contract that the debtor could not assume without the counterparty's consent. See In re Access Beyond Technologies, Inc., 237 B.R. 32, 43. In reaching this conclusion, the court held that the cross-license agreement was “not an assignment, but a mere naked license” because the rights it conferred on the debtor were not exclusive. Id. Thus, despite the fact that the cross-license agreement at issue in Access Beyond was “irrevocable and royalty free,” it was still subject to section 365 of the Bankruptcy Code. Id. at 44.

If we apply 365(n) to the patent cross-license agreement at issue in Access Beyond, the debtor could not assume the agreement without the counterparty's consent; however, if forced to reject the agreement, the counterparty would be able to retain its licensing rights in perpetuity without providing any ongoing consideration to the debtor. In such a circumstance, the counterparty has no incentive to assent to the debtor's assumption of the agreement because it may retain its license free of cost under 365(n). Effectively, this would give rise to the sort of hold-up problem contemplated in the Jaffe case.

In next month's issue, we discuss the problems that section 365(n) presents to debtors who are party to cross-license agreements creates for debtors.

Jeff J. Marwil is a partner with the firm of Proskauer Rose LLP (“Proskauer”) and the U.S. co-head of Proskauer's Business Solutions, Governance, Restructuring & Bankruptcy Group (“BSGR&B Group”). Jeremy T. Stillings and Brandon W. Levitan are associates with Proskauer and members of its BSGR&B Group.