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

First, if the debtor wishes to regain its rights as licensee, it will be forced to effectively pay twice for the same license. By treating the each of the licenses in the cross-license agreement as distinct, section 365(n) has effectively given the counterparty its license for free, allowing it to re-license its patents to the debtor for additional consideration.

Second, the debtor may have made significant investments in reliance on the validity of its license. To understand why this is such a problem, one has to understand the reasons that parties engage in cross-licensing. For those not familiar with the concept, “patent thicket” refers to the development of a “dense web of overlapping intellectual property rights.” See Jaffe v. Samsung Elecs. Co., Ltd., 737 F.3d 14, 19 (citing Carl Shapiro, Navigating the Patent Thicket: Cross Licenses, Patent Pools, and Standard Setting, in 1 Innovation Policy and the Economy 119, 120 (Adam B. Jaffe et al. eds., 2001)).

This “dense web” of intellectual property rights has two consequences. First, it may be impossible for industry participants to design around each and every patent implicated by a new product. Id. Second, even if designing around such patents were theoretically possible, the number of potentially applicable patents is so great that “it is not always possible to identify which ones might cover a new product.” Id.

In the semi-conductor industry, the problem of the “patent thicket” is made worse by the enormous costs of bringing a new product to market:

The problem of the patent thicket is exacerbated by the enormous costs incurred to bring a new semiconductor product to market. According to one expert, the price of building a new semiconductor fabrication facility can now exceed $5 billion. These sunk costs could create a classic “holdup” problem if a new product were ultimately found to infringe someone else's patent, with the patent's owner being able to extract a substantially higher royalty after the investment had been made than if a license had been negotiated beforehand.

Id.

Thus, “to avoid this holdup premium and enhance their design freedom, competitors in the semiconductor industry have routinely entered into broad, non-exclusive cross-license agreements with each other, 'sometimes with the addition of equalizing payments (either up-front payments or so-called running royalties) to account for differences in the size and breadth of the respective patent portfolios.'” Id.

This brings us back to the reason that later renegotiating such agreements creates problems. Once parties begin to act in reliance on their cross-license agreements, the status quo shifts dramatically. For example, the debtor may have built a billion dollar manufacturing facility in reliance on its ability to use certain of the counterparty's designs. While the debtor originally could have chosen a different design, the costs of switching the design of its facilities and products may now be astronomical.

The Fourth Circuit's Decision in Jaff'

Quimonda AG (Quimonda) was a German corporation that manufactured semiconductor devices. After initiating an insolvency proceeding under German law, Quimonda ceased operating and began looking for ways to monetize its chief assets, which were approximately 10,000 patents, about 4,000 of which were U.S. patents. Id. at 18. On June 15, 2009, the German administrator charged with overseeing Quimonda's insolvency proceeding, Dr. Michael Jaff' (the Quimonda Administrator), petitioned the United States Bankruptcy Court for the Eastern District of Virginia to recognize the German insolvency proceeding as a “foreign main proceeding” under Chapter 15 of the Bankruptcy Code. Id. at 19.

The Quimonda Administrator also sought and obtained a separate order pursuant to section 1521 of the Bankruptcy Code granting him the sole and exclusive authority to represent Quimonda in the U.S. and administer its assets (the Supplemental Order). Id. at 19-20. The Supplemental Order made section 365 of the Bankruptcy Code applicable to Quimonda's Chapter 15 proceeding.

Apparently not realizing the protections afforded licensees of intellectual property under section 365(n) (the German equivalent to section 365 does not contain a comparable provision), the Quimonda Administrator sent letters to “companies that had cross-license
agreements with Quimonda, invoking section 103 of the German Insolvency Code and declaring that the licenses of Quimonda's patents were “'no longer enforceable.'” Id. at 20. The Quimonda Administrator “intended to re-license Quimonda's patents for the benefit of Quimonda's creditors, replacing licenses paid for in-kind via cross-license agreements with licenses paid for with cash through royalties.” Id. at 17.

After Quimonda's licensees responded that they were electing to retain their rights under section 365(n) of the Bankruptcy Code, the Quimonda Administrator moved the bankruptcy court to amend the Supplemental Order either deleting entirely any reference to section 365 of the Bankruptcy Code, or including a proviso stating that 365(n) was inapplicable. Id. On direct appeal from the bankruptcy court, the Fourth Circuit affirmed the bankruptcy court's decision, “finding reasonable its exercise of discretion in conducting the balancing analysis under ' 1522(a) and concluding that attaching the protection of ' 365(n) was necessary when granting Jaff' the power to administer Quimonda's U.S. patents.” Id. at 31.

The potential implications of the Quimonda decision were such that the Semiconductor Industry Association, The Chamber of Commerce of the United States of America, the National Association of Manufacturers, and the Business Software Alliance (together, the Amici) jointly filed an amicus brief with the Fourth Circuit outlining the potential consequences for the semiconductor industry and the economy were the court to allow the Quimonda Administrator to deny the licensees their 365(n) rights. See Jaff' v. Samsung Elecs. Co., Ltd., 737 F.3d 14 (4th Cir. 2013) (No. 12-1802), ECF 42-1. The Amici predicted the following consequences, were the court to permit Quimonda's Administrator to unilaterally reject its cross-licenses:

In the absence of the protection and certainty that cross-licensing provides, semiconductor firms will be reluctant to make the sizeable investments necessary to operate competitively. Semiconductor firms will be forced to pay twice for a license: once when they enter the cross-license and then again after a cross-licensor's patents have been incorporated and switching costs are high. This creates the very real possibility that post-rejection licensing negotiations will result in a royalty demand that reflects switching costs and not the ex ante value of the practiced patent. The end result is that consumers are harmed, U.S. manufacturing is threatened, and innovation suffers.

Id. at 4.

In its balancing of competing interests, the bankruptcy court concluded that “the risk to the very substantial investment the [Licensees] ' particularly IBM, Micron, Intel, and Samsung ' [had] collectively made in research and manufacturing facilities in the United States in reliance on the design freedom provided by the cross-license agreements, though not easily quantifiable, [was] nevertheless very real.” Jaff', 737 F.3d 14, 30. Giving credence to the findings of the bankruptcy court, the Fourth Circuit held that the bankruptcy court's “thorough examination of the parties' competing interests” was “comprehensive and eminently reasonable.” Id. The concerns are no less present when an economically viable debtor's rights under a cross-license agreement are at issue. Renegotiating these license rights may turn an otherwise viable going concern debtor towards liquidation, and to make matters worse, the counterparties are likely to be the debtor's direct competitors.

Conclusion

The essential flaw in section 365(n) is that it treats the license granted the non-debtor counterparty and the reciprocal license granted the debtor as two distinct entities, when the intent of the parties is that the licenses be inextricably linked. If treated separately, the debtor is just as vulnerable to the sort of opportunistic re-trading from which section 365(n) is designed to protect non-debtor counterparties.

There are a couple steps companies can take to protect themselves. First, when negotiating cross-license agreements, the parties could agree to expressly make the duration of each license dependent upon the length of time that a reciprocal grant of a license is available. For example, the cross-license agreement could provide as follows:

Limitation on Perpetual Duration. The duration of the reciprocal licenses granted each party under this Agreement shall be co-extensive. Notwithstanding the rejection of this Agreement in bankruptcy by one party (the “Rejecting Party”), the other party's election to continue its rights as licensee under this Agreement pursuant to 11 U.S.C. ' 365(n) (the “Election”) shall be effective in duration for so long as the party making the Election consents to the Rejecting Party's continued use of the Rejecting Party's reciprocal licensing rights.

This strategy dovetails with the language of 365(n), which provides that the counterparty shall retain its rights as licensee for “the duration of the contract.” 11 U.S.C. ' 365(n)(1)(B)(i). While such language would ordinarily be unnecessary where the cross licenses are perpetual, such language would make it explicit that each grant of a license is contingent upon the effectiveness of the reciprocal license. Since this language is consistent with the intent of such cross-license agreements, parties should not have any objection to amending existing cross-license agreements to include such language.

In some cases, this sort of advance planning may not be possible. Companies with significant portfolios of patent cross-license agreements that are considering bankruptcy should consider how 365(n) is interpreted in potential venues. By filing in a “hypothetical” test jurisdiction such as the Third Circuit, the company may be providing significant leverage to its competitors and others with whom it is a party to a cross-license agreement. The ability to assume existing cross-license agreements may have value if the debtor is contemplating reorganization and emergence from Chapter 11 as a going concern.

Jeff J. Marwil is a partner with 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.

Last month, Part One of this Article detailed the effect of applying section 365(n) to cross-license agreements. Part Two herein discusses the problems that section 365(n) presents to debtors who are party to cross-license agreements..

Cross-Licensing and the Patent Thicket

Two principal problems arise when a non-debtor counterparty to a patent cross-license agreement is able to force rejection of a cross-license agreement (effectively unilaterally terminating the agreement) and retain its licensee rights under 365(n).

First, if the debtor wishes to regain its rights as licensee, it will be forced to effectively pay twice for the same license. By treating the each of the licenses in the cross-license agreement as distinct, section 365(n) has effectively given the counterparty its license for free, allowing it to re-license its patents to the debtor for additional consideration.

Second, the debtor may have made significant investments in reliance on the validity of its license. To understand why this is such a problem, one has to understand the reasons that parties engage in cross-licensing. For those not familiar with the concept, “patent thicket” refers to the development of a “dense web of overlapping intellectual property rights.” See Jaffe v. Samsung Elecs. Co., Ltd. , 737 F.3d 14, 19 (citing Carl Shapiro, Navigating the Patent Thicket: Cross Licenses, Patent Pools, and Standard Setting, in 1 Innovation Policy and the Economy 119, 120 (Adam B. Jaffe et al. eds., 2001)).

This “dense web” of intellectual property rights has two consequences. First, it may be impossible for industry participants to design around each and every patent implicated by a new product. Id. Second, even if designing around such patents were theoretically possible, the number of potentially applicable patents is so great that “it is not always possible to identify which ones might cover a new product.” Id.

In the semi-conductor industry, the problem of the “patent thicket” is made worse by the enormous costs of bringing a new product to market:

The problem of the patent thicket is exacerbated by the enormous costs incurred to bring a new semiconductor product to market. According to one expert, the price of building a new semiconductor fabrication facility can now exceed $5 billion. These sunk costs could create a classic “holdup” problem if a new product were ultimately found to infringe someone else's patent, with the patent's owner being able to extract a substantially higher royalty after the investment had been made than if a license had been negotiated beforehand.

Id.

Thus, “to avoid this holdup premium and enhance their design freedom, competitors in the semiconductor industry have routinely entered into broad, non-exclusive cross-license agreements with each other, 'sometimes with the addition of equalizing payments (either up-front payments or so-called running royalties) to account for differences in the size and breadth of the respective patent portfolios.'” Id.

This brings us back to the reason that later renegotiating such agreements creates problems. Once parties begin to act in reliance on their cross-license agreements, the status quo shifts dramatically. For example, the debtor may have built a billion dollar manufacturing facility in reliance on its ability to use certain of the counterparty's designs. While the debtor originally could have chosen a different design, the costs of switching the design of its facilities and products may now be astronomical.

The Fourth Circuit's Decision in Jaff'

Quimonda AG (Quimonda) was a German corporation that manufactured semiconductor devices. After initiating an insolvency proceeding under German law, Quimonda ceased operating and began looking for ways to monetize its chief assets, which were approximately 10,000 patents, about 4,000 of which were U.S. patents. Id. at 18. On June 15, 2009, the German administrator charged with overseeing Quimonda's insolvency proceeding, Dr. Michael Jaff' (the Quimonda Administrator), petitioned the United States Bankruptcy Court for the Eastern District of Virginia to recognize the German insolvency proceeding as a “foreign main proceeding” under Chapter 15 of the Bankruptcy Code. Id. at 19.

The Quimonda Administrator also sought and obtained a separate order pursuant to section 1521 of the Bankruptcy Code granting him the sole and exclusive authority to represent Quimonda in the U.S. and administer its assets (the Supplemental Order). Id. at 19-20. The Supplemental Order made section 365 of the Bankruptcy Code applicable to Quimonda's Chapter 15 proceeding.

Apparently not realizing the protections afforded licensees of intellectual property under section 365(n) (the German equivalent to section 365 does not contain a comparable provision), the Quimonda Administrator sent letters to “companies that had cross-license
agreements with Quimonda, invoking section 103 of the German Insolvency Code and declaring that the licenses of Quimonda's patents were “'no longer enforceable.'” Id. at 20. The Quimonda Administrator “intended to re-license Quimonda's patents for the benefit of Quimonda's creditors, replacing licenses paid for in-kind via cross-license agreements with licenses paid for with cash through royalties.” Id. at 17.

After Quimonda's licensees responded that they were electing to retain their rights under section 365(n) of the Bankruptcy Code, the Quimonda Administrator moved the bankruptcy court to amend the Supplemental Order either deleting entirely any reference to section 365 of the Bankruptcy Code, or including a proviso stating that 365(n) was inapplicable. Id. On direct appeal from the bankruptcy court, the Fourth Circuit affirmed the bankruptcy court's decision, “finding reasonable its exercise of discretion in conducting the balancing analysis under ' 1522(a) and concluding that attaching the protection of ' 365(n) was necessary when granting Jaff' the power to administer Quimonda's U.S. patents.” Id. at 31.

The potential implications of the Quimonda decision were such that the Semiconductor Industry Association, The Chamber of Commerce of the United States of America, the National Association of Manufacturers, and the Business Software Alliance (together, the Amici) jointly filed an amicus brief with the Fourth Circuit outlining the potential consequences for the semiconductor industry and the economy were the court to allow the Quimonda Administrator to deny the licensees their 365(n) rights. See Jaff' v. Samsung Elecs. Co., Ltd. , 737 F.3d 14 (4th Cir. 2013) (No. 12-1802), ECF 42-1. The Amici predicted the following consequences, were the court to permit Quimonda's Administrator to unilaterally reject its cross-licenses:

In the absence of the protection and certainty that cross-licensing provides, semiconductor firms will be reluctant to make the sizeable investments necessary to operate competitively. Semiconductor firms will be forced to pay twice for a license: once when they enter the cross-license and then again after a cross-licensor's patents have been incorporated and switching costs are high. This creates the very real possibility that post-rejection licensing negotiations will result in a royalty demand that reflects switching costs and not the ex ante value of the practiced patent. The end result is that consumers are harmed, U.S. manufacturing is threatened, and innovation suffers.

Id. at 4.

In its balancing of competing interests, the bankruptcy court concluded that “the risk to the very substantial investment the [Licensees] ' particularly IBM, Micron, Intel, and Samsung ' [had] collectively made in research and manufacturing facilities in the United States in reliance on the design freedom provided by the cross-license agreements, though not easily quantifiable, [was] nevertheless very real.” Jaff', 737 F.3d 14, 30. Giving credence to the findings of the bankruptcy court, the Fourth Circuit held that the bankruptcy court's “thorough examination of the parties' competing interests” was “comprehensive and eminently reasonable.” Id. The concerns are no less present when an economically viable debtor's rights under a cross-license agreement are at issue. Renegotiating these license rights may turn an otherwise viable going concern debtor towards liquidation, and to make matters worse, the counterparties are likely to be the debtor's direct competitors.

Conclusion

The essential flaw in section 365(n) is that it treats the license granted the non-debtor counterparty and the reciprocal license granted the debtor as two distinct entities, when the intent of the parties is that the licenses be inextricably linked. If treated separately, the debtor is just as vulnerable to the sort of opportunistic re-trading from which section 365(n) is designed to protect non-debtor counterparties.

There are a couple steps companies can take to protect themselves. First, when negotiating cross-license agreements, the parties could agree to expressly make the duration of each license dependent upon the length of time that a reciprocal grant of a license is available. For example, the cross-license agreement could provide as follows:

Limitation on Perpetual Duration. The duration of the reciprocal licenses granted each party under this Agreement shall be co-extensive. Notwithstanding the rejection of this Agreement in bankruptcy by one party (the “Rejecting Party”), the other party's election to continue its rights as licensee under this Agreement pursuant to 11 U.S.C. ' 365(n) (the “Election”) shall be effective in duration for so long as the party making the Election consents to the Rejecting Party's continued use of the Rejecting Party's reciprocal licensing rights.

This strategy dovetails with the language of 365(n), which provides that the counterparty shall retain its rights as licensee for “the duration of the contract.” 11 U.S.C. ' 365(n)(1)(B)(i). While such language would ordinarily be unnecessary where the cross licenses are perpetual, such language would make it explicit that each grant of a license is contingent upon the effectiveness of the reciprocal license. Since this language is consistent with the intent of such cross-license agreements, parties should not have any objection to amending existing cross-license agreements to include such language.

In some cases, this sort of advance planning may not be possible. Companies with significant portfolios of patent cross-license agreements that are considering bankruptcy should consider how 365(n) is interpreted in potential venues. By filing in a “hypothetical” test jurisdiction such as the Third Circuit, the company may be providing significant leverage to its competitors and others with whom it is a party to a cross-license agreement. The ability to assume existing cross-license agreements may have value if the debtor is contemplating reorganization and emergence from Chapter 11 as a going concern.

Jeff J. Marwil is a partner with 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.