IP Licenses In Bankruptcy

Legal uncertainty abounds for intellectual property licensees and licensors when their license counterparties enter the murky waters of bankruptcy. When a licensor hits the skids, a licensee's two primary concerns should include: 1) whether the protections afforded by Bankruptcy Code section 365(n) are available if the debtor-licensor rejects the license; and 2) protecting its rights if the debtor-licensor seeks to sell the intellectual property. By contrast, when a licensee considers filing for bankruptcy, it must consider whether it can assume or assign the license.

Assuming, Rejecting, and Assigning IP Licenses

A key decision for any debtor is whether to reject, or assume and assign its “executory contracts.” By assuming a contract, a debtor reaffirms the contract and agrees to honor its obligations going forward. To assume a contract, the debtor must cure or provide “adequate assurance” that all defaults will be cured, and provide adequate assurance of future performance. By rejecting a contract, the debtor disavows the contract and refuses to continue performing thereunder. A rejection is treated as a prepetition breach of the contract, and the counterparty is entitled to a general unsecured claim, which may be paid only cents on the dollar. Last, the debtor may assign a contract to such party, notwithstanding any contractual provision prohibiting assignment, so long as a debtor provides adequate assurance that the assignee can perform the contractual obligations.

But a debtor's ability to assign executory contracts is not unfettered. Rather, Bankruptcy Code section 365(c) provides that a debtor may not assume or assign an executory contract if applicable law excuses the counterparty from accepting performance from or rendering performance to a new party. This restriction protects counterparties from being forced to accept performance by a different party when non-bankruptcy law would prevent such a result.

Debtor-Licensor's Rejection of an ' ntellectual Property' License

The Fourth Circuit in Lubrizol Ent., Inc. v. Richmond Metal Finishers, Inc. ( In re Richmand Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985), held that a patent licensee loses its license rights when a licensor rejects the license in bankruptcy. In response to Lubrizol , Congress enacted section 365(n) to provide additional protection to intellectual property licensees. Under section 365(n), if a debtor rejects an intellectual property license, the licensee may elect to retain its right to use the licensed property (though the debtor is relieved of all affirmative obligations under the agreement).

Section 365(n) applies to “intellectual property,” yet the Bankruptcy Code's definition of that term excludes foreign patents and copyrights, trademarks, service marks, trade names, and rights of publicity. Fortunately for licensees, courts in two recent decisions rejected Lubrizol and held that the licensee of a trademark, while outside the Bankruptcy Code's definition of “intellectual property,” could continue using the trademark. See Sunbeam Products v. Chicago Am. Mnfc., 686 F.3d 372 (7th Cir. 2012); In re Crumbs Bake Shop Inc., No. 14-24287, 2014 WL 5508177 (Bankr. D.N.J. Oct. 31, 2014).

Only a limited number of cases have addressed the holding of Lubrizol and its progeny, and thus uncertainty remains. However, courts have recently rejected the hardline decision in Lubrizol in favor of a broader and more practical interpretation of “intellectual property.” Nonetheless, licensees should continue to anticipate potentially adverse outcomes in this context and plan accordingly.

Sales of Intellectual Property by a Debtor-Licensor

Taken together, Bankruptcy Code sections 363(b) and (f) permit a debtor to sell assets (including intellectual property) “free and clear” of all liens, claims, and encumbrances. In other words, a debtor can sell property, even if another party asserts an interest in the property to be sold. However, an intellectual property licensee may have two special rights in connection with such a sale.

First, if a licensee has a lien on the property to be sold, the licensee can generally “credit bid” its indebtedness in connection with the sale. Distilled to its basics, credit bidding allows a lienholder to bid for the asset to which its lien attaches by using the debt it is owed to offset the purchase price. Credit bidding provides a lienholder two primary benefits: 1) it protects the lienholder against the risk that its collateral will be sold at a depressed price; and 2) it can provide an advantage at the auction because, unlike other bidders, a lienholder needs to commit new capital only if its bid exceeds the amount of its secured claim.

Second, a New Jersey bankruptcy court recently held that 363 sales are not free and clear of a licensee's right under section 365(n) to continue use of the debtor-licensor's intellectual property. Crumbs Bake Shop , 2014 WL 5508177. [See article by Azzopardi, et al., in this issue.] Phrased differently, even if a licensee does not have a lien on the licensed property to be sold, it may still be entitled to use the licensed property under section 365(n).

Assumption and Assignment By Debtor-Licensees

Similar to the rights afforded to a debtor-licensor, a debtor-licensee may assume, reject, or assume and assign intellectual property licenses. However, the implications of doing so are different when the licensee is in bankruptcy. Specifically, section 365(n) does not apply when a debtor-licensee rejects an intellectual property license ' the licensor retains ownership of the intellectual property, and thus there are no concerns about the licensor's ability to continue using the intellectual property after rejection. However, a debtor-licensee's ability to assume and assign an intellectual property license will vary depending on several factors, including: 1) whether the license is exclusive or nonexclusive; 2) the type of intellectual property; and 3) the jurisdiction of the bankruptcy case.

Courts have generally held that a debtor-licensee may not assign a nonexclusive patent license because such licenses are deemed personal and non-assignable under federal law. Everex Sys., Inc. v. Cadtrak Corp. ( In re CFLC, Inc.), 89 F.3d 673, 679 (9th Cir. 1996). Of course, if the license contains a provision permitting assignment by the licensee, then assignment would likely be permitted. With regard to the assignability of exclusive patent licenses, federal law has not been definitively established, and application of such law in the bankruptcy context is limited. Even though a debtor-licensee of an exclusive patent has much broader rights than the licensee of a nonexclusive patent ( e.g. , the right to sue for patent infringement), some courts have held that such licenses are also non-assignable without the licensor's consent. In re Hernandez, 285 B.R. 435, 440 (Bankr. D. Ariz.2002); ProteoTech, Inc. v. Unicity Int'l, Inc., 542 F. Supp. 2d 1216, 1219 (W.D. Wash. 2008); In re Aerobox Composite Structures, LLC, 373 B.R. 135, 141 (Bankr. D.N.M. 2007).

Similar to patent licenses, courts have generally held that a debtor-licensee may not assign a nonexclusive copyright license because such licenses do not transfer ownership rights, thus rendering the license “personal” to the licensee. In re Patient Educ. Media, Inc., 210 B.R. 237, 240-43 (Bankr. S.D.N.Y. 1997). However, some courts have permitted a debtor-licensee to assign exclusive copyright licenses because such licenses convey an ownership interest. In re Golden Books Family Entm't, Inc., 269 B.R. 311, 319 (Bankr. D. Del. 2001).

Finally, courts have generally held that a debtor-licensee may not assign a trademark license because such licenses are deemed personal under non-bankruptcy law. N.C.P. Mktg. Group, Inc. v. Blanks (In re N.C.P. Mktg. Group, Inc.), 337 B.R. 230, 237 (D. Nev. 2005).

Although the above limitations on assignment would seemingly not affect a debtor-licensee's ability to assume an intellectual property license, such is not the case. The source of confusion lies in the interpretation of Bankruptcy Code section 365(c), which refers to a debtor's inability to “assume or assign” executory contracts that are non-assignable under non-bankruptcy law. In addressing this issue, courts utilize what have become known as the “hypothetical test” and the “actual test.”

Under the actual test, a court considers whether the debtor will actually assign the otherwise non-assignable contract. If the debtor does not intend to assign the contract, then assumption is permitted. Under the hypothetical test, the court disregards the debtor's actual intent, and simply deems the contract non-assumable because of the hypothetical possibility that the debtor could attempt to assign the contract after assumption occurs. The First and Fifth Circuits have expressly adopted the actual test, while the Third, Fourth, Ninth, and Eleventh Circuits use the hypothetical test. In re Aerobox Composite Structures, LLC, 373 B.R. 135, 140, n.7 (Bankr. D.N.M. 2007).

As a result of the foregoing assignment issues, debtor-licensees must use care in connection with any contemplated sale under section 363 that includes assignment of intellectual property licenses. And even where a debtor-licensee merely seeks to assume an intellectual property license, it may not be able to do so. These uncertainties make it that much more difficult for a debtor to navigate the choppy waters of Chapter 11. Further, the compressed timeline for 363 sales and the Chapter 11 process in general often leaves debtor-licensees in a difficult position.

Licensors and Licensees

Both licensees and licensors should consider the above issues pre-bankruptcy and take measures, some which are discussed below, to mitigate risks in the event of a bankruptcy filing.

Licensors should consider the following:

• Limit the term of any exclusive license, subject to renewal at the licensor's discretion. A debtor-licensee may assume an executory contract only as it existed prior to the bankruptcy filing, and thus a license agreement that expires by its own terms cannot be assumed (or assigned) by a debtor-licensee.
• Include in its license agreements specific requirements for adequate protection in the event of a bankruptcy filing. Although such provisions are not necessarily binding, they may influence a bankruptcy court's determination of adequate assurance, either by the debtor-licensee or its purported assignee.

Licensees should consider the following:

• Use an intellectual property escrow agreement. Although the enforceability and usefulness of such agreements in the event of a bankruptcy filing are beyond the scope of this article, such agreements may help to ensure the licensee's continued access to the licensed property after the licensor's bankruptcy filing.
• Obtain a security interest in the intellectual property as security for the licensor's obligations. This reduces the likelihood of rejection by the licensor in bankruptcy, which would trigger damages in the form of a secured claim.
• Structure the payment of royalties over the course of the license's term, rather than paying most or all royalties up-front. A debtor-licensor is less likely to forego the continued stream of revenue by rejecting the license.
• Vigilantly defend its rights in connection with a 363 sale by a debtor-licensor, lest it be deemed to consent to the sale free and clear of its interest. See FutureSource LLC v. Reuters Ltd., 312 F.3d 281, 285 (7th Cir. 2002).
• Include in its license agreements language permitting assignment. At least one court has held that such language operates as consent by the licensor to assignment, notwithstanding applicable non-bankruptcy law. In re Glycogenesys, Inc., 352 B.R. 568 (Bankr. D. Mass. 2006).

Additionally, given the discrepancies in recent court decisions and the ever-changing landscape, a licensor or licensee seeking bankruptcy protection should carefully consider the jurisdiction in which it files.

Conclusion

Consideration of bankruptcy issues during the negotiation of intellectual property licenses is understandably not a priority for some. Yet many licensors and licensees depend to a significant degree on the use of intellectual property in their day-to-day operations, and thus parties should be aware of the troubled roads that lie ahead in the event of a bankruptcy filing, however unlikely.

Timothy W. Walsh is a partner and the head of the Restructuring & Insolvency practice of McDermott Will & Emery LLP. Gregory Kopacz and Darren Azman are associates in the practice.

Legal uncertainty abounds for intellectual property licensees and licensors when their license counterparties enter the murky waters of bankruptcy. When a licensor hits the skids, a licensee's two primary concerns should include: 1) whether the protections afforded by Bankruptcy Code section 365(n) are available if the debtor-licensor rejects the license; and 2) protecting its rights if the debtor-licensor seeks to sell the intellectual property. By contrast, when a licensee considers filing for bankruptcy, it must consider whether it can assume or assign the license.

Assuming, Rejecting, and Assigning IP Licenses

A key decision for any debtor is whether to reject, or assume and assign its “executory contracts.” By assuming a contract, a debtor reaffirms the contract and agrees to honor its obligations going forward. To assume a contract, the debtor must cure or provide “adequate assurance” that all defaults will be cured, and provide adequate assurance of future performance. By rejecting a contract, the debtor disavows the contract and refuses to continue performing thereunder. A rejection is treated as a prepetition breach of the contract, and the counterparty is entitled to a general unsecured claim, which may be paid only cents on the dollar. Last, the debtor may assign a contract to such party, notwithstanding any contractual provision prohibiting assignment, so long as a debtor provides adequate assurance that the assignee can perform the contractual obligations.

But a debtor's ability to assign executory contracts is not unfettered. Rather, Bankruptcy Code section 365(c) provides that a debtor may not assume or assign an executory contract if applicable law excuses the counterparty from accepting performance from or rendering performance to a new party. This restriction protects counterparties from being forced to accept performance by a different party when non-bankruptcy law would prevent such a result.

Debtor-Licensor's Rejection of an ' ntellectual Property' License

The Fourth Circuit in Lubrizol Ent., Inc. v. Richmond Metal Finishers, Inc. ( In re Richmand Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985), held that a patent licensee loses its license rights when a licensor rejects the license in bankruptcy. In response to Lubrizol , Congress enacted section 365(n) to provide additional protection to intellectual property licensees. Under section 365(n), if a debtor rejects an intellectual property license, the licensee may elect to retain its right to use the licensed property (though the debtor is relieved of all affirmative obligations under the agreement).

Section 365(n) applies to “intellectual property,” yet the Bankruptcy Code's definition of that term excludes foreign patents and copyrights, trademarks, service marks, trade names, and rights of publicity. Fortunately for licensees, courts in two recent decisions rejected Lubrizol and held that the licensee of a trademark, while outside the Bankruptcy Code's definition of “intellectual property,” could continue using the trademark. See Sunbeam Products v. Chicago Am. Mnfc. , 686 F.3d 372 (7th Cir. 2012); In re Crumbs Bake Shop Inc., No. 14-24287, 2014 WL 5508177 (Bankr. D.N.J. Oct. 31, 2014).

Only a limited number of cases have addressed the holding of Lubrizol and its progeny, and thus uncertainty remains. However, courts have recently rejected the hardline decision in Lubrizol in favor of a broader and more practical interpretation of “intellectual property.” Nonetheless, licensees should continue to anticipate potentially adverse outcomes in this context and plan accordingly.

Sales of Intellectual Property by a Debtor-Licensor

Taken together, Bankruptcy Code sections 363(b) and (f) permit a debtor to sell assets (including intellectual property) “free and clear” of all liens, claims, and encumbrances. In other words, a debtor can sell property, even if another party asserts an interest in the property to be sold. However, an intellectual property licensee may have two special rights in connection with such a sale.

First, if a licensee has a lien on the property to be sold, the licensee can generally “credit bid” its indebtedness in connection with the sale. Distilled to its basics, credit bidding allows a lienholder to bid for the asset to which its lien attaches by using the debt it is owed to offset the purchase price. Credit bidding provides a lienholder two primary benefits: 1) it protects the lienholder against the risk that its collateral will be sold at a depressed price; and 2) it can provide an advantage at the auction because, unlike other bidders, a lienholder needs to commit new capital only if its bid exceeds the amount of its secured claim.

Second, a New Jersey bankruptcy court recently held that 363 sales are not free and clear of a licensee's right under section 365(n) to continue use of the debtor-licensor's intellectual property. Crumbs Bake Shop , 2014 WL 5508177. [See article by Azzopardi, et al., in this issue.] Phrased differently, even if a licensee does not have a lien on the licensed property to be sold, it may still be entitled to use the licensed property under section 365(n).

Assumption and Assignment By Debtor-Licensees

Similar to the rights afforded to a debtor-licensor, a debtor-licensee may assume, reject, or assume and assign intellectual property licenses. However, the implications of doing so are different when the licensee is in bankruptcy. Specifically, section 365(n) does not apply when a debtor-licensee rejects an intellectual property license ' the licensor retains ownership of the intellectual property, and thus there are no concerns about the licensor's ability to continue using the intellectual property after rejection. However, a debtor-licensee's ability to assume and assign an intellectual property license will vary depending on several factors, including: 1) whether the license is exclusive or nonexclusive; 2) the type of intellectual property; and 3) the jurisdiction of the bankruptcy case.

Courts have generally held that a debtor-licensee may not assign a nonexclusive patent license because such licenses are deemed personal and non-assignable under federal law. Everex Sys., Inc. v. Cadtrak Corp. ( In re CFLC, Inc.), 89 F.3d 673, 679 (9th Cir. 1996). Of course, if the license contains a provision permitting assignment by the licensee, then assignment would likely be permitted. With regard to the assignability of exclusive patent licenses, federal law has not been definitively established, and application of such law in the bankruptcy context is limited. Even though a debtor-licensee of an exclusive patent has much broader rights than the licensee of a nonexclusive patent ( e.g. , the right to sue for patent infringement), some courts have held that such licenses are also non-assignable without the licensor's consent. In re Hernandez, 285 B.R. 435, 440 (Bankr. D. Ariz.2002); ProteoTech, Inc. v. Unicity Int'l, Inc. , 542 F. Supp. 2d 1216, 1219 (W.D. Wash. 2008); In re Aerobox Composite Structures, LLC, 373 B.R. 135, 141 (Bankr. D.N.M. 2007).

Similar to patent licenses, courts have generally held that a debtor-licensee may not assign a nonexclusive copyright license because such licenses do not transfer ownership rights, thus rendering the license “personal” to the licensee. In re Patient Educ. Media, Inc., 210 B.R. 237, 240-43 (Bankr. S.D.N.Y. 1997). However, some courts have permitted a debtor-licensee to assign exclusive copyright licenses because such licenses convey an ownership interest. In re Golden Books Family Entm't, Inc., 269 B.R. 311, 319 (Bankr. D. Del. 2001).

Finally, courts have generally held that a debtor-licensee may not assign a trademark license because such licenses are deemed personal under non-bankruptcy law. N.C.P. Mktg. Group, Inc. v. Blanks (In re N.C.P. Mktg. Group, Inc.), 337 B.R. 230, 237 (D. Nev. 2005).

Although the above limitations on assignment would seemingly not affect a debtor-licensee's ability to assume an intellectual property license, such is not the case. The source of confusion lies in the interpretation of Bankruptcy Code section 365(c), which refers to a debtor's inability to “assume or assign” executory contracts that are non-assignable under non-bankruptcy law. In addressing this issue, courts utilize what have become known as the “hypothetical test” and the “actual test.”

Under the actual test, a court considers whether the debtor will actually assign the otherwise non-assignable contract. If the debtor does not intend to assign the contract, then assumption is permitted. Under the hypothetical test, the court disregards the debtor's actual intent, and simply deems the contract non-assumable because of the hypothetical possibility that the debtor could attempt to assign the contract after assumption occurs. The First and Fifth Circuits have expressly adopted the actual test, while the Third, Fourth, Ninth, and Eleventh Circuits use the hypothetical test. In re Aerobox Composite Structures, LLC, 373 B.R. 135, 140, n.7 (Bankr. D.N.M. 2007).

As a result of the foregoing assignment issues, debtor-licensees must use care in connection with any contemplated sale under section 363 that includes assignment of intellectual property licenses. And even where a debtor-licensee merely seeks to assume an intellectual property license, it may not be able to do so. These uncertainties make it that much more difficult for a debtor to navigate the choppy waters of Chapter 11. Further, the compressed timeline for 363 sales and the Chapter 11 process in general often leaves debtor-licensees in a difficult position.

Licensors and Licensees

Both licensees and licensors should consider the above issues pre-bankruptcy and take measures, some which are discussed below, to mitigate risks in the event of a bankruptcy filing.

Licensors should consider the following:

• Limit the term of any exclusive license, subject to renewal at the licensor's discretion. A debtor-licensee may assume an executory contract only as it existed prior to the bankruptcy filing, and thus a license agreement that expires by its own terms cannot be assumed (or assigned) by a debtor-licensee.
• Include in its license agreements specific requirements for adequate protection in the event of a bankruptcy filing. Although such provisions are not necessarily binding, they may influence a bankruptcy court's determination of adequate assurance, either by the debtor-licensee or its purported assignee.

Licensees should consider the following:

• Use an intellectual property escrow agreement. Although the enforceability and usefulness of such agreements in the event of a bankruptcy filing are beyond the scope of this article, such agreements may help to ensure the licensee's continued access to the licensed property after the licensor's bankruptcy filing.
• Obtain a security interest in the intellectual property as security for the licensor's obligations. This reduces the likelihood of rejection by the licensor in bankruptcy, which would trigger damages in the form of a secured claim.
• Structure the payment of royalties over the course of the license's term, rather than paying most or all royalties up-front. A debtor-licensor is less likely to forego the continued stream of revenue by rejecting the license.
• Vigilantly defend its rights in connection with a 363 sale by a debtor-licensor, lest it be deemed to consent to the sale free and clear of its interest. See FutureSource LLC v. Reuters Ltd. , 312 F.3d 281, 285 (7th Cir. 2002).
• Include in its license agreements language permitting assignment. At least one court has held that such language operates as consent by the licensor to assignment, notwithstanding applicable non-bankruptcy law. In re Glycogenesys, Inc., 352 B.R. 568 (Bankr. D. Mass. 2006).

Additionally, given the discrepancies in recent court decisions and the ever-changing landscape, a licensor or licensee seeking bankruptcy protection should carefully consider the jurisdiction in which it files.

Conclusion

Consideration of bankruptcy issues during the negotiation of intellectual property licenses is understandably not a priority for some. Yet many licensors and licensees depend to a significant degree on the use of intellectual property in their day-to-day operations, and thus parties should be aware of the troubled roads that lie ahead in the event of a bankruptcy filing, however unlikely.

Timothy W. Walsh is a partner and the head of the Restructuring & Insolvency practice of McDermott Will & Emery LLP. Gregory Kopacz and Darren Azman are associates in the practice.