What to Do When an Entertainment Industry Licensee or Licensor Files for Bankruptcy

Legal uncertainty abounds for entertainment industry 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 '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.

Reject, Assume or Assign?

A key decision for any entertainment industry 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. 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 pre-bankruptcy petition breach of the contract, but the counterparty is entitled to a general unsecured claim, which may be paid only cents on the dollar.

Alternatively, the debtor may assign the contract, 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 '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.

The Bankruptcy Code

Congress enacted '365(n) to provide additional protection to intellectual property licensees. Under '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. Entertainment industry licensees should note that courts in two fairly recent decisions 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 Inc. v. Chicago American Manufacturing LLC, 686 F.3d 372 (7th Cir. 2012); In re Crumbs Bake Shop Inc., 522 B.R. 766 (Bankr. D.N.J. 2014). Nonetheless, such licensees should continue to anticipate potentially adverse outcomes in this context and plan accordingly.

Taken together, Bankruptcy Code ”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, a licensee who has a lien on the property to be sold can generally “credit bid” the 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, the Crumbs Bake Shop bankruptcy court 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. 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).

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 copyright license because such licenses do not transfer ownership rights, thus rendering the license “personal” to the licensee. However, some courts have permitted a debtor-licensee to assign exclusive copyright licenses because such licenses convey an ownership interest. See, e.g., In re Golden Books Family Entertainment Inc., 269 B.R. 311 (Bankr. D.Del. 2001).

Furthermore, courts have generally held that a debtor-licensee may not assign a trademark license because such licenses are deemed personal under non-bankruptcy law.

Although these 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 '365(c), which refers to a debtor's inability to “assume or assign” executory contracts that are non-assignable outside of bankruptcy law.

In addressing this issue, courts utilize what have become known as the “hypothetical test” and the “actual test.” Under the actual test, if a 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.

Due to the foregoing assignment issues, entertainment industry debtor-licensees must use care in connection with any contemplated sale under '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 a Chapter 11 bankruptcy. Further, the compressed timeline for '363 sales and the Chapter 11 process in general often leaves debtor-licensees in a difficult position.

Mitigate Risk

Both entertainment industry licensees and licensors should consider the above issues pre-bankruptcy and take measures, some of 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; and
• Include in 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. Such agreements may help to ensure a licensee's continued access to the licensed property after a 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;
• 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 the licensee's rights in connection with a '363 sale by a debtor-licensor, to prevent the licensee to have been deemed to consent to the sale free and clear of its interest; and
• Include in license agreements language that permits assignment. Such language may operate as consent by the licensor to assignment, notwithstanding applicable non-bankruptcy law.

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.

Timothy W. Walsh is a New York-based partner and the head of the restructuring and insolvency practice of McDermott Will & Emery. Gregory Kopacz and Darren Azman have served as associates in the practice.

Legal uncertainty abounds for entertainment industry 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 '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.

Reject, Assume or Assign?

A key decision for any entertainment industry 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. 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 pre-bankruptcy petition breach of the contract, but the counterparty is entitled to a general unsecured claim, which may be paid only cents on the dollar.

Alternatively, the debtor may assign the contract, 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 '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.

The Bankruptcy Code

Congress enacted '365(n) to provide additional protection to intellectual property licensees. Under '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. Entertainment industry licensees should note that courts in two fairly recent decisions 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 Inc. v. Chicago American Manufacturing LLC, 686 F.3d 372 (7th Cir. 2012); In re Crumbs Bake Shop Inc., 522 B.R. 766 (Bankr. D.N.J. 2014). Nonetheless, such licensees should continue to anticipate potentially adverse outcomes in this context and plan accordingly.

Taken together, Bankruptcy Code ”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, a licensee who has a lien on the property to be sold can generally “credit bid” the 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, the Crumbs Bake Shop bankruptcy court 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. 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).

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 copyright license because such licenses do not transfer ownership rights, thus rendering the license “personal” to the licensee. However, some courts have permitted a debtor-licensee to assign exclusive copyright licenses because such licenses convey an ownership interest. See, e.g., In re Golden Books Family Entertainment Inc., 269 B.R. 311 (Bankr. D.Del. 2001).

Furthermore, courts have generally held that a debtor-licensee may not assign a trademark license because such licenses are deemed personal under non-bankruptcy law.

Although these 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 '365(c), which refers to a debtor's inability to “assume or assign” executory contracts that are non-assignable outside of bankruptcy law.

In addressing this issue, courts utilize what have become known as the “hypothetical test” and the “actual test.” Under the actual test, if a 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.

Due to the foregoing assignment issues, entertainment industry debtor-licensees must use care in connection with any contemplated sale under '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 a Chapter 11 bankruptcy. Further, the compressed timeline for '363 sales and the Chapter 11 process in general often leaves debtor-licensees in a difficult position.

Mitigate Risk

Both entertainment industry licensees and licensors should consider the above issues pre-bankruptcy and take measures, some of 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; and
• Include in 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. Such agreements may help to ensure a licensee's continued access to the licensed property after a 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;
• 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 the licensee's rights in connection with a '363 sale by a debtor-licensor, to prevent the licensee to have been deemed to consent to the sale free and clear of its interest; and
• Include in license agreements language that permits assignment. Such language may operate as consent by the licensor to assignment, notwithstanding applicable non-bankruptcy law.

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.

Timothy W. Walsh is a New York-based partner and the head of the restructuring and insolvency practice of McDermott Will & Emery. Gregory Kopacz and Darren Azman have served as associates in the practice.