IP LICENSES

IN BANKRUPTCY

Or

WHAT’S AN EXECUTORY CONTRACT ANYHOW?

Peter Ludwig

Fish & Richardson

New York

February 2012

Disclaimer

______________________________

I’m an IP Lawyer,

not a Bankruptcy Lawyer

_____________________________

This is a Look at IP License Issues

in Bankruptcy,

Not a Bankruptcy Law Lecture

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(1)Bankruptcy Terminology

(2) IP Licenses in Bankruptcy

(3)Drafting Considerations

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SUMMARY

BANKRUPTCY TERMINOLOGY

See Bankruptcy Code-Title 11 U.S.C.

“Intellectual Property”

Definition in 11 U.S.C.§101(35A) of Bankruptcy

Code

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TERMINOLOGY

INTELLECTUAL PROPERTY INCLUDES:

(1) Trade Secrets

(2) Inventions Covered Under 35 U.S.C., Processes, Designs,

Patents

(3) Patent Applications

(4) Copyrights

(5) Plant Varieties

(6) Mask Works (Title 17, Chapter 9) 5

TERMINOLOGY

BUT INTELLECTUAL PROPERTY DOESN’T INCLUDE:

(1) Trademarks / Trade Names

(2) Service Marks

(3) Overseas IP not within treaties between U.S. and country of

origin of work that provide reciprocal protection or are

otherwise protected under 35 U.S.C. or 17 U.S.C.

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TERMINOLOGY

Why Aren’t Trademarks Considered IP for

Bankruptcy Purposes?

Congress; Trademarks “Depend to a large extent on control of

quality and service,” so decided to “Allow the development of

equitable treatment of this situation by bankruptcy courts.”

(Sen. Report 100-505, 100th Congress, 2d Sess. (1988))

In some circumstances (where protection similar to patent and

copyright law needed), trademark may be treated like other IP

assets, e.g., prevent unauthorized use of TM; preserve value of

business name and/or product.

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TERMINOLOGY

“Executory Contract”

Surprising!!

Not defined in Bankruptcy Code

Widely adopted definition by Prof. Vern

Countryman (Harvard Law School), specialist in

commercial law and debtors’ rights

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TERMINOLOGY

“Executory Contract”

Countryman Definition for an Executory Contract

“Contract under which obligation of bankrupt and other party to

contract are so far unperformed that failure of either to complete

performance would constitute a material breach excusing performance

of the other (Countryman, Executory Contracts in Bankruptcy, Part I

(7 Minn Law Review 439, 460 (1973))

*Sometimes referred to as Material Breach Test

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TERMINOLOGY

Countryman Material Breach Test

Test Used by Most Courts

(Minority Approach)

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See, In re La Electronica, Inc., 995 F.2d 320, 322 n.3 (1st Cir. 1993)

See, In re Bradlees Stores, Inc., 2001 WL 1112308 at *6 (S.D.N.Y.

Sept. 20, 2001) (collecting cases)

Functional Test - Contract executory if determination

permits debtor to reject contract as burdensome or

unenforceable.

Decided based on impact on bankruptcy case

TERMINOLOGY

Bankruptcy Proceedings - 2 major formats

CHAPTER 7 - Liquidation (11 USC §701-784)

– Most common form

– Liquidation Proceeding

– Debtor’s non-exempt assets sold by Chapter 7 Trustee

PROCEDURE

– Trustee takes control of non-exempt assets, sells them and pays

creditors whatever proceeds sales permit

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TERMINOLOGY

CHAPTER 11 – Reorganization (11 USC §1101-1174)

– Reorganization proceeding

– Debtor usually remains in possession of its assets (DIP)

– DIP continues to operate business with oversight by

Court and Creditors Committee

– DIP – Fiduciary duty to maximize value for creditors of

the Bankruptcy entity

– Debtor proposed reorganization plan

– Confirmed by Court, if accepted by majority of creditors

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TERMINOLOGY

Section 365 of Bankruptcy Code

Trustee’s Authority to Assume, Assign or Reject

(11 U.S.C. § 365)

Grants bankruptcy trustee (or debtor in possession) authority to

“assume”, assign, or “reject” executory contracts to which

debtor is a party.

TEST: Is “action” in best interest of debtor?

Trustee’s Decision rejected only if “manifestly unreasonable”

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IP LICENSES

Are IP Licenses Executory Contracts?

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Q - Do IP licenses fall under definition of executory

contracts?

A - Probably almost all do.

Q - Why?

A - Unperformed obligations by both parties make IP

license “executory.” (Countryman definition)

IP LICENSES

Unperformed Obligations

Obligation to pay royalties usually not enough to cause

contract to be declared “executory” (See Lubrizol Enters.,

Inc. v. Richmond Metal Finishers, 756 F.2d 1043, 1045

(4th Cir. 1945)

General rule: Provisions that are more like conditions, than

affirmative duties or performance; sufficiently material to

establish agreement as an executory contract

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IP LICENSES

Provisions Held to Establish Executory Obligations

Licensor

Covenant not to sue for infringement

Duty to maintain IP

Licensee

Territorial restrictions

Reporting obligations

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IP LICENSES

BOTTOM LINE

Almost any obligation, besides obligation to pay, enough to

establish IP license as executory contract under bankruptcy

law test.

– See, In re Access Beyond Techs., Inc., 237 B.R. 32, 43 D. Del. 1999);

– Everex Sys., Inc. v. Cadtrak Corp., 89 F.3d 673 (9th Cir. 1996)

– See also, In re Gencor Indus. Inc., 298 B.R. 902, 907 (Bankr. M.D. Fla

2003) Holding that “most favored nations” and “patent defense” were

conditions of payment, not continuing material obligations 17

IP LICENSES

While §365(a) gives trustee or debtor in possession authority to

(1) assume or

(2) reject

executory contracts.

Trustee must assume or reject entire contract; no piecemeal

assumptions

– See, Stewart Title Guaranty Co. v. Old Rep. National Title Insurance

Company, 83 F.3d 735, 741 (5th Cir. 1996)

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IP LICENSES

Decision is matter of debtor/trustees business judgment

– Orion Pictures Corp. v. Showtime Networks, 4 F.3d 1095

(2d Cir. 1993)

Factors in Decision

(a) Benefit to bankrupt’s estate

(b) Dilution to other creditors

(c) Liability as administrative claim if assumed contract subsequently

rejected

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IP LICENSES

Time Limit on Acceptance/Rejection

§365(d) sets time in which trustee/debtor must decide

whether to accept/reject

(1) In Chapter 7 proceeding

- Within 60 days of bankruptcy petition

(2) In Chapter 11 proceeding

- Any time before confirmation of reorganization plan

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IP LICENSES

Acceptance/Rejection

What happens if Chapter 11 debtor doesn’t accept or reject

license?

Termed “Ride Through”

No requirement in bankruptcy code that Chapter 11 debtor

must assume or reject

License is property of debtor after confirmation

1st, 2nd, 3rd, 4th, 5th and 9th Circuits recognize “Ride

Through” doctrine

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AUTOMATIC STAY

11 U.S.C.§362(a)(3)

Triggered by bankruptcy filing

Protects bankruptcy estate from any act to obtain possession

of property of the estate or of property from the estate or to

exercise control over property of the estate

Patents, TM’s & Copyrights are “property of the estate”

Injunction against continuance of any action, by any creditor

against debtor (11 USC § 362)

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AUTOMATIC STAY

Parties can seek stay relief to terminate IP license for cause

e.g. worried that debtor can’t maintain quality control or cure

defaults

See Ford Motor Co. v. Claremont Acquisition Corp, Inc.,

186 B.R. 977 (C.D. Calif 1995)

Stay remains in effect until

(1) Judge lifts stay

(2) Debtor gets discharge

(3) Item is no longer property of the estate

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AUTOMATIC STAY

Replaced by permanent injunction when debtor receives

discharge

P.I. Prohibits creditors from all actions that automatic stay

prohibited

While stay in effect, non-debtor can’t unilaterally terminate

IP license (11 U.S.C. §362(a))

Attempts to terminate - can be contempt of court

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IP LICENSES - DEBTOR AS LICENSEE

Tension Between Bankruptcy and IP Law

§365(a) authorizes debtor to assume or reject any executory

contract

§365(d) authorizes debtor to assign executory contract,

despite existence of provision in contract barring assignment

-----------------

Conflict between

IP Law (concepts of monopoly and non-assignability)

and

Bankruptcy Law (based on maximizing value for all parties)

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IP LICENSES

Assumption by Debtor Licensee

§365(b)(1) - conditions of assumption are

(1) defaults must be cured and

(2) assuming party must provide adequate assurance of

future performance (§365(b) (1))

Examples of Future Performance in IP Licenses:

(1) Pay royalties

(2) Maintain quality

(3) Continued sales 26

IPSO FACTO CLAUSES

§365(e)(1) and §541(c) - clause that automatically

terminates contract upon “insolvency”, “financial condition”,

or filing of bankruptcy

Unenforceable once bankruptcy case has been filed

But could be important (if debtor rejects license) to

determine if contract has been/can be terminated under

contract law

See, One South, Inc. v. Hollowell, 963 So. 2nd 1156 (Miss.

2007)

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IP LICENSES

Limitations on Assignment §365(c) - Trustee can’t assume/assign executory contract if

(a) “Applicable Law” excuses a party, other than debtor from

accepting/rendering performance to entity other than debtor, whether or

not contract restricts assignment of rights, and

(b) Party does not consent to such assumption or assignment

Applicable Law = PAT, TM, Copyright laws: Can prevent DIP from

assigning or assuming contract

Extraordinary - read literally, affords patent licensor ability to decline

honoring executed license with bankrupt licensee

Well-established principle under Federal Common Law, unless otherwise

provided by terms of agreement, non-exclusive license is personal and not

freely assignable 28

IP LICENSES

Limitations on Assignment (1) In most jurisdictions, non-exclusive licenses generally not

assignable over licensor’s objection (unless permitted by

License)

See Everex Systems v. Cadtrak, 89F.3d 673 (9th Cir. 1996));

(2) Exclusive licenses assignable over objection of Licensor

See Leicester v. Warner Bros. Corp., 232 F. 3d 1212 (9th Cir.

2000)

What’s the Rationale Here??

Exclusive licensee acquires actual property rights and may freely

transfer them and licensor can’t transfer them to someone else

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§365(c) Interpretation

Courts differ in how §365(c)(1) should be interpreted

365(c) (Condensed version) Trustee may not assume or

assign executory contract, whether or not contract prohibits

or restricts assignment of rights, if

(1) applicable law excuses a party (other than debtor) to the contract

from accepting performance from or rendering performance to, an

entity other than the DIP or debtor, whether or not such contract or

lease prohibits or restricts assignment of rights or delegation of

duties, and

(2) such party does not consent to such assumption or assignment.

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§365(c)

Query? Does “OR” mean “AND” also?

I.e., what happens when bankrupt party wants only to keep (assume) a

licensee? Does 365(c) mean debtor can neither assign or assume? Or just

that debtor can’t assign?

Can debtor hypothetically assign the license even though it doesn’t want to

(“hypothetical test”) or what is debtor actually proposing to do (“actual

test”)?

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365(c) SUMMARY Problematic Split Among Courts

Most courts agree §365(c)(1) bars assignment of executory

contracts absent non-debtor’s consent, if “applicable law”

(§365(c) requires such consent

Otherwise, non-debtor must accept performance from a new

party

Courts split on whether language of 365(c) prohibits DIP

(Trustee)

(1) from assuming executory contracts or

(2) only from assigning them

Circuits don’t agree: Apply different tests 32

Tests for Determining

Applicability of §365(c)

1) “Actual Test” - 1st Circuit (favors licensee)

If DIP has no intent to assign executory contract to 3rd party,

contract can be assumed if DIP meets requirements of §365

(Defaults cured and can provide assurance of future performance)

See Institut Pasteur v. Cambridge Biotech, 104 F.3d 489 (1st Cir

1997)

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Circuits don’t agree: Apply different tests

Tests for Determining

Applicability of §365(c)

2) “Hypothetical Test” - 3rd, 4th, 9th and 11th Circuits (favors

licensor)

Precludes assumption, or assumption + assignment, of IP license

without consent of licensor, if license not assignable under non-

bankruptcy law without consent of licensor

See, In re West Electronics, 852 F.2d 79 (3rd Cir. 1988); In re Catapult

Entertainment Inc., 165 F3d 747 (9th Cir. 1999); N.C.P. Marketing Group v.

BG Star Products, 279 Fed. Appx 561 (9th Cir. 2008), Cert denied 129 S. CT

1577 (2009)

* Rights of licensee can be taken away

* Potential windfall to licensee 34

Tests for Determining

Applicability of §365(c)

3) “Footstar Test” (New approach to §365(c) dilemma)

– Term “Trustee” in §365(c) should not include debtor-in-possession

– Prohibition against assignment + assumption under §365(c) is

limited to conditions where “Trustee”, not debtor in possession,

wants to assume executory contract

See, In re Footstar Inc., 323 B.R. 566, 573 (Bankruptcy S.D.N.Y. 2005)

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Tests for Determining

Applicability of §365(c)

“Footstar Test” (Sometimes “The New York Test")

– Solution for courts seeking to avoid negative consequences

of debtor/licensee that enters bankruptcy, but wants to

assume, not assign its IP licenses

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FOOTSTAR

Footstar – not involve IP license

Adopted “literal” reading of 365(c)(1)

Meant to be harmonious with objective of §365(c) and

overall objecting of bankruptcy code

No construction of what “or” means

Use of word “Trustee” not include debtor or DIP

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FOOTSTAR

Accordingly right of non-debtor party to object to

assignment doesn’t affect right of DIP or debtor (as

contrasted with right of trustee) to assume an executory

contract

Followed by SDNY in Adelphia Communications (Adelphia

2007 WL 64728 at *3 N. 13)

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FOOTSTAR

Adelphia Court – “Footstar” consistent in outcome with the

decisions of courts following the “actual” test

Notable because many large bankruptcy filings made in

SDNY, e.g., Delphi, Enron, Worldcom, Delta Airlines

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See, In re Footstar, 323 B.R. 566, 570-72 (Bankr. S.D.N.Y.

2005) Judge Adlai Hardin

“Great majority of lower courts have taken the view

that…courts should apply an actual test…to permit assumption

where…debtor in possession…does not intend to assign the

contract.”

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TYPICAL SITUATION ADDRESSED BY

FOOTSTAR

(1) Debtor is patent licensee

(2) License signed before bankruptcy filing

(3) Licensor moves to force DIP to reject license agreement or

to lift automatic stay so licensor can cancel agreement

(4) Licensor argues DIP can’t assign license & under

“hypothetical” test, can’t assume agreement

(5) Licensor argues DIP should be forced to reject license

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Recent decision in Aerobox Composite Structures, LLC

bankruptcy filing 373 B.R. 135, 138, 140-42 (Bankr. M.D.

NM)

Found Footstar was proper interpretation of §365-n

Denied licensor’s motion

DIP not barred by §365(c)(1) from assuming pre-petition

license 42

BOTTOM LINE OF §365(c)

Venue may decide outcome

SDNY follows Footstar

1st Circuit follows actual test

3rd, 4th, 9th, & 11th Circuits follow hypothetical test

6th, 7th, & 10th Circuits unsettled on which test to follow

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§365(n) DEBTOR AS LICENSOR 1988 Intellectual Property Licenses in Bankruptcy Act

(IPLBA) Pub. Law 100-506

§365(n) – rights of IP licensee when trustee rejects executory contract

where debtor is licensor

If executory contract is rejected, licensee can

(1) treat contract as terminated by reason of rejection – seek

damages for breach or termination, or

(2) retain its rights under license, including exclusivity, for

duration of agreement

Doesn’t protect exclusive licensee against failure to record and

“applicable non-bankruptcy law” requires license recordation

Doesn’t apply to trademarks: TM licensees must rely on interpretation

of §365(c)(1) 44

§365(n) DEBTOR AS LICENSOR

Only deals with

(1) rejection by licensor, not by licensee, and

(2) whether license may be (i) assumed or (ii) assumed

and assigned by bankruptcy trustee

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365(n) DEBTOR AS LICENSOR

Protects rights to embodiments of IP to which licensee

entitled under applicable underlying contracts (see S. Rep.

No. 100-505 at 9 (1988)

Licensee has no rights in IP developed after bankruptcy

filing even when rejected license agreement gave rights to

use improvements (Szombathy v. Controlled Shredders Inc.

No. 97 c 481, 1997 WL 183914 (N.D. IL 1997) 46

365-n

TIMING OF ELECTION

When does licensee exercise its right of election under

§365-n?

365(n)(1)(b) allows licensee to “elect to retain its rights”

Right arises only on rejection of license by bankrupt and not

before

See, Dynamic Changes Hypnosis Center, Inc. v. PCH

Holding LLC, 306 B.R. 800, 809 (E.D. VA 2004)

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SOME THOUGHTS ON

LICENSE DRAFTING

What circuit laws may be applicable on bankruptcy of other

party to agreement

Ipso Facto Clauses – unenforceable but could be valuable to

permit termination after rejection of contract

Right to terminate for conduct likely to occur before

bankruptcy; poor financial results, performance delays

Change of control gives right to terminate (avoid Ipso Facto

problems

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SOME THOUGHTS ON

LICENSE DRAFTING

Try to structure license as non-executory

– Only obligation is to pay royalty;

– Put other obligations in separate executory agreement, e.g. patent

maintenance

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SOME THOUGHTS ON

LICENSE DRAFTING

If licensee retains rights, must continue to make royalty

payments

Define triggering event for depositing source code; escrow

over which DIP has no control; not property of estate

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SOME THOUGHTS ON

LICENSE DRAFTING

Try to obtain security interest in underlying IP as security for

performance of debtors obligations (strengthen rights of non-

debtor party)

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Thank you!

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