Business Law Articles
Written By: Claire E. Shin
Los Angeles, California
What is IP in the Bankruptcy World?
In bankruptcy, intellectual property (IP) licenses are considered property of the bankruptcy estate, and a bankrupt party can do a variety of things with these licenses. It is important for holders of IP licenses to know what the possibilities are. But first, what exactly constitutes IP under the Bankruptcy Code?
The Bankruptcy Code defines IP to include: trade secrets; patents; patent applications; and copyrights. Curiously, the Bankruptcy Code’s definition of IP does not include trademarks, and courts are divided regarding whether trademarks should be included in IP, as the term is defined under the Code. Most courts have interpreted the omission of “trademarks” from the definition to mean that trademarks are treated differently than the other forms of IP in bankruptcy.
IP Licenses Are Generally Considered to Be Executory Contracts in Bankruptcy
Although the term “executory contract” is not defined in the Bankruptcy Code, it generally includes contracts on which performance remains due to some extent on both sides. Under the Bankruptcy Code, an IP license is generally considered to be an executory contract because such a license almost always requires some form of continuing performance by both sides. For example, a licensee must continue to pay royalties in order to be able to use the IP, and a licensor is obligated to continue to refrain from suing the licensee for infringement (so long as the agreed-upon royalty payments are made). These obligations constitute outstanding “performance” sufficient to make an IP license an executory contract. Because IP licenses are considered executory contracts, a bankrupt party has certain options, described below, regarding what it can do with these licenses.
Depending upon the facts of the case, a court may hold that an exclusive IP license is not an executory contract because it is essentially an assignment of all rights of the licensor in the IP to the licensee, and there is no remaining performance due on the part of the licensor. When this happens, the license agreement is not considered property of the bankruptcy estate, and is not subject to most of the things discussed below. The distinction between exclusive and nonexclusive licenses can significantly alter parties’ rights and controls over the use, sale or lease of IP during the bankruptcy case.
Executory Contracts Are Property of the Bankruptcy Estate and Are Protected by the Automatic Stay
Because executory contracts are considered to be “property” of the bankruptcy estate, the Bankruptcy Code’s “automatic stay” prevents the counterparty to an IP license from taking any action against the license itself during the bankruptcy, including unilaterally modifying or terminating the license.
Because of the peculiarities of the bankruptcy world, you may find yourself stuck in a situation where the bankrupt party (aka “debtor in possession,” “DIP” or “Debtor,” which has the duties and rights of a bankruptcy trustee) is NOT obligated to perform under those contracts, but YOU ARE required to perform. It is thus very important to talk to a business bankruptcy attorney as soon as you find out that your licensor or licensee has filed for bankruptcy!
What Can the Debtor Do with its IP License in Bankruptcy?
A Debtor has three (well, technically four) choices regarding IP licenses that are executory contracts – (1) assume; (2) reject; (3) assume and assign to a third party; or (4) do nothing.
The Debtor and the estate only become parties to an executory contract (and become bound by the contract) if and when the Debtor “assumes” it. As a rule, the Debtor must assume the entire contract as it found it, rather than cherry-picking just the pieces it likes. But it is not uncommon for parties to negotiate the terms of assumption in bankruptcy.
Upon assumption, the Debtor must cure any pre-bankruptcy defaults under the license. Also, any post-petition (that is, after bankruptcy filing) royalty payments under the license become an “administrative expense,” meaning that those post-petition royalties must be paid on a dollar on the dollar basis.
Rejection of the executory contract relieves the Debtor of its contractual obligations. The rejected license is deemed breached before the bankruptcy filing, giving the counterparty a pre-bankruptcy damages claim, which is typically paid less than 100 cents on the dollar.
Before the Debtor decides to reject the license, the Debtor may – but is not obligated to, at least for the first 60 days – continue to perform for its post-petition use in bankruptcy. The Debtor need not cure any pre-bankruptcy default during this time.
When Debtor is the Licensor, You are the Licensee, and the Debtor Rejects Your IP License:
The Bankruptcy Code has a provision that protects the rights of an IP licensee when the Debtor-licensor rejects the license. When the Debtor-licensor rejects the IP license, you as the non-debtor licensee have two choices: (#1) treat that license as breached and assert a breach of contract claim as you would outside the bankruptcy context; or (#2) elect to keep the rights to use the IP as those rights existed as of the date of the bankruptcy filing, including any exclusivity rights you may have under that IP license, as long as you continue to pay royalties through the bankruptcy case.
But choice #2 has some limitations. First, if you elect to continue to use the IP, you will not be allowed to set off any damages that you have against the Debtor for breach of contract for the ongoing royalty payments. Second, because “IP” in the bankruptcy world does not include trademarks, this protection likely does not apply to trademarks. Third, the election covers only patents and copyrights protected by the U.S. law and no foreign IP rights. Fourth, the right to continue to use the technology is only as to what the technology was as of the date of the bankruptcy filing. The Debtor has no obligation to provide you with updates or upgrades. This can be an important consideration if you are dealing with software that goes through constant updates.
What happens if you pre-paid your royalty payments, and then the Debtor-licensor files for bankruptcy? Would you be able to use your advance against post-petition royalty payments, essentially netting out the Debtor’s obligation to get you that money back? There is no clear answer to this question. Cases seem to go both ways. Some cases suggest that the party that made the advance cannot use it and must pay new dollars for post-petition royalty obligations, and some cases state that you may “recoup” it (not “set off” because you cannot set off your damages if you are going with choice #2) to pay your post-petition royalty obligations. Because there is uncertainty in the law, you should try to contract around it. Make your license agreement specify very clearly that in the event of the licensor’s bankruptcy, you would be able to use your advances (pre-paid royalties) as payments for the post-petition royalties, therefore eliminating any potential dispute.
(3) Assume and Assign (Sale and Transfer of IP Licenses)
The sale and/or transfer in bankruptcy of an IP license (exclusive or non-exclusive) is generally accomplished by the Debtor first assuming the license and then assigning it to the third-party buyer either as a single transaction or as a part of a larger sale of assets under the Bankruptcy Code, typically referred to as a 363 sale.
The Debtor’s ability to assume and assign is limited. Generally, non-exclusive IP licenses cannot be assigned by a debtor-licensee without the licensor’s consent. Some courts (including the Ninth Circuit) have gone further and held that because the Bankruptcy Code does not allow the assignment of non-exclusive IP licenses, a Debtor may not even “assume” such a license without the licensor’s consent, even if the Debtor does not intend to assign the license. (But, the outcome may be different if the Debtor is the exclusive licensee and holds exclusive rights to the IP – talk to your business bankruptcy lawyer).
(4) Do Nothing (If No One Objects to the Debtor Doing Nothing)
Because of the limitation described above, some Debtor-licensees choose to do nothing and try to take advantage of the Bankruptcy Code provision that says that any executory contract that does not get assumed or rejected in a bankruptcy “rides through” the bankruptcy, avoiding any controversy as to whether the Debtor may even assume the license agreement.
It is Important to Be Vigilant!
Bottom line: If you do not speak up, you will be stuck with whatever outcome is produced by other parties in the bankruptcy case – so it pays to be vigilant regarding developments in the bankruptcy case!