By Jordan Markham*
A pdf version of this article may be downloaded here.
In uncertain times, or when dealing with uncertain partners, planning for the possibility of bankruptcy ex ante can provide a very real benefit to a party contemplating a patent licensing agreement. Since the financial crisis of 2008, many contractual partners who formerly looked rock solid have experienced major cash-flow problems. In addition, it has always been the case that in some fields of technology, such as biotech, a significant number of businesses are expected to fail. Thus, it is important to think through at the outset how a license might be treated by a bankruptcy court, and where possible, to structure the agreement accordingly. How to best do this will depend primarily on whether a party is the patentee or the licensee, and on the extent to which rights are transferred (i.e. whether the transaction results in a sale or merely a license agreement). As we shall see, in the context of a bankruptcy proceeding, the patentee is generally better served by a greater, and a licensee by a lesser, transfer of rights.
This article will explore these dynamics in detail. It will first consider the effects of a bankruptcy court’s categorization of a patent rights transfer agreement as either an executory contract or a completed sale, and then it will consider how courts make this categorization. In particular, it will begin by describing the provisions in the Bankruptcy Code that deal with executory contracts and how the parties’ rights depend on whether the debtor is the licensor or the licensee. It will then consider, from the view of patent law, the difference between assignments and licenses. It will move on to explore how courts in bankruptcy categorize assignments and different types of license agreements as either executory contracts or completed sales. Finally, it will conclude with practical suggestions that flow from the preceding analysis.
II. The Treatment of Executory Contracts Under the Bankruptcy Code
A. Section 365(a) and the Power to Accept or Reject an Executory Contract
Under the bankruptcy code, a transfer of intellectual property rights is either a completed sale or an executory contract. But agreements respecting patent rights do not naturally present themselves as one or the other. Transactional intellectual property lawyers usually speak of transfers of patent rights in terms of assignments and licenses. For present purposes, the following simplifications are useful. An assignment is a transfer of all significant rights under a patent, including the right to sue. For bankruptcy purposes, an assignment is usually treated as a completed sale. A license is an agreement whereby a patentee agrees to refrain from enforcing her right to exclude the licensee from exploiting her invention in some way. The vast majority of effective license agreements are considered executory contracts for bankruptcy purposes.
Assignments result in fewer complications than licenses under bankruptcy law. If the bankrupt party is the buyer/assignee and the assignment does indeed amount to a completed sale, the rights under the assignment become property of the bankruptcy estate and may be disposed of accordingly.[FN1]Meanwhile, the seller/patentee need have no dealings with the bankruptcy proceeding except insofar as she is owed compensation by the bankrupt party (in which case her claims will be treated as any other prepetition claim of like kind).[FN2] Where the nondebtor is the buyer/assignee, unless the assignment amounts to a fraudulent transfer,[FN3] it is similarly free from entanglements with the bankruptcy proceeding since the bankrupt seller has already assigned over its rights.[FN4]
In contrast to the simplicity of completed sales, executory contracts are governed by the complex provisions of section 365 of the Bankruptcy Code[FN5] and are the subject of considerable controversy in bankruptcy courts. Section 365(a) permits “the trustee [or debtor in possession[FN6]], subject to the court’s approval, [to] assume or reject any executory contract or unexpired lease of the debtor.”[FN7] Note that section 365(a) pertains to executory contracts, as do the other subsections of section 365. These provisions, therefore, govern the vast majority of license agreements.[FN8] The effect of 365(a) is to allow the debtor[FN9] to assume or reject a contract depending on whether, from the debtor’s perspective, the net gain outweighs the liabilities under the contract.
The power placed in the hands of the debtor by section 365(a) to accept or reject a contract without regard to the preferences of the opposite party is considerably limited by protections built into the remainder of the section or read into it by courts that serve that party’s interests. Courts have held that the debtor must have some minimal business justification for its choice[FN10] and may not, for example, reject a contract for the sole purpose of harming a competitor.[FN11] Further, if the debtor chooses to assume a contract under 365(a), it must assume the entire contract with all of its burdens.[FN12] To comply with section 365(b), the debtor must cure any prior defaults and provide adequate assurance of future performance.[FN13] In the event that the debtor rejects an executory contract, under subsection 365(g), the nondebtor is entitled to a prepetition unsecured damages claim for breach of that contract.[FN14] Finally, as will be discussed below, the power granted to the debtor under 365(a) is further limited by the carve-outs described in 365(c) and 365(n), which apply when the debtor is the licensee and licensor, respectively.
B. When the Nondebtor is Licensee: Section 365(n)
Section 365(n)[FN15] provides an important protection to a licensee from the potentially severe consequences of having rights for which it contracted and on which it may depend suddenly yanked away by an insolvent licensor. The protection of section 365(n) was added relatively recently as part of the Intellectual Property Bankruptcy Protection Act of 1988 in response to a particularly alarming decision by the Fourth Circuit Court of Appeals.[FN16]
In Lubrizol, the debtor licensor sought to reject its non-exclusive license agreement with Lubrizol for no other reason than that its “continued obligation to Lubrizol under the agreement would hinder [its] capability to sell or license the technology on more advantageous terms to other potential licensees.”[FN17] Meanwhile, Lubrizol argued that it would be seriously damaged by having to renegotiate with the debtor at this juncture. The Fourth Circuit was not unsympathetic, stating that “allowing rejection of such contracts … imposes serious burdens upon contracting parties such as Lubrizol.”[FN18] It was further concerned that such a result would “have a general chilling effect upon the willingness of such parties to contract at all with businesses in possible financial difficulty.”[FN19] However, when a statute enacted by Congress is clear, courts will usually apply it literally, regardless of its results or questionable policy. This is what the Fourth Circuit did with section 365(a), allowing the debtor to reject the contract and leaving Lubrizol in a difficult position.
Congress could do nothing for Lubrizol, but it did mitigate the problem for future licensees in Lubrizol’s position. Section 365(n) allows a licensee of “intellectual property”[FN20] to retain its rights under the license, at least to the extent that they do not require specific performance of affirmative obligations of the debtor.[FN21] Exclusive licenses remain exclusive, confidentiality agreements remain in effect, and licensees even retain any option to extend the license built into the agreement.[FN22] In exchange, of course, licensees must continue to pay any royalties due under the agreement.[FN23] Or, alternatively, if the licensee prefers to accept the debtor’s rejection, it has the usual option of treating the rejection as a breach giving rise to prepetition unsecured damages claim under section 365(g).[FN24]
C. When the Nondebtor is the Licensor: Section 365(c)
Section 365(c) is an extraordinary provision which, when read literally, in most cases gives a licensor of patented technology the ability to refuse to honor a contract with a licensee in bankruptcy. Section 365(c) provides:
The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—
(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment…[FN25]
The provision would more readily make sense if it read, “the trustee may not assume and assign any executory contract….” In that case, the licensor would simply be extended the same right under bankruptcy law – to refuse performance from a party with whom it did not contract – that it had prior to the bankruptcy (assuming it had that right). But the statute reads otherwise. It says that if the nondebtor licensor objects to the assumption of the contract by the debtor, and if non-bankruptcy law excuses that licensor from accepting performance from some other (hypothetical) third-party, the debtor itself may not assume the license.
This is a severe limitation on the rights granted to the debtor under section 365(a). The pertinent non-bankruptcy “applicable law” for patent licenses is federal common law.[FN26] It is a well-established principle under this law that unless the terms of the agreement provide otherwise, a non-exclusive patent license is personal in nature and therefore not freely assignable.[FN27] This rule has been extended to exclusive licenses by at least one lower court,[FN28] and that court was almost certainly correct in its decision.[FN29] Although an exclusive license represents a more complete transfer of rights, it is still personal in nature. It would be a serious and unjustifiable burden to ask a patentee to accept performance on an exclusive license from a competitor who sought to suppress rather than exploit the invention. Of course, the code is correct to honor this right under federal common law. But it does not follow that patentees should be free to reject performance from the debtor itself. The terms of section 365(c)(1) allows a licensor, at its whim, to force a renegotiation of terms of access to patented technology to which the debtor had already secured a right. This flies in the face of the core bankruptcy policy in favor of maximizing the value of the estate. Nevertheless, many courts have felt constrained to follow this “plain meaning” of the statute.
This literal interpretation of section 365(c) is usually called the “hypothetical test.” The test asks whether the licensor would be excused from doing one thing (acquiescing to assignment to a hypothetical third party) in order to determine whether it is excused from doing another (acquiescing to assumption). The Third, Fourth, Ninth, and Eleventh Circuits take the “hypothetical test” approach.[FN30] This approach has the merits of leaving lawmaking to a representative elected body and of holding Congress to its words.[FN31] Plain meaning dogmatists would also claim that it has the advantage of predictability since anyone can read the statute and know what it means without delving deep into the case law or engaging in some kind of mystical divination of Congressional purpose.[FN32]
Such a divination was attempted by the First Circuit Court of Appeals in Summit Inv. & Dev. Corp. v. Leroux.[FN33] The court in this case looked to two pieces of statutory history[FN34] to justify the conclusion that subsection 365(c) – and, more to the point in Leroux, 365(e) as well[FN35]– contemplates a “case-by-case inquiry” into whether the nondebtor party was actually being forced to accept performance under its executory contract from someone other than the debtor party with whom it originally contracted.[FN36] This approach is referred to as the “actual test.”
Before looking to statutory history, the court in Leroux concluded that 365(c) is ambiguous and capable of alternative readings.[FN37] It is not true that 365(c) alone is ambiguous. It speaks clearly. However, as has been noted by advocates and courts, section 365(f) conflicts with section 365(c).[FN38]Section 365(f)(1) provides:
Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.[FN39]
That 365(f) allows the assignment of contracts notwithstanding applicable law indicates a drafting error. Section 365(f)(1) is conditioned on 365(c), and 365(c) expressly prohibits both assumptions and assignments when they are excused by applicable law. Thus, 365(f)(1), by way of 365(c)(1), renders itself superfluous.[FN40] One or the other provision is in error. But the way the statute conflicts does not lead logically to the conclusion that the “actual test” is correct. Policy intuition, on the other hand, does lead to this conclusion. The actual test does not unduly burden the estate by permitting a hold-up style renegotiation, and it also does not force a patentee to accept performance from a third party where federal common law would excuse it. It is in keeping with sound bankruptcy policy and, not surprisingly, it is the test favored by respected commentators and academics.[FN41]
Of course, from a licensor’s point of view, the hypothetical test is preferable to the actual test. It has the virtue of insuring the nondebtor against being locked into an agreement with a partner who is only marginally viable, or whose management or ownership has changed in a way that is disagreeable to the licensor.[FN42] Particularly for a patentee who has granted an exclusive license, and thereby promised not to license the technology to another party, the burden of having to accept performance from a defunct partner is substantial.[FN43] That these burdens probably do not justify the terms of 365(c) as Congress drafted it,[FN44] and that not all courts apply the hypothetical test, should give pause to a potential licensor. The area of law is unstable and probably not to be depended upon.
In fact, at least one court in a “hypothetical test” jurisdiction has allowed a work-around solution to the debtor’s 365(c) problem. In In re Hernandez,[FN45] the court permitted the debtor to intentionally neglect to accept or reject an exclusive license agreement under 365(a) so that the license would simply “ride through” the bankruptcy unaffected.[FN46] The so called “ride through” doctrine has been approved by courts of appeals in other contexts[FN47] and could provide an effective shield for debtor licensees against 365(c). The major drawback from the debtor’s perspective is that since the contracts are not accepted under 365(a), the protection against ipso facto clauses in 365(e) does not apply.[FN48]
What lessons can we learn from the material just surveyed? As a nondebtor licensee, it would be helpful to structure an agreement as an assignment when possible, since an assignee is beyond the reach of the bankruptcy court. However, when this is not a realistic option, the licensee’s rights are reasonably well protected by section 365(n). The only further precaution that might be helpful is to provide for the option to extend the length of the agreement, since these options will be honored by a bankruptcy court.
As a licensor, it is advantageous to have the agreement in the form of an executory contract. This is because section 365(c) allows for at least some continuing control over the technology. In a jurisdiction where the “actual test” is followed, the licensee will be prevented from assigning the license without the licensor’s consent. In a “hypothetical test” jurisdiction, the licensor will have the right to refuse performance even from the licensee. Executory contracts include practically all licenses agreements in most jurisdictions, but it would be helpful to have at least some of the licensee’s payments in the form of royalties, rather than a single lump sum. Specifying any other significant ongoing obligations imposed on the licensor would also be helpful. Finally, in order to avoid a “ride-through” situation, a licensor should include an ipso facto clause in the contract.
* Jordan Markham earned his J.D. from NYU Law School in May of 2010. He will be joining Milbank Tweed LLP as an associate in January of 2011, and in the interim has been working at the White Plains IP boutique, Leason Ellis LLP.
[FN1] See 11 U.S.C. § 541(a)(1) (2000) (defining the property of a bankruptcy estate as including “all legal or equitable interest of the debtor in property…”).
[FN2] See 11 U.S.C. § 507 (2000) (establishing claim priorities).
[FN3] See id. § 548.
[FN4] Of course, if the buyer has not completed its obligations under conditions of the sale (for example, the buyer owes cash payments), these will remain owed to the estate.
[FN5] 11 U.S.C. § 365 (2000).
[FN6] See id. § 1107 (2000).
[FN7] Id. § 365.
[FN8] For the sake of readability this paper shall speak of licenses rather than patent rights transfers in the context of executory contracts. Similarly, it shall speak of licensees and licensors rather than transferees and transferors. This simplification is justified by the extreme rarity of patent rights transfers that are not licenses but are treated as executory contracts.
[FN9] A debtor in possession, as a general rule, has the same rights and duties as a trustee under the bankruptcy code. See 11 U.S.C. § 1107. For the purpose of readability, this paper shall use the term debtor rather than trustee or debtor in possession.
[FN10] See Johnson v. Fairco Corp. (In re Johnson), 61 B.R. 317, 320 (Bankr. N.D. Ill. 1986) (describing the business judgment standard as a “lax standard” that disturbs a debtor’s actions “[o]nly where [such actions] are in bad faith or in gross abuse of its managerial discretion.”).
[FN11] See In re Petur U.S.A. Instrument Co., 35 B.R. 561, 563 (Bankr. W.D. Wash. 1983); Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1047 (4th Cir. 1985) (the question is “whether the decision of the debtor that rejection will be advantageous is so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.”).
[FN12] 3 Collier on Bankruptcy ¶ 365.03 (15th ed. rev. 2006).
[FN13] 11 U.S.C. § 365(b).
[FN14] However, even if specific performance would ordinarily be available (which is unlikely in an intellectual property licensing context), it is not available with respect to a party in bankruptcy. Lubrizol, 756 F.2d at 1048 (citing H.R. Rep. No. 95-595, at 349 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6305) (“Under 11 U.S.C. § 365(g), [the licensee] would be entitled to treat rejection as a breach and seek a money damages remedy; however, it could not seek to retain its contract rights in the technology by specific performance even if that remedy would ordinarily be available upon breach of this type of contract.”).
[FN15] 11 U.S.C. § 365(n).
[FN16] 3 Collier on Bankruptcy P 365.14 (“In enacting section 365(n), Congress effectively overruled the decision of the Court of Appeals for the Fourth Circuit in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), which had permitted a debtor in possession to reject a technology licensing agreement and terminate the licensee’s right to use the license.”).
[FN17] 756 F.2d at 1047.
[FN18] Id. at 1048.
[FN20] Intellectual property under the code includes patent, copyright and trade secret rights but, notably, excludes trademark rights. 11 U.S.C. § 101(35A) provides:
The term “intellectual property” means—
(A) trade secret;
(B) invention, process, design, or plant protected under title 35;
(C) patent application;
(D) plant variety;
(E) work of authorship protected under title 17; or
(F) mask work protected under chapter 9 of title 17;
to the extent protected by applicable nonbankruptcy law.
[FN21] 11 U.S.C. § 365(n)(1)(B).
[FN22] Id. § 365(n)(1)(B)(ii).
[FN23] Id. § 365(n)(2)(B).
[FN24] Id. § 365(n)(1)(A).
[FN25] § 365(c) (emphasis added).
[FN26] Everex Sys., Inc. v. Cadtrak Corp. (In re CFLC, Inc.), 89 F.3d 673, 679-80 (9th Cir. 1996) (holding, after lengthy analysis, that the statutory “applicable law” is federal law, and that federal law does not permit free assignment of patent licenses); Institut Pasteur v. Cambridge Biotech Corp., 14 F.3d 489, 492 (1st Cir. 1997) (same conclusion).
[FN27] Troy Iron & Nail Factory v. Corning, 55 U.S. (14 How.) 193, 216 (1852) (“A mere license to a party, without having his assigns or equivalent words to them, showing that it was meant to be assignable, is only the grant of a personal power to the licensees, and it is not transferable by him to another.”); Lane & Boley Co. v. Locke, 150 U.S. 193, 195-96 (1883) (holding that patent licenses, as a form of personal property, are not assignable unless expressly made so); In re CFLC, Inc., 89 F.3d at 679-80; Institut Pasteur, 14 F.3d at 492.
[FN28] In re Hernandez, 285 B.R. 435 (Bankr. D. Ariz. 2002).
[FN29] See Peter S. Menell, Bankruptcy Treatment of Intellectual Property Assets: An Economic Analysis, 22 Berkeley Tech. L.J. 733, 798 (2007) (“Unless the patentee has transferred so much of the patent bundle to an exclusive licensee as to constitute an assignment, it seems appropriate for a bankruptcy court to read the non-assignability of patent license rule to apply whether or not the license agreement granted exclusive or nonexclusive rights.”).
[FN30] Third Circuit: In re W. Elec., Inc., 852 F.2d 79 (3d Cir. 1988); see also In re Access Beyond Techs., Inc., 237 B.R. 32 (Bankr. D. Del. 1999).
Fourth Circuit: RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257, 262 n.9 (4th Cir. 2004); see also In re Travelot Co., 286 B.R. 447 (Bankr. S.D. Ga. 2002).
Ninth Circuit: Perlman v. Catapult Entm’t (In re Catapult Entm’t), 165 F.3d 747, 747 (9th Cir. 1999).
Eleventh Circuit: City of Jamestown v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534, 537, reh’g denied, 38 F.3d 575 (11th Cir. 1994).
[FN31] See In re Catapult Entm’t, 165 F.3d at 754.
[FN32] It is the view of this author that the rigid application of statutory nonsense is more likely to result in outrage and confusion than comfortable predictability.
[FN33] 69 F.3d 608 (1st Cir. 1995).
[FN34] S. Rep. No. 95-989, at 59 (1978), reprinted in 1980 U.S.C.C.A.N. 5787, 5845 (“This section will require the courts to be sensitive to the rights of the nondebtor party to executory contracts and unexpired leases. If the trustee is to assume a contract or a lease, the court will have to ensure that the trustee’s performance under the contract or lease gives the other contracting party the full benefit of his bargain.”); H.R. Rep. No. 95-1195, at § 27(b) (1980) (“This amendment makes it clear that the prohibition against the trustee’s power to assume an executory contract does not apply where it is the debtor that is in possession and the performance to be given or received under a personal service contract will be the same as if no petition had been filed because of the personal nature of the contract.”).
[FN35] Section 365(e) mirrors 365(c):
(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—
(i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(ii) such party does not consent to such assumption or assignment; …
[FN36] 69 F.3d at 612-13; see also Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997), cert. denied, 521 U.S. 1120 (1997) (following and applying the Leroux interpretation of 365(c) with respect to an executory nonexclusive patent license).
[FN37] 69 F.3d at 612-13.
[FN38] Perlman v. Catapult Entm’t (In re Catapult Entm’t), 165 F.3d 747, 751 (9th Cir. 1999); In re Catron, 158 B.R. 629, 636 (E.D. Va. 1993), aff’d, 25 F.3d 1038 (4th Cir. 1994); In re Cardinal Indus., Inc., 116 B.R. 964, 976-77 (Bankr. S.D. Ohio 1990).
[FN39] 11 U.S.C. § 365(f)(1) (emphasis added).
[FN40] Attempts to reconcile the provisions are thoroughly unconvincing. See In re Catapult Entm’t, 165 F.3d at 751, and cases cited therein.
[FN41] See David G. Epstein, Steve H. Nickles & James J. White, Bankruptcy § 5-15, at 258-59 (1993) (advocating that “Congress should amend section 365(c)(1) to make clear that ‘applicable law’ prohibitions on assignment do not preclude assumption in bankruptcy” and urging courts to permit a trustee or debtor to assume a contract notwithstanding a prohibition on assignment in the “applicable law” so as to ensure a harmony between subsections (c) and (f) of section 365); 3 Collier on Bankruptcy ¶ 365.06[d][iii]; Daniel J. Bussel & Edward A. Friedler, The Limits on Assuming and Assigning Executory Contracts, 74 Am. Bankr. L.J. 321, 322 n.6 (2000) (arguing that the “’actual test’ yields correct results from the point of view of bankruptcy policy and allows results in bankruptcy to effectively mirror the results outside of bankruptcy”).
[FN42] For example, a provision in the non-exclusive license in Institute Pasteur allowed a competitor of the patentee to gain access to the patentee’s coveted technology by acquiring the debtor. 104 F.3d at 494-95.
[FN43] A patentee has limited time to commercially exploit her patent. Section 154(c)(2) of the Patent Act provides that the patent term begins when the patent is issued and ends 20 years from the date that the patent application was filed. Since it take years to procure a patent from an overburdened patent office, patent terms are typically considerably fewer than 20 years.
[FN44] Congress, in overriding ipso facto clauses in section 365(e), has expressed the view that, in general, the burden to a nondebtor party of having to accept performance from or render performance to a party in bankruptcy is outweighed by the need to maximize the value of the estate and to rehabilitate the debtor.
[FN45] 287 B.R. 795 (Bankr. D. Ariz. 2002).
[FN47] See, e.g., Stumpf v. McGee (In re O’Connor), 258 F.3d 392 (5th Cir. 2001), and cases cited therein.
[FN48] See 11 U.S.C. § 365(e)(1).