Intellectual property is the lifeblood of most technology companies. Whether a company earns revenues from licenses for the technologies it has developed or uses technology licensed from others, it needs to protect its investments and rights. This is especially important if one of the parties to a licensing agreement runs into financial trouble and files for bankruptcy.

Bankruptcy affects the rights under an intellectual-property license, both when the debtor is the licensee and when the debtor is the licensor. For example, a licensor may be able to terminate a license agreement if the licensee enters into bankruptcy.

Intellectual property is a specific category of general intangible assets that enjoys special legal recognition and protection, largely under federal statutes. Of the four types of intellectual property—patents, copyrights, trademarks and trade secrets—the first three are exclusively or primarily governed by federal law. When this article uses the term "intellectual property," it is referring to these three types. The Bankruptcy Code, however, does not include U.S. trademarks in its definition of intellectual property.

The Basics

When a bankruptcy case is filed, an automatic stay halts most creditors, including a software licensor, from collecting against the debtor. At the same time, a bankruptcy estate is created comprising virtually every asset, including intellectual property, in which the debtor holds a legal or equitable interest as of the petition date.

Courts regularly consider intellectual property licenses as executory contracts under §365 of the Code. Under that section, both parties to the contract have a continuing obligation to maintain the confidentiality of the licensed software, the licensee is obligated to pay some form of a royalty or refrain from prejudicing the licensor's intellectual property rights, and the licensor is obligated not to sue the licensee for infringement.

During the bankruptcy, the trustee for the debtor will examine the licensing agreement and determine whether the debtor will reject or assume the agreement. By rejecting the contract, the debtor refuses to be bound further by it, and the other party to the contract is left with a pre-petition claim for damages for breach of contract. If the debtor chooses to assume the licensing agreement, there are certain statutory conditions that the debtor must first meet. According to §365(b), the debtor cannot assume a contract unless, at the time of assumption, the trustee, among other things, cures any defaults or provides adequate assurance that it will do so promptly and continue to do so under the contract. After the debtor has satisfied the statutory requirements for assumption of an executory contract, the debtor may assign the contract for value to a third party, even though a clause in the contract may prohibit or restrict such assignment. To follow through with this assignment, the debtor must provide the licensor adequate assurance that the third-party assignee will fulfill the contract.

A Hypothetical Case

Financially Distressed Corp. has enjoyed great success developing applications for financial services firms in need of flexible, high-value software. It has developed a valuable financial software tool, Best Execution, which dominates the market and enjoys high name recognition. However, sales and profits have steadily declined over the past year and a half.

The Best Execution technology is based on a bundle of intellectual property rights that Financially Distressed owns or licenses from others. The intellectual property and related agreements include patents owned by Financially Distressed, patents licensed from third parties, and the trademark and copyright associated with Best Execution.

If the Debtor Is the Licensee

If the licensee files for bankruptcy, can it continue to use the license? Can it assume or assign the license? What are the licensor's options? Suppose Financially Distressed files for bankruptcy. Will it be able to continue to use the intellectual property it has licensed from others while it is in bankruptcy? Given how quickly many chapter 11 reorganizations move, it is important that the licensor monitor the case to ensure that the court does not permit the debtor-licensee to transfer the license to a third party without the licensor's consent. Otherwise, its inaction might be seen as consent to the relief sought by the debtor.

The debtor's ability to assume or assign its executory contracts is not unconditional. Under federal common law, intellectual property licenses are treated similarly to personal-services contracts. Section 365(c) requires consent for an assumption or assignment if applicable nonbankruptcy law excuses the nondebtor party to the contract from accepting performance from, or rendering performance to, an entity other than the debtor. Section 365(c) is aimed at contracts that, regardless of their terms, would not be assignable under applicable nonbankruptcy law. Federal common law generally restricts licensees' ability to transfer or assign their intellectual property licenses without the licensor's consent. Accordingly, courts consistently hold that nonexclusive intellectual property licenses cannot be assigned under §365(c) without the licensor's consent.

There is a split among the circuits, however, as to whether a debtor can simply assume an executory contract that would not be assignable under nonbankruptcy law; this split arises from the language in §365(c) that provides that a trustee/debtor "may not assume or assign any executory contract." The dominant circuit view is that §365(c) must be given its plain-language interpretation.² The U.S. Courts of Appeals for the Third, Fourth, Ninth and Eleventh Circuits have adopted the "hypothetical test," which states that if the debtor could not assign the license under nonbankruptcy law without the consent of the other party, then the debtor cannot assume the license, even if there is no intention to assign the license.³

The Fourth Circuit's recent decision In re Sunterra Corp. recently held that §365(c) prevents assumption of a nonexclusive intellectual property license without the consent of the nondebtor-licensor.⁴ This makes it more difficult for a debtor-licensee to continue doing business with a nonconsenting intellectual property licensor after a bankruptcy is filed. The licensor is essentially given the power to decide the purported treatment of the license by virtue of §365(c). The hypothetical test ensures that no one other than the debtor-licensee will use the licensor's intellectual property unless the licensor consents to the assumption of the license agreement.⁵ Nevertheless, the licensor should remain active in the bankruptcy to protect its rights because inaction may be seen as consent.

Can the licensor enforce the termination-upon-bankruptcy provision? If the license cannot be assigned without the licensor's consent under applicable nonbankruptcy law, the licensor may be able to enforce the termination-upon-bankruptcy provision of the Code in §365(e)(2)(A):

(e)(2) Paragraph (1) of this subsection [i.e., "ipso facto" clauses] 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—

(A)(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....

As noted above, intellectual property licenses are treated similarly to personal-services contracts: The license is personal to the licensee because there is an understanding that the licensor specifically chose the licensee with the hope that the licensee would not harm the licensor's intellectual property.⁶ Section 365(e)(2) basically provides that termination-upon-bankruptcy provisions are enforceable if applicable nonbankruptcy law does not permit the licensee to assign the license without the licensor's consent and the licensor has not consented. However, the licensor must give its consent in advance under the terms of the license, e.g., through an assignment provision that permits assignments in connection with the sale of substantially all of the licensee's assets.

If a licensor wants to try to enforce a termination-upon-bankruptcy provision, it likely would do so through a motion either to have the license deemed rejected because the licensee cannot assume it without the licensor's consent,⁷ or for relief from the automatic stay to permit the licensor to enforce the termination-upon-bankruptcy provision. Most bankruptcy judges are going to be reluctant to permit either form of relief.

What happens to the royalties due under the license? Would they be unsecured claims or administrative expenses? In bankruptcy, the treatment of royalty payments under an intellectual property license depends largely on whether the debtor is the licensor or the licensee. When the debtor is the licensee, it must continue to make the required royalty payments if it wants to keep the benefits of the license. Were it to stop making these payments, it would be in default, and the licensor could seek relief from the stay to terminate the license. This assumes that the license provides termination as one of the remedies for failure to make the royalty payments.

If the debtor-licensee were to assume the license and the licensor or bankruptcy court permitted the assumption, the debtor-licensee would be required to cure all defaults, which would include paying the licensor for any unpaid pre- or post-petition royalties.⁸ If the debtor-licensee were to reject the license, the licensor could make a claim, which likely would include three components:

1. an unsecured claim for the rejection damages
2. an unsecured claim for unpaid pre-petition royalties
3. an administrative claim for unpaid post-petition royalties, with respect to which the licensor would have to show some benefit to the estate.

If the Debtor Is the Licensor

If the licensor has a lender with a blanket lien on the licensor's assets (including intellectual property), and the lender forecloses, would the lender take the intellectual property free of, or subject to, the licensee's license? Article 9 of the Uniform Commercial Code governs the procedures for obtaining and perfecting security interests in personal property and fixtures by facilitating the ability of owners of rights in property to obtain financing secured by that property. As discussed above, however, intellectual property is predominantly subject to federal regulation. Court decisions have held that these federal regulations preempt the application of Article 9 to the extent that Article 9 supplies a different rule. However, the courts have consistently held that the UCC governs the perfection of a security interest in a patent or a trademark for purposes of defeating the claims of a lien creditor, including a trustee in bankruptcy. Further, §9-109(c)(1) states that Article 9 will not apply to the extent that "a statute, regulation or treaty of the United States preempts this article." While Article 9 does not apply to all aspects of the financing of intellectual property, e.g., it does not preempt contrary federal law or enable a licensee to grant a security interest in the licensor's property, it does facilitate the ability of a licensee to obtain financing secured by its rights under the license.

Article 9 considers intellectual property a general intangible. Section 9-321 provides that a nonexclusive licensee of a general intangible in the ordinary course of business "takes its rights under a nonexclusive license free" of a security interest created by its immediate licensor. Section 9-321 applies to a nonexclusive licensee, but not an exclusive licensee. Section 9-321 also applies to the immediate licensor. Accordingly, an ordinary-course nonexclusive license will survive the secured party's, e.g., lender's, foreclosure against its licensor, and the licensee will continue to enjoy its rights under the license, assuming that it meets its obligations. Section 9-321 concerns the rights of a secured party and a licensee from the secured party's borrower, but does not concern the rights of a licensor and its licensee.

The nonexclusive licensee in the ordinary course is not totally off the hook. "Takes free" means that the nonexclusive licensee may continue to use the license following the secured party's foreclosure against the licensor only if all the terms of the license are met—e.g., license fees are paid.

The difficult part is knowing what a "nonexclusive" license is. If Financially Distressed was granted an "exclusive" license for use in the United States, is that really considered exclusive when a license for use in Israel might be granted? Article 9 does not define "nonexclusive licensee." The Uniform Computer Information Transactions Act (UCITA) has defined "nonexclusive license," but only a very small minority of states have enacted UCITA. However, this may be the closest thing to a definition, and a court may look to UCITA's definition for guidance. UCITA's definition is very narrow (and, as evidenced below, "exclusive" is very broad). It states that:

"Nonexclusive license" means a license that does not preclude the licensor from transferring to other licensees the same information, informational rights or contractual rights within the same scope. The term includes a consignment of
a copy.

Under the UCITA definition, a license does not qualify as "nonexclusive" if it in any way precludes the licensor from entering into another license with another licensee within the same scope. If a license contains any restriction on the licensor's right to enter into a competitive license, the license, according to UCITA, may be deemed "exclusive" and §9-321 would not provide the licensee with any protection from a lender's foreclosure.

Section 365(n) protects licensees when the debtor is the licensor of intellectual property. Specifically, this section sets forth the rights of intellectual property licensees when a trustee or debtor-in-possession (DIP) rejects an intellectual property license, and only when the debtor is the licensor.⁹ Further, it guards the interests of the licensee in its continued use of the intellectual property and permits the debtor-licensor to avoid certain future obligations that may burden the estate.

If the debtor-licensor were to assume the license, the licensee would need to continue to perform. The licensee would continue to be required to pay royalties to the debtor-licensor pursuant to the terms of the license. If the licensee did not perform its obligations, it would risk being in breach or having the license terminated by the licensor.

If the debtor-licensor were to reject the license, the licensee could either oblige and treat the license as terminated and file a claim for damages, or not agree and obviate the potentially harsh effect of the rejection by electing to retain its rights under §365(n)(1)(B).

If the licensee were to elect to retain its rights, §365(n)(2) requires the licensee to make all the royalty payments and waive any right to setoff or to an administrative expense claim. Section 365(n)(2) requires the licensee to make payments under the contract for its term and any applicable period for which the licensee "extends such contract." This suggests that the licensee may have the option to retain rights to a portion, but not all, of the remaining term of the contract and its period of extension. This election pertains only to the rights the licensee had when the debtor went into bankruptcy, not any future rights the agreement may provide. The rights retained include any exclusivity provision, and any rights under an agreement supplementary to the contract, for the duration of the contract and any extension right available to the licensee under applicable law. Section 365(n) does not require that the term of the license be commenced in order for the licensee to have the right to retain its rights under the license. When a licensee exercises its §365(n) rights, the harder issues tend to be determining what rights the licensee had "immediately before the case was commenced" and what payments are appropriately characterized as "royalties."

Since §365(n) is limited to licenses of intellectual property, it is necessary to refer to the definition of "intellectual property" in §101(35A). It is important to remember that trademark licenses do not have rights covered by §365(n). Accordingly, trademark licenses are treated like any other executory contract.

Conclusion

The connection between intellectual property and bankruptcy in the context of licensing underscores the importance of understanding the rights of the licensor and licensee both pre-and post-bankruptcy. Understanding these rights under bankruptcy law and applicable nonbankruptcy law enables an attorney to be proactive in protecting the client's interests.

Footnotes

¹ Karen "Kitt" Turner is a member and Craig S. Blumsack is an associate at the national law firm Eckert Seamans Cherin & Mellott LLC. Return to article

² In re Sunterra Corp., 361 F.3d at 269. Return to article

³ In re West Elecs. Inc., 852 F.2d 79, 83 (3d. Cir. 1988); In re Sunterra Corp., 361 F.3d at 269; In re Catapult Entm't., 165 F.3d at 750; In re James Cable Partners, 2 F.3d 534, 537 (11th Cir. 1994). Return to article

⁴ In re Sunterra Corp., 361 F.3d at 269. Return to article

⁵ In re Catapult Entm't., 165 F.3d at 750. Return to article

⁶ PPG Industries Inc. v. Guardian Industries Corp., 597 F.2d 1090, 1093 (6th Cir. 1979) (stating it has long been held by federal courts that agreements granting patent licenses are personal and not assignable unless expressly made so). Since a typical exclusive license can be granted to only one licensee, federal laws treat an exclusive patent or copyright license as equivalent to ownership. The general rule to keep in mind is that exclusive patent or copyright licenses are freely transferable without the consent of the licensor, unless the agreement expressly requires consent. The general rule for nonexclusive patent or copyright licenses, having more than one licensee, is that they are not transferable without the consent of the licensor, unless the license permits transfer or assignment. This is also the case if the nonexclusive license agreement is silent on whether it can be assigned. Trademark licenses, exclusive or nonexclusive, are in a separate category because they generally require the trademark registrant's consent to transfer the license. Unlike patent and copyright law, federal trademark law does not equate exclusive trademark licenses with ownership of the registered mark. Mitz, Daniel R., Yamaguchi, Nancy and Gillette, Stephen E. "How to Secure the License You Pay For," Mergers & Acquisitions, 41 (June 2005). Return to article

⁷ See, e.g., In re Catapult Entm't., 165 F.3d 747. Return to article

⁸ 11 U.S.C. §365(b). Return to article

⁹ Collier on Bankruptcy, ¶365.14 (15th Ed. 2005). Return to article