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The Risk of an Offensive Use of Catapult

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Since the U.S. Court of Appeals for the Ninth Circuit issued its decision in Perlman v. Catapult Entertainment Inc. (In re Catapult Entertainment Inc.),2 the courts and commentators have examined it as a prohibition on the assumption of certain intellectual property licenses and a risk to confirmation of a plan of reorganization. However, there appears to be a dearth of opinions or articles focusing on an offensive use of Catapult by the licensors of intellectual property licenses. In the context of other types of non-assumable executory contracts, a number of courts have concluded that the automatic stay should be modified to allow the non-debtor contracting party to terminate the pre-petition executory contract. This article briefly reviews the background of the cases addressing the assignability and assumability of intellectual property licenses, including Catapult, and apply the analysis to the context of a motion for relief from the automatic stay to allow the licensor to terminate an existing license.

Intellectual Property Licenses Are Executory Contracts

The initial question addressed by the courts in cases relating to intellectual property licenses is whether the license is an executory contract. While 11 U.S.C. §365(a) authorizes a trustee or debtor-in-possession (DIP) to assume or reject an executory contract, the Bankruptcy Code is silent as to the definition of an executory contract. Most courts have defined an executory contract as being one "on which performance remains due to some extent on both sides."3 Based on a similar definition, the Ninth Circuit has determined that a license of intellectual property is an executory contract. See Everex Systems Inc. v. Cadtrak Corp. (In re CFLC Inc.).4

In CFLC, prior to filing for bankruptcy, the debtor paid a one-time royalty payment to Cadtrak in exchange for a royalty-free, worldwide, non-exclusive license to use certain patents. The license agreement provided, among other things, that the license was non-transferable, and that the debtor had no right to sublicense. In its bankruptcy case, the debtor filed a motion to assume and assign the license, and Cadtrak objected. In determining whether the license was an executory contract, the court noted that Cadtrak owed significant continued performance on the license because it had to continue to refrain from suing the debtor for infringement: "A non-exclusive patent license is, in essence, 'a mere waiver of the right to sue' the licensee for infringement."5 The court further noted that the licensee owed performance because it had to mark all products made under the license with proper statutory patent notice; such obligation is material because failure to mark the products would deprive the patent-holder of damages in an infringement action before the infringer has the actual notice of the infringement. Therefore, the court held that the non-exclusive patent license was an executory contract under 11 U.S.C. §365.6

Intellectual Property Licenses Are Not Freely Assignable

In the context of a non-exclusive patent license, the CFLC court provided an excellent rationale for the prohibition on the assignment by a licensee of a license of intellectual property. The CFLC court noted that "the fundamental policy of the patent system is to 'encourage the creation and disclosure of new, useful and non-obvious advances in technology and design' by granting the inventor the reward of 'the exclusive right to practice the invention for a period of years'"7 The CFLC court further reasoned that allowing free assignability of nonexclusive patent licenses would undermine the reward that encourages invention because a party seeking to use the patented invention could either seek a license from the patent-holder or seek an assignment of an existing patent license from the licensee. In essence, every licensee would become a potential competitor with the licensor—patent-holder in the market for licenses under the patent. While the patent-holder could presumably control the absolute number of licenses in existence under a free assignability regime, it would lose the very important ability to control the identity of the licensees. Thus, any license a patent-holder granted—even to the smallest firm in the product market most remote from its own—would be fraught with the danger that the licensee would assign it to the patent-holder's most serious competitor, a party to whom the patent-holder itself might be absolutely unwilling to license. As a practical matter, free assignability of patent licenses might spell the end to paid-up licenses such as the one involved in this case. Few patent-holders would be willing to grant a license in return for a one-time lump-sum payment, rather than for-use royalties if the license could be assigned to a completely different company which might make far greater use of the patented invention than could the original licensee.8

Thus, in order to further the policies of the patent system, the CFLC court held that under federal patent law a non-exclusive patent license is personal and non-delegable, and therefore would excuse the licensor from accepting performance from, or rendering it to, anyone other than the debtor.9

The rationale for restricting the transferability of non-exclusive patents also applies to trademarks and copyrights. The owner of a trademark or a copyright should be allowed to enjoy the benefits of its creativity without having to worry that a licensee will assign the rights to the trademark or copyright to an entity with which the trademark or copyright owner would refuse to conduct business, such as a competitor or (in the perception of the trademark or copyright owner) an unqualified entity. Therefore, in order to further the policies of the trademark and copyright systems, both a trademark license and a copyright license, like a patent license, is personal and non-delegable and, therefore, the licensor is not required to accept performance from an entity other than the licensor.10

Section 365(c)(1) Prohibits the Assumption of Intellectual Property Licenses

While 11 U.S.C. §365(a) authorizes a trustee or DIP to assume or reject an executory contract, the authority is not absolute. 11 U.S.C. §365(c)(1) prohibits a trustee or debtor-in-possession from assuming an executory contract 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.
The Ninth Circuit in Perlman v. Catapult Entertainment Inc.11 addressed the limitations of a DIP assuming certain executory contracts under 11 U.S.C. §365(c)(1). In Catapult Entertainment, the debtor in 1994 entered into a non-exclusive patent license with Perlman. Subsequently, in 1996, Catapult filed for bankruptcy under chapter 11. As part of its reorganization plan, Catapult filed a motion with the bankruptcy court seeking to merely assume the non-exclusive patent license. Perlman objected. Both the bankruptcy court and the district court held that the debtor could assume the non-exclusive patent licenses, and the Ninth Circuit reversed. The Catapult Entertainment court reasoned that the plain language of 11 U.S.C. §365(c)(1) links non-assignability under "applicable law" together with the prohibition on assumption in bankruptcy.

In other words, the statute by its terms bars the [DIP] from assuming an executory contract without the non-debtor's consent where applicable law precludes assignment of the contract to a third party. The literal language of §365(c)(1) is thus said to establish a "hypothetical test:" a [DIP] may not assume an executory contract over the non-debtor's objection if applicable law would bar assignment to a hypothetical third party, even where the [DIP] has no intention of assigning the contract in question to any such third party.12

In Catapult Entertainment, the Ninth Circuit held that the debtor was unable to assume the non-exclusive patent license because applicable non-bankruptcy law prohibited the assignment of such license without the consent of the licensor.13

Based on the reasoning of Catapult Entertainment, since applicable patent, trademark or copyright law prohibits the assignment of a license without the consent of the licensor, then a debtor or trustee is unable to assume the license. Therefore, cause exists for a bankruptcy court to grant the licensor relief from the automatic stay to take the actions necessary to terminate the license.

Inability of the Debtor or Trustee to Assume an Intellectual Property License Is Cause for Relief from the Automatic Stay

11 U.S.C. §362(d)(1) provides:

(d) On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying or conditioning such stay—
(1) for cause, including the lack of adequate protection of an interest in property of such party in interest...

Courts that have addressed the issue have concluded that cause exists to terminate the automatic stay if the debtor cannot assume an executory contract to allow the non-debtor contracting party to terminate the executory contract. In In the Matter of West Electronics Inc.,14 the debtor was a party to a defense contract with the U.S. government. After the debtor filed for bankruptcy, the government filed a motion for relief from the automatic stay to terminate the executory contract. The government argued cause existed to terminate the automatic stay to allow it to terminate the automatic stay because 41 U.S.C. §15, the anti-assignment statute, prohibited the debtor assigning the contract to another entity absent the consent of the government, which consent was being withheld, and as a consequence, the executory contract could not be assumed pursuant to 11 U.S.C. §365(c)(1).

The bankruptcy court and the district court disagreed with the government and refused to terminate the automatic stay. The Third Circuit disagreed, stating:

We conclude that assignment of a contract calling for the production of military equipment is precisely what Congress intended to prevent when it prohibited assignments in 41 U.S.C. §15. Thus, [the debtor] could not force the government to accept the "personal attention and services" of a third party without its consent. It therefore necessarily follows that under 11 U.S.C. §365(c)(1), [the debtor], as a [DIP], cannot assume this contract.
"[The debtor] argues that 41 U.S.C. §15 should not be construed to foreclose an assignment of a contract from a debtor to a [DIP], since they are such closely related entities. [The debtor's] argument misses the point, however, for 11 U.S.C. §365(c)(1) creates a hypothetical test—i.e., under the applicable law, could the government refuse performance from "an entity other than the debtor or the [DIP]" (emphasis in West). Thus, the relevant inquiry is not whether 41 U.S.C. §15 would preclude an assignment from [the debtor] as a debtor to [debtor] as a [DIP], but whether it would foreclose an assignment by [the debtor] to another defense contractor.15

Thus, the court concluded that cause existed to terminate the automatic stay under 11 U.S.C. §362(d)(1) to allow the government to terminate the defense contract since the debtor was prohibited by 11 U.S.C. §365(c)(1) from assuming the contract.16

Since a debtor licensee is prohibited by applicable non-bankruptcy law from assigning an intellectual property license to another entity absent the consent of the licensor, pursuant to 11 U.S.C. §365(c)(1), the debtor or trustee is thus prohibited from assuming the license. Since a debtor or trustee cannot assume an intellectual property license and if the licensor will not consent to the assumption of the license, no reason exists to require the license to remain in place. Therefore, cause as defined by West Electronics exists to terminate the automatic stay to allow the licensor to terminate the license.17

Conclusion

In Catapult, the Ninth Circuit Court of Appeals addressed conflicting federal laws. On the one hand, the Ninth Circuit was faced with a policy decision by Congress to protect the property rights of patent-holders, which rights are encompassed in the patent statutes. On the other hand, the Ninth Circuit was faced with a policy decision by Congress to maximize the recovery to creditors of debtors, which policy is encompassed in the Bankruptcy Code. The court concluded that the policies promoted by the patent system took precedent over the policies promoted by the bankruptcy statutes and, as a consequence, held that a DIP or a trustee was prohibited from assuming a patent license. The Ninth Circuit's decision in Catapult provides the licensor of certain intellectual property rights with extraordinary power over a DIP or a trustee. To the extent licensed patented technology, copyrighted material or trademarks are critical to the operation and reorganization of a debtor, the licensor of the intellectual property can not only block confirmation of a reorganization plan, but may also be able to force an early liquidation of a debtor if it chooses to obtain relief from the automatic stay to terminate the license.

While it is understandable that a licensor of intellectual property would be opposed to an outright assignment of the license to another (especially a competitor), such opposition should not apply to the assumption of the license by the licensee. Indeed, potential recoveries by the creditors through an operating reorganization (as opposed to liquidation) of the licensee are jeopardized by prohibiting the mere assumption by the licensee of the license. Therefore, Congress should re-evaluate the relative priorities of the Bankruptcy Code and the various intellectual property statutes in order to more adequately balance these inconsistent policies in the context of reorganizations.


Footnotes

1 Shareholder with Jenkens & Gilchrist, a professional corporation, in Dallas. Return to article

2 165 F.3d 747 (9th Cir. 1999), cert. dismissed, 120 S.Ct. 369 (1999). Return to article

3 See, e.g., Eastern Air Lines Inc. v. Insurance Company of the State of Pennsylvania (In re Ionosphere Clubs Inc.), 85 F.3d 992, 998 (2d Cir. 1996) (quoting National Labor Relations Board v. Bildisco & Bildisco, 465 U.S. 513, 522 n. 6, 104 S.Ct. 1188, 1194 n.6, 79 L.Ed.2d 482 (1984)). Return to article

4 89 F.3d 673, 677 (9th Cir. 1996) (an "executory contract" is one on which performance is due to some extent on both sides and in which the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuses the performance of the other). Return to article

5 Id. Return to article

6 Id.; see, also, In re Access Beyond Technologies Inc., 237 B.R. 32 (Bankr. D. Del. 1999) (holding that a non-exclusive patent license is executory because both parties had at least one duty, which was an agreement not to sue the other for infringement of the patents covered by the license); In re Luce Industries Inc., 14 B.R. 529 (S.D.N.Y. 1981) (the district court assumed, without any discussion, that a license of a trademark is an executory contract). Exclusive intellectual property licenses are also generally treated as executory contracts under the Bankruptcy Code, because the licensor has a continuing obligation to refrain from licensing the intellectual property to third parties, and the licensee has a continuing obligation to pay royalties, account to the licensor, etc. See Encino Bus. Management Inc. v. Prize Friz Inc. (In re Prize Friz Inc.), 32 F.3d 426, 428 (9th Cir. 1994); In re Select-A-Seat Corp., 625 F.2d 290 (9th Cir. 1980). Return to article

7 CFLC, 89 F.3d at 679 (citing Bonito Boats Inc. v. Thundercraft Boats Inc., 489 U.S. 141, 150-51, 109 S.Ct. 971, 977-78, 103 L.Ed.2d 118 (1989)). Return to article

8 CFLC, 89 F.3d at 679. See Patient Education Media, 210 B.R. 237, 242-24 (Bankr. S.D.N.Y. 1997) (adopting the reasoning of CFLC in the context of a non-exclusive copyright). See, also, Tap Publications Inc. v. Chinese Yellow Pages (New York) Inc., 925 F.Supp. 212 (S.D.N.Y. 1996) (federal law prohibits the assignment by a licensee of a trademark license without the consent of the licensor.). Return to article

9 CFLC, 89 F.3d at 679 (citing Gilson v. Republic of Ireland, 787 F.2d 655, 658 (D.C. Cir. 1986); Stenograph Corp. v. Fulkerson, 972 F.2d 726, 729 n.2 (7th Cir. 1992); PPG Industries Inc. v. Guardian Industries Corp., 597 F.2d 1090, 1093 (6th Cir.), cert. denied, 44 U.S. 930, 100 S.Ct. 272, 62 L.Ed.2d 187 (1979); Unico Industries Inc. v. Kelley Co., 465 F.2d 1303, 1306 (7th Cir. 1972), cert. denied, 410 U.S. 929, 93 S.Ct. 1365, 35 L.Ed.2d 590 (1973)). See, also, In re Alltech Plastics Inc., 71 B.R. 686, 689 (Bankr. W.D. Tenn. 1987). Return to article

10 See Tap Publications, 925 F.Supp at 218 (relating to trademarks); Patient Education Media, 210 B.R. at 242-24 (relating to copyrights). Return to article

11 In re Catapult Entertainment, 165 F.3d 747 (9th Cir. 1999), cert. dismissed, 120 S.Ct. 369 (1999). Return to article

12 Catapult Entertainment, 165 F.3d at 750 (citing Epstein, David G., Nichols, Steve H. and White, James J., Bankruptcy §5-15 at 474 (1992); In re James Cable, 27 F.3d at 537; In re West Electronics, 852 F.2d at 83). Return to article

13 It should be noted that on facts almost identical to those of Catapult, the First Circuit Court of Appeals reached a different conclusion. In Institute Pasteur v. Cambridge Biotech, 104 F.3d 489 (1st Cir. 1997), cert. denied, 521 U.S. 1120 (1997), the First Circuit held that a DIP could assume a non-exclusive patent license. Return to article

14 852 F.2d 79 (3rd Cir. 1988). Return to article

15 West Electronics, 852 F.2d at 83. Return to article

16 West Electronics, 852 F.2d at 84. See, also, In re TechDyn Systems Corp., 235 B.R. 857, 864 (Bankr. E.D. Va. 1999) (same). Return to article

17 In the event a court follows the reasoning and holding of First Circuit in Cambridge Biotech, cause would not exist to terminate the automatic stay. Return to article



 
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Sunday, April 1, 2001

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