Rights with respect to executory contracts— contracts under which the corporation and the counterparty still have material obligations to each other
By Michael H. Strub
The economic impact of the pandemic has been catastrophic. As of the end of August, bankruptcy filings by companies with at least a half-billion dollars in liabilities had surged 120% year-over-year, according to the investment bank Jefferies. For many of these companies, their intellectual property, including patents and trademarks, are significant assets, and counsel for these businesses, as well as counsel for their creditors, licensees and licensors, will need to understand these issues that arise to avoid pitfalls and take full advantage of opportunities to exploit the full value of a company’s IP for the benefit of their clients.
Under the Bankruptcy Code, the debtor can assume an executory contract and continue to perform its obligations during and after emerging from bankruptcy; assume the contract and assign it to a third party; or reject the contract and pay contract damages. If it assumes or assigns the contract, however, it must convince the bankruptcy court that the license will continue to be performed, which is known as “adequate assurance of future performance.”
Most types of IP licenses are treated as executory contracts because the licensor and the licensee usually owe continuing material obligations to one another. On the licensee’s side, the duty to pay royalties, adhere to confidentiality provisions and indemnify the licensor have all been held to be material ongoing obligations. For its part, the licensor will have ongoing obligations to forbear from suing the licensee and may have other continuing duties such as providing updates that would make the contract executory.
If a corporation files a bankruptcy petition, while its management may continue to exercise certain control, the corporation is a different entity (or estate) under the control of the bankruptcy court. If the debtor is a licensee of IP, the licensor may not wish to allow the debtor to continue to license its property. Most IP licenses contain anti-assignment provisions, and if the debtor were to assume the license, this could be construed as an assignment from the pre-petition entity to a post-petition entity.
Section 365 of the Bankruptcy Code provides that a debtor-licensee may not assume the license without the consent of the licensor if “applicable law” would prevent the debtor from assigning the contract to a third party. “Applicable law” does not include the enforceability of an anti-assignment provision in the contract, which is disregarded under the Bankruptcy Code, but under federal law, patent licenses generally cannot be assigned. Is patent law “applicable law?”
There is a split among the circuit courts regarding whether a debtor-licensee can assume an executory contract that is not assignable. The Third, Sixth and Ninth circuits apply the “hypothetical test” under which the debtor may not assume a license if the debtor could not assign it to a third party—regardless of whether, in fact, the debtor intends to assign the license to a third party. This test, though, has been criticized as inconsistent with the Bankruptcy Code’s goal of maximizing the value of the estate for the benefit of other creditors and for giving the licensor a windfall if it could relicense the IP to another party for more money.
The courts have held that a debtor may assume the license, so long as the debtor does not intend to assign the contract to a third party. These courts reason that the distinction between the licensee pre- and post-bankruptcy is not sufficient for the licensor to support the proposition that it is accepting performance from a party other than the party to whom it licensed its rights. Applying the same reasoning, district court opinions in the Tenth and Second circuits have held that the debtor is not prohibited from assuming the license unless pre-petition management—acting as the debtor-in-possession—is no longer in control of the company.
If the debtor is a licensor, can it reject an unfavorable pre-petition license? In Lubrizol Enters. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1044 (4th Cir. 1985), the court held that Richmond Metal could reject a license to Lubrizol for a metal coating process that was important for Lubrizol’s business. Congress reacted to that decision by enacting Section 365(n) of the Code, which provides that, if the licensor rejects the license, the licensee still has the ability to retain the licensed rights and to enforce exclusivity provisions provided the licensee makes the required license payments. As a general matter, however, if the licensor rejects the license, it need not continue to provide affirmative duties, such as maintenance, technology updates, upgrades, consultation, help or other services.
Potential IP licensors and licensees should recognize the possibility of bankruptcy and attempt to address issues that may arise in the body of the license. A licensor, for example, could specify what a licensee must do post-petition to provide adequate assurance of future performance. A licensee could require the licensor to place the IP and any supporting technology into an escrow that would release the IP to the licensee upon the licensor’s failure to perform or bankruptcy filing, or it could specify in the license how much it was paying for rights in addition to simply using the IP.
Enforcement of such provisions will be up to the court, but it may adopt, or at least be influenced by, the parties’ negotiated agreements.
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