This blog publishes articles and updates focused on bankruptcy law, restructuring matters, creditor and debtor considerations, court decisions, and procedural developments that affect businesses and individuals navigating financial distress.

Content includes practical analysis of case outcomes, regulatory changes, and emerging trends, as well as perspectives from legal practitioners on how bankruptcy and insolvency issues are addressed in real-world scenarios.

March 2009

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Business Bankruptcy Issues Recent Developments

U.S. Supreme Court Shows Interest In Deciding Whether The Hypothetical Test Or The Actual Test Should Be Used To Determine If IP Licenses Can Be Assumed In Bankruptcy

It looks like the U.S. Supreme Court, or at least two of the Justices, is interested in deciding whether the "hypothetical test" or the "actual test" should be used in determining whether an intellectual property license can be assumed by a debtor in possession under Section 365(c)(1) of the Bankruptcy Code. That was the clear message from the somewhat unusual statement by Justice Kennedy, with whom Justice Breyer joined, issued on March 23, 2009, in connection with the Supreme Court’s denial of a writ of certiorari in the N.C.P. Marketing Group, Inc. case. You can read a copy of the entire statement by following the link in the prior sentence.

The N.C.P. Marketing Case. As a refresher, in 2005, the U.S. District Court for the District of Nevada issued its first of a kind decision, In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), holding that trademark licenses are personal and nonassignable in bankruptcy absent a provision in the trademark license to the contrary. Click here for a copy of the N.C.P Marketing Group decision and here, here, and here to read earlier posts on the case. Last May, the Ninth Circuit affirmed the District Court’s judgment "for the reasons provided by that court" in an order designed as "not for publication."

Assumption And Assignment. A key basis for the District Court’s decision in the N.C.P. Marketing Group case was the way the Ninth Circuit has interpreted Section 365(c)(1), specifically on the question of whether a debtor in possession can assume an intellectual property license. In bankruptcy parlance, assumption means that the debtor gets to keep the license. Usually, debtors are allowed to exercise their business judgment when deciding whether to assume or reject (read: breach and stop performing) an executory contract, as well as to assume and assign one to a third party. However, Section 365(c)(1) of the Bankruptcy Code puts a limit on a debtor’s ability to assign executory contracts, and perhaps even to assume them, when "applicable law" gives the non-debtor party to the contract the right to refuse to deal with someone else. In the N.C.P. Marketing Group decision, the District Court held that federal trademark law under the Lanham Act was such "applicable law" and rendered non-exclusive trademark licenses nonassignable.

The Key Bankruptcy Code Section. Section 365(c)(1) is so important to this debate that it bears careful review. Here’s what it says:

(c) 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.

Hypothetical Versus Actual Test. If a debtor cannot assign an IP license without consent of the licensor, can it at least assume the license? That question has led courts to examine ever so closely the first seven words of Section 365(c): "The trustee may not assume or assign…"

  • When the statute says that the trustee may not assume or assign an IP license, does the word "or" really mean "and" too?
  • Put differently, what happens when a debtor is only trying to assume (keep) an IP license and is not actually trying to assign it? Does the Bankruptcy Code language mean that it can neither assume nor assign the license or does it only mean that the debtor cannot assign the license?
  • That, in a nutshell, is the difference between the so-called "hypothetical test" (which reads Section 365(c)(1)’s language as asking whether the debtor hypothetically could assign the license even if it’s only proposing to assume it) and the "actual test" (which interprets the statute’s language as asking only what the debtor is actually proposing to do).
  • The U.S. Courts of Appeals for at least three circuits have adopted the hypothetical test. The Ninth Circuit (covering California, Nevada, Arizona, and a number of other Western states), the Third Circuit (which includes Delaware, the venue of many Chapter 11 cases), and the Fourth Circuit (covering Virginia, West Virginia, Maryland, and North and South Carolina), have held that Section 365(c)(1) gives most IP licensors a veto right over proposals by a Chapter 11 debtor to assign — and even to assume — IP licenses.
  • For a more complete discussion of these issues, take a look at this earlier post, entitled "Assumption of Intellectual Property Licenses in Bankruptcy: Are Recent Cases Tilting Toward Debtors?"

Justice Kennedy’s Statement. N.C.P. Marketing Group petitioned the U.S. Supreme Court for a writ of certiorari, seeking review of the decision denying it the ability to assume the trademark license. Although also voting to deny review, Justice Kennedy issued a three-page statement on that decision to express his view, joined in by Justice Breyer, that the Supreme Court should considering granting certiorari in a future case on the "significant question" of whether the hypothetical test or the actual test should be applied in interpreting Section 365(c)(1) of the Bankruptcy Code. Justice Kennedy summed up his analysis this way:

The division in the courts over the meaning of §365(c)(1) is an important one to resolve for Bankruptcy Courts and for businesses that seek reorganization. This petition for certiorari, however, is not the most suitable case for our resolution of the conflict. Addressing the issue here might first require us to resolve issues that may turn on the correct interpretation of antecedent questions under state law and trademark-protection principles. For those and other reasons, I reluctantly agree with the Court’s decision to deny certiorari. In a different case the Court should consider granting certiorari on this significant question.

Justice Kennedy’s discussion of the two tests suggests that he (and perhaps Justice Breyer) may be leaning toward the actual test. Although noting that the actual test "may present problems of its own," including that it aligns Section 365 "with sound bankruptcy policy only at the cost of departing from at least one interpretation of the plain text of the law," Justice Kennedy aimed most of his criticism in the statement at the hypothetical test.

  • Specifically, Justice Kennedy commented that one "arguable criticism of the hypothetical approach is that it purchases fidelity to the Bankruptcy Code’s text by sacrificing sound bankruptcy policy." He stated that the hypothetical test "may prevent debtors-in-possession from continuing to exercise their rights under nonassignable contracts, such as patent and copyright licenses." Continuing, he noted that without these licenses, "some debtors-in-possession may be unable to effect the successful reorganization that Chapter 11 was designed to promote."
  • He also remarked on what he perceived as a "windfall" to nondebtor parties to valuable executory contracts. While outside of bankruptcy the nondebtor cannot renege on its agreement, if the debtor files bankruptcy "then the nondebtor obtains the power to reclaim–and resell at the prevailing, potentially higher market rate–the rights it sold to the debtor." Although most non-exclusive licenses are not treated as a sale of intellectual property, Justice Kennedy appears to view the potential loss of IP license rights due to a bankruptcy filing as an unfair result.

Conclusion. In denying review in the N.C.P. Marketing Group case, the Supreme Court has let stand the decision of the courts below that, where the hypothetical test applies as it does in the Ninth Circuit, a non-exclusive trademark license cannot be assumed by a debtor in possession. However, given the detailed statement issued by Justice Kennedy, and joined in by Justice Breyer, it appears that the chances of the Supreme Court granting certiorari in a future IP license assumption case have increased. If such a case reaches the Supreme Court, the current split in the circuits on this important intersection between bankruptcy and intellectual property law may finally be resolved.

Business Bankruptcy Issues Recent Developments

If Madoff Investors Are Sued By The SIPA Trustee And Pay Money Back, Can They File Proofs Of Claim After The Bar Date?

Recently, I posted about SIPA liquidations of brokerage firms, prompted by the Securities Investor Protection Act (known as SIPA) liquidations of Lehman Brothers, Inc. and Bernard L. Madoff Investment Securities LLC. An interesting issue has come up in the Madoff case involving investors who redeemed their accounts before the Madoff bankruptcy was filed. In other alleged Ponzi scheme cases, trustees have sued such investors asserting fraudulent transfer or other claims. The investors in turn often raise defenses, including that they redeemed their accounts in good faith and without any knowledge of the alleged fraud, and lengthy and complex litigation usually results.

Resolution of such litigation can come long after the deadline set for filing proofs of claim (known as a "bar date"). This raises a question: if investors end up paying money back to the estate as a result of the trustee’s litigation, will they be able to file proofs of claim — after the bar date — for the amounts they have to return? Before turning to that question, let’s take a look at how such post-bar date claims are dealt with in non-SIPA bankruptcy cases.

Section 502(h) Of The Bankruptcy Code. Under the Bankruptcy Code, if a person or entity is sued by the bankruptcy estate (usually by a trustee, the debtor in possession, or a creditors’ committee) for receipt of an alleged preference or fraudulent transfer, they will be able to file a proof of claim if they end up paying money back to the bankruptcy estate in settlement or as a result of a judgment. Bankruptcy Code section 502(h) expressly covers this situation:

(h) A claim arising from the recovery of property under section 522, 550, or 553 of this title shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.

Section 502(h) recognizes that resolution of avoidance actions may come long after the original bar date for filing proofs of claim has past and allows holders of these later-arising claims to share in the estate along with other creditors. The Bankruptcy Code treats these claims as having arisen at the time of the payment back to the bankruptcy estate and allows proofs of claim to be filed months or even years after the bar date. 

The Claims Bar Date In SIPA Liquidations. In a SIPA liquidation, there are generally two claims bar dates. The first bar date set is for customer claims, in which customers of the failed brokerage firm seek to recover the securities in their accounts (or more likely in the Madoff case, the securities that were supposed to have been in their accounts). The Securities Investor Protection Corporation insurance of up to $500,000 applies to customer claims. A second bar date, usually a few months later, is for general claims. General creditors may include customers with claims in excess of the $500,000 SIPC protection or those who have more traditional trade creditor or other claims. 

The Madoff Case. In the Madoff case, last month several investors filed a motion seeking to have the bar date order clarified with regard to their potential claims in the event that the Madoff trustee later sued them and they were forced to return funds under a fraudulent transfer or other avoidance (sometimes called a  "clawback") cause of action after the general claims bar date.

  • These investors had previously redeemed some or all of their investments, and were seeking an order holding that claims arising from avoidance actions could be filed within 30 days after the judgment giving rise to the claim became final, a provision common in non-SIPA bankruptcy bar date orders due to Bankruptcy Code section 502(h).
  • The moving parties were concerned that without this clarification, any such claims they filed after the bar date might be held to be barred. On the other hand, if they were forced to file a protective claim before the bar date, they would submit to the court’s equitable jurisdiction and may be held to have waived their right to a jury trial in any avoidance action brought against them.
  • The Madoff trustee filed an opposition to the motion (copy available at the prior link) arguing, among other things, that these investors were not creditors, had not been sued, and as a result did not present an actual case or controversy ripe for adjudication. In addition, the trustee argued that Section 502(h) of the Bankruptcy Code was inapplicable, contending that it was inconsistent with an absolute bar date provision under SIPA. (The SIPA statute provides that Bankruptcy Code provisions are generally applicable in SIPA cases to the extent consistent with SIPA.)
  • The SIPC also filed a response to the motion (copy available at the prior link) making arguments similar to those advanced by the trustee. In particular, the SIPC argued that Section 502(h) was inconsistent with what the SIPC called SIPA’s "immutable" bar date.

The Court’s Decision. In a five-page decision issued on February 24, 2009, U.S. Bankruptcy Judge Burton R. Lifland denied the motion, first holding that the Court did not have the discretion to extend the bar dates involved. (A copy of the decision is available by clicking on the link in the prior sentence.) The Court then stated that the motion essentially sought a determination of whether Section 502(h) of the Bankruptcy Code was applicable in SIPA liquidations. Because no avoidance action had yet been filed, the Court held that the requested relief, if granted, would amount to an improper advisory opinion.

  • As a result, the Court refused to decide whether Bankruptcy Code Section 502(h) applies in SIPA cases, commenting as follows: "Although section 78fff(b) of SIPA specifies that the provisions of the Bankruptcy Code shall apply in SIPA liquidation proceedings, to the extent that they are consistent with SIPA, it is unclear whether section 502(h) of the Code would apply. 15 U.S.C. § 78fff(b) (1981)."
  • The Court concluded by noting that the investors could file a protective proof of claim before the general claims bar date, although that would subject them to the Court’s equitable jurisdiction.

An Open Question. Although the Court denied the motion, it left open the ultimate issue involved — whether Section 502(h) of the Bankruptcy Code applies in SIPA liquidations and permits parties to file proofs of claim after the bar date if they are sued by a trustee and later have to return funds or other property. With the issue undecided for now, some investors may choose to file a protective proof of claim before the bar date passes.