Recent Developments

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Business Bankruptcy Issues Recent Developments

Applying Its Stern v. Marshall Ruling On The Power Of Bankruptcy Courts, The U.S. Supreme Court Issues A Narrow Decision In Executive Benefits Case

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 Image Courtesy of Mike M.S.

The Stern v. Marshall Decision. In its 2011 decision in Stern v. Marshall, decided by a 5-4 vote, the U.S. Supreme Court held that even though Congress designated certain state law counterclaims as “core” proceedings, Article III of the U.S. Constitution prohibits bankruptcy courts from finally adjudicating those claims. Stern v. Marshall left a number of questions unanswered, including the following:

  1. Is a fraudulent conveyance claim under state law or the Bankruptcy Code a “Stern claim” for which a bankruptcy court is constitutionally prohibited from entering final judgment?;
  2. Can a bankruptcy court enter a final judgment on “Stern claims” with the parties’ consent?; and
  3. Can a bankruptcy court treat a “core” Stern claim as “non-core” under 28 U.S.C. Section 157 and follow the statutory procedures for submitting proposed findings of fact and conclusions of law to the district court for de novo review, even though there appears to be a gap in the statute and it does not expressly provide for that approach?

The Decision And Appeals Below. These issues were in play in cases around the country, including the Ninth Circuit’s decision in In re Bellingham, a case that involved a bankruptcy trustee’s fraudulent conveyance claims against Executive Benefits Insurance Agency (“EBIA”) and other defendants. The trustee ultimately filed a motion for summary judgment in the bankruptcy court, which granted judgment in favor the trustee, including on the fraudulent conveyance claims. EBIA appealed to the district court, which affirmed the bankruptcy court’s decision after a de novo review of the summary judgment ruling.

  • EBIA appealed again to the Ninth Circuit and, after the Supreme Court’s Stern v. Marshall decision was issued, sought to dismiss its appeal, arguing that Article III did not permit the bankruptcy court to issue a final judgment on the fraudulent conveyance claims.
  • The Ninth Circuit denied the motion, holding that although Article III did not permit a bankruptcy court to enter final judgment on a fraudulent conveyance claim against a noncreditor without consent of the parties, EBIA had impliedly consented to the bankruptcy court’s adjudication in the case.
  • The Ninth Circuit also noted that the bankruptcy court’s judgment could be treated as its proposed findings of fact and conclusions of law under the “non-core” statutory scheme, subject to the de novo review given by the district court in the case.

When the Supreme Court granted review of the Ninth Circuit’s decision in Executive Benefits Insurance Agency v. Arkinson, many thought the Supreme Court’s decision would answer these questions. In fact, there was a palpable fear among bankruptcy professionals that the Supreme Court might hold consent of the parties to be insufficient to overcome Article III concerns, and further that the Supreme Court might limit bankruptcy court jurisdiction over fraudulent transfer claims and require their adjudication solely in the district court. Other commentators questioned whether a ruling could put the federal magistrate judges system at risk, since they too exercise jurisdiction to enter final judgments with the consent of the parties.

The Supreme Court’s Narrow Decision. However, in an unanimous 9-0 decision in Executive Benefits Insurance Agency v. Arkinson, issued on June 9, 2014 (follow link for copy of opinion), Justice Clarence Thomas, writing for the Supreme Court, reached the decision by addressing only the third question, the one involving statutory construction. In affirming the Ninth Circuit’s decision, the Supreme Court expressly “reserve[d] … for another day” a decision on the question of whether Article III permits a bankruptcy court to enter final judgment on a Stern claim with the consent of the parties. It also did not decide whether a fraudulent conveyance claim is actually a Stern claim, noting instead that because neither party contested that conclusion its opinion simply assumed, without deciding, that it was a Stern claim.

Here’s how the Supreme Court described its holding:

We hold today that when, under Stern’s reasoning, the Constitution does not permit a bankruptcy court to enter final judgment on a bankruptcy-related claim, the relevant statute nevertheless permits a bankruptcy court to issue proposed findings of fact and conclusions of law to be reviewed de novo by the district court. Because the District Court in this case conducted the de novo review that petitioner demands, we affirm the judgment of the Court of Appeals upholding the District Court’s decision.

It restated that decision another way later in the opinion:

As we explain in greater detail below, when a bankruptcy court is presented with such a claim, the proper course is to issue proposed findings of fact and conclusions of law. The district court will then review the claim de novo and enter judgment. This approach accords with the bankruptcy statute and does not implicate the constitutional defect identified by Stern.

The reason the Supreme Court held its approach “accords with the bankruptcy statute,” and there is no “statutory gap” is because 28 U.S.C. Section 157 has a severability provision:

The plain text of this severability provision closes the so-called “gap” created by Stern claims. When a court identifies a claim as a Stern claim, it has necessarily “held invalid” the “application” of §157(b)—i.e., the “core” label and its attendant procedures—to the litigant’s claim. Note following §151. In that circumstance, the statute instructs that “the remainder of th[e] Act . . . is not affected thereby.” Ibid. That remainder includes §157(c), which governs non-core proceedings. With the “core” category no longer available for the Stern claim at issue, we look to §157(c)(1) to determine whether the claim may be adjudicated as a non-core claim—specifically, whether it is “not a core proceeding” but is “otherwise related to a case under title 11.” If the claim satisfies the criteria of §157(c)(1), the bankruptcy court simply treats the claims as non-core: The bankruptcy court should hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.

The Supreme Court also commented how it noted in Stern that its decision there had not meaningfully changed the division of labor between bankruptcy and district courts. Referring back to that point, the Supreme Court in Executive Benefits rejected EBIA’s argument that district courts are required to hear all Stern claims in the first instance, since such an approach would have dramatically altered the division of responsibility set by Congress.

The De Novo Review Solution. The Supreme Court did not have to reach the consent issue in this case because it concluded “that EBIA received the de novo review and entry of judgment to which it claims constitutional entitlement.” That happened when the district court on appeal reviewed de novo the bankruptcy court’s grant of summary judgment, and then the district court itself entered judgment for the trustee.

  • The Supreme Court found that here appellate review alone provided sufficient de novo review to satisfy Article III because the bankruptcy court’s conclusions of law were reviewed de novo by the district court acting as an appellate court.
  • A bankruptcy court decision to grant summary judgment on a Stern claim, at least if appealed and affirmed by a district court on appeal after a de novo review of the legal issues, should be constitutionally sufficient even without consent given Executive Benefits.  However, parties and bankruptcy courts may be uncomfortable relying on that narrow ruling given the uncertainty of a how a particular litigation may proceed.
  • Importantly, the Supreme Court did not hold that appellate review alone is sufficient de novo review of Stern claims in all procedural settings.  Appellate courts typically review de novo only a bankruptcy court’s legal conclusions, not its findings of fact, which are entitled to greater deference on appeal. In contrast, the non-core procedure under 28 U.S.C. Section 157(c)(1), in which the bankruptcy court makes only proposed findings of fact and conclusions of law, requires the district court to engage in a full de novo review of both legal and factual issues.

Where Does This Leave The Consent Issue? By leaving for another day the consent question, and by assuming but not deciding whether fraudulent conveyance claims are Stern claims, the Supreme Court resolved the Executive Benefits case on the narrowest of grounds. As in Stern, the Supreme Court once again left bankruptcy courts and parties litigating these claims with important, unanswered questions.

  • To address the consent issue, after Stern a number of bankruptcy courts adopted local rules and procedures to require parties either to make an affirmative decision indicating whether they consented to the bankruptcy court entering final judgment or implying such consent from the lack of a timely objection.
  • Although the Supreme Court did not reach the consent issue in Executive Benefits, the decision may persuade bankruptcy courts to reconsider the focus on consent.
  • The Supreme Court’s clear holding that there is no “statutory gap,” and its statement that bankruptcy courts “should” use the non-core procedure for Stern claims, may well lead bankruptcy courts to issue proposed findings of fact and conclusions of law on all Stern claims for de novo review by district courts.
  • Although the report and recommendation approach adds another layer of delay and cost for parties, and places an additional burden on already overcrowded district courts, the Supreme Court has now gone on record calling this the “proper course” for Stern claims, while technically reserving the consent issue.
  • Given this jurisprudence, more bankruptcy courts may conclude that the non-core approach is preferable to continuing down the unsettled consent path for Stern claims, although others may still test whether consent is sufficient.

Conclusion. Despite the fears of some, the Supreme Court’s decision did not take away the ability of bankruptcy courts to hear Stern claims in the first instance, reaffirming that they continue to have a role in the adjudication of these claims. While it remains to be seen how bankruptcy courts and parties will react, the Executive Benefits decision may increase the number of bankruptcy courts opting to issue reports and recommendations for de novo review by district courts, and fewer may continue to attempt to enter final judgments with consent of the parties. That said, the consent issue may yet have its day at the Supreme Court as other cases move through the bankruptcy system, so stay tuned.

Business Bankruptcy Issues Recent Developments

Patent Reform Bill, And Its Revisions To Bankruptcy Code Section 365(n), Stalls In The Senate

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Image courtesy of Matt H. Wade

In December 2013 I wrote about the Innovation Act, H.R. 3309, a bill focused on patent infringement litigation and other patent law reforms that passed the House of Representatives on a bipartisan basis. My interest in the bill was because it would make the most sweeping changes to the treatment of intellectual property licenses in bankruptcy since the 1988 enactment of Section 365(n) of the Bankruptcy Code. Follow the link in this sentence for a full discussion of the proposed law.

Proposed Changes In The House-Passed Innovation Act. To bring you up to date, here are the four major changes the Innovation Act would make to Section 365(n)’s protections for IP licensees.

  • First, it would extend Section 365(n)’s protections, including through an amendment to Section 101(35A) of the Bankruptcy Code’s definition of intellectual property, to licenses of trademarks, service marks, and trade names.
  • Second, rejection of a trademark, service mark, or trade name license would not relieve the trustee (or presumably a debtor in possession in a Chapter 11 case) of the debtor’s contractual obligations to monitor and control the quality of a licensed product or service.
  • Third, it would expand the payments that a licensee would have to continue to make to the estate, if it elected to retain its license rights, to include not only “royalty” payments but also “other” payments under the license.
  • Fourth, it would amend Section 1522 of the Bankruptcy Code to make Section 365(n) directly applicable to Chapter 15 cases, providing that if a foreign representative rejects or repudiates an IP license, the licensee would be entitled to elect to retain its IP rights under Section 365(n).

If enacted and signed by the President, the Innovation Act’s revisions would apply as of the date of enactment to pending and future cases.

After House Passage, Action On A Senate Version. After passing the House, the Innovation Act moved to the Senate and was referred to the Senate Committee on the Judiciary. Senator Patrick Leahy, the Senate Judiciary Committee Chairman, had introduced a similar bill, S. 1720, the “Patent Transparency and Improvements Act of 2013.”  As introduced, that bill would have made many of the same changes to Section 365(n) and the Bankruptcy Code definition of intellectual property (specifically, adding in coverage of trademarks as discussed above) as in the House-passed Innovation Act. The Senate bill would have also addressed the applicability of Section 365(n) in Chapter 15 cases, but by amending a different section of Chapter 15.

The Legislation Hits A Roadblock. The Senate Judiciary Committee held a hearing on S. 1720, and a number of discussions and negotiations involving companies affected by patent litigation ensued. However, those efforts reached an impasse and on May 21, 2014, Senator Leahy announced:

We have been working for almost a year with countless stakeholders on legislation to address the problem of patent trolls who are misusing the patent system. This is a real problem facing businesses in Vermont and across the country.

Unfortunately, there has been no agreement on how to combat the scourge of patent trolls on our economy without burdening the companies and universities who rely on the patent system every day to protect their inventions.  We have heard repeated concerns that the House-passed bill went beyond the scope of addressing patent trolls, and would have severe unintended consequences on legitimate patent holders who employ thousands of Americans.

I have said all along that we needed broad bipartisan support to get a bill through the Senate. Regrettably, competing companies on both sides of this issue refused to come to agreement on how to achieve that goal.

Because there is not sufficient support behind any comprehensive deal, I am taking the patent bill off the Senate Judiciary Committee agenda.  If the stakeholders are able to reach a more targeted agreement that focuses on the problem of patent trolls, there will be a path for passage this year and I will bring it immediately to the Committee.

We can all agree that patent trolls abuse the current patent system.  I hope we are able to return to this issue this year.

Conclusion. Senator Leahy’s statement makes clear that the focus of this legislation is on patent litigation reform, not bankruptcy and IP licenses. The fate of the legislation will depend on whether the interested parties can reach agreement on those patent issues. However, the stalling of the patent legislation also means the bankruptcy provisions, at least for now, will stay on hold; it seems unlikely the bankruptcy provisions would move forward in legislation separate from the overall patent reform effort. Stay tuned, but the odds now seem considerably lower that these changes to the treatment of IP licenses in bankruptcy will be enacted.

Business Bankruptcy Issues Recent Developments

What The U.S. Supreme Court’s Unamimous Decision In A Homestead Exemption Case Says About The Power Of Bankruptcy Courts In Business Cases

 

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It seems that most bankruptcy decisions by the U.S. Supreme Court involve individual debtors, and the Supreme Court’s latest opinion is no exception. Even though the decision is not in a business bankruptcy case, it examines the bankruptcy court’s powers under Section 105(a) of the Bankruptcy Code. Section 105(a) is commonly invoked in business bankruptcy cases to prevent business disruption through “first day” motions and orders, as part of a Section 363 sale of assets free and clear of liens, and in granting other relief to facilitate a debtor’s reorganization. This fact makes the Supreme Court’s most recent decision, discussed below, of interest for both individual and business bankruptcy cases.

The Key Holding: Exempt Property Really Is Exempt. In an unamimous decision issued on Tuesday, March 4, 2014 in Law v. Siegel (click on the link for a copy of the opinion), the Supreme Court held that a bankruptcy court cannot surcharge a debtor’s homestead exemption to pay for the Chapter 7 trustee’s administrative expenses, even if those expenses were incurred as a result of the debtor’s fraudulent misrepresentations.

  • The bankruptcy court had surcharged the debtor’s $75,000 California homestead exemption to cover the trustee’s fees and costs, but the Supreme Court reversed. It held that Bankruptcy Code Section 522(k)’s explicit language that a debtor’s exempt property “is not liable for payment of any administrative expense” (other than in inapplicable and specific circumstances detailed in that section), precludes a bankruptcy court from invoking either its authority under Section 105(a) to issue orders to “carry out” the provisions of the Bankruptcy Code, or its inherent sanctioning powers, to surcharge the debtor’s homestead exemption.
  • In short, where Congress has declared a debtor’s exempt property off limits, a bankruptcy court cannot not use Section 105(a) to override that specific statutory limitation.

Implications For Business Bankruptcy Cases?  As a business bankruptcy blog, the focus here is on whether the Supreme Court’s decision tells us anything about a bankruptcy court’s powers outside the exempt property context (especially since corporate debtors cannot claim exemptions). At first blush, the Supreme Court’s decision is, of course, a direct rejection of the use of Section 105(a), at least to impose a surcharge on exempt property. But does the decision otherwise weaken a bankruptcy court’s powers under Section 105(a) and its inherent powers?

An insight into the answer seems to come at the very end of the decision. After acknowledging that its holding imposes a heavy financial burden on the Chapter 7 trustee, and could lead to inequitable results in other cases, the Supreme Court addressed what else a bankruptcy court could do to respond to a debtor’s misconduct:

Our decision today does not denude bankruptcy courts of the essential “authority to respond to debtor misconduct with meaningful sanctions.” Brief for United States as Amicus Curiae 17. There is ample authority to deny the dishonest debtor a discharge. See §727(a)(2)–(6). (That sanction lacks bite here, since by reason of a postpetition settlement between Siegel and Law’s major creditor, Law has no debts left to discharge; but that will not often be the case.) In addition, Federal Rule of Bankruptcy Pro­cedure 9011—bankruptcy’s analogue to Civil Rule 11—authorizes the court to impose sanctions for bad-faith litigation conduct, which may include “an order directing payment. . . of some or all of the reasonable attorneys’ fees and other expenses incurred as a direct result of the viola­tion.” Fed. Rule Bkrtcy. Proc. 9011(c)(2). The court may also possess further sanctioning authority under either §105(a) or its inherent powers. Cf. Chambers, 501 U. S., at 45–49. And because it arises postpetition, a bankruptcy court’s monetary sanction survives the bankruptcy case and is thereafter enforceable through the normal proce­dures for collecting money judgments. See §727(b). Fraud­ulent conduct in a bankruptcy case may also subject a debtor to criminal prosecution under 18 U. S. C. §152, which carries a maximum penalty of five years’ imprisonment.

But whatever other sanctions a bankruptcy court may impose on a dishonest debtor, it may not contravene express provisions of the Bankruptcy Code by ordering that the debtor’s exempt property be used to pay debts and expenses for which that property is not liable under the Code.

Conclusion. The Supreme Court’s discussion of the range of actions a bankruptcy court could take to address debtor misconduct helped narrow the decision to situations where a bankruptcy court uses Section 105(a) in contravention of express statutory language. The Supreme Court’s effort to make clear that, outside of those settings, bankruptcy courts possess a broad range of authority, specifically including under Section 105(a), Bankruptcy Rule 9011, and its inherent powers, seems to reinforce, rather than weaken, the power of bankruptcy courts. That makes this decision important for individual — and business — bankruptcy cases.

Image courtesy of Flickr by Kyle Rush

Business Bankruptcy Issues Recent Developments

Cooley’s New Absolute Priority Blog Has Launched

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I’m pleased to let you know that the Corporate Restructuring and Bankruptcy Group at Cooley LLP, of which I am a member, has just launched the new Absolute Priority blog, the new format going forward for our group’s popular Absolute Priority newsletter. Follow the link in the prior sentence to visit the new Absolute Priority blog and, while there, be sure to enter your email address at the “Follow Blog via Email” sign-up to receive notification emails when new posts are added.

I hope you’ll enjoy the new Absolute Priority blog, as well as this In The (Red) blog, to which you can also subscribe using the links on the right side of the page.

Business Bankruptcy Issues Recent Developments

Winter 2014 Edition Of Bankruptcy Resource Now Available

I hope you had a wonderful holiday season and Happy New Year everyone.

To start the new year off, the Winter 2014 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. 

This edition of Absolute Priority covers a range of cutting edge topics, including:

  • An Eleventh Circuit ruling that indirect benefits from a Subchapter S election can constitute reasonably equivalent value for fraudulent transfer purposes;
  • The Ninth Circuit’s decision permitting recharacterization claims; and
  • A recent Seventh Circuit decision on the validity of a cross-collateralized real estate lien.

It also reports on some of our recent representations, including for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others, and our work for Chapter 11 debtors. Recent committee cases include Mervyn’s Holdings, Appleseed’s Intermediate Holdings, and Underground Energy, among others. Recent debtor representations include Cylex (now Immunology Partners), IntraOp Medical (now MC Liquidation), and Nirvanix.

I hope you find the latest edition of Absolute Priority to be of interest. Please note that this will be the final issue in newsletter format, as soon our group will be providing future insights through a new Absolute Priority blog, in addition to this In The (Red) blog. Stay tuned for more details. 

Business Bankruptcy Issues Recent Developments

Innovation Act, Passed By The House, Would Make Major Changes To Section 365(n)’s IP Licensee Protections

It isn’t law yet, but on December 5, 2013, the U.S. House of Representatives passed a significant patent reform bill known as the "Innovation Act." Although the focus of the legislation is on patent infringement litigation and other patent law revisions, the Innovation Act, H.R. 3309, would also make major changes to Section 365(n) of the Bankruptcy Code. Follow the link in the prior sentence for a copy of the Innovation Act in the form passed by the House and received in the Senate last week. It would also address the interplay between Section 365(n) and Chapter 15 cross-border bankruptcy cases, the subject of my last post, on the Qimonda AG decision from the U.S. Court of Appeals for the Fourth Circuit.

Licensee Protections Under The Current Version Of Section 365(n). Section 365(n) was added to the Bankruptcy Code in 1988 to protect licensees of intellectual property in the event the licensor files bankruptcy.

  • Under Section 365(n) as it now exists, if a debtor or trustee rejects a license, the licensee can elect to retain its rights to the licensed intellectual property, including a right to enforce an exclusivity provision.
  • In return, the licensee must continue to make any required royalty payments.
  • The licensee also can retain rights under any agreement supplementary to the license, which should include source code or other forms of technology escrow agreements.
  • Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • To read more about the current version of Section 365(n)’s benefits and its protections, follow the link in this sentence.

Limits Of The Current Section 365(n). These existing protections have several significant limitations. First, the Bankruptcy Code’s special definition of "intellectual property" excludes trademarks from the scope of Section 365(n)’s protections (although a recent Seventh Circuit decision may have opened an alternative path for trademark licensees to retain their rights). Another is that Section 365(n) is in the U.S. Bankruptcy Code and applies only in a U.S. bankruptcy case. Most other countries do not have protections similar to Section 365(n).

Proposed Changes In The House-Passed Innovation Act. The Innovation Act would make four major changes to Section 365(n)’s protections for licensees.

  • First, it would extend Section 365(n)’s protections, including through an amendment to Section 101(35A) of the Bankruptcy Code’s definition of intellectual property, to licenses of trademarks, service marks, and trade names.
  • Second, rejection of a trademark, service mark, or trade name license would not relieve the trustee (or presumably a debtor in possession in a Chapter 11 case) of the debtor’s contractual obligations to monitor and control the quality of a licensed product or service.
  • Third, it would expand the payments that a licensee would have to continue to make to the estate, if it elected to retain its license rights, to include not only "royalty" payments but also "other" payments under the license.
  • Fourth, it would amend Section 1522 of the Bankruptcy Code to make Section 365(n) directly applicable to Chapter 15 cases, providing that if a foreign representative rejects or repudiates an IP license, the licensee would be entitled to elect to retain its IP rights under Section 365(n).

If enacted and signed by the President, the Innovation Act’s revisions would apply as of the date of enactment to pending and future cases.

Will The Innovation Act Become Law? I’m a bankruptcy lawyer, not a political analyst, but it’s fair to say we shouldn’t get too excited about these potential legislative changes just yet. The Innovation Act has passed only the House and has been referred to the Senate Committee on the Judiciary, where the bill meets an uncertain fate. Even if the Innovation Act passes the Senate, the Section 365(n) provisions could be amended or the legislation could otherwise stall. However, the Innovation Act is not a one-party bill: it passed the House with a large bipartisan majority on a 325-91 vote. That suggests it has the potential for support in the Senate.

Potential Impact Of Innovation Act’s Changes To Section 365(n). If the changes to Section 365(n) do become law, they would be the most significant revisions since its enactment in 1988.

  • The biggest changes would be the extension of Section 365(n)’s protections to trademarks, service marks, and trade names, together with the monitoring obligations on a trustee. In the 25 years since Section 365(n) was enacted, trademark licensees have lived under the specter of losing trademark license rights in bankruptcy. These revisions would be a sea change in the trademark area.
  • In addition, the Innovation Act provides that the trustee or debtor in possession would not be relieved of a contractual obligation to continue to monitor the quality of goods or services using a mark, in effect limiting the benefits of rejection to an estate for the protection of consumers. However, it’s unclear how a trustee would be able to meet such an obligation, particularly if an estate had no assets, and how a trustee could meet a long-term obligation to monitor quality given that the Chapter 7 case would eventually be closed. These were some of the difficult issues that led Congress to leave trademarks out of Section 365(n) originally.
  • Another significant change is the requirement that a licensee that elects to retain its IP rights under Section 365(n) essentially continue to make all payments under the license agreement and not simply those determined to be "royalty" payments. If this provision becomes law, drafters of license agreements will need to consider how rejection and the non-performance of the licensor’s obligations would impact payments otherwise required under the license agreement.
  • As a timely anticipation of the Fourth Circuit’s Qimonda AG decision, the Innovation Act would apply Section 365(n) in all Chapter 15 cases through an amendment to Section 1522. The language used — applying when a foreign representative rejects or "repudiates" a license agreement — suggests that the House intended this to cover not only rejection under Section 365 of the Bankruptcy Code but also equivalent foreign law powers to repudiate or disclaim contracts. By placing the Section 365(n) reference in a new, separate subsection of Section 1522 governing protection of creditors and other interested persons, it seems that Section 365(n) would apply in all Chapter 15 cases, regardless of whether the foreign representative sought preliminary or discretionary relief under Sections 1519 or 1521.

Conclusion. If it becomes law in its current form, the Innovation Act would bring the most sweeping changes to Section 365(n) since its enactment in 1988. Although there’s a long way to go before that actually happens, the breadth of the proposed changes and their impact on bankruptcy and IP law makes this piece of legislation one to watch. Stay tuned.

Business Bankruptcy Issues Recent Developments

When Worlds Collide, The Sequel: Fourth Circuit Rules On Section 365(n)’s IP Licensee Protections In Chapter 15 Cross-Border Bankruptcy

My how time flies in protracted bankruptcy litigation. More than four years ago, as I reported back at the time, the Bankruptcy Court in the Chapter 15 cross-border bankruptcy case of Qimonda AG issued its first decision on the application of Section 365(n) in that case. After an initial appeal, a four-day trial on remand, and another appeal, last week the U.S. Court of Appeals for the Fourth Circuit issued a major decision that may bring the litigation to a close.

Even if you are not a Chapter 15 bankruptcy aficionado, this decision has important implications for licensees of intellectual property, especially when the IP owner is a foreign entity.

Before diving into the Fourth Circuit’s decision and examining where the decision leaves licensees, let’s first take a look at Section 365(n), Chapter 15, and the long and winding road that led to the Fourth Circuit’s decision. Or, if so inclined, you can just jump to the discussion of the Fourth Circuit’s decision and where it leaves licensees, found toward the end of this post.

Section 365(n) And Licensee Rights. Section 365(n) was added to the Bankruptcy Code to protect licensees of intellectual property in the event the licensor files bankruptcy.

  • Under Section 365(n), if the debtor or trustee rejects a license, a licensee can elect to retain its rights to the licensed intellectual property, including a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payments.
  • The licensee also can retain rights under any agreement supplementary to the license, which should include source code or other forms of technology escrow agreements.
  • Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
  • For more on Section 365(n)’s benefits and protections, follow the link in this sentence.

Limits Of Section 365(n). These protections, however, have their limits. One is that the Bankruptcy Code’s special definition of “intellectual property” excludes trademarks from the scope of Section 365(n)’s protections (although at least one recent decision may have opened an alternative path for trademark licensees to retain their rights). Another is that Section 365(n) is in the U.S. Bankruptcy Code and applies only in a U.S. bankruptcy case. Most other countries do not have protections similar to Section 365(n).

Chapter 15 Bankruptcy. Chapter 15 allows a foreign entity’s official representative to obtain U.S. bankruptcy protection for assets and interests in the United States, ancillary to the insolvency proceedings in the entity’s home country. It was was added to the Bankruptcy Code to implement certain cross-border insolvency procedures when corporations or others have assets and interests in more than one country. To read more on Chapter 15 bankruptcy, follow the link in this sentence.

Does Section 365(n) Apply In Chapter 15 Cases? An open question has been what would happen if a foreign licensor were the subject of a cross-border case under Chapter 15 of the U.S. Bankruptcy Code. Would Section 365(n) apply to protect licensees in a Chapter 15 proceeding?

  • In the Qimonda case, the two worlds collided — Chapter 15’s cross-border bankruptcy procedures and Section 365(n)’s protections for IP licensees.
  • The first bombshell came in November 2009. Judge Robert G. Mayer of the U.S. Bankruptcy Court for the Eastern District of Virginia issued an initial decision, holding that Section 365(n)’s protections did not apply in the Chapter 15 case, starting the four-year journey to the Fourth Circuit’s decision.

The Qimonda Chapter 15 Case. Qimonda, a German company that manufactured semiconductor devices, was in an insolvency proceeding in Germany. The principal assets of Qimonda’s estate were approximately 10,000 patents, of which roughly 4,000 were U.S. patents. It had issued licenses of rights under those U.S. patents to third party licensees. Qimonda’s German insolvency administrator had filed the Chapter 15 case to seek recognition by the Bankruptcy Court of the pending German insolvency proceeding as a “foreign main proceeding.” The Bankruptcy Court granted recognition and, at the request of the administrator, granted him discretionary relief under Section 1521(a)(5) of the Bankruptcy Code, entrusting to him the administration of all of Qimonda’s assets within the United States, primarily the 4,000 U.S. patents. In its supplemental order granting relief under Section 1521, the Bankruptcy Court on its own provided that, among other things, Section 365 of the U.S. Bankruptcy Code would apply to the Chapter 15 case (it does not apply automatically in Chapter 15 cases).

U.S. Licensees Invoke Section 365(n). Following the Bankruptcy Court’s supplemental order, certain U.S. licensees asserted Section 365(n) rights in an attempt to retain their rights to the intellectual property that Qimonda had licensed them.

The Bankruptcy Court’s Decision. In November 2009, Judge Mayer issued the first decision on the issue, agreeing with Qimonda’s administrator and modifying the prior supplemental order to exclude the effect of Section 365(n). Judge Mayer provided that Section 365(n) would apply only if the administrator “rejects an executory contract pursuant to Section 365 (rather than simply exercising the rights granted to the Foreign Representative pursuant to the German Insolvency Code).”

Appeal To The District Court. The licensees appealed to the District Court, which remanded the case back to the Bankruptcy Court.

  • The District Court ordered the Bankruptcy Court to consider the requirement under Section 1522(a) of the U.S. Bankruptcy Code to ensure that “the interests of the creditors and other interested entities, including the debtor, [were] sufficiently protected.” The District Court held that the Bankruptcy Court had to balance the relief granted to the German insolvency administrator as foreign representative with the interests of those affected by that relief.
  • As a separate basis for remand, the District Court directed the Bankruptcy Court to consider whether Section 365(n) is a fundamental U.S. public policy such that, under Section 1506 of the U.S. Bankruptcy Code, subordinating it to Section 103 of the German Insolvency Code would be “manifestly contrary to the public policy of the United States.”

The Bankruptcy Court On Remand. On remand, another Bankruptcy Judge, Stephen S. Mitchell, held a four-day evidentiary hearing, with testimony on the likely impact of applying, or not applying, Section 365(n) to licenses under Qimonda’s U.S. patents. At the outset, the administrator had committed to re-license the licensees under a “reasonable and nondiscriminatory” royalty license (known as RAND), but the licensees pressed to keep their existing license rights without having to negotiate and pay a new royalty. At stake for the Qimonda estate was approximately $47 million in estimated re-licensing fees. The licensees argued the stakes were far higher on their side. They contended that a failure to apply Section 365(n) would destablize the system of licensing and cross-licensing in place to address the “thicket” of multiple patents held by different parties in the semiconductor industry, and in turn that would reduce investment and innovation.

Ultimately, the Bankruptcy Court issued its decision and, under Section 1522(a), balanced the interests of Qimonda and the licensees in favor of requiring that Section 365(n) apply to the administration of Qimonda’s U.S. patents. Taking up the other issue raised by the District Court, the Bankruptcy Court independently held that “deferring to German law, to the extent it allows cancellation of the U.S. patent licenses, would be manifestly contrary to U.S. public policy.” Under Section 1506, the Bankruptcy Court concluded that U.S. public policy required that Section 365(n)’s protections apply to Qimonda’s U.S. patents.

The Fourth Circuit’s Decision. After procedural hurdles were cleared, a direct appeal to the Fourth Circuit followed. On December 3, 2013, the Fourth Circuit issued its 45 page opinion affirming the Bankruptcy Court’s decision to apply Section 365(n). After first examining the history, purpose, and structure of Chapter 15, the Fourth Circuit turned to the three arguments the German administrator had advanced on appeal.

  • No request for Section 365(n) to apply. The administrator argued that in seeking discretionary relief under Section 1521, he had never asked for either Section 365 or 365(n) to apply; since relief under Section 1521 has to be requested by the foreign representative, he asserted that his decision not to request it should resolve the question. The Fourth Circuit rejected the argument, holding his view of the relationship between Sections 1521(a) and 1522(a) “too myopic.” Instead, it held that if any discretionary relief is granted under Section 1521(a), the interests of creditors and the debtor must be “sufficiently protected” under Section 1522(a).
  • Erroneous test under Section 1522(a). The administrator next argued that the “sufficiently protected” standard is designed only to make sure that all creditors can participate in the foreign proceeding on an equal footing, not to change the substantive outcome in that foreign proceeding. Reviewing the Guide to Enactment of the Model Law on which Chapter 15 is based, the Fourth Circuit also rejected this argument. It held that Section 1522(a) requires a balancing of interests before discretionary relief is granted, and anticipates a particularized analysis of the impacts on creditors and the debtor from the relief sought.
  • Faulty balancing analysis. Finally, the administrator argued that the Bankruptcy Court abused its discretion in balancing the interests involved. Specifically, he asserted that the lower court overstated the risk to the licensees’ investments made in reliance on the licenses that Qimonda had granted, especially given the administrator’s RAND license offer. The Fourth Circuit rejected this argument as well, agreeing with the Bankruptcy Court’s assessment of the risks. These included the risks to investments already made and the threat of infringement litigation contrary to the Qimonda licenses. The Fourth Circuit also held that although the RAND proposal would reduce the licensees’ risks, it would not sufficiently protect them. The outcome of those negotiations were uncertain, there were significant hold-up risks in the RAND license negotiations. Moreover, it was unclear whether even new RAND licenses would survive if the administrator sold the patents in the German proceeding — and the purchaser later filed an insolvency proceeding under German law.

In the final section of the decision (Part IV), the Fourth Circuit returned to the purposes of Chapter 15 and Section 365(n). It stated that in affirming the Bankruptcy Court’s decision based on Section 1522(a), it was also indirectly furthering the public policy behind Section 365(n). However, the Fourth Circuit did not reach Section 1506. Unlike the Bankruptcy Court, the Fourth Circuit did not hold that subordinating Section 365(n) to Section 103 of the German Insolvency Code would be “manifestly contrary to the public policy of the United States.” Interestingly, Part IV of the opinion only got two votes. Circuit Judge Wynn concurred in the judgment and in the first three parts of the decision, but not in Part IV, which he found to be “unnecessary dictum.”

Where Does The Decision Leave Licensees? While plainly good news for the Qimonda licensees, who can now use Section 365(n) to retain their pre-existing IP rights, the Fourth Circuit’s decision leaves a number of unanswered questions for future cases.

  • Is a decision allowing a foreign representative to reject licenses without applying Section 365(n) protection “manifestly contrary to the public policy of the United States” under Section 1506? The Bankruptcy Court thought it was, but the Fourth Circuit carefully chose not to reach the issue. It remains an open question even in the Fourth Circuit, much less in Chapter 15 cases filed in the rest of the country. Section 1506, quoted below, is so important because it’s Chapter 15’s local law trump card:

Nothing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.

By declining to reach the Section 1506 question, the Fourth Circuit kept the Section 1506 trump card in the deck. That leaves licensees with continued uncertainty about whether Section 365(n) will in fact be applied in the next Chapter 15 case.

  • Must courts apply Section 365(n) every time a foreign representative requests any discretionary relief under Section 1521? The Fourth Circuit’s decision required courts to balance the particular interests of creditors and the debtor under Section 1522(a), not just their access to the foreign court. To coin a phrase, this means “substantive sufficient protection” instead of just “procedural sufficient protection.” The Qimonda decision should help licensees tip the balance in their favor, especially when a foreign representative is asking to administer U.S. patents. However, the Fourth Circuit holding was that the Bankruptcy Court’s exercise of discretion was reasonable. It did not hold that no other decision was possible. That makes it a little less clear whether the Fourth Circuit would allow this particularlized balancing to go the other way — a refusal to apply Section 365(n) — in another case.
  • What if the foreign representative doesn’t seek any discretionary relief? Remember, the Fourth Circuit affirmed the Bankruptcy Court only under Section 1522(a), which in turn applies only when a foreign representative requests discretionary relief under Section 1521 (or relief under Section 1519 before recognition).  Most foreign representatives will seek discretionary relief, and specifically seek to have U.S. assets entrusted to them. That is what Qimonda’s German administrator did. However, if a foreign representative decided not to request any such relief, the balancing of interests called for by the Fourth Circuit would not be triggered. That could leave licensees with only Section 1506’s public policy trump card, which the Fourth Circuit did not invoke.
  • What if the foreign representative doesn’t file a Chapter 15 case at all? This one is pretty easy. If the foreign representative chooses not file a Chapter 15 case in the first place (or of course a Chapter 11 or Chapter 7 case), then there would be no U.S. bankruptcy case in which to try to invoke Section 365(n). That’s one of Section 365(n)’s major limitations, and one licensees — and the attorneys who draft their licenses — should remember.

Conclusion. The Fourth Circuit’s Qimonda decision is important for licensees of intellectual property owned by a foreign entity. It signals that U.S. courts will incline to protect licensees by applying Section 365(n) when an insolvent foreign entity’s administrator or other representative asks for assistance from the U.S. bankruptcy courts. However, the Fourth Circuit did not go as far as some licensees would have liked, stopping short of declaring that an attempt to reject licenses without applying Section 365(n) would be “manifestly contrary” to U.S. public policy. That makes the Qimonda decision a helpful, but perhaps not decisive, tool for IP licensees. It of course remains to be seen whether other courts will follow the Qimonda decision or chart a different path.