Page 32 – The Business Bankruptcy Blog

Infringement Claims: Is Bankruptcy The End Of The Line?

Defending intellectual property ("IP") litigation can be expensive and, if unsuccessful, often crippling for the defendant’s business. Sometimes an accused infringer facing IP litigation will seek bankruptcy protection to invoke the automatic stay. Unless lifted by the bankruptcy court, the automatic stay will prevent further litigation against the debtor, outside of the bankruptcy claims process, for pre-bankruptcy claims.

The collision between infringement litigation and bankruptcy, however, raises issues beyond the automatic stay, especially with respect to continuing and past infringement claims. This post addresses these questions in the context of both corporate and individual debtors.

Continuing Infringement

What if a corporate debtor continues to infringe?

If a corporation or other business debtor in Chapter 11 is continuing to infringe intellectual property rights, the IP owner may have what’s known as an "administrative claim" in the debtor’s bankruptcy case. Administrative claims, as the name implies, are claims that result from the administration of the bankruptcy estate and include claims for payment for products and services delivered to a debtor post-petition and for fees and expenses of bankruptcy lawyers and other professionals advising the Chapter 11 debtor in possession and creditors committee. Administrative claims are paid ahead of all pre-petition unsecured claims and almost all other priority claims, and sometimes can have a major impact on a debtor’s ability to reorganize.

A recent decision by the U.S. Court of Appeals for the Sixth Circuit in the Eagle-Picher Industries Chapter 11 case held that post-petition patent infringement claims qualify as administrative claims. In that case, although the debtor faced a $20 million administrative claim related to patent infringement litigation, the court held that the claim survived confirmation of the debtor’s bankruptcy plan.

A non-debtor IP owner may also be able to get relief from the automatic stay (see my earlier post on that topic) to pursue infringement claims, including to seek injunctive relief for continuing infringement, in a court other than the bankruptcy court. It is possible that the automatic stay will not even apply to post-petition acts of infringement, but IP owners and debtors should get advice from a bankruptcy attorney about their specific situation.

Are continuing infringement claims covered by an individual’s bankruptcy discharge?

Individual debtors will generally get a discharge of their pre-bankruptcy debts. A decision from the U.S. Court of Appeals for the Federal Circuit earlier this year, however, makes clear that an individual who files bankruptcy does not get a free pass to keep on infringing a patent. In Hazelquist v. Guchi Moochie Tackle Company, Inc., 437 F.3d 1178 (Fed. Cir. 2006), the court held that the debtor’s bankruptcy discharge was only retrospective, covering claims relating to acts prior to bankruptcy, and did not immunize the debtor from claims for continuing infringement. As a result, the court ruled that the patent holder could assert claims against the debtor outside of bankruptcy court for each act of post-petition infringement. It’s an interesting decision and the full opinion is available here. You might also enjoy reading the Patently-O blog’s post on the decision by Dennis Crouch, who seems to like the tackle company’s name as much as I do.

Past Infringement

What about claims for past infringement?

An IP owner can file a proof of claim for past infringement claims, but that claim will most likely be considered an unsecured claim and may end up being paid cents on the dollar. Filing a proof of claim is certainly the less costly way to go, and with a corporate debtor may be the principal remedy available for past infringement damages.

If the infringer is an individual, however, another question is whether claims for past infringement can be declared nondischargeable, allowing the IP owner to pursue the debt notwithstanding the bankruptcy discharge. (As discussed in an earlier post, the notion of nondischargeable debts applies only to individuals and not to corporations or other entities.) Although seeking a nondischargeability determination often doesn’t make economic sense, owners of intellectual property sometimes believe that it’s important to protect those rights through vigorous pursuit of infringers, even against those who file bankruptcy.

So is an infringement claim nondischargeable? A recent decision from the Bankruptcy Appellate Panel (known in the trade as "the BAP") of the U.S. Court of Appeals for the Ninth Circuit said yes, at least when the claim is for truly willful copyright infringement. Why? Well, under the Bankruptcy Code, a debt that results from a "willful and malicious injury" is nondischargeable. In In re: Albarran, decided on July 24, 2006, the BAP held that a judgment for willful copyright infringement, which included an award of statutory damages, interest, and attorney’s fees, involved "willful and malicious injury." The BAP’s decision is available here.

In essence, the BAP held that willful copyright infringement, involving an intent to harm or knowledge that one’s actions were substantially certain to cause harm, (1) is an injury to the copyright holder and (2) statutory damages under the Copyright Act qualify as a debt arising from this injury even though the plaintiff may not have suffered identifiable economic damage. Willful injury under the Bankruptcy Code requires that the debtor intend the consequences of his action, generally excluding negligent or reckless conduct. In In re: Albarran, the BAP concluded that the particularly willful nature of the copyright infringement involved satisfied this requirement. With willfulness determined, the court was able to imply the element of malice.

Does the answer depend on the type of IP infringed?

The BAP’s decision involves copyrights and not patents or trademarks, so the question remains whether willful patent or trademark infringement would also be considered a nondischargeable "willful and malicious injury" under the Bankruptcy Code. The BAP’s decision did make several references to the kinship between copyright and patent law and noted that "patent infringement has historically been viewed as a tort because of its invasion of another’s rights." In 2004, in a case called In re Trantham, a BAP from a different circuit, the Sixth Circuit, held that a claim for willful patent infringement was nondischargeable. You can read that decision here. Although the answer is not settled yet, if a debtor were found to have engaged in intentional patent or trademark infringement, the odds are that a bankruptcy court would find damages for such conduct to be nondischargeable.

Is a BAP the same as the U.S. Court of Appeals?

Although these BAP decisions are very instructive, a word of caution is in order. Unlike a U.S. Court of Appeals itself, a BAP is made up of bankruptcy judges only, not federal circuit judges. Given a BAP’s place in the judicial system’s hierarchy, its decisions are not given the same precedential weigh as U.S. Court of Appeals decisions. This means that it’s possible for a U.S. Court of Appeals itself to reach a different conclusion. (In fact, an appeal to the Ninth Circuit from the BAP’s In re: Albarran decision was just filed last week.) Still, the two BAP decisions in In re: Albarran and In re Trantham are well-reasoned and may be followed by other courts.

Impact Of Asset Sale

Can a debtor sell assets free and clear of infringement claims?

Generally, a debtor will be able to sell its assets in a Section 363 bankruptcy sale free and clear of claims (see earlier post on asset sales), including claims for past infringement. However, if an IP owner asserts claims for continuing infringement related to the assets and how they are used, the sale will in all likelihood not be free and clear of those continuing infringement claims. Instead, the purchaser could well end up buying the defense of an infringement lawsuit along with the assets.

A Final Note

Do last year’s bankruptcy law changes have an impact?

Given the amendments to the Bankruptcy Code made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, even if an individual debtor got a discharge of a willful infringement claim, he or she would have a very hard time getting another discharge within the next eight years. The message to individual infringers in bankruptcy: discharge or not, better stop infringing.

Recent Developments

Cooley Godward To Merge With Kronish Lieb, Creating Nationwide Bankruptcy Practice

I wanted to share with you some very exciting news about my firm and practice. Yesterday, Cooley Godward announced that the firm will merge with Kronish Lieb Weiner & Hellman LLP, a premier 110-lawyer New York firm with highly ranked bankruptcy, tax and complex commercial and white collar litigation practices. The merger will create a 550-lawyer firm with a coast-to-coast, high-caliber litigation practice, extensive corporate transactional capabilities and a significant presence in New York. The merger will be effective October 1, 2006, and the new firm name will be Cooley Godward Kronish LLP. Click here if you’d like to read the full press release.

The combination brings together Kronish’s leading bankruptcy and restructuring practice, ranked #1 in The Deal’s Bankruptcy Insider league tables in 2006 for Top Unsecured Creditor Law Firms, with Cooley’s deep expertise representing creditors committees, debtors, and other clients in bankruptcy matters involving technology companies and intellectual property assets. The combined firm will have more than 20 bankruptcy and restructuring attorneys nationwide.

Kronish has represented scores of unsecured creditors committees in some of the nation’s largest and best-known bankruptcies and out-of-court workouts, including Montgomery Ward, Federated Department Stores, and Footstar. Kronish has also represented numerous employee and retiree committees including, most notably, the United Airlines ESOP Committee, the Enron Employee Related Issues Committee, the Bonwit Teller Retiree Committee and the LTV Retiree Committee.

In addition, Kronish has served as reorganization counsel in significant debtor cases, including the $5 billion Metromedia Fiber Network Chapter 11 case and, together with Cooley, the $1.2 billion Old UGC Chapter 11 case.

Having worked with Kronish’s bankruptcy attorneys on a number of matters over the past several years, I couldn’t be more delighted with the news and look forward to working with my new colleagues to serve our combined firm’s clients.

Business Bankruptcy Issues Recent Developments

Trademark Licensees In Bankruptcy: A Leg Up For Trademark Owners?

Apparently, until last November, no court had been called upon to resolve whether a trademark licensee in bankruptcy can assume, or assume and assign, a non-exclusive trademark license without the trademark owner’s consent.

The decision. We got the first answer to that question in a case called In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), when the U.S. District Court in Nevada held that trademark licenses are personal and nonassignable, absent a provision in the trademark license to the contrary. Click here for a copy of the N.C.P Marketing Group decision. In reaching its conclusion, the court held that under the Lanham Act, the federal trademark statute, a trademark owner has a right and duty to control the quality of goods sold under the mark:

Because the owner of the trademark has an interest in the party to whom the trademark is assigned so that it can maintain the good will, quality, and value of its products and thereby its trademark, trademark rights are personal to the assignee and not freely assignable to a third party.

The U.S. Court of Appeals for the Ninth Circuit (which includes Nevada, California, and other western states) had previously interpreted the key Bankruptcy Code provision involved, Section 365(c)(1), to prevent a debtor from assuming an agreement when it does not have the right to assign it. (For a discussion about how bankruptcy can affect intellectual property licenses, including the impact of this earlier Ninth Circuit case, you may want to read my earlier post on the topic.)

Building on this Ninth Circuit law, the trademark owner in the N.C.P. Marketing Group case argued that under trademark law the debtor could neither assume nor assign the non-exclusive trademark license at issue. The district court agreed, holding that the bankruptcy court correctly granted the trademark owner’s motion to compel the debtor to reject the trademark license, forcing the debtor to give up its license rights.

Good news for trademark owners. The decision is good news for trademark owners. Many have have long worried that if a licensee files bankruptcy it might be able to use the Bankruptcy Code’s general power to assume and assign executory contracts to assign trademark licenses to third parties over the trademark owner’s objection. The N.C.P. Marketing Group decision extends to trademark owners protections already recognized by many courts for patent and copyright holders. The case does not address whether the same rule would apply to exclusive trademark licenses, but given the trademark owner’s similar rights and duties to control the quality of goods sold under a licensed mark, the result could be the same.

Bad news for debtor licensees. The decision, of course, is bad news for trademark licensees that file bankruptcy. If the decision is followed by other courts, trademark licensees in bankruptcy will be unable to assign their rights to third parties or even to keep those rights for themselves without the trademark owner’s consent. The value of these debtors, and their ability to repay creditors, could suffer as well.

On appeal. The district court’s decision may not be the last word. The debtor has appealed to the Ninth Circuit, although a ruling could be a number of months away. I will report on the Ninth Circuit’s decision when it comes down. In the meantime, this is only one district court decision, applying Ninth Circuit law, so its full impact has yet to be determined.

Just for kicks. Finally, for those interested, the trademarks involve the Billy Blanks® Tae Bo® fitness program. At least until the Ninth Circuit rules on appeal, the district court’s decision will give trademark owners like Billy Blanks a "leg up" in their efforts to control their marks.

Recent Developments The Financially Troubled Company

Deepening Insolvency: New Delaware Decision Holds That No Such Cause Of Action Exists

Over the past few years, a number of bankruptcy and other federal courts have held that plaintiffs, often bankruptcy trustees or other bankruptcy estate representatives, could pursue a cause of action against a corporation’s directors and others for "deepening insolvency." What has made a deepening insolvency claim so attractive to plaintiffs and troubling to defendants is the lack of clarity about what conduct might give rise to such a claim, how damages for it might be calculated, and whether it would allow for expanded recoveries under other causes of action.

What is deepening insolvency? Courts have described deepening insolvency as the "fraudulent prolongation of a corporation’s life beyond insolvency," resulting in "damage to the corporation caused by increased debt" and similarly as the “fraudulent expansion of corporate debt and prolongation of corporate life.” A more colorful way of putting it might be, under some circumstances, "better dead than (deeper in the) red."

A question of state law. Since federal courts apply state law to many substantive issues, those federal courts that have recognized a deepening insolvency cause of action have done so by predicting how state courts would rule on the question. With so many companies incorporated there, Delaware’s view on deepening insolvency may be the most important. For that reason, many attorneys took note when in the past few years bankruptcy courts in Delaware allowed deepening insolvency claims to go forward, based on their prediction that Delaware state courts would also recognize the cause of action.

The new Delaware decision. Although federal courts had issued rulings, no Delaware state court had decided whether a cause of action for deepening insolvency exists under Delaware law. Well, that changed on August 10, 2006, when Delaware’s corporate law court, the Court of Chancery, issued a decision in a case called Trenwick America Litigation Trust v. Ernst & Young LLP, et al. Click here to read the court’s decision.

In Trenwick America, Vice Chancellor Strine squarely held, in unusually strong language, that no cause of action for deepening insolvency exists under Delaware law. The court also elaborated on how the business judgment rule can protect directors when a corporation is insolvent or in the zone of insolvency. Since the decision is almost 90 pages long, I’ve quoted below from the key deepening insolvency discussion (although I left out the extensive footnotes). It makes for interesting reading — even if you’re not a lawyer.

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success. Put simply, under Delaware law, ‘deepening insolvency’ is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure. With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one. So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders. Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility. Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud. The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure. If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.” That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one. If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler. No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor. Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part. None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

You might find Professor Larry Ribstein’s discussion of the new decision interesting, as well as the comments made by Francis Pileggi, who publishes the Delaware Corporate and Commercial Litigation Blog. They also discuss another aspect of the decision, the holding that directors of a wholly owned subsidiary corporation did not breach their fiduciary duties by taking on debt for the benefit of the parent corporation, even though both the parent and subsidiary ended up in bankruptcy.

Echoes of Production Resources. Some of you may recall that Vice Chancellor Strine was also the author of the November 2004 Production Resources decision, which interpreted Delaware law more favorably for directors of corporations that are insolvent or in the "zone of insolvency." The Production Resources decision was the subject of an earlier post.

This new decision builds on Production Resources and, in so doing, follows an approach similar to one recently taken by a bankruptcy court in New York in In re Verestar, Inc. The June 2006 Verestar decision cited to Production Resources and predicted that Delaware courts would reject deepening insolvency as a cause of action. Click here for a copy of the Verestar decision; its deepening insolvency discussion starts at page 41.

Conclusion. With a clear voice from the Delaware Court of Chancery, the Trenwick America decision reinforces a recent trend among some federal courts to step away from recognizing deepening insolvency as a separate cause of action. As with any new decision, however, the real test of its influence will be the extent to which other courts, including Delaware’s highest court, the Delaware Supreme Court, follow its holding and reasoning.

Business Bankruptcy Issues

Selling A Bankruptcy Claim: Opportunity And Risk

At one time or another just about every creditor in a large corporate Chapter 11 bankruptcy case will receive an offer to purchase the creditor’s claim. These offers typically come from professional claims traders, most of which are in the business of buying claims at a discount to what they believe will be the claims’ ultimate value. Some claims buyers, including hedge funds and other distressed debt investors, may buy claims with the strategic objective of controlling the direction of the Chapter 11 case by owing a substantial percentage of one or more classes of creditors.

How do claims buyers find out about your claim? Within the first few weeks after a bankruptcy is filed, the debtor must file schedules of its assets and liabilities. Creditors holding secured claims are listed on Schedule D and those with unsecured claims are listed on Schedule F. These schedules show the amount the debtor believes it owes each creditor and whether it thinks the claim is disputed, contingent, or unliquidated. Claims buyers will often first contact creditors with claims listed as being undisputed, not contingent, and liquidated because those claims are less likely to be subject to litigation later in the bankruptcy case.

If you express interest in selling your claim, you may be sent a "confirmation" document with key terms such the percentage on the dollar to be paid and the amount of the claim to be purchased. The actual document that transfers the claim, however, is usually a separate "claim assignment agreement." You should carefully review all of the documentation, including the claim assignment agreement, before committing to sell your claim.

Selling a claim can sometimes be beneficial, but there are also risks. When evaluating whether to sell your claim, here are some of the key points to keep in mind:

Liquidity. The main advantage of selling your claim is getting some cash for it now. Although creditors often believe that selling their claim will also eliminate any further risk of loss, for the reasons discussed below claim assignment agreements usually keep you at risk even after you sell your claim. If you’re willing to accept those risks, you can get immediate liquidity by selling your claim instead of having to wait months or years to receive whatever payment — which sometimes is in the form of stock or debt instead of cash — the bankruptcy estate ultimately distributes.
Price. Given the claims buyer’s usual objective of buying at a discount, coupled with the time value of money, the price you are offered could end up being lower than the value you could recover if you held your claim and waited for distributions to be made later in the case. The price offered for claims can also rise or fall over time as more information about creditors’ likely recovery becomes available.
Read the fine print. Occasionally, claims buyers add detailed provisions and representations to the claim assignment agreement that operate to give the buyer an option to "put" or sell all, or the disputed part, of the claim back to you upon the mere filing of an objection or other challenge to the claim — even if the objection is ultimately defeated. Why? Well, if the price paid for your claim later turns out to have been too high, the claims buyer might use the filing of a claim challenge to get its money back, plus interest. Since commonplace events such as claim objections and preference actions may be classified as triggering "challenges," it’s important to watch out for these provisions.
Defending the claim. Often the claims buyer will put a provision in the claim assignment agreement requiring you to defend the claim against any objection at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed. If a portion of your claim is disputed, however, you may well want the right to defend the claim so you can keep what you’ve been paid. Either way, you may incur costs in the bankruptcy case after you sell your claim.
Setoff or other special claims. Claim assignment agreements may also include provisions limiting your right to assert a setoff or recoupment against the debtor (concepts discussed in an earlier post) or requiring you to pay back all or a portion of the purchase price if you do. If you have significant setoff rights, be careful to preserve those rights if you sell your claim. Likewise, if you have an administrative claim or reclamation claim (which could be paid at 100 cents on the dollar), be sure it’s clear how those valuable rights will be treated.
Creditors’ committee. If you’re serving on the official committee of unsecured creditors in a Chapter 11 case, you should get legal advice on whether, or under what conditions, you may sell your claim. You likely will have received confidential information about the debtor while on the creditors’ committee, and this could restrict your ability to sell your claim. Generally, you will also have to resign from the committee if you sell your claim.
Court-ordered restrictions. In some cases, bankruptcy courts may restrict creditors — especially those with very large claims — from selling their claims. This is done to preserve the tax benefits of a debtor’s net operating losses or NOLs, which can be lost if ownership of a large amount of claims or equity interests changes. As this example shows, these orders can be very complicated and you may want to consult with a bankruptcy attorney to determine whether any restrictions apply to you.

If you sell your claim, you will often be required to sign an additional document with a name such as "Evidence of Transfer of Claim," which does not mention the price paid and which will be filed with the bankruptcy court. Thereafter, you may receive a notice from the bankruptcy court that the claims buyer has filed the Evidence of Transfer of Claim document and giving you 20 days to object to the transfer. This notice is designed to prevent unscrupulous individuals from fraudulently assigning claims to themselves and is only a formality in a legitimate claims sale.

Claims buyers can provide creditors with a ready market for their claims, generating liquidity months or years before creditors otherwise would receive a distribution from the bankruptcy estate. Selling a claim is not risk free, however, so be sure to consult with a bankruptcy attorney for specific advice on how best to protect your rights if you do choose to sell.

Business Bankruptcy Issues

Intellectual Property Licenses: What Happens In Bankruptcy?

The major role intellectual property, or "IP," plays in our economy makes intellectual property licenses an especially significant type of executory contract. Whether you are a licensor or licensee, it’s important to know what can happen to IP licenses when a bankruptcy is filed.

Licensor in bankruptcy. A licensor in bankruptcy (or its bankruptcy trustee) has the option of assuming or rejecting a license. Generally, a debtor licensor can assume a license if it meets the same tests (cures defaults and provides adequate assurance of future performance) required to assume other executory contracts. Many licensees will not have a problem with assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is the fear of losing their rights to the licensed IP, which often can be mission critical technology, if the license is rejected.

Special protections. Recognizing this concern, the Bankruptcy Code, in Section 365(n), provides licensees with special protections. If the debtor or trustee rejects a license, under Section 365(n) a licensee can elect to retain its rights to the licensed intellectual property, including even 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 includes 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.
Watch out for trademarks. While many people would expect intellectual property to include trademarks, the Bankruptcy Code has its own limited definition of "intellectual property." The bankruptcy definition includes trade secrets, patents and patent applications, copyrights, and mask works. Importantly, however, it does not include trademarks. This distinction means that trademark licensees enjoy none of Section 365(n)’s special protections and those licensees are at risk of losing their trademark rights in a bankruptcy.

Licensee in bankruptcy. The law is different when an IP licensee files bankruptcy. The Bankruptcy Code, in Section 365(c)(1), contains an exception to the general rule that executory contracts can be assumed and assigned to third parties if defaults are cured and adequate assurance of future performance is demonstrated. The exception kicks in when "applicable law" precludes such an assignment absent consent of the nondebtor party.

Restrictions on assignment. Case law from several United States Courts of Appeals holds that "applicable law" — here patent and copyright law (and perhaps trademark law) — in fact precludes an assignment of rights under an intellectual property license unless the IP owner has consented. These courts have ruled that non-exclusive patent and copyright licenses are personal and nonassignable. As a result, a patent or copyright holder can prevent a debtor licensee from assuming and assigning a non-exclusive license to a third party without the licensor’s consent.
License at risk. In the Ninth Circuit, which includes California, a licensor not only can stop a debtor from assigning the license to a third party, it can even prevent a debtor from keeping the license for itself. Although the reason is technical, stemming from how the Ninth Circuit has interpreted Section 365(c)(1) of the Bankruptcy Code, the impact can be very real. For those interested, the landmark Ninth Circuit decision on this point is In re Catapult Entertainment, Inc.,165 F.3d 747 (9th Cir. 1999).

Get advice. The interplay between bankruptcy and intellectual property law is complex. Whether you are a licensor or licensee, you should get legal advice about your specific license agreement and the ways you may be able to protect your rights if a bankruptcy is filed. Likewise, companies that anticipate having to file bankruptcy should pay careful attention to their IP licenses before they file.

Recent Developments The Financially Troubled Company

Directors Of Insolvent Corporations: Duties And Protections

The fiduciary duties that directors owe a Delaware corporation and its shareholders are generally held to expand to include the interests of creditors when the company is insolvent or in the "zone of insolvency." A hot topic among directors, particularly those serving on boards of troubled companies, is how best to meet their fiduciary duties and avoid the potential for personal liability in these situations.

One of the most important decisions in recent years on this issue came from the Delaware Court of Chancery, the corporate law court, in November 2004 in a case called Production Resources. Why is the case important? In short, the Production Resources court interpreted the law in a way that gives directors more protection when they make business judgments for a troubled company.

First, the Production Resources court rejected a trend among some courts and commentators that had sought to impose on directors of insolvent or potentially insolvent corporations a new set of fiduciary duties, beyond those owed to the corporation, in favor of creditors. That trend started back in 1991 with the Court of Chancery decision in the Credit Lyonnais case — the decision that helped coin the phrase “vicinity” or “zone” of insolvency.

Second, it held that the common exculpatory provision found in the corporate charter of most Delaware corporations, protecting directors from liability for monetary damages for a breach of the fiduciary duty of care, applies to claims made by creditors as well as by shareholders or the corporation itself.

This analysis discusses the Production Resources decision in more detail. (A pdf of the analysis is available as well.) A "zone of insolvency" conference last November also produced an interesting discussion reported by Professor Larry Ribstein. If you want to read the 54-page Production Resources decision itself, click here.

The decision’s ultimate impact will depend on whether other courts (including bankruptcy courts where these issues are often litigated) decide to follow its approach — so stay tuned.

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