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Business Bankruptcy Issues Recent Developments

Assumption Of Trademark Licenses In Bankruptcy: An Update On The N.C.P. Marketing Case

Over a year ago, I posted on a first of its kind decision in In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), in which the U.S. District Court for the District of 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 and here to read the earlier post on the case.

The N.C.P. Marketing Court’s Analysis. In reaching its conclusion, the District 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 trademark owner in that case, Billy Blanks of the Billy Blanks® Tae Bo® fitness program, successfully moved the court to compel rejection of the trademark license because under the "hypothetical test" analysis of Section 365(c)(1) of the Bankruptcy Code adopted by the U.S. Court of Appeals for the Ninth Circuit, contracts that cannot be assigned by the debtor without the nondebtor party’s consent cannot be assumed by the debtor either. (For a full 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?")  

The Ninth Circuit Appeal. In December 2005, the parties appealed this decision to the Ninth Circuit. The appeal was fully briefed and had been scheduled for oral argument on November 5, 2007.

  • In July 2007, however, the N.C.P. Marketing Chapter 11 case was converted to Chapter 7. 
  • On October 24, 2007, the Chapter 7 trustee asked the Ninth Circuit to reschedule the oral argument because of a pending settlement in the case.
  • In response, the Ninth Circuit took the oral argument off calendar and directed the parties to move to dismiss the appeal if the settlement is approved by the Bankruptcy Court.

Still No Court Of Appeals Decision. If the settlement is approved, no Ninth Circuit decision will be issued. Instead, this case seems to be headed to an ending similar to that in In re Wellington Vision, Inc. (see this earlier post on the Wellington Vision case for more details), perhaps the only other bankruptcy decision to date to address this trademark issue. There, conversion of the case to Chapter 7 also led to a settlement without an appellate decision. With these recent developments in the In re N.C.P. Marketing case, trademark licensors and licensees will have to wait longer still for an appeals court decision on this important issue at the intersection of trademark and bankruptcy law.

Business Bankruptcy Issues Recent Developments

Patent Law Collides With Bankruptcy: Federal Circuit Denies Bankruptcy Liquidation Trust Standing To Sue For Patent Infringement

The United States Court of Appeals for the Federal Circuit has jurisdiction over, among other areas, patent appeals, so it’s not every day that a Federal Circuit decision appears on this business bankruptcy blog. (Actually, it’s been about a year since this post discussing another Federal Circuit decision.) However, a September 19, 2007 opinion (available here) of the Federal Circuit rested largely on the intersection of patent law and the terms of a Chapter 11 plan of reorganization. Since the decision denied a trust created under the plan standing to bring the debtor’s patent infringement claims, it’s a significant one for debtors and creditors alike. After discussing the court’s decision I’ll conclude with my suggested take-away from the case.

The At Home Corporation Plan And Liquidation Trusts. The litigation arose in the At Home Corporation Chapter 11 bankruptcy case, which was filed in September 2001. As part of the confirmed plan of liquidation, a general unsecured creditor liquidation trust (called GUCLT) was created to pursue various claims for the benefit of creditors, including certain patent infringement claims against Microsoft Corporation. A separate liquidation trust (called AHLT) received ownership of the At Home patent at issue in the litigation, among other assets. GUCLT was not granted a license to the patent.

The Patent Litigation And Federal Circuit Decision. The patent litigation reached the Federal Circuit in 2006. Although the plan and related documents granted GUCLT the express right to pursue the patent litigation claims at issue, the Federal Circuit found that to be insufficient to confer standing. It held that the patent statutes provide protection to the party with a right to exclude, not the party with a right to sue. Because the right to exclude others from practicing the patent (part of AHLT’s rights) had been separated from the right to sue for infringement (GUCLT’s rights), GUCLT was not protected under the patent statutes. The Federal Circuit summed up the situation this way:

The problem for GUCLT and AHLT is that the exclusionary rights have been separated from the right to sue for infringement. The liquidation plan contractually separated the right to sue from the underlying legally protected interests created by the patent statutes—the right to exclude. For any suit that GUCLT brings, its grievance is that the exclusionary interests held by AHLT are being violated. GUCLT is not the party to which the statutes grant judicial relief. See Warth, 422 U.S. at 500. GUCLT suffers no legal injury in fact to the patent’s exclusionary rights. As the Supreme Court stated in Independent Wireless, the right to bring an infringement suit is “to obtain damages for the injury to his exclusive right by an infringer.” 269 U.S. at 469; see also Sicom, 222 F.3d at 1381 (“Standing to sue for infringement depends entirely on the putative plaintiff’s proprietary interest in the patent, not on any contractual arrangements among the parties regarding who may sue…”); Ortho, 52 F.3d at 1034 (“[A] right to sue clause cannot negate the requirement that, for co-plaintiff standing, a licensee must have beneficial ownership of some of the patentee’s proprietary rights.”).

Since GUCLT had the right to sue but not the right to exclude others from practicing the patent, and since AHLT had the right to exclude others but not the right to sue for infringement, neither liquidating trust could sue for the infringement alleged in the GUCLT’s underlying lawsuit. The Federal Circuit ruled that the problem could not be solved by the typical practice of joining the legal title holder, here AHLT, to the patent litigation as a party. Although such joinder solves prudential standing requirements, the court held that it does not solve the constitutional standing requirement of actual legal injury. GUCLT did not suffer legal injury because it had no right to exclude others from practicing the patent.

The Federal Circuit’s majority opinion prompted an interesting dissent, which ended with the following:

While I do not read any precedent as directly governing the peculiar circumstances of this case, I also do not read any as precluding co-plaintiff standing for GUCLT. I believe that, in denying all possibility for enforcing the patent, the majority opinion extends limitations on co-plaintiff standing without a reasoned basis. Accordingly, while neither GUCLT nor AHLT individually may pursue infringement litigation, I would not deprive the patent of all value. Because I would allow GUCLT and AHLT, as co-plaintiffs, standing to sue Microsoft, I respectfully dissent.

The View From IP Bloggers. Dennis Crouch of the Patently-O patent law blog has an interesting post on the case, and he gets special thanks for first reporting on the decision. For another view, you may find this post from the Patry Copyright Blog published by William Patry, Google’s Senior Copyright Counsel, of interest.

Important Lessons. On his patent law blog, Dennis Crouch gives the practice pointer that he believes patent lawyers should learn from the decision: "A non-title-holder must be granted an exclusive license as well as full litigation rights in order to have standing to sue for patent infringement." That is helpful advice for patent lawyers, but I have a suggestion of my own.

  • When intellectual property such as patents, copyrights, or trademarks is involved in a bankruptcy case, get expert advice from IP counsel, in addition to bankruptcy advice. The problem may be separating exclusionary rights from the right to sue for patent infringement one day and transferring a trademark without its goodwill the next.
  • This suggestion applies when dealing with, for example, the transfer of IP in a bankruptcy case, whether by liquidation trusts, Section 363 asset sales, or something else, or assessing the risk of continuing patent infringement when purchasing IP assets.
  • As the Federal Circuit’s decision shows, the interplay between IP issues and bankruptcy cases can be complex and the possible outcomes surprising. Getting expert advice can help you avoid these and other traps for the unwary.
Business Bankruptcy Issues The Financially Troubled Company

Are “Termination On Bankruptcy” Contract Clauses Enforceable?

Practically every contract has a provision that makes the bankruptcy or insolvency of one contracting party a trigger for the other party to terminate the contract. These are standard fare and rarely negotiated unless they also include a provision for the reversion back of ownership of property, often intellectual property, upon bankruptcy or insolvency. This post takes a look at these provisions and examines whether they are enforceable.

The Typical Ipso Facto Clause. Termination on bankruptcy provisions are often known as ipso facto clauses (the Latin phrase meaning "by the fact itself") because the language provides that the fact of bankruptcy itself is enough to trigger the termination of the agreement. Here’s a common provision:

This Agreement shall terminate, without notice, (i) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of either party’s debts, (ii) upon either party making an assignment for the benefit of creditors, or (iii) upon either party’s dissolution or ceasing to do business.

Variants of this language are found in many types of contracts, including licenses, leases, and development agreements. Some provide that termination is automatic and others first require notice. Termination triggers may include:

  • Filing a voluntary bankruptcy;
  • Having an involuntary bankruptcy filed against a party;
  • Becoming insolvent (frequently the term is left undefined in the contract);
  • Admitting in writing that the party is insolvent;
  • Making a general assignment for the benefit of creditors (a liquidation alternative recognized under the laws of many states); or
  • Tripping a financial condition covenant.

The bankruptcy or insolvency of either party is frequently a termination trigger. However, when the financial condition of only one contracting party is in doubt, the more financially stable party may insist on a one-sided provision allowing it to get out of the agreement upon the weaker party’s insolvency or bankruptcy. 

Notso Fasto: The Bankruptcy Code Stops The Clause In Its Tracks. These termination provisions may be common, but are they enforceable? The short answer, which may be surprising to some, is generally "no." Two key provisions of the Bankruptcy Code lead to this result. First, Section 541(c) of the Bankruptcy Code provides that an interest of the debtor (the bankrupt company or person) in property becomes "property of the estate," meaning that the debtor does not lose the property or contract right, despite a provision in an agreement:

that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.

11 U.S.C. §541(c). Translated from bankruptcy-ese, this statute means that a clause that terminates a contract because of the "insolvency" or "financial condition" of the debtor, or due to the filing of a bankruptcy case, will be unenforceable once a bankruptcy case has been filed.

A second Bankruptcy Code provision, Section 365(e)(1), governs ipso facto clauses in executory contracts, which are agreements under which both sides still have important performance remaining (discussed in more detail in this earlier post). Section 365(e)(1) provides:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
11 U.S.C. §365(e)(1). This statute generally makes ipso facto provisions in executory contracts and leases unenforceable.

Why Put Ipso Facto Clauses In Contracts In The First Place? If these termination provisions are generally unenforceable, why do parties seem to include them in almost every contract? There are three main reasons.

Force Of Habit. One reason is that under the old Bankruptcy Act of 1898, replaced by the Bankruptcy Code in 1979, these ipso facto clauses were enforceable. Over the years, lawyers and businesses got used to including them in their contract forms and they have continued to write them into many agreements. Since it’s always possible that the Bankruptcy Code could be changed to reinstate the old rule, lawyers often see little reason to take them out.

It Takes An Actual Bankruptcy. Another and perhaps more important reason is that the rule applies only if a bankruptcy is actually filed. If an ipso facto provision provides that the agreement terminates upon a party’s insolvency, and no bankruptcy case is ever filed, it’s possible that the solvent party could terminate the agreement using the ipso facto provision. But be forewarned: if a bankruptcy case is later filed, an insolvency-based termination made before the bankruptcy filing may not be enforced in the bankruptcy case. This means that the debtor may still have a chance to retain the rights under the contract, including assuming or assigning an executory contract during the bankruptcy case.

A Limited Exception In Bankruptcy. A third reason is that an important, albeit limited, exception to the rule applies even after a bankruptcy is filed. The exception stems less from the ipso facto clause itself and more from the rules governing assumption of certain types of executory contracts, including intellectual property licenses (at least in some circuits).

  • Section 365(e)(2) of the Bankruptcy Code, in conjunction with Section 365(c)(1), provides that an ipso facto clause can be enforceable if the debtor or trustee is not permitted by "applicable law" to assume or assign the executory contract. Simply put, if applicable law provides that an IP license or another executory contract cannot be assumed by the debtor or trustee without the other party’s consent, then the non-debtor contracting party can force rejection of the license or seek relief from the automatic stay to terminate the agreement based on the ipso facto clause.
  • Although an analysis of the law governing assumption and assignment of IP licenses and related agreements is beyond the scope of this post, you can find a detailed discussion in an earlier one entitled "Assumption of IP Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" 

A Word To The Wise. Parties include "termination on bankruptcy" provisions in contracts all the time, despite the general rule making them unenforceable in bankruptcy. Unfortunately, some do so without realizing that the provision may be ineffective, and that can lead to trouble. If enforcing an ipso facto clause is important to one of your agreements, especially if you also seek the highly problematic reversion of intellectual property or other rights upon such a termination, be sure to get specific legal advice on your situation, including whether alternative approaches may exist to help achieve your objectives.

Business Bankruptcy Issues Recent Developments

Another Court Follows The Footstar Decision On Assumption Of IP Licenses In Bankruptcy

Intellectual property licenses continue to be significant to companies across a wide range of industries. This fact makes their treatment in business bankruptcy cases a topic of keen interest. 

Can A Debtor Licensee Retain IP License Rights? When the debtor in possession is a licensee under a patent, copyright, or trademark license, a key question arises: Can the license be assumed (bankruptcy-speak for kept) or will the bankruptcy filing put the licensor in a position to force rejection of the license — resulting in the ultimate termination of the debtor’s right to use the licensed IP?  A new case, discussed below, recently sided with the debtor in possession.

One Statute, Three Tests. This issue has led to a significant split of authority among bankruptcy courts and courts of appeal around the country, stemming from different interpretations of the language in Section 365(c)(1) of the Bankruptcy Code. That section provides as follows:

(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.

Some courts, including the U.S. Court of Appeals for the Ninth Circuit, have sided with the licensor and interpret Section 365(c)(1) to prohibit both assignment and assumption. Other courts, including the First Circuit, have permitted such licenses to be assumed.

  • Despite the split, most courts agree that Section 365(c)(1) prohibits assignment of executory contracts without the non-debtor contracting party’s consent if "applicable law" requires such consent because that would require the non-debtor party to accept performance from a new party. 
  • A number of courts have held that when the "applicable law" is federal patent, copyright, or trademark law, such consent is required.
  • Courts diverge, however, on whether the statute’s language should be read to prohibit a debtor in possession from assuming such executory contracts or only from assigning them.

Rather than cover that ground here, if this topic is new to you I suggest reading an earlier post entitled "Assumption Of Intellectual Property Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" It discusses in detail how different courts have interpreted Section 365(c)(1), leading to the licensor-favorable "hypothetical test," the debtor-favorable "actual test," and the newer, debtor-favorable Footstar analysis. 

A Word On Footstar. Before moving on to the new decision, a brief word about the Footstar case may be helpful. In In re Footstar, Inc,, 323 B.R. 566 (Bankr. S.D.N.Y. 2005), Judge Adlai Hardin of the U.S. Bankruptcy Court for the Southern District of New York took a somewhat different approach in analyzing the statute. He concluded that Section 365(c)(1)’s use of the word "trustee" does not (as other courts had taken for granted) include the debtor or debtor in possession when assumption is sought because assumption does not require the non-debtor party to accept performance from a new party other than the debtor or debtor in possession. A trustee is a new party and the statute logically provides that a trustee may not "assume or assign" such an executory contract.

A Common Scenario. How does this issue come up in Chapter 11 cases? Well, here’s a typical situation. The debtor is the licensee under a prepetition patent license. The patent licensor files a motion to compel the debtor in possession to reject the patent license agreement or alternatively to have the automatic stay lifted to permit the licensor to cancel the agreement. The licensor argues that under the "hypothetical test" interpretation of Section 365(c)(1), the debtor in possession cannot assign the license and, as a result, cannot assume the license either. With neither option open, the licensor argues, the debtor in possession should be compelled to reject the license.

The Aerobox Decision. This was the situation that recently played out in the In re Aerobox Composite Structures, LLC Chapter 11 bankruptcy case. Ruling on just such a motion by a patent licensor, on July 27, 2007, Judge Mark B. McFeeley of the U.S. Bankruptcy Court for the District of New Mexico issued an 11-page decision holding that the actual test, and Judge Hardin’s analysis in Footstar, was the correct interpretation of Section 365(c)(1). As such, he denied the licensor’s motion and held that the debtor in possession was not barred by Section 365(c)(1) of the Bankruptcy Code from assuming the prepetition patent license at issue in that case. The Bankruptcy Court summed up its holding as follows:

Similarly, the bankruptcy court in Footstar reasons that it makes perfect sense for the statute, which uses the term, “trustee,” to prohibit the trustee from assuming or assigning a contract, because the trustee is an “entity other than the debtor in possession” but it makes no sense to read “trustee” to mean “debtor in possession.” Footstar, 323 B.R. at 573. Doing so

would render the provision a virtual oxymoron, since mere assumption [by the debtor in possession] (without assignment) would not compel the counterparty to accept performance from or render it to “an entity other than” the debtor.

Id.

This Court agrees.

Thus, where the debtor-in-possession seeks to assume, or, as is the situation in the instant case, where the debtor-in-possession has neither sought to assume nor reject the executory contract but simply continues to operate post-petition under its terms, 11 U.S.C. § 365(c)(1) does not prohibit assumption of the contract by the debtor-in-possession and cannot operate to allow the non-debtor party to the executory contract to compel the Debtor to reject the contract. In reaching this conclusion, the Court finds that the “actual test” articulated in Cambridge Biotech, and the reasoning of the court in Footstar, is the better approach to § 365(c)(1) when determining whether a debtor-in-possession is precluded from assuming an executory contract.

Venue Still Matters. The decision is interesting because it represents another bankruptcy court, this time outside of the Southern District of New York, endorsing the analysis in the Footstar decision. That said, Judge McFeeley wrote on something of a clean slate because the Tenth Circuit has not yet taken a view on whether the hypothetical test, the actual test, or the Footstar analysis controls. As this circuit-by-circuit chart of Section 365(c)(1) decisions shows (last updated in March 2007), many other circuits have staked out a position on the issue. Absent a Supreme Court decision or new legislation resolving the circuit split, where a debtor files bankruptcy will continue to make a big difference in the relative rights of licensors and debtors over intellectual property licenses in Chapter 11 cases.

Business Bankruptcy Issues Recent Developments

The “Ride Through” Doctrine Rides Again: Ninth Circuit BAP Lets A License Agreement Ride Through Chapter 11

In a June 18, 2007 decision in In re J.Z. L.L.C. (available here), the Bankruptcy Appellate Panel (BAP) of the U.S. Court of Appeals for the Ninth Circuit faced an interesting question: Did the so-called "ride through" doctrine from the old Bankruptcy Act of 1898 survive enactment of the Bankruptcy Code in 1978? The BAP’s introduction to the decision sums up its answer:

We confront the puzzle of the status of an executory contract that was neither assumed nor rejected during a chapter 11 case in which there was a confirmed plan that did not involve transfers of property of the estate or creation of new entities. We conclude that the “ride through” doctrine developed under the former Bankruptcy Act retains vitality in chapter 11 cases when the debtor continues operating and does not change form.

After a chapter 11 case was closed, the reorganized debtor sued in state court to enforce a license that it had granted prepetition regarding the use of its manufacturing technology. The state court declined to act without a bankruptcy court ruling that the license, which had been neither assumed nor rejected during the chapter 11 case, remained in effect. The bankruptcy court ruled that the license contract survives under the “ride through” doctrine, that the debtor has standing to enforce the contract because all property of the estate vested in the debtor on confirmation, and that the reorganized debtor should not be judicially estopped. We AFFIRM.

Executory Contracts And Bankruptcy. I have previously discussed the importance of executory contracts in bankruptcy, and specifically how licenses of intellectual property are treated. Both of those posts were premised on the bankruptcy court being asked to decide whether an intellectual property license could be assumed, assumed and assigned, or rejected during the bankruptcy. This case, however, presented a very different situation in which the Chapter 11 debtor did not take any action during the Chapter 11 case to assume or reject the executory contract (here a license agreement permitting the non-debtor party to manufacture, promote, and sell a horizontal grinder on an exclusive basis for five years). In addition, although aware of the bankruptcy case, the non-debtor party to the contract also did not seek to force a decision on assumption or rejection pursuant to Section 365(d)(2).

The BAP’s Reasoning. The BAP’s 28-page decision carefully analyzes the issues raised in the case and makes a number of interesting conclusions.

  • First, not only did the debtor neither assume nor reject the license agreement, it also failed to list it on its bankruptcy schedules (specifically Schedule G). Nevertheless, the BAP held that the non-debtor licensee’s failure to disclose it to the Bankruptcy Court or creditors left it "in the grandstand and not on the playing field" on its argument that the debtor should lose the right to enforce the agreement.
  • Second, even though the license agreement was unscheduled, once the debtor’s Chapter 11 plan was confirmed, all property of the estate — including this unscheduled asset — revested in the reorganized debtor under Section 1141(b) of the Bankruptcy Code.
  • Third, while judicial estoppel can sometimes apply to limit the debtor’s ability to sue on an unscheduled asset,  the BAP decided against applying judicial estoppel here, noting that when creditors could be harmed by such limits one "should not become so angry at a debtor that a creditor is taken out and shot." The BAP did acknowledge that the state court hearing the debtor’s lawsuit against the licensee could reach a different conclusion.
  • Fourth, under the language and structure of the Bankruptcy Code, an "executory contract that is not assumed in a chapter 11 case is not ‘deemed rejected.’ As a matter of straightforward statutory construction, it follows that some other alternative, i.e., ‘ride through,’ must be available."
  • Fifth, the "ride through" or "pass through" doctrine was well established under the Bankruptcy Act of 1898 and nothing in the Bankruptcy Code of 1978 requires a conclusion that Congress intended to disturb that existing doctrine. In addition, the lack of clarity over which contracts are executory and which are non-executory (and thus not subject to assumption or rejection) bolsters the view that a "ride through" alternative exists for contracts.

For more background on the Bankruptcy Court’s decision below (available here), affirmed by the BAP, be sure to read Warren Agin’s December 2006 post on his Tech Bankruptcy Blog, which gives his always insightful perspective on these IP and bankruptcy issues. 

Significance Of A BAP Decision. It’s worth noting that unlike a U.S. Court of Appeals, the 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 that the U.S. Court of Appeals for the Ninth Circuit could reach a different, and overruling, conclusion. However, the BAP’s decision in this case is well-reasoned and three other circuits (the First, Second, and Fifth) have also ruled that the ride through doctrine still applies today. This makes the BAP’s decision of special interest.

A Strategic Use Of The "Ride Through" Doctrine? As discussed in an earlier post on assumption of IP licenses, in several circuits a debtor cannot even assume many in-licenses of intellectual property without the licensor’s consent.

  • In those circuits, a debtor may consider whether it could retain licenses simply by choosing to have them "ride through" the Chapter 11 case, neither moving to assume the license nor (the debtor hopes) having the licensors move to compel rejection. This scenario makes the old "ride through" doctrine of particular interest, especially if the debtor licensee has not defaulted under the agreement and is seeking only to keep the license agreement after reorganizing in Chapter 11.
  • While it’s true that the occasional executory contract may slip through without a formal decision to assume or reject, it’s the prospect of a debtor being able to use the doctrine as alternative way of preserving valuable intellectual property licenses that has bankruptcy lawyers giving the "ride through" doctrine a closer look.

Stay tuned, but the BAP’s decision in In re JZ L.L.C. may encourage more such efforts in the future.

Business Bankruptcy Issues Recent Developments

A Second District Court Decides Whether A Trademark License Can Be Assumed In Bankruptcy

Once again, a district court has faced the issue of whether a non-exclusive trademark license can be assumed by a debtor in possession. Before the November 2005 decision in In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), no court had directly addressed that question. The decision in the N.C.P. Marketing case, now on appeal to the Ninth Circuit, held that trademark licenses are personal and nonassignable, absent a provision in the trademark license to the contrary, and in a hypothetical test jurisdiction such as the Ninth Circuit, they cannot be assumed by the debtor in possession. For a more detailed discussion on the N.C.P. Marketing case, you may find this post of interest. For an analysis of some recent trends on the broader topic of assumption of IP licenses, try this post.

The Wellington Vision Case. Earlier this year, a second district court, this time the U.S. District Court for the Southern District of Florida, faced the same question in an appeal in the In re Wellington Vision, Inc. Chapter 11 bankruptcy case.

  • Pearle Vision sought relief from the automatic stay to terminate a franchise agreement with Wellington Vision, arguing that Wellington could not assume the agreement because it Included a non-exclusive license of Pearle Vision trademarks.
  • The U.S. Bankruptcy Court for the Southern District of Florida granted the motion for stay relief by this two-page order, holding that the inclusion in the franchise agreement of a trademark license made the agreement, under federal trademark law, non-assignable absent consent by Pearle Vision.

Appeal To The District Court. Wellington Vision filed an appeal from the Bankruptcy Court’s decision.

  • In its opening brief, Wellington argued that (1) Pearle Vision had failed to establish that the franchise agreement included a trademark license, (2) a provision in the franchise agreement allowing for assignments on consent that cannot be unreasonably withheld meant that the parties had opted out of applicable law, and (3) Section 365(c)(1) of the Bankruptcy Code only prohibits assumption or assignment by a trustee, not by a debtor in possession, citing the Footstar case.
  • Pearle Vision argued in its answer brief that "applicable law" is the federal Lanham Act, which makes trademark licenses personal and non-assignable, and that Section 365(c)(1) creates a hypothetical test and precludes assignment or assumption of the license.
  • Wellington’s reply brief asserted that the District Court should not apply Section 365(c)(1) to debtors in possession and further that it should hold that this license was assignable by its terms.

The District Court’s Decision On Appeal. On February 20, 2007, Judge Alan S. Gold of the U.S. District Court for the Southern District of Florida affirmed the Bankruptcy Court’s decision in this 14-page decision. The District Court first held that the franchise agreement expressly included a non-exclusive license to certain Pearle Vision trademarks, making the Lanham Act the "applicable law" to be considered under Section 365(c)(1). It then held that the agreement’s provisions contemplating assignment under certain conditions did not constitute consent to any specific assignment or an "opt out" of the Lanham Act’s general restrictions on assignment, distinguishing In re Quantegy, 326 B.R. 467 (Bankr. M.D. Ala. 2005), relied on by Wellington. Finally, the District Court held that Section 365(c)(1) did apply to debtors in possession and not just to trustees, citing the Eleventh Circuit’s decision in City of Jamestown v. James Cable Partners, L.P., 27 F.3d 534 (11th Cir. 1994).

No Further Appeal Has Been Filed. Unlike the N.C.P. Marketing case, the District Court’s decision in this case will not be appealed. While the appeal was pending, the Wellington case was converted to a Chapter 7 case. Also, within the past two months litigation between Pearle, Wellington, and a guarantor of certain debt owed to Pearle was settled, resolving the issues decided by the District Court.

Trademark Owners Win Another One. Although it did not cite the N.C.P. Marketing decision, the Wellington Vision court becomes only the second district court to address the assumability of trademark licenses — and the second to hold that they are not assumable when the hypothetical test applies. This is more good news for trademark owners, who typically want as much control as possible over licenses to their marks, but bad news for debtors, who face the prospect of losing valuable trademark licenses (and franchise agreements including them) if they file bankruptcy. Stay tuned for more developments on this issue, including the Ninth Circuit’s decision in N.C.P. Marketing, which is likely still months away.

Special thanks to Warren Agin of the Tech Bankruptcy blog, whose post entitled The Descent Into Darkness Continues, first discussed the Wellington Vision case. The title of that post also gives you a sense of how many bankruptcy lawyers feel about the hypothetical test, its application to IP licenses, and its impact on debtors. 

Business Bankruptcy Issues Recent Developments

Assumption Of Intellectual Property Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?

Executory contracts present a host of interesting issues in bankruptcy cases. This is especially true when the executory contract involves a license of intellectual property (or "IP"). In the past I’ve devoted several posts to the topic, including how IP licenses are treated in bankruptcy and the unique issues presented when a trademark licensee or trademark licensor files bankruptcy. 

In this post, I’ll drill down a bit deeper into the question of how courts have analyzed whether a Chapter 11 debtor can assume or assign an IP license to a third party over the IP licensor’s objection. If you’re new to the topic, be forewarned: the courts are all over the map on the issue. For those who’d like a scorecard, you’ll find a link to a circuit-by-circuit chart in the "Where Does Your Court Stand?" section toward the end of this post.

Assumption And Assignment. 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.

The Key Bankruptcy Code Section. Since Section 365(c)(1) is so important to this debate, 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.

What’s "Applicable Law?" Collectively, a number of courts have interpreted the phrase "applicable law" to mean patent, copyright, and trademark law, holding that these federal intellectual property laws excuse a non-debtor party to an IP license from accepting performance from or rendering performance to an entity other than the debtor in bankruptcy. As a result, these courts have held that an IP licensor who does not consent can successfully block a debtor from assigning a patent, copyright, or trademark license to a third party during a bankruptcy case. This rule applies with greatest force to non-exclusive IP licenses but may also apply to certain exclusive licenses too. For more on this subject, read Professor Menell’s article on the bankruptcy treatment of IP assets, which I discussed last month.

What Constitutes Consent? Consent to assumption or assignment of an IP license can come in three ways. First, the licensor can affirmatively consent in writing after a bankruptcy case has been filed. Second, a licensor that fails to object after a motion has been filed seeking to assume, or to assume and assign, a license agreement will likely be deemed to have consented. Third, a number of license agreements expressly permit assignment under certain circumstances and many, but not all, courts will treat such provisions as providing the consent required under Section 365(c)(1)(B). A provision sometimes found in license agreements allows assignment in conjunction with a sale of all or substantially all of the assets of the licensee. Warren Agin of the Tech Bankruptcy blog wrote about a recent Massachusetts case (in which I represented the buyer) enforcing a similar provision.

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 three circuits have adopted the hypothetical test. The Ninth Circuit (covering California, 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.
  • The leading hypothetical test decision is from the Ninth Circuit in In re Catapult Entertainment, Inc.,165 F.3d 747 (9th Cir. 1999). In Catapult, the court built on an earlier decision holding that a non-exclusive patent license could not be assigned without the patent holder’s consent and, adopting the hypothetical test, held that such a patent license also could not be assumed over the patent holder’s objection.
  • Leading the charge for the actual test is the First Circuit’s decision in Institut Pasteur, et al. v. Cambridge Biotech Corporation, 104 F.3d 489 (1st Cir. 1997). That circuit includes Massachusetts, among other states.

A Third Test From New York. Despite this predominantly licensor-favorable backdrop, in several recent decisions courts have sided with Chapter 11 debtors. This emerging trend is noteworthy because two of those decisions come from the Southern District of New York. That’s where many of the largest Chapter 11 bankruptcy cases tend to be filed, such as Enron, WorldCom, Delphi Corporation, Dana Corporation, Northwest Airlines, and Delta Airlines, to name a few, making it perhaps the most important bankruptcy court in the country.

The New York Cases: Footstar And Adelphia. In a 2005 decision in In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005), the Bankruptcy Court for the Southern District of New York broke new ground. Although it did not involve intellectual property licenses, the case put Section 365(c)(1)’s language front and center and came up with a third way of analyzing this critical section. Judge Adlai Hardin adopted a new "literal" reading of section 365(c)(1), one that he found was "entirely harmonious with both the objective sought to be obtained in Section 365(c)(1) and the overall objectives of the Bankruptcy Code, without construing ‘or’ to mean ‘and.’" His approach? Section 365(c)(1)’s use of the word "trustee" does not (as other courts had taken for granted) include the debtor or debtor in possession. As such, the right of the non-debtor party to object to assignment does not by itself affect the right of the debtor in possession (as opposed to a trustee) to assume an executory contract.

In January 2007, Judge Robert Gerber, also of the Bankruptcy Court for the Southern District of New York, faced the same issue in the Adelphia Communications Chapter 11 case. In his decision on the Section 365(c)(1) issue, Judge Gerber expressly rejected the cases following the "hypothetical" test as "incorrectly decided," and instead embraced Judge Hardin’s Footstar decision, describing it as "consistent in outcome with the decisions of" those courts following the "actual" theory. In a footnote, Judge Gerber stated: "[W]here there is no Second Circuit authority, [the Bankruptcy Court for the Southern District of New York] follows the decisions of other bankruptcy judges in this district in the absence of clear error. But to say that the Footstar decisions should be followed under that standard would be faint praise here. In this Court’s view, Judge Hardin’s analysis in those decisions was plainly correct." This suggests that other judges in the Southern District of New York may follow suit, at least unless the Second Circuit were to rule otherwise.

For a detailed analysis of the Footstar decision, be sure to read the article by Cooley Godward Kronish partners Jay Indyke and Richard Kanowitz, and associate Brent Weisenberg, who were directly involved in the case, which appears in the April 2007 issue of the Journal of Bankruptcy Law and Practice. It’s called “Ending the Hypothetical’ vs.‘Actual’ Test Debate: A New Way to Read Section 365(c)(1),” 16 J. BANKR. L. & PRAC. 2 Art. 2 (2007).

Another Circuit Follows The Actual Test. The Fifth Circuit (covering Texas, Louisiana, and Mississippi) also jumped into the fray, albeit interpreting a different but related section, Section 365(e), with its February 2006 decision in Bonneville Power Administration v. Mirant Corp., 440 F.3d 238 (5th Cir. 2006). Upon the Chapter 11 bankruptcy of Mirant Corporation, the Bonneville Power Administration (BPA) attempted to terminate its executory contract with Mirant based on an ipso facto clause, a provision that makes a bankruptcy filing a breach of contract. While these provisions generally are not enforced, the BPA relied on Section 365(e)(2)(A), which closely mirrors the language of Section 365(c)(1)(A), and argued that it could terminate the contract because applicable law — the federal Anti-Assignment Act, 41 U.S.C. Section 15 — excused it from accepting performance from or rendering performance to an entity other than the debtor or debtor in possession. After a lengthy analysis, the Fifth Circuit joined the First Circuit (rejecting the position of the Third, Fourth and Ninth Circuits) and expressly adopted the "actual" test. The Fifth Circuit held that the ipso facto clause was null and void under Section 365(e)(1) because Mirant, the debtor in possession, was not actually planning to assign the contract. For a more detailed discussion of the case, be sure to check out Steve Jakubowski’s excellent post over at the Bankruptcy Litigation Blog.

Where Does Your Court Stand? With courts coming out on different sides of the hypothetical versus actual test issue, and with the Footstar and Adelphia courts advancing yet another view of Section 365(c)(1), you might be looking for a chart to keep up with all the decisions. Well, as part of a presentation I made last month to the Commercial Law and Bankruptcy Section of the Bar Association of San Francisco (and with a big assist from Brian Byun, an associate in the Bankruptcy & Restructuring Group at my firm who also contributed to this blog post), we put together just such a circuit-by-circuit chart of the various decisions. You may find this circuit map useful when reviewing the chart. 

How Often Does This Come Up? The answer is frequently. Most corporate debtors have critical in-licenses of intellectual property and either need to assume them or, as part of a Section 363 asset sale, assume and assign them to the buyer. IP licensors are understandably protective of their intellectual property. Still, even when they have the right to object to assumption or assignments, in my experience many IP licensors will agree to allow debtors to assume, and sometimes even to assign to a buyer, important licenses. There may be an added cost, either in the form of a fee or the imposition of conditions to protect the licensor’s rights. That said, not all licensors will consent to assumption or assignment. In hypothetical test jurisdictions, debtor licensees may end up losing their license rights.

Location, Location, Location. This phrase is most often associated with real estate, but it could just as well apply to the venue of a bankruptcy case when assumption of an IP license is at issue. A debtor’s ability to assume an IP license over the objection of the licensor can be radically different depending upon where the bankruptcy case is pending. Perhaps the developing circuit split over Section 365(c)(1) will lead the U.S. Supreme Court to agree to take up the issue. Until that happens, or Congress amends the law, what a debtor can do with its IP licenses will continue to depend, in no small part, on where it files bankruptcy.