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Business Bankruptcy Issues Recent Developments

When Worlds Collide: Do Section 365(n) IP Licensee Rights Work In A Chapter 15 Cross-Border Bankruptcy?

Section 365(n) And Licensee Rights. I have discussed in the past how 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 payment.
  • 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 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 limitation comes from the fact that the Bankruptcy Code’s special definition of "intellectual property" excludes trademarks from the scope of Section 365(n)’s protections. Another major limitation is that since Section 365(n) is a U.S. Bankruptcy Code provision, it only applies in a U.S. bankruptcy case.

What Happens To Section 365(n) In Chapter 15 Cases? One issue that was less clear was what would happen if a foreign licensor were the subject of a case under Chapter 15 of the U.S. Bankruptcy Code. Would Section 365(n) apply to protect licensees in a Chapter 15 proceeding?

  • Chapter 15 allows an entity’s foreign representative to obtain U.S. bankruptcy protection for assets and interests in the United States. It was was added to the Bankruptcy Code a few years ago to implement certain cross-border insolvency procedures when corporations had assets and interests in more than one country. To read more on Chapter 15 bankruptcy, follow the link in this sentence. 
  • Section 365(n) and Chapter 15 recently collided in the Chapter 15 case of Qimonda AG, and led to a decision by Judge Robert G. Mayer of the United States Bankruptcy Court for the Eastern District of Virginia on that very issue. 
  • The Bankruptcy Court’s decision, discussed below, is available by following the link in this sentence.

The Qimonda Chapter 15 Case. In the Qimonda AG Chapter 15 case, the Bankruptcy Court had previously recognized the pending German insolvency proceeding as a "foreign main proceeding" under Chapter 15 of the U.S. Bankruptcy Code. As part of the Chapter 15 proceeding, the Bankruptcy Court had entered a supplemental order providing, among other things, that Section 365 of the U.S. Bankruptcy Code would apply to the Chapter 15 case.

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 intellectual property that Qimonda AG had licensed them.

The Bankruptcy Court’s Decision. After considering the motion and opposition, Judge Mayer issued a decision agreeing with Qimonda AG’s foreign representative and he modified the prior supplemental order to exclude the effect of Section 365(n) by providing that it would apply only if the foreign representative "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)." In reaching this decision, the Bankruptcy Court considered the effect of its recognition of the German insolvency proceeding given the purpose of Chapter 15:

The principal idea behind chapter 15 is that the bankruptcy proceeding be governed in accordance with the bankruptcy laws of the nation in which the main case is pending. In this case, that would be the German Insolvency Code. Ancillary proceedings such as the chapter 15 proceeding pending in this court should supplement, but not supplant, the German proceeding.

That objective is particularly relevant in this case where there are many international patents.  The patents themselves are issued under the laws of various nations. While there may be multiple international patents, the multiple international patents protect the same idea, process or invention in the country that issued the patent. If the patents and patent licenses are dealt with in accordance with the bankruptcy laws of the various nations in which the licensees or licensors may be located or operating, there will be many inconsistent results. In fact, the same idea, process or invention may be dealt with differently depending on which country the particular ancillary proceeding is brought. Rather than having a coherent resolution to Qimonda’s patent portfolio, the portfolio may be shattered into many pieces that can never be reconstructed. In this case, Qimonda licensed its patents to companies that are operating in various nations. It is clear that the patent rights are not being exploited solely, and even possibly principally, in the United States. In fact, they are being utilized throughout the world. If the laws of the various nations in which the patents are being used would be applicable, there will be many different treatments of the patents that have been licensed by Qimonda AG and many different and inconsistent results throughout the world. This is detrimental to a systematic bankruptcy proceeding and detrimental to the resolution of the German bankruptcy proceeding itself. It diminishes the value of these assets. It results in an inefficient insolvency administration. It may well be detrimental to parties who are or wish to license the patents. It is not difficult to envision that if the patent portfolio is splintered without overall administration or control, some parties may be left with incomplete patent protection. Holding an American patent without holding a patent enforceable in the Europe may significantly restrict its use and utility. This is at odds with the Congressionally stated purposes in §1501.

                                          *       *        *

All the patents should be treated the same. There should not be disparate results simply because of the location of a factory or research facility or corporate office. This would be the result if the supplemental order were left in place. It is clear that the inclusion of §365 in the supplemental order was improvident. It had unintended consequences that significantly and adversely affect the main proceeding in Germany.

Conclusion. The Qimonda AG decision underscores that although Section 365(n) of the Bankruptcy Code offers significant protection to licensees, its benefits frequently stop at the water’s edge. When the licensor is based outside of the United States, Section 365(n) will be of little help, even if the license covers U.S. issued patents and the foreign licensor obtains protection for its U.S. assets and interests under Chapter 15 of the Bankruptcy Code. Licensees must continue to keep the limits of Section 365(n) in mind when negotiating licenses of intellectual property from foreign licensors.

Business Bankruptcy Issues

Protecting IP Rights From A Licensor’s Bankruptcy: What You Need To Know About Section 365(n)

Many companies rely on in-bound licenses of intellectual property, especially those involving patents or trade secrets, and spend millions of dollars on research, development, and ultimately commercialization of drugs or products incorporating the licensed IP. With so much at stake, licensees frequently ask a critical question: Can our license rights be terminated if the licensor files bankruptcy?

Assumption Or Rejection. A license is typically held to be an executory contract. This means that a licensor in bankruptcy (or its bankruptcy trustee) has the option of assuming or rejecting the 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.  Most licensees will not object to the assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is whether they risk losing their rights to the licensed IP if the license is rejected.

Bankruptcy Code Section 365(n). To address this concern, in 1988 Congress added Section 365(n) to the Bankruptcy Code to give licensees 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 a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payment. 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.

Some Important Limitations. If the license is rejected, however, the licensor will no longer have to perform under the license. This means the licensor will not have to update or continue to develop the IP, and will not have to make available any updates later developed. In addition, Section 365(n) only applies in a U.S. bankruptcy case. It generally will not be of any help in a bankruptcy or insolvency of a non-U.S. licensor under applicable foreign law.

No Protection For Trademark Licensees. Many people expect intellectual property to include trademarks, but when Section 365(n) was enacted a special, limited definition of "intellectual property" was also added to the Bankruptcy Code. The bankruptcy definition includes trade secrets, U.S. patents and patent applications (less clear as to foreign patents), copyrights, and mask works, but it does not include trademarks. This distinction means that a trademark licensee enjoys none of Section 365(n)’s special protections and is at risk of losing its trademark license rights if the licensor files bankruptcy. For more on the special bankruptcy risk facing trademark licensees, follow the link in this sentence.

Getting The Most Out Of Section 365(n). Although Section 365(n) gives licensees significant comfort within limits, there are a number of approaches a licensee can take to maximize the statute’s benefits while avoiding its pitfalls. Here are a few to consider:

  • Make sure you actually have a granted license. Section 365(n) only applies to actual license rights as they existed at the time the bankruptcy case was commenced. This means that an agreement by the licensor to grant a license to IP at some later date, including a springing license grant on a bankruptcy filing, will likely be unenforceable if a bankruptcy is filed. Get a present grant of a license to any important IP or risk not having a license to it at all.
  • Consider a technology escrow. Licensees sometimes forget that Section 365(n) is not self-executing. This means that Section 365(n) doesn’t require the licensor to deliver the embodiment of the licensed intellectual property to the licensee unless the license or an agreement supplementary to the license expressly provides for such a right. One solution is to include this delivery provision in the license itself. Another common approach is to establish a technology (often a source code) escrow into which the embodiment and updated versions of the embodiment are in fact deposited, to be released to the licensee on specified conditions.
  • Refer to Section 365(n) in the license. Section 365(n) applies to licenses of bankruptcy-defined intellectual property whether it is mentioned in the license or not. That said, including an express reference that the license involves such IP, as the old saying goes, "wouldn’t hurt." A provision in the license that the agreement involves IP covered by Section 365(n), although not binding on the bankruptcy court, may be helpful in persuading a bankruptcy trustee — or the bankruptcy judge — that the IP involved is indeed subject to Section 365(n)’s protections.
  • Save the election until later. If you do include a Section 365(n) reference in the license, it’s usually better to state that no Section 365(n) election is then being made. Things change, and there is always a chance that the IP will turn out to be less important in future years, meaning you might elect to treat a rejected license as terminated.
  • Get bankruptcy advice before you sign the license. As the points above illustrate, even with Section 365(n), protecting your IP license can be tricky if a bankruptcy is later filed. Be sure to seek advice from bankruptcy counsel knowledgeable about IP licenses when the license is being drafted, not just after the licensor gets in financial trouble.

Conclusion. Section 365(n) of the Bankruptcy Code can provide valuable protections for licensees of intellectual property, but those protections have their limitations. Taking steps to maximize your rights when the license is being drafted can make a big difference if the licensor later files bankruptcy.

Business Bankruptcy Issues Recent Developments

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

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

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

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

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

(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment.

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

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

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

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

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

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

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

Business Bankruptcy Issues Recent Developments

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 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 Financially Troubled Company

New Case Addresses Whether A Security Interest In A Patent Can Be Perfected With Just A PTO Filing

When a debtor grants a security interest in a patent issued by the U.S. Patent and Trademark Office (PTO), the creditor must take steps to perfect that security interest. Given that the PTO issues patents but the Uniform Commercial Code (UCC) generally governs perfection of security interests, creditors have often filed both a UCC-1 financing statement and made a filing in the PTO to cover all the bases.

Perfection By UCC Filing. In 2001, the Ninth Circuit held that a creditor who filed a UCC-1 financing statement properly perfected a security interest in a patent even if it did not also make a filing with the PTO. The decision in the In re Cybernetic Services, Inc. case, officially Moldo v. Matsco, Inc., 252 F.3d 1039 (9th Cir. 2001), rested on the Ninth Circuit’s determination that the federal Patent Act does not cover liens on patents and does not preempt the UCC with respect to perfection of security interests. This seemed to settle the question of whether a UCC filing alone was enough to perfect a security interest in a patent, at least in the Ninth Circuit.

Does A PTO Filing Alone Perfect? Judge William C. Hillman of the U.S. Bankruptcy Court for the District of Massachusetts faced the opposite question in the In re Coldwave Systems, LLC case. There the creditor sought to rely on a PTO filing alone to perfect its security interest in a patent because the Bankruptcy Court avoided as a preference a tardy UCC filing made long after the security interest was granted but within 90 days of the bankruptcy petition. The creditor’s much earlier PTO filing of a Recordation Form Cover Sheet, recording the conveyance of the security agreement between the debtor and the creditor, was not subject to avoidance as a preference. The creditor argued that the PTO filing was sufficient to perfect its security interest, even in the absence of a UCC filing.

UCC Perfection Or Bust. In his 14-page decision issued on May 15, 2007, Judge Hillman held that the PTO filing was insufficient to perfect the creditor’s security interest because the Patent Act (specifically Section 261 of Title 35), did not create a system for the perfection of security interests in patents. After first concluding that "[t]he Federal statute does not protect holders of security interests," Judge Hillman held as follows:

There is nothing in §261 that addresses in any way the conflict between one who is not a holder of an interest by way of assignment, grant, or conveyance and a bankruptcy trustee. We must look to other law for the answer. 

That other law was the UCC. Holding that a patent is a general intangible, the Court ruled that nothing in the UCC excepts general intangibles from the rule requiring perfection by a UCC filing. Since no valid UCC filing perfected the creditor’s security interest, it was unperfected and the Chapter 7 trustee prevailed.

The Bottom Line. The Coldwave Systems decision is consistent with the Ninth Circuit’s earlier Cybernetic Services ruling. Together they teach creditors that the only way to perfect a security interest in a patent is by an unavoidable and proper UCC filing. Any creditor relying on a PTO filing alone will end up unperfected and unsecured. While there may be other reasons for a creditor to make a PTO filing, such as potentially protecting against an improper assignment of the patent, perfection of a security interest is not one of them.

Want More? For more on the Coldwave Systems and Cybernetic Services decisions, be sure to read Warren Agin’s excellent post on the Tech Bankruptcy blog, entitled "An Expert Builds On Cybernetic Services." Warren also gets special thanks for first posting on Judge Hillman’s interesting decision.

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.