IP LICENSES IN BANKRUPTCY WHAT S AN EXECUTORY CONTRACT ANYHOW?

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1 IP LICENSES IN BANKRUPTCY Or WHAT S AN EXECUTORY CONTRACT ANYHOW? Peter Ludwig Fish & Richardson New York February 2012

2 Disclaimer I m an IP Lawyer, not a Bankruptcy Lawyer This is a Look at IP License Issues in Bankruptcy, Not a Bankruptcy Law Lecture 2

3 SUMMARY (1)Bankruptcy Terminology (2)IP Licenses in Bankruptcy (3)Drafting Considerations 3

4 BANKRUPTCY TERMINOLOGY See Bankruptcy Code-Title 11 U.S.C. Intellectual Property Definition in 11 U.S.C. 101(35A) of Bankruptcy Code 4

5 TERMINOLOGY INTELLECTUAL PROPERTY INCLUDES: (1) Trade Secrets (2) Inventions Covered Under 35 U.S.C., Processes, Designs, Patents (3) Patent Applications (4) Copyrights (5) Plant Varieties (6) Mask Works (Title 17, Chapter 9) 5

6 TERMINOLOGY BUT INTELLECTUAL PROPERTY DOESN T INCLUDE: (1) Trademarks / Trade Names (2) Service Marks (3) Overseas IP not within treaties between U.S. and country of origin of work that provide reciprocal protection or are otherwise protected under 35 U.S.C. or 17 U.S.C. 6

7 TERMINOLOGY Why Aren t Trademarks Considered IP for Bankruptcy Purposes? Congress; Trademarks Depend to a large extent on control of quality and service, so decided to Allow the development of equitable treatment of this situation by bankruptcy courts. (Sen. Report , 100 th Congress, 2d Sess. (1988)) In some circumstances (where protection similar to patent and copyright law needed), trademark may be treated like other IP assets, e.g., prevent unauthorized use of TM; preserve value of business name and/or product. 7

8 Surprising!! TERMINOLOGY Executory Contract Not defined in Bankruptcy Code Widely adopted definition by Prof. Vern Countryman (Harvard Law School), specialist in commercial law and debtors rights 8

9 TERMINOLOGY Executory Contract Countryman Definition for an Executory Contract Contract under which obligation of bankrupt and other party to contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing performance of the other (Countryman, Executory Contracts in Bankruptcy, Part I (7 Minn Law Review 439, 460 (1973)) *Sometimes referred to as Material Breach Test 9

10 TERMINOLOGY Countryman Material Breach Test Test Used by Most Courts (Minority Approach) Functional Test - Contract executory if determination permits debtor to reject contract as burdensome or unenforceable. Decided based on impact on bankruptcy case See, In re La Electronica, Inc., 995 F.2d 320, 322 n.3 (1st Cir. 1993) See, In re Bradlees Stores, Inc., 2001 WL at *6 (S.D.N.Y. Sept. 20, 2001) (collecting cases) 10

11 TERMINOLOGY Bankruptcy Proceedings - 2 major formats CHAPTER 7 - Liquidation (11 USC ) Most common form Liquidation Proceeding Debtor s non-exempt assets sold by Chapter 7 Trustee PROCEDURE Trustee takes control of non-exempt assets, sells them and pays creditors whatever proceeds sales permit 11

12 TERMINOLOGY CHAPTER 11 Reorganization (11 USC ) Reorganization proceeding Debtor usually remains in possession of its assets (DIP) DIP continues to operate business with oversight by Court and Creditors Committee DIP Fiduciary duty to maximize value for creditors of the Bankruptcy entity Debtor proposed reorganization plan Confirmed by Court, if accepted by majority of creditors 12

13 TERMINOLOGY Section 365 of Bankruptcy Code Trustee s Authority to Assume, Assign or Reject (11 U.S.C. 365) Grants bankruptcy trustee (or debtor in possession) authority to assume, assign, or reject executory contracts to which debtor is a party. TEST: Is action in best interest of debtor? Trustee s Decision rejected only if manifestly unreasonable 13

14 IP LICENSES Are IP Licenses Executory Contracts? Q - Do IP licenses fall under definition of executory contracts? A - Q - A - Probably almost all do. Why? Unperformed obligations by both parties make IP license executory. (Countryman definition) 14

15 IP LICENSES Unperformed Obligations Obligation to pay royalties usually not enough to cause contract to be declared executory (See Lubrizol Enters., Inc. v. Richmond Metal Finishers, 756 F.2d 1043, 1045 (4th Cir. 1945) General rule: Provisions that are more like conditions, than affirmative duties or performance; sufficiently material to establish agreement as an executory contract 15

16 IP LICENSES Provisions Held to Establish Executory Obligations Licensor Covenant not to sue for infringement Duty to maintain IP Licensee Territorial restrictions Reporting obligations 16

17 IP LICENSES BOTTOM LINE Almost any obligation, besides obligation to pay, enough to establish IP license as executory contract under bankruptcy law test. See, In re Access Beyond Techs., Inc., 237 B.R. 32, 43 D. Del. 1999); Everex Sys., Inc. v. Cadtrak Corp., 89 F.3d 673 (9th Cir. 1996) See also, In re Gencor Indus. Inc., 298 B.R. 902, 907 (Bankr. M.D. Fla 2003) Holding that most favored nations and patent defense were conditions of payment, not continuing material obligations 17

18 IP LICENSES While 365(a) gives trustee or debtor in possession authority to (1) assume or (2) reject executory contracts. Trustee must assume or reject entire contract; no piecemeal assumptions See, Stewart Title Guaranty Co. v. Old Rep. National Title Insurance Company, 83 F.3d 735, 741 (5th Cir. 1996) 18

19 IP LICENSES Decision is matter of debtor/trustees business judgment Orion Pictures Corp. v. Showtime Networks, 4 F.3d 1095 (2d Cir. 1993) Factors in Decision (a) Benefit to bankrupt s estate (b) Dilution to other creditors (c) Liability as administrative claim if assumed contract subsequently rejected 19

20 IP LICENSES Time Limit on Acceptance/Rejection 365(d) sets time in which trustee/debtor must decide whether to accept/reject (1) In Chapter 7 proceeding - Within 60 days of bankruptcy petition (2) In Chapter 11 proceeding - Any time before confirmation of reorganization plan 20

21 IP LICENSES Acceptance/Rejection What happens if Chapter 11 debtor doesn t accept or reject license? Termed Ride Through No requirement in bankruptcy code that Chapter 11 debtor must assume or reject License is property of debtor after confirmation 1st, 2nd, 3rd, 4th, 5th and 9th Circuits recognize Ride Through doctrine 21

22 AUTOMATIC STAY 11 U.S.C. 362(a)(3) Triggered by bankruptcy filing Protects bankruptcy estate from any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate Patents, TM s & Copyrights are property of the estate Injunction against continuance of any action, by any creditor against debtor (11 USC 362) 22

23 AUTOMATIC STAY Parties can seek stay relief to terminate IP license for cause e.g. worried that debtor can t maintain quality control or cure defaults See Ford Motor Co. v. Claremont Acquisition Corp, Inc., 186 B.R. 977 (C.D. Calif 1995) Stay remains in effect until (1) Judge lifts stay (2) Debtor gets discharge (3) Item is no longer property of the estate 23

24 AUTOMATIC STAY Replaced by permanent injunction when debtor receives discharge P.I. Prohibits creditors from all actions that automatic stay prohibited While stay in effect, non-debtor can t unilaterally terminate IP license (11 U.S.C. 362(a)) Attempts to terminate - can be contempt of court 24

25 IP LICENSES - DEBTOR AS LICENSEE Tension Between Bankruptcy and IP Law 365(a) authorizes debtor to assume or reject any executory contract 365(d) authorizes debtor to assign executory contract, despite existence of provision in contract barring assignment Conflict between IP Law (concepts of monopoly and non-assignability) and Bankruptcy Law (based on maximizing value for all parties) 25

26 IP LICENSES Assumption by Debtor Licensee 365(b)(1) - conditions of assumption are (1) defaults must be cured and (2) assuming party must provide adequate assurance of future performance ( 365(b) (1)) Examples of Future Performance in IP Licenses: (1) Pay royalties (2) Maintain quality (3) Continued sales 26

27 IPSO FACTO CLAUSES 365(e)(1) and 541(c) - clause that automatically terminates contract upon insolvency, financial condition, or filing of bankruptcy Unenforceable once bankruptcy case has been filed But could be important (if debtor rejects license) to determine if contract has been/can be terminated under contract law See, One South, Inc. v. Hollowell, 963 So. 2nd 1156 (Miss. 2007) 27

28 IP LICENSES Limitations on Assignment 365(c) - Trustee can t assume/assign executory contract if (a) Applicable Law excuses a party, other than debtor from accepting/rendering performance to entity other than debtor, whether or not contract restricts assignment of rights, and (b) Party does not consent to such assumption or assignment Applicable Law = PAT, TM, Copyright laws: Can prevent DIP from assigning or assuming contract Extraordinary - read literally, affords patent licensor ability to decline honoring executed license with bankrupt licensee Well-established principle under Federal Common Law, unless otherwise provided by terms of agreement, non-exclusive license is personal and not freely assignable 28

29 IP LICENSES Limitations on Assignment (1) In most jurisdictions, non-exclusive licenses generally not assignable over licensor s objection (unless permitted by License) See Everex Systems v. Cadtrak, 89F.3d 673 (9 th Cir. 1996)); (2) Exclusive licenses assignable over objection of Licensor See Leicester v. Warner Bros. Corp., 232 F. 3d 1212 (9 th Cir. 2000) What s the Rationale Here?? Exclusive licensee acquires actual property rights and may freely transfer them and licensor can t transfer them to someone else 29

30 365(c) Interpretation Courts differ in how 365(c)(1) should be interpreted 365(c) (Condensed version) Trustee may not assume or assign executory contract, whether or not contract prohibits or restricts assignment of rights, if (1) applicable law excuses a party (other than debtor) to the contract from accepting performance from or rendering performance to, an entity other than the DIP or debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, and (2) such party does not consent to such assumption or assignment. 30

31 Query? Does OR mean AND also? 365(c) I.e., what happens when bankrupt party wants only to keep (assume) a licensee? Does 365(c) mean debtor can neither assign or assume? Or just that debtor can t assign? Can debtor hypothetically assign the license even though it doesn t want to ( hypothetical test ) or what is debtor actually proposing to do ( actual test )? 31

32 365(c) SUMMARY Problematic Split Among Courts Most courts agree 365(c)(1) bars assignment of executory contracts absent non-debtor s consent, if applicable law ( 365(c) requires such consent Otherwise, non-debtor must accept performance from a new party Courts split on whether language of 365(c) prohibits DIP (Trustee) (1) from assuming executory contracts or (2) only from assigning them Circuits don t agree: Apply different tests 32

33 Tests for Determining Applicability of 365(c) Circuits don t agree: Apply different tests 1) Actual Test - 1st Circuit (favors licensee) If DIP has no intent to assign executory contract to 3rd party, contract can be assumed if DIP meets requirements of 365 (Defaults cured and can provide assurance of future performance) See Institut Pasteur v. Cambridge Biotech, 104 F.3d 489 (1 st Cir 1997) 33

34 Tests for Determining Applicability of 365(c) 2) Hypothetical Test - 3rd, 4th, 9th and 11th Circuits (favors licensor) Precludes assumption, or assumption + assignment, of IP license without consent of licensor, if license not assignable under nonbankruptcy law without consent of licensor See, In re West Electronics, 852 F.2d 79 (3rd Cir. 1988); In re Catapult Entertainment Inc., 165 F3d 747 (9 th Cir. 1999); N.C.P. Marketing Group v. BG Star Products, 279 Fed. Appx 561 (9 th Cir. 2008), Cert denied 129 S. CT 1577 (2009) * Rights of licensee can be taken away * Potential windfall to licensee 34

35 Tests for Determining Applicability of 365(c) 3) Footstar Test (New approach to 365(c) dilemma) Term Trustee in 365(c) should not include debtor-in-possession Prohibition against assignment + assumption under 365(c) is limited to conditions where Trustee, not debtor in possession, wants to assume executory contract See, In re Footstar Inc., 323 B.R. 566, 573 (Bankruptcy S.D.N.Y. 2005) 35

36 Tests for Determining Applicability of 365(c) Footstar Test (Sometimes The New York Test") Solution for courts seeking to avoid negative consequences of debtor/licensee that enters bankruptcy, but wants to assume, not assign its IP licenses 36

37 FOOTSTAR Footstar not involve IP license Adopted literal reading of 365(c)(1) Meant to be harmonious with objective of 365(c) and overall objecting of bankruptcy code No construction of what or means Use of word Trustee not include debtor or DIP 37

38 FOOTSTAR Accordingly right of non-debtor party to object to assignment doesn t affect right of DIP or debtor (as contrasted with right of trustee) to assume an executory contract Followed by SDNY in Adelphia Communications (Adelphia 2007 WL at *3 N. 13) 38

39 FOOTSTAR Adelphia Court Footstar consistent in outcome with the decisions of courts following the actual test Notable because many large bankruptcy filings made in SDNY, e.g., Delphi, Enron, Worldcom, Delta Airlines 39

40 See, In re Footstar, 323 B.R. 566, (Bankr. S.D.N.Y. 2005) Judge Adlai Hardin Great majority of lower courts have taken the view that courts should apply an actual test to permit assumption where debtor in possession does not intend to assign the contract. 40

41 TYPICAL SITUATION ADDRESSED BY FOOTSTAR (1) Debtor is patent licensee (2) License signed before bankruptcy filing (3) Licensor moves to force DIP to reject license agreement or to lift automatic stay so licensor can cancel agreement (4) Licensor argues DIP can t assign license & under hypothetical test, can t assume agreement (5) Licensor argues DIP should be forced to reject license 41

42 Recent decision in Aerobox Composite Structures, LLC bankruptcy filing 373 B.R. 135, 138, (Bankr. M.D. NM) Found Footstar was proper interpretation of 365-n Denied licensor s motion DIP not barred by 365(c)(1) from assuming pre-petition license 42

43 BOTTOM LINE OF 365(c) Venue may decide outcome SDNY follows Footstar 1st Circuit follows actual test 3 rd, 4 th, 9 th, & 11 th Circuits follow hypothetical test 6 th, 7 th, & 10 th Circuits unsettled on which test to follow 43

44 365(n) DEBTOR AS LICENSOR 1988 Intellectual Property Licenses in Bankruptcy Act (IPLBA) Pub. Law (n) rights of IP licensee when trustee rejects executory contract where debtor is licensor If executory contract is rejected, licensee can (1) treat contract as terminated by reason of rejection seek damages for breach or termination, or (2) retain its rights under license, including exclusivity, for duration of agreement Doesn t protect exclusive licensee against failure to record and applicable non-bankruptcy law requires license recordation Doesn t apply to trademarks: TM licensees must rely on interpretation of 365(c)(1) 44

45 365(n) DEBTOR AS LICENSOR Only deals with (1) rejection by licensor, not by licensee, and (2) whether license may be (i) assumed or (ii) assumed and assigned by bankruptcy trustee 45

46 365(n) DEBTOR AS LICENSOR Protects rights to embodiments of IP to which licensee entitled under applicable underlying contracts (see S. Rep. No at 9 (1988) Licensee has no rights in IP developed after bankruptcy filing even when rejected license agreement gave rights to use improvements (Szombathy v. Controlled Shredders Inc. No. 97 c 481, 1997 WL (N.D. IL 1997) 46

47 365-n TIMING OF ELECTION When does licensee exercise its right of election under 365-n? 365(n)(1)(b) allows licensee to elect to retain its rights Right arises only on rejection of license by bankrupt and not before See, Dynamic Changes Hypnosis Center, Inc. v. PCH Holding LLC, 306 B.R. 800, 809 (E.D. VA 2004) 47

48 SOME THOUGHTS ON LICENSE DRAFTING What circuit laws may be applicable on bankruptcy of other party to agreement Ipso Facto Clauses unenforceable but could be valuable to permit termination after rejection of contract Right to terminate for conduct likely to occur before bankruptcy; poor financial results, performance delays Change of control gives right to terminate (avoid Ipso Facto problems 48

49 SOME THOUGHTS ON LICENSE DRAFTING Try to structure license as non-executory Only obligation is to pay royalty; Put other obligations in separate executory agreement, e.g. patent maintenance 49

50 SOME THOUGHTS ON LICENSE DRAFTING If licensee retains rights, must continue to make royalty payments Define triggering event for depositing source code; escrow over which DIP has no control; not property of estate 50

51 SOME THOUGHTS ON LICENSE DRAFTING Try to obtain security interest in underlying IP as security for performance of debtors obligations (strengthen rights of nondebtor party) 51

52 Thank you! 52