Three Steps Licensees Can Take to Protect Their IP Rights in Bankruptcy

August 19, 2020 Articles
IP Watchdog

During periods of widespread economic disruption such as the present, operating businesses must be able to identify and respond to threats to the financial health of their contracting counterparts in order to protect key company assets. For companies that license intellectual property from third parties, such as copyrights, trademarks or patents, the bankruptcy of a licensor could have a serious impact on the company’s ability to use those assets, which in turn could materially impair the value of the company assets or significantly hinder a company’s ability to serve its clients.

This article will describe the consequences of bankruptcy on licensed intellectual property and outline steps licensees can take to protect their intellectual property rights in the face of a licensor’s insolvency.

Licensor Debtor Leverage Under the Bankruptcy Code

The United States Bankruptcy Code (11 U.S.C. Title 11) provides debtors in possession (a technical term for an insolvent licensor once it files for bankruptcy) or trustees of a bankrupt estate with two significant tools designed to protect and facilitate the orderly reorganization or liquidation of the bankrupt estate: the automatic stay and the ability to assume or reject executory contracts. Both of these tools may threaten the value and operation of an inbound license from the debtor and provide the licensor with significant leverage.

Automatic Stay of Actions

The moment a debtor files for bankruptcy, Section 362 of the Bankruptcy Code provides an automatic stay of all actions against the debtor or the property of the debtor’s estate, which provides relief to the debtor so it can effectively reorganize or administer the estate without contentious interference from creditors. The stay also helps the debtor’s creditors as a whole by preventing any one creditor from racing to secure the value of the estate’s assets for itself to the detriment of the debtor’s other creditors. Once a licensee is on notice that a bankruptcy case has been filed, any willful violation of the automatic stay could result in actual damages, including attorney’s fees, and potentially punitive damages in excess of the actual harm suffered being awarded to the debtor.

Therefore, the exercise by a licensee of normal contractual and self-help remedies can overnight become a minefield. As a result, a licensee considering how to protect itself against a licensor that may be in bankruptcy must presume the automatic stay is in effect and consult with counsel on how to obtain relief from the bankruptcy court.

Ability to Assume or Reject Executory Contracts

Section 365(a) of the Bankruptcy Code provides that, subject to certain limitations and qualifications, a trustee or debtor in possession “may assume or reject any “executory contract” or unexpired lease of the debtor.”

Note that this right of acceptance or rejection is entirely one-sided: in this case only the bankrupt licensor (in the form of the trustee or debtor in possession), and not the licensee, has the power to reject a contract. If the trustee or debtor in possession chooses to assume an executory contract, then the bankrupt licensor must continue to perform under that contract as it ordinarily would. So far, no blood, no foul.

Rejection, on the other hand, does not terminate or repudiate contract; rather, rejection relieves the licensor from its obligations to perform, though the licensor is considered to be in breach of the contract. Rejection effectively places the licensee in the position of a party whose counterparty has breached its contract, however, the non-debtor party can only seek damages and not specific performance. This is likely to be cold comfort for the licensee: if a licensor rejects an executory contract, the licensee can sue the bankrupt licensor for damages for nonperformance post-petition but the licensee will be treated as a general creditor of the debtor (and therefore very likely to receive pennies on the dollar), but will not be able to seek specific performance so as to continue using the intellectual property.

Is an Intellectual Property License ‘Executory’?

The critical question in determining whether bankrupt licensor can reject a license is whether the license is “executory”. A contract is generally considered “executory” if there remain significant unperformed obligations by both parties to the contract. Whether a contract is executory will depend on the terms of the contract and the bankruptcy court’s analysis of the ongoing obligations.

Because exclusive licenses generally require the licensor to refrain from licensing the applicable intellectual property to third parties and to maintain the registration of the underlying intellectual property, and because the licensee under an exclusive license is generally required to pay royalties, abide by confidentiality restrictions, and account to the licensor, exclusive licenses are generally considered executory and therefore subject to the trustee’s or debtor in possession’s choice of whether to assume and continue honoring the license or reject the license and cease performing under it.

Non-exclusive licenses, which may be critical to a licensee’s operations and mission, have also been found by courts to be executory where the license has included further obligations to be performed by each party, making them subject to potential rejection by the licensor.

All Is Not Lost: Special Rights of a Licensee in a Licensor’s Bankruptcy

Fortunately, bankruptcy law is not completely one-sided in favor of the licensor. The Bankruptcy Code to some extent recognizes the critical role intellectual property licenses play in modern commerce. To provide relief to licensees of intellectual property who may otherwise lose their ability to use their license in connection with their licensor’s bankruptcy, Section 365(n) of the Bankruptcy Code was enacted to make clear that the rights of a licensee of intellectual property cannot be unilaterally cut off as result of the licensor’s rejection of the license under Section 365(a).

Section 365(n) provides that if a trustee or debtor in possession rejects “an executory contract under which the debtor is a licensor of a right to intellectual property,” the licensee may:

(i) treat license as terminated and assert a claim for breach of contract; or

(ii) elect to retain its rights to use the licensed intellectual property (including exclusive rights) as such rights existed immediately before commencement of the licensor’s bankruptcy case, for the duration of contract. A licensee that elects to retain its rights under an applicable license must continue to pay royalties due under the contract for the duration of the license.

Trademarks and trade names are conspicuously absent from the Bankruptcy Code’s definition of “intellectual property”, which for a period of time left licensees of trademarks without the protections of Section 365(n). However, in 2019, the Supreme Court of the United States held in Mission Product Holdings Inc. v. Tempnology, LLC that a debtor’s rejection of a trademark license under Section 365 of the Bankruptcy Code amounts to a breach of the license agreement and the licensee retains the rights to the licensed marks for the remainder of the license term, which prospectively provides that licenses of trademarks will receive the same treatment as licenses of other “intellectual property” under Section 365(n).

Limits to a Licensor’s Protections Under the Bankruptcy Code

Despite its broad protection for intellectual property licenses, Section 365(n) does not make a licensee whole. It essentially freeze’s the licensee’s rights to those it could exercise on the immediate eve of the licensor’s bankruptcy.

Thus, although Section 365(n) can save many licenses from otherwise being rejected by a debtor in possession or trustee, Section 365(n) does not appear to protect a licensee’s right to use intellectual property created after the filing of the debtor’s bankruptcy petition. This limitation may create serious problems for a licensee of intellectual property that is in process of being created when the licensor’s bankruptcy petition is filed. If copyrighted computer software is updated after the debtor’s filing of a bankruptcy petition, Section 365(n) may not provide the licensee with a right to use the software as updated. Section 365(n) may also halt the licensor’s obligations to maintain the license or the underlying intellectual property.

And although Section 365(n) and its related jurisprudence provide protection to licensees of intellectual property, if non-bankruptcy law requires a license of intellectual property to be recorded and the licensee has not done so, Section 544 of the Bankruptcy Code may allow the trustee or debtor to avoid the license notwithstanding Section 365(n).

For instance, under the Copyright Act, an exclusive license is considered a “transfer of copyright ownership” and is therefore subject to the recording requirements of the Copyright Act in order to maintain priority over subsequent transfers. If an exclusive license of a registered copyright is not recorded with the U.S. Copyright Office, the Bankruptcy Code may still allow a licensor to avoid the license.

What Can a Licensee Do?

If a licensee suspects that a licensor of key intellectual property may go bankrupt, it should consider the following actions:

  1. Keep track of the licensor’s solvency status: If a debtor has filed for bankruptcy, a stay will automatically be put in place under Section 362 of the Bankruptcy Code. It is important for licensees to stay on top of this process and note when the automatic stay has gone into effect to promptly begin considering their options and to avoid any willful violation of the automatic stay that could result in damages, fees, and punitive awards. Typically a debtor will provide written notice of the stay to affected parties, but licensors can stay on top of this by monitoring filings by the licensor or affirmatively requesting updates or notice of any bankruptcy filings. Most importantly, licensees should stay alert and keep an eye on pre-bankruptcy warning signs from its licensors, especially in economic downturns or periods of instability.
  2. Carefully consider the option of rejecting the license: Licenses that are not executory contracts will generally continue in operation through the bankruptcy, but if a license still has significant obligations to be performed by both parties, then the licensee should evaluate whether it will be able to retain its key rights pursuant to Section 365. Licensors can benefit from evaluating this option early on to allow time to find alternate vendors, if necessary, that can provide the type of intellectual property owned by the insolvent licensor.
  3. Confirm that the license has been properly recorded: If the license itself requires recordation under non-bankruptcy law in order for the licensee’s rights in the license to be perfected, licensees should ensure that they have filed any necessary recordings with the appropriate entity. The type of intellectual property at issue will determine where the license must be recorded. For example, the Copyright Act requires an exclusive copyright license to be filed in the Copyright Office, while a trademark license and a patent license should be recorded with the Patent and Trademark Office under the Lanham Act and the Patent Act, respectively. Failure to record rights under an intellectual property license may obviate the benefits of Section 365(n) for a non-debtor licensee.

In general, licensors who may be exposed by a licensee’s bankruptcy should be proactive if they fear that a licensee may be facing bankruptcy and should consult counsel early in the process to evaluate the potential impact of the automatic stay, the licensor’s ability to reject the license, and any impact that a lack of recording of the license may have.

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