Originally published Summer 2004

As our society’s dependence on technology continues to grow, it is not unusual for a company’s principal assets to consist of its intellectual property rights. During the turbulent economy of the last few years, many technology companies have had to seek bankruptcy protection. Unfortunately, the intersection of our nation’s bankruptcy laws and the laws affecting intellectual property rights is complex and historically has been somewhat murky. This is due, in large part, to the fact that the goals of the laws relating to the protection of intellectual property rights are in direct conflict with the principal objectives of the Bankruptcy Code, which are to maximize the return to creditors and to provide a debtor with a "fresh start." There are potential complications which could result when a party to a license of intellectual property rights files for bankruptcy, but there also are strategies for protecting the non-debtor party to the license agreement.

Bankruptcy Code. The Bankruptcy Code contains a number of provisions which could affect licenses of intellectual property rights. Section 541 of the Bankruptcy Code broadly defines the property of the bankruptcy estate as including "all legal and equitable interest of the debtor in property ...." This definition clearly includes intellectual property, which the Bankruptcy Code defines as including patents and patent applications, copyrights, trade secrets, and mask works. (Trademarks are excluded from the Bankruptcy Code’s definition of intellectual property and, therefore, are not entitled to some of the protections discussed in this article.)

The most significant provision of the Bankruptcy Code affecting the rights of intellectual property licenses is Section 365 which generally provides the debtor with authority to assume, assign, or reject any executory contracts to which it is a party. Although the term "executory contract" is not defined in the Bankruptcy Code, courts typically have adopted the so-called "Countryman" definition, which provides that a contract is executory where "the obligations of both the debtor and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other." A determination of whether an intellectual property license is an executory contract is a threshold issue in ascertaining what a party’s rights are in the event of a bankruptcy proceeding. In general, most intellectual property license agreements will be deemed to be executory contracts for bankruptcy purposes.

If a license is deemed an executory contract, the debtor generally is permitted to "assume" (i.e., keep in effect) or "reject" (i.e., terminate) the license. If the license is rejected, the rejection is treated as a pre-petition breach of contract by the debtor, entitling the non-debtor to an unsecured claim for damages. If the debtor assumes the license, or assumes and assigns it to a third party, the debtor must: (a) cure any default or provide adequate assurance of cure; (b) compensate the non-debtor, or provide adequate assurance of compensation, for any pecuniary loss or any default; and (c) provide adequate assurance of future performance under the license. Upon assumption, all obligations under the license become post-petition obligations of the bankruptcy estate. However, if the license is assumed and assigned to a third party, the bankruptcy estate is relieved of all obligations accruing after such assignment. Also, it is significant to note that, with limited exceptions, the Bankruptcy Code invalidates "ipso facto" bankruptcy clauses which purport to terminate automatically a license upon the filing of a bankruptcy by a party to the license.

The general power to assume or reject a license is, however, limited expressly by another section of the Bankruptcy Code which prohibits assumption if (1) applicable law excuses the non-debtor from accepting performance from or rendering performance to an entity other than the debtor and (2) the non-debtor withholds its consent. As several commentators have noted, what one section of the Bankruptcy Code appears to give (i.e., the right to assume and assign contracts), this other section seems to take away. That is, the debtor’s right to assume or assign is subject to the law regarding acceptance or performance by the non-debtor. This apparent conflict in the Bankruptcy Code has lead to inconsistent decisions by courts faced with the issue of whether a debtor may assume and assign a license of intellectual property rights. There is a growing amount of case law standing for the proposition that the rights protected by intellectual property law are not trumped by the language of the Bankruptcy Code. Several courts have held that, because federal patent law and federal copyright law make non-exclusive patent and copyright licenses personal and non-assignable, these federal laws constitute "applicable law excusing a party other than the debtor from accepting performance absent consent of the non-debtor party," and, therefore, such licenses could not be assigned absent the consent of the non-debtor. The Bankruptcy Code thus may prevent not only assignment of certain intellectual property licenses, but also may prohibit the assumption of such licenses by a reorganizing debtor.

Another section of the Bankruptcy Code applies to intellectual property licenses only when the debtor is the licensor. Prior to the enactment of this section, courts generally allowed a debtor to reject an intellectual property license that was burdensome to the estate. In response to this practice, the Bankruptcy Code was changed to strike a balance between the interests of the debtor-licensor and the licensee. If the debtor-licensor rejects a license, the licensee may choose to treat the rejection of the license as a termination of the license agreement, and may assert a pre-petition claim for damages relating to the breach. Alternatively, the licensee may elect to retain its rights in the license, as such rights existed immediately before the bankruptcy case. In the event that the licensee elects to retain its rights, the Bankruptcy Code requires the debtor to provide to the licensee any intellectual property held by the debtor, and the Bankruptcy Code prohibits the debtor from interfering with the licensee’s contractual rights to use the intellectual property or obtain it from a third party such as an escrow agent. The option to retain rights to the license is subject to the licensee’s continuing obligation to make any royalty payments due under the license agreement.

Protecting the Non-Debtor. Good drafting is important in order to minimize the impact of a bankruptcy filing on an intellectual property license. Given the protections afforded both the licensor and licensee under certain sections of the Bankruptcy Code, the license could indicate that the rights conveyed are governed by the appropriate section(s) in the event the licensor files for bankruptcy protection. The license also could contain a provision to the effect that the licensor’s failure to perform its continuing obligations constitutes a material breach under the license excusing performance by the licensee, to address the issue of whether the license is an executory contract.

If a source code escrow agreement is utilized, and if it is to be a separate agreement from a related software license, the license could recite that such escrow agreement is an "agreement supplementary to" the license to ensure that the licensee can retain its rights under the escrow agreement in the event that the license is rejected.

Since, under one section of the Bankruptcy Code, a licensee under a rejected intellectual property license must continue to pay royalties, the license should distinguish between royalty payments made for the use of the intellectual property and payments made for other services such as maintenance, support, development, training, etc.

Finally, where appropriate, a party should consider taking a security interest in the licensed intellectual property and other assets to secure the various obligations under the license. If a security interest is obtained, it may require some act of perfection to be enforceable against third parties, so make sure that all such transfers are promptly and properly perfected.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.