Canada: Intellectual Property Licences And Insolvency Laws

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Information Technology, May 2008

Amendments to Canada's bankruptcy and insolvency legislation are another step closer to taking effect with the passage, in December 2007, of Bill C-12, "An Act to amend the Bankruptcy and Insolvency Act, the Companies' Creditors Arrangement Act, the Wage Earner Protection Program Act and chapter 47 of the Statutes of Canada, 2005" (C-12). When proclaimed into force, the amendments will partially clarify the rights of a licensee of intellectual property from an insolvent licensor. However, a number of uncertainties remain.

Legislative History

C-12 is the latest addition to a long-anticipated package of amendments to Canadian bankruptcy and insolvency laws. Prior to C-12 was Bill C-55, which was passed in 2005 but was not proclaimed into force. Amendments intended to correct certain flaws in the 2005 legislation were introduced to the house last spring as Bill C-62, but died when Parliament was prorogued. These amendments were reintroduced last fall as Bill C-12.

The Problems with Intellectual Property Licences and Insolvency Laws

C-12 is meant to clarify the rights of a licensee of intellectual property in the event of the insolvency of the licensor. Existing Canadian caselaw — most notably the 2005 British Columbia Court of Appeal decision in New Skeena Forest Products Inc. v. Don Hill & Sons Contracting Ltd. — supports the view that trustees in bankruptcy and receivers have the power to disclaim a debtor's executory contracts (i.e., contracts with unperformed obligations). The existence of this power suggests that an insolvent licensor (or a receiver or trustee acting on its behalf) could disclaim intellectual property (including software) licences, and prohibit the licensee from continuing to use the licensed intellectual property, even if only to negotiate terms more favourable to the licensor. In the event of any such disclaimer, the licensee may be left with only an unsecured claim for damages arising from the termination of the licence.

Canadian caselaw dealing specifically with IP licences in insolvency is sparse and somewhat inconsistent. In Re Erin Features No.1 Ltd., the trustee in bankruptcy sought to disclaim an agreement in which the bankrupt Erin Features had granted Modern Cinema Marketing Ltd. exclusive marketing rights in Canada to a film. The B.C. Supreme Court assumed without deciding that a trustee in bankruptcy has the power to disclaim executory contracts, but ultimately concluded that contract at issue could not be subject to disclaimer, on the grounds that the grant of exclusive marketing rights conveyed a property interest that could not be reversed. Although the court avoided an undesirable result, commentators have criticized the court's reasoning as inconsistent with the principle that a licence does not transfer a property interest.

In contrast, in Re T. Eaton Co., which involved a restructuring under the Companies' Creditors Arrangement Act, the Ontario Superior Court permitted Eaton's to disclaim an agreement with National Retail Credit Services Company (NRCS) granting NRCS an exclusive licence to supply credit card services to Eaton's customers and to use Eaton's trademarks in connection with such services. NRCS had paid Eaton's a significant amount of money for these rights. When Eaton's sought to disclaim the agreement in the course of its restructuring, NRCS applied to the court for specific performance. In denying the application, Farley J. held that to generally restrict debtor companies from repudiating contracts would constitute an insurmountable obstacle to effecting compromises and reorganizations and, accordingly, NRCS was entitled only to a claim for damages. Citing the English case Heap v. Hartley, Farley J. further held that the licences granted were not in the nature of a property interest.

Looking at the policy behind bankruptcy and insolvency laws, the rationale for giving a trustee in bankruptcy powers to disclaim certain types of executory contracts does not apply in the same way to intellectual property licences as it does to contracts for goods and services. To allow a debtor to disclaim an obligation for future delivery of fungible goods or services is reasonable where it promotes a fair compromise among creditors and maximizes overall recovery. The other party to the contract can take steps to mitigate the event of non-supply (or pre-emptive steps to hedge the risk) that may be unavailable or impractical in respect of intellectual property. Moreover, contracts to supply goods or services depend upon the ongoing viability of the insolvent party's operation and its ability to acquire and deliver the goods or services it purveys. In contrast, in the case of an intellectual property licence, nothing active may be demanded of the insolvent licensor at all, merely forbearance.

Because of the unique nature of intellectual property, to obtain a substitute may be extremely costly or impossible. It is generally not practical to choose a licensor based on its prospective solvency; moreover, it is arguably inefficient to encourage licensees to make such choices. Licensees bargain for the right to use intellectual property and pay for the expectation of continued use, even if there are ongoing royalty or maintenance payments to be made. To upset such arrangements unjustly enriches the licensor and its creditors at the expense of a party that should be treated as a bona fide holder for value.

When the amendments come into force, a licensee's right to use intellectual property, including the right to enforce an exclusive use, will be explicitly protected against rejection or disclaimer by the licensor in the course of licensor proposals under the Bankruptcy and Insolvency Act or restructurings under the Companies' Creditors Arrangement Act. The protection will apply during the term of the licence agreement, including any renewal as of right, subject to the licensee's continued performance of its obligations under the agreement in relation to the use of the intellectual property. The provisions do not protect the licensee against disclaimer of the licensor's other obligations under the licence agreement, such as obligations for ongoing maintenance, support or indemnity. The legislation is silent on whether the licensee has rights to any improvements made by the licensor on the licensed intellectual property post-bankruptcy.

The condition that the licensee continue to perform its obligations under the agreement may give rise to uncertainty in the situation where the agreement includes a licence as well as other arrangements between the parties, such as ongoing technical support, for a single bundled fee. In the event that the licensor disclaims the support obligations, it may be difficult to determine the correct fee that the licensee must pay in order to preserve its right to use the IP in accordance with the requirements of the legislation.

C-12 corrects certain deficiencies in the 2005 legislation, which did not explicitly address the issues of exclusive licences or renewals. Nevertheless, a number of deficiencies and uncertainties remain. In particular, because the amendments address only licensor proposals under the Bankruptcy and Insolvency Act and restructurings under the Companies' Creditors Arrangement Act, they do not address other circumstances where a trustee in bankruptcy or a receiver appointed over the assets of the licensor seeks to disclaim or terminate the licence or to sell the underlying intellectual property to a third party, free and clear of any existing licence rights. While some commentators do not consider this a risk, others have expressed concern that the proposed amendments still do not adequately protect the rights of licensees in insolvency proceedings.

Additional provisions of C-12 give a court power to order assignment of an insolvent person's contractual rights and obligations to another person who has agreed to the assignment. Although the court is required to consider whether it is appropriate to make the assignment, and the court's power to order assignment expressly does not apply to "rights and obligations that are not assignable by reason of their nature", the scope and extent of these limitations are not clear, particularly with respect to licence agreements. Accordingly, it seems possible that the provisions may permit a debtor-licensee to assign a licence agreement despite a contractual provision requiring the licensor's consent.

The U.S. Approach

The treatment of intellectual property licences under C-12 to some extent parallels that in the United States Bankruptcy Code (U.S. Code). The relevant provisions were developed in the wake of Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., which allowed a bankrupt debtor in possession to reject an intellectual property licence, leaving the licensee with nothing but a claim for damages. The U.S. Code gives debtors a general right to disclaim executory contracts, but provides an exception in section 365(n) for intellectual property licences. Licensees may choose to retain their rights under the licence provided that they continue making any royalty payments due to the debtor, without any right of setoff. While the regime under C-12 has similarities to the U.S. model, it differs in several ways.

In the Canadian legislation, the term "intellectual property" is used but not defined, and thus would appear to include trade-marks, in contrast to the corresponding provisions under the U.S. Code, which do not apply to trade-marks. In the U.S. Code, the trustee is expressly required to provide the licensee upon request with any intellectual property and associated embodiments to which the licensee is entitled, and is prohibited from interfering with the licensee's rights to obtain the intellectual property or embodiments from another entity, thus reducing potential uncertainty around source code escrow agreements. The Canadian legislation is silent on this issue.

Conclusions

While C-12 resolves some uncertainties around the ability to disclaim intellectual property licence agreements in restructuring proceedings, the proposed amendments do not address circumstances where a trustee in bankruptcy or a receiver appointed over the assets of the licensor seeks to disclaim or terminate the licence or sell the underlying intellectual property to a third party, free and clear of any existing licence rights. As well, the amendments introduce new uncertainties that will need to be worked out in the courts.

Going forward, licensees will want to take steps to ensure that the application of the amended statutes to their agreements is clear, and in particular to separate the licensee's obligations in respect of the use of the intellectual property from other obligations under the agreement (for example, fees for maintenance and support services).

In addition, licensees should continue to consider use of other methods to protect against disclaimer by an insolvent licensor, including source code escrow, drafting the licence agreement in non-executory terms, obtaining an assignment or partial assignment of the intellectual property, taking a security interest in the intellectual property, or contracting with a licensor that resides in a jurisdiction with stronger protections for licensees.

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.

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