United States: Bankruptcy 101 For Intellectual Property Licenses

Generally, license agreements are "executory contracts" in bankruptcy. Executory means performance is due from both sides. When a party to an executory contract becomes a debtor in bankruptcy, it may either reject or assume the contract. However, non-debtor parties (or "counterparties") enjoy some protections, especially when the contract is a license agreement for intellectual property.

The basics.

Rejection relieves the debtor of performance, and the counterparty keeps a claim for damages. Although rejection claims often receive pennies on the dollar, assumption can be even worse. Assumption means the debtor and the counterparty must continue to perform the contract. The debtor also may be able to assign the contract to a third party—even if the contract says that it can't. As a result, if you are a counterparty, you may find yourself managing intellectual property with someone you don't know or trust.

What to do if your license is rejected and you are the licensor.

If you license intellectual property to a licensee that becomes a debtor in bankruptcy, there is little you can do to prevent the debtor licensee from rejecting the license agreement. If you are a licensor, you may welcome the opportunity to sever your relationship with an insolvent licensee. Although your rejection claim may have small value, if your license agreement is rejected, you (the licensor) should be able to retrieve and secure your intellectual property. It is important for the licensor to monitor the bankruptcy case. If you are the licensor, you may want to force an early decision to reject the license agreement or ask the bankruptcy court to terminate the license. In any event, if you are the licensor, you should consider filing a claim for damages with the bankruptcy court.

What to do if your license is rejected and you are the licensee.

If the licensor files bankruptcy, the licensee of intellectual property may wish to keep its rights. Congress recognizes that it would be unfair if licensors could terminate a license by filing bankruptcy. Section 365(n) of the Bankruptcy Code says that if the licensor rejects a license agreement for intellectual property, the licensee has two options: (1) it may treat the license as terminated, return the intellectual property, and file a claim for damages; or (2) it may waive its claims for damages and retain the right to use the intellectual property for the duration of the license and for the stated royalties or other payments required by the license agreement.

Section 365(n) protection of a licensee's rights is not perfect. For example, the licensee can enforce exclusivity provisions, but not maintenance, support, or other provisions. To prevent the licensor from using bankruptcy to rescind the right to use intellectual property, however, the licensee must monitor the case and move promptly to exercise its rights when the licensor debtor seeks rejection.

The curious case of trademarks.

The special treatment of IP licenses in Section 365(n) is limited to patents, copyrights, and trade secrets. The definition of "intellectual property" does not include trademarks. Courts are split over the significance of this omission. Most courts have concluded that trademark licensees do not have the option to retain their rights if the debtor/licensor rejects. Others say the bankruptcy court has the power to grant these rights to a trademark licensee. The rules will be different depending on where the debtor files bankruptcy.

What to do if the debtor wants to assume your license.

To assume a contract, the debtor must protect the counterparty's interests. First, the debtor must cure all defaults, including defaults in paying amounts due under the license agreement. Second, the debtor must compensate the counterparty for any actual losses as a result of default. Third, the debtor must provide "adequate assurance" that it will perform the contract going forward. "Adequate assurance" can mean many things, depending on the circumstances. For an IP license, it means the debtor must show the financial, technical, and operational ability to perform the agreement.

If the debtor asks the court to assume your license agreement, you should move quickly to review the debtor's finances and business plan to ensure that the debtor will be able to cure all defaults and perform the license agreement after the assumption. In addition, in some jurisdictions if a debtor cannot assign an IP license (see next section), then it also cannot assume the license in the first place. In summary, your rights may vary depending on where the bankruptcy case is filed.

What to do if the debtor wants to assign your license.

In a bankruptcy case, a debtor may assign most contracts even if the contract says that it is not assignable; however, to assign a contract, the debtor first must assume it. Accordingly, as part of the assumption, the counterparty is entitled to have all defaults cured and damages paid. In addition, the debtor must prove the third party assignee can provide the "adequate assurance" of performance discussed in the last section. This means that the proposed assignee must have at least the financial and operational capacity that the debtor had when it entered the license.

Moreover, in bankruptcy cases IP licenses enjoy special protections. Although contract provisions that say an agreement cannot be assigned are not enforceable in bankruptcy, bankruptcy law does respect non-bankruptcy laws that say an agreement cannot be assigned. Many courts have held that federal law prevents the assignment of copyright, patent, and trademark licenses without the licensor's consent. For example, franchise agreements may include licenses to use the frachisor's IP, such as trademarks, trade names, trade secrets, or patents. These licenses may not be assignable under applicable non-bankruptcy law. Whether "applicable law" protects your license agreement from assignment must be determined case-by-case and may be affected by the location of the bankruptcy case.

Assignment of a license agreement to a solvent third party may be a better route than rejection or continued performance by the debtor. Even so, understanding your rights is important when dealing with the proposed assignee.

The bottom line.

If the other party to your IP license agreement files bankruptcy, you face a complicated situation. You may have more rights than under an average contract, but prompt attention is necessary to understand your rights, and prompt action may be necessary to protect them. The details are technical and the rules change depending on the nature of your agreement, the type of intellectual property involved, and the location of the case.

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.