Intellectual Property In Bankruptcy: An Overview

An Overview of Intellectual Property in Chapter 11 Bankruptcy

A version of this article was published in June 2012. 

When a company files for bankruptcy, Section 541 of the Bankruptcy Code creates a bankruptcy “estate” comprised of virtually all its interests in property. The estate includes the debtor’s interests in tangible assets, like real estate, equipment, vehicles, etc., and its interests in any intangible assets, like patents, copyrights, trademarks, and other intellectual property. These property interests extend beyond property that is owned by the debtor and include interests created under any leases and licenses. Consequently, there is the potential for any company that owns intellectual property, or licenses intellectual property to or from someone else, to be impacted by the bankruptcy process, regardless of whether it ever finds itself in the position of the insolvent debtor seeking bankruptcy protection.

In this overview, we will briefly delve into some areas where intellectual property law and bankruptcy law intersect, focusing on how a bankruptcy filing, especially under Chapter 11 of the Bankruptcy Code, can affect the rights of those holding intellectual property rights.

The Automatic Stay – Safeguarding the Debtor’s Bankruptcy Estate

The Bankruptcy Code provides the Chapter 11 debtor with various protections and tools that have been designed to give it some breathing space to formulate and execute a plan to reorganize its financial affairs. Foremost is the “automatic stay” created by Section 362. The automatic stay provides immediate protection to a debtor upon the filing of a bankruptcy petition. It prevents pre-petition creditors from taking any actions to collect from the debtor, enforce liens against the debtor’s property, or pursue legal proceedings against the debtor or its property outside of the bankruptcy process. It also prohibits actions to obtain possession of, or exercise control over, the debtor’s property. The automatic stay is fundamental to bankruptcy and the court will only grant non-bankrupt parties relief from these prohibitions if certain conditions are met.

Now, let us consider how the automatic stay can impact the holder of intellectual property rights. Imagine you are the owner of a valuable patent and have evidence that several third parties are infringing on it. Before you can commence legal action, one of the infringers files for bankruptcy protection. The automatic stay could complicate your infringement claim. While you may still pursue legal action against the other non-bankrupt infringers, you would be prohibited from including the bankrupt infringer in your suit unless you seek and obtain relief from the automatic stay from the bankruptcy court. In some cases, your best or only option may be to address your infringement claim against the debtor within the bankruptcy process itself.

Alternatively, consider the scenario where you have licensed the patent to a third party and they are paying you royalties. Everything is going great until your licensee suddenly files Chapter 11, the royalties stop, and your licensee’s future ability to perform under the license agreement appears uncertain. You might be tempted to immediately terminate the license and seek to re-license the patent to a different party. Unfortunately, subject to certain exceptions in the Bankruptcy Code, any provision in your license agreement which provides for immediate termination if your licensee files bankruptcy is probably unenforceable under bankruptcy law. And any attempt by you to terminate the license agreement anyway would probably implicate the automatic stay’s prohibition on exercising control over the debtor-licensee’s interest in the licensed patent. Termination for non‑bankruptcy defaults may still be available, but the stay and Section 365 of the Bankruptcy Code will govern the timing and process, and relief from the stay may be required.

If it appears the debtor-licensee will continue to use and benefit from the patent during the bankruptcy, you will want to apply to the court for an administrative expense claim. If the debtor’s use of the patent is critical to its operations, then payment of your royalties during the bankruptcy case may be considered an actual and necessary cost of preserving the debtor’s estate. If the application is allowed, then payment of your royalties will be entitled to priority over payments to certain other creditors. But you should keep in mind that only the value actually conferred on the debtor’s bankruptcy estate qualifies for administrative priority and any pre-bankruptcy arrearages will generally remain unsecured.

Section 363 Sales – The Sale of Property “Free and Clear” of Third-Pary Interests

If a debtor is authorized to continue operating while in Chapter 11, then it is allowed to enter into contracts in the ordinary course of its business without court approval. Thus, a debtor in bankruptcy who is in the business of licensing or selling intellectual property may be able to enter into a new agreement to license or sell intellectual property to you without bankruptcy court approval. But if such transactions are outside of the ordinary course of business for the debtor, they must comply with Section 363 of the Bankruptcy Code, which generally requires notice and a hearing before approval. What constitutes the “ordinary course” can itself be the subject of dispute and judicial scrutiny.

Section 363 allows the sale of debtor property “free and clear” of any interests or liens when certain conditions are met. While this provision can be a powerful tool for a bankrupt debtor to sell and maximize the value of the intellectual property it owns, such a sale could cause harm to its non-bankrupt licensee. If you are the licensee of intellectual property and your licensor files bankruptcy and is later permitted to sell the intellectual property free and clear of all interests, would that include your right to use the intellectual property? The answer may depend on the facts and jurisdiction where the bankruptcy case is filed, as courts have disagreed on whether a licensee’s rights are an “interest” that can be stripped under Section 363.

Thankfully, the Bankruptcy Code provides mechanisms to safeguard licensees in such scenarios, including the right to notice and a hearing before a sale that could affect your licensed interest in the property. But you must take advantage of these mechanisms by asserting your rights and objecting to any sale that may negatively impact you. It also behooves you to closely monitor the bankruptcy proceedings and, if any sale of your licensed intellectual property appears possible, negotiate for the preservation of your license agreement. Proactive involvement, such as a request to the Bankruptcy Court for adequate protection of your interests, may help secure your continued ability to use the licensed intellectual property after a sale.

Executory Contracts – The Debtor’s Power to Assume or Reject (or Assume and Assign)

Section 365 of the Bankruptcy Code addresses the debtor’s executory contracts. A contract is considered “executory” so long as both parties to the contract still have ongoing performance obligations to each other under its terms. In bankruptcy, the debtor, with court approval, may either assume (continue to perform) or reject (cease to perform) its obligations under an executory contract. If the debtor is allowed to assume a contract, then it typically can also, subject to certain limitations, assign that contract to a third party by way of a sale under Section 363. The ability to assume or reject executory contracts allows a debtor to either retain and maximize the value of contracts that it considers beneficial to its reorganization, or to shed itself of contracts that it considers disadvantageous and likely to hinder its reorganization. In a Chapter 11 bankruptcy, unless the court orders otherwise, the debtor may seek approval to assume or reject an executory contract at any time before the confirmation of its bankruptcy plan.

An intellectual property license agreement often has the effect of creating an executory contract because the terms of the agreement typically create some ongoing obligations for both licensor and licensee. But intellectual property licenses are a special type of contract, where the parties’ identities often matter a great deal. For example, a trademark owner would not want to license its mark to a company that has a reputation for selling goods or services that the trademark owner considers inferior or scandalous. Consequently, whether an intellectual property license can be assumed or assigned in bankruptcy depends on a variety of factors, including whether the debtor is the licensor or licensee, the type of intellectual property being licensed, the terms of the license agreement, and the jurisdiction where the bankruptcy is filed.

In many jurisdictions, a licensee of intellectual property that files bankruptcy cannot assume the license agreement without the licensor’s consent. This result often follows from a specific provision of the Bankruptcy Code that bars assumption or assignment if applicable non-bankruptcy law would, due to the special nature of an intellectual property license, excuse the licensor from accepting performance from someone other than the original licensee. Many courts treat non-exclusive patent and copyright licenses as non-assignable under federal law, and in some jurisdictions that non-assignability can also prohibit mere assumption by the debtor‑licensee absent the licensor’s consent. This can bar the debtor-licensee’s assumption of the license agreement even without a proposed assignment to a third party. In other jurisdictions, by contrast, courts focus on whether the debtor actually proposes assignment, permitting assumption without assignment. Outcomes vary by jurisdiction and the type of intellectual property involved. Obviously, a licensee that would be unable to reorganize without the licensed intellectual property needs to seriously consider the consequences of a bankruptcy filing.

Of course, a debtor’s rejection of an intellectual property license agreement can create a variety of problems for its counterparty. If you are licensing a patent from a debtor under a pre-bankruptcy license agreement and the court allows the debtor to reject the agreement without your consent, the debtor would no longer be required to perform certain affirmative obligations that were ancillary to the grant of the license, subject to some specific protections for licensees of “intellectual property” written into Section 365(n) of the Bankruptcy Code. (Note that “intellectual property” is a defined term in the Bankruptcy Code and does not include trademarks.) For example, any ongoing obligations to enforce the patent against infringers in your licensed territory for your benefit typically are not compelled post‑rejection. Fortunately, Section 365(n) preserves your right to continue using the intellectual property and with continued access to any related embodiments in the debtor’s possession.

The debtor’s rejection of the license agreement in this scenario will not operate to rescind or terminate your license to use the licensed intellectual property so long as you elect to retain your license and continue paying the fees or royalties owed to the debtor. In its 2019 opinion in Mission Product Holdings, Inc. v. Tempnology, LLC, the U.S. Supreme Court explained that such a rejection is treated as a breach of the license agreement, not a rescission, and any rights that would survive a breach of contract under non-bankruptcy law generally survive a rejection in bankruptcy. For trademarks, which are excluded from the Bankruptcy Code’s definition of “intellectual property,” this opinion indicated that continued use of a licensed trademark may be permissible, notwithstanding the debtor-licensor’s rejection of the license agreement, if such rights would survive a licensor’s breach outside of bankruptcy. Outcomes in specific cases will depend on the license terms and applicable non‑bankruptcy law.

Finally, since rejection is a breach of the license agreement, a rejection naturally gives rise to a claim in the bankruptcy case for any resulting damages. In most cases, that claim is treated as a general unsecured claim because the breach is deemed to occur immediately before the bankruptcy filing. And if it is the type of breach that would entitle a licensee to terminate the license agreement under its terms or applicable non-bankruptcy law, the licensee may elect to treat the agreement as terminated.

Conclusion

Bankruptcy can substantially impact the enforcement and use of your intellectual property rights. Understanding the impact can help you avoid a loss of rights that may prove costly.

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.