August 07, 2009

The U.S. Supreme Court recently declined an opportunity to address a long-standing split of authority among the circuit courts as to which test should be applied by bankruptcy courts when asked to determine whether an intellectual property license can be assumed by a debtor in possession under Section 365(c)(1) of the Bankruptcy Code.

The Supreme Court denied a petition for a writ of certiorari for the case N.C.P Marketing Group, Inc. v. Blanks (in re N.C.P Marketing Group, Inc.),[1]  but, in an unusual step, Justices Kennedy and Breyer issued a statement indicating that Supreme Court might consider the issue if it is presented with the appropriate case.

The undecided issue is whether the so-called “hypothetical test” or the “actual test” should be used in determining whether a debtor-in-possession in bankruptcy can assume an intellectual property license. Until the Supreme Court settles this issue, licensors and licensees should be vigilant in drafting and negotiating anti-assignment provisions. In addition, secured creditors are advised that, if a debtor-in-possession cannot assume an intellectual property license, any so-called blanket liens will not automatically defeat licensors’ rights in the debtor’s licensed inventory.[2]

The power to assume and assign in bankruptcy

A debtor’s authority to assume and assign executory contracts—such as license agreements[3] —derives from Section 365(c)(1) of the Bankruptcy Code, which provides:

(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if:

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment.

(Emphasis added.)

Generally, a debtor’s right to assume an executory contract in bankruptcy means that, a licensee debtor may continue to use, and operate under, a pre-petition contract (e.g., an existing license). In contrast, a debtor’s right to assign[4]  an executory contract means that the debtor may transfer its rights under that contract to a third party. If a debtor opts not to assume and/or assign an executory contract, the debtor is said to reject that contract, which allows that debtor to breach the agreement, cease performance going forward, and limit its continued liability under that agreement. The debtor’s decision to assume, assign, or reject an executory contract is generally evaluated on the reasonableness of the debtor’s business judgment in reaching its decision.

However, Section 365(c)(1) of the Bankruptcy Code circumscribes a debtor’s ability to assign executory contracts, and even, in some courts’ view, simply to assume them, when “applicable law” gives the non-debtor party to the contract the right to refuse to deal with some other contracting party. In the context of intellectual property licenses, courts have held that federal trademark law under the Lanham Act is “applicable law” that renders non-exclusive trademark licenses as personal and nonassignable, absent an express provision in the license consenting to assignment. They have also ruled that federal common law prohibits the assignment of a non-exclusive patent or copyright license without the licensor’s consent.[5]

The hypothetical versus actual test

As noted above, assumption and assignment under Section 365 implicate two different, if related, powers granted to the debtor. The question then arises: If non-bankruptcy law—such as the Lanham Act—prohibits assignment of a license under Section 365, is a debtor also prohibited from assuming that license? The answer lies in the appropriate interpretation of the “assume or assign” language in Section 365(c). The split between the courts on this issue turns on whether the use of “or” in the above clause really means “and.” Substantial rights of licensors, debtors, and secured creditors hinge on these two small words.

Under the so-called “hypothetical test,” courts read the “or” in Section 365(c)(1) quite literally, reasoning that a non-debtor licensor can stop a debtor from assuming or from assuming and assigning an intellectual property license if the licensor could refuse to accept performance by a hypothetical third party under applicable non-bankruptcy law. Under the hypothetical test, therefore, even if a debtor does not seek to assign a license to a third party, but merely seeks to assume the license and continue to operate under the license, the debtor, nevertheless, cannot even assume that license under Section 365(c)(1). As of the date of this alert, the Third, Fourth, Ninth, and Eleventh Circuit Courts embrace application of the hypothetical test.[6]

Conversely, under the so-called “actual test,” courts tend to read the “or” as “and/or”, looking to the actual intent of the debtor with respect to any third-party assignment of the subject intellectual property license. That is, if the debtor does not intend to assume and thereafter assign its rights under the license to a third party—assignment that would be prohibited under applicable non-bankruptcy law—then the debtor is not prohibited from merely assuming the license itself as the debtor-in-possession. In the First and Fifth circuits, the focus, rather, is a case-by-case analysis by the court of the likely performance of the debtor-in-possession under the license.[7] The goal is to ensure that the non-debtor licensor gets the benefit of its bargain going forward, by examining whether the debtor-in-possession is capable of future performance under the license. Under the actual test, a court will only prevent assumption if the licensor can demonstrate that assumption by the debtor-in-possession does not provide adequate assurance of an agreeable standard of future performance.

What to do?

Justices Kennedy and Breyer recognized the importance of resolving the split on whether the hypothetical or actual test is the appropriate one. The Supreme Court believed, however, that the N.C.P. Marketing case was not the “most suitable case” for resolving the split. Justices Kennedy and Breyer nevertheless noted the fundamental flaw with the hypothetical test is that it shows fealty to the language of the statute while tending to undermine the Bankruptcy Code’s policy of maximizing value in the estate and giving a debtor its best shot at reorganization. If a debtor is unduly barred from assuming a license that is critical to its survival, important bankruptcy policy goals may be endangered. Conversely, the two justices recognized that adherence to the actual test can be seen to subvert the plain language of Section 365, and courts are generally wary of reading beyond plain, unambiguous statutory text to enforce policy goals.

So, where does that leave licensors and licensees while “the Supremes” wait for the “most suitable case” to come along to settle this split of authority? In those instances in which a licensee that is contemplating bankruptcy has some ability to make a choice as to the jurisdiction for its bankruptcy filing,[8]  it would be advised to file within the First or Fifth circuits,[9]  which embrace the actual test and, therefore, provide significantly more flexibility to the licensee under Section 365.

Moreover, licensors and licensees can take certain drafting steps that might affect their rights and the rights of counterparties to assume and/or assign agreements in bankruptcy. First, a licensor should insist on clear anti-assignment language that bars any and all assignments of the subject license and excuses the licensor from accepting performance from any entity other than the licensee. More specifically, a licensor should insist on anti-assignment language that, while as broad as possible, explicitly prohibits assignment to any parent, sub, affiliate, or other licensee-related entity. In addition, although it is not clear that such a provision would be enforced by a bankruptcy court, the licensor could include a provision specifically prohibiting the assumption and/or the assignment of the license in the licensee’s bankruptcy proceeding. The licensor should also insist on language that (i) prohibits the sharing of the licensed technology by any affiliated company, and (ii) terminates a license effective immediately on a change of control at the licensee.
[10]

Conversely, a licensee should look to include the fewest barriers to transferability of its rights in the license, e.g., advance consent to an assignment to affiliates, free sharing of licensed technology with affiliates, and no termination should there be a change of control at the licensee. It would be extremely helpful to a licensee in bankruptcy to include in its license a provision by which the licensor consents to the assumption of the license in a licensee bankruptcy proceeding, provided that the requirements of Section 365 of the Bankruptcy Code, i.e., cure of any default, compensation for any damages caused by any such defaults, and adequate assurance of future performance, are met. With such a clause, the licensee will not be at risk for being prohibited from assuming the license agreement as part of its rehabilitation in a Chapter 11 proceeding. If the clause also consents to assignments under Section 365, the creditors of the licensee will be able to realize value from the license and any affected product.

As for a secured creditor, the analysis of collateral value and exit strategies require that the lender consider how it will realize value from collateral upon a borrower’s default. If the collateral is subject to an intellectual property license, the lender has to consider whether it will have the ability to liquidate the collateral and what role an intellectual property license will play in that regard. There are several steps the lender should take when the loan is first being negotiated and documented. First, the lender should make a default under the license agreement a default under the loan agreement. As a corollary, it should seek to amend the license to require notice to the lender and an opportunity to cure whenever the licensee defaults under the license. That way, the lender can decide if it wants to advance funds to cure the default, rather than risk a loss of the license and the resultant loss of value to the business enterprise. Second, to enhance the foreclosure sale value of its collateral, the lender should seek the licensor’s consent to the transfer of the license by the lender to a third-party buyer via a foreclosure sale. As part of this consent, the lender should obtain a provision in the license that excepts a collateral assignment of the license to the lender from any restrictions on assignment of the license. If the lender and licensee cannot get that much from the licensor, the lender should at least request a provision that gives the lender a limited license to sell the licensee’s inventory and other goods, subject to the intellectual property license, if the lender ever has to foreclose on its collateral.

We are available to discuss any of the concepts touched upon in this Bankruptcy Alert, to assist in drafting licenses or loan agreements, and to provide support in asserting or protecting license rights in an insolvency proceeding.

1. The underlying Nevada U.S. District Court case can be found at 337 B.R. 230 (D.Nev. 2005).
2. Notwithstanding secured creditors’ perfected liens in “all inventory” of the debtor, a license agreement may require return of the licensed inventory to the licensor, or even require the debtor-in-possession to destroy, rather than liquidate, the licensed inventory,
3. Broadly speaking, an “executory contract” is one under which both parties still have substantial performance obligations running to one another as of the date of the bankruptcy filing, such that failure of performance by either party would amount to a breach of the contract, e.g., to pay royalties, to keep information confidential, etc.
4. Assignment involves a preliminary step of assumption. That is, a debtor is said to “assume and assign” an executory contract under Section 365.
5. Harris v. Emus Records Corp., 734 F. 2d 1329, 1333-34 (9th Cir. 1984); Everex Sys., Inc. v. Cadtrax Corp. (in re CFLC, Inc.), 89 F. 3d 673, 677-78 (9th Cir. 1996); Perlman v. Catapult Entertainment, Inc. (in re Catapult Entertainment, Inc.), 165 F.3d 747, 749-50 (9th Cir. 1999); in re Alltech Plastics, Inc., 71 B.R. 686, 689 (W.D. Tenn. 1987).
6. See, e.g., in re West Electronics, Inc., 852 F.2d 79 (3rd Cir. 1988); RCI Technology Corp. v. Sunterra Corp. (in re Sunterra, Corp.), 361 F.3d 257 (4th Cir. 2004); in re Catapult Entertainment, 165 F. 3d at 749-50; Jamestown v. James Cable Partners, Inc. (in re James Cable Partners, Inc.), 27 F.3d 534 (11th Cir. 1994).
7. See, e.g., Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997); Bonneville Power Admin. v. Mirant Corp. (in re Mirant Corp.), 440 F.3d 238 (5th Cir. 2006). Many lower courts also favor the “actual test.” See, e.g., in re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005); Texaco Inc. v. Louisiana Land and Expl. Co., 136 B.R. 658, 668-71 (M.D. La. 1992); in re GP Express Airlines, Inc., 200 B.R. 222, 231-33 (Bankr. D. Neb. 1996); in re Am. Ship Bldg. Co., 164 B.R. 358, 362-63 (Bankr. M.D. Fla. 1994); in re Fastrax, 129 B.R. 274, 277 (Bankr. M.D. Fla. 1991); in re Hartec Enters., Inc., 117 B.R. 865, 871-73 (Bankr. W.D. Tex. 1990), vacated on other grounds, 130 B.R. 929 (W.D. Tex 1991); in re Cardinal Indus., Inc., 116 B.R. 964, 976-82 (Bankr. S.D. Ohio 1990) (rejecting hypothetical test in connection with similar statutory language of § 365(e)(2)(A)).
8. The appropriate venue of a business bankruptcy case is set out in 28 U.S.C §1408 and includes the state in which the entity was incorporated or formed, its principal place of business, the location of its principal assets, or the district in which a bankruptcy case is pending for an affiliate.
9. The following states and territory are located within the First and Fifth circuits: First Circuit—Maine, New Hampshire, Massachusetts, Connecticut, and Puerto Rico; Fifth Circuit—Texas, Louisiana, and Mississippi.
10. See Cambridge Biotech, 104 F.3d at 494-95.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.