Article by Richard M Cieri and Michelle M Morgan
It is always painful to watch a customer or supplier tipping toward financial distress. But when the troubled company licenses your firm a key technology or other intellectual property, the potential for disaster is clear. Often, when entering into a transaction, little thought is given to the impact of bankruptcy on a licensing relationship. Today, an examination of that scenario – and how to better prepare for it – would seem only prudent.
The intersection of bankruptcy and intellectual property law appears particularly interesting now that the "New Economy " and its complex web of intellectual property arrangements is experiencing some old-fashioned stress. The good news is that, way back in 1988,Congress recognized that licensing deals are a special kind of contract that should not be too easily dissolved by a bankruptcy filing.
However, the remedies of the Intellectual Property Bankruptcy Protection Act address only some of these concerns, and the remedies offered even for these are only partial. In the current climate, companies should look well beyond these statutory protections and take a proactive stance in ensuring their intellectual property lifelines.
This Technology Commentaries reviews the special protections for licensing contracts that exist under federal bankruptcy law, looks at ways of optimizing these protections through careful contract drafting, and suggests other steps that companies can take to establish greater security in their licensing relationships.
Limited Licensee Protections under Sec.365(n)
One of the beauties of bankruptcy for debtors is that it allows them to reject burdensome contracts as long as they are "executory " –i.e. still requiring some performance by both parties at the time of the bankruptcy filing. The typical intellectual property and technology license falls into this category. A debtor or bankruptcy trustee only needs to establish a sound business justification for rejecting an executory contract. As a result,until 1988,a nondebtor licensee had no real ability to block or prevent rejection of its license agreement with a debtor.
In 1988,Congress recognized the potentially devastating impact of the rejection power on licensees by enacting the Intellectual Property Bankruptcy Protection Act. The Act amends section 365 of the Bankruptcy Code, adding a new subsection 365(n)that, as the legislative history explains, "corrects the perception of some courts that section 365 was ever intended to be a mechanism for stripping innocent licensee [s ] of rights central to the operations of their ongoing business and stripping the American licensing system of its dependability and flexibility."
Section 365(n) provides that, subject to certain conditions, a licensee of technology and intellectual property from a company in bankruptcy can retain certain rights under the license agreement for both the initial term and any lawful extensions thereof despite the debtor ’s or bankruptcy trustee ’s rejection of the contract. Section 365(n) further protects a licensee ’s interests by empowering it to require a debtor or bankruptcy trustee to turn over source code or other embodiments of the intellectual property placed in escrow.
The protections of section 365(n)are far from perfect, however. Major shortcomings for licensees include:
- No trademark protection : Trademark, trade name, and service mark license agreements are explicitly not covered by the Intellectual Property Bankruptcy Protection Act. Other types of technology and intellectual property also may be excluded..
- No future performance : If the debtor wishes to reject the intellectual property license, the licensee can retain only those rights in the licensed property that existed on the bankruptcy petition date and may not have any right to postpetition modifications or enhancements. In the worst-case scenario, while section 365(n)lets the licensee enforce an exclusivity clause, the licensor may be able to develop an advanced version of the technology in bankruptcy and license it to a third party.
- No administrative or setoff claims : A licensee using section 365(n) to retain an intellectual property license that the debtor/licensor wishes to reject waives any right that it may have to assert an administrative or setoff claim under the license. A licensee thus may only assert general unsecured claims against the estate, unless (as discussed below) it is a secured creditor.
Invoking Section 365(n)to Assert Licensee Rights
Immediately upon receiving notice of a licensor/ debtor ’s bankruptcy petition, the licensee should serve a written request on the bankruptcy trustee or debtor in possession for (i)performance of the license agreement or turn over of the intellectual property licensed and any related escrowed property, and (ii)compliance with its duty not to interfere with the licensee ’s rights under the license agreement. If the licensee then receives notice of the licensor/ debtor ’s motion to reject the license agreement, and if it desires to retain its rights under the agreement, the licensee should again serve a written request upon the bankruptcy trustee or debtor in possession for (i) turn over of the intellectual property licensed and any related escrowed property; and (ii)compliance with its duty not to interfere with the licensee ’s rights under the license agreement.
Drafting Section 365(n)-Ready Contracts
There are traps for the unwary that can dilute the protections otherwise afforded by section 365(n) of the Bankruptcy Code. The time to avoid these traps is in drafting intellectual property and technology licensing contracts, long before a licensor ’s bankruptcy filing.
Agreement as executory
To avoid uncertainty over whether section 365(n)can be invoked, make sure that the license is clearly an executory contract, identifying the ongoing obligations of each party and providing that the failure to perform any of these obligations constitutes a material breach of the license. In the usual intellectual property and technology licensing scenario, both parties do have obligations that continue until the termination of the agreement. The licensor ’s duty is to forebear from prosecuting for infringement and to defend and indemnify the licensee in infringement suits relating to the licensed property. The licensee ’s duty is to pay royalties and provide an accounting to the licensor. These would typically satisfy the "executory " requirement for invoking section 365(n).
Right to terminate
To keep open a licensee ’s option to terminate a license that has been rejected under section 365(n),the license agreement should define the term "event of default " to include, among other things:(i)the licensor ’s rejection of the license agreement under section 365(n)of the Bankruptcy Code; and (ii)the licensor ’s breach or failure to perform or observe any of its obligations, covenants, or agreements under the license agreement. The license agreement also should specifically recognize the licensee ’s rights upon a licensor ’s default, including the right to terminate the license agreement and/or to obtain possession of the intellectual property and any escrowed property.
Liquidated damages clause
Because it would be difficult to ascertain the amount of the licensee ’s damages upon the licensor ’s default, the license agreement should contain a liquidated damages clause. A potentially large liquidated damages award in favor of the licensee also may discourage the debtor from rejecting the license agreement. The enforceability of any liquidated damages clause would be determined under applicable nonbankruptcy law.
Royalty payments: Less is better
Because a licensee must continue to make all royalty payments under section 365(n),the licensee should avoid characterizing as such monetary obligations other than percentage payments for use and/or sale of the intellectual property. Indeed, licensing/service fees should be made explicitly contingent on the licensor fulfilling servicing or R&D obligations. Alternatively, servicing or R&D could be covered in a separate agreement to prevent the lumping together of any service fees with the royalty fees if a licensor chooses.3 to reject those obligations postbankruptcy. In a similar vein, a licensee may want to structure the royalty fees to be discounted if the licensee loses its rights to future improvements of the licensed property; the downside is that a bankruptcy court may characterize the reduction as an unenforceable ipso facto clause under section 365(e)of the Bankruptcy Code.
Right to improvements
Because a licensee only is entitled to retain its rights under the license agreement as they existed on the bankruptcy petition date under section 365(n), include a provision granting the right to use all improvements of and enhancements to the intellectual property developed by the licensor during the term of the license agreement. Although it is not certain whether such a provision would be enforced by a bankruptcy court, there is no harm in including this language if it is acceptable to the licensor.
Escrow agreement
Finally, a licensee should request that the licensor transfer source codes or other embodiments or other key information relating to the licensed intellectual property into an escrow account. The escrow agreement should (i) acknowledge that the agreement is "supplementary " (as that term is used in section 365(n)of the Bankruptcy Code)to the license agreement; and (ii) direct the escrow agent to release the escrowed property to the licensee upon an event of default by the licensor under the license agreement.
Keeping Intellectual Property Out of Bankruptcy
Aside from being positioned to invoke section 365(n) protection, there are a number of more fundamental strategies for ensuring access to key intellectual property and technology. The goal of all of them is to prevent the intellectual property from becoming property of the debtor/licensor ’s bankruptcy estate in the first place.
Sale or absolute assignment
Clearly, this is the ultimate security arrangement. But structuring such a deal can be difficult, particularly when the original owner is a start-up enterprise whose most valuable asset is the intellectual property in question. A possible solution in this case is to license back to the original owner the right to use such intellectual property. Additionally, under this structure, the original owner could be granted an option to repurchase the intellectual property upon a default by the would-be licensee of its license obligations to the owner. However, a court might then determine that the original owner retained a sufficient property interest in the intellectual property to bring it into the owner ’s bankruptcy estate.
Intellectual property trusts
An alternative to an outright sale or absolute assignment would be for the intellectual property owner to transfer ownership to a trust, which would then license the intellectual property to the licensee. The trust agreement could be structured to prohibit the trustee from filing a bankruptcy petition or incurring any obligations other than the license agreement.
Bankruptcy remote entities.
A second alternative is to have the owner transfer title to the intellectual property to a new corporation established solely and specifically for the purpose of owning the intellectual property and licensing it to others. The articles of incorporation and by-laws of such a corporation would have to forbid it from engaging in certain activities, incurring debt or otherwise encumbering its assets, or filing a voluntary petition for bankruptcy. A limitation on the corporation ’s ability to amend its articles of incorporation or by-laws also would be required. The corporation should have different classes of stock that would allow the licensee some control of its governance while giving the original owner of the intellectual property economic benefits.
Finally, internal mechanisms should be implemented by the entity to ensure its separateness in case the original owner of the intellectual property files for bankruptcy.
Creating Incentives to Honor Licenses in Bankruptcy
If an intellectual property owner will not part with its ownership interests, the licensee may be able to build into its agreement incentives for the owner not to reject the license postbankruptcy. For instance, a licensee could secure performance of an agreement by having the licensor grant the licensee a security interest in the intellectual property. This would have the effect of converting a prebankruptcy general unsecured damage claim into a secured claim should the debtor/licensor choose to utilize its rights under section 365 of the Bankruptcy Code to reject or otherwise breach the license agreement..4
In a bankruptcy case, a secured licensee has leverage. It could threaten to foreclose on the security interests to satisfy claims rising out of the bankrupt ’s possible rejection or breach of its license agreement. It also could pressure the debtor/licensor to assume the agreement promptly by requesting adequate protection for the debtor/licensor ’s use of the licensee ’s collateral (which collateral should include the cash proceeds resulting from the licenses of the intellectual property) pursuant to the provisions of sections 361 and 363 of the Bankruptcy Code.
Such a security agreement must be carefully structured:
Collateral that secures the debtor/licensor ’s obligations to the secured party/licensee should be specifically described
. Failure to do so will result in an uncertain lien priority status postbankruptcy. Note that collateral may change with time.Representations must balance the desires of a debtor/licensor to keep information confidential against the need of a secured party/licensee to acquire information necessary to perfect and to protect its security interests in the intellectual property.
Events of default
: Take care not to condition the exercise of the security agreement solely upon the debtor/licensor ’s commencement of a bankruptcy case or its insolvency. Such events of default most likely will constitute unenforceable ipso facto clauses under section 365(e) of the Bankruptcy Code.Perfecting the security interest:
The licensee must take any and all steps necessary under applicable law to perfect the security interest against third parties. Unfortunately, it is usually unclear whether such a security interest must be perfected under the applicable state version of the Uniform Commercial Code (the "UCC") or under applicable federal law, such as the Patent Act, the Copyright Act, or the Lanham Act. The scope of Article 9 of the UCC — which has been interpreted to include computer programs, software, trade names, trademarks, trade secrets, goodwill, and licenses to use them — is limited and may be preempted by federal law. It maybe best to comply with both.
Conclusion
Investing in the intellectual property and technology of a financially troubled or startup company obviously carries inherent risks. Those risks largely can be eliminated through an outright purchase of the intellectual property and technology or by entering into a license to use the intellectual property and technology with a trust or another protected entity. Failing that, risks can be reduced by drafting licenses to take full advantage of the protections afforded under section 365(n)of the Bankruptcy Code.
Additionally, the entity may take a security interest in the intellectual property and technology not only to secure the financially troubled or startup company ’s performance of the license, but also to make the rejection of any such license in a bankruptcy case less attractive.
This Technology Commentaries is a publication of Jones, Day, Reavis & Pogue and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and the receipt of it does not constitute, an attorney-client relationship.
© 2001 Jones, Day, Reavis & Pogue. All rights reserved.
