In October 2014, GT Advanced Technologies (GT), a Delaware corporation with a principal place of business in New Hampshire, filed a petition for relief under Chapter 11 of the Bankruptcy Code (Code) in the District of New Hampshire. The locus of the filing was somewhat of a surprise to many, given the steady migration of large Chapter 11 cases to the so-called “magnet” bankruptcy venues of Delaware and the Southern District of New York. Although GT’s motivation for filing in New Hampshire is unclear, some of the advantages awaiting debtors that file in the First Circuit are apparent, particularly in the realm of intellectual property (IP) licensing. In-licensed IP rights — the right of a debtor as licensee to use IP owned by a third party — are often among the most valuable assets in a business bankruptcy case, but a debtor’s ability to maximize that value may vary greatly depending on the venue where the bankruptcy petition is filed.

The starting point for examining this value variance is Code section 365, which authorizes a debtor to reject, assume, or assign executory contracts. Although the term “executory contract” is not defined by the Code, it is commonly understood to embrace a contract under which both parties have material unperformed obligations. Most IP licenses typically qualify as executory contracts because their standard terms usually create ongoing material obligations, such as the duty to maintain IP, covenants not to sue for infringement, territorial restrictions and the payment of royalties.1

Once it is clear that section 365 applies to a debtor’s IP in-license, section 365(c) must be considered. That provision precludes a debtor from assuming or assigning an executory contract, i.e., keeping or transferring its license rights, where: (i) “applicable law” excuses the counterparty from accepting performance from or rendering performance to an entity other than the debtor; and (ii) the counterparty does not consent to the assumption or assignment. There is sharp disagreement over the proper interpretation of section 365(c) in a number of respects. Specifically, there is a divide with respect to whether a debtor can assume (keep for itself) an IP license without the consent of the licensor even where there is no intent to assign the license to a third party.

A slim majority of federal appellate courts, including the Third Circuit Court of Appeals, interpret the plain language of section 365(c) as creating what has been dubbed a “hypothetical test,” which evaluates a debtor’s ability to assume based on whether applicable law would permit the debtor hypothetically to assign the license to a third party, even where no assignment is planned. See, e.g., In re West Electronics Inc., 852 F.2d 79 (3d Cir. 1988). Importantly, federal patent, copyright and trademark laws — considered “applicable law” under section 365(c) — generally restrict a licensee’s ability to transfer IP rights without the licensor’s consent. Consequently, in jurisdictions such as the Third Circuit (which includes Delaware), an IP licensee may only assume a license if the licensor consents. In addition to express consent after the bankruptcy filing, consent may come in the form of advance consent granted in the license itself (although there could be a dispute as to how express that consent must be), and may be implied from notice and failure to object (subject to due process and similar concerns). In certain jurisdictions, other mechanisms may exist for retaining rights under a license absent formal assumption.

In contrast, other courts, including the First Circuit Court of Appeals, have adopted what has been called an “actual test” for determining whether a debtor licensee may assume an executory contract. Under that test, a court must determine whether the debtor actually intends to transfer the license, thereby forcing the licensor to accept performance from a third party. If so, the debtor is prevented under section 365(c)(1) from assuming the license. The actual test provides two significant advantages to debtors in the First Circuit. First, it increases flexibility in reorganizations by allowing debtors to use valuable licensing rights in their continuing business operations. Second, subject to certain limitations, debtors may be able to effect what some have referred to as “de facto assignments” of license rights through a stock sale. In the seminal case on this point, Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1996), the First Circuit held that a debtor’s sale of all of its stock did not constitute an assignment of the debtor’s patent license because, notwithstanding the change in stock ownership, the debtor remained the counterparty to the contract. In other words, because a corporation is distinct from its shareholders, a stock sale — as opposed to a merger — does not effect a transfer of title that would run afoul of federal patent law. Of course, the First Circuit indicated that a case-by-case analysis is required, and it seems unlikely that a court would permit a debtor simply to continue on in perpetuity as a shell for the enjoyment of IP rights by third parties.2 The U.S. Supreme Court in 2009 recognized the importance of the circuit split on the actual vs. hypothetical test issue, but declined to take up the question in the context of the case it was deciding. A good case for Supreme Court review is likely to percolate at some point.

Notably, a different analysis is required — and venue matters in different ways, not necessarily highlighted in the First Circuit as of yet — where the debtor is a licensor. Although a bankrupt licensor is free to reject executory contracts, section 365(n) provides additional protections to licensees of “intellectual property.” Interestingly, the Code’s definition of intellectual property encompasses copyright and patent rights, but makes no mention of trademark rights. Consequently, the licensee of a rejected copyright or patent license agreement can elect to retain its rights under the agreement so long as it makes the required royalty payments, while the licensee of a trademark is at risk of losing its license. However, in recent years, courts have indicated an increased willingness to protect the rights of trademark licensees. For example, in the recent case of In re Crumbs Bake Shop Inc., 522 B.R. 766 (Bankr. D.N.J. Nov. 3, 2014), the Bankruptcy Court held based on the plain language of section 365 and on equitable principles that a trademark licensee could retain its rights following rejection by the debtor. In reaching its decision, the Bankruptcy Court relied in part on the Seventh Circuit’s decision in Sunbeam Products Inc. v. Chicago Am. Mfg. LLC, 686 F.3d 372 (7th Cir. 2012), in which the court held that rejection results only in a breach of the license agreement; it does not vitiate the licensee’s rights to continue to use the licensed IP. While legislation is currently pending in Congress that would result in the express inclusion of trademarks in the Code’s definition of “intellectual property,” this remains an open issue in Massachusetts, and there is fertile ground for argument on each side.

Although this article merely scratches the surface of the interplay between IP rights and bankruptcy, it hopefully serves as a reminder of the importance of the subject and the role that bankruptcy venue can play in affecting the substantial rights of the parties to a license agreement. Understanding the distinctions in the treatment of IP in different venues presents planning opportunities at the outset of the licensing relationship. While “drafting around” the section 365 case law may or may not be respected in bankruptcy, and while venue remains a relatively open choice for parties filing bankruptcy petitions, it is certainly worth considering whether contractual language or structural changes may mitigate bankruptcy risks for license parties. This continues to be a developing area of the law and, whether one is representing a client contemplating bankruptcy, contemplating a license agreement or contemplating a bankruptcy litigation strategy, understanding the interplay between these two fields is essential.

- Justin Kesselman