Bankruptcy presents risks for, among many others, intellectual property (“IP”) licensees. Fortunately, there is a provision in the federal bankruptcy law that is designed to protect IP licensees when a licensor becomes insolvent.
The Intellectual Property Licenses in Bankruptcy Act was passed in 1988. It was added to Chapter 11 of the Bankruptcy Code as Section 365(n). Before the addition of Section 365(n), when an IP licensor went bankrupt, it could reject its IP licensing agreements and withdraw the authorizations it had previously granted to use its IP. This caused substantial harm to licensees’ businesses when they were structured around licensed IP.
Section 365(n) protects IP licensees, under certain conditions, by creating an option to continue using IP after a bankrupt licensor rejects an agreement.
Section 365(n) requirements
First, Section 365(n) does not protect all forms of IP. Instead, “intellectual property” is specifically defined in Section 365(n) as:
- trade secrets;
- plant varieties; and
- copyrights (including mask works).
Notably, trademarks are excluded. However, some federal bankruptcy courts have taken steps to work around this exclusion.
Second, Section 365(n) only pertains to licenses that are “executory.” The Bankruptcy Code does not define this term, but most bankruptcy courts use what is known as “the Countryman definition” to determine whether agreements are executory. Under this definition, an executory contract is one that requires future performance by both parties. IP licenses typically meet this definition because there are usually ongoing duties owed by both the licensor and licensee. IP license agreements usually require the licensor to refrain from suing the licensee during the term of the agreement, and usually require the licensee to make payments in exchange. Non-executory licenses, in contrast, are agreements where one or both parties do not have ongoing responsibilities. This means one or both sides of the contract have been completely performed, such as with certain IP licenses, where the licensee has paid a lump sum for use of the IP.
Assumption and assignment of executory IP agreements
In bankruptcy proceedings, an insolvent company may deal with its executory agreements in one of three ways: assumption, assignment or rejection.
When a bankrupt company assumes an agreement, it agrees to continue meeting its obligations in the agreement. The Bankruptcy Code requires that, when an agreement is assumed, the insolvent company must accept the agreement’s terms in their entirety. But parties may (and often do) re-negotiate terms during the course of the bankruptcy. For example, the parties may agree to delay payments or limit technical support.
If a bankrupt company assumes an agreement, it must also cure any pre-bankruptcy defaults that occurred under the agreement.
The Bankruptcy Code also authorizes insolvent companies, in certain circumstances—after they have assumed an agreement—to assign their obligations to another party. Typically, the insolvent company may assign its obligations even if there is a provision in the agreement barring assignment. The insolvent company, however, must show that that the assignee is capable of performing the obligations in the agreement. Also, provisions in copyright and state law can prevent an assignment if the license is exclusive and the licensee does not consent to the assignment.
Section 365(n) offers no protection to licensees with respect to assignments, and if an IP license is assigned, licensees can be left exposed to several risks. For example, the insolvent company may assign the agreement to a competitor of the licensee.
Rejection of executory IP agreements
Under the general federal bankruptcy law provisions, bankrupt companies can reject executory agreements. When an agreement is rejected, the insolvent company is no longer required to meet its obligations under the agreement.
When an agreement is rejected by a bankrupt company, the solvent company’s remedy, in general, is a breach of contract claim. However, breach of contract claims brought by IP licensees are typically unsecured. In other words, an IP licensee’s potential damages for breach of an IP agreement are a function of several factors: the number of creditors, the order of securitization of the various creditors’ debt, and where the licensee falls in that line. Given these considerations, the licensee will almost never recover the full amount that it is owed. Moreover, the licensee will not be able to continue to use the IP it contracted for, and if it does, it may expose itself to a breach of contract claim.
Section 365(n) is designed to protect IP licensees in the event an IP agreement is rejected. If an insolvent party rejects an executory IP agreement, Section 365(n) allows licensees to elect to retain certain rights under the license for the remaining duration of the agreement.
In order to take advantage of the protections afforded by Section 365(n), the licensee must make a written request to the insolvent company, within a certain window of time. The request must be made after the bankruptcy petition is submitted but before the insolvent company makes a decision to assume or reject the agreement.
The rights afforded by Section 365(n) are limited in certain respects. The licensee’s right to continue to use the IP only extends to the state of the technology at the date of the bankruptcy filing. So, for example, an insolvent licensor has no obligation to provide the licensee with updates or upgrades after a licensee invokes Section 365(n). This is more important to some licensees than others; for example, updates may be very important to software licensees, but less important for IP licenses related to industrial manufacturing processes.
IP licensees and their counsel should be aware of Section 365(n) and its conditions and requirements. These conditions and requirements should be kept in mind when drafting IP licenses. Also, licensees should be vigilant in tracking their IP licensors’ financial outlooks so that, if a time comes when they need to do so, they can avail themselves of the protections afforded by Section 365(n).