Since 1988, section 365(n) of the U.S. Bankruptcy Code has protected licensees of intellectual property from having their licenses rejected by an insolvent licensor.  While this statute addresses certain contingencies and exceptions, the basic rule is that an insolvent licensor is not free to terminate (or ‘reject’) an intellectual property license the way it is free to shed itself of other contracts.

But what if the licensor is based overseas and licenses U.S. patents? In Jaffe v. Samsung Electronics Company, the Fourth Circuit Court of Appeals recently addressed that first-of-its-kind question.

Chapter 15 of the Bankruptcy Code includes a procedure, based upon a model law promulgated by the UN, by which the administrator of a foreign bankrupt company can ask a U.S. bankruptcy court for permission to control the bankrupt company’s U.S. assets and for an array of other privileges, including the right to prevent creditors from taking actions that would frustrate the foreign proceeding and the right to examine witnesses and seek the production of documents. In weighing such a request, a U.S. bankruptcy court is authorized to consider the interests of the insolvent, its creditors, and others affected by the request.

In 2009, Qimonda AG, a large German semiconductor manufacturer, filed for bankruptcy in Germany.  Its principal asset was a portfolio of about 10,000 patents, roughly 4,000 of which were U.S. patents. These patents were subject to cross-license agreements with other industry players. Dr. Michael Jaffe was appointed as the German bankruptcy administrator for Qimonda.

Dr. Jaffe applied to the U.S. bankruptcy court for recognition under Chapter 15 of the Bankruptcy Code and for powers within the U.S. that a bankruptcy trustee in a U.S. proceeding would ordinarily have.  The court granted the request, but made it conditional on compliance with section 365.

With Qimonda basically out of business, it had nothing to gain from the incoming license rights that it had obtained in the cross-licenses.  Dr. Jaffe undertook to monetize the patent portfolio by notifying all parties to the cross-license agreements that the licenses were being terminated under the German bankruptcy proceeding.  Dr. Jaffe’s plan was to re-license these patents for the benefit of Qimonda’s creditors, replacing the in-kind cross-licenses with royalty-bearing licenses.

Upon receiving this notification, several licensees, principally Samsung, ran to court to argue that section 365(n) protected them from such a rejection of their cross-licenses.  Dr. Jaffe persuaded the court to drop its requirement that section 365(n) be followed.  The bankruptcy court decided to defer to the German courts.

The Qimonda licensees appealed to the U.S. District Court, which concluded that the bankruptcy court had not given enough thought to the question and remanded the case with instructions to consider the issues presented a little more deeply.

On remand, Dr. Jaffe adopted a clever approach.  He offered to make Qimonda’s patents available to all comers on reasonable and non-discriminatory (RAND) terms.  Should there be any difficulty in ascertaining what those terms might be, Dr. Jaffe offered to submit the question to binding arbitration before the World Intellectual Property Organization (WIPO), a UN agency based in Geneva.

Dr. Jaffe presented an expert who testified that these RAND licenses would probably yield a modest $47 million annually in license revenue.  In contrast, the licensees’ expert was less sanguine, predicting that Dr. Jaffe’s tactics would destabilize the semiconductor industry, reduce investment and innovation in the U.S. and harm consumers worldwide.

After a four-day hearing, the bankruptcy court determined that it would do more harm than good to permit the termination of the cross-licenses.  It also found that to permit such a termination would violate a fundamental public policy of the United States.  Dr. Jaffe appealed this ruling to the Fourth Circuit Court of Appeals.

Several parties filed amicus briefs in this appeal.  Oddly, the United States supported Dr. Jaffe, saying that the bankruptcy court had no business dictating the terms of a German insolvency proceeding.  Several major U.S. trade organizations took the contrary point of view.

The court of appeals agonized over the balancing of interests that the bankruptcy court had engaged in, ultimately supporting its conclusion.  Two of the three appellate judges also approved the bankruptcy court’s finding that section 365(n) expresses a fundamental principle of US public policy, and that it had the power to apply such a policy in this context.

The court of appeal’s ruling included a few points of particular interest.  First, while the offer to license the Qimonda patents on RAND terms was significant, many parties to the cross-license agreements had built very substantial manufacturing facilities in reliance upon these (and other) cross-licenses.  With this enormous sunk cost, these companies were no longer in a position, as they might have been earlier, to design around the Qimonda patents.

Second, the court pointed out that if the existing cross-licenses could be rejected in a German bankruptcy proceeding and replaced with a royalty-bearing license, nothing would prevent a third party from forming a subsidiary that would purchase those patents, filing for insolvency in Germany, rejecting these RAND license agreements and then suing the semiconductor companies for infringement.  The word “troll” appears in this discussion.

Jaffe v. Samsung is a win for a Korean manufacturer over a German bankruptcy administrator in United States courts.  It is also a victory for the many industries that rely extensively upon cross-licenses to clear the patent thicket that confronts them, and for all companies that rely upon in-licensed U.S. intellectual property rights held by foreign owners.  The common understanding that licenses survive bankruptcy remains undisturbed, at least here in the United States.  In Germany, not so much.

The ruling in this case has two independent supports.  The first is the balancing of interests, which was fact-intensive and stands to vary substantially from case to case.  The second was the public policy ground, which promises to be more durable even when cases with different fact patterns arise in the future.