A Non-Debtor’s Intellectual Property Rights In Light of A Licensor’s Declaration of Bankruptcy

Intellectual Property   |   Creditors’ Rights and Bankruptcy   |   February 6, 2012

It is no mystery that the past few years have been plagued by an overwhelming increase in the amount of bankruptcy filings. In many instances, the bankruptcy filers own intellectual property, including patents, trade secrets, copyrights, and trademarks, that they have licensed to various entities. As a result, these entities, or non-debtor licensees, may find themselves in a quandary having to evaluate how their intellectual property rights will be impacted by the bankruptcy proceedings of the debtor licensors. This article considers a few of the options that may be available to non-debtor licensees.

Licensee’s Retention of Rights Under An Intellectual Property License

One of the first steps involved in evaluating the rights of a non-debtor licensee is determining whether the intellectual property license is an “executory contract.” That determination hinges upon whether material unperformed obligations remain on both sides of the license agreement. If the court determines the license agreement to be executory, the debtor can either accept the benefit of a profitable contract, by “assuming” the contract and fully performing, or avoid the burden of an unprofitable contract, by “rejecting” the contract and paying specified damages. The court may authorize the “assumption” if the benefit to the estate outweighs the burden imposed on the estate by continued performance under the contract.

Conversely, a court may allow “rejection” when the debtor believes, in its business judgment, that a contract would be burdensome to its reorganization. When the debtor rejects an executory contract, the contract is treated as if it had been breached as of the filing date of the debtor’s bankruptcy petition. 11 U.S.C. § 365(g)(1). The debtor is relieved of further affirmative obligations set forth in the contract. In return, the non-debtor receives a general unsecured claim for damages against the debtor’s estate. 11 U.S.C. § 502(g)(2).

Section 365(n) was added to the Bankruptcy Code to specifically address a non-debtor licensee’s intellectual property rights where the debtor licensor rejects the license. According to Section 365(n), in that situation, the non-debtor licensee can essentially override the rejection and “retain” its rights under that agreement – rather than just settling for a general unsecured claim against the debtor licensor’s estate. 11 U.S.C. § 365(n)(1)(B). Consequently, the debtor licensor must provide the licensee with the intellectual property (including any embodiments) that existed immediately before the filing of the case. 11 U.S.C. § 365(n)(3)(A). Also, the debtor licensor cannot interfere with the licensee’s rights to use such intellectual property or to obtain it from a third party. 11 U.S.C. § 365(n)(3)(B). However, the non-debtor licensee must continue to make all royalty payments due under the license. 11 U.S.C. § 365(n)(2)(B).

Utilizing Escrow Agreements To Ensure Access To Retained IP.

Section 365(n) does not, however, provide complete protection. Rather, it covers only licensed intellectual property that exists as of the date of the bankruptcy filing. The non-debtor licensee has no right to any intellectual property created after the bankruptcy, such as a new software release. When the creation date is at issue, the licensee may provide corroboration through the utilization of an intellectual property escrow agreement. This type of agreement provides for a third party to hold documents and information concerning intellectual property such as source code, product designs, or laboratory notebooks.

An intellectual property escrow may be established upon the execution of a license agreement. Thereafter, the licensor has an affirmative duty to update the escrow as the intellectual property is updated. It is imperative that the licensee monitor the licensor’s performance of these provisions so the most current version of the intellectual property is always in the escrow, particularly at the time of the bankruptcy filing.

An escrow agreement may further protect the licensee’s use of technology by removing the licensor’s control over the intellectual property and placing it for safekeeping with a third party. Thus, an escrow arrangement can potentially keep the intellectual property altogether out of the debtor’s estate.

Of course, the non-debtor licensee has no right to receive post-bankruptcy services, such as software maintenance and technical support. In other words, there is no affirmative duty of the part of the debtor licensor to continue performing after filing.

Transfer of Intellectual Property Rights During Bankruptcy.

Another issue that arises during bankruptcy proceedings is when a licensor attempts to assign a license at issue or sell the underlying intellectual property. The licensee may desire to purchase the intellectual property or to prevent transfer to a competitor or an unacceptable potential business partner. Special attention must be given to non-bankruptcy intellectual property law, which can affect such an assignment or sale, and consequentially the value of the licensee’s intellectual property rights.

Where a debtor licensor attempts assignment of the license, Section 365(c)(1) provides that a trustee may not assign an executory contract, whether or not the contract prohibits assignment, if: (i) applicable law excuses the non-debtor from accepting or rendering performance, and (ii) the non-debtor does not consent. As such, the applicable law relating to the specific underlying intellectual property must be considered.

Where a debtor licensor attempts to sell its intellectual property rights, other than in the ordinary course of business, Section 363(b)(1) provides that a trustee may generally sell estate property after notice is given to all creditors and parties in interest, and a hearing is held in open court. As long as the sale order provides that the sale is free and clear of all liens, the purchaser of the intellectual property can be confident in its title. Under Section 363(f), a sale is free and clear of liens of another if applicable non-bankruptcy law permits it. Accordingly, the law relating to the particular intellectual property that is part of the debtor’s estate must be considered.

For example, intent-to-use based trademark applications can only be assigned to successors to the business of the applicant if that business is still existing and on-going. 15 U.S.C. § 1060(a)(1); 37 C.F.R. 3.16. The assignment of an intent-to-use application to an entity that is not the successor to the applicant’s business before filing an allegation of use renders the trademark application and any resulting registration void. Trademark Manual of Examining Procedure 7th Edition 501.01(A) (2010); see also The Clorox Co. v. Chemical Bank, 40 USPQ 2d 1098 (T.T.A.B. 1996). In contrast, a trademark for which an actual-use application has been filed, or a registered trademark, shall be assignable with the goodwill of the business in which the mark is used. 15 U.S.C. § 1060(a)(1). In other words, such a trademark may not be sold to any other party except in connection with a sale of the underlying business. Otherwise, the application becomes void and any subsequent registration is subject to cancellation.

Relief From An Automatic Stay On The Sale of Intellectual Property Rights.

Another issue to be considered by a non-debtor licensee is the impact of an automatic stay, which may limit the debtor’s ability to sell its intellectual property. Section 362(a) stays any act of debt collection against the debtor’s property once the debtor files for bankruptcy. A sale of intellectual property may constitute debt collection, and hence amount to a violation of the automatic stay. See In re Just Brakes Corporate Sys., Inc., 108 F.3d 881 (8th Cir. 1997).

However, a non-debtor licensee, as a party-in-interest, may obtain relief from the stay upon a showing of cause. 11 U.S.C. § 362(d)(1). In the context of a trademark or patent application, such cause may be shown where a debtor failed to respond to an office action from the U.S. Patent and Trademark Office, or failed to pay required fees. These omissions may result in a lack of adequate protection for a licensee of the trademark or patent.

As explained above, many of the above provisions depend on court interpretation of the Bankruptcy Code and applicable intellectual property law. For example, whether or not an intellectual property license is an executory contract depends on the particular terms of the agreement. As such, counsel from both bankruptcy and intellectual property attorneys is advised.

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