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A Primer on the Treatment of IP Licenses in Bankruptcy
by Joseph Allen Kelly
Intellectual property rights can be among a company's most valuable assets. Whether a company licenses its intellectual property – or licenses intellectual property from another – a bankruptcy filing can create significant financial and operational uncertainty for both parties to the license agreement. The Bankruptcy Code provides the tools necessary for licensors and licensees to protect their interests. However, understanding how intellectual property rights will be treated in bankruptcy requires familiarity with the interplay between intellectual property law, Article 9 of the Uniform Commercial Code, and the Bankruptcy Code.
This article provides an overview of the UCC's treatment of intellectual property licenses, how these licenses are viewed under the Bankruptcy Code, and the assumption, rejection, and sale of these licenses in bankruptcy.
I. Licenses and Article 9
The UCC regulates the perfection of security interests in intellectual property rights. Under Article 9, intellectual property is considered a general intangible. U.C.C. § 9-102(42) and comment d. General intangibles must be perfected by recordation. See U.C.C. § 9-310(a). As a general rule, any payments received under a license are considered "proceeds" as they involve "rights arising out of collateral." U.C.C. § 9-102(a)(64)(C). Last, because a security interest perfected under Article 9 attaches to "any identifiable proceeds of collateral," (U.C.C. § 9-315(a)(2)), a properly perfected interest in an intellectual property license creates a properly perfected security interest in the proceeds from that license.
II. Trademark, Patent, and Copyright Licenses in Bankruptcy
Trademark Licenses
Lawyers typically think of intellectual property as encompassing patents, copyrights, trademarks, and trade secrets. The Bankruptcy Code, however, does not include trademarks in its definition of the term "intellectual property." 11 U.S.C. § 101(35A). The reason for this distinction is that trademark licensors use license agreements to control the quality of the goods or services associated with the mark. This allows a licensor to avoid consumer confusion and dilution or loss of the mark.
As will be discussed below, the Bankruptcy Code allows licensees of intellectual property under certain circumstances to retain the use of intellectual property over the objection of the debtor. By excluding trademark license rights from the Bankruptcy Code's definition of intellectual property, a licensor of a trademark is better able to control the quality and use of the mark.
Where a mark is used as collateral, only Article 9 perfection, not registration under trademark law, is sufficient to protect the secured party from avoidance by a bankruptcy trustee. (A quick note about two concepts imbedded in this last thought: (1) the term "trustee" is used in this article, but under the Bankruptcy Code, the term "trustee" includes a Chapter 11 debtor-in-possession; and (2) as used in this article, "avoidance" refers to the power of the trustee under certain circumstances to reach back and undo a transfer of an interest in property that took place prior to the filing of the bankruptcy case.)
Patent Licenses
Patent licenses are essentially contracts under which the licensor agrees to not sue the licensee for infringing the licensor's bundle of otherwise exclusive patent rights. As will be seen below, under sections 363 and 365 of the Bankruptcy Code, a patent license may not be assigned by a debtor or assumed by a trustee over the objection of the licensor. When a patent serves as collateral, perfection under Article 9 is critical, as patent law recording requirements do not protect an assignee from a bankruptcy trustee's avoidance powers. See, e.g., In re Cybernetic Servs., Inc., 239 B.R. 917, 920-21 (B.A.P. 9th Cir. 1999), aff'd, 252 F.3d 1039 (9th Cir. 2001).
Copyright Licenses
Applicable case law reflects that it is very difficult to convey exclusive rights to a copyright without also transferring actual ownership of the copyright. So, for purposes of this article, it is only relevant to discuss nonexclusive copyright licenses. Under the Copyright Act, a nonexclusive license prevails over a conflicting transfer of copyright ownership under conditions where the nonexclusive license was taken in good faith prior to the alleged transfer of ownership. 17 U.S.C. § 205(e) (2006). Like patent and trademark licenses, an interest in a copyright license should be perfected by an Article 9 filing, despite pre-Revised U.C.C. precedent to the contrary. As a leading treatise on Article 9 counsels, "The careful lawyer will . . . file everywhere it is possible to do so with respect to a patent, trademark or copyright." White & Summers, Uniform Commercial Code § 30.12(b) (4th ed. 1995).
III. Assumption, Rejection, and Sale of Licenses under the Bankruptcy Code
The definition of "property" of the bankruptcy estate in section 541 of the Bankruptcy Code is broadly construed and includes licenses. Generally, intellectual property licenses are considered "executory contracts." Black's Law Dictionary defines an executory contract as one "under which debtor and nondebtor each have unperformed obligations and the debtor, if it ceased further performance, would have no right to the other party's continued performance."
For executory contracts such as licenses, the Bankruptcy Code generally permits a trustee to lease or sell the property (11 U.S.C. § 363), or to assume or reject them subject to court approval and certain other conditions (11 U.S.C. § 365). However, as will be shown below, when intellectual property is involved, the trustee's discretion is greatly curtailed by section 365(n) of the Bankruptcy Code.
Limitations on the Sale of Licenses in Bankruptcy
An important principle to keep in mind is that the Bankruptcy Code, particularly section 363 which provides for the sale of estate assets, does not expand the property rights of the estate beyond the parameters of nonbankruptcy law that creates the property right in the first place. For example, section 363(f)(1) makes clear that the trustee may not sell certain property if applicable nonbankruptcy law prohibits the sale. Similarly, the Lanham Act only allows the assignment of a trademark when it includes the goodwill associated with the trademark. See 15 U.S.C. § 1060(a)(1). Thus, a trustee cannot use section 363 of the Bankruptcy Code to request a sale that would otherwise violate the Lanham Act.
Assumption and Rejection of Licenses Where the Debtor Is a Licensee
There is some disagreement among the circuits as to whether a trustee can assume an executory contract otherwise unassignable under non-bankruptcy law. A plurality of circuits have held that the plain language of section 365(c) controls, and that the trustee cannot assume the license if the debtor could not assign the license under non-bankruptcy law absent consent of the licensor. See, e.g., In re West Elecs. Inc., 852 F.2d 79, 83 (3rd. Cir. 1988); In re Sunterra Corp., 361 F.3d 257, 269 (4th Cir. 2004); In re Catapult Entm't., 165 F.3d 747, 750 (9th Cir. 1999); In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994). As a result of these and similar cases, the majority of courts that have addressed this issue have held that, where the debtor is the licensee of intellectual property, the licensor, and not the trustee, has the power to decide the license's fate under section 365(c). This outcome protects the licensor's interest by ensuring that no one will use the licensor's intellectual property without its consent. This also provides debtors a strong incentive to think critically about what intellectual property licenses it needs to function as a going concern.
Assumption and Rejection of Licenses Where the Debtor Is a Licensor
The Bankruptcy Code provides a mechanism to balance the interests of the parties in situations in which the debtor is the licensor of intellectual property. Initially, the trustee has the power to decide whether it wishes to assume or reject the intellectual property right in question. If the trustee assumes the license, the licensee is obligated to continue to pay royalties to the licensor under the terms of the license. If the licensee then fails to perform its obligations, it risks breach or having the license terminated by the licensor.
If, on the other hand, the trustee decides to reject the license, the parties are governed by section 365(n). Specifically, if the trustee as licensor opts to reject the license agreement, the licensee can elect to treat the rejection as a termination of the license agreement or to retain its rights under the license agreement despite the rejection. If the licensee elects to retain its rights, section 365(n) allows the licensee to continue using the intellectual property rights that existed immediately before the filing of the bankruptcy petition. 11 U.S.C. § 365(n)(1)(B). In such a case, section 365(n)(2) requires the licensee to continue making all royalty payments to the debtor and waive any right to setoff for damages or to an administrative expense claim. 11 U.S.C. §§ 365(n)(2)(B), -(n)(2)(C)(i). If the licensee chooses not to retain its rights, the licensee is left with a general unsecured claim against the estate for contract damages, to be satisfied at the percentage received by other unsecured creditors in the case.
In this way, the Bankruptcy Code does not allow a licensee to hijack future royalty payments to offset losses that are otherwise not compensable in the bankruptcy proceeding. However, a licensee that accepts these limitations is allowed continued use of the intellectual property rights and, thus, is not unduly punished just because the licensor filed for bankruptcy protection.
IV. Conclusion
The bankruptcy filing of a party to an intellectual property licensing agreement creates issues that involve the intersection of Article 9, intellectual property law, and the Bankruptcy Code. Whether representing debtor or creditor, licensor or licensee, lawyers can protect client interests only by understanding how these statutory schemes overlap and work together.
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