Licensing in Bankruptcy

Published in:

NABT American Bankruptcy Trustee Journal
The Official Publication of the National Association of Bankruptcy Trustees
Volume 38, Issue 02, Spring 2022

By Scott Douglass, Patterson Intellectual Property Law, P.C., Nashville, Tennessee, Dominic Rota, Esquire, Patterson Intellectual Property Law, P.C., Nashville, Tennessee and Michael Wennerlund, Esquire, Bell, Carrington, Price & Gregg, LLC, Franklin, Tennessee

| Bell Carrington

Introduction

The COVID-19 pandemic disrupted the financial present and economic future of businesses leading to a 10-year high of corporate bankruptcies in 2020.1 This list includes Rubie’s Costume Co., Pier 1 Imports, Gold’s Gym, Brooks Brothers, Cirque du Soleil, J. Crew, Stein Mart, and Guitar Center.2 And, many more small businesses across the United States have been devastated by mandatory lockdowns and voluntary shutdowns.

Bankruptcy affects not only company’s ability to continue to conduct business, but also its capacity to preform preexisting obligations under contracts with third parties, including licenses for intellectual property (e.g., copyrights, trademarks, or patents). The U.S. Bankruptcy Code’s prohibition on interfering with the rights of a licensee in a contract with a bankrupt licensor turns a pedestrian issue of creditor’s rights into an acute legal dispute at the intersection of bankruptcy, intellectual property, and contract law. The pandemic has provided interesting context for the Supreme Court’s recent decision clarifying a licensee’s rights when a licensor files for bankruptcy.

Primer on Bankruptcy and Licenses

Like real or personal property, intellectual property is considered an asset that could be the subject of disposition in bankruptcy proceedings. Licensing agreements for intellectual property are subject to disposition in a bankruptcy, just as other commercial contracts would be. Accordingly, a petition for bankruptcy protection could dramatically disrupt the relationship between a licensor and licensee, even in the absence of other liabilities or assets one might be accustomed to seeing in a commercial bankruptcy.

The Bankruptcy Code provides that a petition for bankruptcy, whether filed by a debtor or creditor, triggers an “automatic stay.”3 During an “automatic stay,” a creditor is prevented from taking any further legal action against the debtor (and the debtor’s estate) with respect to debts owed prior to the commencement of the bankruptcy proceedings. Among other things, the stay preserves the rights of the debtor and its estate, so that the debtor’s business may continue to function uninterrupted while the debtor, creditors, and trustee determine the goal of the bankruptcy and the means through which the goal will be achieved. One of the means of preserving a business and navigating out of bankruptcy is to decide which contracts and agreements can or should be accepted or rejected.

About the Authors

Scott Douglass is a shareholder at Patterson Intellectual Property Law, P.C. in Nashville, Tennesee. He advises clients on brand protection, licensing, and enforcement issues and litigates trademark and copyright disputes. Scott can be contacted at smd@iplawgroup.com.

Dominic Rota is a registered patent attorney at Patterson Intellectual Property Law, P.C. in Nashville, Tennessee. He prosecutes, enforces, and litigates patent and trademark issues, and guides clients to compliance with information security and data privacy standards. Dominic can be contacted at dar@iplawgroup.com

Michael Wennerlund is the Managing Attorney for Tennessee at Bell, Carrington, Price & Gregg, LLC in Franklin, Tennessee. He represents financial institutions and creditors generally in federal and state courts. Michale can be contacted at mwennerlund@bellcarrington.com.

Most intellectual property licensing agreements contain language authorizing the licensor or licensee to terminate the license if the other party enters bankruptcy. This clause is known as an ipso facto clause because the condition for termination is automatically triggered by the mere act of filing the petition for bankruptcy. Yet, the Bankruptcy Code also entitles a debtor to “assume or reject any executory contract.”4 Although the Bankruptcy Code does not define the term “executory contract,” the U.S. Supreme Court has nevertheless provided a definition, albeit a fairly broad one:”[a] contract is executory if ‘performance remains due to some extent on both sides.’”5 So despite its repeated inclusion, an ipso facto clause is generally unenforceable, as it is in contravention to the Bankruptcy Code’s provision entitling the debtor and trustee to accept or reject executory contracts for the benefit of the estate. The debtor’s statutory right to “assume or reject any executory contract” often shields the debtor from ipso facto clauses.

The Bankruptcy Code’s preservation of rights in the forms of the automatic stay and the prohibition on ipso facto clauses are factors in licensing intellectual property. But the loss of two tools normally available to a contracting party – termination and the right to sue – does not mean that the licensor and licensee are optionless when one of them enters bankruptcy. So, what can a licensor or licensee do?

Rights of a Licensee When a Licensor Seeks Bankruptcy Protection

When a debtor-licensor enters bankruptcy, it may be incentivized to terminate and reject any ongoing licensing agreements, freeing the debtor to license or assign its trademarks and thereby satisfy its debts to other creditors. Or a licensor may valuate its intellectual property and find that the licensing of its intellectual property is decreasing or diminishing the value of the intellectual property. Accordingly, the debtor may see fit to terminate its licensing agreements to bolster the value of its intellectual property assets at bankruptcy. After all, a function of bankruptcy is to maximize the value of the debtor’s assets and to move away from prior contracts that could prevent the debtor from meeting the demands of senior creditors.

However, the Bankruptcy Code is written for the protection of creditors as well as the debtor. Allowing a licensor to terminate a licensing agreement due to the licensor’s own bankruptcy would harm an “innocent” licensee by stripping the licensee of the license it had fairly negotiated and paid for, and still anticipated to benefit therefrom. Without the license, the licensee would not be allowed to sell the licensed goods or services to is customers, denying it the benefit of the agreement it made with the debtor-licensor. Moreover, a key component of a trademark license is the goodwill and reputation of the licensed property, which bolsters credibility, consumer recognition, and trustworthiness in the licensed brand sold by the licensee. So, does the “innocent” licensee have any rights in and to the licensed intellectual property, where the licensor has petitioned for bankruptcy?

Under 11 U.S.C. § 365(n)(1), where a licensor of intellectual property has entered into bankruptcy and the contract is rejected, a licensee of intellectual property may elect to either: (1) “treat such contract as terminated” or (2) “retain its rights…under such contract…for (i) the duration of such contract, and (ii) any period for which such contract may be extended by the licensee as of right under applicable non-bankruptcy law.” In other words, a licensee is statutorily enabled to continue to use the licensed intellectual property of the licensor, even where the licensor has entered bankruptcy.

One shortcoming of 11 U.S.C. § 365(n) is that it applies to certain forms of intellectual property such as trade secrets, patents, and copyright, but is completely silent on trademarks. Fortunately, the Supreme Court recently clarified this oversight. In Mission Prod. Holdings, Inc. v. Tempnology, LLC, the U.S. Supreme Court spe­cifically asked “whether the debtor-licensor’s rejection of [a licens­ing] contract deprives the licensee of its rights to use [a] trade­mark.”6 The Court answered it does not: “[a] rejection breaches a contract but does not rescind [the licensing agreement] .”7 Practically speaking, all rights that would ordinarily survive a breach of contract remain in place, even after the licensor has become bank­rupt. Thus, like other licensees of intellectual property, a trademark licensee may choose between two remedies: (i) treat the contract as breached, thereby entitling it to pursue any and all forms of relief (e.g., monetary damages) flowing from the breach of contract; or (ii) if possible, continue to exercise the licensee’s rights under the agreement, including use of the trademark.

While the Bankruptcy Code does not permit a creditor-Licensor or creditor-Licensee to terminate the Licensing agreement based solely upon the bankrupt state of the counterparty, the prohibition on terminating executory contracts does not bar a creditor from otherwise enforcing their Legitimate rights in the License.

Where a licensee elects to continue using its licensed rights, the bankrupt state of the licensor-and even the licensor’s rejec­tion of the contract-does not impede the licensee from continu­ing to perform under the licensing agreement. At worst, the li­censee would be entitled to seek damages for the time it was denied the benefit of the rejected agreement (as was the case in Mission Prod. after a court prohibited the licensee from using the marks). At that point, the licensee’s only remedy is to pursue a claim of breach of contract. Seeking damages for the debtor’s breach may not be an ideal solution, since the breach would be deemed to have occurred immediately before the bankruptcy. Thus, the debtor would be an unsecured creditor that is junior to more-senior creditors, but the ability to continue using the mark under the license agreement may be worth the trouble.

All in all, notwithstanding a licensor’s entry into bankruptcy and rejection of the licensing agreement, a licensee may con­tinue to make use of licensed intellectual property or may seek its damages from the debtor-licensor. Thus, an “innocent” li­censee may be spared the worst consequences of the licensor’s insolvency-rejection of the executory licensing agreement-by continuing to use the licensed intellectual property in accordance with the terms and conditions of the licensing agreement predat­ing the licensor’s bankruptcy.

Rights of a Licensor When a Licensee Seeks Bankruptcy Protection

A licensee’s bankruptcy may suggest that the licensee is not able to continue paying royalties under the license agreement. As the Bankruptcy Code generally disables the effect of an ipso facto termination clause, the licensor of the intellectual property likely cannot terminate the licensing agreement on the basis that a licensee has entered bankruptcy. Where does that leave a licensor against a bankrupt licensee?

While the Supreme Court did not take up this question, the answer would seem to be equivalent for licensees and licensors: the licensee’s rejection would constitute a breach, and the licen­sor could continue to perform, thereby demanding payment of ongoing royalties (if the licensee had the wherewithal to con­tinue using the marks) or payment of a minimum royalty (if one were included in the license agreement). In the absence of per­formance or payment of the minimum royalty, the licensor, probably now an unsecured creditor, would have to get in line and seek damages-and face the risk of a write-down that its fellow unsecured creditors would bear.

Alternative Remedies for the Creditor-Licensor or the Creditor Licensee?

While the Bankruptcy Code does not permit a creditor-licen­sor or creditor-licensee to terminate the licensing agreement based solely upon the bankrupt state of the counterparty, the prohibition on terminating executory contracts does not bar a creditor from otherwise enforcing their legitimate rights in the license.

For example, a creditor-licensor can prevent the licensee (i.e., the debtor) from assigning the licensee’s interest to a third party as part of the licensee’s restructuring. This creditor-licensor protection is rooted in the Bankruptcy Code, which states that a debtor-licensee may not assign an executory contract, such as a licensing agreement, where “applicable law excuses a party … to such contract … from accepting performance or rendering performance to an entity other than the debtor … whether or not such contract … prohibits or restricts assignment of rights …. “8 Under “applicable law” (i.e., non-bankruptcy law), a party may not generally assign its license in the intellectual property without consent of the licensor, as licensing agreements almost always contain a provision forbidding or prohibiting the licensee’s assignment of its interest in the license.

In other words, while a licensor may not be permitted to terminate a licensing agreement with a bankrupt licensee solely on the basis of the licensee’s bankruptcy, the licensor could prevent the licensee from transferring or assigning the licensee’s interest in the licensed intellectual property to a third party. This preserves the licensor’s crucial duty to monitor and enforce quality control over its licensed intellectual property. This protection can limit the damage a desperate, bankrupt licensee could do to a licensor’s brand by preventing the licensee from off-loading the license to a third party with whom the licensor would not otherwise contract.

Similarly, if the licensee fails to adhere to the quality control provisions found in a trademark license or abuses its rights under the license such that it infringes the licensor’s rights, the licensor may still take steps to protect itself. In these scenarios, the licensor may still terminate the license despite the licensee’s right to accept or reject contracts that it would otherwise enjoy (subject to other procedures required by the Bankruptcy Code). Licensors should consider including pro­visions that would be easy for a solvent licensee to satisfy, such as a minimum annual royalty and/or quality-control obligations but that could trigger the licensor’s option to terminate if the licensee entered bankruptcy and was inca­pable of meeting its contractual responsibilities. This may give the licensor all the leverage it needs to ensure termina­tion once a licensee becomes a debtor. If the licensor’s reason for terminating a license during the licensee’s bankruptcy stems from the licensee’s default on paying the royalty owed under the contract, the licensor may need to get involved in the bankruptcy in a different way: as a creditor getting in line with other creditors, all of which are seeking compensation for the licensee’s debt.

Notwithstanding the loss of a brand’s goodwill after a li­censee seeks bankruptcy protection, a licensor may still be able to exercise some degree of control over its licensed intellectual property by negotiating terms prohibiting the licensee from assigning its rights, by requiring a minimum annual royalty as well as running royalties, and by requiring other actions that a bankrupt licensee may find difficult to satisfy.

Licensees also can take steps to protect themselves before a licensing agreement ever gets construed in Bankruptcy Court. Primarily, the licensee should do its due diligence to ensure its licensor is in sound financial condition. And part of its due diligence should be to verify whether the to-be-licensed intel­lectual property is collateral to a security agreement with a third party. Intellectual property, like other forms of tangible property, may be used as collateral to satisfy a loan, or other valuable offering, by a third party.9 Prior to entering into a licensing transaction, a licensee should conduct some pre-li­censing due diligence to ascertain whether the to-be-licensed intellectual property has been proposed as collateral by the licensor for the benefit of a third-party creditor. The existence of prior security interests might be a red flag (for more than one reason) and thus could trigger additional requirements from the licensor to maintain the integrity of the brand.

A safeguard a licensee might plan for in negotiating its license agreement would be to withhold a year’s worth of minimum royalties. This anticipated pay-day might be enough to convince a debtor-licensor not to reject the licensing agree­ment at bankruptcy. Trademark licenses are required to include quality control provisions, and licensees justifiably expect that the brand’s value will not be diminished during the term of the license. Thus, it could be useful for the licensee to include a termination clause providing the licensee an escape hatch if the licensor’s bankruptcy drags on or sullies the goodwill associated with the licensed trademark, thereby destroying the value of the bargain for which the licensee originally contracted. Such provision could be as simple as allowing the licensee to terminate if a bankruptcy proceeding lasts more than 24 months.

Conclusion

The COVID-19 pandemic was expected to devastate the economy; surprisingly, however, fewer companies have sought bankruptcy protection than many anticipated.10 The COVID-19 pandemic brought the issues of bankruptcy and intellectual property licenses to the forefront. For bankrupt licensees, the consequences for the licensor are relatively straightforward: the licensor will likely be unable to meaningfully collect past­due or ongoing royalties or payments. For licensees of bankrupt licensors, the Bankruptcy Code and recent Supreme Court guidance provide some protections to ensure the license cannot be terminated without other cause. Notwithstanding these protections, parties to a licensing agreement, particularly a licensee, should conduct pre-licensing due diligence to ascertain if there are any issues of title, right, or interest in the to-be-li­censed intellectual property.

Endnotes

1 Tayyeba Irum, Chris Hudgins, US Corporate Bankruptcies End 2020 at IO-Year High Amid COVID-19 Pandemic, S&P Global (January 5, 2021), available at https://www.spglobal.com/ marketin telligence/ en/news-insights/latest-news-headlines/ us-corporate-bankruptcies-end-2020-at-10-year-high-amid­covid-l 9-pandemic-61973656.

2 Emily Paradise, F om Brooks Brothers to L’Occitane, Main Street Bankruptcies Continue, NBC News (February 2, 2021), available at https://www.nbcnews.com/business/consumer/which­maj or-retail-companies-have-filed-bankruptcy-coronavirus­pand emic-hit-n1207866.

3 See 11 U.S.C. § 362(a).

4 11 U.S.C. § 365(a).

5 Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019) (quoting NLRB v. Bi/disco & Bi/disco, 104 S.Ct. 1188, 1194 n.6 (1984)).

6 Mission Prod., 139 S. Ct. at 1657.

7 Mission Prod., 139 S. Ct. at 1657-58 (emphasis added).

8 11 U.S.C. § 365(c)(l)(A).

9 Article 9 of the Uniform Commercial Code (“U.C.C.”) defines a “general intangible” as “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction,” including “payment intangibles and software.” U.C.C. § 9-102(a)(42). Although Article 9 fails to explicitly classify intellectual property, it has come to be classified as a “general intangible,” which is a form of “catch-all” for all forms of collateral not explicitly defined in Article 9 of the U.C.C.

10 Bankruptcy Filings Drop 24 Percent, United States Courts (February 4, 2022), available at https://www.uscourts.gov/ news/2022/0 2/04/bankruptcy-filings-drop-24-percent.