In November 2021, Bitcoin reached its peak at over $68,000 per coin. The NASDAQ sat over 16,000. And homes were being snatched up at record prices at a record pace. What a difference a year makes.
Inflation has taken a big bite out of consumer spending. The Federal Reserve has increased interest rates. Cryptocurrency and stock prices have dropped substantially. Housing has slowed. And many economists, financial analysts and business leaders are calling for a bumpy economy—and possibly a recession—in 2023.
Not surprisingly, this has led to greater financial uncertainty for many businesses, resulting in more loan defaults and a significant year-over-year increase in bankruptcy filings. The American Bankruptcy Institute reports that commercial chapter 11 bankruptcy cases increased in November 2022 by 74% relative to November 2021.
Given the rise in bankruptcies, it’s important to consider the implications of bankruptcy law on intellectual property (IP), as more companies will almost certainly be dealing with these issues in the year to come.
One of the most common and important IP issues that arises in a bankruptcy case is what impact bankruptcy law has on the rights of IP licensees and licensors.
The Bankruptcy Basics
An outstanding IP license is generally treated as an “executory contract,” which means a contract under which both parties have continuing obligations to perform. An executory contract may be either “assumed” or “rejected” by the bankrupt debtor, in its business judgment, subject to certain conditions,
If an executory contract is assumed, the debtor must continue to fulfill its obligations under the contract and “cure” (i.e., pay to the contract counterparty) any pre- or post-bankruptcy filing amounts due under the contract. If the contract is rejected, the rejection is treated as a breach by the debtor, and the counterparty to the contract is left with a claim in the bankruptcy for rejection damages caused by the breach.
IP Licenses in Bankruptcy
While the rules around assumption and rejection of executory contracts may seem pretty straightforward based on the description provided above, things get a bit more complicated when the contract at issue is an IP license. The options and outcomes differ based on whether the bankrupt debtor is an IP licensee or licensor.
Debtor as Licensee
If a debtor is the licensee, and the license contract is executory, the debtor may choose to reject the contract if, for example, the debtor has no use for the license or deems it unprofitable. In the event of rejection, the non-debtor licensor could file a claim in the bankruptcy proceedings, although its claim for damages would be limited to a pre-petition claim—likely unsecured—which in most bankruptcies receives mere pennies on the dollar in terms of a recovery.
If, on the other hand, the debtor decides to assume the contract (i.e., it wants to continue to utilize the license during and after emergence from bankruptcy), the analysis becomes more complex. It’s common for IP licenses to be unassignable to a third party. However, the Bankruptcy Code, in general, permits debtors to assume and assign contracts to third parties. This often happens in the context of a sale process in bankruptcy, where a third party buys the debtor’s assets in what’s referred to as a “363 sale.”
IP licenses are treated differently under the Bankruptcy Code to protect an IP licensor from having their IP assigned by a debtor-licensee to a third party without their consent—and in some jurisdictions (the Third, Fourth, Ninth and Eleventh Circuits) debtors are not even allowed to assume an IP license in the first place. Section 365(c) of the Bankruptcy Code generally bars the assumption or assignment of a contract where applicable law prohibits it without consent. Pursuant to, for example, patent law, only the patent owner can assign a patent. And many state laws prohibit IP licensees from assigning licenses without consent, so “applicable law” generally prohibits assignment in bankruptcy.
Debtor as Licensor
In the past, if a debtor-licensor decided to reject an IP license it granted to a non-debtor contract counterparty, the third party’s rights to the license would be terminated upon rejection. In 1988, to protect the rights of non-debtor licensees, Congress added a carve out in the form of Section 365(n) of the Bankruptcy Code.
Section 365(n) provides that, in the event of the rejection of an IP license agreement by a debtor, the licensee can choose either to treat the contract as terminated or to retain its rights and continue to utilize the IP for the remainder of contract term.
However, the rights granted to licensees under Section 365(n) are limited to only certain types of IP defined in the Bankruptcy Code, including (i) trade secrets, (ii) an invention, process, design or plant protected under Title 35, (iii) a patent application, (iv) a plant variety, (v) a work of authorship protected under Title 17, and (vi) a mask work protected under Chapter 9 of Title 17.
To the extent the licensee elects to retain its rights under the rejected license, its rights are limited to those that existed before the debtor filed for bankruptcy, and the licensee must continue to pay royalties.
It’s important to note that trademarks are not included in the Bankruptcy Code’s definition of “intellectual property,” which, before 2019, meant that licensees of trademarks could not avail themselves of the protections of Section 365(n). In 2019, the U.S. Supreme Court ruled in Mission Product Holdings Inc. v. Tempnology, LLC that despite a debtor-licensor’s rejection of a trademark license, the licensee retains the rights to the licensed marks for the remainder of the license term, which effectively means that trademark licenses are treated the same way as other IP licenses under Section 365(n).
Be Proactive to Protect Your IP
Ups and downs in the economy are inevitable, which means it’s always a good idea for businesses to take steps to protect themselves against risks such as a customer or supplier, or IP licensor or licensee, filing for bankruptcy. If your business is a licensor or licensee of IP, monitor the financial health of those you do business with. Build protections into IP licensing agreements. For example, a licensee of IP should seek to make clear in the underlying agreement that the IP falls within the parameters of Section 365(n) of the Bankruptcy Code so that it can avail itself of its protections should a licensor reject the agreement in bankruptcy.
There is no way to completely mitigate the risks from a contract counterparty’s bankruptcy filing, but with careful planning and diligent oversight, an IP licensor or licensee can limit the damage and protect its rights.
