• A Practitioner's Guide To Section 365(n) Of The U.S. Bankruptcy Code
  • April 29, 2003 | Author: Michael R. Egger
  • Law Firm: Fenwick & West LLP - San Francisco Office
  • Practitioners who draft license agreements that involve intellectual property are well advised to be familiar with the provisions of Section 365(n) of the U.S. Bankruptcy Code. Section 365(n) specifies certain rights and obligations of licensors and licensees with respect to licenses of intellectual property following a licensor's filing of bankruptcy (for the purposes of this article, a licensor that has filed for bankruptcy is sometimes referred to as the "trustee"). Section 365(n) does not apply in the event a licensee files for bankruptcy.

    Under U.S. bankruptcy law, the trustee has the right to assume or reject executory contracts (which include licenses of intellectual property). In order to assume an executory contract, the trustee must cure any defaults, compensate the licensee for any damages incurred by the licensee as a result of any defaults and provide adequate assurances of future performance. As to an intellectual property license, if the trustee assumes the license, the licensee's rights remain in effect as if the licensor had never commenced bankruptcy proceedings. Where Section 365(n) becomes relevant is during the period after the trustee files a bankruptcy petition (but prior to the trustee's election to accept or reject a license agreement) and, more important, after the trustee rejects a license agreement.

    As a starting point for understanding the scope of Section 365(n), it is important first to examine the definition of "intellectual property" under U.S. bankruptcy law. Section 101(35A) defines "intellectual property" as including: (1) trade secret; (2) invention, process, design or plant protected under title 35; (3) patent application; (4) plant variety; (5) work of authorship protected under title 17; or (6) mask work protected under chapter 9 of title 17, to the extent protected by applicable nonbankruptcy law. Trademarks are not included in the definition of intellectual property. Also, although from a policy standpoint there would not seem to be any reason to exclude foreign patents, it is unclear whether foreign patents are included in this definition of intellectual property.

    With respect to the period after the trustee files a bankruptcy petition (but prior to the trustee's election to accept or reject a license agreement), Section 365(n)(4) provides that, upon the licensee's written request, the trustee must, to the extent provided under the license agreement (or under any agreement supplementary to the license agreement), either perform its obligations under the license agreement or furnish the licensee with the licensed intellectual property (including any embodiment of the intellectual property). Also, during this period, the trustee may not interfere with the licensee's rights under the license agreement (or under any agreement supplementary to the license agreement) to obtain the licensed intellectual property (or any embodiment of the intellectual property) from a third party, such as an escrow agent.

    As a practice pointer directed toward the rights specified in Section 365(n)(4), the licensee should include in the license agreement (and, as applicable, in any supplementary agreement, such as an escrow agreement) a provision confirming that the licensed intellectual property is deemed to be "intellectual property" under U.S. bankruptcy law and expressly requiring the trustee to furnish the licensed intellectual property to the licensee upon the occurrence of specific performance-related breaches. An example of this type of provision is as follows: "The parties acknowledge that the Licensed Intellectual Property is "intellectual property" for purposes of Section 365(n) of the U.S. Bankruptcy Code and that Licensee will have the right to exercise all rights provided by Section 365(n) with respect to the Licensed Intellectual Property. In the event that the Licensor materially breaches its maintenance obligations under this Agreement, Licensee will have the right to require the delivery by Licensor (or in the event of a filing of bankruptcy by or against Licensor, by the trustee) to Licensee of all Licensed Intellectual Property (including all embodiments thereof)."

    Section 365(n)(1) addresses the licensee's rights following the trustee's rejection of the license agreement. Specifically, upon such a rejection, the licensee may elect: (1) to treat the rejection as a termination of the license agreement, or (2) to retain its rights under the license agreement (or under any agreement supplementary to the license agreement) to the licensed intellectual property, as such rights existed immediately prior to the commencement of the bankruptcy case. If the licensee elects to treat the rejection as a termination of the license agreement, the licensee will lose its rights to the licensed intellectual property and will have the right to seek damages on a pre-petition, unsecured basis for a breach of contract claim-this remedy existed pre-Section 365(n) and this provision does not alter a licensee's remedy.

    Section 365(n)(1)(B) makes express that a licensee's retained rights include the right to enforce any exclusivity provisions of the license agreement, but exclude any rights under applicable nonbankruptcy law to obtain specific performance of the agreement. Moreover, a licensee's retained rights will remain in effect for the duration of the agreement and for any extension period to which the licensee is entitled under applicable nonbankruptcy law.

    It cannot be overemphasized that under Section 365(n)(1)(B), the licensee is entitled to retain only those rights that existed immediately prior to the commencement of the bankruptcy case. The licensee will not be entitled to retain any rights that are contingent upon or are intended to come into effect upon the occurrence of events that did not occur prior to the commencement of the bankruptcy case. For example, if the licensee contemplates that it will require the right to modify the licensed intellectual property if the licensor fails to maintain the licensed intellectual property, the license agreement must provide the licensee with a present grant of these rights (as opposed to providing that the licensor will grant these rights to the licensee upon the occurrence of the event in question).

    Because a licensor often is reluctant to agree to an unconditional present grant of rights, as described above, it is common to combine a present grant of rights with a covenant not to exercise the rights until the occurrence of the event in question. An example of this type of provision is as follows: "Licensor hereby grants to Licensee a nonexclusive, nontransferable, royalty-free license to use, copy and modify the Licensed Intellectual Property for the purposes of maintaining and supporting the Licensed Intellectual Property. Licensee covenants and agrees that it will not exercise the license rights granted in this Section unless and until Licensee materially breaches its maintenance obligations under this Agreement."

    It is very important for a licensee to remember that, although Section 365(n) provides the licensee with the right to retain its license rights and to obtain the licensed intellectual property, once the trustee rejects the license agreement, the trustee is relieved from any other performance obligations under the agreement. Thus, the trustee will no longer have an obligation to provide maintenance, support, consultation, further development, indemnification, etc., even if these benefits are provided to the licensee in the license agreement. Although in most instances it is likely that a licensee would desire to retain its rights, in considering whether to treat a trustee's rejection as a termination of the license agreement, a licensee should consider the practical ramifications and costs associated with using the licensed intellectual property, absent any further performance by the licensor.

    Section 365(n)(2)(B) provides that, if the licensee elects to retain its rights, the licensee must make all royalty payments required under the license agreement for as long as it continues to exercise these rights. The term "royalty" is broadly construed, i.e., it is deemed to include any payment for the use of the intellectual property, whether denominated as a royalty, license fee or otherwise. See In re Prize Frize, Inc., 32 F.3d 426 (9th Cir. 1994).

    A licensee would be well advised to have the license agreement clearly delineate any royalties or license fees that are payable with respect to the licensed intellectual property from other fees that the licensee may be required to pay for maintenance, training or other services. Without this delineation, the licensee may be required to pay amounts for services that it will no longer be entitled to receive from the licensor, as discussed above. The same concern is applicable to payments for intellectual property that is not included in the definition of "intellectual property" under U.S. bankruptcy law. For example, if a portion of a royalty payment is in consideration for the right to use the licensor's trademark, the licensee should ensure that the license agreement clearly identifies that portion of the royalty payment. Otherwise, although trademarks are not included in the definition of intellectual property, the licensee may be required to pay that portion of the royalty attributable to the trademark rights (as part of the overall royalty payment that the licensee makes to retain its rights in the licensed intellectual property), even though the licensee's right to use the licensor's trademark will not be preserved under the Section 365(n) election.

    Section 365(n)(1)(C) provides that, if the licensee elects to retain its rights, the licensee is deemed to waive any right of setoff it may have under applicable nonbankruptcy law. This waiver means that the licensee can no longer claim that its payment obligations should be reduced by the damages it has incurred as a result of the filing of bankruptcy by the licensor. The licensee is also deemed to waive any right to any claim for administrative expenses under Section 503(a), a category of expenses that a licensee of intellectual property would be unlikely to have incurred.

    Finally, like Section 365(n)(4)(A), which addresses the licensee's right to obtain the licensed intellectual property during the period after the trustee files a bankruptcy petition (but prior to the trustee's election to accept or reject a license agreement), Section 365(n)(3)(A) provides the licensee with the right to obtain the licensed intellectual property from the trustee following the trustee's rejection of the license agreement. Also, like Section 365(n)(4)(B), Section 365(n)(3)(B) requires that the trustee not interfere with the licensee's rights under the agreement or a supplementary agreement to obtain the licensed intellectual property (or any embodiment of the intellectual property) from a third party. (The practice pointer discussed above with respect to Section 365(n)(4) is equally applicable to Section 365(n)(3).)

    Section 365(n) leaves a number of issues unresolved. For example, it is unclear under Section 365(n) whether a licensee that elects to retain its rights is released from its nonroyalty obligations, e.g., confidentiality, marketing obligations and cross-licensing. Moreover, as previously discussed, the treatment of foreign patents following a licensor's filing of bankruptcy is unclear. Nevertheless, given the ever-growing reliance on technology, it is essential for practitioners who draft license agreements that involve intellectual property to be thoroughly familiar with the provisions of Section 365(n) in order to structure these agreements (and any supplementary agreements, such as escrow agreements) accordingly.