This series addresses the needs the legal community has for technology licensing knowledge by laying out basic concepts, identifying traps for the unwary and offering drafting and negotiating tips. Click here to read parts one, two and three.

The bankruptcy of a party to a license agreement can have a profound impact on the parties to that agreement. Counsel need to have a basic understanding of how license agreements are treated in bankruptcy, and draft accordingly.

Some applicable bankruptcy principles

1. In general, a clause that purports to terminate the agreement or otherwise change a party's rights automatically upon the filing of a bankruptcy petition (called an ipso facto provision), is not enforceable under U.S. bankruptcy law. A license agreement could, however, contain a valid right to terminate prior to bankruptcy based on likely bankruptcy precursors such as performance delays or poor financial results.

2. Under U.S. Bankruptcy Code Section 365, the trustee or debtor-in-possession has the right to either assume or reject any executory contract. A contract is generally found to be executory if both parties have material obligations still to be performed and, as a practical matter, most non-exclusive licenses will be considered executory. (The treatment of exclusive licenses is less clear, and will be beyond the scope of this article.) Upon assumption, a trustee or debtor-in-possession has the further right to choose retaining the contract or assigning it to a third party for value regardless of any anti-assignment provision in the contract.

Assumption will normally occur when the licensee is bankrupt if the rights under the license are considered to have value. The bankrupt licensee will either keep operating under the agreement or sell it to a third party, often as part of the sale of the related operational assets.

Rejection, when done by a bankrupt licensor, removes the encumbrance and increase the value of the underlying IP assets.

The foregoing actions are likely to be a significant deviation from the parties' original intentions. Fortunately for the non-bankrupt party, there are some exceptions to the foregoing.

Exceptions protecting licensors when the licensee files

Under U.S. Bankruptcy Code Section 365(c)(1), the right to assume and assign does not apply when applicable non-bankruptcy law excuses the non-debtor party from “accepting performance from or rendering performance to” a new party. Therefore, since the federal common law is clear that the licensee position in a non-exclusive license cannot be assigned by the licensee without the consent of the licensor, this provision leads to preventing the licensee from unilaterally assuming and assigning the agreement to a third party. vThe statutory language and case law regarding Section 365, however, can lead to what some might consider a perverse result for the licensee. Depending on whether the applicable court follows the actual or hypothetical tests for evaluating the right to assume a non-exclusive license, a debtor-in-possession licensee may be blocked, not only from assigning to a third party, but also from assuming and continuing its own operations under its non-exclusive licenses. This problem follows generally from the theory that the debtor-in-possession is considered to be a separate legal entity from the pre-petition debtor.

• Drafting Tip for Licensees: Try, at a minimum, to get the right to assign to a successor in a corporate restructuring or reorganization situation and, if possible, the right to assign to a successor pursuant to an acquisition

• Drafting Tip for Licensors: Be careful using a “consent not to be unreasonably withheld” clause. Some courts have held this to change the default common law rule of no assignment by the licensee and, therefore, give the trustee or debtor-in-possession the right to assign. Something like “consent in the sole and absolute discretion of the licensor” would be the ideal.

Protection for licensees when the licensor files

If a licensor files for bankruptcy and rejects a license, this could have catastrophic results for the licensee. To address this problem, Congress in 1988 added Section 365(n) to the U.S. Bankruptcy Code.

Section 365(n) states that if a license agreement is rejected by the licensor, the licensee has two basic choices:

1. Treating the rejection as a breach and seeking damages through the bankruptcy court (by filing a proof of claim as an unsecured, prepetition creditor)
2. Continuing to use the IP as permitted under the agreement and continuing to pay the applicable royalties (if any)

While a big improvement in the law for licensees, there are some important limitations regarding Section 365(n). First, it does not apply to trademarks or to non-U.S. intellectual property. Second, upon rejection, all of the licensor's future obligations will cease and the licensee will not be getting any contracted-for technical support or future IP developed by the licensor.

The bottom line

The foregoing is only a summary of selected issues, and one should always consult bankruptcy practitioners as appropriate. It is safe to say, however, that in general licensors will want to prohibit the licensee's assignment and should therefore draft to emphasize the personal nature of the license agreement and the unique aspects of the licensee. Licensees will generally want the right to assign and should therefore try to include explicit permissions in the agreement.

This series addresses the needs the legal community has for technology licensing knowledge by laying out basic concepts, identifying traps for the unwary and offering drafting and negotiating tips. Click here to read parts one, two and three.

The bankruptcy of a party to a license agreement can have a profound impact on the parties to that agreement. Counsel need to have a basic understanding of how license agreements are treated in bankruptcy, and draft accordingly.

Some applicable bankruptcy principles

1. In general, a clause that purports to terminate the agreement or otherwise change a party's rights automatically upon the filing of a bankruptcy petition (called an ipso facto provision), is not enforceable under U.S. bankruptcy law. A license agreement could, however, contain a valid right to terminate prior to bankruptcy based on likely bankruptcy precursors such as performance delays or poor financial results.

2. Under U.S. Bankruptcy Code Section 365, the trustee or debtor-in-possession has the right to either assume or reject any executory contract. A contract is generally found to be executory if both parties have material obligations still to be performed and, as a practical matter, most non-exclusive licenses will be considered executory. (The treatment of exclusive licenses is less clear, and will be beyond the scope of this article.) Upon assumption, a trustee or debtor-in-possession has the further right to choose retaining the contract or assigning it to a third party for value regardless of any anti-assignment provision in the contract.

Assumption will normally occur when the licensee is bankrupt if the rights under the license are considered to have value. The bankrupt licensee will either keep operating under the agreement or sell it to a third party, often as part of the sale of the related operational assets.

Rejection, when done by a bankrupt licensor, removes the encumbrance and increase the value of the underlying IP assets.

The foregoing actions are likely to be a significant deviation from the parties' original intentions. Fortunately for the non-bankrupt party, there are some exceptions to the foregoing.

Exceptions protecting licensors when the licensee files

Under U.S. Bankruptcy Code Section 365(c)(1), the right to assume and assign does not apply when applicable non-bankruptcy law excuses the non-debtor party from “accepting performance from or rendering performance to” a new party. Therefore, since the federal common law is clear that the licensee position in a non-exclusive license cannot be assigned by the licensee without the consent of the licensor, this provision leads to preventing the licensee from unilaterally assuming and assigning the agreement to a third party. vThe statutory language and case law regarding Section 365, however, can lead to what some might consider a perverse result for the licensee. Depending on whether the applicable court follows the actual or hypothetical tests for evaluating the right to assume a non-exclusive license, a debtor-in-possession licensee may be blocked, not only from assigning to a third party, but also from assuming and continuing its own operations under its non-exclusive licenses. This problem follows generally from the theory that the debtor-in-possession is considered to be a separate legal entity from the pre-petition debtor.

• Drafting Tip for Licensees: Try, at a minimum, to get the right to assign to a successor in a corporate restructuring or reorganization situation and, if possible, the right to assign to a successor pursuant to an acquisition

• Drafting Tip for Licensors: Be careful using a “consent not to be unreasonably withheld” clause. Some courts have held this to change the default common law rule of no assignment by the licensee and, therefore, give the trustee or debtor-in-possession the right to assign. Something like “consent in the sole and absolute discretion of the licensor” would be the ideal.

Protection for licensees when the licensor files

If a licensor files for bankruptcy and rejects a license, this could have catastrophic results for the licensee. To address this problem, Congress in 1988 added Section 365(n) to the U.S. Bankruptcy Code.

Section 365(n) states that if a license agreement is rejected by the licensor, the licensee has two basic choices:

1. Treating the rejection as a breach and seeking damages through the bankruptcy court (by filing a proof of claim as an unsecured, prepetition creditor)
2. Continuing to use the IP as permitted under the agreement and continuing to pay the applicable royalties (if any)

While a big improvement in the law for licensees, there are some important limitations regarding Section 365(n). First, it does not apply to trademarks or to non-U.S. intellectual property. Second, upon rejection, all of the licensor's future obligations will cease and the licensee will not be getting any contracted-for technical support or future IP developed by the licensor.

The bottom line

The foregoing is only a summary of selected issues, and one should always consult bankruptcy practitioners as appropriate. It is safe to say, however, that in general licensors will want to prohibit the licensee's assignment and should therefore draft to emphasize the personal nature of the license agreement and the unique aspects of the licensee. Licensees will generally want the right to assign and should therefore try to include explicit permissions in the agreement.