We all know our nation’s economy is unsteady and the future for even the best of enterprises is uncertain. Some would say the current state of things is lousy. So what can you do to advise a client that has existing intellectual property licenses or those who are thinking about granting IP licenses and there are questions about the licensee or potential licensee entering bankruptcy?
A discussion of some critical issues that can affect licensors’ rights is presented below, but they are not exhaustive by any means. Furthermore, the next step after identifying a potential bankruptcy problem is to associate with competent bankruptcy counsel so that you can avoid another set of potential pitfalls.
IP rights that can be licensed include patents, trademarks, copyright and trade secrets. In some cases, more than one right may be involved in a license and each of the rights will need to be analyzed separately. If the license includes patented technology and an associated trademark, different treatments may be afforded each of the rights. One of them may be essential to the continuation of the licensee’s business while the other does not affect the licensee’s ability to continue in business. Recognizing that there are a number of issues that a licensor will have to deal with upon the filing of a petition in bankruptcy by a licensee, the best advice we can give our clients is to do your due diligence and prepare for the worst.
With that to brighten your day, we take a deeper look at what might happen to your client’s intellectual property licenses if a licensee takes advantage of the protection of bankruptcy court. The issue is not trivial with the economy taking its toll on what were well-positioned companies and such a failure may be critical to your client in today’s marketplace.
As a first step, you and your client, the licensor or potential licensor, must evaluate the IP in the licensing portfolio, its value to your client’s company and the financial strength of any company that is, or might become, a party to any license agreement. Once a licensee files a bankruptcy petition, rights under the license agreement become less certain as they relate to the enforceability of the agreement, including the right to continue to receive royalty payments, the ability to control the use of the licensed IP and the ability to control the assignment of those IP rights.
For example, under the Bankruptcy Code, payments made by a debtor prior to the filing of its petition for bankruptcy may be deemed preferential and avoidable transfers. Section 547 of the Bankruptcy Code sets forth the definition of an avoidable preference payment. If a licensor is not specific about the nature of royalty payments, pre-petition royalty payments may be considered voidable as preference payments. Are the payments in settlement of past infringement, do they settle pending litigation, do they reflect cross-licensing and are they due and owing at the time of execution?
If a licensor allows the debtor licensee to use the licensed IP through the filing of the debtor licensee’s petition for bankruptcy, without prepayment, the royalty payments transferred would likely be exempt from recovery by a trustee under section 547(b). This is on the order of a pay-as-you-go license. However, the payment in advance of royalties by a licensee may be considered preferential, depending on the amount paid and when the debtor licensee filed its petition. This is a typical provision where the licensee makes an annual minimum payment against actual earned royalties. Generally a prepayment of future royalties where the licensee has continued use of the licensed IP after this payment is made will not be considered uncompensated “new value” under section 547(c) (4). This may not be the case if the royalties due at the time the bankruptcy petition is filed exceeds the advance fee and the licensor has allowed the continued use of the licensed IP without compensation at the time of filing.
Although there is no way to ensure that a licensee’s payments are not avoided, continued due diligence regarding the licensee’s financial position may alert the licensor to the likelihood that the licensee is becoming a potential bankruptcy filer. Timely information may permit corrective activity. Termination by the licensor well in advance of the filing of a petition for bankruptcy can protect all payments made by the licensee under the agreement from avoidance. However, such a termination generally requires a license term, like a negative covenant, that deals with the licensee’s financial condition. Likewise, placing financial conditions on the continued allowance of the licensed IP may protect royalty payments received from the licensee.
Section 503(a) of the Bankruptcy Code provides a means for entities to file requests for payment of administrative expenses. Therefore, a licensor may request payment of administrative expenses for the debtor’s continued use of the IP after the filing of the petition for bankruptcy. According to section 503, in order to receive administrative fees, the claim must arise from “a transaction with the debtor-in-possession; and the goods or services supplied enhanced the ability of the debtor-in-possession’s business to function.” For example, in In re Jack/Wade Drilling Inc., the continued use of a licensor’s trademarks for the sale of debtor’s goods or services post petition allowed the licensor, who was seeking administrative fees, to receive the minimum royalty payment in accordance with the agreement. This is especially applicable in those instances, such as franchisees, where the IP is a necessary element of continuing the business or preserving the estate during the bankruptcy.
Many licenses include an “ipso facto” clause that renders the license void, or declares the licensee in breach, if the licensee seeks bankruptcy protection. However, these clauses are rarely, if ever, enforced. Section 365(e) of the Bankruptcy Code can render certain provisions of executory contracts and unexpired leases null, as such provisions purport to affect a trustee’s right to assume or reject the contracts or leases. Accordingly, ipso facto clauses are not enforced against the estate where it allows the IP licensor to terminate or modify the debtor’s (and therefore the estate’s) rights or obligations under the license agreement.
Furthermore, under Section 365, a trustee in bankruptcy (or, in a Chapter 11 case, the debtor in possession) has the authority to assume, assign or reject an executory contract, such as an IP license, notwithstanding any contrary provision appearing in licenses, contracts or leases. While Section 365(c)(1) provides some protection for the licensor in case the licensee is proceeding under Chapter 11, a licensee that is proceeding under a Chapter 7 liquidation may be free to assume, reject or assign the license. An IP licensor should insist on a provision clearly stating that the licensee has no right to assign the license to a third party, specifically a third party that the licensor believes to be an infringer of the licensed IP. As discussed above, most intellectual property licenses are not assignable without the permission of the licensor. However, issues can arise in stock sales, asset purchases or where a third party secures the license rights of the acquired debtor. This possibility highlights the importance of ensuring that the licensee’s right to prevent a transfer is clearly stated in the four corners of the agreement. In addition to placing restrictions on the licensee’s continuing rights under the license based on changes in its stock ownership or corporate control, it is often desirable to include a statement of the importance to the estates. A simple statement might be: It is agreed that the rights granted herein are not critical to the continuation of a licensee’s business and the resulting revenue is not a substantial financial factor for licensee.
In the absence of controlling bankruptcy law, interests of the debtor in property are determined by reference to state law. Generally that means that the interest of the debtor in property, as of the commencement of a bankruptcy case, is based on the agreement as to whether termination results from the filing of the bankruptcy petition. Therefore, the termination provisions of license agreements must make clear the parties’ intentions as to the termination of the license upon the filing of the petition. That provision must also include a notice to the licensor prior to the filing of the bankruptcy petition. A license agreement must be terminated prior to the filing of a bankruptcy petition by a debtor in order for the termination to escape the bankruptcy laws.
Any entity that seeks to generate revenue from licensing must be clear about the value of the licensing portfolio it offers. Beyond the important reviews of the portfolio and its cost to the licensor, the licensor must evaluate the perceived value of the license to the licensee. Does an exclusive license carry the greatest value? If it is to be exclusive, how to value it and assess financial health of the potential licensees is critical. If it is to be non-exclusive, what is the risk that one licensee will go into bankruptcy and damage the value of the license to others? Collecting and evaluating this information can provide the IP licensor with a better picture of its market position and form a framework for evaluating each potential licensee.
Conducting a detailed review of each licensee is essential to determining the viability of the licensee and whether they will be able to fully perform their obligations under the agreement. Although most bankruptcy issues relate to post-petition events, much of the preparation to avoid a bad outcome turns on what the IP licensor did before the debtor licensee became insolvent. Periodic reviews of a licensee’s financial position are one way to protect against the consequences of an insolvent licensee and eventual bankruptcy petitioner. Most license agreements grant the licensor the right to audit of the licensee’s books, at least to the extent related to the licensed IP. This right should be exercised as soon as the licensor has a concern. Although, this audit may not provide a complete picture of the licensee’s financial position, it will provide some information, such as volume level and market activity, that may be used to determine the licensee’s potential to become insolvent. For potential licensees, licensors should request at least basic financial information, but something short of a complete audit. It is also advisable to do a Google search for any problems on the horizon. If the potential licensee is the target of an investigation, a potential recall subject or part of a troubled industrial group, this search will frequently turn up general information or gossip that even someone in the industry may have overlooked.
If troublesome information is found about an existing licensee, the license should be evaluated to determine if modifications are possible. As discussed above, there may be terms in the license agreement that will allow the addition of some protection to the licensor in the event the licensee seeks bankruptcy protection. To the extent possible, the license agreement should be modified to ensure that the benefit bargained for is protected. It may be possible to amend the agreement or to restrict the assignment of the agreement, totally or without prior approval by the licensee. Where it is clear that the licensee has not or cannot perform under the existing terms of the agreement, the business aspect must be evaluated and termination should be considered.
The complexity of the current economy, the growing potential for bankruptcy and a licensor’s need to protect the value of its IP rights require study far beyond what is explored in this article. The issues are many and the times uncertain. While effort is not a guarantee against business failure, the best advice you can give a licensor’s is to do its due diligence and be prepared for the unexpected.
Matthew I. Cohen is an associate at Volpe & Koenig. His practice focuses on obtaining and enforcing IP rights in the consumer electronics, electronic components and wireless communications industries. Darryl W. Shorter is an associate with the firm. He concentrates his practice on securing and protecting IP rights with a focus on electronics, electro-mechanical and computer software.
