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March 2004

Assumption and Assignment of Patent and Copyright Licenses in a Bankruptcy Case

By Michael Kogan

Licensors of intellectual property are often confronted with a licensee's Chapter 11 bankruptcy case leading to uncertainty as to the effect on the license. Pursuant to Section 365(a) of the Bankruptcy Code, a Chapter 11 debtor may assume or reject the duties of an executory contract which may include an intellectual property license, subject to the court's approval. The term "executory" is not defined in the Bankruptcy Code, but the legislative history of the section suggests a broad reading of the term. According to congressional reports, an executory contract generally includes contracts on which performance remains due to some extent on both sides. The breadth of the definition suggested by the legislative history, however, may be overly broad, "since it is the rare agreement that does not involve unperformed obligations on either side." In re Columbia Gas Sys., Inc., 50 F.3d 233, 238 (3dCir. 1995) (quoting Mitchell v. Streets (In re Streets & Beard Farm P'ship), 882 F.2d 233, 235 (7th Cir. 1989). Courts and commentators have struggled to more precisely formulate a workable definition of "executory contract" in a bankruptcy context.

Section 365 was included in the Bankruptcy Code to give the debtor the option of assuming contracts where performance by the non-bankrupt party will benefit the estate, or, of rejecting contracts where further performance by the debtor will not benefit the estate. In bankruptcy, a debtor can escape the burden of an unprofitable contract by agreeing to pay specified rejection damages, or, a debtor can accept the benefit of a profitable contract by assuming the contract and fully performing.

Based on this purpose, one commentator characterized an executory contract as a combination of assets and liabilities held by the bankruptcy estate. Columbia Gas, at 238 (citing Thomas H. Jackson, The Logic and Limits of Bankruptcy Law, 106-7 (1986)). If the package of assets and liabilities provide a net asset to the bankruptcy estate, the debtor will assume the contract. Columbia Gas, at 238. If the debtor assumes the executory contract, the debtor accepts the liabilities with the assets and must render at full value the bargained-for performance. If the package of assets and liabilities does not provide a net asset to the bankruptcy estate, the debtor will reject the executory contract. Id. If the executory contract is rejected, the debtor no longer bears the obligation of further performance under the contract, but instead breaches the contract and incurs liability for that breach in the form of rejection damages assessed as a prepetition, unsecured claim for contract damages. Columbia Gas, at 238 (citing Thomas H. Jackson, The Logic and Limits of Bankruptcy Law, 108 (1986), In re Taylor, 913 F.2d 102, 106-07 (3d Cir. 1990); University Medical Ctr. v. Sullivan (In re University Medical Ctr.), 973 F.2d 1065, 1078 (3d Cir. 1992)).

In cases where the non-bankrupt party has fully performed, however, it makes no sense to talk about assumption or rejection. Columbia Gas, at 239. At that point, the debtor already has obtained the benefit of the non-bankrupt's performance under the agreement. Assumption of the agreement will bring the debtor no new assets. Nor will rejection create any new liabilities because the non-bankrupt party already has a claim against the debtor's estate for the debtor's non-performance. Neither rejection nor assumption would benefit the estate. Rejection of the contract in this context "is no different from abandoning property of the estate." Columbia Gas, at 239.

These considerations lead many courts to adopt the Countryman definition of "executory contract" for the purposes of Section 365. According to Professor Countryman, an executory contract is a "contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other." Vern Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439, 460 (1973). Thus, unless both parties have unperformed obligations that would constitute a material breach if not performed, the contract is not executory. Columbia Gas, at 239.

The Assignability Of Nonexclusive Patent And Copyright Licenses In A Bankruptcy Case.

Nonexclusive patent licenses are executory contracts that generally may be assumed or rejected, because each party to the contracts owes material continuing performance to the other. See In re CFLC, Inc., 89 F.3d 673, 677 (9th Cir. 1996); In re Patient Educ. Media, Inc., 210 B.R. 237, 241 (Bankr. S.D.N.Y. 1997). Nevertheless, a debtor may not assign a nonexclusive patent license to a third party, absent consent of the licensor, because federal patent law precludes the holder of a nonexclusive license from assigning it. CFLC, 89 F.3d, at 679; see also Commissioner v. Sunnen, 333 U.S. 591, 609, 68 S. Ct. 715, 724-35 (1948).

In CFLC, the debtor-licensee moved to assume a nonexclusive patent license and assign it to a buyer unrelated to the debtor. The patent licensor objected on the basis that Section 365(c) of the Bankruptcy Code prevented the assignment, because applicable federal common law precludes the assignment of nonexclusive patent licenses. The Ninth Circuit agreed with the licensor that federal patent law was "applicable law" under Section 365(c) and that under federal patent law, nonexclusive licensees may not assign patent licenses without the licensor's consent. CFLC, 89 F.3d at 679. Similar principles appear to apply in the case of nonexclusive copyright licenses. See Patient Educ. Media, Inc., 210 B.R., at 242-43 (following CFLC's rule for nonexclusive copyright licenses).

The Split of Authority Regarding Whether A Nonexclusive Patent License May Even Be Assumed By The Debtor In Possession.

In addition to the proscription on a debtor-licensee's ability to assign a nonexclusive patent license, the debtor licensee now faces the threat of the loss of its patent license altogether in light of the Ninth Circuit Court of Appeals' decision in In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999).

In Catapult, the debtor in possession moved to assume two nonexclusive patent licenses over the licensor's objections. In determining whether the debtor in possession could assume the nonexclusive patent licenses, the Ninth Circuit interpreted Section 365(c)(1) of the Bankruptcy Code as creating a "hypothetical test" regarding a debtor in possession's ability to assume an executory contract and found that, if, under applicable law, a debtor is not allowed to assign an executory contract to a third party without the nondebtor party's consent, then the debtor in possession cannot assume the contract even though the debtor in possession may have no intention of assigning it to a third party. Id., at 750. Relying on its earlier decision in CFLC, the Ninth Circuit stated that federal patent law constituted applicable law under which nonexclusive patent licenses are "personal and assignable only with the consent of the licensor." Id. (quoting CFLC, 89 F.3d at 680). Thus under Catapult, a debtor in possession's inability to assign a nonexclusive patent license precludes the debtor in possession from assuming the license as well. See also In re Access Beyond Technologies, Inc., 237 B.R. 32, 48-49 (Bankr. D. Del. 1999) (debtor in possession may not assume or assign nonexclusive patent license without licensor consent).

This "hypothetical test" governing the assumption of executory contracts has been adopted by other circuit courts. See e.g. In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994); In re West Elec., Inc., 852 F.2d 79, 83 (3d Cir. 1988); In re Catron, 158 B.R. 629, 633-38 (E.D. Va. 1993). The Catapult decision, however, is not the law of the land. The First Circuit Court of Appeals has held that a debtor in possession may assume a nonexclusive patent license agreement and transfer its stock to another entity without the consent of the licensor. See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997). In Institut Pasteur, the debtor in possession moved to assume a patent license agreement and sought to confirm a plan transferring the debtor's stock to a subsidiary of a direct competitor of the licensor. The licensor objected to the stock transfer because it would cause a "de facto" assignment of the license to a direct competitor. Institut Pasteur, 104 F.3d, at 490-91. The First Circuit rejected this argument and allowed the debtor in possession to assume the license agreement and transfer its stock, reasoning that the fact that federal common law prohibits the assignment of patent licenses to strangers does not preclude a debtor in possession from assuming a patent license agreement and transferring its stock to a third party. Id., at 493-94.

With respect to the debtor in possession's ability to assume the nonexclusive patent license, the First Circuit rejected the "hypothetical test" adopted by Catapult, in favor of an "actual test" which involves a case-by-case inquiry into whether the nondebtor party is actually being forced to accept performance from an unrelated third party. See In re TechDyn Sys. Corp. 235 B.R 857, 860-61 (Bankr. E.D. Va. 1999) (citing authorities for the proposition that while the majority of circuit courts have endorsed the "hypothetical test," the majority of lower courts have utilized the "actual test").

Other Considerations Regarding Assumption And Assignment.

Notwithstanding cases such as CFLC and Catapult, if the nondebtor licensor does not object to the assumption and/or assignment of a patent license until after confirmation of a plan, principles of res judicata may bar the licensor from asserting that applicable non-bankruptcy law prohibits the debtor from assuming and/or assigning the nonexclusive patent license. See Department of Air Force v. Carolina Parachute Corp., 907 F.2d 1469, 1473 (4th Cir. 1990) (where the debtor's plan of reorganization provided for assumption and assignment of a contract to manufacture parachutes for the United States government and the United States failed to object to the plan, the United States was barred by principles of res judicata from terminating the contract even though the United States' characterization of the bar on assignment in the Anti-Assignment Act, 41 U.S.C. §15, appeared to be correct).

Additionally, although cases such as Catapult would bar a debtor-licensee from assuming and assigning a nonexclusive patent (and copyright) license, Catapult nevertheless left open the issue regarding whether such proscriptions apply to the assumption and assignment of exclusive patent (and presumably copyright) licenses. See Catapult, 165 F.3d, at 750 n.3 ("[W]e express no opinion regarding the assignability of exclusive patent licenses under federal law...") (emphasis in original). Subsequent cases have held that the debtor-licensee may assume and assign exclusive patent and copyright licenses. See Murray v. Franke-Misal Techs. Group L.L.C.; In re Supernatural Foods, L.L.C., 268 B.R. 759 (Bankr. M.D. La. 2001) (because generally applicable law did not prohibit assignment, trustee could assume and assign exclusive patent license, despite a provision to the contrary in the agreement); In re Golden Books Family Entertainment, Inc., 269 B.R. 311 (Bankr. D. Del. 2001) (assignability of copyright license turns on whether it is exclusive or nonexclusive; exclusive copyright license of children's book character was assignable by debtor); But cf. In re Hernandez, 285 B.R. 435 (Bankr. D. Ariz. 2002) (patent licensee could not assume exclusive patent license notwithstanding no intent to transfer license); Gardner v. Nike, Inc., 279 F.3d 774 (9th Cir. 2002) (holding in non-bankruptcy context that exclusive copyright licensee did not have the right to transfer its rights in a copyright license without the licensor's consent).

Finally, a question arises whether a debtor-licensee, unable to assume a patent (or copyright) license, may choose simply not to address the license in its bankruptcy case and allow the license to simply "ride through" the bankruptcy. At least one court has answered in the affirmative. See In re Hernandez, 287 B.R. 795 (Bankr. D. Ariz. 2002) (holding that exclusive patent license need not be assumed or rejected by debtor, but may "ride through" the bankruptcy case). As a practical matter, "ride through" will be useful when the debtor is not in default under the license. However, even if the debtor is in default, a Chapter 11 plan may cure most defaults without assuming the licenses. See 11 U.S.C. §1123(a)(5)(G).

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