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Technology Access Report
JANUARY 2002

NOW THAT THE TIDE HAS TURNED:
THE IMPACT OF BANKRUPTCY ON CUSTOMERS OF TECHNOLOGY LICENSORS AND SERVICE PROVIDERS

JOEL RIFF, DEBORAH MILLER and PATRICK COSTELLO*

Until recently, companies providing technology products and services were growing like weeds, sprouting up everywhere and having little difficulty finding business opportunities as well as the funding necessary to fuel their growth. But, as the tide has turned, it is no longer unusual to find that a technology vendor or service provider has exhausted its resources and sought bankruptcy relief. It is vital that customers of such vendors understand how certain of the bankruptcy law's provisions may impact them.

CHAPTER 7 AND CHAPTER 11 BANKRUPTCY PROCEEDINGS

The U.S. Bankruptcy Code provides that a company may file a petition for relief under either Chapter 7 or Chapter 11. While Chapter 7 and Chapter 11 cases differ in their goals and administration, they invoke a common set of unique bankruptcy powers, including the right to reject executory contracts.

A Chapter 7 bankruptcy proceeding is a straightforward liquidation of the debtor company's assets. A Chapter 7 trustee - a person with no previous affiliation with the debtor - is appointed by the bankruptcy court. The trustee exercises management and control of the debtor's assets, has the duty to liquidate the corporate assets in an expeditious manner, and distributes any available proceeds to creditors. The trustee typically does not operate the business. The officers, directors, and shareholders of the corporation are divested of all management and control over the assets.

A Chapter 11 case is significantly more open-ended than a Chapter 7 case. A Chapter 11 case is referred to as a reorganization. A company may seek to implement a plan of reorganization that restructures the corporate assets and liabilities and permits the corporation to emerge from bankruptcy and continue business operations. However, a company may also utilize Chapter 11 to maximize the funds recovered on liquidation of assets by selling its assets as a going concern. In such a "liquidating" Chapter 11 case, the company does not emerge from the bankruptcy and the creditors receive sale proceeds under a relatively simple plan of liquidation. Given the difficulties of retaining highly skilled employees through the duration of a Chapter 11 case, many technology companies - even those who do not intend to use Chapter 11 merely as a means to sell assets but actually want to emerge restructured - decide soon after the Chapter 11 case is commenced, that a prompt sale of the company's assets followed by a liquidating plan is the best means to maximize the value of the corporate assets.

In a Chapter 11 proceeding, a trustee is not automatically appointed and the existing corporate managers typically continue to exercise management and control over the corporate assets and their disposition. A trustee can be appointed, but for that to happen a party must bring a motion for the appointment of a trustee and must typically demonstrate fraud, dishonesty, self-dealing, or gross mismanagement on the part of the corporate managers; therefore the appointment of a Chapter 11 trustee is relatively infrequent. Where the corporate managers remain in control, the corporate debtor is referred to as a "debtor-in-possession." The debtor-in-possession has virtually the same authority and powers of a trustee, including the power to reject executory contracts.

A debtor-in-possession has the right to convert the bankruptcy case from Chapter 11 to Chapter 7. Creditors cannot force the corporate managers to "reorganize" under Chapter 11 instead of a straight liquidation under Chapter 7. For this reason, bankruptcy courts will often consider the nature and extent of a party's rights and remedies under Chapter 7 as a "baseline" for determining the appropriate scope of a party's rights and remedies in a Chapter 11 case.

ASSUMPTION OR REJECTION OF TECHNOLOGY LICENSE AGREEMENTS

Section 365(a) of the Bankruptcy Code applies in both Chapter 7 and Chapter 11 cases, and provides that the trustee/debtor-in-possession may "assume" or "reject" an "executory contract." Assumption means that the trustee/debtor-in-possession reaffirms that it will be bound by the obligations of the contract in order to continue to receive the benefits under the contract. Rejection of an executory contract means that the trustee/debtor-in-possession is effectively relieved of the obligation to further perform under the contract. If the unperformed obligations are material, the failure to perform such obligations may constitute a material breach entitling the non-debtor party to terminate the contract. Virtually all technology licenses are executory contracts.

If, on the other hand, an executory contract is assumed, the trustee/debtor-in-possession must cure all material performance defaults under the contract and provide adequate assurance that it can perform its obligations under the contract. If the contract is one that is assignable, the trustee/debtor-in-possession may be able to realize value from the contract by assigning it to a qualified third party. (Issues of assignability are discussed below.)

In a Chapter 7 proceeding, all executory contracts and unexpired leases are automatically rejected sixty (60) days after the commencement of the proceeding, unless the Chapter 7 trustee specifically moves to assume the contract or requests that the bankruptcy court extend the time to do so. This Chapter 7 preference for rejection is significant in a Chapter 11 case, because the bankruptcy court will give consideration to the likely outcome in a hypothetical Chapter 7 case in determining whether it should approve the rejection of an executory contract in the Chapter 11 case. In other words, there will be a very strong presumption in favor of the right of the trustee/debtor-in-possession to reject the license agreement, because that is the result of the automatic rejection that occurs in a Chapter 7 liquidation.

In a Chapter 11 case, the trustee/debtor-in-possession effects the rejection of the license agreement by serving on the licensee a motion stating that it seeks to reject the license agreement. The bankruptcy court does not substitute its own judgment for that of the trustee/debtor-in-possession. The role of the bankruptcy court is merely to determine whether the trustee/debtor-in-possession has exercised "business judgment" in making the decision to reject the contract. The "business judgment" test will be satisfied if the trustee/debtor-in-possession can allege, with respect to any portion of its unperformed obligations, that: (1) it does not have or will not have the ability to render the performance; or (2) performance of the obligation would be burdensome either because it is not profitable or because it can better utilize the resources in another manner. Moreover, the bankruptcy court will not attempt to balance the detriment to the non-debtor party against the benefit to the trustee/debtor-in-possession in determining whether the debtor-in-possession has exercised reasonable business judgment. For example, the fact that the detriment to a licensee from the licensor's rejection of a license agreement far outweighs the benefit to the licensor does not detract from the fact that rejection may provide some benefit to the licensor. Finally, the bankruptcy court will take into account that the detriment to the non-debtor is not any greater than would occur in a hypothetical Chapter 7 case. The combination of these considerations means that - as a practical matter - a non-debtor licensee cannot successfully challenge the debtor licensor's decision to reject the license agreement. While it is theoretically possible that a court could find that rejection constitutes a gross abuse of the debtor's business judgement, such a finding is extremely rare and generally requires a finding of bad faith on the part of the debtor.

While a rejection is deemed a breach of contract, the damages resulting from such a breach are treated as an unsecured claim against the debtor, with such claim receiving only its pro rata share of any funds that become available for distribution to unsecured creditors generally. The unsecured creditors get paid only after the secured creditors and other priority creditors are paid in full. The distributions finally made to unsecured creditors often amount to no more than a few cents on every dollar owed by the debtor, leaving the party damaged by rejection of a license agreement largely uncompensated for the debtor's breach.

THE LUBRIZOL DECISION

The general rule is that where the trustee/debtor-in-possession rejects an executory contract, the trustee/debtor-in-possession is relieved all of future performance obligations under the contract. Rejection of a license agreement by a licensor can yield harsh results for a licensee.

In a closely-watched 1985 decision, Lubrizol Enterprises v. Richmond Metal Finishers, the U.S. Court of Appeals for the Fourth Circuit found a non-exclusive technology license to be an executory contract and thus subject to rejection by the debtor in a Chapter 11 bankruptcy. The license agreement for a patented metal coating process had been signed in 1982 and was to remain in effect for sixteen years.

In Lubrizol, the court adopted the generally accepted definition of an "executory contract" for purposes of Section 365(a) as one in which the "obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other." The licensor in Lubrizol had the following continuing duties, which were deemed sufficient by the court to render the agreement an "executory contract": (1) to notify the licensee of any patent infringement suit and to defend such suit; (2) to notify the licensee of any other potential use of the licensed technology; (3) to not license the technology to a third party at a royalty rate lower than the licensee's rate, unless the licensee's rate was reduced to the same lower rate as that granted the third party; and (4) to indemnify the licensee for losses arising out of any misrepresentation or breach of warranty by the licensor. The court also noted that, to be executory under Section 365(a), the contract must be executory as to both parties. In this case, the licensee had agreed to make continuing royalty payments, to deliver quarterly reports, to keep books of account subject to audit, and to maintain the confidentiality of the licensed technology. The court ruled that these obligations sufficed to make the agreement executory as to the licensee as well.

The Lubrizol decision came as a shock to licensees of intellectual property. Three years after it was decided, Congress determined that intellectual property licensees needed relief from the dangers of license agreements being prematurely pulled out from under them as occurred in Lubrizol and in 1988 added a new Section 365(n) to the Bankruptcy Code. This provision gives licensees an option intended to substantially reduce the adverse consequences of the Lubrizol decision. In doing so, Congress tried to balance the intent of the bankruptcy laws to give debtors a fresh start, with the need of licensees to be more certain of the continuation of their investments in licensed intellectual property, and thus more willing to make such investments.

Under Section 365(n)(1), if a debtor/licensor decides to reject its license of intellectual property, its licensee now has one of two choices: (1) it may treat the rejection as a breach of the license agreement and file a claim against the debtor/licensor in the amount of the licensee's damages from the breach; or (2) it may notify the debtor/licensor that the licensee elects to retain its rights under Section 365(n), provided that the licensee continues to pay the licensor royalties as specified in the license agreement. The good news is that the licensee is able to maintain most of its license rights as they existed immediately prior to the debtor's bankruptcy filing, including any exclusive rights of the licensee. But the bad news is the licensee's election does not apply to any of the following: to any obligations of the debtor/licensor to perform any future acts under the agreement, including obligations of further development, maintenance, and support; to any trademark licenses; and possibly (depending on how the bankruptcy courts construe the definition of "intellectual property" in Section 101(35A) of the Bankruptcy Code) to any licenses of foreign patents. In addition, if the agreement does not allocate the consideration to be paid by the licensee between the basic right to use the intellectual property and the licensor's other obligations, all of the consideration may be deemed part of the licensee's ongoing royalty obligations.

EXAMPLES

Consider the application of Section 365(n)(1) in two hypothetical situations:

Customized Application Contract

Vendor Corp., a software developer and licensor, entered into a license agreement with Licensee Inc. that obligated Vendor to customize its existing software product as requested by Licensee and to maintain and support the product throughout the five-year life of the contract, with Licensee having the right to distribute the customized product to its end-user customers under Vendor's trademark. As is typical, in the contract Vendor promised to indemnify Licensee against any third-party claims of copyright, trademark, and patent infringement. Six months after the contract was signed Vendor, having completed only a portion of the customization, files a Chapter 11 petition and promptly ceases development work on the customized product.

This license agreement will be deemed an executory contract because Vendor still has continuing contractual obligations to Licensee (for example, to complete development, to maintain and support the customized product, and to indemnify Licensee if it is sued by a third party alleging that the customized product infringes the third party's copyrights, trademarks, or patents), and Licensee still has continuing contractual obligations to Vendor (including to pay Vendor a royalty each time Licensee distributes a copy of the customized product to an end-user customer).

Based upon Section 365(a) as interpreted in Lubrizol, Vendor has the right to reject the contract because it is executory as to both parties. Once Vendor rejects the contract, Vendor is relieved of the obligations under it, except for licenses to "intellectual property" that Licensee both: (1) had under the contract as such license rights exist immediately prior to the filing of the bankruptcy petition by Vendor; and (2) elects to retain under Section 365(n)(1)(B). This could include all of Licensee's license rights to distribute the customized product as the product existed immediately prior to the filing of the bankruptcy petition by Vendor.

But Licensee would not be able to retain the following important rights: the right to require Vendor to complete its development of the customized product; the right to have Vendor provide ongoing maintenance and support for the customized product; the right to use Vendor's trademarks when marketing the customized product; possibly the right to commercialize the product under Vendor's foreign patent rights; and the right to have Vendor indemnify it in the event that a third party sues Licensee alleging that the customized product infringes the third party's copyrights, trademarks, or patents.

While Section 365(n)(1)(B) definitely improves a licensee's position as compared to its position prior to the enactment of Section 365(n), the exceptions to its coverage described above will usually mean that a licensee such as this one will be unable to commercialize the customized product as it had intended when it signed the contract with Vendor. For example, Licensee may lack the technical expertise to complete the customization of the product by itself and to maintain and support the product or may be unable to market it successfully without using Vendor's trademark. Section 365(n) will then be of little use to Licensee. Licensee would be left with only an unsecured claim against Vendor for damages under the contract based on Vendor's rejection. All of Vendor's unsecured creditors would share in any pro rata distribution of Vendor's assets, which would typically fall far short of fully compensating Licensee for its loss.

Game Software Contract

Licensor Co., a licensor of software used by game developers as a generic engine for inclusion in computer games, signed a contract with Customer Ltd. under which Licensor licensed the source code for its software engine to Customer so that Customer could customize the engine as needed for inclusion in its computer game and do first level maintenance and support of the engine, in addition to Licensor providing Customer with second level maintenance and support. The contract specified that Customer would distribute the game to its end-user customers under Customer's own trademark. Licensor agreed in the contract to indemnify Customer against any third-party claims of copyright and patent infringement with regard to the engine. Six months after the contract was signed, Licensor files a Chapter 11 petition, while Customer continues its efforts to customize the engine for inclusion in the final version of Customer's game.

This contract will be deemed an executory contract because Licensor still has continuing unperformed obligations to Customer (for example, to provide second level maintenance and support for the customized product and to indemnify Customer if Customer is sued by a third party alleging that the engine infringes the third party's copyrights or patents), and Customer still has continuing contractual obligations to Licensor (including to pay Licensor a royalty each time Customer distributes the customized engine to a customer as part of its computer game).

Licensor now has the right to reject the contract because it is executory. If Licensor does so, all of Licensor's obligations under the contract are automatically terminated, except for licenses to "intellectual property" that Customer both: (1) had under the contract as they existed immediately prior to the filing of the bankruptcy petition by Licensor; and (2) elects to retain under Section 365(n)(1)(B). Thus, Customer could elect to retain all of its rights to customize and distribute the customized engine as such rights existed immediately prior to the filing of the bankruptcy petition by Licensor. But Customer would not be able to retain either the right to have Licensor indemnify it in the event that a third party sues Customer alleging that the engine infringes the third party's copyrights or patents or, possibly, the right to commercialize the product under Licensor's foreign patent rights. The lack of indemnification would probably not, by itself, prevent Customer from commercializing the game; it would only add an element of risk for Customer.

The manner in which the Bankruptcy Code defines "intellectual property" creates some uncertainty as to whether a licensee's right to retain license rights includes rights in foreign patents. Section 365(n)(1)(B) provides for the licensee to retain its rights to intellectual property. However, the definition of "intellectual property" in Section 101 (35A) refer to an "invention, process, design or plant protected under Title 35". This definition clearly covers U.S. patents, but it may have inadvertently failed to adequately covered foreign issued patents. If the courts determine that Section 365(n)(1)(B) does not cover foreign patent rights and Licensor had obtained patents in any foreign countries, Customer's commercialization of the game in those countries (but not in the United States) would infringe Licensor's patents in those countries. If Customer was intending to distribute the game in those foreign countries, it would be well advised to negotiate with Licensor after Licensor's bankruptcy filing for a separate patent license allowing Customer to distribute the game in those countries. But, even without such a foreign patent license, Customer's ability to commercialize, distribute, maintain, and support the game in the U.S. would be unhampered.

As these two examples illustrate, while Section 365(n)(1)(B) will give certain licensees almost all of what they initially bargained for, the exceptions to its coverage will mean that, in cases like the first example, a licensee may get little benefit from Section 365(n).

ROYALTY ALLOCATION

Section 365(n)(2)(B) requires that a licensee electing to retain its rights under a license agreement that is rejected by a debtor/licensor in bankruptcy must make all royalty payments due under the agreement for its duration. To avoid having to make payments for services or license rights that are no longer provided by debtor/licensor because they are not covered by Section 365(n)(1), the licensee should consider having the contract expressly allocate its payment obligations among the software license (which will continue), and maintenance and support and the trademark licenses (which will not continue).

For example, in the second situation described above, assume that the contract requires that Customer pay Licensor a royalty of $10 for each copy of the game that contains the customized engine, and that the contract makes no mention of any separate payments due for Licensor's maintenance and support of the engine. A bankruptcy court might well determine that Section 365(n)(2)(B) requires that Customer continue to pay Licensor the entire royalty for each copy, even though Licensor is no longer maintaining or supporting the engine. But, if the contract had specified a royalty of only $9 and a fee of $1 for maintenance and support for each game sold, the court should only require that Customer continue to pay the $9 per copy fee. As this example illustrates, it is possible to draft the contract in a way that anticipates the application of Section 365(n).

DRAFTING OTHER LICENSE PROVISIONS TO MAXIMIZE PROTECTIONS FOR LICENSEE IN THE EVENT OF REJECTION

While there is no way to draft a licensee agreement to avoid all the risks to a licensee posed by a bankruptcy filing and subsequent rejection of the license agreement by the licensor, the licensee agreement can be drafted to maximize the licensee's rights in such an eventuality.

As discussed in the Customized Application Contract example, the fact that a licensee's rights under Section 365(n) do not extend to any continuing development or maintenance obligations, may leave the licensee with a license to an incomplete and unusable technology. The licensee may maximize its Section 365(n) rights by requiring the licensor to grant it license rights that include the right to develop, enhance, and modify the intellectual property technology. For such rights to survive as part of the licensee's Section 365(n) rights, this right must be a present right. It cannot be a "springing right" that comes into existence only in the event of the licensor's bankruptcy. A licensee may expect its licensor to resist such a right to independently develop the technology. The licensor, after all, expects to remain in control of its technology and presumably derive significant additional consideration from completing its development. A drafting approach that probably obviates the "springing right" issue is to provide the licensee with a present grant of all rights necessary to develop the technology, but require that the licensee forbear from exercising this aspect of its license rights unless and until the licensor materially defaults on and fails to cure its development obligations. With such a forbearance, the licensee is contractually precluded from exercising its right to develop the technology unless the licensor materially defaults on its development obligations, so the agreement proceeds as contemplated. Even if the licensor files for bankruptcy relief, it may still honor its development obligation and thereby prevent the licensee for exercising its development rights. But if the licensor elects to reject those development obligations, then the licensee would have the right to continue the development of the technology on its own. Such a right clearly does not provide the licensee with the full benefit of its bargain, as it may require the licensee to expend substantial additional resources in order to replace the expertise and personnel that the licensor was supposed to provide. Such provisions do, however, provide the licensee with the ability to proceed with the development and thereby avoid having the licensee's entire investment held hostage to the licensor's rejection of the license agreement. It is important that the provisions which trigger the expiration of the licensee's forbearance be based on the licensor's non-performance of its obligations, not on the mere fact of its bankruptcy. The same form of present grant of rights with an obligation to forbear can be used to ensure that a licensee has a right to maintain and even sub-license intellectual property.

THE DEBTOR AS LICENSEE

The special protections of Section 365(n) apply only to the rejection of an executory contract where the debtor is the licensor. They have no application and provide no protection to a debtor who is a licensee and is seeking to preserve its license rights.

Section 365(a) provides a debtor licensee with the same options as a debtor licensor with respect to executory license agreements: assumption (and possibly assignment) or rejection. If the trustee/debtor-in-possession rejects the license agreement, it presumably forfeits its license rights. It is quite likely that a trustee/debtor-in-possession of a technology company will want to assume (or assume and assign) many license agreements. However, the trustee/debtor-in-possession may find that, absent the cooperation and consent of the licensor, it is barred from either assuming or assigning the license agreement.

Section 365(e) permits the trustee/debtor-in-possession to "override" a contractual restriction or prohibition against assignment of an executory contract. However, notwithstanding the effect of Section 365(e), Section 365(c) bars the trustee/debtor-in-possession from assuming or assigning an executory contract if applicable non-bankruptcy law excuses the other party (i.e., the licensor) from accepting performance from, or rendering performance to, a party other than the debtor. The Ninth Circuit Court of Appeals, in the 1999 case In re Catapult Entertainment, Inc., held that, with respect to a non-exclusive patent license agreement, federal common law makes such licenses personal and nonassignable without the licensor's consent, and that such federal common law is applicable non-bankruptcy law for purposes of Section 365(c). Accordingly, Section 365(c) bars both the assumption and assignment of a non-exclusive patent license. Other courts have held that Section 365(c) similarly bars the assumption or assignment of a non-exclusive copyright license.

Thus, a licensee who files for bankruptcy relief may find that it cannot hold onto or transfer its non-exclusive patent or copyright licenses without the licensor's consent, which presumably would be granted at a hefty price if at all. A troubled company with significant inbound patent or copyright licenses must carefully weigh the benefits of bankruptcy against the risk that its inbound license rights will be forfeited.

APPLICATION SERVICES PROVIDERS

While the focus of this discussion has been the rejection of license agreements, rejection under Section 365(a) of the Bankruptcy Code applies equally to all other executory contracts, including contracts for application services offered over the Internet. These are typically contracts where, rather than receiving and installing a software application program, a customer accesses the service provider's Web site through the Internet in order to make use of the software application program as installed on the service provider's Web site. In these cases, the customer is purchasing services rather than licensing software. Such contracts are generally executory for both parties because, at a minimum, the service provider has promised to provide the services on an ongoing basis and the customer has agreed to pay the service provider fees for the services. Therefore, these contracts may be rejected by the service provider if it files for bankruptcy and, since no license of intellectual property is involved, Section 365(n) does not apply. So a customer who believes that it has locked in a service provider for a specified duration at a specified rate may suddenly discover that the underlying contract is rejected in bankruptcy and its contract rights have been reduced to an unsecured pro rata claim for damages.

For example, assume that ASP Inc. has software that can generate detailed maps of any location in the world and that Travel Corp. is a travel agency that wishes to enhance its Web site by including a customized version of ASP's online mapping functionality. Depending on how they wish to configure their relationship, ASP and Travel could sign either a license agreement or an application services agreement. If ASP licenses its online mapping software to Travel, Travel would install the software on Travel's server computer, and Travel's customers could then obtain online maps when visiting Travel's Web site. In this situation, Travel's license to the software would be within the scope of Section 365(n)(1)(B). But if ASP and Travel enter into an application services agreement instead of a license agreement, ASP delivers no software to Travel; instead, Travel places a link on its Web site that takes its customers to the customized version of ASP's online mapping software located on ASP's server computer. This application services agreement would not be covered by Section 365(n)(1)(B) and, following a bankruptcy filing by ASP, Travel could be left without the service for which it had bargained.

CONCLUSION

Particularly in the current economic situation, licensees of technology and customers of application services providers should consider the possibility of their licensors or service providers going bankrupt. While Section 365(n) of the Bankruptcy Code provides some protection to licensees by allowing them to retain certain specified intellectual property rights under a rejected license agreement, this protection will be of little value to some licensees.

* Deborah Miller is a partner with GCA Law Partners LLP, a Mountain View, California law firm representing technology companies. Her practice focuses on technology licensing and electronic commerce. Joel Riff is a former partner with GCA Law Partners LLP. Patrick Costello is of counsel to Bialson, Bergen & Schwab, a Palo Alto firm representing technology companies in a broad-range of domestic and international credit matters. His practice focuses on representing creditors, creditors' committees and other interested parties in formal and informal insolvency proceedings.