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July 2014: Bankruptcy and Restructuring Update

Business Litigation Reports

Intellectual Property Licenses in Bankruptcy—Uncertainties Remain Following the Eighth Circuit’s En Banc Decision in Interstate Bakeries. The bankruptcy of a party to an intellectual property license presents serious challenges. Not only are there monetary issues—such as unpaid royalties—but also questions as to the continued exploitation of the intellectual property itself.

Lewis Brothers faced this problem when Hostess and its predecessor, Interstate Bakeries (“IBC”), filed for Chapter 11—twice in one decade. IBC had sold to Lewis Brothers one of its bakery divisions, including a perpetual, royalty-free exclusive license to exploit trademarks associated with the business. After IBC filed for bankruptcy in 2004, it asked the Bankruptcy Court to treat Lewis Brothers’ license as an “executory contract,” which IBC could assume or reject pursuant to Bankruptcy Code § 365 (11 U.S.C. § 365). Lewis Brothers objected, contending that the license was no longer “executory” because it was an integral part of the consummated sale of the business. Lewis Brothers feared that, if IBC were to reject the license, it would lose its ability to use brand names associated with its products. Although IBC ultimately assumed Lewis Brothers’ license, IBC nonetheless obtained a ruling that the license was executory. Lewis Brothers appealed, because it remained concerned that the adjudication of the license as executory would place it at risk in the future.

Lewis Brothers’ concerns were valid because IBC (which had changed its name to Hostess) filed a second Chapter 11 in 2012. Hostess sought to sell “free and clear” its remaining bread businesses to a third party, including the trademarks that had been licensed to Lewis Brothers. Lewis Brothers objected, contending (as it had in the first Chapter 11 case) that the license could not be rejected. Although a three-judge panel of the Eighth Circuit had affirmed the first Bankruptcy Court’s finding that the license was executory, Lewis Brothers pursued en banc review. Meanwhile, in the second bankruptcy case, Lewis Brothers was able to obtain a reservation of rights, and thus the sale of Hostess’ remaining business was subject to whatever rights Lewis Brothers had to the trademarks.

Lewis Brothers’ rights were vindicated in Lewis Bros. Bakeries, Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 751 F.3d 955 (8th Cir. 2014), in which an 8 to 3 majority of the Eighth Circuit, sitting en banc, held that the trademark license was not executory. Applying what is known as the “Countryman definition,” the court held that a contract is “executory” when “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.” Under this definition, many intellectual property licenses would be considered to be “executory contracts,” due to the licensee’s duty to pay royalties, and the licensor’s agreement to allow the licensee to continue to exploit the intellectual property. The Eighth Circuit, however, concluded that the Lewis Brothers’ license was merely one component of the overall sale of IBC’s business, which sale had been “substantially performed.” Thus, if either party were to breach at this point, it would not excuse performance of the remaining obligations under the license (principally, IBC’s duty to permit Lewis Brothers to exploit the trademarks). The Eighth Circuit’s decision followed another recent holding that a trademark license acquired as part of a consummated sale of a business was not executory. In re Exide Techs., 607 F.3d 957 (3rd Cir. 2010).

The Interstate Bakeries decision shows that at least some intellectual property licenses may not be affected by bankruptcy. The scope of the decision, however, is limited to those licenses that have been “substantially performed” by at least one party. Thus, many (if not most) licenses will still be treated as executory contracts. As a result, great uncertainty will remain because different rules apply depending upon (i) whether the bankrupt is the licensor or licensee, (ii) whether the license is exclusive or non-exclusive, and (iii) the type of intellectual property that is licensed.

When the Licensor Goes Bankrupt. The Bankruptcy Code provides some protection for licensees under executory intellectual property licenses, but the scope of that protection is limited. If the rejected license involves a debtor’s patent or copyright, then the non-debtor licensee may elect either to (i) treat the license as terminated, in which case the non-debtor licensee will be relieved of all further obligations, but can no longer exploit the license, or (ii) continue to use the intellectual property generally pursuant to the license, including the payment of royalties to the debtor, but without the benefit of any ongoing affirmative performance by the debtor (such as continuing product support). 11 U.S.C. § 365(n). The law is unclear as to trademarks, however, which Congress excluded from the definition of “intellectual property.” 11 U.S.C. § 101(35A). The majority view appears to be that a trustee or debtor may reject an executory trademark license, and thus deprive the licensee of any further rights. See Exide, 607 F.3d at 966 (Ambro, J., concurring). This is the fate that concerned Lewis Brothers, were its license held to be executory. However, a recent decision by the Seventh Circuit reaches a contrary result, holding that “rejection” of a trademark license is not tantamount to its termination, but is rather the equivalent of a breach under nonbankruptcy law. Sunbeam Prods. v. Chi. Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012). As such, the licensee may elect to disregard the debtor’s breach, and continue to use the trademark for the remainder of the license term.

Legislation has been introduced in the U.S. Senate (S. 1720) and House (H.R. 3309) to codify the result of Sunbeam by extending Bankruptcy Code Section 365(n) protections to trademark licensees. The legislation also would codify the result of Jaffe v. Samsung Electronics Co., 737 F.3d 14 (4th Cir. 2013), which held that Section 365(n) protects the rights of patent licensees within the United States, even when patent licenses have been terminated in a foreign insolvency proceeding. We will be watching the progress of this legislation closely, but the window for passage in this congressional term is closing.

When the Licensee Goes Bankrupt. The bankruptcy of an intellectual property licensee also presents significant issues. The debtor licensee (or, if appointed, the bankruptcy trustee in its stead) generally must do one of three things with respect to the license: reject it, assign it to a third party, or assume it for the debtor’s own use after the bankruptcy. If the license is rejected, then the debtor can no longer use the intellectual property. Any past-due royalties or other amounts owing will be claims in the bankruptcy case, payable—often at cents-on-the-dollar—pursuant to the terms of a plan (in Chapter 11) or by the trustee from the liquidation of the debtor’s assets (in Chapter 7). Licenses, however, often have value, either in their own right, or as part of the debtor’s overall business. When this is the case, the trustee or debtor may seek to assign the license, or to assume it. To do so, the trustee or debtor must “cure” any defaults under the license by paying the licensor in cash all past amounts owing under the license, and correcting any other outstanding breaches.

Debtors and trustees are limited in their ability to assign or assume intellectual property licenses over the licensor’s objection. Although the Bankruptcy Code generally overrides contractual restrictions on the assignment of executory contracts, this is not true with respect to contracts that are considered “personal” in nature. See 11 U.S.C. § 365(c). Most courts have held that a debtor-licensee’s rights under a nonexclusive intellectual property license are personal, and thus cannot be assigned over the objection of the licensor. One federal circuit has suggested that even exclusive licenses may be non-assignable, see Gardner v. Nike, Inc., 279 F.3d 774 (9th Cir. 2002), but not all courts agree, see In re Golden Books Family Entm’t, Inc., 269 B.R. 300, 311 (Bankr. D. Del. 2001).

Because of rather confusing language in Section 365(c), the same prohibition on assignment (to third parties) of many intellectual property licenses may also prohibit their assumption by the debtor (for itself in its post-bankruptcy capacity), even if the bankruptcy results in no change to the debtor’s ownership and management. See, e.g., Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747 (9th Cir. 1999). A minority of courts, however, allow a debtor to assume its intellectual property licenses, even if the licensor does not consent. See, e.g., In re Adelphia Commc’ns Corp., 359 B.R. 65, 72 (Bankr. S.D.N.Y. 2007). Two Justices of the U.S. Supreme Court have suggested that this conflict may be ripe for resolution. See N.C.P. Mktg. Grp., Inc. v. BG Star Prods., Inc., 556 U.S. 1145 (2009).

As can be seen, the treatment of intellectual property licenses depends upon many factors, not the least of which is the jurisdiction in which the debtor’s bankruptcy case is pending. Until either Congress or the Supreme Court acts to clarify the law, parties to intellectual property licenses will continue to face great uncertainty in bankruptcy.