COVID-19 Bankruptcy Issues Complicate IP Contracts

By Abigail Reardon, Maria Swiatek and Sterling Chan
Law360 is providing free access to its coronavirus coverage to make sure all members of the legal community have accurate information in this time of uncertainty and change. Use the form below to sign up for any of our weekly newsletters. Signing up for any of our section newsletters will opt you in to the weekly Coronavirus briefing.

Sign up for our Bankruptcy newsletter

You must correct or enter the following before you can sign up:

Select more newsletters to receive for free [+] Show less [-]

Thank You!



Law360 (August 21, 2020, 3:14 PM EDT) --
Abigail Reardon
Abigail Reardon
Maria Swiatek
Maria Swiatek
Sterling Chan
Sterling Chan
A company's intellectual property rights[1] are some of its most valuable assets. They are also often the most encumbered, or the most enhanced, by contract.

The burdens and benefits of IP appear in stand-alone licenses or cross-licenses, but they are also almost uniformly included in multiyear commercial agreements for the supply, manufacture, sale or distribution of products, services, or the components thereof.

Strategically savvy companies endeavor to align their contract rights and obligations throughout their company, global affiliates, and supply chain. However, as a practical matter, not every contingency can be planned for in what are generally very long-term agreements. 

The COVID-19 pandemic requires companies to address its impacts on their business. Doing so will likely require companies to deal with, or be, a distressed company.

It is critical for companies to reexamine the contractual burdens and benefits that are a part of their IP portfolio, and strategically plan ahead for what the company wants these IP rights to look like when business returns to a semblance of normalcy, or after a renegotiation with counterparties/potential acquirers of distressed counterparties, or formal bankruptcy proceedings.  

The path forward is guided by principles of contract law, contractual language, and their interaction with principles of bankruptcy law. We address these issues below, hopefully as guidance for companies dealing with existing contracts as well as companies contemplating renewal, renegotiation or new contractual relations involving IP in these uncertain times.

Basic Contract Considerations

Does the company want the IP contract rights or obligations in question to continue? That depends on the value of such rights to the company, which in turn depends on whether the company has the burden or benefit of the contract rights, what the company gets in return, and whether the company itself is distressed. A few important gating issues for this analysis include:

1. Does the contract burden or benefit the company and some or all its affiliates? 

2. How important is the contract to the company or to its affiliates?

3. What are the change-in-control provisions, and how are they triggered?

4. Is the contract assignable or transferrable, and, if so, are there limitations on those rights?

5. Are there provisions that may be triggered by declining performance due to financial issues, resource availability, or government action (e.g., nonpayment of royalties or deficient product fulfillment)?

  • If so, does the company want to trigger those rights?
  • What are the consequences of exercising those rights?

6. Are there provisions granting rights after breach or after termination, like a last time buy right or a tail right for certain products, or products on order or in inventory?

7. Should a party notice a breach and terminate, or just notice a breach, or do nothing?

8. Are there provisions short of a notice of breach or termination that could be triggered, such as an IP escrow clause?

9. Are there ways to expedite resolution of issues resulting from a unique short-term crisis, short of full-blown dispute resolution, and how eager or able to engage in these efforts is the counterparty or perhaps a potential acquirer of the counterparty?

In answering these questions, companies are encouraged to consider the impact of bankruptcy laws, which can change the parties' contractual agreements.

Basic Bankruptcy Considerations

What happens to IP contracts in a formal bankruptcy? Do the contracts continue, are they terminated, are they breached, and, if so, do performance obligations continue in the face of a breach but no termination? 

The answers depend on the application of provisions of the U.S. bankruptcy laws, which generally favor debtors and the opportunity for a fresh start. However, in many instances, U.S. bankruptcy law is supplemented by state contract law, and a bankruptcy court will apply state law to decide whether and to what extent negotiated contract provisions should be enforced. This is another reason to select by contract a governing law. Below is an overview of key bankruptcy considerations.

Enforcing Contract Rights Prefiling

Once a bankruptcy petition is filed, U.S. bankruptcy law grants debtors an automatic stay of pending litigation against creditors. It therefore makes little sense in most instances to commence a litigation against a counterparty likely to file a bankruptcy petition, because the litigation will not proceed once a petition is filed, and chances are slim for obtaining a judgment, and priority creditor status, before a filing. 

The analysis is different to the extent there are other obligors, guarantors or other potential defendants who are not likely to file a petition — the extent to which relief from the automatic stay is possible against a nonfiling defendant is the subject of much litigation in the bankruptcy courts, and a favorable result is by no means certain. It is also worth noting that in some states such as New York, expedited procedures for litigation of claims on "an instrument for the payment of money," like a note, are available and sometimes warranted.

Ultimately, when dealing with a distressed counterparty, companies may find it most useful to exercise existing self-help contract rights prior to a bankruptcy filing. A notable example is to exercise the right of setoff, on the theory that asking for forgiveness rather than permission is a better course of action. Below are examples of other self-help rights which can be provided for by contract.

One now-common provision in many supply agreements containing IP rights is a provision entitling the buyer to exercise a default license. The buyer can license the supplier's IP to a third party that is engaged to manufacture the supplier's product for the buyer.

A default license typically applies if the supplier fails to meet some performance criteria (e.g., delivery schedule, chronic lateness, defects, failure to meet forecasted capacity, etc.). This contract right can be a powerful tool that provides the concerned counterparty with the ability to secure performance without terminating a contract or declaring a breach by a distressed counterparty.

Another useful provision in both licensing and supply agreements is a technology escrow, which is often deployed when the licensee's financial status is uncertain. The licensor agrees to deposit the relevant IP into an escrow account. The licensee has a right to release of the IP in escrow upon the occurrence of the specified release conditions, including, for instance, where the licensor's financial situation deteriorates to a predetermined level.

This mechanism, coupled with a default license in a supply agreement, allows the licensee to continue full use of the licensor's IP if the licensor is unwilling or unable to perform. 

Assumption or Rejection of Executory Contracts

Section 365(a) of the Bankruptcy Code[2] gives a debtor a clear advantage by permitting the debtor to determine whether it will assume or reject that has not yet been fully performed (known as an executory contract). If the debtor elects to assume, then it is generally required to cure any defaults and provide adequate assurances of continuing to perform as a condition of the contract remaining in effect.

If a licensor-debtor elects to reject, the licensee has rights codified in Section 365(n) of the Bankruptcy Code.[3] Under Section 365(n), the nondebtor licensee can either (1) treat the rejection as a breach of contract and sue for damages; or (2) retain its rights under the license, including any exclusivity rights therein, with the caveat that the licensee must also continue making royalty payments.

However, (1) in the event the licensee elects to retain its license rights under Section 365(n), the debtor licensor is relieved of all other obligations under the license (including, most pertinently, the licensor's obligation to maintain, update, or continue developing the IP); and (2) the licensee's obligations to continue making royalty payments cannot be offset by any damages that the licensee suffers as a result of the rejection.

Section 365(n)'s protections were extended to trademarks by the U.S. Supreme Court in its May 2019 decision in Mission Product Holdings Inc. v. Tempnology LLC.[4] In Mission Product, the court also clarified that a debtor licensor's rejection of a contract during bankruptcy proceedings is a breach rather than a rescission of the contract.

A breach does not normally entitle the breaching party to terminate a contract, while rescission puts the parties back into their positions before there was a contract. A breach entitles the nonbreaching party to damages, while a rescission does not. Accordingly, when a debtor-licensor rejects a license agreement, the licensee can decide that it wants its license to continue.  

Section 365(n) and Mission Product address the rights of a licensee when the licensor is the debtor. But what about the interests of the licensor, as a pure licensor, licensor-buyer or licensor-supplier when the licensee is the debtor?

Does the debtor-licensee's decision to assume an executory contract mean the licensor is stuck with what is in effect a different licensee, and a different counterparty in the form of the debtor? What if there is a concern that the debtor might end up under the control of a competitor or other third party the licensor would never have contracted with in the first place?

Section 365(n) does not address the above legitimate business concerns of a licensor. If a licensor has concerns that a debtor-licensee's assumption of a license may adversely impact the value of the licensor's IP or its business, the licensor is encouraged to consider affirmative action effective before a bankruptcy filing, including grounds for termination under the contract's provisions on material breach. 

A recent decision from the U.S. Bankruptcy Court for the Southern District of New York in In re: Firestar Diamond Inc.[5] illustrates the strategic nuances of managing disputes between a debtor-licensee and a licensor.

Firestar involved a licensor's motion to compel rejection of the license, on the ground that rejection was necessary to protect the value of the IP given the debtor's embroilment in a massive fraud. While the licensor could have terminated the license, it did not do so.

Instead, the licensor sought to compel rejection of the license, and the trustee for the debtor agreed. Rejection was not termination but rather breach by the debtor-licensee. Accordingly, the licensor retained its right to breach damages (with a very low priority in bankruptcy), while extricating itself from the license it claimed was harming the value of its IP — having its cake and eating it too.

The lesson of Firestar is that a licensor must carefully and strategically review its agreements, and not act with haste or without an end game.

Foreign Bankruptcy Considerations

Given globalization of the IP market, the likelihood is high that companies will encounter a counterparty with significant IP rights that files for bankruptcy in a non-U.S. jurisdiction. It is settled that the ownership or rights to U.S. IP must be determined under U.S. law. Chapter 15 of the US bankruptcy law provides for a proceeding ancillary to a foreign bankruptcy to be commenced here by the representative of the debtor. 

In one such proceeding, Jaffé v. Samsung Electronics Co.,[6] the U.S. Court of Appeals for the Fourth Circuit rejected a foreign trustee's efforts to reject some 4,000 U.S. patent licenses in the semiconductor industry (in an attempt to obtain new, royalty-bearing licenses), applying U.S. law and U.S. public policy to protect the rights of the licensees.   

Accordingly, a U.S. licensor, as well as a U.S. licensee, enjoy protections of their license rights in U.S. IP based on U.S. law and public policy that might not otherwise be available in the country where the main bankruptcy proceeding is pending.

Conclusion

Protecting IP rights in the days of the COVID-19 pandemic raises critical questions for both domestic and global companies. The above discussion is intended facilitate the following key considerations, which are applicable even under normal circumstances: Hone your business objectives, read your contracts and work with the best advisers to think strategically.



Abigail Reardon and Maria Swiatek are partners, and Sterling Chan is an associate, at DLA Piper.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.


[1] E.g. patent rights, know-how, trade secrets, trademarks or trade names. The thinking set forth in this article generally applies with equal strength to each of these kinds of rights, except as otherwise noted.

[2] 11 U.S. Code § 365(a).

[3] 11 U.S. Code § 365(n).

[4] Mission Product Holdings, Inc. v. Tempnology, LLC , 587 U.S. ---, 139 S. Ct. 1652 (2019).

[5] In re: Firestar Diamond, Inc. , Case No. 18-10509 (SHL), April 17, 2020.

[6] Jaffé v. Samsung Elec. Co. , 737 F.3d 14 (4th Cir. 2013).

For a reprint of this article, please contact reprints@law360.com.

Hello! I'm Law360's automated support bot.

How can I help you today?

For example, you can type:
  • I forgot my password
  • I took a free trial but didn't get a verification email
  • How do I sign up for a newsletter?
Ask a question!