Bankruptcy Law: Traps for the Unwary


Automatic Stay: The Mother of All Injunctions.

11 U.S.C. 362 provides that when a petition in bankruptcy is filed under sections 301, 302 or 303 of Title 11 the filing operates as a stay, applicable to all entities, of:

  1. The commencement or continuation of an action or proceeding against a debtor that was or could have been commenced before the commencement of the bankruptcy case;
  2. The enforcement of a judgment obtained before the commencement of the bankruptcy case;
  3. Any act to obtain possession of property of the estate or to exercise control over property of the estate;
  4. Any act to create, perfect, or enforce any lien against the estate;
  5. Any act to create, perfect, or enforce against property of the debtor any lien to the extent the lien secures a claim that arose before commencement;
  6. Any act to collect, assess or recover a claim against the debtor that arose before commencement;
  7. The setoff of any debt owing to the debtor that arose before commencement against any claim against the debtor; and
  8. The commencement or continuation of a proceeding before the United States Tax Court concerning the debtor.

The purpose of the automatic stay is to give the debtor a breathing spell from creditors by stopping all collection efforts, all harassment, and all foreclosure actions. This permits the debtor to attempt a repayment or reorganization plan, or to be relieved of the financial pressures that led to the bankruptcy. Maritime Elec. Co., Inc. v. United Jersey Bank, 959 F. 2d 1194 (3rd Cir. 1991). As one court has held:

The automatic stay is designed to effect an immediate freeze of the status quo at the outset of the [bankruptcy] proceeding, by precluding and nullifying most post-petition actions and proceedings against the debtor in nonbankruptcy fora, judicial or nonjudicial, as well as most extrajudicial acts against the debtor, or affecting property in which the debtor, or the debtor's estate has a legal, equitable, or possessory interest. The automatic stay is activated immediately on the filing of a voluntary . . . petition under Bankruptcy Code 301, and remains in effect until the entry of an order under Bankruptcy Code 362(c)(2), granting or denying a discharge or closing or dismissing the . . . case, or until the entry of an order granting relief from the stay pursuant to Bankruptcy Code 362(d)(3)(f). Judicial actions or proceedings, as well as extrajudicial acts, in violation of the automatic stay, are generally void and without legal effect. Interstate Commerce Commission v. Holmes Transportation, Inc., 931 F.2d 169 (1st Cir., 1991).

The automatic stay also preserves what remains of the debtor's solvent estate and provides systematic equitable liquidation or reorganization procedures for all creditors, thus preventing a mad scramble for the debtor's remaining assets in a variety of uncoordinated proceedings in different courts. Matter of Holtkamp, 669 F. 2d 505 (7th Cir. 1982).

Automatic stay issues have been frequently litigated in the intellectual property context, as shown in the following sections.

Jurisdiction.

A federal district court has jurisdiction to determine the applicability of the automatic stay. Broadcast Music, Inc.. v. Game Operators Corp., 107 B. R. 326 (D.C. Kan. 1989). In Game Operators, the assignees of public performance rights for musical compositions brought a copyright infringement action against jukebox owners. The jukebox owners noted that they had filed a petition in bankruptcy and alleged the automatic stay was an affirmative defense to the infringement action. They further asserted that the district court lacked jurisdiction because of the filing of the petition in bankruptcy.

The district court held, citing In re Baldwin-United Corp. Litigation, 765 F. 2d 343, 347 (2nd Cir. 1985), "(W)hether the stay applies to litigation otherwise within the jurisdiction of a district court or court of appeals is an issue of law within the competence of both the court within which the litigation is pending, . . . and the bankruptcy court supervising the reorganization." Game Operators at 327.

"(I)t is settled that both the bankruptcy court and the court in which the other litigation exists may construe the automatic stay." Matter of Mahurkar Double Lumen Hemodialysis Catheter Patent Litigation, 140 B. R. 969 (N.D. Ill. 1992). However, while the enforcement of the automatic stay is a core proceeding, which gives a bankruptcy judge the power to issue injunctions through a combination of 11 U.S.C. 105(a) and 28 U.S.C. 157(b)(2), the bankruptcy judge does not have the power to extend the automatic stay to forbid any other court from determining the meaning of stay provisions of the Bankruptcy Code. Id.

In Mahurkar, Judge Easterbrook of the Seventh Circuit, sitting by designation, wrote an entertaining opinion decrying the bankruptcy court's issuance of a temporary restraining order preventing Mahurkar from filing a reply brief in federal district court addressing interpretation of the stay, or from arguing its motion orally.

Kendall Med-West, one of the litigants in the Mahurkar case, had filed a bankruptcy petition while Mahurkar, one of Kendall's adversaries in this patent litigation, held contingent claims against Kendall. Kendall stood on its rights under the automatic stay, but instructed a former employee not to attend a deposition in the patent matter. Mahurkar filed a motion seeking an order that Kendall cease its interference.

Kendall then sought a TRO from the bankruptcy court, asserting that the very act of seeking an interpretation of the stay from the district court violated the stay. In response, Judge Easterbrook wrote:

"For a bankruptcy judge to issue an injunction with the effect of preempting resolution of a pending motion in a district court is unheard of. Well, perhaps not un-heard of. I found one case in which a bankruptcy court did so, and the district judge brushed the order aside in derision, treating the order as so patently unauthorized that no further explanation was warranted."

Scope of the Automatic Stay.

Even in light of the above, it is far more likely that an action is stayed by 11 U.S.C. 362 than one that isn't. As the Ninth Circuit has stated so succinctly, "The scope of the automatic stay is undeniably broad." In re Bialac, 712 F.2d 426 (9th Cir. 1983). Costly litigation will most likely be the result of actions taken by creditors or adverse parties after a bankruptcy filing if there is even a slight question of whether such action violates the stay. Of course, the taking of such actions may be so crucial to a party's interest that the risk of resulting litigation may be acceptable. But a finding of willfulness on the part of a party violating the stay mandates an award of damages, including costs and attorneys' fees, and possible punitive damages. See 11 U.S.C. 362(h).

11 U.S.C. 362(b)(1) through (16) provides a list of actions that are not violations of the stay. While this list may seem extensive, the case law is even more extensive with actions that are violations of the stay. See, e.g. In re Knaus, 889 F.2d 773 (8th Cir. 1989) (failure by a creditor to return debtor's property, which was taken lawfully pre-petition, was a stay violation); In re Prudential Lines, Inc., 928 F.2d 565 (2nd Cir. 1991) (a parent corporation's claim of a worthless stock deduction in the stock of a subsidiary in Chapter 11 which effectively eliminated the subsidiaries' net operating loss, was an act to exercise control over estate property, and violated automatic stay); In re Fuller, 134 B. R. 945 (9th Cir. B.A.P., 1992)(creation or perfection of liens); In re Neuman, 128 B. R. 333 (S.D.N.Y., 1991)(stay stops all foreclosure actions); In re Phillips, 124 B. R. 712, (W.D. Tex. 1991)(removal of action from state to federal court after debtor/defendant filed bankruptcy, violated automatic stay).

In the intellectual property arena, it has been held that someone defending a suit brought by a debtor does not risk violation of the automatic stay by filing a motion to dismiss the debtor's suit. United States v. Inslaw, 932 F. 2d 1467 (D.C. Cir. 1991). Inslaw, Inc. had developed computer program enhancements and entered a licensing agreement with the federal government. Inslaw filed for Chapter 11 reorganization and also brought an adversary proceeding to determine its proprietary interest in the enhancements. The Government had continued to use the program enhancements after Inslaw filed the Chapter 11 petition.

The bankruptcy court held that Inslaw had a property interest in the enhancements (intangible trade secret rights) and that the Department of Justice's continued use was an "exercise of control" over property of the estate. Thus the Department's use constituted a violation of the automatic stay.

The Court of Appeals reversed. It held that the bankruptcy court's interpretation of the scope of "exercise of control" created both scope and jurisdictional problems.

"Whenever a party against whom the bankrupt holds a cause of action (or other intangible property right) acted in accord with his view of the dispute rather than that of the debtor-in-possession or bankruptcy trustee, he would risk a determination by a bankruptcy court that he had "exercised control" over intangible rights (property) of the estate." Inslaw, Id.

If this were so, the bankruptcy court would be exercising its "core" jurisdiction and would be subject to review by constitutionally empowered Article III courts only under the deferential "clearly erroneous" standard. Id. The D.C. Circuit found that such an interpretation raised severe constitutional problems, via the vesting of too much power in a non-Article III (bankruptcy) court.

It has been held, however, that a letter purporting to terminate the assignment of a patent to an assignee, sent while the assignee's Chapter 11 bankruptcy case was pending, was void as violating the automatic stay. Chesapeake Fiber Packaging v. Sebro Packaging Corp., 143 B. R. 360 (D. Md. 1992).

It has also been held that an action seeking an injunction against a debtor's ongoing sale of catheters, which allegedly infringed a patent, is within the scope of the automatic stay. Matter of Mahurkar at 976. (Mahurkar claimed that an injunction was not an "action or proceeding" within the meaning of 362(a)(1), and that even if the fact that he complained of a continuing wrong meant it was not a action "that was or could have been commenced before the commencement of the case under this title" (emphasis added)).

Judge Easterbrook held that, because there is no distinction between law and equity, an action for injunction is an "action or proceeding". Further, he held that the bankruptcy court is the place in which to seek redress for continuing wrongs, as part of an overall policy decision to grant creditors equal rights.

Property of the Estate.

The automatic stay protects property of the estate. "The estate is created by the filing of a petition and comprises property of the debtor wherever located and by whomever held", including (among other things) "all legal or equitable interests of the debtor in property as of the commencement of the case". 11 U.S.C. 541(a)(1). "It is undisputed that [property of the estate], encompasses causes of action that belong to the debtor, as well as the debtor's intellectual property, such as interests in patents, trademarks and copyrights." Inslaw at 1471.

In In re Berlyn Corp., however, the bankruptcy court held that a supersedeas bond deposited by the debtor in a patent infringement action was not property of the estate. In re Berlyn Corp., 133 B.R. 170 (Bankr. D. Mass. 1991). In Berlyn, Berlyn and Kalman were in the final stages of a lengthy patent dispute. Kalman received a judgment in excess of $1.5 million. Berlyn appealed and deposited a $1.7 million supersedeas bond. The court of appeals affirmed on liability for patent infringement, but deferred action on a suggestion for rehearing en banc, made on the narrow grounds that a plaintiff should have been added to the action. Kalman moved for disbursement of the deposit.

Though liability was established, the bankruptcy court held that, although the supersedeas deposit was not property of the estate, the motion by Kalman for disbursement was an "action or proceeding . . . to recover a claim against the debtor that arose before the commencement of the case." The motion thus violated the automatic stay.

Relief From the Stay.

Relief from the stay is available under the following conditions:

On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay --

  1. for cause, including the lack of adequate protection of an interest in property of such party in interest; or
  2. with respect to a stay of an act against property under subsection (a) of this section, if -
    • the debtor does not have an equity in such property, and
    • such property is not necessary to an effective reorganization. 11 U.S.C. 362(d).

Only the bankruptcy court may exercise this equitable power. Matter of Mahurkar, at 975.

It has been held, for example, that a victory on the merits in an underlying patent infringement case is adequate cause for relief from the stay, at least where the movant seeks disbursement of a supersedeas bond deposited to cover the appeal in a patent infringement case. In re Berlyn Corp., supra.

The Trustee's Avoiding Powers: What You Thought Belonged to Your Client, May Not.

The trustee in bankruptcy has all the rights and powers of a judgment lien creditor as of the commencement of the bankruptcy case. 11 U.S.C. 544. This power, which elevates the trustee above unsecured and unperfected secured creditors as of the time of filing, serves "essentially to marshal all of the debtor's assets, including some that the debtor itself could not recover, in order to enhance the resources available to the pool of creditors." Matter of Quality Holstein Leasing, 752 F. 2d 1009, 1014 (5th Cir. 1985).

The powers found in 11 U.S.C. 544 et. seq. allow the trustee to avoid certain transfers by the debtor as illegal preferences; 547(b) sets out the basic rule: a trustee may avoid a transfer made by a debtor on or within 90 days prior to the filing of the petition in bankruptcy, provided said transfer was made to benefit a creditor, on account of an antecedent debt, and made while the debtor was insolvent. Section 547 also establishes a presumption that a debtor was insolvent for the 90 day period prior to filing.

This preference statute is designed to compel restoration of any preferential payment, as well as to discourage creditors from engaging in unusual collection practices which help to dismember the debtor and hasten its slide into bankruptcy, and to facilitate the goal of equal distribution among creditors. In re Miniscribe Corp., 123 B. R. 86 (Bankr. D. Colo. 1991).

11 U.S.C. 548 allows trustees to avoid fraudulent transfers that occur within one year prior to the debtor's filing of a petition in bankruptcy. When interpreting this section, courts often focus on whether or not the debtor receives less than reasonably equivalent value in return for the transfer, and is either insolvent as a result of the transfer. In re Decalcomania Mfg. Corp., 142 B. R. 6670 (Bankr. D.N.J. 1990).

Within an intellectual property context, the courts have held that a debtor's assignment of patents within 90 days of the filing of a petition in bankruptcy is a voidable preference under 547. In re Otto Fabric, Inc., 55 B. R. 654 (Bankr. D. Kan. 1985).

In Otto, City Bank (as creditor) sought relief from the automatic stay, while Otto (as debtor) sought to avoid any lien the Bank may have had via the patent assignment as a preference. The Bank perfected its interest in the patent assignment under 35 U.S.C. 261 (which establishes a reporting system for patents) within the 90 day preference period. The Bank also filed a financing statement on the same patents just prior to recording the assignment with the Patent and Trademark Office, outside the 90 day preference period.

If filing a financing statement governs perfection, the assignment was not a voidable preference. If, however, 35 U.S.C. 261 governs perfection, the assignment can be avoided by the trustee.

The bankruptcy court held that "Patent and Trademark Office filing is an adequate system that entirely preempts UCC filing", rejecting the rule of In re Transp. Design & Technology, Inc., 48 B. R. 635 (Bankr. S. D. Cal. 1985). Id. at 657. Thus, assignment was ruled a voidable preference.

In City Bank and Trust Co. v. Otto Fabric, Inc., 83 B. R. 780 (D. Kan. 1988), however, the district court reversed the bankruptcy court and held that a federal filing is not necessary to perfect a security interest in patents. The court held that the failure of 35 U.S.C. 261 to mention protection against lien creditors [S]uggests that it is unnecessary to record an assignment or other conveyance with the Patent Office to protect the appellant's security interest against the trustee. In other words, regardless of whether preemption is total or partial, the statute does not require a federal filing for protection against lien creditors. Id. at 782.

The court distinguished the grant of a security interest from the conveyance of title or ownership rights, and likened the grant of a security to granting a license in a patent, which need not be recorded in the patent office. Reasoning that to require a federal filing to perfect security interests as against lien creditors would reduce the flexibility of patents as collateral in secured transaction, the court noted that such a requirement would be contrary to the functional goals of the U.C.C.

The same reasoning applies to the perfection of security interests in trademarks. Article 9 of the U.C.C. governs perfection, rather than the Lanham Act. In re Roman Cleanser Co., 43 B. R. 940 (Bankr. E. D. Mich. 1984) aff'd, 802 F.2d 207 (6th Cir. 1986).

"An 'assignment' of a trademark is an absolute transfer of the entire right, title and interest to the trademark . . . The grant of a security interest is not such a transfer." Id. at 944.

Bankruptcy trustees may not avoid a security interest in a patent or trademark that is the subject of a state filing, provided of course it is timely and not a fraudulent transfer.

Intellectual Property Licensing and the Bankruptcy Code - An Overview (or an Oxymoron?).

With certain exceptions, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." 11 U.S.C. 365(a). The purpose of this section is to allow a trustee to pick and choose among the debtor's agreements and assume those which benefit the estate and reject those which do not. In re G-N Partners, 48 B. R. 462 (Bankr. D. Minn. 1985). Furthermore, a debtor-in-possession under Chapter 11 exercises the rights and powers of a Chapter 11 trustee and therefore may reject executory contracts. In re Rovine Corp., 5 B.R. 402 (Bankr. W.D. Tenn. 1980).

In a Chapter 7 bankruptcy, an executory contract is deemed rejected if it is not assumed within 60 days after the order for relief. 11 U.S.C. 365(d)(1). In a case under Chapter 9, 11, 12 or 13 the trustee may assume or reject an executory contract (except that of non-residential real property) any time before the confirmation of a reorganization plan, but the court may set a deadline at the request of any party to such a contract. 11 U.S.C. 365(d)(2). While the Bankruptcy Code does not define "executory contract", legislative history provides that they generally include contracts on which performance remains due to some extent on both sides. In re Richmond Metal Finishers, 34 B. R. 521 (Bankr. E. D. Va. 1983).

Section 365 is of special import to the intellectual property practitioner. "To say that much has been written and little concluded about what constitutes an executory contract is an understatement. Hume noted that 'Beauty in things exists in the mind which contemplates them.' I think that the same is true of executory contracts." In re G-N Partners at 465.

In 1988, Congress enacted the Intellectual Property Licenses in Bankruptcy Act, which forever altered the relationship between a licensor and licensee. Congress first defined what "intellectual property" is and, importantly, is not, in the scope of bankruptcy practice. Pursuant to 11 U.S.C. 101(60), Intellectual property means -

  • trade secret;
  • invention, process, design or plan protected under title 35;
  • patent application;
  • plan variety;
  • work of authorship protected under Title 17; or
  • mask work protected under Chapter 9 of Title 17; to the extent protected by applicable nonbankruptcy law.

This definition is meant to be exclusive, and pointedly does not include trademarks or service marks. The legislative history reveals that the lack of bankruptcy protection for trademarks and the like relates to the quality control of goods and services sold by a licensee, and not a piece of intellectual property, per se.

The Intellectual Property Licenses in Bankruptcy Act also added 365(n) to the Bankruptcy Code. 365(n) permits an intellectual property licensee to treat a trustee's rejection of a license as a termination of the licensing agreement, or, at the licensee's option, to retain the licensee's rights under the licensing agreement. If the licensee chooses to retain its rights, the licensee:

  1. may enforce any exclusivity provision in the licensing agreement;
  2. may continue to exercise its rights under the licensing agreement;
  3. may continue making royalty payments;
  4. upon written request to the trustee, the licensee may receive any intellectual property to the extent called for in the licensing agreement; and
  5. upon written request of the licensee, the trustee must not interfere with the rights of the licensee set out in the licensing agreement. See 11 U.S.C. 365(n)(1)-(4).

The Bankruptcy Code does not define or mandate what a licensee must do to "elect" to retain its rights. However, the cases interpreting 365(n) have held that there must be an affirmative election of some fashion. See In re El International, 123 B.R. 64 (D. Idaho, 1991). There, since the licensee did not make such an affirmative election, the court treated its claim like any other claim resulting from a rejected executory contract, i.e., an unsecured claim. The court would not permit the licensee to utilize the liquidated damages claim included in the licensing agreement. The wary practitioner will, when confronted with a bankruptcy situation, do more than simply "retain" intellectual property under a licensing agreement; he or she will also make an affirmative election, in writing, to the trustee, to retain all rights granted under the licensing agreement. Your malpractice carrier will thank you.

While definitionally not "intellectual property" in the bankruptcy context, it has been held that a trademark licensing agreement was an executory contract, where the contract was not terminated pre-petition, had not been subject to a pre-petition decree of specific performance, and had not been fully performed by both sides, or by either of the parties thereto. In re New York City Shoes, Inc., 84 B. R. 947 (Bankr. E. D. Pa. 1988).

In In re Richmond Metal Finishers, Inc., 34 B. R. 521 (Bankr. E.D. Va. 1983), the bankruptcy court held that because both parties had a continuing obligation under a technology license agreement, and failure to honor such obligations would constitute a material breach, the agreement was an executory contract the trustee could reject pursuant to 365.

The creditor in Richmond Metal Finishers was obligated to pay the debtor a royalty for the use of its technology over a 16 year period, royalties had not yet been paid, and the debtor owed the creditor continuing contingent obligations with respect to patent rights and indemnification.

The court held that even obligations that may never arise may form the basis of classifying a contract as executory. Moreover, the obligation to defend a license from patent infringement suits and to indemnify the licensee from infringement claims was enumerated specifically by the Bankruptcy Court for the Southern District of New York in In re O.P.M. Leasing Services, Inc., 23 B. R. 104 (Bankr. S.D.N.Y. 1982) as an obligation sufficient to make a contract executory. Richmond Metal Finishers at 524, 525.

"Under the business judgment test, a court should approve the debtor's proposed rejection if such rejection will benefit the estate. Id. at 525. The court approved the rejection, noting that rejection should be approved where a contract, while not actually burdensome to the debtor nonetheless prevents the debtor from entering a more advantageous arrangement.

However, it has been held that where a debtor's only obligation under a technology purchase agreement is to pay the creditor in the event of liability on account of patent infringement claims, the agreement is not an executory contract. Matter of Van Dyk Research Corp., 113 B. R. 487 (Bankr. D.N.J. 1981).

Furthermore, an agreement assigning a patent to a Chapter 11 debtor, under which the sole continuing obligation of the debtor was to pay royalties to the assignor unless the debtor used the assignor to manufacture the product, was not an executory contract subject to rejection. Chesapeake Fiber Packaging Corp. v. Sebro Packaging Corp., 143 B.R. 360 (D. Md. 1992). The court held that a contract is not executory as to a party simply because that party is obligated to make payments of money, noting that the agreement at issue was an outright grant of title rather than a licensing agreement. Licensing agreements, and the rejection or assumption of such agreements are subject to 11 U.S.C. 365(n). For a good general discussion of 11 U.S.C. 365(n), see In re Prize Frize, Inc., 150 B. R. 456 (9th Cir. B.A.P., 1993). For an interesting opinion regarding the assignability of patent licenses, see In re Alltech Plastics, 71 B. R. 456 (Bankr. W.D. Tenn. 1987).

Conclusion.

This paper has not sought to set forth every intersection (or collision) of bankruptcy and intellectual property law. However, it is the writer's belief that the three issues presented -- the automatic stay, property of the estate, and executory contracts -- are those with which most patent law practitioners will most often find themselves confronted.