In the rapidly changing world of technology, it is not uncommon for large companies to become dependent on start-up, financially vulnerable firms through the licensing of key technology. With the now you're hot, now you're not pace of the high-tech world, many licensors have been forced into bankruptcy, jeopardizing the right of the licensee to use the technology.
Prior to 1988, a licensee could not rely on a licensing agreement for the continued use of the licensed technology in the event of a licensor bankruptcy. After intense lobbying by vendors and trade groups (including launching a celebrated case, Lubrizol Enterprises v. Richmond Metal Finishers, Inc., which illustrated the plight of a licensee whose licensor goes into Chapter 11),Congress enacted the Intellectual Property Bankruptcy Act of 1988 codified in Section 365(n) ofthe Bankruptcy Code to limit the power of the licensor to prevent the continued use of the license.
Limited Scope of Section 365(n)
Section 365(n) of the Bankruptcy Code only applies to licenses of intellectual property in the context of a licensor bankruptcy. Moreover, Section 365(n) applies only to the following types of intellectual property:
- trade secrets
- patentable inventions and patent applications
- plant varieties
- works of authorship protected under U.S. copyright law
- mask works protected under Chapter 9 of the copyright laws (part of the Semiconductor Chip Protection Act of 1984)
Noticeably absent from the covered agreements are trademarks, trade names and service mark licensing arrangements. Congress excluded trademarks because they depend primarily on the obligation of the licensor to maintain quality control over the products bearing the mark covered by the license.
Protections of Section 365(n)
If a debtor/licensor rejects an executory license, Section 365(n) of the Bankruptcy Code provides the licensee with the option of treating the license as terminated by virtue of the rejection and asserting damages for breach, or retaining its rights under the license for its duration and any applicable extensions. Section 365(n) expressly provides that the licensee may only retain its rights as such rights existed immediately before the case commenced. Section 365(n) provides no rights to the licensee in intellectual property that the licensor may create after the bankruptcy filing.
Affirmative Covenants Unenforceable
As to the scope of the retained rights, the licensee may retain its rights as such rights existed prior to the filing including a right to enforce any exclusivity provision, but excluding any other right under applicable non-bankruptcy law to specific performance of such contract.
Under these provisions, the exclusive rights granted to the licensee will still be enforceable, but other rights of the licensee cannot be specifically enforced. The licensor will thus be relieved of any burdens to take additional affirmative acts under the contract such as infringement protection, training and development and maintenance obligations.
Additionally, in exchange for being permitted to retain its rights, the licensee is required to make all royalty payments due under the license in accordance with the contract and for the remaining term and is deemed to have waived any setoff rights with respect to those payments and any claim for administrative expenses. While setoffs are not permitted, Courts have allowed recoupment of certain advances made by the licensee.
In construing the term royalty, Congress has directed the courts to look to the substance, and not the label given to the transaction. In a Ninth Circuit Court of Appeals case, In re Prize Frize,32 F.3d 426 (9th Cir. 1994), the Court held that all payments due for the use of intellectual property should be treated as royalties regardless of how the payments are labelled by the parties, and thus held that a fixed license fee was in fact a royalty under Section 365(n). It is noteworthy that the Court suggested it might have held otherwise if the license fee had been payable in consideration for affirmative covenants such as warranties or indemnifications that were not enforceable by the licensee. Thus, when drafting royalty provisions, the licensee should be careful to separate out payments covering affirmative obligations like maintenance, training or development. If the payments are not segregated out and are lumped together as royalty payments, the licensee may end up paying for affirmative obligations that the licensor is not required to perform.
Although Section 365(n) removed some of the uncertainty and risk associated with a licensor bankruptcy, drafters of an intellectual property license arrangement are well-advised to consider the effect of a potential bankruptcy upon the arrangement. As with any transaction, testing the rights, duties, obligations and expectations of each party against a theoretical bankruptcy may provide additional protection and certainty to reduce the often disruptive effects of a bankruptcy filing.