When a company goes into bankruptcy, the bankruptcy laws make available to it a series of special tools not otherwise available to companies outside of bankruptcy. These tools are designed either to give the debtor a chance to reorganize its business operations so that it may become a profitable enterprise and thereby propose a plan of reorganization to its creditors, or to allow the company's assets to be liquidated with the proceeds being distributed to creditors. One of these special tools is the right to assume or reject unexpired contracts and leases. If rejected, the debtor can walk away without ongoing liability and the non-debtor party will be left with a claim on which it may receive pennies on the dollar. If assumed, the bankrupt company can move forward with the contract or lease as if no bankruptcy ever occurred. Once assumed, the unexpired contract or lease can then be assigned to a third-party, even when the contract or lease has a specific provision prohibiting assignment. It is, therefore, normal course for a debtor in bankruptcy to review each of its unexpired contracts and leases to see which it should keep and which it should discard, as well as which of those to be discarded might realize value if assigned to third parties.
The Basics
In general, an executory contract can be assumed by the bankrupt if it can:
- Cure existing defaults;
- Monetary defaults must be cured although courts have differed over whether non-monetary defaults need be cured.
- Defaults that are caused by the filing of the bankruptcy case or the financial condition of the debtor do not need to be cured.
- Compensate the non-debtor party for any damages the defaults caused;
- Provide adequate assurance of future performance.
Once the executory contract is assumed, it can be assigned to a third-party.
Executory contracts can be rather easily rejected. Courts usually rely on the debtor's business judgment to determine if rejection should be authorized.
The Exceptions
Certain executory contracts cannot be assumed or assigned without the consent of the other party to the contract. These are contracts where "applicable law" excuses the non-debtor party to the contract from accepting performance from someone other than the debtor or the debtor in possession. This provision has been generally applied to prohibit the assumption or assignment of contracts for personal services.
There is a dispute amongst the courts as to whether non-exclusive patent licenses can be assumed or assigned without the consent of a non-debtor licensor. There are also special rules for assuming or assigning shopping center leases, timeshare contracts, and aircraft leases.
- Contracts to make a loan cannot be assumed.
- There are special rules that protect tenants in possession when the debtor rejects a lease.
- There are special rules that protect licensees of intellectual property when the debtor is a licensor of that intellectual property and rejects the license. However, intellectual property for this purpose includes trade secrets, patents and copyrights, but not trade names.
The Analysis of Computer Software License Agreements
The Fourth Circuit Court of Appeals recently decided that a debtor in possession could not assume a non-exclusive license agreement involving a copyrighted software program registered with the United States Copyright Office unless it first obtained the affirmative assent of the non-debtor licensor. The case, In re Sunterra Corporation, decided by the Court of Appeals on March 18, 2004, is helpful in identifying issues that should be addressed when a license agreement is negotiated, since by the time of a bankruptcy filing by the licensee the opportunity to do so will have evaporated.
Facts
The facts are straightforward. RCI, formerly known as Resort Computer Corporation, developed software for the resort and hospitality industry. Sunterra owned and managed timeshare resorts and licensed RCI's software so that its timeshare customers could trade their timeshare rights. Under the software license agreement, for which Sunterra paid RCI $3.5M, Sunterra acquired a non-exclusive, worldwide, perpetual, irrevocable, royalty-free license to use, copy, modify, and distribute a specific RCI software program that RCI had registered with the United States Copyright Office. In accordance with the software license agreement, Sunterra then spent $38M to modify the software to its needs. Under the terms of the software license agreement, Sunterra owned the modifications and licensed those modifications back to RCI. Each party was obligated to keep the source code confidential.
Sunterra later filed a Chapter 11 case in the District of Maryland and confirmed a plan of reorganization. Before confirmation, RCI filed a motion asking the bankruptcy court to rule that the software license agreement was deemed rejected because it was an executory contract that could not be assumed without RCI's consent. RCI contended that its consent was required by §365(c) of the Bankruptcy Code, and because RCI refused to provide its consent, the license could not be assumed. Sunterra prevailed in the bankruptcy court as well as the district court. RCI then appealed to the Fourth Circuit.
Analysis
Is the Software License Agreement an Executory Contract?
The parties disagreed over whether the software license agreement was an executory contract. The Bankruptcy Court had held it was not executory. The District Court disagreed and found the software license agreement was an executory contract. The Fourth Circuit's analysis of this issue was fairly simple. By Fourth Circuit precedent, it was required to apply the following test to determine executoriness: whether 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." In the view of the Fourth Circuit, the agreement was executory because each party had a material ongoing obligation to keep confidential the software source code developed by the other.
As an Executory Contract, Can the Debtor Assume It?
Having found the software license agreement was an executory contract, the Court now had to determine if Sunterra could assume the agreement. This was a true reorganization, rather than a sale of assets, so there was no need for Sunterra to assign the license agreement to a third party. The court decided that a non-exclusive software license is governed by the same principles as govern a non-exclusive patent license, i.e., that the licensor must affirmatively consent to the transfer of the license to a third-party. The court looked to the assignment clause in the license, which permitted the assignment of the license to a successor in interest that acquired substantially all of the assets of the debtor. However, the court then distinguished an assignment from an assumption. While the licensor might have assented to an assignment, it had not assented to an assumption. Accordingly, the debtor did not have the licensor's assent to the assumption and the debtor's motion was denied.
This means that Sunterra, having spent $38M to modify the software after having paid RCI $3.5M for the software license, was left without anything! Imagine the bargaining power that RCI now has over the negotiations for a new software license!
Drafting Considerations
Here are some bankruptcy-related issues that should be considered when drafting or negotiating a software license agreement:
- The licensee might want to make sure the licensor's copyright of the software is registered with the U.S. Copyright Office.
- The case referred to above involved a registered copyright.
- The Bankruptcy Code's protections for licensees where the license is rejected
- by the licensor/debtor might be interpreted as limited to registered copyrights.
- Consider whether the license should be exclusive or non-exclusive.
- If exclusive, the debtor will be treated as having an ownership interest in the copyright and may be able to assign that ownership interest without the licensor's consent.
- Consider carefully the terms of the assignment clause in the license.
- Should the licensor consent to language that permits the licensee to assign the license without the licensor's subsequent written consent, even to an entity within the corporate family of the licensee or to a successor in interest?
- Should the licensor consent to language that permits the licensee to assume of the license without the licensor's subsequent written consent in the event of the licensee's bankruptcy proceeding?
- Consider the terms of the provision that allows the licensor to recover its attorney's fees and costs.
- Should the licensor be entitled to recover attorney's fees and costs associated with a licensee's bankruptcy case, including the cost of its counsel monitoring the licensee's bankruptcy proceeding or attending hearings that do not directly implicate the license agreement? If so, should these be limited to those arising after a default?
- The licensor should not rely on provisions in a software license agreement that say the license is terminated if the licensee ever files for bankruptcy. These clauses are not effective in bankruptcy cases.
Welcome to Richard Bernard
We are pleased to announce that Richard Bernard has joined the firm as an associate in the Bankruptcy and Reorganization Group. Richard will reside in both our Garden City and New York City offices.
Prior to joining Nixon Peabody LLP, Mr. Bernard was a bankruptcy associate in the New York City office of Paul, Hastings, Janofsky & Walker LLP. There he represented, among others, General Electric and its subsidiaries as asset acquirers, secured creditors, and lessors in numerous bankruptcy cases, including Enron, PSINet, and Owens Corning; NEON Communications as debtor in possession; and Wells Fargo Retail Finance as agent for secured creditors of FAO Schwartz.
Mr. Bernard was a judicial law clerk for the Honorable Robert A. Mark, chief judge of the United States Bankruptcy Court, Southern District of Florida, following receipt of his Juris Doctor degree.
NEWS AND NOTES
Practice Group and Attorney News
Daniel Sklar and Peter Tamposi – Mr. Sklar and Mr. Tamposi, both of our Manchester office, are currently representing the debtor of the Golf Club of New England in a Chapter 11 reorganization proceeding in the Bankruptcy Court of New Hampshire. They expect to file the plan of reorganization shortly.
Daniel Sklar and Mark Berman – Mr. Sklar, of our Manchester office, and Mr. Berman, of our Boston office, have been recognized for their bankruptcy knowledge in the newly published Chambers USA Guide of leading business lawyers.
Mark Berman – Mr. Berman, of our Boston office, is the co-chair of the 11th Annual Northeast Bankruptcy Conference, sponsored by the American Bankruptcy Institute. The conference has consistently drawn the largest attendance of any of the ABI's regional conferences.
Howard Gorney – Mr. Gorney, of our Boston office, recently completed a course to become a trained mediator, specializing in bankruptcy and bankruptcy-related matters.
John Duncan and Mark Berman – Mr. Duncan, of our San Francisco office, and Mr. Berman, of our Boston office, coauthored an article entitled "Top Ten Things to Know If You Are an Investor or a Director of a Failing Business." The article was published on Findlaw.com and in "Counsel to Counsel," published by Martindale Hubbell.
Doug Spelfogel – Mr. Spelfogel, of our Garden City office, is lead counsel for the creditors committee in the Chapter 11 case of a major landfill operator in Louisville, Kentucky. He recently participated in a contested matter where the court, in a detailed written opinion, denied the request of the state to terminate the debtor's license to operate, paving the way for the debtor to succeed in its efforts to sell its business and produce a dividend for creditors.
Doug Spelfogel – Mr. Spelfogel, of our Garden City office, recently lectured on the Revised Uniform Commercial Code and its effect on Bankruptcy Law at a continuing legal education program in New York City. Doug is also scheduled to speak on Bankruptcy Practice in New York at a New York State Bar Association program in June.
Craig Tractenberg and Richard Pedone – Mr. Tractenberg, of our Philadelphia office, and Mr. Pedone, of our Boston office, are currently representing the Ground Round Franchise Council and numerous franchisees in the bankruptcy of the Ground Round Restaurant chain.