Circuit split over IP licenses in bankruptcies vexing issue

The U.S. Supreme Court’s recent decision to pass on a chance to address a long-standing division of opinion among federal circuits — over which test bankruptcy courts should apply when weighing whether an intellectual property license can be kept by a debtor — has renewed a spirited discussion about the tests and which circuits are the preferred venues.

Differing views by lawyers weighing in on the issue suggest it may not be resolved anytime soon. “The split is here for the foreseeable future,” bankruptcy attorney Victor G. Milione, of Nixon Peabody, recently pronounced, referring to the court’s decision to deny a petition for certiorari this spring. Still, Milione and other practitioners believe that the court acknowledged, through comments by two of its justices, the importance of dealing with the split.

Indeed, Justices Anthony M. Kennedy and Stephen G. Breyer issued a statement, after the court declined to hear the case of N.C.P. Marketing Group, Inc. v. Blanks, indicating that the court might consider the issue if a more “suitable” case were brought.

At the core of the debate is the question of whether a debtor that is holding an IP license, that could be deemed critical to fulfilling the bankrupt company’s mission, can keep the license or whether the licensor can terminate it.

“It’s truly bizarre that, in our system, a question like this goes unanswered,” said Boston IP attorney Lee T. Gesmer, of Gesmer & Updegrove, “and even more bizarre that Congress hasn’t solved it. Congress knows the courts have viewed the language in two different ways.” ‘Day of reckoning’ delayed Only this circuit and the 5th Circuit, based in New Orleans, use what is known as the actual test to determine if a debtor-in-possession in bankruptcy can assume an IP license.

The focus in these two circuits, according to Milione, is on “a case-by-case analysis by the [bankruptcy] court of the likely performance of the debtor-in-possession under the license,” the goal being to ensure that the non-debtor licensor “gets the benefit of its bargain going forward” by examining whether the debtor-in-possession is capable of future performance under the license.

Several other circuits, including the 3rd, 4th, 9th and 11th, use the hypothetical test, which, as Boston business-bankruptcy attorney Janet E. Bostwick explained, provides that, if a bankruptcy debtor hypothetically would have been prevented from assigning an IP license to a third party under a non-bankruptcy law, the debtor cannot keep the license. Warren E. Agin, whose practice at Swiggart & Agin in Boston is focused on bankruptcy and IP issues, told Lawyers Weekly that the unanswered question of whether a debtor can keep its IP license has generated numerous disputes.

He cited as an example RCI Technology Corp. v. Sunterra Corp., involving a time-share company named Sunterra, which had obtained a license for software it used to track the ownership and leasing of the time shares under its control from a technology company called RCI. According to Agin, Sunterra had paid RCI a one-time fee for the license and had gone on to spend $30 million to $40 million to customize the software. In 2000, Sunterra filed for bankruptcy, and RCI claimed that the time-share company could no longer use the software it had licensed from RCI. With the case being litigated in the 4th Circuit, which applies that hypothetical test for keeping a license, it was unclear whether Sunterra would be entitled to retain the license.

Agin said that Sunterra was able “to delay the day of reckoning” about the license and, according to news reports, emerged from bankruptcy in 2002, with $300 million in financing from Merrill Lynch Mortgage Capital Inc.

Five years later, in 2007, Diamond Resorts International, also a time-share company, purchased Sunterra. That outcome notwithstanding, the wrangling over Sunterra’s software license demonstrates that the stakes — and the level of contentiousness — in such cases can be high. ‘Fundamental flaw’ and ‘fealty’ Both Agin and Milione emphasized that disputes over the “test” issue are less frequent in this circuit because the use of the actual test is, in Agin’s words, “fairly settled law.” Nonetheless, Milione cited Kennedy’s and Breyer’s statement about the need to resolve the split, saying the justices noted “the fundamental flaw with the hypothetical test [which shows] fealty to the language of the statute while tending to undermine the Bankruptcy Code’s policy of maximizing value in the estate and giving a debtor its best shot at reorganization.”

Unduly barring a debtor from keeping a license that is vital to its survival, Milione added, could mean that “important bankruptcy goals may be endangered.” However, referring to the two Supreme Court justices’ acknowledgement that adherence to the actual test could be interpreted as subverting the section of the Bankruptcy Code dealing with a debtor’s ability to assign IP contracts, Milione said that “courts are generally wary of reading beyond plain, unambiguous statutory text to enforce policy goals.” Asked whether a local bankruptcy lawyer should stay with this actual-test circuit, Agin said the lawyer is bound to follow the law in the district where the bankruptcy is located. If a bankruptcy has been filed in a circuit where the hypothetical test rules, Milione said that a lawyer might want to try to have the case handled in Bankruptcy Court in the 1st Circuit.

“If the only assets a company had were IP assets, you might focus on the 1st [Circuit] as a better venue because you’d have a better likelihood of transferring that IP license to a new entity pursuant to a plan of reorganization,” he said. Gesmer agrees that many companies are “limited in what circuit they can choose” to hash out the issue of which company in a bankruptcy case gets the IP license.

One exception, he said, might be a company whose license contract says “no assignments” but whose operations are in two circuits, such as in Boston and San Francisco, in which case that company would be allowed to file bankruptcy in either circuit. “But if I file [in San Francisco] in the 9th, that circuit has held that I cannot continue the license agreement for the software unless the contract [governing the license] would allow me to assign it,” he said, “[so] it would be better to file here [in the 1st Circuit] because [under the actual test] the licensor would not be able to terminate the contract while I’m in bankruptcy.”

Bostwick, too, sees choices for a bankruptcy lawyer deciding where to file on behalf of a holder of IP licenses. “Often a company has a couple of venue options: the state of incorporation or where the principal assets are located,” she said. In the end, it seems that much depends on the value of the specific IP license. “If your company is based on a license you have and there’s a restriction under a non-bankruptcy law that prevents you from transferring it, you certainly would not want to file in a hypothetical circuit where you wouldn’t be able to assume [or keep] the license and go forward,” Bostwick said. “On the other hand, if the license is one small license to use one small piece of software that you think can be replaced, that’s not going to be a factor in where you file for bankruptcy.”

Sidebar: Checking the fine print – and checking it twice
Boston intellectual property attorney Lee T. Gesmer has some straightforward advice for an IP licensee that wants to be certain it can hold onto its license even if it finds itself bankrupt: Put the plan in writing in a carefully drafted contract.
“The key is, if our client is the licensee that is heading for bankruptcy, that contract does not permit the licensor to terminate the license,” Gesmer said.
He regards such a contract as “a pre-nup,” an agreement that two future spouses would negotiate before they wed so that both understand who will own what during and after the marriage.
Gesmer said that, with the IP licensee’s interests in mind, his firm recommends this “multi-tiered” approach to the contract:

• Have a provision in the executory contract that permits assignments. “Often a licensor doesn’t care if a contract is assigned, as long as performance continues,” he said. “If we succeed on this term, the Section 365(c) [the Bankruptcy Code section that covers a debtor’s authority to assume and assign executor contracts] problem is completely avoided.”
• Have a provision stating that the agreement is not terminable in a Chapter 11 bankruptcy so long as the debtor-in-possession continues to perform.
• Include a provision ensuring that “in the event that Licensee files Chapter 11 bankruptcy, Licensee may assume the license, and nothing in Section 365(c)(1) of the Bankruptcy Code may be used or invoked by Licensor to prevent Licensee from assuming this license.” The language in such a provision, Gesmer said, would be expanded to cover the debtor-in-possession and trustees “and to require continuing performance.”

In summarizing his checklist, Gesmer acknowledged that, in most situations, the licensee does not have “the market power” to insist on the terms he outlined. In that case, he would revert to a licensee’s choice-of-venue option.
“If you have none of these protections,” he said, “you may be forced to file in the most ‘friendly’ forum.”

— Barbara Rabinovitz