The Risk of an Offensive Use of Catapult

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Apr 2001

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Since the U.S. Court of Appeals for the Ninth Circuit issued its decision in
Perlman v. Catapult Entertainment Inc. (In re Catapult Entertainment Inc.),<a href="#2" name="2a">2</a> the courts and commentators have examined it as a prohibition on the assumption of
certain intellectual property licenses and a risk to confirmation of a plan of
reorganization. However, there appears to be a dearth of opinions or articles focusing
on an offensive use of Catapult by the licensors of intellectual property licenses.
In the context of other types of non-assumable executory contracts, a number of
courts have concluded that the automatic stay should be modified to allow the
non-debtor contracting party to terminate the pre-petition executory contract. This
article briefly reviews the background of the cases addressing the assignability and
assumability of intellectual property licenses, including Catapult, and apply the
analysis to the context of a motion for relief from the automatic stay to allow the
licensor to terminate an existing license.

<h3>Intellectual Property Licenses Are Executory Contracts</h3>

The initial question addressed by the courts in cases relating to intellectual
property licenses is whether the license is an executory contract. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… 11 U.S.C.
§365(a)</a> authorizes a trustee or debtor-in-possession (DIP) to assume or reject
an executory contract, the Bankruptcy Code is silent as to the definition of an
executory contract. Most courts have defined an executory contract as being one "on
which performance remains due to some extent on both sides."<a href="#3" name="3a">3</a> Based on a similar
definition, the Ninth Circuit has determined that a license of intellectual property
is an executory contract. See Everex Systems Inc. v. Cadtrak Corp. (In re
CFLC Inc.).<a href="#4" name="4a">4</a>

In CFLC, prior to filing for bankruptcy, the debtor paid a one-time royalty
payment to Cadtrak in exchange for a royalty-free, worldwide, non-exclusive license
to use certain patents. The license agreement provided, among other things, that the
license was non-transferable, and that the debtor had no right to sublicense. In
its bankruptcy case, the debtor filed a motion to assume and assign the license, and
Cadtrak objected. In determining whether the license was an executory contract, the
court noted that Cadtrak owed significant continued performance on the license because
it had to continue to refrain from suing the debtor for infringement: "A
non-exclusive patent license is, in essence, 'a mere waiver of the right to sue'
the licensee for infringement."<a href="#5" name="5a">5</a> The court further noted that the licensee owed
performance because it had to mark all products made under the license with proper
statutory patent notice; such obligation is material because failure to mark the
products would deprive the patent-holder of damages in an infringement action before the
infringer has the actual notice of the infringement. Therefore, the court held that
the non-exclusive patent license was an executory contract under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§365</a>.<a href="#6" name="6a">6</a>

<h3>Intellectual Property Licenses Are Not Freely Assignable</h3>

In the context of a non-exclusive patent license, the CFLC court provided an
excellent rationale for the prohibition on the assignment by a licensee of a license
of intellectual property. The CFLC court noted that "the fundamental policy of the
patent system is to 'encourage the creation and disclosure of new, useful and
non-obvious advances in technology and design' by granting the inventor the reward of
'the exclusive right to practice the invention for a period of years'"<a href="#7" name="7a">7</a> The CFLC

court further reasoned that allowing free assignability of nonexclusive patent licenses would undermine the reward that encourages invention
because a party seeking to use the patented invention could either seek a license
from the patent-holder or seek an assignment of an existing patent license from
the licensee. In essence, every licensee would become a potential competitor
with the licensor—patent-holder in the market for licenses under the patent. While
the patent-holder could presumably control the absolute number of licenses in
existence under a free assignability regime, it would lose the very important
ability to control the identity of the licensees. Thus, any license a
patent-holder granted—even to the smallest firm in the product market most remote
from its own—would be fraught with the danger that the licensee would assign it
to the patent-holder's most serious competitor, a party to whom the
patent-holder itself might be absolutely unwilling to license. As a practical
matter, free assignability of patent licenses might spell the end to paid-up
licenses such as the one involved in this case. Few patent-holders would be
willing to grant a license in return for a one-time lump-sum payment, rather
than for-use royalties if the license could be assigned to a completely different
company which might make far greater use of the patented invention than could the
original licensee.<a href="#8" name="8a">8</a>

Thus, in order to further the policies of the patent system, the CFLC court held
that under federal patent law a non-exclusive patent license is personal and
non-delegable, and therefore would excuse the licensor from accepting performance from,
or rendering it to, anyone other than the debtor.<a href="#9" name="9a">9</a>

The rationale for restricting the transferability of non-exclusive patents also applies
to trademarks and copyrights. The owner of a trademark or a copyright should be
allowed to enjoy the benefits of its creativity without having to worry that a licensee
will assign the rights to the trademark or copyright to an entity with which the
trademark or copyright owner would refuse to conduct business, such as a competitor
or (in the perception of the trademark or copyright owner) an unqualified entity.
Therefore, in order to further the policies of the trademark and copyright systems,
both a trademark license and a copyright license, like a patent license, is personal
and non-delegable and, therefore, the licensor is not required to accept performance
from an entity other than the licensor.<a href="#10" name="10a">10</a>

<h3>Section 365(c)(1) Prohibits the Assumption of Intellectual Property Licenses</h3>

While <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(a)</a> authorizes a trustee or DIP to assume or reject
an executory contract, the authority is not absolute. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c)(1)</a>
prohibits a trustee or debtor-in-possession from assuming an executory contract if:
<blockquote>
(1)(A) applicable law excuses a party, other than the debtor, to such
contract or lease from accepting performance from or rendering performance to an
entity other than the debtor or the debtor-in-possession, whether or not such
contract or lease prohibits or restricts assignment of rights or delegation of
duties; and

(B) such party does not consent to such assumption or assignment.
</blockquote>

The Ninth Circuit in Perlman v. Catapult Entertainment Inc.<a href="#11" name="11a">11</a> addressed the
limitations of a DIP assuming certain executory contracts under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§365(c)(1)</a>. In Catapult Entertainment, the debtor in 1994 entered into
a non-exclusive patent license with Perlman. Subsequently, in 1996, Catapult filed
for bankruptcy under chapter 11. As part of its reorganization plan, Catapult filed
a motion with the bankruptcy court seeking to merely assume the non-exclusive patent
license. Perlman objected. Both the bankruptcy court and the district court held that
the debtor could assume the non-exclusive patent licenses, and the Ninth Circuit
reversed. The Catapult Entertainment court reasoned that the plain language of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §365(c)(1)</a> links non-assignability under "applicable law" together with
the prohibition on assumption in bankruptcy.

In other words, the statute by its terms bars the [DIP] from assuming an
executory contract without the non-debtor's consent where applicable law precludes
assignment of the contract to a third party. The literal language of
§365(c)(1) is thus said to establish a "hypothetical test:" a [DIP]
may not assume an executory contract over the non-debtor's objection if
applicable law would bar assignment to a hypothetical third party, even where
the [DIP] has no intention of assigning the contract in question to any such
third party.<a href="#12" name="12a">12</a>

In Catapult Entertainment, the Ninth Circuit held that the debtor was unable to
assume the non-exclusive patent license because applicable non-bankruptcy law prohibited
the assignment of such license without the consent of the licensor.<a href="#13" name="13a">13</a>

Based on the reasoning of Catapult Entertainment, since applicable patent,
trademark or copyright law prohibits the assignment of a license without the consent of
the licensor, then a debtor or trustee is unable to assume the license. Therefore,
cause exists for a bankruptcy court to grant the licensor relief from the automatic
stay to take the actions necessary to terminate the license.

<h3>Inability of the Debtor or Trustee to Assume an Intellectual Property License Is Cause
for Relief from the Automatic Stay</h3>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §362(d)(1)</a> provides:
<blockquote>
(d) 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—

<blockquote>
(1) for cause, including the lack of adequate protection of an interest
in property of such party in interest...
</blockquote>
</blockquote>

Courts that have addressed the issue have concluded that cause exists to terminate
the automatic stay if the debtor cannot assume an executory contract to allow the
non-debtor contracting party to terminate the executory contract. In In the Matter
of West Electronics Inc.,<a href="#14" name="14a">14</a> the debtor was a party to a defense contract with
the U.S. government. After the debtor filed for bankruptcy, the government filed
a motion for relief from the automatic stay to terminate the executory contract. The
government argued cause existed to terminate the automatic stay to allow it to terminate
the automatic stay because <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §15</a>, the anti-assignment statute,
prohibited the debtor assigning the contract to another entity absent the consent of the
government, which consent was being withheld, and as a consequence, the executory
contract could not be assumed pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c)(1)</a>.

The bankruptcy court and the district court disagreed with the government and refused
to terminate the automatic stay. The Third Circuit disagreed, stating:

<blockquote>
We conclude that assignment of a contract calling for the production of military
equipment is precisely what Congress intended to prevent when it prohibited
assignments in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §15</a>. Thus, [the debtor] could not force the
government to accept the "personal attention and services" of a third party without
its consent. It therefore necessarily follows that under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§365(c)(1)</a>, [the debtor], as a [DIP], cannot assume this contract.

"[The debtor] argues that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §15</a> should not be construed to
foreclose an assignment of a contract from a debtor to a [DIP], since they
are such closely related entities. [The debtor's] argument misses the point,
however, for <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c)(1)</a> creates a hypothetical
test—i.e., under the applicable law, could the government refuse performance
from "an entity other than the debtor or the [DIP]" (emphasis in West).
Thus, the relevant inquiry is not whether <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §15</a> would preclude
an assignment from [the debtor] as a debtor to [debtor] as a [DIP], but
whether it would foreclose an assignment by [the debtor] to another defense
contractor.<a href="#15" name="15a">15</a>

</blockquote>

Thus, the court concluded that cause existed to terminate the automatic stay under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §362(d)(1)</a> to allow the government to terminate the defense contract
since the debtor was prohibited by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c)(1)</a> from assuming the
contract.<a href="#16" name="16a">16</a>

Since a debtor licensee is prohibited by applicable non-bankruptcy law from assigning
an intellectual property license to another entity absent the consent of the licensor,
pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c)(1)</a>, the debtor or trustee is thus prohibited
from assuming the license. Since a debtor or trustee cannot assume an intellectual
property license and if the licensor will not consent to the assumption of the
license, no reason exists to require the license to remain in place. Therefore, cause
as defined by West Electronics exists to terminate the automatic stay to allow the
licensor to terminate the license.<a href="#17" name="17a">17</a>

<h3>Conclusion</h3>

In Catapult, the Ninth Circuit Court of Appeals addressed conflicting federal
laws. On the one hand, the Ninth Circuit was faced with a policy decision by
Congress to protect the property rights of patent-holders, which rights are
encompassed in the patent statutes. On the other hand, the Ninth Circuit was faced
with a policy decision by Congress to maximize the recovery to creditors of debtors,
which policy is encompassed in the Bankruptcy Code. The court concluded that the
policies promoted by the patent system took precedent over the policies promoted by
the bankruptcy statutes and, as a consequence, held that a DIP or a trustee was
prohibited from assuming a patent license. The Ninth Circuit's decision in Catapult provides the licensor of certain intellectual property rights with extraordinary power
over a DIP or a trustee. To the extent licensed patented technology, copyrighted
material or trademarks are critical to the operation and reorganization of a debtor,
the licensor of the intellectual property can not only block confirmation of a
reorganization plan, but may also be able to force an early liquidation of a debtor
if it chooses to obtain relief from the automatic stay to terminate the license.

While it is understandable that a licensor of intellectual property would be opposed
to an outright assignment of the license to another (especially a competitor), such
opposition should not apply to the assumption of the license by the licensee.
Indeed, potential recoveries by the creditors through an operating reorganization (as
opposed to liquidation) of the licensee are jeopardized by prohibiting the mere
assumption by the licensee of the license. Therefore, Congress should re-evaluate
the relative priorities of the Bankruptcy Code and the various intellectual property
statutes in order to more adequately balance these inconsistent policies in the context
of reorganizations.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Shareholder with Jenkens & Gilchrist, a professional corporation, in Dallas. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 747 (9th Cir. 1999), cert. dismissed, 120 S.Ct. 369 (1999)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Air Lines Inc. v. Insurance Company of the State of Pennsylvania (In re Ionosphere Clubs Inc.),

85 F.3d 992, 998 (2d Cir. 1996)</a> (quoting National Labor Relations Board v. Bildisco & Bildisco, 465 U.S. 513,
522 n. 6, 104 S.Ct. 1188, 1194 n.6, 79 L.Ed.2d 482 (1984)). <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 673, 677 (9th Cir. 1996)</a> (an "executory contract" is one on which performance is due to some extent
on both sides and in which the obligations of both parties are so far unperformed that the failure of either party to complete performance
would constitute a material breach and thus excuses the performance of the other). <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Access Beyond Technologies Inc., 237 B.R. 32 (Bankr. D. Del. 1999)</a> (holding that
a non-exclusive patent license is executory because both parties had at least one duty, which was an agreement not to sue the other for
infringement of the patents covered by the license); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Luce Industries Inc., 14 B.R. 529 (S.D.N.Y. 1981)</a> (the
district court assumed, without any discussion, that a license of a trademark is an executory contract). Exclusive intellectual property licenses
are also generally treated as executory contracts under the Bankruptcy Code, because the licensor has a continuing obligation to refrain from
licensing the intellectual property to third parties, and the licensee has a continuing obligation to pay royalties, account to the licensor,
etc. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bus. Management Inc. v. Prize Friz Inc. (In re Prize Friz Inc.), 32 F.3d 426, 428 (9th Cir.
1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Select-A-Seat Corp.,</a><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 625 F.2d 290 (9th Cir. 1980)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 89 F.3d at 679</a> (citing Bonito Boats Inc. v. Thundercraft Boats Inc., 489 U.S. 141, 150-51,
109 S.Ct. 971, 977-78, 103 L.Ed.2d 118 (1989)). <a href="#7a">Return to article</a>

(adopting the reasoning of CFLC in the context of a non-exclusive copyright). See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Publications Inc. v. Chinese Yellow Pages
(New York) Inc., 925 F.Supp. 212 (S.D.N.Y. 1996)</a> (federal law prohibits the assignment by a licensee of a trademark
license without the consent of the licensor.). <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 89 F.3d at 679</a> (citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Republic of Ireland, 787 F.2d 655, 658 (D.C. Cir.
1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Corp. v. Fulkerson, 972 F.2d 726, 729 n.2 (7th Cir. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Industries Inc. v.
Guardian Industries Corp., 597 F.2d 1090, 1093 (6th Cir.), cert. denied, 44 U.S. 930, 100 S.Ct. 272,
62 L.Ed.2d 187 (1979)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Industries Inc. v. Kelley Co., 465 F.2d 1303, 1306 (7th Cir. 1972),

cert. denied, 410 U.S. 929, 93 S.Ct. 1365, 35 L.Ed.2d 590 (1973)</a>). See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Alltech Plastics
Inc., 71 B.R. 686, 689 (Bankr. W.D. Tenn. 1987)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Publications, 925 F.Supp at 218</a> (relating to trademarks); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Education Media, 210 B.R. at 242-24</a>

(relating to copyrights). <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Catapult Entertainment, 165 F.3d 747 (9th Cir. 1999), cert. dismissed, 120 S.Ct. 369
(1999)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Entertainment, 165 F.3d at 750</a> (citing Epstein, David G., Nichols, Steve H. and White, James J.,

Bankruptcy §5-15 at 474 (1992); In re James Cable, 27 F.3d at 537; In re West Electronics, 852 F.2d at
83). <a href="#12a">Return to article</a>

<a name="13">13</a> It should be noted that on facts almost identical to those of Catapult, the First Circuit Court of Appeals reached a different
conclusion. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Pasteur v. Cambridge Biotech, 104 F.3d 489 (1st Cir. 1997), cert. denied, 521 U.S. 1120
(1997)</a>, the First Circuit held that a DIP could assume a non-exclusive patent license. <a href="#13a">Return to article</a>

<a name="14">14</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 79 (3rd Cir. 1988)</a>. <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Electronics, 852 F.2d at 83</a>. <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Electronics, 852 F.2d at 84</a>. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re TechDyn Systems Corp., 235 B.R. 857, 864 (Bankr.
E.D. Va. 1999)</a> (same). <a href="#16a">Return to article</a>

<a name="17">17</a> In the event a court follows the reasoning and holding of First Circuit in Cambridge Biotech, cause would not exist to terminate
the automatic stay. <a href="#17a">Return to article</a>

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Journal Authors

Gregory G. Hesse

Journal Date

Sunday, April 1, 2001 - 12:00