A Secured Creditors Rights to Intellectual Property Licensed by a Debtor in Bankruptcy

Journal Issue

May 2001

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When financing a "high-tech" entity, most lenders require the grant of a security
interest in intellectual property under which the borrower is the licensor.

Many high-tech entities have failed and filed for bankruptcy. Chapter 7 filings
are common because the debtor has exhausted its capital. Although the debtor/licensor
is out of business, the third-party licensees are not necessarily insolvent.

Section 365(n) provides that, notwithstanding the rejection of a license
agreement, a licensee may retain its rights under the license for the duration of the
agreement. A licensee retaining its rights under §365(n) must continue to make
royalty payments under the license agreement to the licensor. The royalty payments would
provide a secured lender with an additional source of recovery when its high-tech
debtor fails.

<h3>The Bankruptcy Code and License Agreements</h3>

License agreements are typically executory contracts because performance is due from
both parties to the agreement. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Energy Corp. v United States, 50
F.3d 233, 238-39 (3d Cir. 1995)</a>, citing Countryman, Vern,
"Executory Contracts in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…: Part I," 57 Minn. L. Rev. 439, 450
(1973)</a>. As an executory contract, a license agreement is deemed rejected in a
chapter 7 bankruptcy if the trustee does not assume or reject the executory contract
within 60 days from the order of relief. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(d)(1)</a>. In
a chapter 7 bankruptcy, license agreements are routinely deemed rejected.

After being deemed rejected, however, a license agreement is not necessarily a
"dead contract." Instead, pursuant to §365(n)(1)(A) and (1)(B), the
licensee has the right to treat the agreement as breached or, alternatively, to retain
its rights under the license agreement. The licensee must make the royalty payments
required under the license agreement if it determines to retain its rights. These
payments are an asset of the bankruptcy estate. A license agreement, and the proceeds
therefrom, is collateral in which a secured lender may take a security interest,
assuming the applicable loan documents so provide. Accordingly, royalty payments made
by a licensee retaining its rights under a license agreement pursuant to §365(n)
are subject to the security interest of a secured lender taking a security interest
in the license agreement. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re AGI Software Inc., 199 B.R. 850
(Bankr. D. N.J. 1999)</a>.

<h3>Case Law Interpreting a Lender's Rights Under §365(n)</h3>

In AGI Software, the chapter 7 trustee conceded that he neither assumed nor
rejected a license agreement and, since more than 60 days had passed since the order
for relief, the license agreement was deemed rejected. Nonetheless, the licensee was
permitted under §365(n) to enforce the license agreement to the extent it was
effective immediately prior to the petition date. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Software, 199 B.R.
at 857</a>.

Assuming the license agreement was effective, the licensee could retain its rights
thereunder by making royalty payments. Thus, it was possible for the debtor's secured
lender to enforce the license agreement as the secured lender held a security interest
in proceeds from the license agreement. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; As long as the licensee retained its
rights in the license agreement under §365(n) and made royalty payments as required
thereunder, such royalty payments would be due to the secured lender. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Software, 199 B.R. at 857</a> (where the court ultimately determined that the
license agreement terminated prior to the petition date, and therefore, §365(n)
did not apply).

Indeed, a licensee is required to immediately make all royalty payments due in
order to continue to enjoy the use of a license agreement. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Prize Frize
Inc., 150 B.R. 456 (9th Cir. BAP 1993)</a>, aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d
426</a>. As stated by the Ninth Circuit, "Section 365(n) has struck a fair
balance between the interests of the bankrupt and the interests of a licensee of the
bankrupt's intellectual property. The bankrupt cannot terminate and strip the licensee
of rights that the licensee had bargained for. The licensee cannot retain the use of
those rights without paying for them." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Business Management Inc. v. Prize
Frize Inc., 32 F.3d 426, 428 (9th Cir. 1994)</a>.

Since a licensee cannot retain its rights under a license agreement without making
royalty payments, it only follows that even after the conclusion of a bankruptcy
proceeding, a licensee must make royalty payments. While a licensee may assert that
its duty to make royalty payments extends to the debtor only, it is logical that such
a duty passes through the debtor to a secured lender that obtained relief from the
automatic stay and/or otherwise foreclosed upon its security interests.

A grant of a security interest, after all, gives the secured lender a property
interest. The termination of the automatic stay, just as the conclusion of a
bankruptcy proceeding after which the debtor ceases to exist, does not extinguish the
existence of that property interest. It follows that a secured lender's property
interest in a license agreement, and the proceeds therefrom, survive after stay
termination, bankruptcy estate closing and even discharge (where appropriate). After
all, when a secured lender forecloses on its property interest by surrender or
termination of the automatic stay, the secured lender has the right to dispose of such
property. This right typically results in the sale, or retention through credit
bidding, of the property interest.

When a sale of the property interest occurs, the right to proceeds under a license
agreement transfers to the purchaser. Thus, a royalty payment due under a rejected
license agreement to a debtor is now due the purchaser from the foreclosing secured
lender. Similarly, a secured lender that credit-bid its debt at a sale of the
debtor's former property stands in the shoes of a purchaser at a foreclosure sale.

The royalty provisions of a license agreement are enforceable by a secured lender
and/or its assignee/purchaser, who foreclosed upon or otherwise obtained the rights
under a license agreement and the proceeds therefrom. Due to the security interest
grant and foreclosure, whether through stay termination or cessation of existence after
a chapter 7 bankruptcy, the secured lender and/or the purchaser therefrom stands in
the shoes of the licensor with all appurtenant rights. Thus, an additional avenue of
collection on a secured claim exists in a chapter 7 case.

<h3>Conclusion</h3>

Section 365(n) is clear in its requirements. A licensee whose license
agreement was rejected may retain its rights thereunder at its discretion. However,
the licensee must pay royalty payments due under the license agreement, which
constitute the proceeds and are collateral of the secured lender.

Such rights are enforceable with the threat of termination of the license agreement
if royalty payments are not made, which furthers the ability to collect. Practitioners
must consider this additional source of debt collection, both before and after receiving
a security interest, to maximize upon an otherwise deficient claim. Considering the
potential for additional recovery, practitioners are wise to pay careful attention to
the grant of a security interest in a debtor/borrower's license agreements and the
proceeds therefrom.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Tuesday, May 1, 2001 - 12:00

Bankruptcy Rule

2001