Bankruptcy Considerations in Technology Transactions

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Apr 2004

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Technology companies typically own or license essential intellectual property. Through various contracts such as
license agreements, cross-license agreements, web site design and development agreements, software development
agreements, web page linking agreements, technology sharing agreements, joint ventures for sharing intellectual
property rights and other agreements, technology companies operate their businesses using valuable patents,
copyrights and trademarks. These contracts are generally deemed "executory contracts" in bankruptcy and are often
the most valuable "assets" an e-commerce or dot.com debtor possesses. However, a bankruptcy filing may strip the
value of such executory contracts and cripple a company's efforts to reorganize. This article will explore certain
bankruptcy rules governing executory contracts of intellectual property and suggest practical methods for
maintaining their value in bankruptcy.

<h3>Basic Bankruptcy Rulesfor Executory Contracts</h3>

Section 365 of the Bankruptcy Code offers special treatment for executory contracts involving intellectual property.
Under the "Countryman definition," contracts under which performance remains due on both sides are considered
executory for bankruptcy purposes. Although the Code itself contains no definition of the term "executory contract,"
bankruptcy courts apply the Countryman definition to analyze the unperformed duties of each party and thus
determine "executoriness."

Once a contract is deemed to be "executory," §365(a) governs its assumption and rejection. In general, a debtor may
exercise "business judgment" to decide whether to assume or reject an executory contract, assessing the benefits and
burdens to its business that flow from the contract. If a debtor decides that the benefits of a particular contract
outweigh its burdens, it will file a motion with the bankruptcy court requesting that assumption be allowed. In
order to assume an executory contract, however, a debtor must cure all defaults under the contract or provide
"adequate assurance" that it will promptly cure, and provide adequate assurance of future performance. If a debtor
rejects an executory contract, the contract is deemed breached as of the date of the debtor's bankruptcy petition, and
the nondebtor party may file a general unsecured claim for damages.

<h3>Bankruptcy Obstacles to the Assumption and Assignment by a Licensee in Bankruptcy of Licenses of Patents, Copyrights</h3>

If the debtor is a licensee of patents or copyrights, the filing of a bankruptcy petition may trigger a number of
unexpected hurdles to continuing essential license rights. An executory contract may not be assigned if "applicable
non-bankruptcy law" excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the
debtor. Because the courts have concluded that patent and copyright law constitutes applicable non-bankruptcy law
that excuses performance from another, the Code prohibits assignment of intellectual property licenses without the
consent of the non-debtor party, even if the license in question is silent on any consent requirement.<a href="#1" name="1a">1</a>

In addition, many courts have held that a literal reading of Code §365(c)(1) (dealing with assumption and
assignment of executory contracts) prohibits even the assumption of an intellectual property license under a so-called
"hypothetical test." At the circuit court level, a majority of courts have endorsed the "hypothetical test."<a href="#2" name="2a">2</a> These
courts reason that a debtor-in-possession (DIP) may not assume an executory contract over the non-debtor's
objection if applicable non-bankruptcy 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.

Obviously, a bankruptcy decision preventing a debtor with critical IP license agreements from assuming those
agreements would not only cripple the debtor and its business, but stymie any potential reorganization. Moreover, if
the debtor intends to rely on the assignment of valuable license agreements to reorganize its business, a prohibition
on assignment would defeat that intention.

<h3>Practical Strategies for Licensee/Debtor to Maintain Licenses in Bankruptcy</h3>

(a) Once in bankruptcy, persuade the licensor of the benefits it will receive in permitting a debtor to assume and
assign its license. For example, the prospect of additional license fees or the retention of cross-licenses may be
incentives for consent. Involve the licensor parties as early as possible in the bankruptcy, and lobby for their
support. If the licensor consents to assignment, the debtor should be permitted to both assume and/or assign the
license under the language of 11 U.S.C. §365(c)(1).

(b) Allow the license to "pass through" the bankruptcy without assumption or rejection. At the conclusion of the
case, all property of the estate revests in the debtor pursuant to 11 U.S.C. §1141(b). Although a licensor may seek
to compel the debtor's assumption or rejection or request relief from the automatic stay in order to terminate the
license, the bankruptcy court should permit the debtor to continue to use the license throughout the case as long as
the debtor is current on its royalty obligations.

(c) When negotiating the license agreement, consider adding a bankruptcy clause that affirmatively states that in
the event the licensee files for bankruptcy, the debtor/licensee or trustee has the explicit right to assume the license
and to continue to use the technology. To bolster the enforceability of such language, the drafter should state that
patent, copyright or other applicable intellectual property law does not control assignment for purposes of the
assumption by the debtor of the license agreement. This language may only be appropriate in certain situations, for
instance, in the case of a cross-license between parties with relatively equal bargaining leverage.

(d) Consider making the license an exclusive license. The characterization of a license as "exclusive" or
"nonexclusive" may affect the determination of whether a contractual arrangement is an executory contract in the first
place. Under a nonexclusive license, the licensee has a mere right to use the intellectual property, but the licensor
retains the rights of ownership. Under an exclusive license, the licensor may be deemed to have transferred title to
the licensee in a "non-executory sale."<a href="#3" name="3a">3</a> A non-executory sale would not be subject to assumption or rejection under
§365 of the Code. Note, however, that the label given to a contractual arrangement is not dispositive, and the courts
will look to the true nature and economic reality of the contractual relationship.

(e) If a joint venture between unrelated parties is contemplated, consider contributing the technology to the
venture so that the venture can continue to operate in the event of the bankruptcy of either joint venturer.

<h3>Maintaining Licenses When Licensor Goes Bankrupt</h3>

Until the enactment of §365(n) of the Code in 1988, licensees were also at risk when their licensors declared
bankruptcy. If the debtor/licensor rejected the license agreement in question for its own business reasons, the
licensee would be left with a terminated license and forced to forfeit its license rights.<a href="#4" name="4a">4</a> Section 365(n) now provides
special protections for licensees to avoid these harsh results.

Under §365(n)(1), the non-debtor licensee may elect to either (a) treat the license as terminated and/or breached and
retain a general unsecured claim, or (b) continue to use the intellectual property.<a href="#5" name="5a">5</a> If the non-debtor licensee elects to
retain its rights, the debtor licensor is only required to (a) provide access to the intellectual property, (b) not interfere
with the exercise of the licensee's rights under the license and (c) comply with any exclusivity provision in the
license agreement.

The licensee must continue to pay royalties<a href="#6" name="6a">6</a> and must waive any rights it may have to setoff or administrative
claims for unperformed affirmative obligations of the licensor. In addition to retaining the rights under the license
agreement, pursuant to §365(n)(1)(B) the licensee may also retain rights under "any agreement supplementary to
such contract." A source code escrow agreement would likely be considered an agreement supplementary to a license
agreement.

Importantly, §365(n) protections only apply to "intellectual property," and the term intellectual property as defined
in §101(35A) of the Code conspicuously excludes trademarks and trade names. The Second Circuit has indicated in
dicta that Congress specifically excluded trademarks and trade names from the protection provided to other
intellectual property licenses.<a href="#7" name="7a">7</a> Hence, rejection of a trademark or trade name license may leave the licensee with no
recourse. To avoid this result, a licensee of trademark and other intellectual property rights may attempt to
intertwine the various property rights (including royalties that cover all such rights) so that the trademark and trade
name rights are bound up with other rights under §365(n).

<h3>Using Source Code Escrow Agreements</h3>

A source code escrow agreement is a contract among the technology licensor, the licensee and a third party who
serves as an escrow agent. The escrow agent provides a repository for the human readable program statements, called
the source code. A source code escrow agreement establishes the conditions under which the escrow agent may
release the source code to the licensee, such as the filing of bankruptcy by the licensor.

Source code escrow agreements have traditionally been used by licensees attempting to avoid the negative impact of
a bankruptcy filing by their licensors. In such circumstances, the existence of a source code escrow agreement may
protect the licensee's use of technology despite rejection of a license agreement by the licensor in its bankruptcy.
Section 365(n)(1)(B) makes clear that an agreement "supplementary" to the license agreement, such as a source code
escrow agreement, should be protected and enforceable when a licensee elects to retain its rights under §365(n).

No cases have been published that test the enforceability of a source code escrow agreement in bankruptcy. One
court has suggested that source code escrow agreements should be enforceable,<a href="#8" name="8a">8</a> and several bankruptcy cases
consider the enforceability of other types of escrow agreements. Those cases hold that escrow agreements are
enforceable so long as certain formalities are followed.<a href="#9" name="9a">9</a> Following is a discussion of those items that should be
included in a source code escrow agreement.<a href="#10" name="10a">10</a>

(a) The escrow agent should be a neutral third party and ideally, a party that specializes in administering
technology escrow accounts. Because a source code escrow agreement is a form of express trust, the escrow agent
must serve as a trustee for the benefit of the escrow beneficiary, the licensee. The escrow agent should not be
affiliated with either the licensor or licensee other than in its capacity as agent for the escrow.

(b) The source code escrow agreement should be a written contract that covers the following subject matter. The
source code escrow agreement must clearly identify the property that is to be placed in escrow. The source code
escrow agreement must also clearly establish the conditions under which the source code is to be released. In the
event that the source code is released, the source code agreement should define the permissible uses for the released
source code.

(c) The source code should be delivered to the escrow agent and be fully documented and commented. The
bankruptcy court must be able to identify the escrowed property and distinguish it from other assets of the debtor.
Often licensees and licensors develop new technologies based on existing technology. A fully commented and
documented copy of the source code will aid the court in distinguishing the property that is in escrow from the
property of the estate.<a href="#11" name="11a">11</a>

(d) An experienced technology escrow agent can help with the administration of the escrow account and can
recommend procedures for ensuring that the source code is maintained by the licensor and that documentation and
comments are up to date. The source code escrow agreement should address issues such as updates to and
maintenance of the source code, an audit process and termination procedure. An experienced technology escrow
agent will likely have a form of escrow agreement that will cover these issues.

<h3>Conclusion</h3>

Under the Code, the various forms of license agreements used by technology companies are generally held to be
"executory contracts." As such, whether you or your clients are licensees in bankruptcy or victims of a licensor's
bankruptcy, a bankruptcy filing may strip the value of a license agreement and cripple a company's efforts to
reorganize. There are, however, practical devices that can be used to maintain the value of technology licenses in
bankruptcy. As a licensee, take steps to ensure that you will be in a position to assume and assign the license in the
event you become bankrupt. In the event that the licensor becomes bankrupt, §365(n) offers some protection for
licensees. This protection can be bolstered by the use of a source code escrow agreement.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Note that trademark law is distinguishable and permits the unauthorized assignment of executory contracts. Courts have concluded that unauthorized assignment does not
necessarily implicate infringement unless the use of the trademark by the assignee is likely to confuse, cause mistakes by or deceive customers. <a href="#1a">Return to article</a>

<a name="2">2</a> See In re Catapult, 165 F.3d 247 (9th Cir. 1998); In re James Cable Partners L.P., 27 F.3d 534 (11th Cir. 1994); In re West Electronics Inc., 852 F.2d 79 (3d. Cir. 1988). But, see
Summit Inv. & Dev. Corp. v. Leroux, 69 F.3d 608 (1st Cir. 1995) (disagrees with "hypothetical test" and applies "actual test," which asks whether actual assignment is
contemplated.). <a href="#2a">Return to article</a>

<a name="3">3</a> See In re Independent Serv. Org. Antitrust Litig., 203 F.3d 1322 (Fed. Cir. 2000) (asserting that property right is transferred where exclusive license to copyright is granted);
(Ortho Pharm. Corp. v. Genetics Inst. Inc., 52 F.3d 1026, 1032 (Fed. Cir. 1995) (recognizing exclusive licensee's right to sue on patent). <a href="#3a">Return to article</a>

<a name="4">4</a> See Lubrizol Inc. v. Richmond Metal Finishers Inc., 756 F.2d 1043 (4th Cir. 1985). <a href="#4a">Return to article</a>

<a name="5">5</a> Section 365(n) is limited to "intellectual property." Trademarks and tradenames are omitted from the definition of intellectual property under Code §101(35A). <a href="#5a">Return to article</a>

<a name="6">6</a> The term "royalty payments" is broadly construed. Even if a payment is called something else, it may be deemed to constitute a royalty payment for the use of intellectual
property, such as when payments are based on a percentage of sales of end products that are incorporated into or derived from licensed intellectual property. <a href="#6a">Return to article</a>

<a name="7">7</a> See Licensing by Paolo Inc. v. Sinatra (In re Gucci), 126 F.3d 380, 394 (2d Cir. 1997); In re Centura Software Corp., 281 B.R. 660 (Bankr. N.D. Cal. 2002). The legislative
history, however, suggests that Congress only determined to postpone congressional action in this area and to allow the development of "equitable treatment" by bankruptcy
courts. See S. Rep. No. 100-505, at 5 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3204. <a href="#7a">Return to article</a>

<a name="8">8</a> See, e.g., Behr Venture Partners Ltd. v. Bedford Computer Corp. (In re Bedford Computer Corp.), 62 B.R. 555, 568 n.11 (Bankr. D. N.H. 1986) (suggesting that source code
escrow agreement maybe effective). <a href="#8a">Return to article</a>

<a name="9">9</a> See, e.g., Hassett v. Blue Cross and Blue Shield of Greater New York (In re O.P.M. Leasing Servs. Inc.), 46 B.R. 661, 665 (Bankr. S.D.N.Y. 1985); 5 Collier on Bankruptcy
§541.09 (15th ed. rev'd. 1997); cf. e.g., Rajala v. The Holland Corp. (In re Chesapeake Assoc. Ltd.), 141 B.R. 737, 745 (Bankr. D. Kan. 1992) (holding that an escrow was
ineffective because the escrow agent was an agent of a party and not a neutral third party). <a href="#9a">Return to article</a>

<a name="10">10</a> For a more detailed discussion, see Mobley, Keith, "Protecting IP Assets with Technology Escrow," The Bankruptcy Strategist, Nov. 2001 at 6. <a href="#10a">Return to article</a>

<a name="11">11</a> See Behr Venture Partners Ltd. v. Bedford Computer Corp. (In re Bedford Computer Corp.), 62 B.R. 555, 568 n.11 (Bankr. D. N.H. 1986) (holding that a venture capital partner
cannot reclaim "new technology" from developer partner who filed bankruptcy, because the court was unable to distinguish "existing technology" from "new technology"). <a href="#11a">Return to article</a>

Journal Authors

Erin L. Connor

Risa Lynn Wolf-Smith

Journal Date

Thursday, April 1, 2004 - 12:00

Bankruptcy Rule

2004