Sicko, the need for improvement was apparent. Costs had spiraled out of control, quality of care was inconsistent and health care providers faced daunting operational and financial challenges. Incredibly, as other industries aggressively deployed technology to deliver products and services more efficiently, the otherwise technologically advanced U.S. health care industry lagged behind. Although not a panacea, the improved deployment of technology is widely regarded as an important component in improving the U.S. health care system.
To that end, in 2004, President Bush signed an executive order establishing the position of the National Coordinator for Health Information Technology (coordinator). The coordinator is charged with the task of developing, maintaining and overseeing a strategic national plan for the adoption of health information technology (HIT) by the U.S. health care industry. In 2005, the coordinator released a final report approved by a HIT Leadership Panel containing recommendations for moving toward that goal. Improved utilization of HIT could save billions of dollars per year in health care costs by reducing hospital stays, encouraging tests and early treatment and cutting administrative costs.
However, as with other economic transformations, the path to a technologically improved health care system will not be pain free. Health care providers face a challenging landscape characterized by unreimbursed costs and, in many areas, overcapacity. Even newly emerging companies focused on HIT must face traditional obstacles to success such as competition, regulatory issues and financing challenges.
This article addresses issues a party to a HIT license agreement faces upon the insolvency of the counterparty. Part I addresses the general rules applicable to the treatment of technology licenses in bankruptcy. Part II addresses issues of concern to a technology vendor when a health provider/licensee experiences financial distress. Part III addresses issues of concern to a health care provider/licensee when the technology vendor is insolvent.
Part I. Basic Rules for the Treatment of Technology Licenses in Bankruptcy
Section 365 of the Bankruptcy Code governs the treatment of a debtor’s so-called executory contracts in a bankruptcy case. An “executory contract” is generally one under which performance remains due to some extent on both sides. For example, a contract that has been terminated or has expired before a bankruptcy filing is not executory. Licenses of intellectual property like HIT or software, however, typically constitute executory contracts.
With limited exceptions and subject to certain requirements, a debtor may assume any executory contract, even if the debtor has defaulted under the contract. An assumed contract is binding on both the debtor and the nondebtor. The debtor must assume both the burdens and benefits of a contract; assumption of the benefits only is not permitted. If certain requirements are met, the debtor may be permitted to assign an assumed contract to a third party, thereby imposing on the nondebtor party with a counterparty it did not select.
As an alternative to assumption, a debtor may reject any contract. Rejection renders a contract prospectively unenforceable. Upon rejection, a debtor cannot subsequently assert any rights under the contract. A debtor’s rejection of a contract entitles the nondebtor to an unsecured nonpriority claim in the bankruptcy case for damages.
A debtor need not decide whether to assume or reject an executory contract immediately upon filing a bankruptcy case. In chapter 7 liquidation cases, an executory contract generally is deemed rejected unless it is assumed within 60 days after the case begins. In a chapter 11 reorganization case, the debtor may delay the assumption or rejection of an executory contract until the confirmation of a plan of reorganization. With a motion by the nondebtor counterparty and a showing of cause, however, the bankruptcy court may require the debtor to decide within a shorter period whether to assume or reject an executory contract.
Restrictions on the Assumption and Assignment of Contracts
The Code prohibits a debtor from assigning certain executory contracts over the nondebtor counterparty’s objection where applicable nonbankruptcy law excuses the nondebtor from accepting performance. The classic example of such a contract is a personal services contract. Similarly, at least if they are nonexclusive, neither a patent license agreement nor a copyright license agreement may be assigned by a debtor/licensee to a third party without the consent nondebtor licensor’s consent.
Some licensors have prevented not only the assignment by debtor/licensees of their rights under technology licenses, but even the debtor’s assumption of the license. Three federal courts of appeal (including the Third Circuit, which includes Delaware) have held that debtors cannot assume contracts they have no ability to assign. Nondebtor licensors in courts following the rule enunciated by those circuits, therefore, enjoy incredible leverage over the debtor-licensee and can seek to obtain control of the license upon the debtor/licensee’s bankruptcy filing. Other courts have rejected that rule and permit a debtor to assume a technology license as long as the debtor itself will continue to perform under the license.
Special Rules for Bankruptcy Cases Filed by a Licensor
Section 365(n) of the Code governs the respective rights of the parties to a license of “intellectual property” (including licenses to HIT), where the licensor has become a debtor in bankruptcy and has rejected the license agreement. Section 365(n) provides the nondebtor licensee with two options. The licensee may treat the license as terminated and file a general unsecured claim against the bankruptcy estate for breach of contract damages, in which case the licensee will forfeit all rights to continued use of the intellectual property covered by the license. Alternatively, the licensee may opt to retain its rights under the license to the technology, including rights of exclusivity, for the initial term of the license as well as for any optional extension periods available at the licensee’s discretion. However, the licensee must continue to pay all royalties due the licensor and is deemed to waive any rights of setoff it might have against the licensor as well as any administrative claims against the bankruptcy estate. Moreover, rejection of the license agreement, relieves the debtor-licensor of any affirmative obligations with respect to the license, such as training of licensee users or updating the intellectual property.
Part II Guarding Against a Provider Insolvency—Tips for the Vendor Licensor
HIT vendors should draft license agreements to protect themselves as much as possible from a potential health care provider-licensee insolvency or bankruptcy. To that end, a HIT vendor licensor should consider the following:
- Ensure that the license arrangement will be construed as an executory contract. As noted above, an executory contract is one in which performance remains due on both sides. If the provider has no continuing obligation to the vendor under the license, a bankruptcy court may conclude that the document created an absolute transfer of rights as opposed to a mere license of rights.
- The license should contain an acknowledgement of the parties’ intent that the license be considered executory and should state the reasons why. Ongoing obligations, such as maintenance of confidentiality and reporting, will help prevent the provider from claiming an outright ownership right in the licensed HIT, especially if the license is exclusive. Where the license is exclusive, the licensor should obtain a security interest in the licensed HIT.
- Prohibit or limit assignment by the provider to third parties. The Code prohibits enforcement by the nondebtor of most so-called anti-assignment clauses in contracts. Yet, as discussed above, these clauses in software licenses can be enforced by the nondebtor licensor/vendor.
- Reinforce termination rights. The right to terminate on account of a bankruptcy filing is also generally unenforceable in bankruptcy. Licensors should enhance termination clauses to include other termination triggers suggesting financial difficulty, such as the departure of key executives or the licensee/provider’s failure to meet certain nonfinancial milestones.
- Limit the term of the agreement. A debtor is able to assume and assign only those executory contracts in effect as of the petition date. Annual automatic renewal clauses, unless notice of nonrenewal has been given, are one way to limit the term of a license agreement.
Part III. Guarding Against a Vendor Insolvency—Tips for the Licensee Provider
During the negotiation of a HIT technology license, a licensee/health care provider should take certain steps to maximize the protections provided by the Code when a vendor/licensor becomes a debtor in bankruptcy.
- Allocate payments. The total amount paid by the licensee to the vendor should be allocated between an obligation to pay fees for rights the licensee can retain and a separate obligation to pay fees for rights or services the licensee may not be obligated to perform after the rejection of the license, such as maintenance and support fees. By specifying the obligations to which the payments are applied, the licensee can avoid paying for performance that the vendor may elect not to provide upon rejection.
- Supplemental agreements must be executory. The licensee should insist that supplemental agreements include maintenance and support agreements and source code escrow agreements. Maintenance and support agreements are executory if they require future services from the vendor in exchange for payments by the licensee. A source code escrow agreement can be made executory by requiring the licensor to deposit the source code and documentation for all updates and enhancements of the licensed technology.
- Source code escrow agreements are essential. If the source code is not licensed under a software license agreement, a licensee should enter into source code escrow arrangements, under which the licensor vendor deposits source code and documentation with a third party. Escrow agreements should be carefully crafted to provide the appropriate “triggers” for release of the deposited materials and rights to the licensee with regard to use of such materials. Source code escrow agreements should expressly give the licensee the right to receive the escrowed materials upon the insolvency or filing for bankruptcy protection of the licensor for example. They should also provide the licensee with the right to use the materials to modify and maintain the licensed technology and to use the licensed technology to provide support to sub-licensees and internal users. This distinct grant in the source code escrow agreement must be carefully drafted as a present grant to use the escrowed material and not just a license right becoming effective upon bankruptcy.
Conclusion
The health care system will deploy HIT technology aggressively over the next decade. This deployment should help achieve lower costs and improve the quality and delivery of health care for the system as a whole. Without a doubt, the road will be bumpy as both vendors and providers encounter challenges to their own financial health from many directions. It is important for those doing business in the HIT market to understand how to protect themselves to ensure that a diseased contract party does not infect counter-parties.
In closing, it is clear that the focus of this article has been on the Code. The financial distress of a technology vendor or a health care provider, however, will not always result in a filing under the Code, but may result in a proceeding (e.g., assignment for the benefit of creditors or receivership) under nonbankruptcy (generally state) law. Nevertheless, the drafting techniques discussed above also offer the substantial protection to a nondebtor party to a license agreement in nonbankruptcy insolvency contexts.