The Hawaii Bankruptcy Court’s ruling in In re Minesen Co. [1] is a cautionary tale of how seemingly innocuous contract language can have unintended consequences — effectively waiving applicable nonbankruptcy law and overriding contract language to allow assignment without counterparty consent. Well-established federal law protects certain contracts (commonly IP contracts) from being assigned in a chapter 11 or other bankruptcy proceeding without counterparty consent. For example, courts have long held that nonexclusive licenses cannot be assigned without consent because they are personal and generally nonassignable under nonbankruptcy law. After Minesen, however, whether these contracts are ultimately protected remains up for debate.
In Minesen, the bankruptcy court held that a contract counterparty had waived the protections of the Anti-Assignment Act applicable to federal government contracts by including language in the contract that provided that such party’s “consent [to assignment] will not be unreasonably withheld.” If applied broadly to intellectual property licenses, the holding of Minesen could potentially result in otherwise-protected intellectual property contracts being assigned in bankruptcy over counterparty objection, regardless of whether consent is being “reasonably” withheld.
Assumption and Assignment Generally
Under § 365 of the Bankruptcy Code, a debtor can seek to assume (continue) and assign (novate) an executory contract [2] or unexpired lease to another party, [3] subject to certain conditions. Notwithstanding any purported restrictions on assignment in the contract, [4] most executory contracts can be assumed and assigned to a third party if the debtor complies with § 365. An exception to this general rule is § 365(c)(1), which expressly states that a debtor cannot assume or assign an executory contract if (1) applicable law excuses a party (other than the debtor) from accepting performance from or rendering performance to an entity other than the debtor, regardless of whether the contract prohibits or restricts the assignment of rights or delegation of duties; and (2) the contract counterparty does not consent to the assignment. [5]
There is well-developed case law that says that the following types of contracts fall into the “applicable law” carve-out under the Bankruptcy Code: (1) personal service contracts; [6] and (2) nonexclusive licenses of copyrights, [7] patents [8] and trademarks [9] that are not assignable as a matter of federal law. [10] However, as this carve-out is a two-part test — the second part being the consent of the counterparty — it has long been argued that where a contract includes a pre-negotiated consent provision, that provision should govern and override the Bankruptcy Code’s standard for assumption and assignment. For example, some contracts will allow assignment in certain defined circumstances, including: (1) upon a change of control; (2) in connection with a sale of all or substantially all assets; or (3) in connection with a transfer or sale to an affiliate. Other contracts make it clear that an assignment is subject to the counterparty’s discretion, and that discretion can be absolute or subject to a reasonableness qualifier. Where contracts are negotiated at arm’s-length by sophisticated parties, courts have typically respected the benefit of the bargain cut by such parties.
Minesen: Contractual “Consent” to Assignment, Not to Be Unreasonably Withheld, Equates to a Waiver of Applicable Law’s Anti-Assignment Protection
Minesen involved a bankrupt hotel operator that sought to assume several contracts related to operating a lodging facility housing army servicememembers and their families. The contract counterparty, the U.S. Army Morale, Welfare and Recreation Fund, objected to assumption. [11] The Fund argued that the Anti-Assignment Act prevented the Fund from being forced to accept performance from any party other than the debtor and that the Anti-Assignment Act is an “applicable law” under § 365(c)(1) of the Bankruptcy Code. Therefore, based on these two statutes, the Fund argued that assumption was prohibited absent its consent.
In the contract in question, assignment was prohibited without the Fund’s consent, but the parties had agreed that such consent would “not be unreasonably withheld.” According to the Minesen court, by including the reasonableness qualifier in the assignment provision, the Fund had “agreed to limit its power to reject assignments.” [12] Because of this concession, the court held that the Fund waived the protections of the Anti-Assignment Act and § 365(c) of the Bankruptcy Code did not, therefore, preclude assumption of the contract.
The court did not stop there, however. Importantly, it also determined that it need only consider whether the debtor had satisfied the cure, compensation and adequate-assurance-of-future-performance requirements of § 365, notwithstanding the parties’ contractual agreement that the Fund could, in its reasonable discretion, withhold consent to assignment. By applying the Bankruptcy Code’s standard for assumption and not the parties’ contractually agreed-upon reasonable discretion standard, the Minesen court rendered the “applicable law” anti-assignment carve-out toothless. While the contract language should have protected the Fund’s ability to decide in its reasonable discretion who it would transact with, the Minesen court instead read the contract language as a waiver of consent rights, allowing the debtor to assume the contract over the Fund’s objection.
Implications
The implications of Minesen are critical for IP contracts, which typically are protected by the “applicable law” carve-out, because Minesen demonstrates that prohibiting assignment of a contract may not always be enforced by a bankruptcy court, even when a debtor seeks to assume and assign an otherwise nonassignable contract. Lawyers who draft IP license agreements should take heed of the lessons in Minesen and carefully craft anti-assignment provisions to clearly and unequivocally bar assignment without counterparty consent. Otherwise, in a licensor bankruptcy, IP licenses — notwithstanding the protections that otherwise would exist outside of bankruptcy to prevent such assignment — could potentially wind up in the hands of competitors.
It is therefore critical that language in IP agreements prohibiting assignment is drafted in a way that is both precise and absolute, with no doubts left about the possibility of assignment to an undesirable counterparty. If drafted in such a way, it will be less likely that courts will have an avenue to override “applicable law” that would otherwise prevent the assignment of such license agreements.
[1] 635 B.R. 533 (Bankr. D. Hawaii 2021).
[2] Executory contracts are contracts with outstanding material obligations on both sides, the breach of which would excuse performance by the nonbreaching party.
[3] 11 U.S.C. § 365.
[4] See 11 U.S.C. § 365(f).
[5] See 11 U.S.C. § 365(c) (providing that, in addition to “applicable law” carve-out, contracts to make a loan, extend a financial accommodation, or issue a security of debtor, or a nonresidential real property lease that has been terminated under nonbankruptcy law, may not be assumed and assigned under § 365 of Bankruptcy Code). There is currently a circuit split regarding whether contracts that are not assignable under applicable nonbankruptcy law can be assumed by the debtor, and three main tests have emerged. Several circuits, including the Ninth and Third Circuits (see In re Catapult Entm’t Inc., 165 F.3d 747, 750 (9th Cir. 1999)), have applied the “hypothetical” test, which provides that a debtor may not assume an executory contract over the nondebtor’s objection if applicable law would bar the assignment to a “hypothetical” third party, even where the debtor does not actually intend to assign the contract in question to that third party. The First Circuit and lower courts in other circuits follow an “actual” test that allows assumption by a debtor that does not intend to assign the contract to a third party. Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997) (“[T]he bankruptcy court must focus on the performance actually to be rendered by the debtor-in-possession with a view to ensuring that the nondebtor party ... will receive the ‘full benefit of [its] bargain.’”). The U.S. Bankruptcy Court for the Southern District of New York and at least one other lower court follow the “Footstar test,” which provides that a debtor in possession, but not a bankruptcy trustee, may assume (but not assign) an executory contract over the nondebtor’s objection if applicable law prohibits assignment. See In re Footstar Inc. 323 B.R. 566, 570 (Bankr. S.D.N.Y. 2005) (adopting variation of hypothetical test, but holding that bar on assumption only applies to bankruptcy trustee, and not debtor in possession).
[6] In re Compass Van & Storage Corp., 65 B.R. 1007, 1010 (Bankr. E.D.N.Y 1986) (explaining that contracts whose “impetus” are based upon personal services are excluded from § 365).
[7] In re Patient Educ. Media Inc., 210 B.R. 237, 242 (Bankr. S.D.N.Y. 2007) (explaining that federal policy designed to protect limited monopoly of copyright owners and restrict unauthorized use constitutes applicable nonbankruptcy law that prevents assignment without consent).
[8] In re Catapult Entm’t Inc., 165 F.3d 747, 750 (9th Cir. 1999).
[9] N.C.P. Mktg. Group Inc. v. Billy Blanks (In re N.C.P. Mktg. Group Inc.), 337 B.R. 230, 237 (D. Nev. 2005).
[10] See, e.g., In re Patient Educ. Media, 210 B.R. at 240-41 (explaining that because nonexclusive license does not transfer any rights of ownership, nonexclusive license is personal and cannot be assigned to third party without consent of owner). Exclusive licenses are not subject to this requirement. See id. at 240.
[11] Even though Minesen did not plan to assign the contracts to a third party, as discussed the Ninth Circuit uses the “hypothetical test,” which prevents assumption of the contract if assignment to a hypothetical third party would be prohibited.
[12] Minesen, 635 B.R. at 545.