Much has been made during the past several years of the plight of the technology licensee when the technology licensor files for bankruptcy. A licensee worries that its license agreement would be deemed to be an executory contract and therefore subject to rejection by the bankrupt licensor; upon rejection, the licensee could lose its rights to the technology, together with its investment in the development and marketing of the technology. In 1988, Congress amended the Federal Bankruptcy Code in response to these concerns by adding new provisions which protect licensees by allowing them continued access to the technology under certain circumstances.
There is another side to the coin, however, and it seems to have been given short shrift — that is, the plight of the licensor, when its licensee files for bankruptcy. Take, for instance, a situation in which a scientist invents a remarkable biotechnology breakthrough, obtains a patent, and grants an exclusive license of the technology to a promising start-up company. What happens to the technology (and the investor’s efforts and investment) if the licensee becomes bankrupt? The answer: the licensor may lose its rights to the technology if the license agreement is not carefully thought out and drafted.
This article will discuss the consequences to the licensor of the licensee’s bankruptcy and contains several practical steps which the licensor can take to minimize the identified risks of the licensee’s bankruptcy.
The Bankrupt Licensee: A Parade of Horribles
The main thing to keep in mind is that bankruptcy law is designed to operate in a manner which preserves the assets of the bankruptcy debtor, including preserving for the benefit of a bankrupt licensee rights granted under a license agreement. As discussed more fully below, this means that, in the worst case, the licensed technology could end up being retained by a bankrupt licensee while the licensor would retain only a general unsecured claim in the bankrupt licensee’s bankruptcy case for sums due under the license agreement. In addition, of course, the licensor could miss out on alternative possibilities for successful commercial exploitation of the licensed technology. Finally, the licensor’s previous investment in the development of the technology could become valueless to it.
In the bankruptcy context, if the technology license agreement is a valuable asset of the bankrupt licensee, then the licensee, or the trustee if one is appointed, will undoubtedly move to ensure that it retains the benefits of the license agreement. From the standpoint of the licensor, the most beneficial manner for the bankrupt licensee to retain the benefits of the license agreement is for the bankrupt licensee to assume the license agreement pursuant to Section 365(a) as an “executory contract.” (Executory contracts are not defined in the Bankruptcy Code, but are generally described as contracts in which there are material unperformed obligations by both parties. By contrast, executed contracts do not have material unperformed obligations by both parties.) Assumption of the license agreement as an executory contract requires the curing of all of the bankrupt licensee’s defaults under the agreement, and the provision to the licensor of adequate assurance of future performance under the license agreement. Section 365(b). The assumption essentially puts the licensor in the position it would have been in absent the licensee’s bankruptcy, and even provides for the payment to the licensor of any damages arising from the defaults which are required to be cured.
From the bankrupt licensee’s perspective, however, it is most advantageous to have the license agreement characterized not as an executory contract, but rather as a fully executed conveyance of the licensed rights. Under such a characterization, the bankrupt licensee holds title to the licensed rights; the licensor has no basis to compel a return of the licensed rights; and the bankrupt licensee’s future obligations under the license agreement constitute mere pre-petition monetary obligations which are general unsecured claims in the bankrupt licensee’s bankruptcy case.
Suggestions to Stop (or at least Slow Down) the Parade
There are a variety of practical steps which a licensor can take in the contracting process with a licensee which can help minimize the possibility that a bankrupt licensee would be able to assert successfully that the license constitutes an executed, rather than executory agreement, as well as help to provide other protections in the event of default or bankruptcy of the licensee. These include:
• Consider obtaining a security interest in valuable collateral of the debtor-licensee (or, subject to the fraudulent conveyance concerns described in suggestion (2) below, of an affiliated or non-affiliated third party) to secure all of the debtor-licensee’s obligations under the license agreement. At a minimum, this collateral should include all of the rights granted/licensed to the debtor-licensee under the license agreement itself. With such collateral, if the debtor-licensee rejects the license agreement in bankruptcy, or takes the position that the license agreement constitutes an executed (rather than an executory) agreement, the licensor’s claims for the royalties due (if the agreement is held to be executed), or for damages for breach upon rejection (if the agreement is held to be executory), will be secured by any rights retained by the debtor-licensee. This may give the licensor sufficient leverage to obtain the technology back from the debtor.
• Consider obtaining an adequate guaranty from the parent or other affiliate of the debtor-licensee. Note, however, that under certain circumstances a bankruptcy court may stay, during the pendency of the bankruptcy case, enforcement of such a guaranty if such enforcement may hinder progress in the bankruptcy case. Moreover, guarantees by third parties who are either insolvent, or who are rendered insolvent by the guaranty, may be avoidable as fraudulent conveyances if no benefit accrues to the guarantor as a result of the guaranty.
• Include in the license agreement a self-effectuating termination provision for breach, with little or no notice to, or opportunity to cure by, the licensee and with no requirement of any other action by licensor. If licensor can successfully negotiate this, the license agreement may terminate pursuant to its own terms following a breach and prior to the commencement of a bankruptcy by the licensee. In such a circumstance the licensee’s rights are deemed terminated prior to the bankruptcy and the license agreement never becomes an asset of the licensee’s bankruptcy estate. The bankrupt licensee may still argue, however, that the license agreement constituted an executed conveyance of the licensed rights, which rights do, therefore, constitute property of the bankruptcy estate, while the licensee’s obligations to make payments constitute mere general unsecured claims. Accordingly, any termination provision should also specifically include an immediate and automatic reversion of the technology to the licensor.
• Taking a chapter from the book of loan documents by bank counsel, consider including a provision in the license agreement which allows termination by the licensor if the debtor-licensee’s financial status worsens, or if the licensor otherwise becomes insecure about the licensee’s prospects to perform its obligations under the license agreement. These covenants could afford the licensor the opportunity to terminate the license and take back the technology prior to the filing of the bankruptcy petition. Such provisions do not, of course, preclude the “executed conveyance” argument. Moreover, you can anticipate that the licensee will object to these types of termination provisions, as they are typically subjective and can afford the licensor a great deal of leverage over the licensee. In addition, many licensors may not have the resources, sophistication or wherewithal to monitor adequately the financial status or prospects of the licensee. Finally, such provisions could also actually precipitate a bankruptcy filing by a licensee which fears that it must act quickly or otherwise lose its rights to the technology.
• Include covenants that protect the licensor from financial loss; for example, have license fees payable in advance, not in arrears.
• Reduce the licensor’s exposure by minimizing the duration of the license, making it renewable by the licensee at regular intervals upon: (a) payment of advance fees; (b) achieving predetermined milestones; and/or (c) there being no defaults by the licensee at, or any time prior to, the time of renewal.
• In order to minimize the bankrupt licensee’s successful assertion of the “executed conveyance” argument, and maximize the likelihood that a bankruptcy court will find the license agreement an executory contract, the licensor should consider including in each license agreement provisions which require each party to perform ongoing obligations until the agreement expires. For example, in a license agreement, there could be ongoing license or royalty fee payments and accountings due from the licensee, a continuing obligation of the licensor not to license or disclose the technology to others in specified markets or territories, indemnity obligations regarding infringement imposed on each party, and a requirement on licensor’s part to provide the licensee with, and for the licensee to incorporate, updates, enhancements or modifications to the technology. Such obligations should not be severable; accordingly, the licensor should include provisions in the license agreement which support the essential, integral nature of all the obligations.
• A non-exclusive license is preferable to an exclusive license for purposes of establishing that no absolute conveyance or absolute assignment of the technology was intended. In addition, you can include language in the contract to the effect that no absolute conveyance is intended, and that upon termination or breach of the license agreement the technology reverts to licensor. Avoid agreements which provide that all of licensor’s rights are licensed indefinitely or in perpetuity, since such provisions have been held by some courts to be the indicia of an absolute conveyance rather than a license.
• If the licensor believes that the technology if returned, would not be easily re-licensed on commercially advantageous terms to a third party, consider including disincentives to any rejection of the contract by the debtor-licensee, such as an obligation to make, accelerate, or increase payments for unperformed obligations, as well as, as mentioned above, securing such obligations with adequate collateral.
• On the other hand, if the licensor would prefer that the license be rejected so that the technology will revert to licensor, the licensor can include tough covenants in the contract to make it harder for the bankrupt licensee to make the cures necessary to an assumption or assignment of the agreement. This could include, for example, provisions for minimum sales, minimum royalties, and/or minimum investment in promotional and marketing activities.
• To help prevent the license agreement from being assumed and assigned to a third party with whom the licensor does not want contractual relations, consider making the license clearly personal to the licensee and prohibiting assignment or delegation of rights or duties by the licensee. The licensor can bolster this by including statements regarding its special relationship with, and the special knowledge or individualized skill of, the licensee, and the trust and confidence it has in the particular licensee. Note, however, that bankruptcy courts will be disinclined to enforce provisions like these in contracts unless the reality matches the language.
• Consider including a confidentiality provision which clearly operates after the termination of the license agreement, so that if the license is rejected by the debtor-licensee, the debtor-licensee remains obligated not to disclose the technology to others.
One provision that counsel to technology licensors typically insert in license agreements, but which is not effective, is the so-called “ipso facto” clause. Under an “ipso facto” clause, the licensor is purportedly allowed to terminate the license merely upon the filing of a bankruptcy petition by or against the licensee. Section 365(e)(1) expressly invalidates such an ipso facto clause. Nothing is gained or lost by including this type of provision, but you may find yourself having to explain to your client why you inserted an invalid clause in the agreement. This can be particularly embarrassing if your client thought it was “fully protected” from the licensee’s bankruptcy because it thought the termination trigger could successfully be pulled.
There are a number of steps a licensor can take and a number of contractual provisions a licensor can include in the license agreement to minimize the potentially devastating impact of the bankruptcy of the licensee. Counsel should consider carefully whether to include some or all of these provisions, paying particular attention to whether the licensor is better off with a rejection of the license agreement or with an assumption of the license agreement by the bankrupt licensee. This will depend in large part upon the licensor’s relationship to the licensee and the availability of alternative methods of exploitation of the technology.
Andrew L. Dudnick is a partner with Dudnick Detwiler Rivin & Stikker LLP in San Francisco, California.
Reprinted with permission from The COTIP Bulletin, 1989 (American Bar Association).