Protecting Against Licensor Bankruptcy in Service and License Agreements Utilizing Section 365n

This article is part two of a four-part series by Mayer Brown on the latest trends in digital transformation. Read part one here.

This article provides an overview of Section 365 of the Bankruptcy Code, a key provision within the Code that allows a debtor to assume, assume and assign, or reject certain executory contracts and unexpired leases. Section 365(n) is a carve-out to the debtor’s broad 365 power that allows a non-debtor counterparty the right to either accept the rejection of a contract/license or continue performing under the contract. This article seeks to explain the scope of Section 365(n) and then touch upon the steps that licensees can take to minimize the loss of the use of their intellectual property licenses in the event a licensor files for bankruptcy.

A Key Carve-out to the Powers Accorded by Section 365 to the Debtor

The Bankruptcy Code, which provides the substantive rules that govern the course of a bankruptcy filing, balances two primary (and occasionally competing) policy objectives: (1) allowing a debtor the “breathing room” to reorganize its affairs (or, in certain cases, to smoothly exit its business by efficiently liquidating its assets); and (2) maximizing the debtor’s estate to allow creditors the best recovery possible.

In several ways, Section 365 of the Bankruptcy Code favors the policy goal of providing a debtor with “breathing room” and power to reorganize its affairs. Section 365 allows a chapter 11 debtor to assume contracts that are commercially beneficial to it and reject contracts that either no longer serve a business purpose or contain unfavorable economic terms. A debtor may elect to assume or reject a contract at any time prior to confirmation of its plan of reorganization. If a debtor assumes a contract, both parties can continue to perform their obligations under the normal course of business. If a debtor assumes and assigns a contract, a third party will step into the shoes of the debtor and perform the debtor’s obligations thereunder. If a debtor rejects a contract, however, then the non-debtor counterparty is no longer entitled to enjoy the benefits negotiated under that contract. Likewise, the non-debtor party is not required to perform its obligations under the now-rejected contract, and it simply becomes an unsecured creditor in the bankruptcy for breach of contract damages.

However, there are limits to the power granted to the debtor by Section 365 of the Bankruptcy Code that permit certain contractual counterparties the ability to continue enjoying the benefits that they have negotiated with the debtor notwithstanding the debtor’s rejection of a contract. These carve-outs reflect legislative determinations that certain contracts are so crucial to a non-debtor’s business operations that to deprive them of such use would be patently unfair. In these situations, once a debtor rejects a contract, the non-debtor contracting party can either elect to accept the rejection or to continue performing under (and receive the benefits of) the agreement.

A key carve-out is 365(n), which allows the non-debtor counterparty to certain intellectual property licenses to continue using those licenses notwithstanding the debtor’s attempts to reject the governing license agreement. In relevant part, Section 365(n) of the Bankruptcy Code states:

If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect—

• to treat such contract as terminated by rejection if such rejection by the trustee amounts to such a breach as would entitle the licensee to treat such contract as terminated by virtue of its own terms, applicable nonbankruptcy law, or an agreement made by the licensee with another entity; or
• to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankruptcy law), as such rights existed immediately before the case commenced for (i) the duration of such contract; and (ii) any period for which such contract may be extended by the licensee as of right under applicable nonbankruptcy law.

Section 365(n) in Action

Section 365(n) affords a safe harbor to licensees of intellectual property. Should a licensor file for bankruptcy and attempt to reject its intellectual property contract, the licensee can either accept the rejection or retain its contracted-for rights and continue to use the intellectual property for the remainder of the term of the contract.

Notably, Section 365(n) only applies to certain types of intellectual property such as trade secrets, patentable inventions and patent applications, plant varieties, and works of authorship protected under U.S. copyright law. The carve-out, however, does not apply to items such as trademarks, trade names, and servicing arrangements related to licenses. This division in the coverage creates a discrepancy between the protections afforded to a licensee of a trademark and the licensee of a patent which, to date, has not been accorded a legislative remedy.

Careful crafting of intellectual property licenses during the drafting stage can help to maximize the protections afforded by Section 365(n) of the Bankruptcy Code. Short shrift by a licensee in addressing a potential bankruptcy by its licensor may jeopardize its rights to use valuable intellectual property in the event its licensor actually files for bankruptcy. Conversely, accounting for such bankruptcy risks will allow the licensee to continue using valuable intellectual property even if its licensor files for protection and ceases performing its obligations under the contract.

Recommendations

There are several drafting mechanisms that a licensee may use to maximize its Section 365(n) rights in the event of its licensor bankruptcy filing:

1. The licensee should explicitly make the license agreement subject to Section 365(n). This is, perhaps, the easiest remedy a licensee can use. While not determinative, language explicitly referencing Section 365(n) sends a clear message about the parties’ understanding of their respective rights in the event of a bankruptcy and may be persuasive evidence if there is dispute regarding whether the contract in question is in fact covered by Section 365(n).
2. The licensee should also ensure that its renewal rights in the contract are clear. As stated above, the protection of Section 365(n) is only for the term of the contract. Therefore, the contract must detail the licensee’s right to renew or extend the license.
3. The licensee should ensure that any payments made under the licensing agreements are allocated fairly and expressly between intellectual property rights and other ancillary services that a licensee may be receiving. Typically, there are other services that are associated with the license (e., consulting services, development services, or other services). If the licensor files and rejects the contract, Section 365(n) will only apply to extend the intellectual property rights within the contract. If there is not a clear allocation between what is due under the license versus the costs associated with the other ancillary services, a licensee may find itself in the position of having to pay for all of the services but only retaining the benefit of the intellectual property rights.
4. Finally, the licensee—if it has sufficient leverage—might also be able to:

• Have a liquidated damages clause incorporated into the license as a disincentive for rejection.
• Require that the licensor transfer the intellectual property subject to the license into a bankruptcy-remote entity. Such an arrangement is common in the financing context and can be deployed within the bankruptcy sphere as well.
• Obtain an escrow of tangible embodiments of the licensed intellectual property (g., a source code) that may permit the full exercise of the licensee’s retained rights.

Conclusion

Taking special care when drafting intellectual property licenses to ensure that such licenses are entitled to utilize Section 365(n) will allow a licensee to mitigate any ensuing and potentially adverse economic disruptions in the event its vendor files for bankruptcy.

“Reprinted with permission from the December 8, 2021 edition of Legaltech News © 2021 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.”