Intellectual Property Licenses: What Happens if Your Licensor Files Bankruptcy?

Editor’s Note: Benjamin E. F. B. Waller is a member of the Financial Institutions and Litigation Sections and the Intellectual Property and Creditors’ Rights Practice Groups of Ward and Smith, P.A.

Every business with a computer, which means virtually every business in the United States, licenses software. What happens if your licensor files bankruptcy? Can you still continue to use the software? Can you at least have access to the source code to fix any bugs that might arise? As you might expect, the answer depends, at least in part, on the language of the licensing agreement.

The Bankruptcy Code

The Bankruptcy Code (the "Code") is set forth in Title 11 of the United States Code. Section 365 of the Code concerns the treatment of "executory" contracts in bankruptcy, specifically allowing the bankruptcy trustee (the "Trustee") to "assume" (allow to continue in effect) or "reject" (terminate) any such contracts. Section 365(n) of the Code specifically addresses intellectual property licenses, granting permission to the Trustee to reject an executory intellectual property licensing agreement where the bankrupt company is the licensor and the Trustee thinks the termination of the license is in the best interest of the bankrupt company.

How is Intellectual Property Defined?

For purposes of Section 365(n), the Code defines "intellectual property" to include only patents, copyrights, and trade secrets, meaning that only these types of intellectual property are addressed by the special terms of this Section.

When is a License "Executory"?

An "executory" contract is one where some portion of the contract remains unperformed or ongoing by both parties. Intellectual property licensing agreements are typically executory because the licensee has an ongoing duty to pay licensing fees or royalties, while the licensor has an ongoing obligation to allow the use of the licensed intellectual property without interference by the licensor.

In some circumstances, a court may determine that a license is not really a license because there has been, in effect, a complete transfer of ownership of intellectual property rights, which means there is no executory contract. In making this determination, the court typically will focus on whether the essential rights in the underlying intellectual property have been transferred, such as whether the licensee has acquired the right of exclusive use in all fields of use, the right to transfer the intellectual property, and the right to sue infringers. Under such a "license," the licensee is, for all intents and purposes, the "owner" of the intellectual property rather than a mere licensee. In such a case, the "licensing agreement" likely will be found to be non-executory, outside the realm of Section 365, and not subject to rejection by the Trustee. If anything less than ownership of the intellectual property has been transferred, the licensing agreement is likely to be executory and, therefore, subject to potential rejection by the Trustee.

What Happens if the Licensor Files Bankruptcy?

As indicated above, if your company licenses intellectual property pursuant to an executory licensing agreement and your licensor files bankruptcy, the Trustee can either assume or reject the license. If the Trustee elects to assume the licensing agreement, the nature of the parties’ relationship does not change much, if at all. It is important to note, however, that if the Trustee decides to assume the license, then, despite any language in the licensing agreement to the contrary, the licensee may not terminate the license and will be required to continue to perform its obligations under the license.

If, on the other hand, the Trustee chooses to reject the license, then the licensee has a choice. The licensee either may: (1) treat the license as terminated by virtue of the Trustee’s rejection and file a claim in the bankruptcy case for money damages arising out of the terminated agreement; or (2) retain its rights under the license and keep using the licensed technology, even though the Trustee has rejected the license.

If the licensee decides to retain its rights under the license, the retained rights include the right to use the licensed intellectual property and to enjoy any exclusivity provision in the license for the duration of the license, including extensions available to the licensee under the license. This means the licensee retains its right to use the licensed intellectual property so long as it makes all required payments under the license, and the Trustee must refrain from interfering with the rights granted in the licensing agreement.

It Seems Like Bankruptcy has No Effect on Intellectual Property Licenses

If the licensee continues to use the intellectual property, either by virtue of the Trustee assuming the license or by virtue of being permitted to use the licensed intellectual property even though the Trustee rejects the license, what’s the issue? The problem is that while the licensee may elect to retain its licensing rights, the Trustee is permitted to reject, separately, all other ancillary, affirmative obligations of the licensor. For instance, the Trustee can reject any obligation of the licensor to provide bug fixes, updates or enhancements. The licensee will be powerless to require the bankrupt licensor carry out these obligations.

How can a Licensee Protect Itself?

For any licensing agreements of intellectual property, the licensee should consider including language which provides that a mere failure by the licensee to assert the retention of its rights shall not be deemed to be a termination of the licensing agreement under Section 365(n). In other words, the licensee should require some affirmative act on its part to terminate the licensing agreement. Licensees also should require detailed renewal options and extension rights to maximize the term of the licensee’s rights.

For software licensing agreements, the licensee should require that any source code and programmer documentation be placed in escrow immediately upon the execution of the licensing agreement and be released to the licensee upon certain triggering events, including the filing of a bankruptcy proceeding by or against the licensor. The software licensing agreement also should provide for a present license to use the source code which will be meaningful only following a triggering event that results in the release of the escrowed information to the licensee. The escrow arrangement should be embodied in a separate escrow agreement. If properly drafted, the escrow agreement will allow the licensee access to the source code so it can support the software on its own since the bankrupt licensor cannot be required to provide support services such as maintaining, repairing, or debugging the software. The escrow agreement should include contact information for the licensor’s key personnel responsible for developing and annotating the source code. The escrow agreement also should require notice to the licensee of any defaults by the licensor, such as a failure to make required periodic payments to the escrow agent, and provide an opportunity for the licensee to cure such defaults on behalf of the licensor. The escrow agreement should further require periodic updates by the licensor as the source code is updated, as well as updated personnel contact information. The licensee may want to monitor the licensor’s compliance with these updating requirements. The licensee also should negotiate for the right to hire employees of the licensor who are familiar with the source code if the licensor becomes unwilling or unable to continue supporting the software.

Conclusion

There are many questions that arise in the context of intellectual property licensing agreements and bankruptcy. For instance, does the licensing agreement concern "intellectual property," as that term is defined in the Code? Is the licensing agreement an executory contract? What steps can be taken by the licensee to protect its rights if the licensor files bankruptcy? Licensees should educate themselves on these issues to understand the effect of the bankruptcy code, and should take affirmative steps to protect their rights by properly drafting licensing agreements and, if appropriate, source code escrow agreements on the front end.

© 2008, Ward and Smith, P.A.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.