In re Spansion: Licenses in Bankruptcy As A Shield To The Licensor Debtor, and Not A Sword To The Licensee.

In re Spansion: Licenses in Bankruptcy As A Shield To The Licensor Debtor, and Not A Sword To The Licensee. I. Introduction Donika P. Pentcheva 1 and Roy P. Issac, Ph.D. 2 The worldwide licensing of technology is one of the keystones to our modern global economy. 3 The importance of licensing is underscored by the change in business climate as countries move from the industrial age to the information age. 4 In the past, the major portion of the wealth of a company or enterprise resided in its tangible assets, such as factories and inventory. 5 Now, in the information age, the health of the company or enterprise resides in its intangible assets, such as its patents, trademarks, trade secrets, and copyrights. 6 The importance of intellectual property rights is often underscored when a business files for bankruptcy relief under the U.S. Bankruptcy Code. The following article will address the interplay between licenses and executory contracts in bankruptcy law, and their application in In re Spansion, a decision issued by the United States Court of Appeals for the Third Circuit. II. General Discussion of the Bankruptcy Regime The U.S. Bankruptcy Code provides protection for individuals and companies. Under Chapter 11 of the Bankruptcy Code, businesses may seek bankruptcy protection, reorganize their debt load and remain in business. A Chapter 11 bankruptcy is commonly referred to as reorganization because it deals with the rehabilitation of financially troubled debtors, such as corporations, partnerships and individuals. 7 Reorganization under the Bankruptcy Code serves the public interest by providing worthy debtors a mechanism to gain relief from crushing debt while maintaining some measure of fidelity to creditors. Its processes involve a determination of those measures necessary to make a troubled debtor economically sound, as well as readjustments of creditors rights in order to make the rehabilitation fair to all parties. 8 The district court, or by referral the bankruptcy court, has original and exclusive jurisdiction of the bankruptcy case itself. A bankruptcy case is initiated when a debtor files a petition for 1 Donika P. Pentcheva is an intellectual property attorney at Westman, Champlin & Kelly, P.A. Ms. Pentcheva is experienced in all aspects of intellectual property portfolio management, including preparation, litigation and enforcement. Ms. Pentcheva also serves on the Board of Directors of several privately-held companies and the Board of Trustees of several not-for-profit organizations. She can be reached at dpentcheva@wck.com. 2 Roy P. Issac is a patent attorney at Elmore Patent Law Group, P.C. Dr. Issac specializes in patent prosecution and strategic patent portfolio development for pharmaceutical, chemical and biotechnology companies. He can be reached at rissac@elmorepatents.com. 3 Licensing Law Handbook, Melvig Jager, Chapter 1, Section 1. 4 Id. 5 Id. 6 Id. 7 Chapter 11 Reorganizations, Second Edition, Section 1:1. 8 Chapter 11 Reorganizations, Second Edition, Section 1:1. 1

bankruptcy relief under any of the various chapters of the Bankruptcy Code. 9 The case is the entire legal proceeding and all administrative matters leading to the discharge of debt order. 10 The bankruptcy case includes all controversies determinable by the bankruptcy court and all matters of administration arising in the case. 11 Under the Bankruptcy Code, and upon the filing of a petition by the debtor, the bankruptcy court assumes control over all property of the debtor and all property of the debtor s estate. In those instances where a company files for bankruptcy relief, the bankruptcy court effectively owns and operates the company from date of the bankruptcy petition filing through the conclusion of the case. The filing of the bankruptcy petition by a debtor creates a bankruptcy estate that generally consists of all of the debtor s assets at the time the petition was filed. Property of the estate is broadly defined to include all of the debtor s legal and equitable interests in property as of the commencement of the case wherever located and by whomever held. 12 The estate includes both tangible and intangible property, including the debtor s interests in patents, trademarks 13, copyrights, causes of action, licenses, and other kinds of interests. The debtor s goodwill and trade secrets may constitute property that becomes part of the bankruptcy estate. The bankruptcy process, at its core, is simply the coordination of the bankruptcy court, trustee, creditors and debtor to determine the sale, disposition, or use of the debtor s estate. In the context of intellectual property, the bankruptcy parties coordinate to determine the disposition of the debtor s patents, trademarks, copyrights and licenses. III. Executory Contracts in Bankruptcy The Bankruptcy Code does not define the term executory contract and there is considerable case law and some uncertainty about the types of agreements encompassed by the term. Generally, executory contracts are contracts that are sufficiently unperformed such that the failure by either party to perform its ongoing obligations constitutes a material breach. 14 In most bankruptcy cases, the only executory contracts that are likely to exist are apartment leases and purchase agreements. A judicial determination as to whether a contract is executory or non- 9 Licensing Law Handbook, Melvig Jager, Chapter 10, Section 17. 10 Bankruptcy Law Manual, Chapter 2A, Section 2. 11 See, e.g., In re Actic Enterprises, Inc., 68 B.R. 71, 76 n.4 (D. Minn. 1986); In re S.E. Hornsby & Sons Sand and Gravel Co., Inc. (E.I. No. 72-0792818) 45 B.R. 988, 944, 12 Bankr. Ct. Dec. (CRR) 713 (Bankr. M.D. La 1985). 12 11 U.S.C. 541(a). 13 See Adams Apple Distributing Co. v. Papeleras Reunidas, S.A., 773 F.2d 925, 931 (7th Cir. 1985), where the court of appeals held that a trademark is an asset of a bankrupt's estate which is saleable in bankruptcy proceedings along with the bankrupt's goodwill or tangible business assets. See also EH Yacht, LLC v. Egg Harbor, LLC, 84 F. Supp. 2d 556, 53 U.S.P.Q.2d 1640 (D.N.J. 2000) (trustee can sell goodwill and trademarks of debtor); In re Sheppard's Dental Centers, Inc., 65 B.R. 274 (Bankr. S.D. Fla. 1986) (treating intangible assets such as patient/employee relationships, contractual relationships with patient and employee relationships, contractual relations with landlords, and goodwill as having value and property of the estate). 14 In re Streets & Beard Farm Partnership, 882 F.2d 233 (7 th Cir. 1989). 2

executory is made at the time of the bankruptcy petition filing. 15 it was fully performed by one party prior to bankruptcy. 16 A contract is not executory if Courts have almost always concluded that patent licenses are executory contracts because they always contain unperformed obligations such as the duty to pay royalties, keep records or police the patent rights against third-party infringers. Section 365(a) of the Bankruptcy Code allows a debtor, acting through a bankruptcy trustee, to reject (void) burdensome executory contracts. 17 For example, a bankruptcy debtor who no longer wishes to be bound by its commercial lease agreement may opt to reject or void that lease. The rationale underlying this power is that the trustee should be able to abandon contracts that impose burdensome liabilities upon the bankruptcy estate, but should also be able to take advantage of favorable contracts that benefit the estate. In those instances where the debtor elects to reject a contract between the debtor and a party to the contract, the party s sole legal recourse is to file a monetary claim against the bankruptcy estate as an unsecured creditor. In bankruptcy, the unsecured creditors often receive little to no reward on their claims. Lastly, under the bankruptcy code, the burden or hardship which rejecting a contract would impose on other parties to such a contract is not a factor to be weighed by the bankruptcy court in ruling on the debtor s decision to reject the contract. 18 15 See In re Columbia Gas System Inc., 50 F.3d 233 (3d Cir. 1995); Matter of Murexco Petroleum, Inc., 15 F.3d 60 (5th Cir. 1994); In re Norquist, 43 B.R. 224 (Bankr. E.D. Wash. 1984); see also In re Schuld Mfg. Co., Inc., 43 B.R. 535 (Bankr. W.D. Wis. 1984) (agreements first made after the bankruptcy petition was filed may not be rejected or assumed pursuant to Section 365 of the Code). But see In re Wang Laboratories, Inc., 154 B.R. 389, 391 (Bankr. D. Mass. 1993) ( The Court holds that the determination of whether a contract is executory is to be made not at the time of filing, but at the time that the issue is before the Court. ). 16 Bankruptcy Law Manual, Chapter 8, Section 41. 17 The Bankruptcy Code does not contain a definition of executory contract. See Bankruptcy Law Manual, Chapter 8, Section 41. This void has resulted in the judicial development of a definition that was first suggested by Professor Vern Countryman, a leading authority on bankruptcy, and that has been adopted by most courts. Id. The definition of executory contract based on substantial nonperformance on both sides, formulated by Professor Countryman in 1973, is based on a practical approach to the trustee s powers. Similar to the power to abandon or accept property of the estate, the option to assume or reject executory contracts and leases is to be exercised only when it benefits the estate. In view of this purpose of benefitting the estate, it does not make sense to permit rejection of contracts that were fully performed by one party, especially since rejection gives the other party a claim against the estate for damages as if the debtor breached. For example, if a creditor fully performed a contract of sale by delivering goods for which the debtor did not pay, rejection of the contract by the debtor would be meaningless in that the estate has whatever benefit it can obtain and rejection would neither add to nor detract from the creditor's claim or the estate's liability. Assumption would also be meaningless, for its only effect would be to give the creditor's claim an administrative expense priority. If there was full performance by the debtor prior to bankruptcy such as where the debtor fully paid for goods not yet delivered by the seller assumption would not improve upon the debtor's right to performance by the other party, and rejection by the debtor would not make sense because it would constitute a breach of a fully performed obligation. For this reason, under Professor Countryman's definition, the debtor's accounts payable and accounts receivable are usually not executory contracts and, therefore, may not be assumed or rejected. 18 See Borman s Inc. v. Allied Supermarkets, Inc., 706 F.2d 187 (6th Cir. 1983). 3

IV. Licenses in Bankruptcy A patent license grants a licensee a right to make a patented product or use a patented method. 19 It does not pass title of the patent, or other intellectual property that is licensed, to the licensee. 20 If a sale of a patent occurs where the seller is paid future profits from the use of the patent, the sale is not a license. 21 In these circumstances, the seller does not retain any control over the use or disposal of the patent. 22 The right to use intellectual property is generally not transferred by sale or assignment. 23 Instead, limited rights to use the intellectual property in a certain manner and for certain purposes are typically transferred by way of a license agreement. As discussed above, patent licenses are executory contracts in bankruptcy. When a debtorlicensor files for bankruptcy relief, the bankruptcy can have a major impact on the continuing performance under the license agreement. 24 While some agreements contain a clause giving a party the right to terminate the license upon the filing for bankruptcy by the other party, those clauses have been held to be unenforceable. 25 Moreover, any attempted termination after the filing for bankruptcy is precluded by the automatic stay 26 provisions of the Bankruptcy Code. 27 In 1985, a landmark case addressing licensing rights in bankruptcy was decided. In Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., the court held that a license on metal coating technology could be rejected by the trustee because the technology could be sold for more money, free of the license. 28 The court upheld the trustee s power to reject and found that the licensee had no further rights. The decision in Lubrizol Enterprises sent a shock wave through industries that rely heavily on licenses in technology as it made clear that licensing agreements involving the use of licensed technology are executory contracts that may be rejected by a debtor in bankruptcy. 29 The result of such rejection was that a licensee, who may have invested substantial sums and even built an entire business around the use of the licensed technology, could lose the right to use the licensed technology and be left with nothing but an unsecured 19 Licensing Law Handbook, Melvig Jager, Chapter 3, Section 1. 20 Id. 21 Id. 22 Classen Immunotherapies, Inc. v. King Pharmaceuticals, Inc., 403 F. Supp. 2d 451, 456, (D. Md. 2005). 23 Drafting License Agreements, Chapter 6, Section 1. 24 Licensing Law Handbook, Melvig Jager, Chapter 10, Section 17. 25 In re Computer Communications, Inc., 824 F.2d 725, 16 Bankr. Ct. Dec. (CRR) 615, 17 Collier Bankr. Cas. 2d (MB) 556, Bankr. L. Rep. (CCH) 71933 (9th Cir. 1987). 26 In order to relieve the financial pressures that caused a debtor to seek bankruptcy relief, the Bankruptcy Code provides that the filing of a voluntary petition results in an automatic stay of certain actions. See 11 U.S.C. 362. This stay, which arises by operation of law and requires no judicial action, halts the collection of claims and protects the debtor from harassment by credits. See Bankruptcy Law Manual, Chapter 2, Section 1. The automatic stay prevents a creditor from pursuing remedies against the debtor s assets to the detriment of other creditors and allows the debtor some breathing room. In re Soares, 107 F.3d 969, 975, 37 Collier Bankr. Cas. 2d (MB) 1281, Bankr. L. Rep. (CCH) P 77333 (1st Cir. 1997). The automatic stay is not intended to alter the substantive rights of creditors, but merely stops collection efforts pending a determination by the bankruptcy court of the creditors and the debtors rights. Bankruptcy Law Manual, Chapter 2, Section 1. 27 11 U.S.C.A. 362(a). 28 Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 12 Bankr. Ct. Dec. (CRR) 1281, 12 Collier Bankr. Cas. 2d (MB) 310, 226 U.S.P.Q. 961, Bankr. L. Rep. (CCH) 70311 (4th Cir. 1985). 29 Bankruptcy Law Manual, Chapter 8, Section 51. 4

claim for damages against the bankrupt licensor. 30 In effect, the actions of the licensor in filing for bankruptcy relief could cause financial turmoil to the licensee, thereby resulting in the licensee having to file for bankruptcy as well. Thus, as it stood in 1987, bankruptcy law could have very detrimental effects on a licensee when a licensor filed for bankruptcy. 31 In 1988, largely in response to the decision in Lubrizol Enterprises, Congress enacted the Intellectual Property Licenses in Bankruptcy Act ( IPLBA ). The main provisions of the IPLBA are incorporated into Section 365(n) of the Bankruptcy Code, and provide protection to the licensee when a licensor files for bankruptcy. 32 The protection granted under Section 365(n) is available to licensees of intellectual property, including patents, trade secrets and copyrights. The protection granted under Section 365(n) does not extend to trademarks, trade names, domain names, or related rights. Additionally, these protections are available only if the license agreement outlines, prior to the bankruptcy filing, the rights of the parties in the event of a potential bankruptcy case. The vested rights of a licensee are protected under Section 365(n) by providing the licensee with two options. First, the licensee may elect to treat the contract terminated 33 under Section 365(n)(1)(A). In that case, the licensee loses its ability to use the content provided under the license, but has a damage claim against the debtor as an unsecured creditor: essentially the same treatment obtained upon breach of a regular executory contract. Second, under Section 365(n)(1)(B), the licensee may elect to retain its rights to such intellectual property under the license, or under a supplementary agreement such as an escrow agreement, as 30 Id. 31 See M. Chertok, Structuring Licensing Agreements with companies in Financial Difficulty Section 365(n) Divining Rod or Obstacle Course, 65 St. John's L. Rev. 1045 (Autumn 1991). In 1986 Congress passed the Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act, Pub. L. No. 99-554, 100 Stat. 3088 (1986) ( the 1986 Amendments ). Aside from several technical and substantive amendments to the Bankruptcy Code, the 1986 Amendments did two major things. First, the 1986 Amendments created new Chapter 12 of the Bankruptcy Code specifically available only to family farmers. Second, the 1986 Amendments substituted a permanent nationwide United States trustee s office for the pilot program that has been created in 1987. See Pub. L. 99-554, Title I, 111, 100 Stat. 3088 (1986). A United States trustee is an arm of the United States Department of Justice. The office serves as the administrative arm of bankruptcy cases. The office is charged, inter alia, with appointing and monitoring the performance of Chapter 7, 11, 12 and 13 trustees; monitoring the appointment of professionals in bankruptcy cases; appointing committees in bankruptcy cases; appointing, at the direction of the bankruptcy court, trustees and examiners; monitoring the financial operations of Chapter 11 debtors; and making criminal referrals to the United States Attorney. The Bankruptcy Code was amended three times in 1988: (1) the Retiree Benefit Bankruptcy Protection Act of 1998 adding 1114 to Chapter 11 providing procedures and standards for modifying payments of retiree benefits in a Chapter 11 case; (2) the Municipal Bankruptcy Amendments of 1988 amending the definition of insolvency as it applied to municipalities so that an insolvent municipality is one that is not generally paying, or is unable to pay, its debts when they become due, except for debts that are the subject of a bona fide dispute; (3) the Intellectual Property Bankruptcy Protection Act keeping secure the rights of intellectual property licensors and licensees which come under bankruptcy protection. Intellectual property was defined to include inter alia, trade secrets, inventions, processes, designs, patent applications, and works of authorship. The amendment further provided that until the trustee rejects, the contract, on the written request of the licensee, the trustee is required to perform the contract, provide such intellectual property held by the trustee, and not interfere with the rights of the licensee as specified in the contract. Pub. L. No. 100-506, 102 Stat. 2538 (1988). The amendment added 11 U.S.C. 365(n) to make it clear that the rights of an intellectual property licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license under 365. See Bankruptcy Law Manual, Chapter 1, Section 8. 32 Pub. L. No. 100-506, 102 Stat. 2538. 33 If the rejection by the trustee amounts to a breach that would allow the licensee to treat the contract as terminated by its own terms, applicable non-bankruptcy law, or an agreement between the licensee and another entity. 5

such rights existed immediately before the bankruptcy case was commenced. The rights that can be retained include the right to enforce exclusivity provisions 34, if any, in the contract, and to protect trade secrets and confidential information. Any retained rights can extend for the life of the license or for any period of contract extension. Under Section 365(n)(2) if the licensee makes such an election, the trustee shall allow the licensee to exercise its rights to the possession and use of the intellectual property. If the license so provides, the licensee can obtain use of the licensor s intellectual property without seeking relief from the automatic stay. 35 Under Section 365(n)(3), if the licensee elects to retain its rights, the trustee, on written request from the licensee, shall, to the extent provided in the contract [ ] provide to the licensee any intellectual property. The trustee is also compelled not to interfere with the contract rights of the licensee, including the right to obtain the intellectual property from some other entity, such as an escrow agent. Under Section 365(n)(4), the trustee must afford the licensee the same rights unless and until the trustee rejects the contract as an onerous executory contract. 36 The retained rights of the licensee cannot include the right to compel specific performance by the debtor-licensor. Thus, if the license called for the licensor to perform services or further develop the technology, for instance, those contract rights are lost. The debtor-licensor in bankruptcy cannot be compelled to perform any affirmative act. The rights of the licensee under Section 365(n) are limited to the possession and use of the intellectual property in the state of the technology as it existed at the time the trustee rejected the contract. The licensee can carry on its business with the intellectual property, but any future or contingent rights granted under the license, such as rights to future improvements in the licensed technology, are not preserved. Lastly, a licensee s option to retain its rights under the license agreement is conditioned on the licensee continuing to make the license payments for the remainder of the term of the contract. If a licensee exercises its right to retain the intellectual property, it shall be deemed to have waived any right to setoff it may have with respect to the contract (either under the Bankruptcy Code or applicable non-bankruptcy law) and any administrative expense claim against the bankruptcy estate resulting from the licensee s continuing performance under the license V. In re Spansion In November 2008, Spansion filed a patent infringement complaint over its flash memory products against Apple with the United States International Trade Commission (ITC). In a letter agreement between Spansion and Apple, Spansion agreed to dismiss the ITC action against Apple and promised to refrain from filing future actions related to those patents. Apple agreed to 34 11 U.S.C. 365(n)(1)(B). 35 11 U.S.C. 365(n)(1). 36 The benefits of Section 365(n) also apply to a contract that depends on a triggering event, such as the issuance of a patent, that may occur after the bankruptcy filing. See 11 U.S.C. 365(n)(1). 6

not disbar Spansion as a supplier, and to consider Spansion for future products if certain conditions were met. On March 1, 2009, Spansion filed for Chapter 11 bankruptcy. Under Section 365(a) of the Bankruptcy Code, Spansion had the right to assume or reject its executory contracts, that is, those contracts where Spansion and Apple owed each other on-going material obligations. If Spansion moved to reject the executory contract, Apple, as the wronged-party, could seek to collect damages for breach of contract as an unsecured creditor. From Apple s perspective, if Spansion moved to reject a licensing contract involving intellectual property, Apple would be left with two options. First, Apple could treat the rejection as a termination of the contract, in which case Apple would have the typical rejection damages claim, as noted above. Alternatively, Apple could elect to retain the licensed intellectual property rights under Section 365(n), including a right to enforce any exclusivity provision in the contract. Following the bankruptcy filing, Spansion filed a motion in the Bankruptcy Court, seeking to reject the agreement as an executory contract under Section 365(a). On September 1, 2009, the Bankruptcy Court granted the motion and issued an order stating that the agreement is rejected. Apple, in turn, filed under Section 365(n), electing to retain its rights as a license agreement. 37 At the core of the argument was whether Spansion s promise to refrain from filing future lawsuits against Apple constituted a valid license as that term is used in the Bankruptcy Code. If the Court ruled that the agreement between Spansion and Apple was not a license, but merely an executory contract, then the protection under Section 365(n) would not apply, and Apple would lose its license rights. The District Court of Delaware held that a covenant not to sue is a valid license, and therefore Section 365(n) permitted Apple to retain its rights under the patent license. The court of appeals for the third circuit affirmed the district court s ruling, confirming the ruling that a covenant not to sue qualifies as a license. The Court s ruling highlights the importance of drafting techniques when an intellectual property attorney constructs a license agreement. The Court s ruling underscores the importance of drafting a license agreement such that if a licensor files for bankruptcy relief, the licensee will be protected. VI. Conclusion The Court in Spansion considered the crucial question of what type of agreements qualify as licenses to fall within the protection of Section 365(n) of the Bankruptcy Code. The Court relied on an expansive view of what constitutes a license and held that a covenant not to sue is a license and as such Section 365(n) applies. When a licensor files for bankruptcy under 37 In re Spansion, 2012 U.S. App. LEXIS 26131. 7

Chapter 11, the licensee can treat a rejection of the licensing agreement as termination of the contract or retain the licensed intellectual property rights. Spansion and Section 365(n) reiterate that bankruptcy, while a shield to the debtor from burdensome conditions of a difficult contract, cannot act as a sword to the solvent licensee. 8