June 22, 2004

Fourth Circuit's Literal Interpretation of Bankruptcy Code a Victory for Licensors of Intellectual Property

Holland & Knight Newsletter
Lynne B. Xerras

When a licensee files bankruptcy, those who license intellectual property may find themselves unwilling participants in complex proceedings before the United States Bankruptcy Courts. In light of the fast pace of many Chapter 11 reorganizations, often involving going-concern sales, it is imperative that the licensor be vigilant in monitoring the case to ensure that an order does not enter permitting the debtor to transfer an intellectual property license to a third-party without the licensor’s consent. The U.S. Court of Appeals for the Fourth Circuit has recently joined three other circuits in holding that a literal reading of the Bankruptcy Code[1] prevents the debtor from obtaining such an order.[2] Nevertheless, the software licensor must have a general understanding of certain bankruptcy law concepts to protect its rights, and should remain proactive in the case lest its silence be deemed as consent to relief sought by a debtor.

General Bankruptcy Principles

While there are many strategic reasons for a corporation to file for bankruptcy, chances are that a company is initiating the bankruptcy to take advantage of the “automatic stay.”[3] In simple terms, the automatic stay halts most collection efforts of a creditor against a debtor-corporation, regardless of whether that creditor has been formally notified that a bankruptcy has been filed. Since the stay provides the debtor a “breathing spell” from the financial pressures that drove it into bankruptcy, the automatic stay is deemed to be the most fundamental protection provided in the Bankruptcy Code. The automatic stay serves to prevent a software licensor from terminating a license despite the existence of pre-bankruptcy defaults.

Another automatic occurrence upon the initiation of a bankruptcy case is the creation of what is known as the “estate” or the “bankruptcy estate.” This estate is comprised of “property of the estate” which is defined broadly[4] to incorporate virtually every asset in which the debtor holds a legal or equitable interest as of the petition date, as well as the proceeds, product, rent or profits from those assets. The debtor’s contracts and leases are part of the bankruptcy estate.

Treatment of Executory Contracts

The treatment of those contracts which are “executory” is set forth in Section 365 of the Bankruptcy Code. If the debtor is a party to an “executory contract” or an unexpired lease, both the non-debtor party and the debtor have certain defined rights and obligations regarding that contract or lease. While the Bankruptcy Code does not contain a definition of “executory contract,” most courts have adopted some form of what is commonly referred to as the “Countryman Test.” Under that standard, a contract is executory if the obligations of both the debtor and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other party under the contract.[5] Of particular importance is the fact that courts deem licenses of intellectual property as executory contracts, subject to the provisions of Section 365.[6]

During the bankruptcy, the debtor must make the decision to either “reject” or “assume” each of its executory contracts and unexpired leases.[7] With certain exceptions, in Chapter 11 reorganization, the debtor may assume or reject an executory contract or unexpired lease at any time prior to the confirmation of a plan of reorganization, or pursuant to a plan.[8] If a debtor “rejects” a contract deemed burdensome, the debtor refuses to be bound further by it and the non-debtor party is left with a pre-petition claim for damages for breach of contract.[9]

In the alternative, the debtor can “assume” an executory contract or lease by choosing to be bound by its terms.[10] The debtor cannot assume a contract, however, without first meeting certain statutory conditions. The debtor must, among other things, cure outstanding defaults under the contract or “provide adequate assurance” that it will do so, and “provide adequate assurance of future performance.”[11] Since assumption may represent the only mechanism for a creditor to recover the pre-petition arrearage owed under a contract, assumption is generally favored over rejection.

Once the debtor has satisfied the Bankruptcy Code provisions relating to assumption and obtained authority of the bankruptcy court to assume a contract or a lease, the debtor may seek to assign that contract for value to a third party.[12] To accomplish assignment, a debtor must demonstrate to the non-debtor party adequate assurance of future performance under the contract by the potential assignee. A debtor may take these steps even though a provision of the contract purports to limit or restrict such assignment.[13]

Special Treatment of Intellectual Property Licenses

The debtor’s ability to assume and/or assume and assign its executory contracts is not absolute, however. Under Section 365(c), consent is needed to accomplish assumption or assignment if “applicable non-bankruptcy law” excuses the non-debtor party to the contract from accepting performance from, or rendering performance to, an entity other than the debtor.[14] Section 365(c), therefore, is directed to contracts that, regardless of their provisions, would not be assignable under applicable non-bankruptcy law. Several courts have held that since federal common law serves to prohibit an assignment of intellectual property licenses without consent of the counterparty, non-exclusive software licenses cannot be assigned under Section 365(c) without consent of the licensor.[15]

While courts uniformly hold that non-exclusive intellectual property licenses are not assignable under 365(c) without consent, a split exists among the circuits concerning whether a debtor can merely assume an executory contract that would not be assignable under non-bankruptcy law. It is clear that the statute is drafted in the disjunctive, stating literally that a debtor may not assume or assign an executory contract without the consent of the non-debtor party if applicable non-bankruptcy law would prevent an assignment. The prevailing circuit view is that the statute must be given its plain meaning despite sound bankruptcy policy favoring an alternate interpretation. In reaching this conclusion, the U.S. Court of Appeals for the Third, Ninth and Eleventh Circuits have adopted what is referred to as a “literal test,” or “hypothetical test.”[16] Under that standard, if hypothetically the debtor could not assign the license under non-bankruptcy law without the non-debtor party’s consent, then the debtor cannot assume it either, even if the debtor has no intention of assigning the license.[17]

In Institut Pasteur v. Cambridge Biotech Corp.,[18] the U.S. Court of Appeals for the First Circuit applied a more pragmatic “actual test,” holding that as long as the non-debtor party is not actually being forced to accept performance under its executory contract from someone other than the debtor, assumption is permitted. The First Circuit, therefore, interpreted the disjunctive “or” of Section 365(c) as a conjunctive “and.”

The Fourth Circuit has recently tipped the scales in favor of the non-debtor licensor when it joined the other circuit courts in holding that Section 365(c) literally prevents assumption of a non-exclusive intellectual property license without the consent of the licensor. In the case of In re Sunterra Corporation, the debtor, Sunterra Corporation (Sunterra) had obtained a “non-exclusive, worldwide, perpetual, irrevocable, royalty-free license” to use software developed by RCI Technology Corporation (RCI) prior to filing a Chapter 11 bankruptcy. During the case, RCI filed a motion requesting that the bankruptcy court deem the license rejected since Sunterra was precluded from assuming the agreement without its consent under Section 365(c). Sunterra opposed RCI’s motion, asserting that Section 365(c) should not be read to prohibit a debtor-in-possession from merely assuming its own contracts. The bankruptcy court denied the motion on the ground that the license was not executory, and also stated that it would be nonsensical to interpret Section 365(c) literally.[19] On appeal, the district court affirmed the bankruptcy court decision, despite finding the license to be executory, as it concluded that Section 365(c) did not preclude Sunterra, the debtor, from assuming the license agreement. The district court made this ruling even though it acknowledged that the statute, read literally, precluded Sunterra from assuming the license since: (1) copyright law excused RCI from accepting performance from a party other than Sunterra; and (2) RCI did not consent to Sunterra’s assumption. Nevertheless, applying the “actual test” of Cambridge Biotech, the district court ruled that assumption was permissible since RCI was not being forced to accept performance from a third-party.[20]

On appeal, the Fourth Circuit initially agreed with the district court that the license at issue was executory. It then conducted a close examination of the provisions of Section 365(c) and reversed the district court’s holding that assumption is permitted without consent under the statute. The appellate court’s ruling was based on the conclusion that, as the statute is drafted in the conjunctive, the mandates of the plain meaning rule of statutory construction dictate that Section 365(c) must be interpreted to prohibit assumption of the license at issue without consent of RCI. The court thus adopted the “literal” test advanced by the Third, Ninth and Eleventh Circuits. In doing so, the Fourth Circuit noted that even though policy might weigh in favor of an alternative reading, it is the task of Congress to modify the statutory provisions of the Bankruptcy Code, not the judiciary. Otherwise, “when the actual test is applied, the disjunctive ‘or’ of Section 365(c) is read as the conjunctive ‘and,’ and the term ‘assume’ is effectively read out of the Statute.”[21] Based on the foregoing, the court concluded that since RCI did not consent to assumption of the license agreement, Sunterra was precluded from assuming that agreement. This ruling makes it increasingly difficult for a debtor to continue doing business with a non-consenting software licensor after a bankruptcy is filed.

Conclusion

When a software licensor finds itself an involuntary participant in the bankruptcy of one of its licensees, it essentially is given veto power over the purported treatment of the license by virtue of Section 365(c). At a minimum, this should offer licensors comfort that the intellectual property that it developed is not at risk of landing in the hands of a competitor. In order to fully protect its rights, however, the licensor can not be an idle participant in the bankruptcy. In each of the cited cases favoring the rights of the non-debtor parties, the licensor was proactive in the case, filing pleadings requisite to prevent the debtor from taking action over objection of the licensor. On the other hand, failure to act can be deemed consent under Section 365(c), thereby eviscerating any protection offered licensors under the Bankruptcy Code. It is imperative, therefore, that each bankruptcy case be closely monitored to ensure that important deadlines are not missed by the licensor. Licensors should also draft their license agreements to explicitly withhold consent to assumption and assignment should a bankruptcy be filed.

 

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1. 11 U.S.C. § 101, et seq. (the Bankruptcy Code)

2. RCI Technology Corporation v. Sunterra Corporation (In re Sunterra),361 F.3d 257 (4th Cir. 2004).

3. 11 U.S.C. § 362.

4. 11 U.S.C. § 541(a).

5. See e.g., Everex Systems, Inc. v. Cadtrak Corp. (In re CFLC, Inc.), 89 F.3d 673, 677 (9th Cir. 1996)(citing Griffel v. Murphy (In re N.A. Wegner), 839 F.2d 533, 536 (9th Cir. 1988)).

6. See e.g., In re Access Beyond Tech., Inc., 237 B.R. 32 (Bankr.D.Del. 1999).

7. 11 U.S.C. § 365(b)(1).

8. 11 U.S.C. § 365(d)(1).

9. 11 U.S.C. § 365(g).

10. 11 U.S.C. § 365(a).

11. 11 U.S.C. § 365(b).

12. 11 U.S.C. § 365(f).

13. 11 U.S.C. § 365(f)(1)-(3).

14. 11 U.S.C. § 365(c).

15. See In re Alltech Plastics Inc., 71 B.R. 686 (Bankr. W.D. Tenn. 1987); In re CFLC Inc., 89 F.3d 673 (9th Cir. 1996); In re Access Beyond Technologies Inc., 237 B.R. 32 (1999)(with regard to patent licenses); In re Patient Education Media Inc., 210 B.R. 237 (Bankr. S.D.N.Y. 1997); In re Golden Books Family Entertainment Inc., 269 B.R. 311 (Bankr.D.Del.2001)(with regard to software licenses).

16. See In re West Elecs., Inc., 852 F.2d 79, 83 (3d Cir. 1988)(characterizing Section 365(c)(1)(A) as posing “a hypothetical question”); In re Catapult Entm’t, Inc., 165 F.3d 747, 750 (9th Cir. 1999)(same); In re James Cable Partners, 2 F.3d 534, 537 (11th Cir. 1994)(same).

17. See id.

18. 104 F.3d 489, 493 (1st Cir.), cert. denied, 521 U.S. 1120 (1997).

19.  Id. at 261.

20. Sunterra, at 262. Id

21. Sunterra, at 269 (citing Barnhart v. Sigmon Coal Co., 534 U.S. 438, 122 S.Ct. 941, 151 L.Ed.2d 908 (2002)).

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