Bankruptcy

Courts are Signaling, but is Congress Listening?

By Michelle Harner

As I previously mentioned, recent amendments to the U.S. Bankruptcy Code have been significant and driven in large part by special interest groups.  Yet, Congress has ignored ambiguity in the Code that has persisted for years, causing confusion, uncertainty and additional expense in numerous chapter 11 cases.  One prime example is section 365 of the Code; in particular, sections 365(c) and (n) in the context of intellectual property licenses.

Section 365(c)(1) of the Code generally prohibits a debtor from assuming or assigning an executory contract or unexpired lease if ?applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties.?  Counterparties use section 365(c)(1) to block assignment of, among other things, intellectual property licenses on the grounds that applicable law restricts alienation of those contract interests.  (For a general overview of licensing issues in bankruptcy, see here and here; list of resources here.)  They also frequently try to prevent the debtor itself from simply assuming the intellectual property license based on the introductory language of section 365(c) (i.e., ?may not assume or assign?) and the ?hypothetical test? developed by the Ninth Circuit in Catapult Entertainment. 

Section 365(n) of the Code generally protects the rights of licensees under the debtor?s intellectual property licenses in the event the debtor seeks to reject the license.  Specifically, a licensee can elect to keep its rights under the license (including any exclusivity rights), but the debtor is released from further obligations under the license upon rejection.  The primary point of contention under section 365(n) is the Code?s definition of ?intellectual property,? which does not include trademarks.  Consequently, debtors arguably can use bankruptcy to take back rights to a trademark it contracted away prepetition.  Notably, this is precisely the type of conduct that Congress sought to redress in enacting section 365(n) in response to the Lubrizol decision.

Recent court decisions highlight the problems inherent in both subsections of 365.  Courts continue to split over the proper interpretation of section 365(c)(1), with recent decisions appearing to reject the Catapult approach and support the ?actual test? developed by the First Circuit in Institut Pasteur.  Notably, in a statement concerning the Supreme Court?s denial of a writ of certiorari in N.C.P. Marketing, Justice Kennedy acknowledged this split and suggested that it represents an ?important? question that needs resolution.  (For a summary of the issues raised by the case, see here.)  Likewise, in the Third Circuit?s Exide decision, Judge Ambro wrote an insightful and persuasive concurring opinion that argued for extending the protections of section 365(n) to trademark licensees.  Courts are taking notice of apparent inconsistencies and challenges for parties under the Code, but will Congress follow suit?

I raise the question because Congress could easily address the issues raised by the language of sections 365(c) and (n).  Much of the Code is premised on providing the debtor a fresh start while doing as little harm as possible to the rights of third parties.  This objective provides useful guidance in the context of section 365.  For example, if the debtor is reorganizing and will maintain the license, the counterparty will receive the benefit of its prepetition bargain and section 365(c)(1) should be inapplicable.  Moreover, unless there are economic or proprietary reasons to treat trademarks differently than other intellectual property (see here suggesting that the answer is no), allowing the licensee to keep its rights under a trademark license while releasing the debtor from its obligations under the license appears to strike the appropriate balance.  As Judge Ambro noted, any other result ?makes bankruptcy more a sword than a shield, putting debtor licensors in a catbird seat they often do not deserve.?

Full post as published by Credit Slips on June 18, 2010 (boomark / email).