“I did not want you to hear this on the news for the first time, but we are filing for bankruptcy next week.” “This is a difficult call to make. We are going out of business and will probably be filing a chapter 7 in the next couple of days.” Needless to say, bankruptcy is problematic for a licensor: the licensee may cease performing, the royalty stream may run dry, and the licensee or a trustee could attempt to sell or assign the license in bankruptcy to an undesirable licensee, or even a competitor. There is however one silver lining in these scenarios - the licensor received a heads up about the bankruptcy before it was filed.
With the benefit of advance notice, a licensor should consider terminating the license before the licensee actually goes into bankruptcy.1 Once the licensee files for bankruptcy protection, the automatic stay will enjoin the licensor from taking any action against the licensee. While termination may still be possible in bankruptcy, first the licensor will need to obtain relief from the automatic stay. Needless to say, it is much easier to terminate a contract outside of bankruptcy than it is to obtain the bankruptcy court’s permission to do so.
It is essential to draft licenses with the possibility of bankruptcy in mind. While most of the tips discussed below are straightforward, a recent bankruptcy case from Hawaii, In re Minesen Co., illustrates the peril of seemingly innocuous language on the licensor’s ability to protect itself in the event of its licensee’s bankruptcy.2
Termination Before Bankruptcy
But first, what actions can a licensor take with advance notice of a bankruptcy? Step one is to review the license and ascertain whether an event triggering the termination right has occurred. At the drafting stage, include as many default and cross-default triggers as possible. For example, in addition to insolvency and material adverse change clauses, consider authorizing termination if the licensor deems itself insecure, if the licensee fails to pay a debt to a third party over a threshold dollar amount, or judgment of a specified size is entered against the licensee. When drafting, be mindful of the timing of any notice provisions and make certain that the termination will be effective as quickly as possible (ideally, immediately). When pulling the termination trigger, follow the contractual provisions precisely. Send the notice to the right recipient at the correct address, and in the manner specified (i.e., by certified mail, overnight delivery or facsimile). If the address has changed but the license still reflects the old address, send notice to both.
The window during which the termination right can be exercised may be brief. Upon learning that the licensee’s financial condition is deteriorating – before the “b” word is even uttered – review the termination provisions and maybe even compose the termination letter so that it can be ready at a moment’s notice.
The licensee may challenge the termination as a breach of the license, or claim that the termination was effectuated improperly, particularly if the license is critical to its operations. In order to prepare for potential court proceedings, retain evidence of the notice and document the event that triggered the right of termination. If the trigger was an oral statement, a person who heard the statement can write a contemporaneous memo to the file or prepare an affidavit memorializing what was said, when, and by whom.
Once in bankruptcy, a licensee may try an additional tactic – reinstating the license by arguing that the termination was a constructive fraudulent transfer. A constructive fraudulent transfer is simply a transfer that satisfies certain statutory tests; it has nothing to do with fraud.3 The licensee or trustee’s biggest hurdle is likely convincing the court that a transfer of valuable property has occurred. Is termination of a contract the type of transfer that could be a constructive fraudulent transfer?
Maybe. Courts are divided on whether the pre-bankruptcy termination of a contract is a “transfer of an interest of the debtor in property.”4 While the cases are fact-specific a frequently-cited 2006 opinion from Delaware is instructive. In that case, the debtor had prepaid for advertising services that it never received. At first blush, a prepayment sounds like a transfer of something valuable, and the court held that the termination of a contract, even in accordance with its terms, can be avoidable as a constructive fraudulent transfer if it results in the loss of valuable rights.5 The court found however that even though a transfer had occurred, the forfeited contract right (the prepaid advertising services) had no value to the debtor’s estate. The court reasoned that the debtor had shut its website down before the contract was terminated and would not have been able to use the advertising services. Moreover, the contract was also not assignable under non-bankruptcy law.6
The issue was revisited recently in Illinois, where a licensor terminated a patent license in accordance with the contractual terms, and loss of the license resulted in the licensee’s bankruptcy.7 The bankruptcy trustee tried to reinstate the license, arguing that the termination was a constructive fraudulent transfer. The bankruptcy court refused, finding that the termination did not result in the relinquishment of a cognizable property right and joining those courts that have held that a pre-petition termination of a contract, in accordance with the contract’s terms, is not a fraudulent transfer.8 A constructive fraudulent transfer case has legs only if the license has value, and there are a variety of provisions that may be included to make it less valuable to a bankruptcy estate. These same provisions can also be vital to a licensor’s ability to obtain relief from the automatic stay to terminate a license post-bankruptcy.
Termination After Bankruptcy
In the last several years, bankruptcy has most often been used as a vehicle to effectuate a sale of a distressed business. Fundamentally, then, a license that cannot be assigned is likely to be of little to no value to a bankruptcy estate, increasing the likelihood that the licensor can obtain relief from the automatic stay to terminate or successfully resist an attempt to assign the license over its objection. The best language outright prohibits assignment or conditions assignment on the licensor’s prior written consent, in its sole and absolute discretion.
Be very wary of softening the consent requirement in any way. The recent case from Hawaii teaches that drafters should resist the temptation to agree to language to the effect that “consent will not be unreasonably withheld.” That exact phrase doomed a non-debtor party into accepting assignment of a contract in the Minesen case.9 The bankruptcy court ruled that the language so limited the non-debtor’s power to withhold consent that the contract could be assigned over its objection. Abbreviating the term and making the term renewable in the licensor’s sole discretion can also reduce the value of the agreement – a license that has expired cannot be revived, even in bankruptcy court.
In addition to its contractual terms, the nature of the license may be significant. A contract may not be assigned in bankruptcy if non-bankruptcy law would excuse the non-debtor party from accepting performance from, or rendering performance to, an assignee.10 Courts generally find that non-exclusive licenses of patents, trademarks and copyrights fall into this category and refuse to permit their assignment over the licensor’s objection due to their personal nature.11 Note, however, that this protection can be inadvertently destroyed by including conditional assignment language in the license. In Minesen, the court found that the non-debtor party had waived protection under the Anti-Assignment Act when it agreed that its consent would not be unreasonably withheld.12
A licensor that transforms itself into an “ex-licensor” before the automatic stay is in place may be able to slip past its licensee’s bankruptcy, relatively unscathed. While it may still have claims against the bankrupt, and if it received payments within the 90-day period before bankruptcy it may have preference exposure, it will be free to deal with the licensed property as it chooses. Once in bankruptcy, the fate of the licensor may rest on whether the license can be assigned. Strong notice, termination and assignment provisions can be effective bankruptcy escape hatches. For existing licenses lacking such safety features, a modification for some other reason may provide the perfect opportunity to build them into the agreement.
1 Even if a contract states that it may be terminated after the commencement of a bankruptcy case, that type of provision (often referred to as an ipso facto clause) is generally not enforceable against a debtor under the Bankruptcy Code. See 11 U.S.C. §365(e)(1).
2In re Minesen Co., No. 19-00849, 2021 Bankr. LEXIS 3178 (Bankr. D. Haw. Nov. 17, 2021).
3See 11 U.S.C. § 548(a)(1)(B). Broadly summarized, a debtor or trustee may avoid a transfer of an interest of the debtor in property if the debtor received less than reasonably equivalent value in exchange for the transfer and (1) was insolvent when the transfer was made or rendered insolvent by the transfer or (2) was engaged in a business with unreasonably small capital.
4Compare In re McConnell, 934 F.2d 662, 664 (5th Cir. 1991) (down payment was a fraudulent transfer when real estate sale contract was terminated); In re Grady, 202 B.R. 120, 123 (Bankr. N.D. Iowa 1996) (termination of a real estate purchase agreement was a transfer); and In re Veretto, 131 B.R. 732, 736-37 (Bankr. D.N.M. 1991) (forfeiture of equity interest in real estate was a transfer) with Coast Cities Truck Sales, Inc. v. Navistar Int’l Transp. Co. (In re Coast Cities Truck Sales, Inc.), 147 B.R. 674, 677-78 (D.N.J. 1992) (pre-bankruptcy termination was not a transfer); Edwards v. Fed. Home Loan Mortgage Corp. (In re LiTenda Mortgage Corp.), 246 B.R. 185, 191 (Bankr. D.N.J. 2000) (pre-bankruptcy termination and cessation of rights under contract was not a transfer); Creditors’ Comm. v. Jermoo’s, Inc. (In re Jermoo’s, Inc.), 38 B.R. 197, 203-06 (Bankr. W.D.Wis. 1984) (pre-petition termination was not a transfer).
5See EBC I, Inc. v. America Online, Inc. (In re EBC I, Inc.), 356 B.R. 631, 641 (Bankr. D.Del. 2006).
6Id. at 362-63.
7See Goldstein v. Hass, et al. (In re VitaHEAT Medical, LLC), 629 B.R. 250 (Bankr. N.D. Ill. 2021).
8 The court acknowledged that the express terms of the license permitted the licensee to assign its rights to third parties, but that apparently did not factor into the court’s decision. VitaHEAT at 255.
9Minesen, 2021 Bankr. LEXIS 3178, at *11-12.
10 11 U.S.C. § 365(e)(2).
11See, e.g., In re Catapult Entertainment, Inc., 165 F.3d 747, 750 (9th Cir. 1999) (“nonexclusive patent licenses are ‘personal and assignable only with the consent of the licensor’”) (citation omitted); In re Patient Education Media, Inc., 210 B.R. 237, 240 (Bankr. S.D.N.Y. 1997) (“licensor cannot assign it to a third party without the consent of the copyright owner”); In re Trump Entertainment Resorts, Inc., 526 B.TR. 116, 123 (Bankr. D. Del. 2015) (“Based on the Court’s research and cases cited by Trump AC, it appears that the substantial weight of authority holds that under federal trademark law, trademark licenses are not assignable in the absence of some express authorization from the licensor, such as a clause in the license agreement itself.”)
12Minesen, 2021 Bankr. LEXIS 3178, at *12.