Financial Transactions Law Briefing -- Assumption of Intellectual Property Licenses in Bankruptcy: Catapult Entertainment, Inc.

4/1/1999

MoFo News Item

Introduction

The decision in the Catapult case discussed in this Memorandum holds that non-exclusive licenses of patents may not be assumed by debtors in possession under the Bankruptcy Code. In so holding, the Ninth Circuit has raised any number of questions for parties concerned with the rights of licensees in intellectual property, such as: Should licenses be taken in entities as remotely removed from bankruptcy risk as possible? Does the potential loss of licenses in bankruptcy affect the value of collateral given by licensees to their lenders? Should secured lenders require secondary licenses from patent owners?

Summary of the Case

In the Catapult case, the owner of certain patents, Stephen Perlman, had granted two non-exclusive licenses to Catapult for use in connection with development of an online gaming network for videogames. Sometime later, Catapult entered into a merger agreement with Mpath Interactive, Inc. ("Mpath") pursuant to which Catapult would file for reorganization under Chapter 11 of the Bankruptcy Code, become a wholly owned subsidiary of Mpath (in a reverse triangular merger in which an Mpath subsidiary merged into Catapult), and pay to creditors and equity holders of Catapult consideration of approximately $14,000,000.

In accordance with its merger agreement, Catapult filed a bankruptcy case, proposed a reorganization plan, and, to effectuate the plan, filed a motion to assume executory contracts, (1) including the Perlman licenses, pursuant to Section 365 of the Bankruptcy Code which provides, in part:

"Except as provided in Section 765 and 766 (2) of this title and in subsections (b), (3) (c), (4) and (d) of this section, the trustee, (5) subject to the court's approval may assume or reject any executory contract or unexpired lease of the debtor."

The Bankruptcy Court granted Catapult's motion to assume the Perlman licenses; the District Court affirmed; and Perlman appealed to the Ninth Circuit.

The Ninth Circuit opinion notes that Section 365(c)(1) has been given two interpretations--(1) that the assumability of an executory contract depends on whether applicable law would bar assignment to a hypothetical third party, regardless of intention to assign or (2) that the assumability of an executory contract depends on whether the contract is actually being assigned. The licensor, Perlman, argued for the "hypothetical" test, while the licensee, Catapult, relied on the "actual" test. Both parties apparently agreed that federal patent law makes non-exclusive patent licenses "personal and nondelegable" so that, absent a contrary provision in the Bankruptcy Code, Catapult, as debtor in possession, could not assume the Perlman licenses.

In arguing for the "actual" test, Catapult pointed out that Section 365(f)(1) of the Bankruptcy Code "provides that executory contracts, once assumed, may be assigned notwithstanding any contrary provisions contained in the contract or applicable law." Catapult argued that interpreting Section 365(c)(1) to prohibit assumption if "applicable law" would prohibit assignment would result in Section 365(f)(1) having no meaning. Because a contract has to be assumed before it is assigned, either a contract could be assumed under Section 365(c)(1) and then assigned or it could not. Section 365(f)(1) would never be applicable. The Ninth Circuit disagreed with this interpretation, stating that the "applicable law" referenced in Section 365(c)(1) to determine whether a contract can be assumed is the law relating to whether a licensor is excused from accepting performance from another licensee, while the "applicable law" referenced in Section 365(f)(1) relates to whether a contract can be "assigned" (without regard to the whether the reason relates to the identity of the assignee).

The Ninth Circuit also rejected Catapult's argument that application of the "hypothetical test" renders Section 365(c)(1) internally inconsistent, because it could prohibit assumption by a debtor in possession in the face of a provision which contemplates that debtors in possession may perform under executory contracts. In reconciling these provisions, the Court held that Section 365(c)(1) requires a determination of whether "applicable law" permits assumption and assignment in two cases-- (1) if the debtor wants to assume and (2) even if the licensor has consented to assumption by the debtor in possession, if the debtor in possession wants to assign.

The Ninth Circuit further rejected Catapult's argument that another part of Section 365 (Section 365(c)(2)) is inconsistent with the "hypothetical" test. Section 365(c)(2) provides that "[t]he trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if … such contract is a contract to make a loan, or extent other debt financing or financial accommodation to or for the benefit of the debtor…." Catapult argued that, since the types of contracts described in this provision are always nonassignable under state law, this provision was necessary because, otherwise, subsection (c)(1) would permit nonassignable contracts to be assumed notwithstanding applicable law. The Ninth Circuit dismissed this argument saying that the uniformity of state law (not internal inconsistency in the face of the "hypothetical" test) limiting assignability of the types of contracts described in subsection (c)(2) was the reason for the apparent internal inconsistency.

Based on a plain reading of the statute, the Court concluded that the "hypothetical" test should be applied to determine whether Catapult could assume the Perlman licenses. Despite the fact that policy arguments can be made in favor of the "actual" test permitting debtors in possession to assume contracts which cannot be assigned, the Court found that the statute requires application of the "hypothetical" test. Accordingly, the court held that "where applicable nonbankruptcy law makes an executory contract nonassignable because the identity of the nondebtor is material, a debtor in possession may not assume the contract absent consent of the nondebtor party."

Discussion

The Catapult case was not necessarily surprising, because there were already on the books decisions that threw into question the status of intellectual property licenses in a bankruptcy setting. For example, the Ninth Circuit had previously decided that non-exclusive licenses of patents were executory contracts which could not be assigned without the consent of the licensor. Everex Sys. v. Cadtrak Corp. (In re CFLC, Inc.), 89 F. 3d 673 (9th Cir. 1996). Similarly, the Ninth Circuit had also decided that mechanical licenses of copyrights were executory contracts in which bankruptcy trustees did not automatically obtain an interest pursuant to Section 70(a)(5) of the old Bankruptcy Act (which was replaced by Section 365 of the Bankruptcy Code. Harris v. Emus Records Corp. 734, F. 2d 1329 (9th Cir. 1984).

What was surprising to many, though, was that Catapult, as debtor in possession, was distinguished from Catapult, as licensee. Once Catapult filed its Chapter 11 petition, it became a different entity which was not automatically entitled to assume and to continue benefiting from its licenses. Once debtors file for protection under the Bankruptcy Code, they are now at risk for losing their non-exclusive patent (and possibly copyright) licenses.

Overall, we would expect new practices to develop in the area of non-exclusive licenses reflecting the impact of this case. In appropriate cases, licensees and their secured creditors will seriously consider the use of bankruptcy remote vehicles as licensees, or implement contingency plans for the loss of licenses. For example, to avoid adverse consequences to their collateral packages from loss of licenses, secured creditors relying on licensed rights may demand direct agreements with licensors either in the form of current licenses or agreements to license to the secured creditors. Upon the bankruptcy of debtors, secured parties would then have available non-exclusive licenses which would facilitate maximization of collateral values even if the debtors' licenses are lost.

Footnotes

1. The Ninth Circuit decision states that the parties assumed that the Perlman licenses were executory contracts, but it is also possible for licenses to be construed as non-executory. See, e.g., In re Stein & Day Incorporated, 81 B.R. 263 (Bankr. S.D.N.Y. 1988).

2. These sections relate to the rights of customers in connection with the liquidation of stockbrokers.

3. Subsection (b) describes the circumstances under which an executory contract or unexpired lease may be assumed if there has been a default.

4. Subsection (c) provides, in part:

"The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if --

"(1)(A) 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; and

(B) such party does not consent to such assumption of assignment…."

5. The Ninth Circuit opinion notes that the term "trustee" includes a debtor in possession, such as Catapult.

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