First Government Contracts then Patents and Now Software: The Hypothetical Test Makes It Harder to Reorganize

First Government Contracts then Patents and Now Software: The Hypothetical Test Makes It Harder to Reorganize

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A recent circuit court decision, RCI Technology Corp. v. Sunterra Corp. (In re Sunterra Corp.),1 adds certain software licenses to the list of executory agreements that a debtor cannot assume for its own benefit because non-bankruptcy law would not permit an assignment of the license to a third party. This holding is consistent with the majority of prior circuit court decisions on government contracts and certain patent licenses. These decisions are based on a literal reading of 11 U.S.C. §365(c), despite arguments of debtors that a literal reading produces an absurd result. This article reviews Sunterra and some of the prior court decisions on this issue, as well as the practical consequences for a company that is facing the prospect of a chapter 11 filing.


RCI Technology Corp. v. Sunterra Corp. (In re Sunterra Corp.)

Sunterra, a large resort-management business, needed an integrated computer system to manage the timeshare ownership program at its resorts. In 1991, Sunterra paid RCI a one-time fee of $3.5 million for a "non-exclusive, worldwide, perpetual, irrevocable, royalty-free use, modify and distribute" certain software of RCI.2 Under the license agreement, Sunterra was authorized to use the software to develop its own software system. Sunterra invested approximately $38 million to develop its own system based on the software.

Nine years later, Sunterra filed a chapter 11 bankruptcy petition, and two years after that, Sunterra's reorganization plan was confirmed. Prior to confirmation of the plan, however, RCI filed a motion to deem the agreement rejected, asserting that Sunterra could not assume the agreement without RCI's consent (which RCI refused to give). RCI lost in the bankruptcy court and lost on appeal to the district court, but won in the Fourth Circuit, which concluded that because of the interaction of bankruptcy law and copyright law, Sunterra was precluded from assuming the agreement.

The decision allowed RCI to charge Sunterra a new royalty fee as a condition to a new, post-bankruptcy license, even though 11 years before, after payment of a one-time fee, Sunterra—and RCI—thought Sunterra had a perpetual, royalty-free license.

Assumption and Assignment of Executory Contracts

Most bankruptcy lawyers would agree with the proposition that the basic rules governing executory contracts give a debtor-in-possession (DIP) more power than the contract counterparty. For example, the debtor can reject executory contracts or unexpired leases that it finds disadvantageous,3 and the counterparty's damages are considered pre-petition claims.4 By contrast, provisions in executory contracts that permit the non-debtor party to terminate upon the debtor's bankruptcy are usually unenforceable.5 Even when the debtor is in default, if a debtor cures those defaults (or gives adequate assurance of prompt cure), the debtor can assume the executory contract or unexpired lease.6 Furthermore, as a general rule, a debtor can assign an assumed agreement to a third party even if the agreement prohibits assignments.7 Once the agreement is assigned, the debtor is no longer obligated on the agreement.8

Sunterra Corp. powerfully demonstrates an important exception to this balance of power. The court's decision turns on the use of the word "or" (rather than the word "and") in Bankruptcy Code §365(c). That subsection creates an exception to the usual power to assume or assign an executory contract. It states:

The trustee9 may not assume or assign any executory contract...if—(1)(A) applicable law excuses [the non-debtor] such contract...from accepting performance from or rendering performance to an entity other than the debtor or debtor-in-possession [DIP]...and (B) such party does not consent to such assumption or assignment... (emphasis added).

In this case, copyright law was the applicable law that excused RCI from accepting performance from, or rendering performance to, a party other than Sunterra. A non-exclusive license to a copyright cannot be assigned by the licensee without the consent of the licensor.10 Therefore, the court's literal reading of §365(c) of the Bankruptcy Code meant not only that Sunterra could not assign the license, but that Sunterra could not assume the license—thus, Sunterra's fully paid, royalty-free, perpetual license was extinguished as a result of Sunterra's bankruptcy filing.11

Sunterra argued that this literal reading of §365(c) leads to an absurd result, but the Fourth Circuit disagreed. Significantly, the Fourth Circuit is not alone: The same result has been reached by several other circuits and several bankruptcy courts (which are sometimes said to be using the "hypothetical" test).12 Other courts, such as the First Circuit and many bankruptcy courts, have refused to apply §365(c) to prohibit a debtor from assuming such an executory contract, even though it would prohibit an assignment.13

The Split in the Circuits

The first circuit court case that applied the "hypothetical" test to the application of §365 was the 1988 decision in In re West Electronics Inc.,14 a case that involved a government procurement contract. West Electronics had a contract with the Air Force to supply power supply units for missile launchers. West suffered a number of setbacks: A computer malfunction destroyed its accounting records, and the government suspended progress payments pending a review of West's financial status. Its first delivery of units were late, although they apparently passed final inspection. The government discovered "serious irregularities" in West's accounting practices, and because of the late deliveries, the failure of its accounting system, its delinquency in paying costs attributable to the contracts and the excess of progress payments over the value of work in progress, determined that the contract should be suspended. Shortly thereafter, the government served a notice to West to show cause why the contract should not be terminated. One week later, the IRS seized West's assets to satisfy a lien, and the next day, West filed chapter 11.

The government moved to lift the automatic stay to terminate the contract, and the bankruptcy court denied the motion. The district court affirmed, indicating that West could assume the contract if it cured its defaults (which West asserted it could do). The Third Circuit reversed based on §365(c)(1):

[I]f non-bankruptcy law provides that the government would have to consent to an assignment of the West contract to a third party, i.e., someone "other than the debtor or the DIP," then West, as the DIP, cannot assume that contract. This provision limiting assumption of contracts is applicable to any contract subject to a legal prohibition against assignment.15

In this case, the legal prohibition was 41 U.S.C. §15, which provided that "no [government] contract...or any interest therein shall be transferred by the party to whom such given to any other party, and any such transfer shall cause the annulment of the contract...transferred, so far as the United States are concerned."

The court went on to explain that §365(c)(1) was a "hypothetical" test, based on a literal reading of the language of the Bankruptcy Code:

West argues that 41 U.S.C. §15 should not be construed to foreclose an assignment of a contract from a debtor to a DIP since they are such closely related entities. West's argument misses the point, however, for 11 U.S.C. §365(c)(1) creates a hypothetical test—i.e., under the applicable law, could the government refuse performance from "an entity other than the debtor or the DIP?" Thus, the relevant inquiry is not whether 41 U.S.C. §15 would preclude an assignment from West as a debtor to West as a DIP, but whether it would foreclose an assignment by West to another defense contractor.

The literal meaning of the words chosen by Congress clearly requires the analysis and conclusion we have just articulated, and we are confident that it is what Congress intended. We think that by including the words "or the debtor-in-possession" in 11 U.S.C. §365(c)(1), Congress anticipated an argument like the one here made and wanted that section to reflect its judgment that in the context of the assumption and assignment of executory contracts, a solvent contractor and an insolvent DIP going through bankruptcy are materially distinct entities. While the relevant case law is very sparse, it supports our understanding of the interplay between 11 U.S.C. §365(c)(1) and 41 U.S.C. §15.16

The First Circuit came to a different result in Institut Pasteur v. Camridge Biotech Corp.17 In that case, Cambridge Biotech Corp. (CBC) was the DIP. Pre-petition, Intitut Pasteur and Pasteur Sanofi Diagnostics (collectively, Pasteur) and CBC had entered into mutual cross-license agreements whereby each acquired a nonexclusive perpetual license to use certain patented technology of the other. The license agreements prohibited assignments or sublicenses to others, but did not contain a clause that terminated the license upon a change in control. CBC's reorganization plan called for the assumption of the licenses, the continuation of the business that utilized the patented technology and the sale of all of CBC's stock to bioMerieux, a major competitor of Pasteur in the area covered by the patent licenses. The plan was confirmed over the objection of Pasteur. The court explained:

The bankruptcy court authorized CBC to assume the cross-licenses over Pasteur's objection. It ruled that the proposed sale of CBC stock to bioMerieux did not constitute a de facto "assignment" of the cross-licenses to bioMerieux, but merely an assumption of the cross-licenses by the reorganized debtor under new ownership, and that Bankruptcy Code §365(c) enabled CBC to assume the cross-licenses as DIP because the pre-petition licensing relationship between Pasteur and CBC was neither "unique" nor "something in the category of a personal services contract."18

Pasteur's argument was based on:

the federal common law of patents [that] presumes that patent licensees, such as CBC, may not sublicense to third parties absent the patent holder's consent. This federal common law rule of presumptive nonassignability thus qualifies as an "applicable law," within the meaning of Bankruptcy Code §365(c)(1)(A), which precludes Pasteur from being compelled to accept performance from any entity other than CBC—e.g., bioMerieux's subsidiary—and therefore prevents CBC from either assuming or assigning these cross-licenses.19

The court disagreed, and followed a prior decision of the First Circuit, stating:

We rejected the proposed hypothetical test in Leroux, holding instead that subsections 365(c) and (e) contemplate a case-by-case inquiry into whether the non-debtor party (viz., Pasteur) actually was being "forced to accept performance under its executory contract from someone other than the debtor party with whom it originally contracted." Where the particular transaction envisions that the DIP would assume and continue to perform under an executory contract, the bankruptcy court cannot simply presume as a matter of law that the DIP is a legal entity materially distinct from the pre-petition debtor with whom the non-debtor party (viz., Pasteur) contracted. Rather, "sensitive to the rights of the nondebtor party (viz., Pasteur)," the bankruptcy court must focus on the performance actually to be rendered by the DIP with a view to ensuring that the non-debtor party (viz., Pasteur) will receive "the full benefit of [its] bargain."20

The Ninth Circuit's 1999 decision in Perlman v. Catapult Entertainment (In re Catapult Entertainment Inc.)21 came down on the side of the hypothetical test, even though it acknowledged that at that time, most cases favored the actual test.

[T]he proper interpretation of §365(c)(1) has been the subject of considerable disagreement among courts and commentators. On one side are those who adhere to the plain statutory language, which establishes a so-called "hypothetical test" to govern the assumption of executory contracts. See In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994) (characterizing §365(c)(1)(A) as posing "a hypothetical question"); In re West Elec. Inc., 852 F.2d 79, 83 (3d Cir. 1988) (same); In re Catron, 158 B.R. 629, 633-38 (E.D. Va. 1993) (same), aff'd. without opp., 25 F.3d 1038 (4th Cir. 1994). On the other side are those that forsake the statutory language in favor of an "actual test" that, in their view, better accomplishes the intent of Congress. See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir.) (rejecting the hypothetical test in favor of the actual test), cert. denied, 521 U.S. 1120, 117 S.Ct. 2511, 138 L.Ed.2d 1014 (1997). Although we have on two occasions declined to choose between these competing visions, today we hold that we are bound by the plain terms of the statute and join the Third and Eleventh Circuits in adopting the "hypothetical test."22

In Catapult, Perlman had granted certain non-exclusive patent licenses to Catapult. The court summarized the basic facts, the governing law and the result under the "plain meaning" of §365(c)(1):

Before applying the statutory language to the case at hand, we first resolve a number of preliminary issues that are either not disputed by the parties, or are so clearly established as to deserve no more than passing reference. First, we follow the lead of the parties in assuming that the Perlman licenses are executory agreements within the meaning of §365. Second, it is well-established that §365(c)'s use of the term "trustee" includes chapter 11 DIPs. Third, our precedents make it clear that federal patent law constitutes "applicable law" within the meaning of §365(c), and that nonexclusive patent licenses are "personal and assignable only with the consent of the licensor."

When we have cleared away these preliminary matters, application of the statute to the facts of this case becomes relatively straightforward:

(c) Catapult may not assume...the Perlman licenses...if
(1)(A) federal patent law excuses Perlman from accepting performance from or rendering performance to an entity other than Catapult...and
(B) Perlman does not consent to such assumption....
11 U.S.C. §365(c) (substitutions in italics). Since federal patent law makes nonexclusive patent licenses personal and non-delegable, §365(c)(1)(A) is satisfied. Perlman has withheld his consent, thus satisfying §365(c)(1)(B). Accordingly, the plain language of §365(c)(1) bars Catapult from assuming the Perlman licenses.23

The court rejected arguments of internal inconsistency, bankruptcy policy and legislative history.24 West applied the hypothetical rule to government contracts, Catapult applied to non-exclusive patent licenses, and now Sunterra Corp. has applied it to certain software licenses pursuant to copyright law.

Ramifications of Sunterra

Unless and until the split in the circuits is resolved, the holding in Sunterra Corp. presents some unique challenges and opportunities in several areas of practice.

Any company that is considering bankruptcy and hopes to emerge as a reorganized debtor25 has another level of due diligence: To what extent does it depend on software licenses where the licensor's consent to assumption under §365 will be required? In addition to the "normal" problems a debtor faces—operational problems, excessive debt load, wages and benefits that are higher than industry averages because of collective bargaining agreements—the potential debtor may now have another economic burden: paying for new software licenses. Whether the licensor waits for confirmation to object to assumption, or seeks the right to terminate shortly after the filing, the problem needs to be considered in advance. By contrast, software licensors have a potential new source of revenue—from what might otherwise be a most unlikely source.

The issue is not limited to software licenses. Since the non-assignability is the result of copyright law, the potential debtor will need to consider all of its licenses to be copyrighted material. So, in addition to the usual due diligence required before filing a chapter 11 case, it is now more clear that an IP audit is necessary. All software licenses and licenses to other copyrighted material need to be collected and examined. Are the license agreements executory? In Sunterra Corp., very little was required to make the license executory—the licensor's obligation of confidentiality. Are they non-assignable under federal copyright law? What provisions, if any, in the license agreement allow assignment? Are these provisions sufficient to trump Code §365(c)?

Potential Ways to Mitigate the Risks

Parties may be able to avoid the results of Sunterra Corp. by drafting around it. Sunterra argued that it already had; the agreement provided that "the provisions of this section shall not preclude the transfer of this license to a successor in interest of substantially all of [Sunterra's] assets if the assignee agrees in writing to be bound by this license." However, the Fourth Circuit decided that this language only applied to assignments and not an assumption of the license by Sunterra. It would seem, therefore, that the Fourth Circuit would require the licensor to consent, in the license agreement, to the licensee's assumption of the license under §365. The Fourth Circuit recognized that another court had found that such an explicit consent was sufficient to avoid the impact of a literal reading of §365.26

Thus, software licensees (and parties to any other contract where, under applicable law, the counterparty to the agreement is not required to accept performance from, or render performance to, an assignee) should add to their license an explicit provision in which the licensor consents to the licensee's assumption of the license in bankruptcy.


1 361 F.3d 257 (4th Cir. 2004). Return to article

2 Id. at 260. Return to article

3 Code §365(a). Return to article

4 Code §365(g). Return to article

5 Code §365(e)(1). Return to article

6 Code §365(b)(1). Return to article

7 Code §§365(f)(2) and (f)(3). Return to article

8 Code §365(k). Return to article

9 A DIP has most of the powers and duties of a trustee. Code §1107. Return to article

10 361 F.3d at 262 n.7. Return to article

11 Sunterra also argued that the license was not an executory contract. However, the court noted that both parties had an ongoing obligation to maintain the confidentiality of the source code, which was sufficient for the Fourth Circuit to conclude that the agreement was "executory" within the meaning of the Bankruptcy Code. 361 F.3d at 264. Return to article

12 See, e.g., Perlman v. Catapult Entm't. (In re Catapult Entm't. Inc.), 165 F.3d 747, 750 (9th Cir. 1999) (patent licenses could not be assumed); Rieser v. Dayton Country Club Co. (In re Magness), 972 F.2d 689, 695 (6th Cir. 1992) (golfing memberships in a private club); In re West Elecs. Inc., 852 F.2d 79, 83 (3d Cir. 1988) (government procurement contract). See, also, City of Jamestown, Tenn. v. James Cable Partners L.P. (In re James Cable Partners), 27 F.3d 534, 537 (11th Cir. 1994) (cable franchise; assignment not permitted by city ordinance, but court held city did not show that applicable law renders performance non-delegable). Return to article

13 Institut Pasteur v. Camridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997) (patent license). The majority of bankruptcy courts also apply the so-called "actual" test. Sunterra Corp., 361 F.3d at 262. Return to article

14 852 F.2d 79 (3d Cir. 1988). Return to article

15 Id. at 83. Return to article

16 Id. (emphasis in original). Return to article

17 104 F.3d 489 (1st Cir. 1997). Return to article

18 Id. at 491. Return to article

19 Id. at 492 (citations omitted). Return to article

20 Id. at 493. Return to article

21 165 F.3d 747 (9th Cir. 1999). Return to article

22 Id. at 749-50 (citations omitted). Return to article

23 Id. at 750-51 (citations and footnotes omitted). Return to article

24 The opinion contained a broad hint to Congress that it should do something about this problem, and the House version of bankruptcy reform in the 106th Congress (H.R. 833) provided that in chapter 11 cases, a DIP or a trustee could assume a contract, notwithstanding the provisions of subsection (c)(1). However, this was dropped from later versions of the bill and is not contained in H.R. 975 (108th Congress bill). Return to article

25 Many companies file chapter 11 cases in order to effect a sale free and clear of liens using §363 of the Code. In such sales, it is almost always true that the debtor also assumes and assigns executory contracts and unexpired leases to the purchaser by using §365. In such a case, it doesn't matter if §365 uses the word "or" or the word "and"—the executory contracts are being assigned. Therefore, non-exclusive software licenses cannot be assigned without the consent of the licensor. The need to obtain such consent must be taken into account as part of the bankruptcy planning. Return to article

26 6 F.3d 492 (7th Cir. 1993). Return to article

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Monday, November 1, 2004