In an earlier "On the Edge" column, Virginia Henschel noted that bankruptcy courts would likely be forced to resolve intellectual property issues in the context of a chapter 11 reorganization.² At the time, the First Circuit Court of Appeals held in its decision of Institute Pasteur v. Cambridge Biotech Corp. that in certain situations, a debtor-in-possession (DIP), which is the licensee under a non-exclusive patent license, may assume the non-exclusive patent license over the objection of the patent owner.³ As a result of the Cambridge Biotech decision, Henschel noted that the back door appeared to be open for the strategic acquisition of otherwise unaccessible patented technology by industry competitors.⁴

Earlier this year, the Ninth Circuit Court of Appeals, in its Catapult Entertainment decision, examined a case virtually identical to the case decided by the First Circuit and shut the "back door" when it held that a DIP may not assume the non-exclusive patent license over the objection of the patent owner.⁵ This article will re-examine earlier decisions relating to a non-exclusive patent license in the context of the Ninth Circuit's decision in Catapult Entertainment.⁶

Non-exclusive Patent Licenses Are Executory Contracts

As a preliminary matter, this article will address recent circuit court decisions relating to non-exclusive patent licenses.⁷ The initial Ninth Circuit case addressing issues relating to non-exclusive patent licenses is Everex Systems Inc. v. Cadtrak Corp. (In re CFLC Inc.).⁸ In CFLC, prior to filing for bankruptcy, the debtor paid a one-time royalty payment to Cadtrak in exchange for a royalty-free, worldwide, non-exclusive license to use certain patents. The license agreement provided, among other things, that the license was non-transferable and that the debtor had no right to sublicense. In its bankruptcy case, the debtor filed a motion to assume and assign the non-exclusive patent license, and Cadtrak objected.⁹

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The Ninth Circuit's decision in Catapult Entertainment, while protecting the interests of the licenseholder, has provided the licensors under non-exclusive patent licenses (and arguably, non-exclusive copyright licenses) with extraordinary power over DIPs.

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Initially the Ninth Circuit in CFLC addressed the issue of whether the license was an executory contract. While 11 U.S.C. §365(a) authorizes a trustee or DIP to assume or reject an executory contract, the Bankruptcy Code is silent as to the definition of an executory contract. In the Ninth Circuit, the courts have defined an "executory contract" as one in which performance is due to some extent on both sides, and in which the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach, and thus excuses the performance of the other.¹⁰ The court noted that Cadtrak owed significant continued performance on the license, since it must continue to refrain from suing the debtor for infringement because "a non-exclusive patent license is, in essence, 'a mere waiver of the right to sue' the licensee for infringement."¹¹ The court further noted that the licensee also has performance obligations because it must mark all products made under the license with the proper statutory patent notice; the obligation is material, because the failure to mark the products would deprive the patent holder of damages in an infringement action before the infringer has the actual notice of the infringement.¹² Therefore, the court held that the non-exclusive patent license was an executory contract under 11 U.S.C. §365.¹³

Federal Law Bars the Assignment of Non-exclusive Patent Licenses

Next, the CFLC court turned to the issue of whether federal or state law applied to the interpretation of the non-exclusive patent license and the limitations on assignability. Pursuant to 11 U.S.C. §365(a), a trustee or DIP may generally assume or reject an executory contract. In the context of this article, Congress placed limitations on assumption and assignment in 11 U.S.C. §§365(c) and (f).¹⁴ As a preliminary matter, the court observed (1) that the statutes governing patents are basically silent on the issue of licenses, and (2) that the construction of patent licenses is generally a matter of state contract law, except where state law would be inconsistent with the aims of federal patent policy.¹⁵ In holding that federal patent policy justified the application of federal law to the assignability of the license, the court reasoned that

the fundamental policy of the patent system is to "encourage the creation and disclosure of new, useful, and nonobvious advances in technology and design" by granting the inventor the reward of "the exclusive right to practice the invention for a period of years." Bonito Boats Inc. v. Thundercraft Boats Inc., 489 U.S. 141, 150-51, 109 S.Ct. 971, 977-78, 103 L.Ed.2d 118(1989). Allowing free assignability—or more accurately, allowing states to allow free assignability—of non-exclusive patent licenses would undermine the reward that encourages invention because a party seeking to use the patented invention could either seek a license from the patent holder or seek an assignment of an existing patent license from the licensee. In essence, every licensee would become a potential competitor with the licensor/patent holder in the market for licenses under the patent. While the patent holder could presumably control the absolute number of licenses in existence under a free assignability regime, it would lose the very important ability to control the identity of the licensees. Thus, any license a patent holder granted—even to the smallest firm in the product market most remote from its own—would be fraught with the danger that the licensee would assign it to the patent holder's most serious competitor, a party to whom the patent holder itself might be absolutely unwilling to license. As a practical matter, free assignability of patent licenses might spell the end to paid-up licenses such as the one involved in this case. Few patent holders would be willing to grant a license in return for a one-time lump-sum payment, rather than for-use royalties, if the license could be assigned to a completely different company which might make far greater use of the patented invention than could the original licensee.¹⁶

Thus, in order to further the policies of the patent system, the CFLC court held that federal law would control the assignability of non-exclusive licenses.¹⁷

Finally, the CFLC court addressed the issue of whether federal law bars the assignment of non-exclusive patent licenses. The court noted that federal law holds a non-exclusive patent license to be personal and non-delegable, and would therefore excuse Cadtrak from accepting performance from, or rendering it to, anyone other than the debtor.18 Therefore, because other applicable law would not require the licensor to accept performance from anyone other than the debtor, the court held that the debtor could not assume and assign the non-exclusive patent license under 11 U.S.C. §365.¹⁹

First Circuit Authorizes Assumption of Non-exclusive Patent License

The First Circuit Court of Appeals was the first appellate court to address the issue of whether a DIP could merely assume a non-exclusive patent license. In Cambridge Biotech, the DIP was the holder of two non-exclusive licenses to utilize patents from the Institute Pasteur. In the plan of reorganization, the debtor proposed the assumption of the non-exclusive patent licenses and the sale of all the debtor's stock to the principal competitor of the Institute Pasteur. The Institute Pasteur objected to the plan, stating that the debtor could not assume the non-exclusive patent license.²⁰

In Cambridge Biotech, the First Circuit followed its earlier decision of Summit Investment and Development Corp. v. Leroux (In re Leroux)²¹ and applied an "actual test" to determine whether the DIP could assume the non-exclusive patent license. Under this "actual test," the court will allow a DIP to assume a contract that is non-assignable as a result of the contract being personal and non-delegable, unless the non-debtor party can establish that it would not receive the benefit of its bargain with the debtor.²² Applying the facts of the case, the First Circuit in the Cambridge Biotech case concluded that no prohibition exists to the debtor assuming the non-exclusive patent license because the Institute Pasteur did not prove that it would no longer be getting "the benefit of its bargain."²³

As an additional argument, the Institute Pasteur protested the fact that the reorganized debtor's stock was being issued to the principal competitor of the Institute Pasteur, an entity with which the Institute Pasteur refused to conduct business. The First Circuit was not moved and, after noting that general corporate law requires the recognition of separate corporate entities, held that the non-exclusive patent was still owned by the debtor, the party with which the Institute Pasteur originally agreed to conduct business.²⁴ As a consequence of this ruling, Henschel noted that the "back door" is open for competitors to acquire otherwise unaccessible technology.²⁵

Ninth Circuit Bars the Assumption by a Debtor of Non-patent Licenses

Earlier this year, the Ninth Circuit slammed shut the "back door" by disagreeing with the First Circuit's decision in Cambridge Biotech, furthering its holding in CFLC and holding that 11 U.S.C. §365(c) prohibits a DIP from assuming a non-exclusive patent license. In Catapult Entertainment, the debtor entered into a non-exclusive patent license with Perlman in 1994. Subsequently, in 1996 Catapult filed for chapter 11. As part of its plan of reorganization, Catapult filed a motion with the bankruptcy court seeking to merely assume the non-exclusive patent license; Perlman objected. Both the bankruptcy court and the district court held that the debtor could assume the non-exclusive patent licenses, and the Ninth Circuit reversed.²⁶

The Ninth Circuit's analysis focuses on the language of 11 U.S.C. §365. The court started with the observation that in the bankruptcy context, a DIP has the authority to assume, assign or reject an executory contract or unexpired lease notwithstanding any contract provisions appearing in the contract or lease. However, the court further noted that this extraordinary authority is not absolute.²⁷

In the context of assumption, the court was focused on the proper interpretation of 11 U.S.C. §365(c)(1). The court noted that a disagreement exists among the courts and commentators as to the test for assumption. On the one side are the courts who adhere to the plain statutory language, and these courts establish a "hypothetical test" to govern the assumption of executory contracts.²⁸ On the other side of the argument are those courts that forsake the statutory language in favor of an "actual test" that, in their view, better accomplishes the intent of Congress.²⁹

The Catapult Entertainment court reasoned that the plain language of 11 U.S.C. §365(c)(1) links non-assignability under "applicable law" together with the prohibition on assumption in bankruptcy. In other words,

the statute by its terms bars the debtor-in-possession from assuming an executory contract without the non-debtor's consent where applicable law precludes assignment of the contract to a third party. The literal language of §365(c)(1) is thus said to establish a 'hypothetical test': a debtor-in-possession may not assume an executory contract over the non-debtor's objection if applicable law would bar assignment to a hypothetical third party, even where the debtor-in-possession has no intention of assigning the contract in question to any such third party.³⁰

The court then held that since federal patent law makes non-exclusive patent licenses personal and non-delegable, 11 U.S.C. §365(c)(1)(A) is satisfied, and as a consequence, the debtor was barred from assuming the Perlman license absent Perlman's consent.³¹

Conclusion

The decisions of the First Circuit in Cambridge Biotech and the Ninth Circuit in Catapult Entertainment highlight the inconsistent policies underlying patent law and bankruptcy law. The First Circuit has concluded, at least in the context of assumption of a non-exclusive patent license, that the bankruptcy policy of maximizing equal distributions to all creditors should prevail over the patent policy of protecting the rights of the patent holder. As a result of the First Circuit's decision, the competitors of a patent owner were given an opportunity to acquire otherwise unaccessible technology. However, the Ninth Circuit has concluded that the language of 11 U.S.C. §365(c) subordinates the bankruptcy policies to patent policies. The Ninth Circuit's decision in Catapult Entertainment, while protecting the interests of the licenseholder, has provided the licensors under non-exclusive patent licenses (and arguably, non-exclusive copyright licenses) with extraordinary power over DIPs. The ability of the licensors to prohibit the assumption of non-exclusive patent licenses may, in certain circumstances, render reorganization impossible for a debtor at the expense of other creditors.

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Footnotes

¹ Shareholder of professional corporation Jenkens & Gilchrist in Dallas. Mr. Hesse obtained his Bachelor of Business Administration cum laude from Southern Methodist University in Dallas in 1986 and his J.D., with honors, from the University of Texas at Austin in 1988. Return to article

² Henschel, Virginia, "'Back Door' Access to Patented Technology," 17 ABI Journal 40 (February, 1998). Return to article

³ Institute Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir.). cert. denied, U.S. _, 117 S.Ct. 2511, 138 L.Ed.2d 1044 (1997). Return to article

⁴ Henschel, Virginia, 17 ABI Journal at 41. Return to article

⁵ Perlman v. Catapult Entertainment Inc. (In re Catapult Entertainment Inc.), 165 F.3d 747 (9th Cir. 1999). Return to article

⁶ The Bankruptcy Code does not provide specific statutory treatment of licenses of intellectual property in the context of the licensee's bankruptcy case. However, in the case of a licensor's bankruptcy case, the rights of the parties to the license of intellectual property are set forth in 11 U.S.C. §365(n). Return to article

⁷ While this article specifically addresses non-exclusive patent licenses, it may also apply to non-exclusive copyright licenses because courts in copyright cases frequently look to patent law for guidance due to the "historic kinship between patent law and copyright law." In re Patient Education Media Inc., 210 B.R. 237, 241 N. 7 (Bankr. S.D.N.Y. 1997) (citing Sony Corp. of America v. Universal City Studios Inc., 464 U.S. 417, 439, 104 S.Ct. 774, 787, 78 L.Ed.2d 574 (1984)). Return to article

⁸ 89 F.3d 673 (9th Cir. 1996). Return to article

⁹ CFLC, 89 F. 3d at 674-675. Return to article

¹⁰ CFLC, 89 F.3d at 677 (citing Griffel v. Murphy (In re N.A. Wegner), 839 F.2d 533, 536 (9th Cir. 1988)). The definition of an executory contract is substantially identical to the definition proposed by Prof. Vern Countryman in Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439, 460 (1973). Return to article

¹¹ CFLC, 89 F.3d at 677 (quoting DeForest Radio Telephone Co. v. United States, 273 U.S. 236, 242, 47 S.Ct. 366, 367-68, 71 L.Ed. 625 (1927)). Return to article

¹² CFLC, 89 F.3d at 677, citing 35 U.S.C. §287. Return to article

¹³ CFLC, 89 F.3d at 677. See, also, In re Alltech Plastics Inc., 71 B.R. 686, 687 (Bankr. W.D. Tenn. 1987), and Patient Education Media, 210 B.R. at 211 ("Bankruptcy courts have generally treated non-exclusive copyright and patent licenses as executory contracts."). While the Ninth Circuit did not rely upon his work, Prof. Countryman concluded in his article that patent licenses were in fact executory contracts. Countryman, Executory Contracts in Bankruptcy, 58 Minn. L. Rev. 479, 501-502 (1974), quoted in Burger King Corp. v. Rovine Corp. (In re Rovine Corp.), 6 B.R. 661, 665- 666 (Bankr. W.D. Tenn. 1980). Return to article

¹⁴ The relevant portion of 11 U.S.C. §365(c) states:

(c) 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 or assignment...

The relevant portion of 11 U.S.C. §365(f) states:

(f)(1) Except as provided in subsection (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection;...
(2) The trustee may assign an executory contract or unexpired lease of the debtor only if—

(A) the trustee assumes such contract or lease in accordance with the provisions of this section; and
(B) adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease.

(3) Notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law that terminates or modifies, or permits a party other than the debtor to terminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease, such contract, lease, right, or obligation may not be terminated or modified under such provision because of the assumption or assignment of such contract or lease by the trustee. Return to article

¹⁵ CFLC, 89 F.3d at 677. Return to article

¹⁶ CFLC, 89 F.3d at 679. See, also, Patient Education Media, 210 B.R. at 242-24 (adopting the reasoning of CFLC in the context of a non-exclusive copyright). Return to article

¹⁷ CFLC, 89 F.3d at 679. See, also, In re Alltech Plastics Inc., 71 B.R. at 689. Return to article

¹⁸ CFLC, 89 F.3d at 679 (Citing Gilson v. Republic of Ireland, 787 F.2d 655, 658 (D.C. Cir. 1986); Stenograph Corp. v. Fulkerson, 972 F.2d 726, 729 n.2 (7th Cir. 1992); PPG Industries Inc. v. Guardian Industries Corp., 597 F.2d 1090, 1093 (6th Cir.), cert. denied, 44 U.S. 930, 100 S.Ct. 272, 62 L.Ed.2d 187 (1979); and Unico Industries Inc. v. Kelley Co., 465 F.2d 1303, 1306 (7th Cir. 1972), cert. denied, 410 U.S. 929, 93 S.Ct. 1365, 35 L.Ed.2d 590 (1973)). See, also, In re Alltech Plastics Inc., 71 B.R. at 689. Return to article

¹⁹ CFLC, 89 F.3d at 679. See, also, In re Alltech Plastics Inc., 71 B.R. at 689, and Patient Education, 210 B.R. at 243 (holding that debtor was prohibited from assigning a nonexclusive copyright to a third party). Return to article

²⁰ Cambridge Biotech, 104 F.3d at 490-491. Return to article

²¹ 69 F.3d 608 (1st Cir. 1995). Return to article

²² Cambridge Biotech, 104 F.3d at 493, Summit Investment, 69 F.3d at 613. Return to article

²³ Cambridge Biotech, 104 F.3d at 495. While the issue was not before the court, the reasoning of Cambridge Biotech implied that the First Circuit would not allow the assumption and assignment of the nonexclusive patent license. Return to article

²⁴ Id. at 494. Return to article

²⁵ Henschel, Virginia, 17 ABI Journal at 41. Return to article

²⁶ Catapult Entertainment, 165 F.3d at 748-749. Return to article

²⁷ Id. at 749 (Citing 11 U.S.C. §§365(c) and (f)). Return to article

²⁸ Id. (citing In re James Cable Partners, 27 F.3d. 534, 537 (11th Cir. 1994)); In re West Electronics Inc., 852 F.2d 79, 83 (3rd Cir. 1988); and In re Catron, 158 V.R. 629, 633-38 (E.D. Va. 1993), aff'd without op., 25 F.3d 1038 (4th Cir. 1994). Return to article

²⁹ Id. (citing Institute Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir.), cert. denied, U.S. _, 117 S.Ct. 2511, 138 L.Ed.2d 1014 (1997)). Return to article

³⁰ Catapult Entertainment, 165 F.3d at 750 (citing one David G. Epstein, Steve H. Nichols and James J. White, Bankruptcy §5-15 at 474 (1992); In re James Cable, 27 F.3d at 537; and In re West Electronics, 852 F.2d at 83). Return to article

³¹ Catapult Entertainment, 165 F.3d at 750. Return to article