Concerns for Licensees of e-Commerce Software In Cross-Border Bankruptcies

Insolvency of a multinational corporation with U.S. and foreign assets brings the prospect of complex bankruptcy. A recent case illustrates some concerns a licensee of e-commerce-related software and other intellectual property could have when a foreign licensor files for bankruptcy outside the United States.

Chapter 15 of the U.S. Bankruptcy Code aims to provide a systematic, consistent resolution to cross-border insolvencies by charging federal bankruptcy courts to cooperate with foreign bankruptcy courts and, for the most part, defer to the insolvency laws of the country where the principal case was filed. Undoubtedly, conflicts exist between the U.S. Bankruptcy Code and insolvency codes of other nations. For instance, under '365(n) of the U.S. Bankruptcy Code (11 U.S.C. '365(n), while an intellectual-property licensor may reject an executory contract, such as a software license, that the bankruptcy estate deems burdensome, a licensee may elect to continue paying licensing fees and retain most of its rights under the license. Without licensee protections in '365(n), a bankrupt licensor could reject and terminate the license under '365(a) and auction the rights to another entity, leaving the licensees to either risk legal liability or re-bid for licenses for which they have already paid.

Such protections, however, are not written into the bankruptcy laws of every country. For example, the German chipmaker Qimonda recently filed for bankruptcy in Germany and also made a Chapter 15 filing in the United States to provide efficient administration of its large U.S. patent portfolio. In that proceeding, a Virginia bankruptcy court had to decide whether the foreign debtor-licensor could retain certain protections under U.S. law, while avoiding other safeguards for the benefit of licensees, such as '365.

This article discusses Chapter 15 and '365 of the Bankruptcy Code in brief, as well as the Qimonda decision and its implications for e-commerce vendors and intellectual-property licensees.

Bankruptcy Code, Chapter 15

Chapter 15 was added to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Chapter 15 provides fair and efficient administration of cross-border insolvencies to protect interests of all creditors and interested entities, and to promote comity between U.S. courts and the foreign bankruptcy courts principally handling the matter (see, 11 U.S.C. '1501).

Generally speaking, a Chapter 15 case is ancillary to a primary proceeding brought in another country, typically the debtor's home country. If the U.S. assets of the foreign debtor are sufficiently complex, then the debtor may commence a full Chapter 7 or Chapter 11 case in the United States.

An ancillary case is commenced under Chapter 15 by a “foreign representative” filing a petition for recognition of a “foreign proceeding” (see, 11 U.S.C. '1504). Upon recognition of a foreign main proceeding, the automatic stay and selected other provisions of the Bankruptcy Code take effect within the United States. 11 U.S.C. '1520; In re Pro-Fit Int'l Ltd., 391 B.R. 850, 864 (Bankr. C.D. Cal. 2008).

Section 365(n) Generally

Section 365 of the U.S. Bankruptcy Code generally allows the debtor (or, as applicable, the bankruptcy trustee) to reject an executory contract that is burdensome to the estate. Section 365(n) does, however, provide certain protections to licensees of most types of intellectual property (e.g., software, copyrights, patents and trade secrets, but not trademark licensees) in the event of a rejection of the underlying license by a bankrupt licensor. Among other things, the Bankruptcy Code allows the licensee either to assert an unsecured claim for a breach of contract or to retain virtually all its then-current rights under the license, and any supplementary agreements, including any right of exclusivity for the duration of the license. Licensees who elect to retain their rights must continue making royalty payments due under the license and waive any right they may have had to set-off or administrative claims. This option protects the licensee's right to use the intellectual property, but relieves the licensor of all its affirmative obligations under the agreement, including the provision of maintenance, support, training or consultation services.

In essence, under '365(n), the debtor cannot terminate and strip the licensee of rights the licensee had bargained for, and the licensee cannot retain the use of those rights without paying for them. But the license resulting from a '365(n) election is a “naked license,” which requires no future active performance by the debtor-licensor.

Enactment of '365(n) was a response to the decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), under which a debtor-licensor was permitted to reject an executory license agreement for a manufacturing process to the detriment of the licensee, where the rejection was beneficial to the debtor going forward. Through '365(n), Congress granted additional rights to non-debtorlicensees of intellectual property in the event of the bankruptcy of the licensor to encourage licensees to enter into licenses and spend more in exploiting the licenses due to greater certainty.

Qimonda Chapter 15 Bankruptcy Case

Qimonda AG, a German semiconductor manufacturer, became insolvent and filed for bankruptcy protection under German law in early 2009. Soon after, the company's duly appointed foreign representative filed a Chapter 15 petition with a Virginia bankruptcy court, requesting that the court take jurisdiction over Qimonda's U.S. assets. The court agreed, recognizing the German bankruptcy case as a “foreign main proceeding.” The court also issued a supplemental order providing certain bankruptcy-law protections to the representative regarding Qimando's U.S assets, including that '365 would apply (see, In re Qimonda AG, No. 09-14766 (Bankr. E.D. Va. Supplemental Order July 22, 2009)).

Subsequently, several patent cross-licensing agreement counterparties with Qimonda (hereinafter the “licensees”) notified the foreign representative that because the representative apparently chose non-performance and termination under German insolvency law, the licensees would exercise rights under '365(n) to prevent termination of cross-licenses and the alleged sale of the Qimonda patents to a company that would presumably seek to liquidate the portfolio or otherwise exploit its value. The licensees claimed that termination of the cross-licenses would be detrimental to them, because they had relied on the certainty of the cross-licenses involving thousands of U.S. patents in the Qimonda portfolio in developing their products, and would potentially be subject to suit and significant liability for patent infringement by the purchaser of the Qimonda patents. The foreign representative then made a motion that the Bankruptcy Court remove the reference to '365 from the supplemental order so that there was no question that the German Insolvency Code, and not the U.S. Bankruptcy Code, controlled the cross-license agreements.

The court granted the foreign representative's motion to amend the supplemental order to remove the reference to '365 of the U.S. Bankruptcy Code, ruling that the application of '365 to the case “substantially undermines” the provisions of the German Insolvency Code, which contains provisions addressing how a debtor may handle executory contracts during bankruptcy. In re Qimonda AG, 2009 WL 4060083 (Bankr. E.D. Va. Nov. 19, 2009). The court rejected the licensees' arguments and stressed that ancillary proceedings such as the Chapter 15 action before the court should “supplement, not supplant” the main German proceeding. Id. at 1.

Putting aside the fairness and public-policy arguments, the court focused on the primary purposes behind Chapter 15: comity and efficiency. The court stressed that if the patent cross-licenses were dealt with in accordance with the bankruptcy laws of the various nations in which the licensees or licensors were located and the countries in which ancillary proceedings were taking place, Qimonda's patent portfolio could be “shattered into many pieces that can never be reconstructed.” Id. at 2. Qimonda licensed its patents to companies around the world, not just in the United States, and the court concluded that disparate treatment of the U.S. patents would yield inconsistent results that would harm the resolution of the German bankruptcy proceeding, and diminish the value of Qimonda's assets. Following the issuance and entry of the order, some of the non-debtorlicensees who asserted objections to the foreign representative's motion filed an appeal to the order.

Lessons Learned

1. Under Qimonda, '365 licensee protections do not appear to extend beyond U.S. borders in cases where a foreign licensor files for bankruptcy protection in a foreign court, despite the existence of U.S. intellectual-property assets. Thus, while the automatic stay under Bankruptcy Code '362(a) is triggered when a main foreign bankruptcy proceeding is recognized by a U.S. court under Chapter 15, intellectual-property licensees, such as licensees of e-commerce software and other intellectual property, are not guaranteed protections under '365(n) should the foreign representative choose to elect non-performance under intellectual-property licenses.

2. When negotiating intellectual-property license agreements with a foreign licensor for use of intellectual property in the United States, a U.S.-based licensee should consider including language in the license agreement that applies U.S. law and provides that the parties to the agreement “acknowledge and agree” that the license “constitutes a license of intellectual property subject to [']365(n) of the U.S. Bankruptcy Code.” While not all courts may apply '365(n), such language would at least indicate the intent of the licensor and licensee to be subject to the rules set out in that provision with respect to the license.

3. When negotiating intellectual-property license agreements with a foreign licensor, beyond investigating the applicable foreign law that would apply in the event of the licensor's insolvency, licensees should also consider certain other alternatives. For example, a licensee of software may seek to adopt a model that was common in the pre-'365(n) era. That is, the software license agreement would require the licensor to deposit the source code with a third-party escrow agent when the license agreement is signed, and to pay for the escrow arrangement at that time. An agreement between the escrow agent and licensor would contain only the responsibilities of the escrow agent (e.g., to protect the source code), and contain no other on-going obligations of the licensor, so such agreement would be non-executory and thus not subject to rejection. Any obligation of the licensor to update the deposit as the software is updated should be in the license agreement. The agreement between the licensor and escrow agent would also transfer title to the media on which the source code is delivered to the escrow agent. The licensee would then enter into an agreement with the escrow agent requiring the escrow agent to release the code at the occurrence of certain triggering events defined by the licensor and licensee in the license agreement, such as any bankruptcy filing or another event in which the licensor could no longer provide support for the software. This agreement would be “executory” in that future performance is required, but the performance would be the escrow agent's and not the licensor's, so this second agreement could not be rejected by the licensor. This arrangement would protect a licensee, ensuring that if the software licensor becomes insolvent, and the licensor rejects the license in bankruptcy in a jurisdiction other than the United States, then the licensee would be able to access the source code, continue to use the software and avoid costly business disruptions that might result from lack of access to the code. However, for an escrow agreement to serve its purpose, the developer must fulfill its deposit obligations and the licensee must exercise its right to test the source code periodically. (Note that in situations where '365(n) applies, an escrow agreement among a U.S. licensor, licensee and escrow agent would be subject to '365(n) as an agreement “supplemental” to the license agreement, and thus could have ongoing obligations for the licensor that the licensee could elect to have continue with the license.)

Insolvency of a multinational corporation with U.S. and foreign assets brings the prospect of complex bankruptcy. A recent case illustrates some concerns a licensee of e-commerce-related software and other intellectual property could have when a foreign licensor files for bankruptcy outside the United States.

Chapter 15 of the U.S. Bankruptcy Code aims to provide a systematic, consistent resolution to cross-border insolvencies by charging federal bankruptcy courts to cooperate with foreign bankruptcy courts and, for the most part, defer to the insolvency laws of the country where the principal case was filed. Undoubtedly, conflicts exist between the U.S. Bankruptcy Code and insolvency codes of other nations. For instance, under '365(n) of the U.S. Bankruptcy Code (11 U.S.C. '365(n), while an intellectual-property licensor may reject an executory contract, such as a software license, that the bankruptcy estate deems burdensome, a licensee may elect to continue paying licensing fees and retain most of its rights under the license. Without licensee protections in '365(n), a bankrupt licensor could reject and terminate the license under '365(a) and auction the rights to another entity, leaving the licensees to either risk legal liability or re-bid for licenses for which they have already paid.

Such protections, however, are not written into the bankruptcy laws of every country. For example, the German chipmaker Qimonda recently filed for bankruptcy in Germany and also made a Chapter 15 filing in the United States to provide efficient administration of its large U.S. patent portfolio. In that proceeding, a Virginia bankruptcy court had to decide whether the foreign debtor-licensor could retain certain protections under U.S. law, while avoiding other safeguards for the benefit of licensees, such as '365.

This article discusses Chapter 15 and '365 of the Bankruptcy Code in brief, as well as the Qimonda decision and its implications for e-commerce vendors and intellectual-property licensees.

Bankruptcy Code, Chapter 15

Chapter 15 was added to the Bankruptcy Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Chapter 15 provides fair and efficient administration of cross-border insolvencies to protect interests of all creditors and interested entities, and to promote comity between U.S. courts and the foreign bankruptcy courts principally handling the matter (see, 11 U.S.C. '1501).

Generally speaking, a Chapter 15 case is ancillary to a primary proceeding brought in another country, typically the debtor's home country. If the U.S. assets of the foreign debtor are sufficiently complex, then the debtor may commence a full Chapter 7 or Chapter 11 case in the United States.

An ancillary case is commenced under Chapter 15 by a “foreign representative” filing a petition for recognition of a “foreign proceeding” (see, 11 U.S.C. '1504). Upon recognition of a foreign main proceeding, the automatic stay and selected other provisions of the Bankruptcy Code take effect within the United States. 11 U.S.C. '1520; In re Pro-Fit Int'l Ltd., 391 B.R. 850, 864 (Bankr. C.D. Cal. 2008).

Section 365(n) Generally

Section 365 of the U.S. Bankruptcy Code generally allows the debtor (or, as applicable, the bankruptcy trustee) to reject an executory contract that is burdensome to the estate. Section 365(n) does, however, provide certain protections to licensees of most types of intellectual property (e.g., software, copyrights, patents and trade secrets, but not trademark licensees) in the event of a rejection of the underlying license by a bankrupt licensor. Among other things, the Bankruptcy Code allows the licensee either to assert an unsecured claim for a breach of contract or to retain virtually all its then-current rights under the license, and any supplementary agreements, including any right of exclusivity for the duration of the license. Licensees who elect to retain their rights must continue making royalty payments due under the license and waive any right they may have had to set-off or administrative claims. This option protects the licensee's right to use the intellectual property, but relieves the licensor of all its affirmative obligations under the agreement, including the provision of maintenance, support, training or consultation services.

In essence, under '365(n), the debtor cannot terminate and strip the licensee of rights the licensee had bargained for, and the licensee cannot retain the use of those rights without paying for them. But the license resulting from a '365(n) election is a “naked license,” which requires no future active performance by the debtor-licensor.

Enactment of '365(n) was a response to the decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. , 756 F.2d 1043 (4th Cir. 1985), under which a debtor-licensor was permitted to reject an executory license agreement for a manufacturing process to the detriment of the licensee, where the rejection was beneficial to the debtor going forward. Through '365(n), Congress granted additional rights to non-debtorlicensees of intellectual property in the event of the bankruptcy of the licensor to encourage licensees to enter into licenses and spend more in exploiting the licenses due to greater certainty.

Qimonda Chapter 15 Bankruptcy Case

Qimonda AG, a German semiconductor manufacturer, became insolvent and filed for bankruptcy protection under German law in early 2009. Soon after, the company's duly appointed foreign representative filed a Chapter 15 petition with a Virginia bankruptcy court, requesting that the court take jurisdiction over Qimonda's U.S. assets. The court agreed, recognizing the German bankruptcy case as a “foreign main proceeding.” The court also issued a supplemental order providing certain bankruptcy-law protections to the representative regarding Qimando's U.S assets, including that '365 would apply (see, In re Qimonda AG, No. 09-14766 (Bankr. E.D. Va. Supplemental Order July 22, 2009)).

Subsequently, several patent cross-licensing agreement counterparties with Qimonda (hereinafter the “licensees”) notified the foreign representative that because the representative apparently chose non-performance and termination under German insolvency law, the licensees would exercise rights under '365(n) to prevent termination of cross-licenses and the alleged sale of the Qimonda patents to a company that would presumably seek to liquidate the portfolio or otherwise exploit its value. The licensees claimed that termination of the cross-licenses would be detrimental to them, because they had relied on the certainty of the cross-licenses involving thousands of U.S. patents in the Qimonda portfolio in developing their products, and would potentially be subject to suit and significant liability for patent infringement by the purchaser of the Qimonda patents. The foreign representative then made a motion that the Bankruptcy Court remove the reference to '365 from the supplemental order so that there was no question that the German Insolvency Code, and not the U.S. Bankruptcy Code, controlled the cross-license agreements.

The court granted the foreign representative's motion to amend the supplemental order to remove the reference to '365 of the U.S. Bankruptcy Code, ruling that the application of '365 to the case “substantially undermines” the provisions of the German Insolvency Code, which contains provisions addressing how a debtor may handle executory contracts during bankruptcy. In re Qimonda AG, 2009 WL 4060083 (Bankr. E.D. Va. Nov. 19, 2009). The court rejected the licensees' arguments and stressed that ancillary proceedings such as the Chapter 15 action before the court should “supplement, not supplant” the main German proceeding. Id. at 1.

Putting aside the fairness and public-policy arguments, the court focused on the primary purposes behind Chapter 15: comity and efficiency. The court stressed that if the patent cross-licenses were dealt with in accordance with the bankruptcy laws of the various nations in which the licensees or licensors were located and the countries in which ancillary proceedings were taking place, Qimonda's patent portfolio could be “shattered into many pieces that can never be reconstructed.” Id. at 2. Qimonda licensed its patents to companies around the world, not just in the United States, and the court concluded that disparate treatment of the U.S. patents would yield inconsistent results that would harm the resolution of the German bankruptcy proceeding, and diminish the value of Qimonda's assets. Following the issuance and entry of the order, some of the non-debtorlicensees who asserted objections to the foreign representative's motion filed an appeal to the order.

Lessons Learned

1. Under Qimonda, '365 licensee protections do not appear to extend beyond U.S. borders in cases where a foreign licensor files for bankruptcy protection in a foreign court, despite the existence of U.S. intellectual-property assets. Thus, while the automatic stay under Bankruptcy Code '362(a) is triggered when a main foreign bankruptcy proceeding is recognized by a U.S. court under Chapter 15, intellectual-property licensees, such as licensees of e-commerce software and other intellectual property, are not guaranteed protections under '365(n) should the foreign representative choose to elect non-performance under intellectual-property licenses.

2. When negotiating intellectual-property license agreements with a foreign licensor for use of intellectual property in the United States, a U.S.-based licensee should consider including language in the license agreement that applies U.S. law and provides that the parties to the agreement “acknowledge and agree” that the license “constitutes a license of intellectual property subject to [']365(n) of the U.S. Bankruptcy Code.” While not all courts may apply '365(n), such language would at least indicate the intent of the licensor and licensee to be subject to the rules set out in that provision with respect to the license.

3. When negotiating intellectual-property license agreements with a foreign licensor, beyond investigating the applicable foreign law that would apply in the event of the licensor's insolvency, licensees should also consider certain other alternatives. For example, a licensee of software may seek to adopt a model that was common in the pre-'365(n) era. That is, the software license agreement would require the licensor to deposit the source code with a third-party escrow agent when the license agreement is signed, and to pay for the escrow arrangement at that time. An agreement between the escrow agent and licensor would contain only the responsibilities of the escrow agent (e.g., to protect the source code), and contain no other on-going obligations of the licensor, so such agreement would be non-executory and thus not subject to rejection. Any obligation of the licensor to update the deposit as the software is updated should be in the license agreement. The agreement between the licensor and escrow agent would also transfer title to the media on which the source code is delivered to the escrow agent. The licensee would then enter into an agreement with the escrow agent requiring the escrow agent to release the code at the occurrence of certain triggering events defined by the licensor and licensee in the license agreement, such as any bankruptcy filing or another event in which the licensor could no longer provide support for the software. This agreement would be “executory” in that future performance is required, but the performance would be the escrow agent's and not the licensor's, so this second agreement could not be rejected by the licensor. This arrangement would protect a licensee, ensuring that if the software licensor becomes insolvent, and the licensor rejects the license in bankruptcy in a jurisdiction other than the United States, then the licensee would be able to access the source code, continue to use the software and avoid costly business disruptions that might result from lack of access to the code. However, for an escrow agreement to serve its purpose, the developer must fulfill its deposit obligations and the licensee must exercise its right to test the source code periodically. (Note that in situations where '365(n) applies, an escrow agreement among a U.S. licensor, licensee and escrow agent would be subject to '365(n) as an agreement “supplemental” to the license agreement, and thus could have ongoing obligations for the licensor that the licensee could elect to have continue with the license.)