When a company’s losses and obligations send it into bankruptcy, one of its most powerful tools available in trying to reorganize and emerge is Section 365 of the U.S. Bankruptcy Code.  Section 365 allows the bankrupt company to reject “executory contracts”, giving it the power to cancel ‘bad contracts’ which still have remaining obligations to be performed.

However, there is an important qualification to Section 365 designed to protect licensees of intellectual property.  Section 365(n) permits a licensee to retain certain intellectual property rights under a license agreement even if the debtor-licensor exercises its rights to rejects that agreement.  For example, assume the debtor-licensor has a license agreement permitting the licensee to use copyrighted software or certain patents for a term that still has three years remaining.  If the licensor rejects this license agreement, it will have no further obligations to licensee (e.g., licensor will not have to issue updates or create new versions, even if the license calls for that).  However, if the licensee exercises its 365(n) rights, it will still have the right to use the licensed technology for the balance of the license term.

The policy behind Section 365(n) benefits both licensors and licensees.  Much of the best new technology is created by young, thinly-capitalized companies.  A prospective business customer considering using that technology as a critical piece of its operations must have the assurance that it will not lose its negotiated license rights if the young tech company goes bankrupt.  With Section 365(n), the licensor is able to convince other companies to license its technology, and the licensees have important protection in taking that chance on the new technology.  However, the license agreement should contain provisions designed to ensure that the licensee will be able to effectively use these preserved rights:

• It should clearly spell out the precise patents, software and other technology I/P being licensed, the scope of that license (uses, territory, etc.), and the duration.
• It is a good idea to have the agreement recite licensee’s rights under Section 365(n).
• If the licensee will agree, the source code or other embodiment of the technology should be deposited into escrow with a reputable third party escrow holder, so the licensee can access the actual technology if the licensee goes into bankruptcy.

And, of course, Section 365(n) creates important caveat emptor issues for opportunistic buyers of I/P assets from a bankruptcy.  If the bankrupt company has previously given a license for certain patents, a buyer would take the patents subject to the licensee’s rights, even if the bankrupt had rejected the license.  And, in the case of In re Cellnet Data Systems, Inc., a buyer of all the bankrupt’s I/P assets lost the rights to a royalty stream from the I/P portfolio.  The bankrupt had granted an exclusive license for use of its IP portfolio.  When Schlumberger acquired all of the bankrupt’s I/P assets, it excluded this license agreement (probably thinking it was taking the assets without that encumbrance).  When the bankrupt rejected the agreement under Section 365, the licensee elected to retain its rights.  Not only did the licensee retain its exclusive rights to use the technology, the court held that the royalties attached to the license agreement, not the I/P acquired by Schlumberger, with the result that the bankrupt estate, not Schlumberger, was entitled to the ongoing royalties.