August 14, 2014

Intellectual Property Licenses and Bankruptcy: The Latest Word

On December 3, 2013, the U.S. Court of Appeals for the Fourth Circuit issued its highly awaited ruling on the Qimonda matter. Jaffé v. Samsung Elec. Co., 737 F.3d 14 (4th Cir. 2013). As the developed economies of the world shift toward intangible property versus tangible, and as multinational corporations increasingly intertwine our economies, the question of proper treatment of licensees' interests when foreign debtors with U.S. assets file for bankruptcy protection has become increasingly important. Qimonda addresses this issue head-on and provides a partial road map for both U.S. licensees and foreign licensors.

Background 

Qimonda AG was a German corporation that manufactured semiconductor devices. As of 2006, it was one of the world's largest manufacturers of dynamic random-access memory (DRAM), which is used in most general-purpose consumer and industrial electronic devices. In 2007, prices dropped for the worldwide DRAM industry because of oversupply. Coupled with the financial market crisis in 2008 that shrank the demand for electronic products, the whole DRAM industry fell into recession. Qimonda filed for insolvency in Munich, Germany, in January 2009, and attorney Dr. Michael Jaffé was appointed administrator, a position similar to a bankruptcy trustee in the United States. The principal assets of Qimonda's estate consisted of some 10,000 patents, about 4,000 of which were U.S. patents. These patents were subject to cross-license agreements with Qimonda's competitors, as is common in the semiconductor industry, to avoid infringement risks caused by the overlapping patent rights of some 420,000 industry patents. 

Jaffé filed an ancillary proceeding in bankruptcy court for the Eastern District of Virginia under Chapter 15 of the U.S. Bankruptcy Code, successfully petitioning the U.S. court to recognize the German insolvency proceeding as a "foreign main proceeding." In re Qimonda AG, 462 B.R. 165 (Bankr. E.D. Va. 2011). Chapter 15, Title 11, of the U.S. Code, titled "Ancillary and Other Cross Border Cases," incorporates the Model Law on Cross Border Insolvency drafted by the United Nations Commission on International Trade Law (UNCITRAL) and allows U.S. courts broad discretion in restructuring U.S. assets when the courts must consider violations of any laws or U.S. public policy. 

The bankruptcy court also entered a supplemental order specifying that 11 U.S.C. § 365 would apply. 11 U.S.C. § 365 gives a bankruptcy trustee power to assume or reject any of the debtor's executory contracts and 11 U.S.C. § 365(n) limits the trustee's ability to unilaterally reject licenses to the debtor's intellectual property and reserves to the licensees the option to elect to retain their rights under the license. With little need for cross-license agreements, since it had no plans to resume its own production operations, Qimonda moved the U.S. Bankruptcy Court to modify the supplemental order to specify that 11 U.S.C. § 365(n) did not apply, so that it could reject the licensing agreements with the goal of replacing them with royalty-bearing licenses on presumably better terms for the benefit of Qimonda's creditors. The bankruptcy court granted Qimonda’s motion. 2009 WL 4060083. Various semiconductor manufacturers who were parties to joint venture and cross-licensing agreements with Qimonda appealed. The District Court affirmed in part and remanded in part. 433 B.R. 547 (E.D. Va. 2010). 

The Bankruptcy Court Ruling on Remand 

On remand, the bankruptcy court ruled that Qimonda's U.S. licensees would be afforded rights under 11 U.S.C. § 365(n), including the licensees' ability to retain their rights under the licenses as those rights existed immediately before the Chapter 15 case commenced, for the duration of the agreements and any agreement extensions. The bankruptcy court (at 462 B.R. at 179) explained how § 365(n) applies when executory contracts of intellectual property are at issue: 

Although a trustee or debtor in possession may reject an executory contract under which the debtor is the licensor of ‘intellectual property’ – which is defined as including United States patents, § 101(35A), Bankruptcy Code – the licensee may elect ‘to retain its rights (including a right to enforce any exclusivity provision of such contract) under such contract.’ § 365(n)(1)(B), Bankruptcy Code. The licensee must, of course, make any royalty payments due under the contract. § 365(n)(2)(B), Bankruptcy Code. In addition, the licensee waives any rights of setoff or administrative claim. § 365(n)(2)(C), Bankruptcy Code. 

The court reasoned that a ruling to the contrary would violate two sections of Chapter 15: § 1506 and § 1522(a). The court said that under 11 U.S.C. § 1506, allowing Qimonda to unilaterally cancel its licenses of U.S. patents would be manifestly contrary to the public policy of the United States, recognizing that the fundamental U.S. public policy of promoting technological innovation would be undermined. The court noted that § 365(n), enacted promptly after the ruling in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), resulted from Congress's determination that allowing patent licenses to be terminated in bankruptcy would impose a burden on U.S. technological development.

Under 11 U.S.C. § 1522(a), licensees must be "sufficiently protected" even if Qimonda's estate would be adversely affected. The bankruptcy court's sufficient-protection analysis involved weighing the balance of harms to both the licensees and Qimonda in accordance with the district court's remand order that the bankruptcy court balance the relief granted to the foreign representative and the interests of those affected by the relief, without unduly favoring one group of creditors over another. 

The bankruptcy court's weighing of interests of both Qimonda and the licensees considered a number of factors. 

Qimonda's Arguments 

Qimonda argued that it had lessened any possible harm to the licensees by committing to relicense its patent portfolio to the licensees at a reasonable and nondiscriminatory (RAND) royalty and any arguments would be settled through good-faith negotiations, and, if necessary, to submit any royalty arguments to arbitration before the World Intellectual Property Organization. RAND royalties are relatively common in high-tech industries because of the role played by standard-setting organizations, which help ensure the interoperability of products, among other functions. To avoid the holdup problem in this context, standard-setting organizations typically require their members to agree in advance to license any patent identified as necessary to a standard at RAND terms. Both Qimonda and the licensees belong to such an organization. Qimonda further argued that to allow the licensees to retain their rights under § 365(n) would prevent Qimonda from obtaining license revenues from the licensees over the terms of the licenses, harming Qimonda in the amount of $47 million per year, according to Qimonda's expert witness, who testified that this amount would not significantly impact the licensees' businesses. 

Licensees' Arguments 

The licensees' experts, on the other hand, claimed that a license rejection would destabilize the system of licensing in the semiconductor industry and others, reducing investment, innovation, and competition, and harming U.S. and worldwide productivity growth and consumers. They also argued that the threat of patent holdup (the difference between hypothetical royalty terms "ex ante" and "ex post") could not be eliminated and would not provide adequate protection for the interests of the licensees, in part because of the danger that Qimonda would subsequently sell the patent portfolio to an entity that might itself file for bankruptcy, thus extinguishing the licensees' licenses once again. One also wonders whether the licensees' experts pointed out the obvious finding that Qimonda's license-fee gain would represent a corresponding harm to the licensees in the form of license-fee cost. The court reasoned at 462 B.R. at 175:

Such cross-license agreements are highly beneficial in conferring ‘design freedom’ on the licensees. In the absence of design freedom, manufacturers are subject to what the experts described as a ‘hold-up premium’ if a particular semiconductor is ultimately determined to infringe on someone else's patent. This is because the construction of a fabrication facility (fab) for semiconductor chips is an enormously expensive undertaking (in the range of two to five billion dollars). Once these expenses (referred to in the testimony as ‘sunk costs’) have been incurred, they cannot be recovered if the design of the chip must be changed to avoid the infringement. The owner of the patent, knowing this, has much more leverage in negotiating a royalty for its use after the fact than if a license had been sought before the investment had been made. The difference between these hypothetical royalty terms (‘ex ante’ and ‘ex post’) constitutes the hold-up premium. 

In its decision, the bankruptcy court recognized that its ruling would result in lower future income to Qimonda, but that the patents would not be rendered worthless. Conversely, the court found that a contrary ruling would create a "very real" risk to the licensees' substantial investments in research and manufacturing facilities in the United States and reliance on the design freedom provided by the cross-license agreements. The court acknowledged that Qimonda's offer to relicense the patents on RAND terms would lessen patent holdup risk, but observed that because of the semiconductor industry's "patent thicket" of around 420,000 patents, and the licensees' sunk costs, which could be around $5 billion per production facility, the licensees did not have the option of avoiding royalties altogether by designing around the patents. 

The district court then granted certification of Jaffé's direct appeal to the Fourth Circuit. 

The Fourth Circuit Ruling 

Jaffé's appeal from the bankruptcy court argued that the court had erred in its analysis of Chapter 15 and abused its discretion in applying it. Jaffé made three arguments relative to § 1522(a) which requires that the bankruptcy court ensure that the interests of the creditors and other interested entities, including the debtor, are sufficiently protected by balancing the relief granted to the foreign representatives and the interests of those affected by that relief, without unduly favoring one group of creditors over another. First, that the district court and the bankruptcy court had erred in even considering § 1522(a) because that section applies only to relief granted under § 1521, that the relief granted under § 1521 may be requested only by the foreign representative, and that the foreign representative never requested the inclusion of § 365(n) as part of the § 1521 relief. Second, that the bankruptcy court misunderstood the type of protection afforded by § 1522(a) by applying a test that balanced the debtor's interests and the creditors' interests instead of a test that placed all creditors on an equal footing. Third, that in balancing the competing interests, the bankruptcy court overstated the risks to the licensees, especially in view of Qimonda's offer to relicense the patents to them, and failed to treat all creditors' interests equally. 

The Fourth Circuit found Qimonda's first argument that the bankruptcy court had erred in considering § 1522(a) too narrow. It found that as a prerequisite to awarding any § 1521 relief, the court was required to ensure sufficient protection of the creditors and the debtor, and that the court was authorized to subject any § 1521 relief "to conditions it considers appropriate." As a result, it ruled that the bankruptcy court's consideration of § 1522(a) was appropriate. 

The Fourth Circuit found the bankruptcy court's interpretation of § 1522(a) to be more logical than Jaffé's, and that the applied test balancing the debtor's interests and the creditors' interests better met the intent of Congress and the drafters of UNCITRAL's Model Law on Cross-Border Insolvency, on which Chapter 15 is based. The court stated: "Chapter 15 does not require a U.S. bankruptcy court, in considering a foreign representative's request for discretionary relief under § 1521, to blind itself to the costs that awarding such relief would impose on others under the rule provided by the substantive law of the State where the foreign insolvency proceeding is pending." 

On the bankruptcy court's implementation of the balancing test, the Fourth Circuit found the bankruptcy court's examination of the parties' competing interests to have been thorough, comprehensive, and reasonable. The court found that Qimonda's RAND proposal to relicense the patents to the licensees would reduce the licensees' risks but that this did not mean that their interests would be sufficiently protected by Qimonda's promise to relicense. No RAND rates were discussed, but two district court cases had set RAND rates in highly publicized cases before the Fourth Circuit's ruling. In those two cases, the RAND rate was set far below the rate argued by the patentees. See Microsoft Corp. v. Motorola, Inc., No. C10 1823JLR, 2013 WL 2111217 (W.D. Wash. Apr. 25, 2013; In re Innovatio IP Ventures, LLC Patent Litig., No. 11 C 9308, 2013 WL 5593609 (N.D. Ill. Oct. 3, 2013). Further, the Fourth Circuit found reasonable the bankruptcy court's recognition of the concern that Qimonda could sell the underlying patents to another foreign purchaser that might itself file for insolvency and reject the RAND licenses. The Fourth Circuit stated, "It is far from clear whether, having once facilitated the termination of license rights in a foreign insolvency proceeding, the genie could ever be put back into the bottle." Based on these findings, the Fourth Circuit affirmed the bankruptcy court's § 1522(a) rulings. 

Having affirmed the bankruptcy court's interpretation of § 1522(a), the Fourth Circuit did not specifically address the bankruptcy court's other rationale that, under § 1506, allowing Qimonda to unilaterally cancel its licenses of U.S. patents would be manifestly contrary to U.S. public policy. But the court stated, "[W]e understand that, by affirming the bankruptcy court's application of § 365(n) following its balancing analysis under § 1522(a), we also indirectly further the public policy that underlies § 365(n)." 

Additional Developments and Considerations 

While other jurisdictions might find otherwise, this Fourth Circuit ruling must be considered a win for licensees under § 365(n), creating new authority for the sufficient protection of U.S. creditors in cross-border Chapter 15 matters, and outlining a potential balance-of-hardships test for determining whether the scales tip toward the debtor versus creditors. The balance-of-hardships test under § 1522(a) could become moot, however, if courts were to conclude that disregarding § 365(n) is manifestly contrary to U.S. public policy under § 1506. 

Since the Fourth Circuit's decision, there have been two parallel actions. The first is congressional action in the form of House Bill 3309, which passed the House on December 5, 2013, and was referred to the Senate Judiciary Committee on December 9, 2013. H.R. 3309 would amend 11 U.S.C. § 1522 to incorporate rights under 11 U.S.C. § 365(n) for licensees of intellectual property even if the contract was rejected in a foreign court. If this bill becomes law, it would put to rest the issue raised in Qimonda. H.R. 3309, 113th Cong. § 6(d)(1) (2013) provides:

(e) Section 365(n) shall apply to cases under this chapter. If the foreign representative rejects or repudiates a contract under which the debtor is a licensor of intellectual property, the licensee under such contract shall be entitled to make the election and exercise the rights described in section 365(n). 

Second, on April 30, 2014, Jaffé filed a petition for writ of certiorari (the "Petition"), seeking review by the United States Supreme Court (2014 WL 1725846). And while one cannot predict whether the United States Supreme Court will grant the Petition, there is no circuit split, which diminishes the chance that the Petition will be granted. The Petition argues that unless Qimonda is overturned, administrators in foreign insolvency proceedings will be less likely to seek relief under Chapter 15, that the Fourth Circuit ruling violates comity, an underlying principle of Chapter 15, and that the respect for U.S. laws in foreign countries will be diminished. 

Drafting Considerations 

The special rights afforded to licensees of intellectual property in bankruptcy highlighted by Qimonda suggest a variety of licensing best practices that should be considered based on the facts and circumstances of a licensing engagement:

  • For patents and other statutorily defined intellectual property, the license agreement should affirm that licensed assets are intellectual property for purposes of § 365(n) and that the licensee enjoys all benefits of that section.
  • For trademarks or other intellectual property not defined in the Bankruptcy Code and when licensors are foreign, licensees may seek to take a security interest in the debtor's assets to secure damages if the license is rejected.
  • The license should address the licensee's access to intellectual property after any bankruptcy.
  • For foreign patents, consider stating in the license that such patents are to be treated as intellectual property under § 365(n).
  • Consider an intellectual property escrow agreement.
  • Separate different intellectual property into different agreements so that those that aren't statutorily defined or are subject to rejection won't entangle other intellectual property.
  • For licensed technologies for which patent thickets exist, require RAND licensing terms in case § 365(n) does not apply and set forth the RAND rate in the license. 

Conclusion 

The Fourth Circuit's opinion will remain governing authority unless the United States Supreme Court weighs in. Further, the Qimonda decision could be ratified in Congress in any event. The issue is likely to remain a matter of continued interest for foreign companies negotiating U.S. patent licenses and the U.S. licensees. It is yet to be seen whether Jaffé's predicted negative consequence for U.S. bankruptcy debtors seeking foreign recognition will come to pass.

Additional Resources

For other materials on this topic, please refer to the following.

Business Law Today 

Patent Portfolios in Bankruptcy Cases: Protecting and Maximizing Their Value
By Geoffrey Groshong and Samantha Pak
July/August 2008 

ABA Web Store 

A Practical Guide to Software Licensing for Licensees and Licensors, 5th Edition (Print)
Author(s): H. Ward Classen
Sponsor(s): Business Law Section
2013, 800 Pages 

This valuable guide focuses on non-mass market agreements and includes updates on the negotiation and contracting process, terminology of a license grant, ancillary clauses, free and open source software, and much more. The companion CD-ROM is filled with customizable and easy-to-use forms and agreements.