Dealing With a Licensee’s Bankruptcy

The envelope arrives from the bankruptcy court.  You open it and realize with a shock that your licensee has filed for bankruptcy, and listed you as a creditor.  Over the last year, it has become an increasingly common event.

But from a licensor’s point of view, a licensee bankruptcy is not automatically the disaster it might appear to be.  There is a Very Good Scenario as well as a Very Bad Scenario for licensors dealing with a licensee’s bankruptcy.

First, some background on bankruptcy law.  Bankruptcy is a process for adjusting the debts of a debtor as set forth in the federal Bankruptcy Code.

The two main categories of business bankruptcy are Chapter 7 and Chapter 11.  Chapter 7 is a so-called liquidation bankruptcy, in which the debtor is carved up, its assets sold, and the proceeds distributed to creditors according to a formula contained in the Bankruptcy Code.  Chapter 11 is a so-called reorganization bankruptcy, in which the debtor survives, and pays off creditors a portion of what it owes them, usually from a combination of loans, selected asset sales, and current revenues.

The Chapter 11 is carried out according to a plan that must be voted on and approved by the creditors.  Chapter 11s sometimes fail, and convert to Chapter 7 liquidations.

The important thing to know about licenses in bankruptcy is that they are normally treated as a kind of asset called an “executory contract,” which is fancy way of saying that the contract is still active.

When licensees go bankrupt, the Bankruptcy Code requires them to choose whether to “assume” the license (accept it in full according to its original terms) or “reject” it (just what the name implies).

As a licensor, normally you would want the licensee to assume—this is the Very Good Scenario.  The reason is that in order to assume, the Bankruptcy Code requires the licensee to promptly come current on royalties and all other contractual obligations, and prove it has the means to stay current in the future.  Which means that if the licensee is in arrears – which bankrupt licensees always are – it will need to quickly come current and stay current, and follow all other terms of the license as originally drafted, just like your very best licensee.  If your license is drafted correctly, you can even require the assuming licensee to pay your bankruptcy court attorney’s fees as part of the assumption process.  Nice!

Why would a licensee decide to assume?  The licensee may have determined that the license is a revenue producer that is critical to its Chapter 11 reorganization efforts, or may have decided to sell that license to a third party as part of either a Chapter 11 or Chapter 7 asset sale.

But what if you do not want the licensee to assume, or assume and assign (sell) the license, despite the obvious financial benefits? You may be able to veto the licensee’s attempt to assume and/or assign, but the answer can vary widely depending on the kind of license and the court that decides the issue, so it is important to consult with a bankruptcy attorney on this issue.

On the other hand, if the licensee decides to reject the license, that is the Very Bad Scenario, and you the licensor will be lucky to get the proverbial ten cents on the dollar, often many months or years later.  In fact, you will normally need to file a claim with the bankruptcy court to receive even the ten cents.

There is one more layer to the bankruptcy cake, which is that the assumption/rejection rules only apply to the licensee’s debts as of the date of the bankruptcy filing.  There is a whole different set of rules that governs payments of royalties on sales made after the date of the bankruptcy filing—and yes, absent a bankruptcy court order, the licensee is normally allowed to continue exercising the license after the bankruptcy filing, even if the license says that it automatically terminates upon the licensee’s filing for bankruptcy.  Such so-called “ipso facto” clauses are automatically invalid under bankruptcy law.  A Chapter 11 licensee may pay you the full royalties on the regular schedule for post-filing use of the license, or you may need to have your attorney file a motion with the bankruptcy court for an “administrative expense claim,” which normally gets paid at more than ten cents on the dollar, but with no guarantee of a hundred cents on the dollar.

So, licensors, after the initial shock of the licensee’s bankruptcy wears off, remember that so far from being an automatic disaster, a licensee bankruptcy may put you in an even better position than you were before.  But whether you stand to realize ten cents or a hundred cents on the dollar, in order to maximize your recovery, make sure you have an attorney knowledgeable about bankruptcy law to guide you through an arcane and specialized process.

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