Royalty Rights in Bankruptcy:

In re: CellNet Data Systems

 

By Noel D. Humphreys and Thomas J. Pasuit[1]

 

I.                   Introduction

The Court of Appeals for the Third Circuit has concluded that software royalty payments flow from a license rather than from the underlying technology, at least for some purposes.  In In re CellNet Data Systems, Inc.,[2] the panel concluded that the licensee must make royalty payments pursuant to section 365(n)[3] of the Bankruptcy Code to the licensor who rejected the license, after the licensor transferred the underlying intellectual property.  The outcome emphasizes the importance of a debtor-licensor’s contract rights and de-emphasizes the link between royalty rights and ownership of intellectual property.

In CellNet, the court faced the question of whether to award the royalty to the debtor (who had rejected the license agreement) or to the owner of the intellectual property rights (who was not the licensor).

II.                11 U.S.C. § 365(a) and (n)

The unusual facts of CellNet arise against the effects, history, and interplay of sections 365(a) and (n) of the Bankruptcy Code.[4]  Section 365(a) authorizes a trustee or debtor-in-possession generally to assume or reject executory contracts, typically including licenses, and unexpired leases.  Rejection relieves the debtor estate of burdensome obligations while at the same time forcing others to continue to conduct business with the debtor after a bankruptcy filing.  On the one hand, rejection frees the debtor from obligations under pre-petition executory contracts and unexpired leases.  On the other hand, if the debtor wishes to obtain the benefits of a pre-petition executory contract or unexpired lease, section 365 requires the trustee or debtor-in-possession to cure defaults of assumed contracts and leases.  Section 365 establishes a mechanism for determination of claims resulting from the trustee's or debtor-in-possession's rejection of an executory contract or unexpired lease. 

The balance is different in the case of licenses of patented or copyrighted technology.  Section 365(n) permits a licensee to elect to continue to patented or copyrighted technology even if the debtor rejects the underlying license.  Congress enacted section 365(n) specifically to protect licensees of copyrights and patents by limiting the effects of the debtor’s right to reject.[5]  When a trustee or debtor-in-possession rejects a license, a licensee may elect to retain its rights and continue to pay the royalties called for by the rejected agreement.  The licensee also keeps its exclusive rights, if the license makes the rights exclusive.

By enacting section § 365(n), Congress responded to the perceived chilling effect on the licensing of intellectual property created by the Fourth Circuit's decision in Lubrizol Enterprises, Inc., v. Richmond Metal Finishers, Inc.[6]  In Lubrizol, the court upheld a debtor's decision to reject a license agreement where the rejection worked a substantial hardship on the licensee.  The licensee had organized its business around a patented machine for which the licensee held an exclusive license.  By rejecting the license, the debtor shut down the licensee’s business.  Not all courts followed the Fourth Circuit's lead.  Nonetheless, Congress determined that if Lubrizol were the law, few companies would license technology, because their business operations would then be at the mercy of the licensor’s bankruptcy decisions.  Congress reasoned that, if the licensor’s bankruptcy does not permit the licensor to deprive the licensee of the technology, then the licensee will pay more for the rights. 

When a non-debtor licensee of intellectual property retains license rights, section 365(n) requires the licensee to "make all royalty payments due" under the license.[7]  Ordinarily, the licensee pays all pre-petition and post-petition royalties to the trustee or debtor-in-possession, as owner of the intellectual property and party to the rejected license agreement.  The Third Circuit in CellNet confronted a situation where one party owned the intellectual property rights and a different party held the licensor’s license rights.

III.             Facts and Background

In 1997, entering into two license agreement (collectively, the “License Agreement”), CellNet Data Systems, Inc. (“CellNet”) licensed a joint venture (“BCN”) between CellNet and Bechtel Enterprises, Inc. (“Bechtel”) exclusively to use CellNet’s copyrighted software outside the United States in exchange for a royalty payment equal to three percent of BCN’s gross revenue.  More than three years later, CellNet filed a petition for relief under chapter 11 of the Bankruptcy Code.  Shortly after filing its petition, CellNet agreed to sell its assets to Schlumberger Resource Management Services, Inc. (“Schlumberger”).  The agreement tracked a pre-petition letter of intent.  The purchase agreement provided that Schlumberger would acquire “all or substantially all of the assets and business operations of [CellNet] and its subsidiaries” other than “Excluded Assets.” 

            The Asset Purchase Agreement provided:

At any time prior to March 25, 2000, [Schlumberger] shall be entitled unilaterally to amend this Agreement … solely for the purpose of excluding any or all of the stock, assets, liabilities and agreements of [CellNet] pertaining to [CellNet’s] joint venture with [Bechtel], or its affiliates … from the stock, assets, liabilities and agreements being acquired….

 

            Later that month, Schlumberger excluded the BCN license from the purchased assets.  Schlumberger believed CellNet would reject the BCN license under section 365(a) because CellNet could not fulfill its obligations under those agreements. Apparently to confirm its belief, Schlumberger requested that CellNet reject BCN’s License Agreement.  Although the parties disputed to whom royalties were due under the BCN licenses, CellNet agreed.  An amendment to the purchase agreement memorialized the agreement.  After the transaction closed, the bankruptcy court granted CellNet authority to reject the BCN licenses under section 365(a) of the Code.

BCN formally elected to retain its rights under the License Agreement under section 365(n).  Bechtel, CellNet, and BCN then ended the joint venture, and Bechtel acquired BCN’s assets and liabilities.  Bechtel agreed to pay to CellNet an advance royalty payment on BCN’s behalf.  The bankruptcy court approved the transaction in June 2000; pending the court’s determination of ownership, the parties deposited Bechtel’s $2,250,000 royalty payment in escrow.

 

IV.              The Decisions

            The bankruptcy court faced the question of whether to award the BCN royalty to CellNet or to Schlumberger.  The arguments were similar at the bankruptcy court, the district court and the appeals court levels.  The arguments proceeded at two levels.  One level was the primacy of the contract language.  CellNet’s estate argued that Schlumberger’s clear and unambiguous exclusion of BCN’s License Agreement from the assets Schlumberger acquired terminated Schlumberger’s interest in the money.  All three courts determined that the contracts were unambiguous on this point.   Schlumberger argued that Third Circuit precedents required explicit contract language to exclude royalties from the sale of assets. All three courts engaged in extensive contract analysis to determine that the Schlumberger asset purchase agreement was not ambiguous. 

 

            The second level of argument was whether CellNet retains any claim to the royalty after rejection of the License Agreement at a time when CellNet is not the owner of the intellectual property.  In CellNet’s view, a rejected contract created a better claim than an outright contract exclusion.   Schlumberger argued that, after the debtor rejected the license, ownership of the underlying intellectual property entitled Schlumberger to the royalty.  Schlumberger also argued that Schlumberger bears the economic burden of Bechtel’s use of the software after the section 365(n) election, and therefore Schlumberger should be entitled to receive the royalty payments.

The bankruptcy court based its decision on contract construction, finding that the exclusion of the License Agreement from the assets that Schlumberger purchased terminated Schlumberger’s claim. The district court characterized the bankruptcy court’s decision as holding that “Schlumberger, although the purchaser of the intellectual property, had refused the right to receive royalties on the intellectual property when it affirmatively excluded the license agreements from the assets it chose to purchase.”[8]

Judge McKelvie’s district court memorandum opinion supported the bankruptcy court’s contract construction.  In addition, the district court’s opinion emphasized that the statutory language of section 365(n) focused on “royalty payments due under such [rejected] contract for the duration of such contract.”[9]  The court wrote, “…it appears Congress intended the language ‘due under the contract’ to provide both the quantity of the royalty payments and the designation of the party intended to received those payments, whether the debtor or its contractual assignee.”[10]

On appeal, the Third Circuit, in an opinion by Judge Richard L. Nygaard, affirmed on these same grounds.  All three courts found that the Schlumberger contract with CellNet unambiguously excluded CellNet’s rights as licensor under the BCN licenses.  The courts found that the contract severed the right to royalties from the underlying ownership of the intellectual property.  Affirming the conclusions below, the Third Circuit held that the debtor was entitled to royalties paid under section 365(n) because the asset purchase agreement unequivocally excluded the License Agreement.

Schlumberger argued that precedent required that the parties explicitly separate the right to receive royalties question this way.  All three decisions accepted CellNet’s position that Schlumberger relinquished its claim when it affirmatively excluded the License Agreement from the purchase of CellNet’s assets. 

            The decisions obviously rely on the contract language, but they fail to explain plainly the critical import of the contract.

            The Third Circuit opinion answered Schlumberger’s argument that the right to royalties derives from ownership of the intellectual property and not from the licenses by stating that although the source of the royalty obligation in general lies in the intellectual property rights, in these circumstances the license is more important.  “Once the royalties were divorced from the intellectual property, the only authority for their existence” was the license agreement.[11]  The Third Circuit opinion supports the district court’s reliance on the statutory language of section 365(n) that “licensee shall make all royalty payments due under such contract.”[12] Both the district court and the Third Circuit interpreted this language to mean that the payments go where they would have gone under the agreement.

            Schlumberger also argued that executory contract rights do not become part of the debtor’s post-petition estate until and unless the executory agreement is assumed.  (If a rejected executory contract were part of the estate, the estate would have to pay post-petition obligations under it, thereby defeating the purpose of the debtor’s right to elect.)  Since the debtor rejected the BCN licenses, Schlumberger argued, there is no contract-oriented basis for the estate to receive the royalty payment.  The district court said that CellNet was relying on the statute, not on the License Agreement, “as the source of its right to the royalties.”[13]  The Third Circuit, without citation, simply stated:  “We need not specify the exact status of the contract.  For our purposes it is suffice [sic] to say that after a licensee has resorted to section 365(n), the rights of the contract as they existed pre-petition and pre-rejection are in force.”[14]

V.                 Some Comments

4Outside of bankruptcy, if a licensor terminated a license for software, the owner of the underlying intellectual property would be able to sue the infringer and collect royalties.  The licensor would have nothing more if it ended the license in such a circumstance.  Here the courts awarded the debtor a better position that it would have received outside the bankruptcy umbrella.  The CellNet decision suggests that that out-of-bankruptcy relationship does not apply in the context of section 365(n).

4Although Judge Nygaard’s opinion did not say so, the Third Circuit panel may have been thinking that since the law is uncertain about which party should receive the royalty, causing the payment to go to the debtor fosters the public policy in favor of maximizing the bankruptcy estate.   None of the decisions attempted to ascertain how the decision would affect the underlying policy goals of Congress in seeking to foster a market for intellectual property licenses.

4The court did not adopt an economics-oriented answer.  Schlumberger argued that since a covenant not to sue for an infringing use lies at the core of a license, the consideration should go to the party with the obligation not to sue.  The Third Circuit rejected this argument, stating that the exclusion of the BCN-related assets from Schlumberger’s purchase simply severs the BCN-related assets from Schlumberger’s “bundle of rights” from the outset.[15]  However, this statement does not explain why rejection does not end the contract rights that trump the intellectual property rights.  As Schlumberger argued, if BCN had ceased to use the intellectual property, presumably BCN’s rights to use the property outside the US would have reverted to Schlumberger, rather than to the estate.

4By separating the payment from ownership of the underlying intellectual property, the CellNet opinion does throw light on one open question concerning section 365(n).  The opinion apparently assumed that BCN’s rights would continue even though there is no continuing obligation to pay royalties.  The parties appeared not to have argued whether a licensee may continue rights under a license that provides for a fee payable entirely up front.  In this case the licensee made a post-petition up-front payment.  Typically the question arises when the up-front royalty payment occurs pre-petition.

4One way to look at the decision is: If the ownership of intellectual property is distinct from contract rights in the related license, the right to royalty payments follows the license agreement and not the ownership interest in the property itself.  A narrower view is that the Third Circuit’s decision is about the nature of rejection of executory contracts in bankruptcy.  The decision may mean that rejection does not cut off the debtor estate’s claim to the fruits of a pre-petition asset in the face of a competing claim on those fruits.  A third alternative may focus merely on statutory interpretation of section 365(n).

VI.              Conclusions

            The CellNet outcome has implications for licensing lawyers and bankruptcy practitioners, but it is hard to predict how CellNet will be interpreted.  It may stand simply for the general proposition that in a sale under the Bankruptcy Code, royalty rights under a license do not necessarily follow the underlying intellectual property when ownership of intellectual property is severed from related rights in a license agreement.  While this holding enhances the debtor estate for the benefit of creditors, it ignores the real-world economic and equitable justifications for linking royalty rights to the underlying intellectual property.  As such, this may be one instance where a debtor in bankruptcy is afforded greater rights than it would be entitled to under non-bankruptcy law.

More simply, the decision may be viewed as an instructional, practical interpretation of section 365(n).  That is, the decision may stand only for the proposition that after a section 365(n) election, the licensee pays royalties to the debtor estate. 

Alternatively, the decision may mean that rejection simply ends the debtor-licensor’s obligations but otherwise leaves the contract in force, meaning that, at least in bankruptcy cases, royalties arise out of contract relationships and not out of intellectual property relationships.

            What the decision does not stand for is that when a debtor rejects a license, the licensee’s obligation to pay royalties follows the intellectual property interests that initially entitled the licensor to receive royalties.

            It remains to be seen whether that outcome will promote Congress’s intent to encourage the market for intellectual property licenses.