An executory contract, within the meaning of Section 365 of the Bankruptcy Code, is a contract whereby “‘performance remains due to some extent on both sides.’” N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 522 n.6, 104 S. Ct. 1188, 1194 n.6 (1984) (quoting H.R. Rep. No. 595, 95th Cong., 1st Sess., at 347 (1977)); see also, Sharon Steel, 872 F.2d at 39 (citing Countryman, Executory Contracts in Bankruptcy, Part 1, 57 Minn. L. Rev. 439, 460 (1973)). The Fourth Circuit in In re Sunterra Corporation, 361 F.3d 257, 264 (4th Cir.2004) stated that under the “Countryman Test” a contract is executory if the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute an material breach excusing the performance of the other. See also, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1045 (4th Cir. 1985); and In re Exide Technologies, 607 F.3d 957, 962 (3rd Cir. 2010). In other words, when a hypothetical breach party has substantially performed before breaching, the other party’s performance is not excused. Exide Technologies, 607 F.3d at 963. Whether a contract is executory is determined as of the date of the petition in bankruptcy and is generally a matter of state law. In re Norquist, 43 B.R. 224 (Bankr. E.D.Wash. 1984); and In re Topco, Inc., 894 F.2d 727 (5th Cir. 1990), reh’g denied, 902 F.2d 955 (1990) (en banc).
In likening licenses to leases, courts have characterized licenses as executory contracts under Section 365. The typical licensing agreement gives the licensee a specified quantum of use of the technology or trademark while ownership remains in the licensor. The licensee ordinarily pays a large upfront payment and ongoing royalties, while the licensor has duties of his own, thus making the license agreement an executory contract for the purposes of Section 365 and giving the debtor-in-possession the power to assume or reject, with rejection giving the non-debtor licensee or licensor a general unsecured claim. However, note that in In re DAK Industries, Inc., 66 F.3d 1091 (9th Cir. 1995), the court looked through the form of a transaction to the economic realities of the particular arrangement and held that the agreement was a lump sum sale of software units, rather than the granting of permission to use intellectual property.
The courts are generally in agreement as to what test (i.e., the Countryman test) is used to determine whether an agreement is executory. However, the opinions vary on when an obligation is deemed material. Lubrizol Enters. Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), 756 F.2d 1043, 1046 (4th Cir. 1985), cert. denied, 475 U.S. 1057 (1986), involved a nonexclusive license to utilize a metal coating process technology. Here, the licensor owed the following duties to the debtor licensee: (1) it needed to notify the licensee of any patent infringement suits and defend in such suits; (2) it needed to notify the licensee of any other use or licensing of the process, and to reduce royalty payments if a lower royalty rate agreement was reached with another licensee; and (3) it needed to indemnify the licensee for losses arising out of any misrepresentation or breach of warranty by licensor. The licensee, in turn, owed the licensor reciprocal duties of accounting for and paying royalties for use of the process and of cancelling certain existing indebtedness.
Based on these facts, the court found the agreement to be executory. The court explained that the license was executory as to the licensor because of the contingent duties that the licensor owed of giving notice of and defending infringement suits and of indemnifying the licensee for certain losses arising out of the use of the technology. It noted that the contingency of an obligation does not prevent its being executory under Section 365. With respect to the licensee, it owed the licensor the unperformed and continuing duty of accounting for and paying royalties during the life of the agreement.
The court recognized that a contract is not executory as to a party simply because the party is obligated to make payments of money to the other party. Therefore, if the licensee had owed the licensor nothing more than a duty to make fixed payments or cancel specified indebtedness under the agreement, the agreement would not be executory as to the licensee. “However, the promise to account for and pay royalties required that [the licensee] deliver written quarterly sales reports and keep books of account subject to inspection by an independent Certified Public Accountant.” This promise went beyond a mere debt, or promise to pay money, and was executory. Additionally, subject to certain exceptions, the licensee was obligated to keep all license technology in confidence for a number of years. Id. at 1046. The court also noted as follows:
The unperformed, continuing core obligations of notice and forbearance in licensing made the contract executory as to [the licensor]. In Fenix Cattle Co. v. Silver (In re Select-A-Seat Corp.), 625 F.2d 290, 292 (9th Cir. 1980), the court found that an obligation of a debtor to refrain from selling software packages under an exclusive licensing agreement made a contract executory as to the debtor notwithstanding the continuing obligation was only one of forbearance.
Id. at 1045-46.
In In re Golden Books Family Entertainment, Inc., 269 B.R. 300 (Bankr. D.Del. 2001), the court found the intellectual property licenses at issue to be executory contracts. It did so based on the simple fact that “each party of the license had the material duty of ‘refraining from suing the other for infringement of any of the [intellectual property] covered by the license.” Id. at 308 (Citing to In re Access Beyond Tech., Inc., 237 B.R. 32 (Bankr. D.Del. 1999)).
In In re HQ Global Holdings, Inc., 290 B.R. 507 (Bankr. D.Del. 2003), the license agreement allowed franchisees to use “certain trade names, trademarks, service marks, logos, emblems, insignia, and other indicia of origin.” The court noted that the agreement unquestionably contained unperformed obligations due from the franchisees, as they were required to keep at least one franchised office center open in their respective territories, were required to pay monthly royalty payments to the debtors while maintaining the debtor’s standards of operation, and were required to provide the debtor with operating reports on a monthly basis. Conversely, the court noted that the debtor could not use the trademark in territories granted to the franchisees. Consequently, the court held that the licenses in question were executory contracts.
In In re Kmart Corp., 290 B.R. 614 (Bankr. N.D.Ill. 2003) the court stated that generally speaking, licenses were executory contracts. Id. at 618. In this case, the license set forth ongoing requirements on the part of Kmart, e.g., Kmart had a continuing duty to notify a subcontractor in writing of any claims, allegations of infringement, or legal suits that may arise. Kmart also had the duty to protect the confidential nature of the software’s trade secrets, a duty to seek consent if Kmart wished to transfer the software to someone else. “Further, and most importantly, Kmart continues to use the software under the License Agreement. This aspect of the agreement is crucial to the determination that the license agreement is an executory contract” Id. The licensor’s converse obligation was to pay a subcontractor to continue to provide service, maintenance, and upgrades on the software that was licensed. The fact that some of the obligations were remote or contingent did not bother the court, as it noted that the contingency or remoteness of obligations imposed by the license agreement did not prevent the agreement from being deemed “executory” in nature, and thus subject to assumption or rejection by debtor. Id.
In In re Sunterra Corporation, 361 F.3d 257 (4th Cir.2004), the debtor was provided a “non-exclusive, worldwide, perpetual, irrevocable, royalty-free license to * * * use, copy, modify, and distribute” software. In this case, the court found the license to be executory. It reached this conclusion solely on the fact that “each party owed at least one continuing material duty to the other under the Agreement – they each possessed an ongoing obligation to maintain the confidentiality of the source code of the software developed by the other, i.e., the Software and the Sunterra Enhancements.” Id. at 265.
In re Exide Technologies, 607 F.3d 957 (3rd Cir.2010), involved a license agreement whereby the licensor licensed its “Exide” trademark to the licensee for use in the industrial battery business. The licensor wanted to continue to use the Exide mark outside of the industrial battery business. To accommodate the needs of both parties, the licensor granted the licensee a perpetual, exclusive, royalty-free license to use the Exide trademark in the industrial battery business. The court found that this agreement was not executory.
First, the court noted that the licensee’s obligation to observe a Use Restriction, i.e., not to use the trademark outside the industrial battery business, is not a material obligation because it is a condition subsequent that requires the licensee to use the mark in accordance with the terms of the Trademark License. The court stated that a condition subsequent is not a material obligation. Id. at 963-64. Further, the court noted that the Use Restriction did not relate to the purpose of the agreement-which is that the licensor would transfer its industrial battery business and the concomitant assets and liabilities to the licensee and the licensee in exchange would pay licensor about $135 million.
Second, the licensee’s obligation to observe the Quality Standards Provision was minor because it requires meeting the standards of the mark for each battery produced; it did not relate to the transfer of the industrial battery business which the licensee acquired form the licensor. Furthermore, the record revealed that the licensor never provided the licensee with any quality standards. Id. at 964. Finally, in regard to the Indemnity Obligation, under the Asset Purchase Agreement, all representations and warranties arising from it expired in 1994, on the third anniversary of the closing and the licensor did not present any evidence that any liability assumed by the licensee was still pending. Id.
In re SuperMedia, Inc., 2013 WL 5567838 (Bankr. D.Del. October 9, 2013) similarly found the license agreement not to be executory. Here, the licensor produced and licensed copyrighted photographic images. On November 12, 2001, the licensor entered into an agreement with Verizon Directories Corp., under which the licensor would provide to the licensee a perpetual, royalty free, non-exclusive license to use copyrighted photographic images owned by the licensor. Among other terms, the license authorized use of the images for up to 600 licensee employees. The agreement’s terms, including the schedule of payment, terminated, at the latest, on December 31, 2004. However, the License continued to remain in effect. This license granted neither exclusive nor sole use of the photos, either in a specific region or to a single individual, advertiser, or publishing company. In other words, other publishing companies, individuals or corporations (whether competing or not) within the same market could simultaneously obtain and publish these photos without regard to geographic region.
Citing to Exide, the court noted that the various negative covenants, restrictions on use and conditions subsequent customarily found in intellectual property licenses may not be considered sufficiently material to subject the license to rejection. However, the court should look to the principles of contract interpretation under relevant non-bankruptcy law to determine the existence of an obligation that would constitute a material breach. Id. at *3. The court found that
[the licensor] has not specified the “material unperformed obligation” under the Agreements, which would cause the Court to deem the Agreement executory. The license is “fully paid” and “royalty free.” [The licensor] does not sufficiently or credibly distinguish Exide which clearly stands for the legal principle that without at least one material unperformed obligation, i.e., that would qualify as a material breach if not performed, the Agreement is not executory. The use and transfer restrictions contained in the Agreement are not affirmative obligations. They are conditions rather than obligations.
Id.
Matter of Provider Meds, L.L.C., 907 F.3d 845 (5th Cir. 2018) involved a patent covering remote pharmaceutical dispensing. The license at issue was a “non-exclusive perpetual license” for “so long as the Patent or Patents are valid and enforceable.” The licensees agreed to pay a one-time licensing fee of $4,000 for each machine placed into operation after the execution of the agreement, and to provide quarterly reports reflecting all new machines placed in service.
The bankruptcy court held, and the district court affirmed, that licensor had an ongoing obligation under the license agreement to refrain from suing its counterparties for patent infringement for machines placed into service after execution of the agreement. It further concluded that the licensees had ongoing material obligations because they were required to provide quarterly reports as to new machines, pay a one-time licensing fee of $4,000 to the licensor for each new machine, and refrain from making public statements about a settled lawsuit.
The licensees claimed, however, that because the license agreement granted a “perpetual” license for so long as the licensor’s patent was valid and enforceable, the licensor would be prohibited from suing the debtors for patent infringement even if they breached their side of the agreement – and so any debtor obligations would not be material, as required by the definition of an executory contract. The debtors pointed to cases holding that where a license is both “irrevocable” and “perpetual,” the licensor may not revoke the license even when the licensee breaches.
The Fifth Circuit, however, stated that a merely “perpetual” license was not itself irrevocable in the face of material breach. Rather, when a license uses the terms “irrevocable” and “perpetual,” “irrevocable” must mean something beyond “not revocable at will,” since otherwise the use of both “irrevocable” and “perpetual” would be superfluous. The court noted that the use of “perpetual” indicates that the license may not be revoked at will; the use of “irrevocable” goes one step further and indicates that the license may not be revoked for any reason, even a breach by the other side. Id. at 856.
Therefore, while the debtor was arguably correct that because the license granted under the license agreement was “perpetual,” under Texas law, it was therefore not revocable at will, this did not mean that the licensor could not be excused from its obligations if the debtors were to materially breach the license agreement. There was simply no authority holding that a license that is only “perpetual,” and not “perpetual and irrevocable,” is irrevocable in the face of material breach. Id.
Matthew T. Gensburg
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