PublishedNovember 26, 2012

Vanishing Licenses – How International Bankruptcy Rules Could Threaten the Networked Patent Economy

Why should the patent community care about developments in cross-border insolvency law?  Though the topic seems esoteric, there are some important practical reasons to pay attention to what’s happening in the bankruptcy courts.  Recall bankrupt Nortel Networks’ sale last year of 6,000 patents to an Apple/RIM/Microsoft-led consortium for $4.5 billion.  The Nortel patent sale gave the world a sobering reminder that many of the most valuable patent portfolios in the industry are in the hands of teetering corporate giants.  Today, an even more significant bankruptcy development is unfolding, a development that could impact tens of thousands of patents subject to industry-wide cross-license agreements.

Despite the high-profile patent litigation that dominates the technology news today, the vast majority of high tech patents are not being asserted in court.  Rather, the bulk of patents in the technology sector are quietly licensed and cross-licensed among market participants, sometimes thousands at a time.  These industry cross licenses, like peace treaties in a war-torn world, form a vital infrastructure atop which product development, manufacturing, sales and distribution can occur without fear of litigation.  Recently, however, a threat to this peace has emerged.

The threat arises in bankruptcy.  Under the bankruptcy laws of most countries, a financially distressed company (called the “debtor”) seeks to eliminate or restructure its debts under the protection of the courts (for the sake of simplicity, I will not distinguish between proceedings under Chapters 7 and 11 of the U.S. Bankruptcy Code).  In a bankruptcy proceeding, the court, or a court-appointed administrator (sometimes referred to as a trustee under U.S. law), has the power to sell off or liquidate the debtor’s assets and divide the proceeds among its creditors.  As we all know, the creditors usually receive pennies on the dollar, and the debtor’s stockholders are left with next to nothing.  The administrator’s role is to maximize the returns to the creditors.  Part of the liquidation procedure involves the debtor’s outstanding contractual obligations.  Clearly, a bankrupt entity in the process of being liquidated cannot be expected to continue to perform its contractual obligations.  As a result, a bankruptcy administrator has broad authority to reject contracts of the debtor that are not yet fully performed (so-called “executory” contracts).  The counter-parties to those rejected contracts have little recourse, other than becoming creditors themselves.  For example, if the debtor in a bankruptcy proceeding has a contractual commitment to deliver 100 bushels of wheat over the course of a year, but only 20 bushels had been delivered prior to the bankruptcy, then the administrator would have the right to reject the contract for the delivery of the remaining 80 bushels, and the buyer could bring a claim for breach of contract damages that would ultimately be resolved in line with the claims of other unsecured creditors.

When the debtor’s contractual obligations involve the licensing of intellectual property rights, rather than bushels of wheat, the simple logic outlined above does not work so well.  If a patent holder is in bankruptcy, can the licenses it has granted to others be rejected?  Doing so would seem to work a significant injustice to licensees who may have already paid for those licenses, and who have made significant investments relying on their freedom to operate under the debtor’s patents.  For this reason, Section 365(n) of the U.S. Bankruptcy Code provides that a debtor’s executory intellectual property licenses (patent, copyright and trade secret, but not trademark) cannot be rejected in a bankruptcy proceeding.

The protections afforded by Section 365(n) have worked well to protect the interests of U.S. intellectual property licensees after the bankruptcy of their licensors.  However, both patent law and bankruptcy law are national in character.  Thus, the rules governing bankruptcy proceedings in the U.S. have little sway abroad.  And most other jurisdictions lack the protections of Section 365(n).  So what happens to the licensees of a multinational technology giant when it seeks bankruptcy protection outside the U.S.?

The answer to that question is being litigated today in a case involving Qimonda AG, a large German DRAM semiconductor manufacturer (once part of the giant Siemens enterprise) that declared bankruptcy in 2009.  Like most semiconductor manufacturers, Qimonda was party to a complex web of patent cross-license agreements, and itself held thousands of patents on DRAM technology.  Qimonda, based in Munich, filed for bankruptcy protection in Germany, whereupon its German administrator sought to reject Qimonda’s patent cross-licenses with other semiconductor manufacturers.  Germany lacks an analog to Section 365(n) of the U.S. Bankruptcy Code, making this rejection appropriate under German law.  The administrator’s stated intention was to sell Qimonda’s patents to the highest bidder, which many feared could be a non-practicing entity.

Like many international technology companies, Qimonda held significant assets, including patents, in the U.S.  Thus, the German administrator also filed an action under Chapter 15 of the U.S. Bankruptcy Code to dispose of Qimonda’s U.S. assets according to the plan approved in the German proceeding.  This plan, as noted above, included the rejection of Qimonda’s many industry patent cross licenses.  At this point, a number of licensees under Qimonda’s U.S. patents intervened in the Chapter 15 proceeding.  These companies included IBM, Intel, Hynix, Micron, Samsung and Infineon (Qimonda’s former parent company).

The Bankruptcy Court initially approved Qimonda’s plan, but its decision was reversed and remanded by the District Court for the Eastern District of Virginia.  In remanding the case, the District Court instructed the Bankruptcy Court to consider Section 1506 of the U.S. Bankruptcy Code, which provides that a foreign bankruptcy proceeding will be accorded comity by the U.S. unless the foreign law is “manifestly contrary to U.S. public policy”, and Section 1522, which requires that U.S. parties must be “sufficiently protected” after application of the foreign law.  Upon remand, the Bankruptcy Court found that allowing the German administrator to terminate Qimonda’s patent licenses in contravention of Section 365(n) would “undermine a fundamental U.S. policy promoting technological innovation”.

Not surprisingly, Qimonda’s German administrator has appealed the Bankruptcy Court’s ruling to the Fourth Circuit, which is currently considering the case.  What is surprising, however, is the diplomatic response that has ensued.  In particular, shortly after the Bankruptcy Court rejected Qimonda’s plan, the Consul General of Germany, Knut Abraham, wrote a letter to the Fourth Circuit urging it to reverse the decision below on grounds of international comity.  Shortly thereafter, the U.S. Department of Justice followed suit.  The DOJ filed a brief as Amicus Curiae, putatively in support of neither party, but urging the Fourth Circuit to reverse the ruling of the Bankruptcy Court and permit the revocation of Qimonda’s license agreements.  According to the German Consul and the DOJ, such a response is necessary as a matter of cross-border insolvency law and international comity.

The Qimonda dispute is significant on a number of levels.  First, it highlights the very real differences between national treatment of patents and patent licenses, even in highly developed countries.  These differences have not previously attracted much attention outside the cross-border insolvency bar, but their current implications for the multibillion dollar technology sector are now being noticed.  Perhaps this increased attention will lead to greater pressure among major industrial nations to harmonize their bankruptcy laws.  Second, the dispute reminds us of the critical role that broad industry-wide cross-licensing plays in major technology industries.  While recent attention has been focused on a few high-profile patent disputes among smartphone manufacturers, dozens of closely related industries have largely avoided such disputes due to broad cross licensing.  If the license structure that underpins these industries can be eroded through bankruptcy proceedings, the stability of these markets may be weakened.  This risk could be accentuated if patents that were once licensed can be sold in bankruptcy to non-practicing entities whose sole goal is monetization of patent assets, without a corresponding need for licenses from other industry players.  And differences in national bankruptcy laws that would allow such strategic behavior could trigger a “race for the bottom” as corporate entities selected jurisdictions for incorporation and/or liquidation based on their flexibility in this regard.

The Fourth Circuit should consider these issues as it hears arguments in Qimonda.  In particular, it should consider the very real risk to the stability of heavily cross-licensed industries when deciding whether to uphold the protections afforded by Section 365(n) of the U.S. Bankruptcy Code, or to disregard these protections in favor of international comity.

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Jorge Contreras

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