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Licensors and licensees must structure their agreements carefully to avoid fallout from their partners' Chapter 11 filings.

You are a licensor, and finally, one of the characters you have developed garners national attention. After careful consideration, you grant XYZ Co., a well-known clothing manufacturer, the exclusive rights to manufacture and sell a line of childrenswear featuring your character. Does the dream turn into a nightmare when, a few weeks later, you read that XYZ Co. filed for bankruptcy protection?

Now, suppose you are a licensee who has been granted the exclusive right to manufacture action figures based on a popular comic book hero. You have just invested considerable sums in production, only to discover the comic publisher has filed for bankruptcy. What do you do?

More and more companies are facing financial woes and potential Chapter 11 filings, and the licensing industry is not immune to this trend. Both licensor and licensee may face considerable problems in proceeding with their plans when the other party to a license agreement files for bankruptcy protection. However, with proper due diligence and careful drafting of a license agreement, some of the problems can be prevented, or at least their effect lessened. (Note: For purposes of this article, all parties are U.S. entities.)

For the Licensee

Consider the case of the comic book publisher (licensor) that files for protection under Chapter 11 of the U.S. Bankruptcy Code.

In a Chapter 11 proceeding, the debtor seeks to reorganize its business by decreasing its debts and perhaps terminating certain agreements it finds burdensome. To allow the debtor to reorganize without having to fend off creditors, Section 362(a) of the Bankruptcy Code provides that certain actions against the debtor are automatically "stayed" (that is, suspended). Thus, during the stay, the licensee would be prevented from taking certain actions against the publisher (for instance, the licensee could not force the publisher to deliver required artwork).

Of perhaps greater concern to the licensee is Section 365 of the Bankruptcy Code, which gives the debtor the right to assume (that is, accept) or reject any contract that has not been fully performed by the parties (what is known as an "executory contract"). Most license agreements (including those described in this article) fall into this category. If the debtor/licensor accepts the contract, then it must cure existing defaults and thereafter should carry out its obligations under the agreement. If the debtor rejects the contract, it is effectively terminated, and the other party merely has a claim for any damages incurred (with damages incurred after the bankruptcy filing ranking ahead of those incurred before the filing). Moreover, during the time period the debtor/licensor is given to determine whether to accept or reject a contract, the other party must continue to carry out its obligations under the contract. The Bankruptcy Code grants the debtor a lengthy, indeterminate period of time to make its determination. Since the burden is on the licensee to have the court set a deadline, the period can stretch for months.

What does all this mean for the licensee that has spent $300,000 ramping up for production of the comic book-based action heroes? The bad news is the debtor/licensor can elect to reject the license agreement (perhaps because another licensee is waiting in the wings ready to offer a better deal), in which case the licensee would simply have a claim for damages, and would have to stand in line with numerous other creditors to obtain what might be pennies on the dollar. Moreover, while the licensor is deciding whether to accept or reject the contract, the licensee is obligated to perform the agreement (i.e., continue with its production plans and pay royalties on any sales).

There is some good news, however. In 1998, Congress amended the Bankruptcy Code by adding Section 365(n), which provides that, even if a debtor/licensor rejects a contract, the licensee may retain its rights with respect to any intellectual property licensed to it under the contract, provided the licensee continues to make any payments due the licensor in connection with such license. Unfortunately, the licensee is not fully protected by Section 365(n), as the definition of intellectual property specifically excludes trademarks. Thus, while the licensee might be able to continue to produce action figures that are based upon copyrighted artwork provided under the license agreement, the licensee would not be able to use the associated trademark, such as "Spider-Man." Since the licensee likely will not want to manufacture figures and market them as "the strong guy in blue and red tights who can climb walls," additional preventive measures would have to be taken to protect the licensor's investment in the transaction and allow it to reap the benefits of the deal.

A prospective licensee should do its homework and confirm that the licensor has sufficient cash on hand to continue its operations. Size certainly does not equal stability, and even if a parent entity has cash on hand, the licensor may be a cash-starved affiliate whose future outlook is questionable. Of course, even if the licensor has a heavy debt load, the licensee may want to proceed, as the potential payoffs may be great. If this is the case, the license agreement can be structured as follows to afford maximum protection to the licensee:

For the Licensor

Having considered the plight of the licensee, what about the licensor that just read its childrenswear licensee, XYZ Co., has filed for bankruptcy. As a result of the automatic stay described above, the licensor cannot take any actions against XYZ Co., even if it is in breach of the license agreement (i.e., it is not paying royalties). Also, the licensor must continue to perform under the agreement until XYZ Co. decides whether or not to accept the contract. For instance, if the license agreement requires the licensor to spend its own funds advertising the XYZ Co. license, the licensor may be obligated to incur such costs even though it is not receiving royalties from XYZ Co., and even though XYZ Co. ultimately may reject the contract.

But the licensor can take preventive measures. In addition to conducting its research into the licensee's financial health, the licensor should keep in mind the following:

While there is no sure-fire means of avoiding the negative impact of a contract partner's bankruptcy filing, a well-drafted agreement can help avoid many of the pitfalls inherent in any bankruptcy. Remember: Time invested now is money saved later.