Authors: M P Ram Mohan & Aditya Gupta
Dr. M P Ram Mohan is a lawyer by training is an Associate Professor in the strategy area of the Indian Institute of Management Ahmedabad (IIMA), and a member of the CIFL Board of Advisors. Mr. Aditya Gupta is currently a research associate at IIMA. This blog piece is a part of the series which features contributions by the members of our Board of Advisors.
[This write-up is based on two studies conducted by the authors available here and here]
The primary purpose of any insolvency legislation is granting a fresh start to an honest but unfortunate debtor. Modern insolvency legislations, including the Insolvency and Bankruptcy Code,(IBC) 2016, maintain that maximising the value of assets available for creditors and easing the closure of unviable businesses as their primary objectives. To this end, many insolvency statutes allow a debtor to reduce its prospective liabilities by interfering and rejecting the performance of pre-petition onerous and burdensome transactions.[1]
In the United States, Section 365 of the American Bankruptcy Code warrants an interference with pre-bankruptcy transactions. It allows a bankrupt estate to absorb contracts that posit a net benefit while rejecting detrimental contracts that can potentially deplete the estate.[2] By rejecting an onerous contract, a bankruptcy estate avoids accrual of liabilities that the performance of the contract would otherwise create. Once rejected, the contract should be treated as a ‘breach’.[3] However, neither does the Code delineate the consequences of a breach within Section 365, nor does the term rejection assume an obvious contract law analogue. This has led to an inconsistent interpretation of the provision, where the meaning of rejection and termination has often been conflated. This conflation and misinterpretation become very problematic in reference to intellectual property licenses. The case of Lubrizol v. RMF,decided by the United StatesCourt of Appeals for the Fourth Circuit, can be cited to discuss the resulting controversy from the intersection of IP licenses during bankruptcy.
In 1985, Richmond Metal Finishers filed for bankruptcy and rejected a patent licensing agreement in favour of Lubrizol enterprises. Interpreting the meaning of rejection, the Court of Appeals for the Fourth Circuit opined that a rejection would amount to the complete recission of the contract, and the licensee cannot continue the use of the licensed intellectual property post rejection. The Court’s decision effectively meant that all the investments made by Lubrizol towards exploitation of the license would be effectively reduced to sunk costs. This led to widespread panic in the IP licensing industry. The licensees started demanding restructuring of their licensing agreements to avoid the incidence of Section 365. The American Congress took note of the negative market externalities created by the Lubrizol decision and enacted the Intellectual Property Bankruptcy Protection Act (IPBPA), 1988. IPBPA was legislated to denude Lubrizol from its precedential authority.
The issues arising at the intersection of IP licenses in bankruptcy are even more pronounced in when the insolvency assumes a cross-border character. Owing to the lack of any overarching international guidance on the subject, there are marked divergences between domestic insolvency legislation which lead to problematic conclusions. The issue manifested itself in 2013 when an American Bankruptcy Court declined to grant the administration of American IP assets to German insolvency proceedings, despite recognising the latter as the foreign main proceedings. The court based its decision on the fact that the protections available to an IP licensee within the American bankruptcy framework are absent from the German insolvency law. In ruling thus, the decision effectively meant that the licensees of American patents would receive a dramatically different treatment than the treatment afforded to German licensees.
While the American bankruptcy jurisprudence has a rich history of dealing with IP licensing issues in bankruptcy, the Indian insolvency jurisprudence has not enjoyed such an opportunity. The two studies conducted by the authors (available here and here) reveal virtually no guidance relating to the treatment of IP licenses in bankruptcy under IBC, 2016.
While the Code provides for interference through multiple provisions, the mandate and scope of these provisions remain obscure and unclear. The following provisions of the Code warrant an interference with pre-bankruptcy transactions:
- Avoidance of vulnerable transactions
Sections 43-51, IBC, 2016 are categorised as ‘claw-back actions’ and allow the retrospective adjustment of pre-petition transactions. The Code allows the National Company Law Tribunal wide powers to upset the effects of vulnerable transactions. The Tribunal’s powers extend as far as to return of the subject property[4] and restore the position which existed prior to a vulnerable transaction.[5] However, avoidance transactions seek to tackle a very nuanced and specific set of pre-petition transactions.
As the Bankruptcy Law Reforms Committee pointed out in 2014, avoidance powers are aimed at upsetting transactions that fall within the category of wrongful or fraudulent trading by the entity or unauthorised use of capital by the management. Therefore, while the avoidance powers upset pre-petition transactions, they are geared towards protecting against fraudulent business activity rather than maximising the debtor’s pool of assets.
- Disclaimer of Onerous property
The Code also provides for interference with unprofitable contracts through a disclaimer vide Regulation 10, Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016..[6] Similar to rejection, the intention for allowing disclaimer is to enable the bankrupt debtor to reject the performance of contracts, which can potentially result in the acquisition of further liabilities and depletion of the bankruptcy estate. The disclaimer operates solely to release the debtor from his obligations in a contract and does not affect the rights and liabilities of any other person.[7] However, unlike the broad power of rejection within Section 365 of the American Bankruptcy Code, a disclaimer operates solely in cases of liquidation and has no bearing on the Corporate Insolvency Resolution Process.
- Residuary Powers
Section 20(2)(b), IBC, 2016 empowers the Interim Resolution Professional and the Resolution Professional[8] to amend and modify the terms of pre-petition contracts. Explaining the scope of this provision, the NCLT Hyderabad in EIH v. Subodh opined that the power of amendment and modification could not be exercised unilaterally without the consent of the concerned party. The NCLT Mumbai in DBM Geotechnics further extended this rationale and opined that pre-petition contracts continue to be governed in the same manner as they would have been governed had insolvency not intervened.
With an understanding of the underlying statutory framework, the obvious question is how far can a bankrupt debtor interfere with pre-petition IP licensing arrangements? The answer to this remains unclear (see here and here). Owing to the lack of any judicial analysis of IP licenses in insolvency, any conclusions on the subject remain highly academic. For example, while disclaimer only operates to release the debtor from his foregoing obligations and should not affect the rights and liabilities of third parties, what would be the effect of a disclaimer in in reference to an exclusivity covenant? Such a covenant would preclude further licensing of the subject IP. The exclusivity covenant can create a subsisting obligation for the licensor. However, the frustration of the exclusivity covenant would affect the rights and liabilities of third party’s other than the bankrupt debtor. What would a disclaimer mean in such a scenario?
Further, given that the Indian insolvency regime is on the precipice of adopting cross-border insolvency regulations, it is imperative that the treatment of IP licenses in insolvency be clarified. Without such clarity, a foreign court will not be able to determine the legal position within the IBC, 2016 and would inevitably subject any Indian cross-border insolvency proceedings to provisions and protections of foreign insolvency frameworks. This can result in unknown consequences for insolvency participants.
The views expressed in this article are those of the author and in no way do they reflect the opinion of the Centre for Insolvency and Financial Laws or any of its Board of Advisors.
[1] See for example, 11 U.S.C. § 365.
[2] Douglas G. Baird, Baird’s Elements of Bankruptcy 120–126 (5th edition ed. 2010).
[3] 11 U.S.C. § 365(g).
[4] Section44(1)(a) & 48(1)(a), Insolvency and Bankruptcy Code, 2016.
[5] Section 51(a), Insolvency and Bankruptcy Code, 2016.
[6] Section 160, Insolvency and Bankruptcy Code, 2016; Regulation 10, Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016.
[7] Section 160(5), Insolvency and Bankruptcy Code, 2016; Regulation 10(1)(d), Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016.
[8] Section 20(2)(b) read with Section 23(2), Insolvency and Bankruptcy Code, 2016.