COVID-19: Major risk flowing from non-exclusive patent licenses under German insolvency law

Executive summary

Under German insolvency law, non-exclusive patent licenses may pose substantial commercial and financial risks in the event of an insolvency of one of the licensed parties. According to mandatory provisions of the German Insolvency Code, the insolvency administrator has the right to opt between performance and non-performance, i.e. to terminate or affirm such licenses. Termination of a non-exclusive license agreement may result in patent infringement or loss of income stream. It is possible to mitigate such risks by various legal means.

Introduction

The COVID-19 pandemic poses a major challenge for large parts of the economy, causing many companies to fail and a domino effect on other companies with which they had business relationships. Where a party to a patent license becomes insolvent, and regular insolvency proceedings are commenced, an insolvency administrator will be vested with the right to administer and dispose of the company’s assets and, thus, take over the management of the business. If a company is subject to insolvency proceedings under self-administration, the debtor in self-administration may make use of the same special rights that would otherwise be conferred to the insolvency administrator.

German insolvency law confers on the administrator (or the self-administrating debtor) a choice as to whether to affirm or terminate a non-exclusive license agreement. Where the administrator (or self-administrating debtor) opts for non-performance:

• The licensee loses the right to use the licensed patents owned by the insolvent licensor, and the licensee’s business can become infringing.
• Any unpaid royalties and damages claims for early termination due by the insolvent licensee will be regular unsecured insolvency claims, and there will be delays in exploiting the patent (and generating future royalties) with a new licensee.

Fortunately, a number of options are available to mitigate such risks. This article considers some of these options – negotiating a patent assignment or an exclusive license, granting sub-licenses or creating security over the patent licenses.

Fate of license agreements in the event of insolvency

License agreements generally include continuing and recurring obligations for each party, most notably, ongoing license payments and the continued grant of the right to use the patent. Such agreements fall within the scope of Sec. 103 of the German Insolvency Code, which applies to agreements containing reciprocal and ongoing obligations for each party as at the date of insolvency. This provision grants the administrator (or the self-administrating debtor) the right to opt between performance (i.e. affirmation) and non-performance of the license agreement (i.e. termination). This causes serious uncertainty for the non-defaulting party. 

According to Sec. 119 of the German Insolvency Code, this right cannot be circumvented by contractual terms, but there are certain options for structuring license agreements in order to mitigate the risks, namely by:

• Agreeing an exclusive license
• Establishing an in-rem right securing the right to use the patent
• Agreeing a subsequent transfer of the patent in the potential event of insolvency

Insolvency of the licensor

Where the licensor becomes insolvent and the insolvency administrator (or self-administering debtor) opts for non-performance of the license agreement, the licensee loses the right to use the patented invention and to distribute the products which fall within the scope of the licensed patent. As the patent is part of the insolvency estate, it can be used to generate proceeds, e.g. by granting an exclusive license or selling the patent to a third party or competitor. This would enable such third party to claim an injunction and damages against the former licensee’s dealings in products or processes which were previously licensed. The licensee would be entitled to claim damages for non-performance with respect to the existing license agreement, but such damage claims would rank as regular unsecured insolvency claims and will therefore only be satisfied on a pro-rata basis along with all other insolvency claims.

Possible measures to reduce the risks

As indicated above, there are various options for structuring license agreements in a way to reduce the risks in the event of the licensor’s insolvency. If an existing license agreement is subsequently amended though, such measures may be challenged in the course of subsequent insolvency proceedings under German insolvency clawback rules (Sec. 129 et seqq. of the German Insolvency Code). Therefore, it is preferable to address the insolvency risks when the initial license agreement is negotiated.

Depending on the value of the licensed patent, the licensee may offer to purchase the licensed patent. In order to agree clawback risks, it is essential that the purchase be structured as a cash transaction at arm’s length (Bargeschäft) in accordance with Sec. 142 of the German Insolvency Code, which requires that the licensee immediately and directly pays to the licensor a purchase price which reflects the fair market value.

Alternatively, if the license is non-exclusive, an exclusive license may be negotiated. Again, the compensation for such exclusive license would need to meet the criteria of an arm’s length transaction.

If the parties wish to continue the current license, it is also possible to provide the licensee with security in form of an in rem right in the patent, such as an expectancy right (Anwartschaftsrecht) or usufruct right (Nießbrauch). Although there is no precedent on the point, these structures have become a recognised way to secure a license agreement.

However, granting a security subsequently to the conclusion of a license may, depending on the circumstances, be subject to significant clawback risks. Therefore, it should be agreed at the outset when the license agreement is entered into.

Finally, in case of a sub-license to an affiliated company, the license agreement between the sub-licensor and the sub-licensee would remain unaffected by the decision of the insolvency administrator to opt for non-performance of the main license agreement vis-à-vis the main licensee.

Insolvency of the licensee

The insolvency of a licensee can cause financial damage to the licensor as royalty income may cease. 

The right to opt between performance and non-performance pursuant to Sec. 103 of the German Insolvency Code also applies to cases where the licensee becomes insolvent.

If the right is exercised in favour of a continuation of the license agreement, any unpaid pre-insolvency license fees would qualify as regular insolvency claims. However, the fees accruing as of the date of the opening of the insolvency proceedings would rank as privileged claims to be satisfied first from the insolvency estate. There remains a residual risk that the estate is insufficient to cover such privileged claims, which would need to be notified to the insolvency court. 

If the right is exercised in favour of non-performance (i.e. termination), any outstanding license fees, as well as any possible damages claims, would qualify as regular insolvency claims which need to be filed in the insolvency proceedings. Regular insolvency claims will only be satisfied on a pro-rata basis. 

Therefore, it should be ensured that the licensor can validly terminate the license agreement when the licensee shows signs of distress. It is important to note, though, that termination rights limiting or excluding the statutory principles of Sec. 103 et seqq. of the German Insolvency Code are void (Sec. 119 German Insolvency Code). Therefore, termination rights based on the occurrence of an insolvency event, on the filing of an insolvency petition or on the opening of insolvency proceedings are generally considered invalid. Additionally, Sec. 112 of the German Insolvency Code, which applies to rent and lease agreements, excludes the right to terminate due to arrears in payment in the event of insolvency. However, it may be possible to agree on a termination right relating to circumstances typically associated with financial distress (e.g. if minimum revenue or minimum sales volume thresholds are not achieved). Thus, contracted termination rights have to be drafted very carefully and on a case-by-case basis.

Conclusion

In view of the potential impact of German insolvency law, the parties of non-exclusive license agreements are encouraged to review the terms of their licenses. Particularly in the unprecedented, uncertain times of the COVID-19 pandemic, it would be advisable to explore what can be done to mitigate any potential insolvency risks, even if imminent issues may not yet be apparent. There are legal means which may help to reduce risks associated with an insolvency of a party to the license agreement; however, it is important that the parties take such measures before the threat of insolvency arises.