Game over.

• Author: Tate, Joshua C.
• Position: Case Note

Perlman v. Catapult Entertainment (In re Catapult Entertainment), 165 F.3d 747 (9th Cir.), cert. dismissed, 120 S. Ct. 369 (1999).

Like ancient Babylonian decrees, the provisions of the current U.S. Bankruptcy Code are imbued with a wisdom few mortals can comprehend. Catapult Entertainment, an insolvent video-game developer, must have been made painfully aware of this by a recent Ninth Circuit opinion that analyzed the status of patent licenses in bankruptcy.(1) Having contracted for certain patent licenses, Catapult saw those licenses snatched away as a direct consequence of having filed for a Chapter 11 reorganization, despite the fact that the Bankruptcy Code normally prohibits solvent parties from terminating contracts merely because of a debtor's insolvency.(2) The explanation given was essentially the same as that offered for throwing Daniel into the lions' den: An established law cannot be altered, even when its consequences are unpleasant.(3) Whether Catapult and future technology firms in its situation will emerge unscathed remains to be seen.

Founded in 1994 "to create an online gaming network for 16-bit console videogames," Catapult had entered into two license agreements with Stephen Perlman that gave Catapult the right "to exploit certain relevant technologies."(4) Two years later, Catapult initiated reorganization proceedings.(5) As a solution to its financial problems, Catapult proposed a "reverse triangular merger" involving another company.(6) The Perlman licenses were to be assumed by Catapult under the plan, which was approved by the bankruptcy court over Perlman's objection,(7) but Perlman's argument that the patent licenses could not be assumed convinced the Ninth Circuit. The source of Catapult's torment in Perlman was 11 U.S.C. [sections] 365(c), which constitutes an exception to the trustee's usually broad discretion to assume "executory contracts" in bankruptcy.(8) Section 365(c) prevents the trustee or debtor-in-possession from assuming executory contracts that could not be assigned outside of bankruptcy without the licensor's consent.(9) Since federal patent law allows the licensor to reject an assignment by the licensee to a third party,(10) and patent licenses are considered to be executory contracts, [sections] 365(c) can be interpreted to render patents non-assumable in bankruptcy. Courts have disagreed, however, over whether the statute prohibits all assumptions of patent licenses in bankruptcy, or only an assumption combined with an actual intention to assign the licenses to a third party.

In an earlier case, the First Circuit had limited [sections] 365(c) to cases in which the trustee or debtor-in-possession actually intended to assign the patent to a third party.(11) By contrast, in the Ninth Circuit's view, [sections] 365(c) prevents a trustee from assuming a debtor's patent licenses without the licensor's consent, even when the trustee has no actual intention of assigning them to a third party.(12) The Ninth Circuit did not even reach the question of whether the trustee in Perlman actually intended to assign these licenses to a third party, holding that this issue was irrelevant under its reading of the Bankruptcy Code.(13) In effect, Catapult lost its licenses simply by going into bankruptcy. Unless future parties can evade the judicial controversy over [sections] 365(c) by a felicitous change in the terms of the license--and such a deus ex machina may not be forthcoming in all cases(14)--small technology firms like Catapult may find it harder to secure financing under the Perlman rule, as lenders might raise the interest rate to compensate for a diminished expected return in the event of bankruptcy. Perlman may be superseded for corporate licensees by bankruptcy reform legislation pending in Congress, but it is not clear that Perlman will lose its effect in the case of a hybrid entity such as a limited liability company (LLC) under the amended [sections] 365(c).(15)

I

After Perlman, technology firms in the Ninth Circuit's jurisdiction may find it difficult to propose a feasible Chapter 11 reorganization plan unless they own the full fights to key patents. When a licensee has filed under Chapter 11, the licensor can withhold its consent from the assumption of the license, keep whatever license fees have already been paid by the debtor, and find another licensee to take the debtor's place (perhaps for a higher fee). Unless the licensor has an independent interest in the survival of the bankrupt firm, any investment the licensee has made in developing the patent will become worthless. Such a result is antithetical to the policy of federal patent law that favors encouraging technological innovation, not to mention inconsistent with the principle that bankruptcy law should not unnecessarily disturb state-law property rights. This Case Note suggests a way to ameliorate the unfortunate effects that the Ninth Circuit's interpretation of the Code might otherwise have on technological investment. In future cases, given certain conditions, the trustee should bring an unjust-enrichment action against the licensor who does not consent to assumption under [sections] 365(c). Provided that the parties had not made a valid agreement that the license fees would be nonrefundable,(16) restitution would compensate a licensee who had paid fees to the licensor without receiving fair value in return.

The proper reading of [sections] 365(c) and its relationship to neighboring provisions have been contested issues in the courts since the Bankruptcy Code was enacted in 1978.(17) In particular...