Recent Third Circuit Mallinckrodt Opinion Highlights the Bankruptcy Benefits of Using Non-Exclusive Licenses When Granting Rights in Intellectual Property

In its recent Mallinckrodt decision, the Third Circuit held that a debtor could discharge its obligation to pay future royalties to a drug developer that sold “the rights to the drug outright” to the debtor for $100,000 up front and a promise to pay a 1 percent royalty on all net sales over $10 million a year in perpetuity. In re Mallinckrodt PLC, 99 F.4th 617, 620 (3d Cir. 2024).

Realizing the significance of this blow to the drug developer, the Third Circuit emphasized that the drug developer could have protected itself from this fate if it had structured its transaction with the debtor differently. Specifically, the Court wrote: “[t]o protect itself, [the drug developer] could have . . . licensed the rights to the drug, kept a security interest in the intellectual property, or set up a joint venture to keep part ownership.” Id. at 622.

This alert will explain what sort of protections the drug developer would have had if it had, as the Third Circuit suggested, structured the transaction as a license—particularly as a non-exclusive license. Ultimately, this alert serves to inform developers of intellectual property to make sure to structure their transactions with bankruptcy considerations in mind.

The Drug Developer’s Problem in Mallinckrodt

I. Contracts in Bankruptcy

To understand the weakness of the drug developer’s case in Mallinckrodt, it is helpful to give a short primer on contracts in bankruptcy.

One of the many considerations for an entity contemplating filing for bankruptcy is section 365 of the Bankruptcy Code (“Section 365”).  Section 365 provides an entity-turned-debtor the power to “assume” or “reject” executory contracts or unexpired leases. 11 U.S.C. § 365(a). Through this power, the debtor can keep in place executory contracts or unexpired leases it sees as favorable (so long as it cures most defaults, including monetary defaults) and leave behind others it sees as unfavorable (though the contract counterparty gets to file a rejection damages claim against the debtor).

This power, however, is not unlimited.  Initially, Section 365 applies only to “executory contracts” and “unexpired leases.” A contract is “executory” if “under the relevant state law governing the contract, each side has at least one material unperformed obligation as of the bankruptcy petition date.” In re Weinstein Co. Holdings LLC, 997 F.3d 497, 504 (3d Cir. 2021).  If a contract is not “executory”, it cannot be assumed or rejected and will simply give rise to a claim—either for or against the debtor’s estate. See id. at 504–05 (explaining that if a debtor or counterparty has fully performed so as to make the subject contract nonexecutory, then the contract simply becomes an asset or liability of the estate). Further, Section 365 provides that the debtor must exercise this right within certain time limits and the subject contracts must be assumed or rejected in whole—not in part. See 11 U.S.C. § 365(d); Lee v. Schweiker, 739 F.2d 870, 876 (3d Cir. 1984) (“a debtor may not assume the favorable aspects of a contract . . . and reject the unfavorable aspects of the same contract . . .”).

II. The Third Circuit’s Opinion

The Third Circuit’s opinion points out how the drug developer’s transaction in Mallinckrodt failed to take the bankruptcy contract rules discussed above into account. The opinion mourns the drug developer’s choice to structure its transaction with the debtor in such a way that it “[left] itself with only a contingent, unsecured claim for money.” Mallinckrodt, 99 F.4th at 622.

As the Third Circuit noted early in its opinion, the bankruptcy court and district court below found that because the drug developer “had fully performed its side of the bargain by transferring ownership outright decades earlier, the contract was not executory.” Id. at 620. This ruling, which the Third Circuit agreed with, left the drug developer with virtually no choice but to argue that its future right to payment did not fall within the Bankruptcy Code’s broad definition of a claim, and alternatively, if it did, the claim did not arise prepetition. The Third Circuit, as expected, was not persuaded by these tenuous arguments.

The Third Circuit readily dismissed the drug developer’s argument that the right to receive future royalties was too indefinite to be considered a claim, emphasizing that the Bankruptcy Code’s broad definition of “claim” in section 101(5)(A) includes a “contingent and unliquidated” claim. Id. at 621. The Court explained that the right to receive future royalties was both contingent and unliquidated because: (i) the claim only accrued upon the triggering event of $10 million in net sales each year; and (ii) the claim amount (i.e., the total amount of royalties to be paid out) was undeterminable.  Id.

The Third Circuit also dismissed the drug developer’s argument that its right to receive future royalties did not arise prepetition because the triggering event (i.e., the company reaching $10 million in net sales each year) had not yet occurred, emphasizing that “a claim can arise before it is triggered.” Id. The Court was not persuaded by the drug developer’s attempt to analogize its contract claim to a tort claim, which requires pre-bankruptcy exposure to the injurious conduct to be found to be a prepetition claim. Id. The Court found this analogy “inapt” and stated it would follow the “regular rule . . . [that] most contract claims arise when the parties sign the contract.” Id. Relying on this rule, the Court held that the drug developer’s claim arose prepetition when it signed the contract because the time of signing is when parties “fix their liability—even if it is still unliquidated or contingent.” Id.

In summary, the drug developer’s problem was that its transaction structure failed to take into account these bankruptcy contract considerations, which left the debtor free to discharge its obligation to pay future royalties and continue selling the drug.

The Difference a Non-Exclusive License Would Have Made

As the Third Circuit noted, “[t]o protect itself, [the drug developer] could have . . . licensed the rights to the drug[.]” Id. at 622.

A general bankruptcy benefit of structuring a sale of intellectual property as a license is that courts generally characterize licenses as being executory in nature due to the ongoing obligations licenses impose on both licensors and licensees. In re Kmart Corp., 290 B.R. 614, 618 (Bankr. N.D. Ill. 2003) (“Generally speaking, a license agreement is an executory contract as such is contemplated in the Bankruptcy Code . . . [and] can impose any number of on-going performance obligations on the parties, including responsibilities relating to reporting, labeling, policing, service, maintenance, and technological upgrades”). Despite this general rule, however, courts do not always find licenses to be executory. Thus, due to this potential risk, and as discussed below, structuring a sale as a non-exclusive license is normally less risky than structuring it as an exclusive license.

In licensing intellectual property, the licensor can choose between two structures: exclusive and non-exclusive.

An exclusive license is one in which the licensor gives the licensee the sole ability to use the intellectual property to the exclusion of itself and third parties. Courts evaluating exclusive licenses have reasoned that, in certain instances, such licenses can resemble a “sale” due to the large portion of rights the licensor transfers under such licenses and, as such, can be found not to be executory. See Kmart Corp., 290 B.R. at 619 (“An exclusive license to use intellectual property . . . may transfer title or ownership to the subject intellectual property. Accordingly, an exclusive intellectual property license would be more likely to constitute a sale because an exclusive license confers upon the licensee (and divests the licensor of) all or some portion of the ownership rights and interests associated with the intellectual property pursuant to well-established principles of patent, copyright and trademark law.”). Therefore, if a debtor-licensee were to seek to continue to use the intellectual property in a scenario in which the exclusive license was found to resemble a “sale”, Section 365 would not require the debtor-licensee to assume the exclusive license, cure any monetary defaults, or continue to pay royalties.

Conversely, a non-exclusive license is one in which the licensor gives the licensee the ability to use the intellectual property but does not exclude third parties nor itself from using the intellectual property. Non-exclusive licenses of intellectual property are almost always considered by courts to be executory contracts because they do not involve the licensor transferring a large portion of its rights. See Id. (“A non-exclusive license typically grants a licensee the mere right to use certain intellectual property; the licensor retains the rights and remedies associated with ownership of the intellectual property. An exclusive license to use intellectual property, by contrast, may transfer title or ownership to the subject intellectual property.”). As such, if a debtor-licensee were to seek to continue to use the intellectual property in a non-exclusive license scenario, Section 365 would require the debtor-licensee to assume the non-exclusive license, cure all existing monetary defaults, and continue to perform in the future by, inter alia, paying any ongoing royalties to the licensor.

Thus, as discussed, a non-exclusive license would have greatly benefitted the drug developer in Mallinckrodt as it would have preserved the drug developer’s right to receive future royalties from the debtor in the event the debtor intended to continue to use the intellectual property. Due to the more clear executory nature of non-exclusive licenses, if the drug developer would have structured the sale as a non-exclusive license, the debtor in Mallinckrodt would have been forced to either assume or reject the contract. Put to this choice, the debtor would likely have been reluctant to reject the contract as doing so would have deprived it of the right to sell the drug, which “hit almost one billion dollars” in sales prior to the bankruptcy.[1] Mallinckrodt, 99 F.4th at 620.

Conclusion

The Third Circuit’s Mallinckrodt decision serves as a reminder to developers of intellectual property to keep bankruptcy in mind when structuring their transactions. A useful structure, depending on the situation, could be to grant the rights as a non-exclusive license, due to the benefits it can provide in the event of a licensee bankruptcy. Developers of intellectual property would benefit from consulting with bankruptcy counsel to better understand how to mitigate potential bankruptcy risks when contemplating a transfer of rights.

[1] Though not the main focus of this article, the drug developer would have had an additional benefit had it structured its intellectual property sale as a non-exclusive license. As a general rule, Section 365 overrides any anti-assignment provisions in executory contracts or unexpired leases, and, thus, debtors have the right to freely transfer their contract rights. One of the exceptions to this right is in the context of non-exclusive licenses of intellectual property. If a non-exclusive license of intellectual property includes a clause prohibiting the assignment of the non-exclusive license without the consent of the licensor, Section 365 has been interpreted to make such anti-assignment provisions enforceable in bankruptcy. See e.g., In re Golden Books Family Entertainment, Inc., 269 B.R. 300, 310 (“prevailing case law holds that nonexclusive intellectual property licenses do not give rise to ownership rights and cannot, as a matter of law, be assigned without the consent of the licensor”).