The Edge of Discretion

30 Aug The Edge of Discretion

The advent of the information age has given rise to economies built not on steel, but on ideas.  It is therefore no surprise that intellectual property assets have assumed an increasingly important component of firm balance sheets – and firm value – throughout advanced economies worldwide.

And yet, though the value of intellectual property is universally recognized and the rights attaching to it increasingly protected, “knowledge assets” are not always treated in the same manner whenever – and wherever – the firm enters restructuring or liquidation.  The story of Qimonda AG is the story of what happens when one country’s rules governing the treatment of an insolvent firm’s intellectual property collide with those of another.

 As the following post suggests, that story is far from over.

Quimonda AG’s Insolvency.

Qimonda AG (Qimonda), a producer of Dynamic Random Access Memory (DRAM) chips, also holds a portfolio of approximately 12,000 patents.  A little more than one-third of this intellectual property originated in the US (i.e., it consists of US patents or pending applications); the balance is of German or other international origin.

Over a 13-year period, Qimonda entered into a series of joint venture and cross-licensing agreements with a number of semiconductor manufacturers.  Under those agreements, Qimonda and these manufacturers cross-licensed tens of thousands of patents.

During 2007 and 2008, prices for PC-based DRAM technology collapsed.  Despite efforts to restructure, Qimonda entered German insolvency proceedings in January 2009.  The Munich court overseeing the proceeding appointed Dr. Michael Jaffé as Qimonda’s insolvency administrator.

Subsequently, Dr. Jaffé sought and obtained recognition in the US for Qimonda’s German insolvency proceeding.  Dr. Jaffé also obtained concurrent, discretionary relief making certain sections of the US Bankruptcy Code applicable to Qimonda’s Chapter 15 proceeding.  These sections included Section 365, which governs executory contracts – including licensing agreements.

Both the German Insolvency Code and the US Bankruptcy Code address the administration of executory contracts.  However, US insolvency practitioners will be aware the US Bankruptcy Code – specifically, section 365(n) – protects the intellectual property licensees of a bankrupt licensor.  Under this subsection, the licensee – at its own option – may preserve its rights under an intellectual property license, despite the bankruptcy trustee’s efforts to reject the license.

The German Insolvency Code provides no such protection.  Instead, Section 103 of that statute simply provides that the court-appointed insolvency administrator may elect performance of contractual obligations or affirm that they remain unenforceable against the estate by electing non-performance.

Dr. Jaffé’s Proposed Treatment of Qimonda’s Cross-Licensing Agreements.

Sometime after obtaining recognition and discretionary relief in Virginia, Dr. Jaffé, acting pursuant to German law, provided notification to certain of Qimonda’s cross-licensing partners of his elected non-performance of Qimonda’s patent cross-licensing agreements.

Those partners, understandably, protested – and argued further that Section 365(n) (made applicable to Qimonda’s Chapter 15 proceeding at Dr. Jaffé’s own request) now prohibited Dr. Jaffé from electing non-performance.  In response, Dr. Jaffe sought the US Bankruptcy Court’s amendment of his previously-granted relief in order to clarify the basis for his non-performance of the cross-licensing agreements.  Specifically, Dr. Jaffé sought a modification of the prior order to provide that Section 365 (and, therefore, Section 365(n)) would be applicable only in such instances where he sought rejection of agreements pursuant to the US statute.

The Cross-Licensing Partners’ Appeal.

Following a hearing held 28 October 2009, US Bankruptcy Court Judge Robert Mayer issued a decision granting Dr. Jaffé’s further request, thereby clearing the way for him to elect non-performance of the cross-licensing agreements under German insolvency law.  Qimonda’s partners promptly appealed to the US District Court for Virginia’s Eastern District, arguing (i) that Section 365 – including Section 365(n) – applies automatically to foreign proceedings recognized under Chapter 15 (and, presumably, may therefore not be “modified” or otherwise trifled with by the Bankruptcy Court in the manner proposed by Dr. Jaffé); and, further (ii) that principles of comity applicable under US case law (and the provisions of Chapter 15) did not require the requested modification of the Bankruptcy Court’s prior order.

In an appellate decision issued 2 July 2010, US District Judge Thomas Selby (Tim) Ellis III remanded the matter back to Judge Mayer for further clarification of two issues – one factual, one legal.  Along the way, however, Judge Ellis offered several important observations regarding the construction of Sections 1521(a) (governing the provision of “any appropriate relief” to the representative of a recognized foreign proceeding) and 1509(c) (governing a recognized administrator’s requests for comity).

Section 1521(a).

A significant portion of Judge Ellis’ 36-page decision is devoted to the conclusion that Section 365 of the US Bankruptcy Code does not apply automatically upon recognition of a foreign “main proceeding.”  This seems unremarkable, given that a simple reading of Section 1520(a) makes only select provisions of the Bankruptcy Code applicable automatically in Chapter 15, and that Section 365 is not among them.  As a result, Section 365 – available to a foreign representative only through specific request pursuant to Section 1521(a) – is susceptible to selective or otherwise limited application by the US Bankruptcy Court.  Indeed, the Bankruptcy Court may determine it does not apply at all.

Far more interesting is Judge Ellis’ conclusion that Dr. Jaffe’s request had been granted without the requisite balancing test set forth in Section 1522.  That section requires that, upon a request for modification of relief previously granted through Section 1519 or 1521, the Court may so modify only after ensuring that “the interests of the creditors and other interested entities, including the debtor, are sufficiently protected.”  11 U.S.C. §1522(a).  Because the evidence relied upon by the Bankruptcy Court to balance creditors’ interests was “anemic,” Judge Ellis remanded the matter for a more full-bodied factual inquiry.

Specifically, Judge Ellis directed focus on two primary issues:

How the application of § 365(n) would unavoidably “splinter” or “shatter” the Qimonda patent portfolio “into many pieces that can never be reconstructed,” thereby diminishing its value and rendering the Qimonda patent portfolio essentially unsalable  (“Left unexplained, in particular, is why this is so, given that the continuation of appellants’ non-exclusive licenses for an unspecified percentage of the Qimonda patent portfolio would preclude neither the sale of the patents themselves nor the grant of additional, non-exclusive licenses.”).

The nature of the U.S. patents licensed to appellants, and whether cancellation of licenses for those patents would put at risk appellants’ investments in manufacturing or sales facilities in this country for products covered by the U.S. patents (“At best, the Bankruptcy Court stated (i) that the application of dissimilar bankruptcy laws to different portions of Qimonda’s patent portfolio ‘may well be detrimental to parties who are or wish to license patents,’ and (ii) that appellees’ demanding that appellants pay new licensing or royalty fees was an ‘unfortunate but an inevitable result’ of Qimonda’s insolvency . . . . It is not readily apparent why this is so.”).

Though leaving little doubt that Section 365’s applicability to a Chapter 15 proceeding was entirely within the Bankruptcy Court’s sound discretion, Judge Ellis nevertheless observed that “the Bankruptcy Code nonetheless ‘limits the opportunity for a completely unencumbered new beginning to the honest but unfortunate debtor,’ as ‘statutory provisions governing nondischargeability reflect a congressional decision to exclude from the general policy of discharge certain categories of debts.’”

Under Judge Ellis’s reading of Sections 1521 (and 1522), a Bankruptcy Court enjoys broad discretion – not only to provide “any appropriate relief” to a foreign representative, but to further amend, modify, or terminate the same relief – provided that the Court engage in the affirmative exercise of articulating why the interests of the debtors and the creditor are protected.

Section 1509(c).

Judge Ellis’ treatment of judicial discretion did not end with Section 1521.  On appeal, Qimonda’s cross-licensing partners also called into question the Bankruptcy Court’s decision to grant comity to Dr. Jaffé’s application of German insolvency law to the cross-licensing agreements.

By contrast to the broad discretionary application of “appropriate relief” under Section 1521, Judge Ellis found that a US Bankruptcy Court’s discretion regarding the comity to be afforded determinations rendered under foreign law and pursuant to Section 1509 is far more limited:

Section 1509 states, in mandatory terms, that “a court in the United States shall grant comity or cooperation to the foreign representative.” 11 U.S.C. § 1509(b)(3) (emphasis added).  . . .  [U]nder the plain terms of § 1509(b)(3), the Bankruptcy Court lacked general discretion to deny the Foreign Administrator’s request for comity; rather, the Bankruptcy Court could only have refused to defer to German Insolvency Code § 103 on the ground that applying German law, instead of § 365(n), would be “manifestly contrary to the public policy of the United States” under § 1506.  Put another way, §§ 1509(b)(3) and 1506, read in pari materia, provide that comity shall be granted following the U.S. recognition of a foreign proceeding under Chapter 15, subject to the caveat that comity shall not be granted when doing so would contravene fundamental U.S. public policy.

What sort of foreign relief would “contravene fundamental US public policy?”

Judge Ellis’ review of decisions addressing the “public policy” exception to Chapter 15’s comity mandate indicated that the focus of this exception is on (i) procedural inequity (e.g., a lack of “due process” as that term is commonly understood by US courts); and (ii) frustration of a US court’s ability to administer the Chapter 15 proceeding and/or severe impingement of a U.S. constitutional or statutory right, particularly if a party continues to enjoy the benefits of the Chapter 15 proceeding (e.g., frustration of the “automatic stay” made applicable upon recognition of Chapter 15).

However, Judge Ellis further found that – as with the “balancing test” required by Section 1522 – the Bankruptcy Court had not gone far enough in its analysis.

Congress enacted Section 365(n) in direct response to contrary case law and in order to protect the US-based licensees of intellectual property.  Yet the entire section is subject to modification or amendment in Chapter 15 upon the Bankruptcy Court’s discretion – or not applicable at all.

In light of these mixed judicial signals, is the protection of Section 365(n) therefore “fundamental?”  Or not?  In granting Dr. Jaffé’s request, the Bankruptcy Court had not explicitly decided this question, so Judge Ellis direct that it do so upon remand.

What Does It Mean?

Judge Ellis’ Qimonda decision is significant for its analysis of Sections 1509 and 1522 – it appears to endorse, at least in general terms, the flexibility required of an internationally-oriented recognition statute and the latitude potentially available to recognized foreign representatives.

However, Judge Ellis’ Qimonda analysis is perhaps most significant for what it doesn’t say.  It leaves unanswered what general factors courts might apply to the “balancing test” of creditors’ and debtors’ interests mandated by Sections 1521 and 1522.  And though it describes the outer bounds of “fundamental US public policy” such that otherwise-mandatory comity ought not to apply to the determinations of non-US tribunals, it does little to address the import (if any) to be derived from Congressional amendments specifically intended to protect the rights (or the interests) of general or special US economic interests.