The Bankruptcy Clause: Comforting but Useless

An experienced reader of license agreements would know exactly where to find what I call the “bankruptcy clause” (about three pages before the end). Usually a sub-paragraph under “Termination,” it provides that the licensor may terminate the agreement immediately if the licensee files for bankruptcy.  It usually says something like this:

This Agreement shall automatically terminate if Licensee files a petition in bankruptcy or is adjudicated bankrupt or insolvent, or makes an assignment for the benefit of creditors, or an arrangement pursuant to any bankruptcy law, or if Licensee discontinues its business or if a receiver is appointed for Licensee or for Licensee’s business and such receiver is not discharged within 60 days.

In some cases (where the licensee has as much bargaining power as the licensor) it might be reciprocal, allowing either party the right to terminate the agreement if the other declares bankruptcy.

Why A Comfort

What provision could make more sense? If it didn’t exist, even the most unsophisticated trademark manager would invent it. There are enough risks with choosing licensees, especially the risk that a licensee won’t make accurate and punctual royalty payments. No licensor wants the added risk that a licensee might stop making those payments forever.

Besides, no one wants to be stuck in a deal with a partner in bankruptcy court; no licensor wants to wait for royalty checks in line behind secured and unsecured creditors. A licensee’s bankruptcy filing, moreover, leaves the licensor and its brand, vulnerable to the arbitrary rulings of the bankruptcy judge. At worst, bankruptcy leaves the license agreement itself available to the high bidder at a bankruptcy auction. When presented with that risk, most licensors would choose simply not to license. No wonder they feel comfortable signing license agreements only if they contain a bankruptcy clause.

Why Useless

But how can you take comfort from a contractual provision that no court can enforce? The bankruptcy clause is exactly such a provision. No court can enforce it because federal bankruptcy law prohibits it.

Section 365(e)(1) of the U.S. Bankruptcy Code states as follows:

(1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on–

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B)  the commencement of a case under this title; or

(C)  the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

Although legislators surely weren’t thinking of trademark licensors when they enacted this law, the effect of it is the same whether the contract in question is an office lease or supply contract or trademark license agreement: a bankruptcy clause is not the way to protect oneself from a defaulting partner’s insolvency.  A provision drafted to comfort a licensor will cause it discomfort if and when the time comes, and will invariably be ignored in court.

Why Keep It?

When a contract clause is clearly unenforceable, lawyers and their clients usually agree that it should be deleted. Why does the bankruptcy clause remain? Reading it provides both client and attorney such comfort that neither can bring itself to persuade the other that the space it occupies in the license agreement is worth giving up.

Presumably it makes licensors feel better about the risks they undertake in sharing their trademark with strangers.   Whether or not it constitutes malpractice to imply that including such a provision offers enforceable rights, it would be better to provide that comfort – or something close to it – with contractual provisions that, unlike the bankruptcy clause, can be used and enforced.

Trademark licensors and their counsel should delete the bankruptcy clause from their form license agreements – almost all of which could spare an extra half-page – and find other ways, contractual and practical, to ward off risks from insolvent licensees.  I will discuss such provisions and practices in next month’s column.

From the November/December 2002 issue of The Licensing Letter