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les Nouvelles June 2015 Article of the Month
Insolvency Impact on Licensing in China

Christopher ShaoweiChristopher Shaowei

Managing Partner
NTD Law Office
Beijing, P. R. China

Shaojie ChiShaojie Chi

NTD Law Office
Beijing, P. R. China

There is no well-established legal framework in China with regard to how to handle the executory licensing contracts in the proceeding of bankruptcy for either of the contractual parties. China does have its Bankruptcy Law though, stating little on how to fairly and properly treat an executory licensing contract for the mutual benefit of both the insolvent party and its counterparty in the licensing deal. As it is, what we are going to discuss is based primarily on our understanding of the prevailing Chinese law, which may have influence upon an executory license concluded by an insolvent party.

Relevant Governing Law

Under the Chinese law, parties of cross-border licensing deals may have freedom to choose the law to govern the contract, and the jurisdiction over any dispute that could arise under the contract. Nevertheless, the chosen law can only be used to interpret the contractual terms and conditions, and as the substantive law in the dispute resolution thereabout. It can hardly be used against the bankruptcy law in the judicial bankruptcy proceeding going on in a Chinese court, due to the fundamental reason that the chosen law relates to the two contractual parties alone, while the bankruptcy law governs the legal relationship among debtors of different sorts and the insolvent entity. Furthermore, bankruptcy law shall normally be applied in accordance with the venue where the insolvent entity was formed and registered as well as the business operation. For example, if a license is concluded between German and Chinese entities and the Chinese party goes bankrupt, irrespective of the governing law under the license being German law, the insolvent Chinese party shall have the priority to say yes or no on the continuity of the license, in accordance with PRC Bankruptcy Law, because the could-be bankruptcy proceeding shall be initiated with a Chinese court. Say, the subject matter under the license is a German patent or trademark owned by the Chinese party, the said IPR shall be categorized as the assets, i.e. the overseas assets of the insolvent party, to be liquidated.

Under PRC Contract Law, which is the fundamental governing law of licensing deals in China, either party may be entitled to a contractual unilateral right to terminate the contract, upon certain agreed conditions being met, before the expiration of the contract, or be entitled to a mandatory unilateral termination right under Article 94 of PRC Contract Law: while under Article 18 of PRC Bankruptcy Law, the administrator of the insolvent entity shall be entitled to declare an executory contract null and void. Legally speaking, in the case of conflict between the two rights, the latter prevails, i.e. irrespective of contractual right to unilaterally rescind the contract by either party of a license, the insolvent party shall have the final say on the fate of the on-going license, which nevertheless shall not preclude the counterparty’s right to resort to a remedy under the Contract Law and the terminated license.

Could-Be Impacts and Potential Ways-Out

1. Insolvent Licensee
More often than not, the licensor would rather terminate the license when the licensee goes insolvency; and it is extremely true when the licensed subject matter is a trademark with a good reputation in particular, let alone the licensed subject matter being a patent or know-how which needs to be exploited properly with strictly regulated production facilities and conditions. Nevertheless, when the insolvent licensee prefers to keep the license going to the common interest of its debtors, the licensor can do nothing but request the licensee to provide a sort of performance guarantee, e.g. performance bond, mortgage, pledge, etc. in accordance with Article 18 of PRC Bankruptcy Law. If the insolvent licensee fails to do so, the license shall be terminated. So the question is whether the administrator or any of the debtors would like to give the licensor a sort of performance bond. The other way-out we suggest is to lay down in the license at the time the contract is signed that immediately when the licensee goes bankrupt, the license shall become null and void automatically. This will lead to a legal issue as to which one shall prevail, the automatic termination or unilateral termination? We incline to the answer the automatic termination. The legal source is that under Article 45 of PRC Contract Law: the parties may agree on some collateral conditions relating to the enforceability of a contract, and the contract with mutually agreed dissolving conditions shall be null and void when such conditions are accomplished; meaning that the license shall be automatically (without any action by the parties) invalidated prior to the insolvent licensee having a chance to decide on a possible continued performance. On the other hand, in terms of the sequence and timing in the course of the proceeding of a valid contract, automatic termination happens immediately when the stipulated contractual conditions are met, which is absolutely earlier than either party can make a decision based upon the situation that happened. In the case of an exclusive license and there being certain sub-licensees, the licensor is better off to get the master license rescinded and negotiate new arrangements directly with the sub-licensees, if the licensor is willing to do so. What if the insolvent licensee introduces a third party, say, one of its debtors, and asks for the transfer of the existing license? It depends upon the licensor’s willingness, because assignment of contractual rights and obligations shall be subject to the approval of the counterparty as stipulated by the Contract Law. Sometimes, this sort of arrangement might be beneficial to both of the licensing parties, provided that the assignment or transfer does no harm to the licensor.

2. An Insolvent Licensor
This situation is more complicated than where the licensee is insolvent. This is because the insolvent party has the final say on the future of the license. As an example, in a case concerning a trademark dispute in China, the goodwill (appraised as approximately USD 18 B.) attached to the licensed TM was cultivated and developed by the licensee over the period of 10-years under the license. Prior to the granting of the license, the TM was only a locally used mark with little market value. The consideration for the grant was the payment of a relatively low annual fee. Suppose that the licensor becomes bankrupt. The most likely consequence would be that it would declare the license null and void; especially in view of the low annual lump-sum royalty payment arrangement. Since the license was built up on a fixed-royalty payment arrangement, it will be unfavorable for the licensor to collect the low royalty as fixed at the time of signing the license when the licensed trademark was less well-known to the consumers, if the licensor decides to adopt the license. However, from the licensee’s point of view, it prefers to get the license being continued because of the value it has added to the TM. What is more, even if the licensee could obtain a favorable judgment or arbitration award because of the loss it would suffer with the termination of the license, how to get it enforced is a further problem to be faced by the licensee. As the licensor is bankrupt, the licensee can do no more than be listed as an ordinary creditor in the bankruptcy proceeding. The potential way-out is for the licensee to try to obtain the mark at as low a value as possible when the TM is auctioned. The licensee might argue that the appraised value of USD 18 B. is connected with it rather than the insolvent licensor; and that if the mark is separated from the licensee who cultivated and developed the market reputation of the mark, its value will be substantively lessened. If the licensee cannot obtain the licensed trademark at a price acceptable to it, it may be forced to adopt a new brand and conduct an extensive advertising campaign to make it known to consumers that the product is the same, but with a changed mark applied to it.

Negotiating a possible assignment of the licensed TM could be a way-out for the licensee, but there is considerable uncertainty in the result because the negotiator from the licensor’s side will not be the representative of the insolvent licensor itself; but the administrator of the insolvent entity, who has a duty to maximize the benefit to all the listed creditors of the bankrupted. Thus, whether or not the licensee may get the licensed subject matter at a favorable price will be subject to the principle of maximizing the common interest of all the debtors of the insolvent licensor. On the other hand, if the administrator and the licensee agree, they may negotiate an arrangement to put the licensed subject matter into an escrow account held by a third party, and keep the existing license going, with the royalties paid, or to be paid, to be incorporated into the account representing the money received from the realization of the licensor’s assets. Where a sublicense is involved, rescinding of a master license may also result in the sub-license being terminated. If that is the case, the licensee may be sued by the sub-licensee for breach of contract. Thus, when concluding a sub-license, it is advisable to include a clause of automatic termination upon the master licensor becoming bankrupt and the master license being terminated.

3. Cross-Licensing
In the existing Chinese legal framework, assignment of licensed subject matter shall not affect a prior existing license containing the assigned IPR. Based upon this general principle, irrespective of who will be the new owner of the assigned subject matter, the counterparty shall be entitled to continue the use of the licensed subject matter. In case of an essential standard patent, if the signing party to the standard organization is allowed to quit the agreement, it will be uncertain whether the new owner of the assigned patent would quit or not. Nevertheless, there is one thing which is certain, if the new owner decides to quit, it shall not have further cross-licensed right to use others’ patents, meaning that it may totally give up the existing business.

4. Public Interest or Policy
Legally speaking, irrespective of mandatory or contractual rights enjoyed by a party, public interest or policy consideration may be taken by a court in the proceeding. Sometimes, even if the insolvent party decides to terminate an executory license, the court may apply public interest or policy principle to make a judgment to the contrary. Say, in a case where the counterparty is a public utility entity, termination of the existing license may seriously affect the public interest; the court may declare the license continuously enforceable upon the counterparty’s request. If that is the case, the insolvent licensee may ask for the transfer of the license to a capable entity; or the insolvent licensor may get the licensed subject matter auctioned, which does not have too much negative impact upon the existing license.

It has not been long since China has established a modern market economy, and there are not many influential case reports in that regard. Although, properly handling appropriate relations between the insolvent party and counterparty of an executory license is possible within the current legal framework in the country, irrespective of varying combined situations.