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March 2013

At a time when well-known names are disappearing from the high street as a result of retailers going into administration, the spectre of corporate insolvencies has never loomed larger.  The life sciences sector is feeling the pressure for a number of well-documented reasons: a difficult funding environment, a challenging regulatory landscape and dwindling pipelines, and these all – sadly - mean that insolvencies in the sector are happening and will continue to happen.  So it is prudent for any life sciences company to consider the potential impact of the insolvency of its counterparty in each agreement that it enters into.  This article considers in particular the impact on IP licences.

What is "insolvency"?

In the UK, a company can become "cash flow insolvent" – meaning it is unable to pay its debts as they fall due – or "balance sheet insolvent", where its liabilities exceed its assets.

What are the main insolvency procedures?

The Insolvency Act 1986, as amended, along with the Companies Act 2006, provides a comprehensive toolbox of different procedures that creditors and debtors may take advantage of.

Administration is the procedure most widely used where a company is a trading company that has a good business which has too many liabilities in his current form to trade solvently or which needs the breathing space of a moratorium.  Administration gives rise to a statutory moratorium, which prevents creditors from taking any action against the company, its property or assets.  The administrators must act in the best interests of all creditors regardless of who has appointed them.  They have a statutory obligation to perform their functions with a view to rescuing the company (not the business) as a going concern, or if that is not reasonably practicable to achieve a better realisation for all creditors than on a liquidation, or if that is not reasonably practicable, to pay a dividend to secured or preferential creditors.   In most cases a rescue of the company is not possible and the administrators will sell the business and assets of the company as a going concern to enable distributions to be made to creditors.

If it is considered that it is unlikely that the business could be sold as a going concern and the business simply needs to be wound down in an orderly fashion then it is more likely that the company will be placed into liquidation – also referred to as "winding up". 

Creditors of an insolvent company that has entered administration or liquidation will be paid in accordance with a statutory order of priority.  In very brief terms, the administrator or liquidator will take their fees and expenses from the proceeds of realisation, and then distributions will be made to the preferential creditors (employees and certain pension scheme payments), the holders of charges over the company’s assets (so called "secured creditors", such as banks) and finally to all other creditors ("unsecured creditors", such third parties owed sums under contracts). 

Liquidators and administrators both have wide ranging powers to enable them to fulfil their statutory obligations and duties.   Liquidators have some additional powers enabling them to disclaim contracts and bring wrongful trading proceedings against the directors.

Liquidators and administrators must be licensed insolvency practitioners.

Issues for licensees with an insolvent licensor

As a life sciences company, you may very well have one or more crucial IP licences on which your business depends.  You should consider carefully what the impact would be on your ability to continue to exploit that IP in the event that the licensor becomes insolvent and where possible consider taking proactive steps to protect your interests.

The US has a statutory regime in place that provides for the protection of licensees' interests in certain circumstances upon a licensor's insolvency.  This often leads licensees to assume that a similar regime will protect their interests in the UK.  This is not, however, the case.

The appointment of an administrator or liquidator will not in itself cause a licence to terminate unless the terms of the licence expressly provide that upon the administration or liquidation of the licensor the licence will automatically terminate. Generally, a licence will only automatically terminate upon the insolvency of the licensee rather than the licensor. However, the licensor's insolvency will give rise to a number of immediate risks to the licence for a licensee to consider.

What happens if the insolvency practitioner sells the underlying IP to a third party?

In most instances the insolvency practitioner will attempt to sell all of the business and assets of the company as a going concern because this generates greater realisations than a sale of the assets on a piecemeal basis.  In a going concern sale the insolvency practitioner will generally sell all of the intellectual property and goodwill of the company without any representations or warranties as to the quality, value or validity of the assets and subject to the rights of any third parties.  It is for the purchaser to carry out due diligence and take on the risk that the asset cannot be used or a third party has competing rights, because generally the purchaser is paying less than they would pay in a solvent situation.

If there is an immediate sale of the intellectual property then a licensee will need to liaise with the purchaser about the whether the licence is to continue.  It is important to note that if a licensee has not registered its interest at the UK Intellectual Property Office and in the other relevant jurisdictions where the patents have been applied for or granted the purchaser will be entitled to take the intellectual property free of the licence and will not be required to honour the licence.

An administrator may sell the business and assets by way of a "pre-pack administration".  This is where the sale and purchase agreement is agreed prior to the appointment of the administrator and then the sale is completed immediately after his appointment.  In this case, by the time the licensee finds out that the licensor has entered administration the licensed intellectual property will already have been sold to a third party.

If there is not a pre-pack and the licensee learns of the administration or liquidation it could itself put in an offer to purchase the intellectual property so that it owns it direct rather than operate via a licence.

Does the insolvency practitioner have to comply with the licensor’s obligations under the licence?

Subject to the terms of the licence, generally a licensor’s obligations will be to renew any registration, monitor the use of the intellectual property pursuant to the licence and sue any infringers and collect the royalties.   If the insolvency practitioner does not pay the renewal fees in respect of the licence this will jeopardise the continued existence of the IP rights.

An insolvency practitioner is not necessarily bound to comply with the licensor’s obligations.  There have been recent cases where the Court has held that an administrator may breach a contract where they are acting in good faith and in the best interests of all creditors, and liquidators may disclaim onerous contracts.  A contract may be considered "onerous" if it is unprofitable or gives rise to a liability to pay money or perform any other onerous act.

Subject to the terms of the licence, a licensor’s obligations may not be considered to be onerous.  If the intellectual property is worth considerably more if the licence is disclaimed then the liquidator may consider disclaimer as an option, but this is rare.  In most cases the insolvency practitioner will sell the intellectual property subject to the licences, or dissolve the company at the end of the liquidation with the intellectual property still owned by the company. In the latter case, the intellectual property will then pass to the Crown bona vacantia and the licensee will need to liaise with the Treasury Solicitor to see whether it can purchase the intellectual property.

Any breach of contract claim that a licensee is able to bring, which in itself will probably be difficult, is likely to be an unsecured claim.  As this ranks behind the preferential and secured creditors the chances of full recovery are virtually non-existent.

Should the licensee continue to pay any royalties?

If the licence has not been terminated on its terms and the insolvency practitioner continues to trade the licensor company, then the licensee should consider continuing to pay any royalties that are due pursuant to the licence.  Failure to do so will otherwise probably give the licensor the right to terminate the licence.  At this time it is recommended that a licensee contacts the insolvency practitioner to ensure they are aware of the licence and will notify any purchaser of it.  The licensee may also consider making an offer to purchase the intellectual property.

How can a licensee protect its position?

Prudent licensees should:

• Consider their contract terms – what are the termination rights?  Is the licence exclusive?  Can the licence be assigned?
• Register their licence interest on all relevant patent registers at national intellectual property offices, and seek local advice in high value jurisdictions as to how best to protect your position, as registration practices vary.
• Obtain step-in rights to pay renewal fees in the event a licensor threatens not to pay or fails to do so.
• Consider taking security over the licensed intellectual property rights.
• Monitor the financial position of licensors of key IP.
• For critical IP, consider more exotic structures, including requiring the licensor to place the IP in an "insolvency remote vehicle" – a company set up solely to hold the relevant IP and without any other liabilities, thereby reducing the risk of the licensor becoming insolvent.

Sub-licensees of IP should also consider how to protect themselves against the insolvency of their immediate licensor.  If company A grants a licence to company B, and company B grants a sub-licence to company C, company C should ensure that it has a right to require a direct licence from A in the event that B becomes insolvent.  This in turn will require company B to incorporate this obligation on company A in the head licence between A and B.

Issues for a licensor with an insolvent licensee

Licensors should also consider how to protect themselves against the possibility of a licensee becoming insolvent.   In most licences the administration or liquidation of a licensee will give rise to a right to terminate the licence.  However, the licensor may wish to consider whether it should permit the administrator or liquidator to continue to use the licence (and pay royalties!) and then permit a new purchaser to take over the licence.  If the licensor does not approve of the new purchaser it could at that stage, subject to the terms of the licence, terminate the licence or potentially argue the assignment of the licence was invalid.

Protections for a licensor have a number of key elements:

• Financial – there is a risk that a licensor may not receive important milestone or royalty payments if its licensee becomes insolvent.  Licensors should consider front-loading payments under a licence and making royalty payments due as a minimum every quarter.  Any amounts due from an insolvent licensee will leave a licensor with a claim alongside the other unsecured creditors.
• Termination rights – licensors should be able to terminate the licence upon a licensee’s insolvency (or ideally an earlier trigger, such as a failure to make timely payments under the licence).  A licensee is likely to take the view that termination upon insolvency is not reasonable, as such a termination simply removes further value from the insolvent company and reduces the chances of any sort of rescue.  If a licensee’s insolvency practitioner is still able, and willing, to make payments due under the licence, why should the licensor terminate?
• No unwanted licensees – licensors of valuable IP can often be sensitive as to the identity of their licensees (for example, they may not want competitors to end up as their licensees).  Prudent licensors will therefore want to ensure that the licence cannot be assigned without their consent, and they may also consider a change of control provision, allowing them to terminate where the control of the licensee is transferred to a third party.  However, a change of control provision is unlikely to be popular with a young licensee company thinking ahead to an exit by way of a share sale.

What you can be doing now

Whether a licensor or a licensee, companies should ensure that they take into account the risks of insolvency of their counterparty when negotiating IP licences and other commercial agreements. 

It is also worth reviewing all key IP licences to understand the degree of insolvency protections already included in them, and considering whether further protective measures should be taken, including ensuring that all licensee interests are registered with appropriate national intellectual property offices.  Strong, active management of important licence relationships will also help to identify early warning signs of insolvency.

Insolvencies laws and practices vary from jurisdiction to jurisdiction.  Next month on Synapse we’ll be looking at insolvency issues in other key EU jurisdictions – essential reading for companies with important licences with counterparties in other countries.

For a more detailed guide on both proactive and reactive planning for counterparty insolvency issues, check out our "Safeguarding Your Business" guide, which details the proactive steps that can be taken to protect against third party and counterparty default, as well as how directors and business owners can respond quickly to protect their business if such parties have already defaulted or are about to do so.  

If you have any questions on this article or would like to propose a subject to be addressed by Synapse please contact us.

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