Third Circuit: Unsecured Claim for Royalties from Intellectual Property Purchased by Debtor Discharged Under Chapter 11 Plan
Mitigating risk of loss associated with a bankruptcy filing should be an element of any commercial transaction, especially if it involves a sale or license of intellectual property rights. A ruling recently handed down by the U.S. Court of Appeals for the Third Circuit provides a stark reminder of the consequences of when it is not. In In re Mallinckrodt PLC, 99 F.4th 617 (3d Cir. 2024), the Third Circuit ruled that, in the absence of any security, a claim asserted by the seller of intellectual property rights for contingent royalties payable under the sale agreement was a prepetition unsecured claim that was discharged when the bankruptcy court confirmed the debtor-buyer's chapter 11 plan.
Bankruptcy Code's Broad Definition of "Claim"
As part of the overhaul of bankruptcy laws in 1978, Congress for the first time included the definition of "claim" as part of the Bankruptcy Code. Specifically, section 101(5) of the Bankruptcy Code provides that the term "claim" means:
(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or
(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
11 U.S.C. § 101(5). "By fashioning a single definition of 'claim' in the Code, Congress intended to adopt the broadest available definition of that term." Collier on Bankruptcy ¶ 101.05 (16th ed. 2024).
Section 101(12) of the Bankruptcy Code, in turn, provides that a "debt" means "liability on a claim."
When a debt or claim "arises" is of crucial significance in bankruptcy. In a chapter 11 case, section 1141(d) of the Bankruptcy Code provides in relevant part that, except for debts of individual debtors excepted from discharge under section 523 or debts of liquidating corporations, and except as otherwise provided in a chapter 11 plan or the order confirming it, "the confirmation of a plan … discharges the debtor from any debt that arose before the date of such confirmation," whether or not the claimant has filed a proof of claim, the claim has been allowed, or the claimant voted to accept the chapter 11 plan. 11 U.S.C. § 1141(d) (emphasis added).
In 1984, the Third Circuit was the first court of appeals to examine the Bankruptcy Code's new definition of "claim" in Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984). Focusing on the "right to payment" language in that definition, the court decided that a claim arises when a claimant's right to payment accrues under applicable non-bankruptcy law. Id. at 337. Thus, because a claim for indemnification or contribution under New York law did not arise until asserted, the Third Circuit held that the automatic stay did not preclude a chapter 7 debtor's accountant from filing a third-party complaint against the debtor for indemnification or contribution in state court litigation commenced by a bank against the accountant seeking damages for its prepetition preparation of the debtor's financial statements. Id.
This "accrual" test was widely criticized by other circuit courts as contradicting the broad definition of "claim" envisioned by Congress and the Bankruptcy Code. See, e.g., Cadleway Props., Inc. v. Andrews (In re Andrews), 239 F.3d 708, 710 n.7 (5th Cir. 2001) (stating that the Frenville "accrual test" has been "universally rejected"); Grady v. A.H. Robins Co., 839 F.2d 198, 201 (4th Cir. 1988) ("We have found no court outside the Third Circuit which has followed the reasoning and holding of Frenville. All of the cases coming to our attention which have considered the issue have declined to follow Frenville's limiting definition of claim.").
In 2010, the Third Circuit decided JELD-WEN, Inc. v. Van Brunt (In re Grossman's Inc.), 607 F.3d 114 (3d Cir. 2010), and expressly overruled Frenville (as well as the 26 intervening years of precedent). In its en banc decision, the court adopted the "exposure" test, a version of the "conduct" test used by other courts. Id. at 125. It held that an asbestos claim is presumptively discharged under a confirmed chapter 11 plan if exposure occurred before bankruptcy, even though the injury was not manifested until years afterward. Id.
However, the court stressed that regardless of the applicable definition of "claim," due process considerations remained an important part of the determination of whether a claim had been discharged, and consequently it remanded the due process analysis to the bankruptcy court. Id. at 125–26. The applicability of Grossman's outside of the asbestos (or tort) context initially was uncertain. In Mallinckrodt, however, the Third Circuit rejected a contract counterparty's attempt to extend the "exposure" test announced in Grossman's to contingent, unliquidated royalty claims payable under a prepetition contract.
Mallinckrodt
In 2001, pharmaceutical company Sanofi-Aventis U.S. LLC ("Sanofi") sold certain intellectual property ("IP"), including trademarks and regulatory rights, relating to Acthar Gel, a drug that relieves chronic inflammation and treats autoimmune diseases, to Mallinckrodt plc (the "debtor"). Sanofi-Aventis U.S. LLC v. Mallinckrodt plc (In re Mallinckrodt plc), 646 F. Supp. 3d 565, 567 (D. Del. 2022), aff'd, 99 F.4th 617 (3d Cir. 2024). Under the sale agreement, the debtor paid Sanofi $100,000 in cash and promised a perpetual royalty of 1% of all annual net sales exceeding $10 million. Id. The debtor granted Sanofi a purchase-money security interest in the Acthar Gel IP to secure the debtor's obligation for the upfront payment, but not the royalty. Id. For many years, the annual royalty was substantial, with annual sales of Acthar Gel in 2019 amounting to nearly $1 billion. Mallinckrodt, 99 F.4th at 620.
In October 2020, the debtor filed for chapter 11 protection in the District of Delaware. As of the filing date, the debtor faced several billion dollars of legal liabilities related to the opioid epidemic and Acthar Gel rebates. Although the debtor continued to manufacture and sell Acthar Gel postpetition, it breached the sale agreement with Sanofi by, among other things, failing to pay royalties. Mallinckrodt, 646 F. Supp. 3d at 566–67.
In 2021, Sanofi filed a motion seeking a determination that the sale agreement was not an executory contract and that its claim for postpetition royalty payments was not dischargeable or, in the alternative, that the sale agreement was executory and the debtor could not continue to sell Acthar Gel if it rejected the sale agreement. Id. at 566.
The bankruptcy court ruled that that the sale agreement was not executory because Sanofi had fully performed its obligations under the agreement by transferring its ownership rights in Acthar Gel to the debtor two decades earlier. Id. at 566–67. The bankruptcy court further concluded that Sanofi's claims for breach of the sale agreement were unsecured claims that would be discharged by operation of section 1141(d) of the Bankruptcy Code upon confirmation of the debtor's chapter 11 plan.
The district court affirmed on appeal, reasoning that Sanofi's contingent claim for future royalties arose at the time of the sale, and because Sanofi did not retain a property interest in the Acthar Gel IP, Sanofi held only an unsecured claim for breach of the agreement that would be discharged upon plan confirmation. Id. at 569–70. Sanofi appealed to the Third Circuit.
The Third Circuit's Ruling
A three-judge panel of the Third Circuit affirmed the district court's decision.
Writing for the panel, U.S. Circuit Court Judge Stephanos Bibas explained that, because Sanofi's right to payment of royalties under the sale agreement was a "claim" under section 101(5)(A) of the Bankruptcy Code, and because that right to payment arose pre-bankruptcy, Sanofi's claim for royalties was dischargeable in bankruptcy pursuant to section 1141(d)(1)(A) of the Bankruptcy Code. Mallinckrodt, 99 F.4th at 621.
The Third Circuit panel rejected Sanofi's argument that the future royalties from Acthar Gel were too indefinite to be a "claim." Judge Bibas explained that Sanofi's "argument fails because the Bankruptcy Code allows for claims that are both contingent and unliquidated." Id. at 620 (citing 11 U.S.C. § 101(5)(A)). According to Judge Bibas, Sanofi held a contingent claim for future royalties because its right to payment was not fixed until triggered in accordance with the express terms of the sale agreement—i.e., by the debtor's sale of more than $10 million of Acthar Gel in any given year. Id. at 621. Sanofi's contingent claim was also unliquidated because the amount of the royalties payable in any given year would not be ascertained or determined until the end of the year. Id.
The Third Circuit distinguished Grossman's and concluded that Sanofi's contingent and unliquidated claim for royalties arose at the time that Sanofi and the debtor signed the sale agreement. Id. Judge Bibas rejected Sanofi's argument that, like a tort claim, its claims for royalties would not arise until Sanofi was harmed by the debtor's "injurious conduct" at the time that the debtor met the sales trigger and refused to pay royalties. Id. "[T]he tort analogy is inapt," Judge Bibas wrote, because the "regular rule" applies: "most contract claims arise when the parties sign the contract." Id. (citations omitted).
According to the Third Circuit panel, "once the parties agree to a contingent right to payment, the claim exists," and even the Third Circuit's overruled decision in Frenville correctly concluded in dicta that, "once the claim exists, bankruptcy can reach it." Id.
Judge Bibas noted that certain contract claims might be exceptions to the general rule if, for example, "fairness might compel special treatment" where: (i) the debtor's postpetition "conduct is so unexpected that the contract could not give the creditor notice"; or (ii) "a debtor games bankruptcy, wielding it as both a sword and a shield." Id. (citations omitted). Sanofi confused these exceptions to the general rule, Judge Bibas explained, because nothing in the language of sections 101(5)(A) or 1141(d)(1)(A) or the out-of-circuit decisions it relied on support the contention that a claim does not exist in bankruptcy until it is triggered by a debtor's postpetition conduct, as distinguished from an "extrinsic event." Id. at 621. Moreover, he noted, the facts in Mallinckrodt "d[id] not involve lack of notice or games-manship" justifying an equitable exception. Id. at 621–22.
Finally, the Third Circuit panel faulted Sanofi, a sophisticated party, for agreeing to a deal that left it unprotected in the event the debtor filed for bankruptcy:
To protect itself, Sanofi could have structured the deal differently. It 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. But it chose not to do so. Instead, it sold its rights outright, leaving itself with only a contingent, unsecured claim for money. And under the Bankruptcy Code, that claim is dischargeable.
Id. at 622.
Outlook
Mallinckrodt is a cautionary tale, especially for owners of IP. Selling IP outright in exchange for an upfront cash payment and a contractual obligation to pay royalties without taking a security interest in the property or future royalties may expose the seller to considerable risk in the event that the buyer later files for bankruptcy. The seller in Mallinckrodt could have mitigated its risk by licensing the IP rather than selling it, or by insisting on a deal that secured its right to future royalties, yet it chose not to do so. Instead, the seller was left with a general unsecured claim that, under Mallinckrodt's confirmed plan, likely will receive a pro rata distribution amounting to a small fraction of the future royalties it would have been paid but for the buyer's bankruptcy filing.
Mallinckrodt also reaffirmed the general rule in bankruptcy that a claim "arises" under a contract at the time that the contract is signed, rather than when a payment obligation under the contract is triggered or matures.
