Pennsylvania District Court Applies "Hypothetical Test" in Determining that Patent License Agreement Is Assignable in Bankruptcy
Disagreement regarding the interpretation of section 365(c) of the Bankruptcy Code has led to divergent rulings among bankruptcy and appellate courts regarding whether a bankruptcy trustee or a chapter 11 debtor-in-possession ("DIP") can assume an executory contract or unexpired lease that is unassignable under applicable non-bankruptcy law without the counterparty's consent—even where the DIP has no intention of assigning the agreement to a third party. Some courts, including several federal circuit courts, have ruled that, absent counterparty consent, the plain language of section 365(c) prohibits a trustee or DIP from assuming an executory contract or unexpired lease if the contract or lease cannot be assigned under applicable non-bankruptcy law. This is known as the "hypothetical test." However, one federal circuit court, and most bankruptcy courts outside of the circuits that have adopted the hypothetical test, apply what is known as the "actual test," under which a DIP, with bankruptcy court approval, can assume an executory contract or unexpired lease if the DIP intends to perform under the agreement itself, even if the agreement could not be assigned under applicable non-bankruptcy law and the counterparty does not consent to assumption.
The U.S. District Court for the Western District of Pennsylvania addressed this question in Crivella Holdings Ltd. v. MeSearch Media Technologies Ltd., No. 2:25-cv-333, 2025 WL 2443400 (W.D. Pa. Aug. 25, 2025). The district court affirmed a bankruptcy court ruling denying a software licensor's motion for relief from the automatic stay to terminate the license agreement. It reasoned that the license was assumable in bankruptcy under the Third Circuit's hypothetical test as a result of language in the agreement stating that it could be assigned to a "successor in interest" of the debtor without the licensor's further consent, thereby overriding federal patent law's general prohibition against the assignment of patents.
Limitations on the Ability to Assume or Assign Certain Contracts and Leases in Bankruptcy
Section 365(a) of the Bankruptcy Code permits a trustee or DIP (pursuant to section 1107(a)), with bankruptcy court approval, to assume or reject most kinds of executory contracts and unexpired leases. This broad power, however, is limited for certain kinds of contracts. For example, section 365(c)(1) of the Bankruptcy Code provides that a trustee or DIP may not "assume or assign" an executory contract or unexpired lease if "applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession" and such party does not consent to assumption or assignment. 11 U.S.C. § 365(c)(1). The provision is designed to "balance the rights of third parties who contracted with the debtor and whose rights may be prejudiced by having the contract or lease performed by an entity with which they did not enter into the agreement." In re Lil' Things, 220 B.R. 583, 591 (Bankr. N.D. Tex. 1998); see generally Collier on Bankruptcy ("Collier") ¶ 365.07[1][d][i] (16th ed. 2025).
Courts have applied this provision to a wide variety of contracts. Among these are personal service contracts, including employment agreements; contracts with the United States government; certain kinds of franchise agreements; and licenses of intellectual property. See id. at ¶ 365.07[1]. Thus, many debtors (especially those in the technology industry) find that their rights with respect to certain executory contracts are significantly limited in bankruptcy.
The Statutory Muddle
As noted, section 365(c)(1) of the Bankruptcy Code prevents a trustee or DIP from assigning a contract without the counterparty's consent if applicable law prevents the contract from being assigned outside bankruptcy without consent. Section 365(c)(1), however, uses the distinctive phrase "assume or assign," as opposed to "assume and assign," which, at first blush, appears to mean that a trustee or DIP cannot assume such a contract and agree to perform under it, even if the trustee or DIP has no intention of assigning the contract to a third party.
Some courts construe the "assume or assign" language to mean that the statutory proscription applies to a trustee or DIP who seeks either: (i) to assume and render performance under the agreement; or (ii) to assume the agreement and assign it to a third party. Under this literal interpretation, the court posits a hypothetical question: Could the debtor assign the contract to a third party under applicable non-bankruptcy law? If the answer is no, the trustee or DIP may neither assume nor assign the contract. This approach is commonly referred to as the "hypothetical test." The Third, Fourth, Ninth, and Eleventh Circuits have adopted this approach. See In re West Elecs. Inc., 852 F.2d 79, 83 (3d Cir. 1988); RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257, 265–71 (4th Cir. 2004); Perlman v. Catapult Entm't, Inc. (In re Catapult Entm't, Inc.), 165 F.3d 747, 749–55 (9th Cir. 1999); City of Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534, 537 (11th Cir. 1994).
A leading bankruptcy commentator has characterized the hypothetical test as "troubling, as it may prevent a debtor in possession from being able to reorganize under circumstances that do not adversely affect the other party to the contract." Collier at ¶ 365.07[1][d] (citation omitted). Moreover, according to the commentator, application of the hypothetical test is inconsistent with the overall objectives of chapter 11 of the Bankruptcy Code:
As a matter of policy, a refusal to permit debtors in possession to assume otherwise nonassignable contracts would present problems for debtors whenever the debtor's business is one in which major contracts are nonassignable under non-bankruptcy law. Such debtors will not, as a practical matter, be able to avail themselves of the benefits of chapter 11 because they will not be able to perform their prebankruptcy contracts without permission from the nondebtor parties to the contracts.
Id. at ¶ 365.07[1][d][iii].
Other courts, having determined that the phrase "may not assume or assign" should be read to mean "may not assume and assign," apply the statutory proscription only when the trustee or DIP actually intends to assign the contract to a third party. This approach is commonly referred to as the "actual test." Its adherents include the First Circuit and the vast majority of lower courts considering the issue. See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493–94 (1st Cir. 1997), abrogated on other grounds by Hardemon v. City of Boston, No. 97-2010, 1998 WL 148382 (1st Cir. Apr. 6, 1998), superseded by 144 F.3d 24 (1st Cir. 1998); Summit Inv. & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608, 612–14 (1st Cir. 1995); In re Welcome Group 2 LLC, 660 B.R. 874, 885 (Bankr. S.D. Ohio 2024) (concluding that the "actual test" both "comports with the plain language of the statute" and is consistent with "the overall objectives of chapter 11 relief and the purposes of the Bankruptcy Code"); In re Jacobsen, 465 B.R. 102, 105–06 (Bankr. N.D. Miss. 2011) (collecting cases). In addition, the Fifth Circuit has applied the actual test in construing section 365(e)(2)—the Bankruptcy Code's exception to the prohibition against enforcement of "ipso facto" clauses that act to terminate or modify a contract as a consequence of a bankruptcy filing. See Bonneville Power Admin. v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238, 248–51 (5th Cir. 2006).
Many "actual test" courts have reasoned that a literal interpretation of section 365(c)(1) could defeat the policy considerations and underlying purposes of the Bankruptcy Code. See, e.g., In re Edison Mission Energy, 2013 WL 5220139, at *10 (Bankr. N.D. Ill. Sept. 16, 2013) ("The Court also finds that the actual test is more congruous with fundamental bankruptcy policy: the maximization of the value of the debtor's estate."); In re Mirant Corp., 303 B.R. 319, 334 (Bankr. N.D. Tex. 2003) (ruling that section 365(c)(1) is "not meant to aid creditors in penalizing an estate"); In re Cumberland Corral, LLC, No. 313-06325, 2014 WL 948473, at *10 (Bankr. M.D. Tenn. March 11, 2014) (concluding that a literal interpretation of section 365(c)(1) would produce an "outcome [that is] contrary to the purposes of the Bankruptcy Code").
In In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005), the court agreed with the ultimate conclusion reached by the "actual test" courts but adopted a different reading of section 365(c)(1) that, in the court's view, harmonized the plain meaning of the statute with the result obtained by applying the actual test. Expanding its analysis of section 365(c) beyond the phrase "assume or assign," the Footstar court reasoned that the term "trustee" in section 365(c) should not automatically be read (as it is in many other provisions "as a matter of simple logic and common sense") to be synonymous with the term "debtor-in-possession." Id. at 570, 573.
Instead, the proscription of assumption and assignment is limited to situations where a trustee, rather than a DIP, seeks to assume an executory contract. Id. at 573–74. Under the Footstar approach, the DIP would be permitted to assume the contract because, unlike a bankruptcy trustee, the DIP is not "an entity other than" itself; nevertheless, the DIP would be precluded from assigning a qualifying contract because assignment would force the non-debtor contracting party to accept performance from or render performance to an entity other than the debtor. Id; accord In re Adelphia Comms. Corp., 359 B.R. 65, 72 n.13 (Bankr. S.D.N.Y. 2007) (noting that Footstar is "plainly correct"); In re Aerobox Composite Structures, LLC, 373 B.R. 135, 141–42 (Bankr. D.N.M. 2007). Footstar thus articulated a rationale for the actual test that relies on the text of the statute itself rather than considerations of bankruptcy policy.
The U.S. Supreme Court declined to address the dispute regarding the proper interpretation of section 365(c)(1) when it denied a petition for certiorari in N.C.P. Mktg. Grp., Inc. v. BG Star Prods., 556 U.S. 1145 (2009). In a statement accompanying the order, Justice Kennedy, joined by Justice Breyer, noted that, even though the case before it was not an appropriate vehicle for review, "[t]he division in the courts over the meaning of § 365(c)(1) is an important one to resolve for bankruptcy courts and for businesses that seek reorganization." The Justices also emphasized that neither test is entirely satisfactory:
The hypothetical test is not … without its detractors. One arguable criticism of the hypothetical approach is that it purchases fidelity to the Bankruptcy Code's text by sacrificing sound bankruptcy policy. For one thing, the hypothetical test may prevent debtors-in-possession from continuing to exercise their rights under nonassignable contracts, such as patent and copyright licenses. Without these contracts, some debtors-in-possession may be unable to effect the successful reorganization that Chapter 11 was designed to promote. For another thing, the hypothetical test provides a windfall to nondebtor parties to valuable executory contracts: If the debtor is outside of bankruptcy, then the nondebtor does not have the option to renege on its agreement; but if the debtor seeks bankruptcy protection, then the nondebtor obtains the power to reclaim—and resell at the prevailing, potentially higher market rate—the rights it sold to the debtor…. Of course, the actual test may present problems of its own. It may be argued, for instance, that the actual test aligns § 365(c) with sound bankruptcy policy only at the cost of departing from at least one interpretation of the plain text of the law.
Id. at 1146–47.
MeSearch Media
Pursuant to a 2019 software license agreement (the "license agreement"), MeSearch Media Technologies, Ltd. (the "debtor") licensed the worldwide, perpetual, and limited-exclusive use of two software patents owned by Crivella Holdings Ltd. ("Crivella"). Regarding assignment, the license agreement provided as follows:
This Agreement and the rights granted hereunder shall inure to the benefit of the parties hereto and shall not be assignable by either party, except to a successor in interest or wholly-owned subsidiary of that party, without the written consent of the other, which consent shall not be unreasonably withheld.
(emphasis added).
In August 2024, certain creditors of the debtor, including Crivella, filed an involuntary chapter 11 case against the debtor and later sought the appointment of a chapter 11 trustee. Pursuant to a September 2024 stipulation, the debtor consented to the entry of an order for relief and to the appointment of a trustee.
Crivella later filed a motion for relief from the automatic stay to terminate the license agreement, contending that the debtor had breached the agreement and that it could not be assumed or assigned by its terms. The bankruptcy court denied the motion, ruling that there was no "cause" for relief from the stay because, among other things, the assignment language in the license agreement permitted assignment to a party other than the debtor or a DIP. See In re MeSearch Media Techs., Ltd., 668 B.R. 828 (Bankr. W.D. Pa. 2025), aff'd sub nom. Crivella Holdings Ltd. v. MeSearch Media Techs., Ltd., No. 2:25-cv-333, 2025 WL 2443400 (W.D. Pa. Aug. 25, 2025).
Crivella appealed the decision to the district court, arguing that the bankruptcy court erred by: (i) finding that the license agreement authorized assumption and assignment of the agreement to a hypothetical third party; and (ii) concluding that the license agreement could be assigned regardless of whether it could be assumed.
The District Court's Ruling
The district court affirmed the bankruptcy court's ruling.
U.S. District Court Judge William S. Stickman IV explained that section 362(d) of the Bankruptcy Code provides that a bankruptcy court may terminate, annul, modify, or condition the automatic stay for "cause," but does not define the term, leaving the meaning of "cause" to the court's discretion after examining the totality of the circumstances of any given case.
On appeal, Crivella renewed its argument that "cause" existed for relief from the stay to permit termination of the license agreement because: (i) its interests in the license agreement were not adequately protected due to the debtor's breach of the agreement; and (ii) the license agreement cannot be assigned without Crivella's consent under applicable non-bankruptcy law (federal patent law).
The district court acknowledged that, when a contract cannot be assumed pursuant to section 365(c)(1), the non-debtor party to the contract is entitled to relief from the stay to seek termination of the agreement. Geden Holdings, 2025 WL 2443400, at *3 (citing West Electronics, 852 F.2d at 83-84). In addition, according to Judge Stickman, West Electronics requires Third Circuit bankruptcy courts to apply the hypothetical test to determine whether an executory contract can be assigned. Thus, the district court wrote, the "'relevant inquiry is not whether [applicable non-bankruptcy law] would preclude an assignment from … a debtor to … a debtor in possession, but whether it would foreclose an assignment by a [debtor] to [a third party].'" Id. (quoting West Electronics, 852 F.2d at 83).
Next, the district court explained that, promoting "the important federal policy underlying patent law to foster and reward invention," federal patent law provides that a patent license agreement is not assignable unless the license agreement expressly provides that it is assignable. Id. Thus, Judge Stickman emphasized, because the license agreement in this case expressly states that assignment is permitted without the further consent of the parties to a "successor in interest," the dispositive issue is "whether a successor in interest is an entity other than the debtor within the meaning of 11 U.S.C. § 365(c)." Id. at *4.
The district court agreed with the bankruptcy court that the term "successor in interest" in the license agreement "is broad enough to encompass an entity other than the Debtor or debtor in possession." Therefore, Judge Stickman wrote, in accordance with the express terms of the license agreement, Crivella must "accept performance from any party other than the Debtor that is a successor in interest to the Debtor." Id. at *6. The district court accordingly ruled that, under section 365(c) and the hypothetical test endorsed in West Electronics, the license agreement may be assigned and there was no cause for relief from the automatic stay.
In so ruling, the district court also agreed with the bankruptcy court's conclusion that the Fourth Circuit's rationale in Sunterra regarding the inability to assign contracts that are not assumable is inconsistent with section 365(c). Judge Stickman quoted that reasoning in relevant part as follows:
Section 365(c) states that a contract cannot be assumed or assigned if the contracting party would not have to accept performance under the agreement from a party other than the debtor per § 365(c)(1)(A), and the party does not consent to assumption or assignment per § 365(c)(1)(B). This Court reads those sections together to mean that if an agreement contains language that it may be assigned per § 365(c)(1)(A), the inquiry ends there. However, even if the agreement prohibits assignment and under applicable law § 365(c)(1)(A) precludes assignment, the parties may still choose to consent to the assignment and may do so under § 365(c)(1)(B). The court in Sunterra failed to consider that consent to assumption or assignment in § 365(c)(1)(B) would overcome a lack of assignability under § 365(c)(1)(A).
This Court further finds that the Sunterra court erroneously held that an agreement must expressly provide for assumption in addition to assignment to satisfy the requirements of the Hypothetical Test and § 365(c). The body of relevant case law on this issue only deals with instances where provisions exist consenting to the assignment of the agreement, since contracting parties, unless their lawyers have advanced knowledge of bankruptcy law, would not have the foresight to include language regarding the assumption of a contract in bankruptcy. This Court does not find that § 365(c) requires language consenting to assumption, but rather, to quote the Petitioning Creditors' point made frequently at oral argument, if the License can be assigned, it can be assumed.
Id. at *5 (quoting In re MeSearch Media Techs., Ltd., 668 B.R. 828, 839 (Bankr. W.D. Pa. 2025), aff'd sub nom. Crivella Holdings Ltd. v. Mesearch Media Techs., Ltd., 2025 WL 2443400 (W.D. Pa. Aug. 25, 2025)).
Finally, the district court noted that its ruling comports with freedom of contract principles. According to Judge Stickman, "'[P]atent law allows a licensor to expressly authorize the use of its name and intellectual property, [and] [h]aving done so, the licensor cannot be heard to complain that the same applicable law excuses him from the consequences of his own contract.'" Id. (quoting In re Quantegy, Inc., 326 B.R. 467, 471 (Bankr. M.D. Ala. 2005)).
Outlook
With the district court's ruling in MeSearch Media, the rift among bankruptcy and appellate courts regarding the proper construction of section 365(c) continues unabated with little prospect of resolution in the absence of U.S. Supreme Court review or legislative action. Because the success of a debtor's bankruptcy case in either restructuring under a chapter 11 plan or generating cash to fund creditor distributions may depend upon the ability to assume, or to assume and assign, executory contracts that may not be assignable without consent under applicable non-bankruptcy law, the confusion regarding whether the actual test or the hypothetical test should apply creates considerable uncertainty. The burden therefore falls squarely upon parties relying on their ability to assign such contracts in bankruptcy to be aware of which approach has been endorsed by the courts in any proposed bankruptcy filing venue.
