In MaIlinckrodt PLC v. Sanofi-Aventis U.S. LLC, No. 23-1111, the U.S. Court of Appeals for the Third Circuit affirmed a Delaware bankruptcy court decision finding a debtor’s obligation to pay a perpetual royalty was an unsecured claim that was dischargeable in bankruptcy. The decision is a cautionary tale for contract counterparties that negotiate future payment rights.

Background

In 2001, Sanofi sold Mallinckrodt a gel that relieves chronic inflammation and treats autoimmune diseases for a $100,000 upfront payment and a perpetual royalty of 1% of all net sales over $10 million per year. Sanofi did not take a security interest in the royalty.

By 2019, sales of the gel hit nearly $1 billion. Subsequently, Mallinckrodt filed for bankruptcy and sought to discharge its obligation to pay future royalty payments to Sanofi, asserting that the obligation was an unsecured claim.

The bankruptcy court agreed with Mallinckrodt, finding that Sanofi’s right to future royalties was an unsecured, contingent claim that was dischargeable. The district court affirmed and Sanofi appealed to the Third Circuit.

The Royalties Were Contingent, Unliquidated Claims Dischargeable in Bankruptcy

The Third Circuit affirmed the bankruptcy court’s decision, finding that Sanofi’s right to future royalties was a contingent and unliquidated claim that could be discharged in Mallinckrodt’s bankruptcy.

The Bankruptcy Code defines a claim to include a “right to payment,” including contingent and unliquidated rights to payment. Moreover, the U.S. Supreme Court has held that the term “claim” in the Bankruptcy Code has “the broadest available definition.”

Sanofi argued that the future royalties were non-dischargeable because the royalties did not constitute a claim. In particular, Sanofi argued that the future royalties were not a "right to payment” (a requisite for having a claim) because the future royalties were too indefinite in that they were tied to sales volume for the gel. 

The Third Circuit rejected this argument, observing that a contingent claim is one that “has not accrued and that is dependent on some future event that may never happen” and includes a right to payment that is not “guaranteed until something triggers it” per the terms of the contract. In the contract between Mallinckrodt and Sanofi, Mallinckrodt had to start paying royalties to Sanofi once sales of the gel reached $10 million. Because the royalties were contingent on the sales, the Third Circuit held that Sanofi had a contingent claim for future royalties that was dischargeable.

The Third Circuit also held that Sanofi’s claim for future royalties was dischargeable even though the claim was unliquidated since the definition of “claim” covers claims in an unascertained amount as well. 

In an effort to avoid this result, Sanofi argued that the claim was not dischargeable because it would not exist until Mallinckrodt reached the sales trigger each year. The Third Circuit also rejected this argument, finding “a claim can arise before it is triggered” and “confusing those concepts reads ‘contingent’ out of the [Bankruptcy] Code’s broad definition of claims.” Instead, “most contract claims arise when the parties sign the contract” even if the claim is still contingent or unliquidated.

Takeaways

In finding that Sanofi’s claim was dischargeable, the Third Circuit noted that “[c]reditors take on risks” which can become a reality when a debtor files for bankruptcy. As a result, negotiating protections at the time of agreement is critical. Indeed, the Third Circuit provided several examples of protections that might have led to a different result for Sanofi, including:

• Licensing the rights to the gel instead of selling it outright;
• Keeping a security interest in the intellectual property; or 
• Setting up a joint venture to keep part ownership of the gel.

Parties negotiating future payment rights should consider their risk of nonpayment in the event their counterparty files for bankruptcy and take steps such as those suggested by the Third Circuit to mitigate those risks at the time of contract.