Microsoft Corp. v. DAK Industries, Inc. (In re DAK Industries, Inc.)

Citation: 66 F.3d 1091Docket: No. 94-55029

Court: Court of Appeals for the Ninth Circuit; October 2, 1995; Federal Appellate Court

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Microsoft Corporation appeals a district court order affirming the bankruptcy court's denial of its administrative expense claim under 11 U.S.C. 503. The case involves a 1991 License Agreement between Microsoft and DAK Industries, granting DAK nonexclusive rights to distribute Microsoft’s Word for Windows software. DAK was required to pay a minimum commitment of $2,750,000 in installments, regardless of sales, with a royalty rate of $55 per copy sold. If sales exceeded the minimum commitment, DAK would pay $55 for each additional copy; if sales fell short, no refunds were issued. The agreement was amended in 1991, reducing the royalty rate to $45, and establishing a new first payment date of December 30, 1991.

DAK made three payments totaling $1,354,167 before filing for bankruptcy on June 11, 1992, without paying the remaining two installments of $1,395,833. Microsoft sought to compel DAK to assume or reject the contract and filed for an administrative expense claim based on DAK’s post-bankruptcy use of the license agreement. The bankruptcy court denied this claim, determining that the payment structure resembled a sale of goods rather than ongoing royalty payments, thus categorizing the debt as a prepetition unsecured claim. The agreement was deemed executory, allowing DAK until May 4, 1993, to decide on its assumption or rejection. Microsoft’s motion for reconsideration was also denied in June 1993.

On May 4, 1993, the debtor rejected the agreement, having sold approximately 13,244 copies of Word before filing for bankruptcy on June 11, 1992, and an additional 7,600 copies from June 11, 1992, to January 21, 1993. The sales figures between January 21, 1993, and the rejection date are not specified. Microsoft appealed the bankruptcy court's denial of its administrative expense claim, which was based on the court's determination that the debtor had benefited from postpetition sales of Word. However, the court characterized the payment structure as resembling installment payments for goods, indicating obligations incurred prior to the bankruptcy filing. The court found that Microsoft did not provide any postpetition consideration to the debtor, leading to the rejection of Microsoft's administrative expense claim and classifying the remaining amounts due as prepetition unsecured claims.

Regarding the review process, the district court and appellate court maintain similar roles in bankruptcy appeals, reviewing factual findings for clear error and legal conclusions de novo. Under the bankruptcy code, an administrative expense claim has priority over unsecured claims, with the claimant bearing the burden to prove that the claim arose from a transaction with the debtor-in-possession and benefitted the estate. The bankruptcy court has broad discretion in such determinations, with a narrow interpretation of necessary costs to preserve the estate. In this case, despite the debtor's rejection of the executory contract, the estate benefited from postpetition sales of the software. Therefore, Microsoft could potentially qualify for an administrative expense claim if the outstanding debt arose after the petition or if consideration was provided postpetition; otherwise, it would only hold a prepetition unsecured claim.

Microsoft contends that the transaction with DAK should be classified as granting DAK the right to use its intellectual property, asserting that the resulting debt originated postpetition due to periodic payments for this use. Microsoft argues that despite the transaction starting before the petition, it continued to provide consideration by allowing DAK to use the property after the petition was filed, likening it to a debtor’s postpetition use of leased property, which creates an administrative expense claim for rent.

In contrast, DAK, along with Tokai Bank and the committee of unsecured creditors, argues that the transaction constitutes a prepetition sale of software units to DAK, claiming the entire debt arose prior to the petition when the sale occurred. DAK asserts that Microsoft did not provide postpetition consideration and that it merely sold software units already purchased prepetition. This perspective suggests the transaction is similar to a debtor selling goods from its inventory postpetition, resulting in an unsecured claim rather than an administrative expense claim.

The court concludes that the transaction is best viewed as a lump sum sale of software units rather than a mere grant of usage rights. Key reasons for this determination include: (1) DAK's entire debt was established prepetition, as defined by the bankruptcy code, where the obligation to pay $2,750,000 existed at the agreement's signing, regardless of the timing of payments; (2) the pricing structure resembled a sale—payments were based on the quantity of units rather than rental duration; and (3) DAK received all rights under the agreement at its commencement, allowing immediate distribution of the software with future installment payments, mirroring a purchase on unsecured credit. The timing of installment payments further supports this analysis, showing no correlation with usage but rather with the overall sale arrangement.

The agreement between DAK and Microsoft is characterized as granting a "right to sell" rather than merely "permission to use" Microsoft’s intellectual property. Unlike precedents where claimants allowed temporary use of their property, DAK sold the Word program directly to consumers, making its actions more akin to inventory sales rather than trademark or device usage. Microsoft did not provide any services or updates postpetition, nor did it incur additional expenses related to DAK after the bankruptcy filing. Consequently, DAK's obligation arose before the petition, and Microsoft is not entitled to an administrative expense claim.

Denying Microsoft's claim is supported by several factors: DAK had already paid Microsoft $1,354,167 prior to bankruptcy, equating to royalties for up to 30,092 copies of Word, and there is no evidence that DAK sold more than that amount. Granting Microsoft a priority claim over other unsecured creditors would be unjust, as it would not enrich the estate and would contradict the intent of Section 503, which aims to facilitate post-bankruptcy transactions by ensuring that new creditors are compensated for services. Microsoft may still recover some outstanding amounts as an unsecured claim.

Microsoft did not conduct business with the debtor after the bankruptcy filing, and the relevant transaction occurred prior to the bankruptcy. Both the bankruptcy court and district court rejected Microsoft’s claim for administrative expenses. DAK calculated it could sell 30,092 copies at an amended royalty rate of $45 each before surpassing its pre-bankruptcy payment obligations, suggesting it could have sold 9,248 additional copies within a specified timeframe. However, DAK clarified it did not disclose the actual sales figures but maintained it did not exceed its paid amount. The court found no evidence of how many copies DAK sold during that period. The analysis focused on the economic realities of the agreement, clarifying that the terminology used (labeling it a 'license' and payments as 'royalties') does not dictate the legal outcome. Microsoft incorrectly relied on the decision in In re Prize Frize, which involved different legal questions regarding royalty payments under 365(n). The current case centers on whether the debt arose postpetition or if Microsoft provided postpetition consideration, determining entitlement to a 503 administrative expense claim. The court emphasized that while 365(n) broadly interprets 'royalty payments' to protect the estate, administrative expenses under 503 are interpreted narrowly to minimize payments from the estate, ensuring fair treatment among unsecured creditors.