Bankruptcy Code and Fundamental Principles of Bankruptcy Law Support Rejection-as-Breach Approach to Trademark Licenses

In its opinion, the Court focused on the text of Section 365 of the Bankruptcy Code. Section 365(a) provides that a trustee or debtor in possession may, subject to court approval, assume or reject an executory contract (executory contracts are a topic for another post; however, many licensing agreements are executory contracts). If an executory contract is rejected, Section 365(g) provides that the rejection is considered a breach. And under applicable nonbankruptcy law, breach of a contract does not eliminate rights the contract had already conferred on the non-breaching party. That is, the debtor and counterparty do not go back to their pre-contract positions.

The Court offered a useful analogy: a dealer leases a photocopier to a law firm and agrees to service it in exchange for a monthly payment. If the dealer stops servicing the copier, the law firm can keep the copier, continue making payments, and seek damages for the interruption in service. Or the law firm can stop the monthly payments, return the copier, and seek damages. The key, as the Court sees it, is that the law firm has the choice—the dealer has no ability to take the copier back by refusing to show up for a service appointment. Likewise, a debtor cannot revoke a trademark license by rejecting (breaching) the license agreement.

Holding Resolves Circuit Split; Overrules Precedent in Fourth Circuit

As we noted in prior coverage of this case, the opinion resolves a split between the First, Fourth, and Seventh Circuit Courts of Appeal. In Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., the Fourth Circuit held that a debtor’s rejection of a patent license precluded the licensee from continuing to use the patent, effectively construing rejection of the license as rescission. Congress later amended the Bankruptcy Code at Section 365(n) to allow a licensee to continue using patents, copyrights, and trade secrets, but Congress did not include trademarks in the amended law. Until recently, therefore, trademarks were handled differently than other intellectual property in the Fourth Circuit and elsewhere. The Court’s opinion now applies a uniform legal standard to all intellectual property across all bankruptcy courts in the country.

Implications for Trademark Licensors

Debtor-licensors are now faced with a Catch-22. Assumption of a trademark license creates an administrative expense that is paid ahead of most other creditors. Rejection, on the other hand, gives rise to a pre-petition claim that is unlikely to be paid in full—an advantage when reorganizing a bankrupt business with unfavorable licensing agreements. But rejection also permits a licensee to continue using the mark. Under trademark law a debtor-licensor must monitor and exercise quality control over the goods and services sold under the license or risk devaluation or loss of the trademark. This can be an expensive proposition, and the debtor will have to choose between expending scarce resources on quality control and risking the loss of a valuable asset.

The good news?

In Mission Product Holdings, the Court acknowledges that special contract terms in a license agreement could allow a rejecting debtor-licensor to revoke the trademark license, notwithstanding the provisions of Section 365 of the Bankruptcy Code. Thus, with strategically-drafted licenses, a licensor-debtor may be able have its cake and eat it too.