On May 20, 2019, the US Supreme Court clarified that when a trademark licensor rejects a trademark license agreement in a Chapter 11 bankruptcy proceeding, the rejection does not rescind the use rights of the licensee under the license agreement. The decision resolved a circuit split on this issue between the First and Seventh Circuits. The Court held that the licensor’s rejection of the license agreement in bankruptcy has the same effect on the licensee’s rights as a licensor’s breach of the license agreement outside of bankruptcy. Trademark licensees now enjoy the same continuing rights as patent licensees when licensors reject license agreements in bankruptcy.

Background on the Dispute Between Mission Product Holdings and Tempnology

Tempnology manufactured and marketed clothing and accessories “designed to stay cool during exercise” under the Coolcore trademarks. In 2012, Tempnology entered into a licensing agreement with Mission Products, granting Mission an exclusive license to distribute certain Coolcore products in the United States and a non-exclusive license to use the Coolcore trademarks internationally.

Tempnology filed a petition for Chapter 11 bankruptcy in September 2015, less than a year before the agreement expired.

Under Section 365(a) of the Bankruptcy Code, a debtor may “assume or reject any executory contract,” subject to the Bankruptcy Court’s approval. Under Section 365(g) of the Bankruptcy Code, contract rejection “constitutes a breach of such contract” as of “immediately before the date of the filing of the [bankruptcy] petition.” Tempnology rejected the license agreement with the Bankruptcy Court’s approval, stopped performance under the agreement, and sought a declaratory judgment that the rejection terminated Mission’s rights to use the Coolcore trademarks.

Section 365(n) of the Bankruptcy Code permits a licensee to continue using “intellectual property” after a licensor’s rejection of a license agreement as long as the licensee continues performance under the agreement. The Bankruptcy Code defines “intellectual property” to include trade secrets, patents, patent applications, and copyrighted works, but it does not include trademarks or trademark licenses. Tempnology argued that because Section 365(n) did not cover trademark licenses, Mission’s rights to use the Coolcore trademarks were terminated. The Bankruptcy Court agreed, but the Bankruptcy Appellate Panel reversed, holding that Tempnology’s rejection of the license agreement in bankruptcy was a breach, which did not eliminate rights already conferred on Mission before the bankruptcy filing.

On appeal, the US Court of Appeals for the First Circuit reversed and reinstated the termination of Mission’s license. The First Circuit endorsed the Bankruptcy Court’s rationale, noting that Congress’s “principal aim” of permitting contract rejection was to “release the debtor’s estate from burdensome obligations,” and concluded that requiring a debtor to maintain quality control over a licensee’s use of the trademarks where the debtor has chosen to reject the license agreement would frustrate that purpose.

The Supreme Court granted certiorari to resolve the split between the First and Seventh Circuits.       

Supreme Court: Contract Rejection in Bankruptcy Is a Breach, Not a Rescission

In an 8-1 decision,¹ the Supreme Court reversed the First Circuit’s decision and held that Tempnology’s rejection of Mission’s trademarks license agreement did not rescind Mission’s use rights under the license.

To reach this conclusion, the Court first analyzed the text of Section 365, which states that the rejection of a contract constitutes a breach. Since “breach” is not a bankruptcy term, the Court looked to its meaning under contract law. The Court applied the example of a lessor-lessee relationship to demonstrate that the lessor’s breach does not permit the lessor to unilaterally terminate the agreement. Even if the lessor files for bankruptcy, the lessor may not reclaim the leased property if the lessee wants to keep using it since those rights survive a breach of the lease under non-bankruptcy law. In the case of licensing agreements, the licensor’s breach of the licensing agreement “does not revoke the license or stop the licensee from doing what it allows.” Similarly, a rejection of the license agreement in bankruptcy permits a debtor to stop performing under the agreement, but a debtor may not rescind the license, so the licensee may still use the licensed marks within the scope of the license.

The Court further noted the general bankruptcy rule reflected by Section 365: “The estate cannot possess anything more than the debtor itself did outside bankruptcy.” Thus, permitting a debtor to rescind contractual rights would allow debtors to re-gain interests that it had previously given up, which contradicts the general bankruptcy rule. The avoidance powers of a trustee or debtor are outlined in the Bankruptcy Code as narrow exceptions, and permitting the rescission of rights would expand the avoidance powers provided by the statute.

The Court thus concluded that the text of the Bankruptcy Code and the core principles of bankruptcy law demonstrate that rejection is a breach, not a rescission. Justice Sotomayor’s concurring opinion emphasized that the Court did not provide an “unfettered right” for licensees to continue using licensed marks post-rejection, but rather merely held that rejection of a license agreement did not terminate a licensee’s rights that would survive the licensor’s breach under applicable non-bankruptcy law. Thus, the “baseline inquiry” is whether the licensee’s rights would survive the licensor’s breach. This inquiry may be impacted by contract terms or state law. An amicus brief filed by the American Intellectual Property Law Association noted some grounds for termination of a licensee’s use rights post-rejection, such as licensee’s non-performance, licensee’s failure to adhere to the terms of the rejected license agreement, or licensee’s failure to observe the licensor’s quality control standards.

Tempnology argued that the express protection of patent and copyright licensees in Section 365(n) created a negative inference that Congress intended to treat trademark licensees differently. The Court rejected this position and noted that the express protections for patent and copyright licensees (and for certain other categories of executory contracts) were enacted over time in response to judicial decisions to the contrary. Specifically, Congress enacted Section 365(n) in response to the Fourth Circuit’s decision in Lubrizol.² But the Court declined to read too much into this Congressional response, noting that “Congress’s repudiation of Lubrizol for patent contracts does not show any intent to ratify that decision’s approach for almost all others.”

Tempnology also argued that providing licensees with a continued right to use trademarks forces the licensor to choose between expending resources on quality control over licensees and potentially losing the marks in the future. Tempnology noted that either option hampers a debtor’s ability to reorganize, which is “a fundamental purpose” of the Bankruptcy Code. The Court noted, however, that while the Bankruptcy Code seeks to aid reorganizations, it does not permit “anything and everything that might advance that goal.” Rejection permits debtors to “escape” future contract obligations, but it does not exempt debtors from the burdens that generally applicable law imposes on property owners.

Potential Impact of the Court’s Decision

The Court’s Mission Products decision makes clear that a trademark licensee otherwise in compliance with its contractual obligations has the right to continue using the licensed marks despite the rejection of the trademarks licensing agreement in bankruptcy. Licensees should note that their rights to continue using the marks post-rejection may still be revoked should they fail to adhere to the terms of the contract, fail to perform under the contract, or fail to observe the licensor’s quality control standards. Thus, licensees should be aware of their contractual rights in cases where the licensor files a petition for bankruptcy, but must be cautious in proceeding with use of the licensed marks, as their subsequent use rights under the contract will be determined by the terms of the contract and the applicable state law.

It is also clear that licensors may not use their executory contract rejection powers to terminate trademark licensing agreements even if the agreements are economically burdensome to the bankruptcy estate. Licensors should consider this principle before entering into trademark licensing agreements and should draft their trademark licensing agreements carefully, in accordance with applicable state law. Thus, when drafting trademark licensing agreements, licensors should weigh the burdens associated with their choice of quality control provisions against the risk of compromising the quality of the licensed products.³

Finally, Supreme Court watchers may recognize a trend. Once again, when deciding an intellectual property law issue, the Court rejected an approach that applies special rules for intellectual property. Instead, it applied contract law and bankruptcy law to resolve the issue, to the surprise of many trademark law specialists who might focus on the unique quality control obligations of trademark owners to justify a different result.
______
 
¹ Justice Elena Kagan delivered the opinion of the Court, in which Justices John Roberts, Clarence Thomas, Ruth Bader Ginsburg, Stephen Breyer, Samuel Alito, Sonia Sotomayor, and Brett Kavanaugh joined. Justice Sonia Sotomayor filed a concurring opinion. Justice Neil Gorsuch filed a dissenting opinion, arguing that the issue was moot because the trademark license agreement had expired by its terms.
 
²Lubrizol Enters. v. Richmond Metal Finishers, 756 F.2d 1043, 1045-1048 (4th Cir. 1985) (holding that rejection of a contract revoked the contract’s grant of a patent license).
 
³ Trademark licensors should also note that the failure to maintain quality control, which is also known as “naked” licensing, may result in a finding that the mark is abandoned for the goods or services that are the subject of the license agreement. 3 J. Thomas McCarthy, McCarthy on Trademarks and Unfair Competition § 18:48 (5th ed. 2019).

[View source.]