August 2018: Bankruptcy & Restructuring Litigation Update

Quinn Emanuel Urquhart & Sullivan, LLP

Quinn Emanuel Urquhart & Sullivan, LLP

Intellectual Property Licenses in BankruptcyGrowing Uncertainty Regarding Bankruptcy’s Effect on Trademark Licenses. The bankruptcy of a counterparty to an intellectual property license may present serious challenges. Not only are there monetary issues—such as unpaid royalties—but also material, unsettled questions as to the continued exploitation of the intellectual property itself.

The federal courts of appeal are sharply divided as to whether a debtor-licensee of intellectual property may continue to use the IP by “assuming” the license, if the non-debtor licensor does not consent. See In re Adelphia Commc’ns Corp., 359 B.R. 65, 72 (Bankr. S.D.N.Y. 2007) (discussing conflicting authorities).But just as much uncertainty exists for non-debtor licensees of trademarks, whose right to exploit the intellectual property may be cut off by a bankrupt licensor or its trustee “rejecting” the license in the licensor’s bankruptcy. Although licensees of patents and copyrights are entitled to special protections from the effects of rejection under the Bankruptcy Code, see 11 U.S.C. § 365(n), it is uncertain whether similar protections are afforded to trademark licensees.

This was the licensee’s fate in Mission Product Holdings, Inc. v. Tempnology, LLC (In re Tempnology, LLC), 879 F.3d 389 (1st Cir. 2018), in which a divided panel of the First Circuit Court of Appeals held that the debtor’s rejection of an agreement containing a trademark license terminated the non-debtor licensee’s rights to the trademark. The licensee has petitioned the U.S. Supreme Court for certiorari to resolve conflicts among the federal courts of appeal as to the consequences of rejection of a trademark license.

Tempnology held patents and trademarks relating to chemical-free cooling fabrics it had developed. In 2012, Tempnology entered into an agreement with Mission, pursuant to which it granted to Mission non-exclusive trademark and patent licenses, along with distribution rights. The parties’ relationship soon soured, along with Tempnology’s financial condition. Tempnology filed for chapter 11 bankruptcy in 2015 and immediately filed a motion in the bankruptcy court to reject its agreement with Mission, which the court granted.

Bankruptcy Code § 365 permits a trustee or chapter 11 debtor-in-possession to assume or reject “executory contracts,” which are contracts under which material performance remains owing by each party. See 11 U.S.C. § 365(a). The power to assume or reject is “a multipurpose elixir for use in nursing a business back to good health.” In re Thinking Machines Corp., 67 F.3d 1021, 1024 (1st Cir. 1995). The trustee or debtor-in-possession may choose assumption if continued performance of the contract would be beneficial to the debtor’s bankruptcy estate, in which case the contract essentially remains in place as if there were no bankruptcy. Id. Alternatively, they may choose rejection as “an emetic to purge the bankruptcy estate of obligations that promise to hinder a reorganization.” Id.

Tempnology and Mission disputed the effect of Tempnology’s rejection of the agreement. Although rejection generally does not, in itself, terminate the contract, the non-debtor counterparty usually cannot compel specific performance from the trustee or debtor-in-possession. Instead, the counterparty is relegated to the status of a creditor whose claim may be discharged for pennies on the dollar. The Bankruptcy Code, however, contains an express exception to the general rule for certain “intellectual property” licensees, including those of patents and copyrights. If the trustee or debtor-in-possession rejects a license covering the debtor’s patent or copyright, the licensee can elect either (1) to treat the license as terminated, in which case the licensee is relieved of all future obligations, but can no longer exploit the license, or (ii) to treat the license as effective, including payment of royalties to the debtor, but without the benefit of any ongoing performance by the debtor (such as continuing product support). 11 U.S.C. § 365(n).

Congress enacted § 365(n) in 1988 in reaction to court decisions that held a debtor-licensor’s rejection of an intellectual property license completely terminated the rights of the licensee. See Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1048 (4th Cir. 1985). But Congress purposely excluded trademarks from the definition of “intellectual property” in 11 U.S.C. § 101(35A), “to allow the development of equitable treatment of this situation by bankruptcy courts.” S. Rep. No. 100-505, 100th Cong. 2d Sess 5 (1988).

In light of § 365(n), Tempnology acknowledged that Mission could elect to treat its rejected patent license as continuing to be in effect. As to the trademark license and distribution agreement, however, Tempnology argued that Mission’s rights terminated upon rejection. The bankruptcy court agreed with Tempnology, but the Bankruptcy Appellate Panel reversed in part, holding that Mission still had the right to use Tempnology’s trademarks and trade names post-rejection. On further appeal, the First Circuit affirmed the bankruptcy court’s holding in a 2-1 decision, concluding that “the rejection left Mission with only a pre-petition damages claim in lieu of any obligation by Debtor [Tempnology] to further perform under either the trademark license or the grant of exclusive distribution rights.” 879 F.3d at 392.

As to Mission’s distribution rights, the First Circuit held that although § 365(n) protects a licensee’s right to use a patent, it does not protect the right to sell a product merely because that right appears in a contract that also contains a an exclusive right to distribute certain products, that was not the equivalent of an intellectual property license, and thus was not within the scope of § 365(n).

As to Mission’s trademark license, the First Circuit majority opinion noted the split of authority resulting from Congress’ exclusion of trademarks from the Bankruptcy Code’s definition of “intellectual property.” One line of cases holds that a debtor-licensor’s rejection of a trademark deprives the licensee of any further rights under the license. These courts have reasoned by negative inference that because Congress did not protect trademark licenses when enacting § 365(n), it intended for Lubrizol’s holding to govern when a debtor-licensor rejects a trademark license—in other words, rejection terminates the trademark licensee’s rights.

Other courts have reached a contrary result, holding that rejection of a trademark license does not result in its termination, but rather is the equivalent of a breach under non-bankruptcy law. Sunbeam Prods v. Chi Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012). These courts reason that, while such “rejection converts a debtor’s duty to perform into a liability for pre-petition damages, it leaves in place the counterparty’s right to continue using a trademark licensed to it under the rejected agreement.” 879 F.3d at 402. As a result, the licensee may elect to disregard the debtor-licensor’s rejection (i.e. breach), and continue using the trademark for the remainder of the license’s term.

The First Circuit majority rejected the Sunbeam approach, holding that it “entirely ignores the residual enforcement burden it would impose on the debtor just as the [Bankruptcy] Code otherwise allows the debtor to free itself from executory burdens.” 879 F.3d at 404. The Sunbeam approach “would allow Mission to retain the use of Debtor’s trademarks in a manner that would force Debtor to choose between performing executory obligations arising from the continuance of the license or risking the permanent loss of its trademarks, thereby diminishing their value to Debtor.” Id. at 403. The First Circuit thus adopted “the categorical approach of leaving trademark licenses unprotected from court-approved rejection, unless and until Congress should decide otherwise.” Id. at 404.

The majority also rejected the approach advocated by Judge Torruella in his dissent, which would have required the bankruptcy court to fashion an equitable remedy based on “the terms of the Agreement, and non-bankruptcy law.” Id. at 407. The majority held that the dissent’s approach “invites further degradation of the debtor’s fresh start options,” and “has the added drawback of imposing increased uncertainty and costs on the parties in bankruptcy proceedings.” Id. at 404.

Although not directly addressed by the First Circuit in Tempnology, there exists yet another line of cases in which courts have ruled in favor of trademark licensees by finding that the license was not an executory contract subject to rejection. These decisions have relied on the fact that at least one of the parties to the license had substantially performed its obligations prior to the bankruptcy, a circumstance that was not present in Tempnology. See, e.g., Lewis Bros. Bakeries, Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 751 F.3d 955 (8th Cir. 2014) (en banc); In re Exide Techs., 607 F.3d 957 (3d Cir. 2010). This line of cases may provide some trademark licensees with relief, even in the First Circuit. However, it might be argued that the logic underlying these opinions does not comport with the First Circuit’s discussion of the importance (i.e., materiality) of the parties’ respective ongoing burdens to protect the quality of the trademark that may exist under a license. See 879 F.3d at 404.

Potential Supreme Court Review. Mission has filed a petition for a writ of certiorari before the U.S. Supreme Court seeking review of the First Circuit’s opinion. According to the petition, the First Circuit’s decision “worsen[ed]” the existing circuit split on the licensee’s rights following a debtor-licensor’s rejection under § 365 of the Bankruptcy Code. The petition urges the court to adopt the holding in Sunbeam and other cases that allow the licensee to elect whether it will disregard rejection and continue use of the license. The petition is scheduled to be considered at the Court’s September 24 conference. Although the granting of certiorari is rare, this case may be of interest to the Court due to the importance of the issue and the conflicting circuit decisions.

Congressional Action. In 2013, legislation was introduced in the U.S. Senate (S. 1720) and House (H.R. 3309) to codify the result of Sunbeam by extending the Bankruptcy Code § 365(n) protections to trademark licensees. The same legislation also would have codified the result of Jaffe v. Samsung Electronics Co., 737 F.3d 14 (4th Cir. 2013), which held that § 365(n) protects the rights of patent licensees within the United States, even when patent licenses have been terminated in a foreign insolvency proceeding.

H.R. 3309 passed the House by a vote of 325 to 91 in December 2013, but never passed the Senate. In May 2014, Senator Patrick Leahy, the sponsor for S. 1720, announced that he was taking the bill off the Senate agenda because there was not a clear consensus for passing the bill into law. The broader bill was more controversial because it involved a large reform to the patent system by changing rules and regulations surrounding patent infringement lawsuits in an attempt to reduce the number of patent infringement lawsuits. Although the House bill was reintroduced in 2015, there has not been any indication that Congress plans to retake the issue in the current Congressional term.

Until Congress or the Supreme Court acts to clarify existing law on the trademark licensee’s rights following a bankruptcy, parties to the licenses will continue to face great uncertainty.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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