First Circuit Rejects Sunbeam Approach to Effect of Rejection of Trademark License in Bankruptcy

by Jones Day
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In Mission Product Holdings, Inc. v. Tempnology, LLC (In re Tempnology, LLC), 879 F.3d 389 (1st Cir. 2018), the U.S. Court of Appeals for the First Circuit ruled that the rejection of a trademark license in bankruptcy means that the licensee loses the ability to use the licensed intellectual property because trademarks are not among the categories of "intellectual property" afforded special protection under the Bankruptcy Code. In so ruling, the First Circuit effectively embraced the approach articulated by the Fourth Circuit in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers Inc.), 756 F.2d 1043 (4th Cir. 1985), and rejected the contrary approach endorsed by the Seventh Circuit—the only other court of appeals that has directly addressed the issue—in Sunbeam Prods., Inc. v. Chicago Am. Manuf., LLC, 686 F.3d 372 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012). The widening rift among the circuits on this issue may be an invitation to U.S. Supreme Court review.

Special Rules Governing Rejection of Certain Intellectual Property Licenses in Bankruptcy

Absent special statutory protection, the rejection of an intellectual property ("IP") license by a chapter 11 debtor-in-possession ("DIP") or a bankruptcy trustee can have a severe impact on the licensee’s business and leave the licensee scrambling to procure other IP to keep its business afloat. This concern was heightened by the Fourth Circuit’s 1985 ruling in Lubrizol. In that case, the court held that, if a debtor rejects an executory IP license, the licensee loses the right to use any licensed copyrights, trademarks, and patents. The court also concluded that the licensee’s only remedy is to file a claim for money damages, since the licensee cannot seek specific performance of the license agreement.

In order to better protect such licensees, Congress amended the Bankruptcy Code in 1988 to add section 365(n). Under section 365(n), licensees of some (but not all) IP licenses have two options when a DIP or trustee rejects the license. The licensee may either: (i) treat the agreement as terminated and assert a claim for damages; or (ii) retain the right to use the licensed IP for the duration of the license (with certain limitations). By adding section 365(n), Congress intended to make clear that the rights of an IP licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license.

However, notwithstanding the addition of section 365(n) to the Bankruptcy Code, the legacy of Lubrizol endures—since by its terms, section 365(n) does not apply to trademark licenses and other kinds of "intellectual property" outside the Bankruptcy Code’s definition of the term. In particular, trademarks, trade names, and service marks are not included in the definition of "intellectual property" under section 101(35A) of the Bankruptcy Code. Due to this omission, courts continue to struggle when determining the proper treatment of trademark licenses in bankruptcy.

In Sunbeam, the Seventh Circuit expressly rejected the Lubrizol approach. Focusing on the impact of section 365(g) of the Bankruptcy Code (specifying the consequences of rejection), the Seventh Circuit explained that, outside bankruptcy, a licensor’s breach does not terminate a licensee’s right to use IP. According to the court, "What § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party’s rights remain in place." The debtor’s unfulfilled obligations under the contract are converted to damages, which, if the contract has not been assumed, are treated as a prepetition obligation. "[N]othing about this process," the court remarked, "implies that any rights of the other contracting party have been vaporized." Instead, rejection "merely frees the estate from the obligation to perform and has absolutely no effect upon the contract’s continued existence" (internal quotation marks and citation omitted).

The Seventh Circuit reasoned that lawmakers’ failure to include trademark licenses among the "intellectual property" protected by section 365(n) should not be viewed as an endorsement of any particular approach regarding rejection of a trademark license agreement. Rather, the Seventh Circuit wrote, the legislative history indicates that "the omission was designed to allow more time for study, not to approve Lubrizol."

The Third and Eighth Circuits also had the opportunity to weigh in on the validity of the Lubrizol approach, but declined to reach the merits for a variety of reasons. See Lewis Bros. Bakeries, Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 751 F.3d 955 (8th Cir. 2014) (ruling that a license agreement was not executory and thus could not be assumed or rejected because the license was part of a larger, integrated agreement which had been substantially performed by the debtor prior to filing for bankruptcy); In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010) (sidestepping the issue and concluding that a trademark license agreement was not executory; in a concurring opinion, Judge Ambro noted that Congress’s decision to leave treatment of trademark licenses to the courts signals nothing more than Congress’s inability, when it enacted section 365(n), to devote enough time to consideration of trademarks in the bankruptcy context).

The First Circuit rejected the Sunbeam approach in Tempnology.

Tempnology

Cold-weather clothing innovation company Tempnology LLC ("Tempnology") entered into a marketing and distribution agreement (the "Agreement") with Mission Product Holdings, Inc. ("Mission") that included, among other things, a license of certain Tempnology trademarks.

The Agreement included a provision permitting either party to terminate the Agreement without cause. Mission exercised this option in 2014, triggering a "wind-down period" of approximately two years. Shortly afterward, Tempnology issued a notice of immediate termination for cause, claiming that Mission violated the agreement. An arbitrator later ruled that Tempnology waived any grounds for immediate termination and that the Agreement remained in effect until the expiration of the wind-down period in July 2016.

Tempnology filed for chapter 11 protection in 2015. It then moved to reject the Agreement. Mission objected, arguing that, notwithstanding rejection, by making an election under section 365(n), Mission retained its rights under the trademark license and that it could continue to exercise those rights without interference from Tempnology or any purchaser of its assets in the bankruptcy case.

Relying on Lubrizol and without any discussion of Sunbeam, the bankruptcy court ruled that, because trademarks are not included in section 101(35A)’s definition of "intellectual property," Mission’s trademark license rights were not protected by section 365(n). Thus, due to the rejection of the Agreement, Mission lost the trademark license rights. See In re Tempnology, LLC, 2015 BL 372538 (Bankr. D.N.H. 2015).

A bankruptcy appellate panel reversed the trademark ruling on appeal. See Mission Prod. Holdings, Inc. v. Tempnology LLC (In re Tempnology LLC), 559 B.R. 809 (B.A.P. 1st Cir. 2016). The panel found that the bankruptcy court’s reliance on Lubrizol was flawed, noting that "Lubrizol . . . is not binding precedent in this circuit and, like the many others who have criticized its reasoning . . . , we do not believe it articulates correctly the consequences of rejection of an executory contract under § 365(g)." Instead, the panel wrote, "[w]e adopt Sunbeam’s interpretation of the effect of rejection of an executory contract under § 365 involving a trademark license."

The First Circuit’s Ruling

A divided three-judge panel of the First Circuit reversed the bankruptcy appellate panel’s trademark ruling.

The First Circuit majority acknowledged that "the conclusion that an agreement finds no haven from rejection in section 365(n) does not entirely exhaust the possible arguments for finding that a right under that agreement might otherwise survive rejection." However, the majority wrote, even "leaving open the possibility that courts may find some unwritten limitations on the full effects of section 365(a) rejection, we find trademark rights to provide a poor candidate for such dispensation."

The First Circuit majority concluded that the "unstated premise" of Sunbeam is flawed. In particular, it explained, freeing a debtor from any continuing performance obligations under a trademark license, while preserving the licensee’s right to use the trademark, simply does not comport with Congress’s principal aim in providing for rejection of a contract—namely, to "release the debtor’s estate from burdensome obligations that can impede a successful reorganization" (citing NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984)).

According to the majority, the effective licensing of a trademark requires the trademark owner (or any purchaser of its assets) to monitor and exercise control over the quality of the goods sold to the public under cover of the trademark, failing which the trademark owner would be left with a "naked license" that would jeopardize the continued validity of its trademark rights. The Sunbeam approach, the majority emphasized, would allow Mission to retain the use of Tempnology’s trademarks "in a manner that would force the company to choose between performing executory obligations under the license or risk the permanent loss of its trademarks."

Such a restriction on Tempnology’s ability to free itself from its executory obligations, even if limited to trademark licenses, the majority wrote, "would depart from the manner in which section 365(a) otherwise operates." Moreover, the court explained, the logic of the approach that trademark rights categorically survive rejection "would seem to invite further leakage," to encompass, for example, exclusive distribution rights, a right to receive advance notice before termination of performance, and other rights.

The Dissent

In a dissenting opinion, circuit judge Juan R. Torruella disagreed with the majority’s "bright-line rule that the omission of trademarks from the protections of section 365(n) leaves a non-rejecting party without any remaining rights to use a debtor’s trademark and logo." Instead, Judge Torruella would follow Sunbeam (and the appellate panel below) in concluding that Mission’s rights to use the licensed trademark "did not vaporize" due to rejection of the Agreement.

Because section 365 is silent as to the treatment of trademark license agreements after rejection, Judge Torruella looked to the legislative history of section 365(n) to divine lawmakers’ intent. He explained that Congress enacted section 365(n) as a direct response to Lubrizol, intending to correct the perception that section 365 was designed to be a mechanism for stripping innocent licensees of rights vital to their ongoing business operations (citing S. Rep. No. 100-505, at 4 (1985)).

Like the Seventh Circuit in Sunbeam, Judge Torruella noted that the legislative history explains that the omission of trademarks from the definition of IP was designed not to leave trademark licensees unprotected—i.e., to endorse the Lubrizol approach—but to allow more time for study. Pending completion of that study, Judge Torruella read the legislative history to encourage "equitable treatment" by the courts to resolve disputes concerning executory trademark licenses, rather than defaulting to the Lubrizol approach, which Congress expressly rejected in enacting section 365(n).

As in Sunbeam, Judge Torruella would look to section 365(g) for the consequences of rejection of a trademark license, which constitutes a breach of the contract, rather than abrogation of whatever rights the trademark licensee may have under applicable nonbankruptcy law.

The majority was critical of the dissent, writing that "our dissenting colleague seems to reject [Sunbeam’s] categorical approach in favor of what Sunbeam itself rejected—an ‘equitable remedy’ that would consider in some unspecified manner the ‘terms of the Agreement, and non-bankruptcy law’ " (quoting Sunbeam, 686 F.3d at 375–76)). According to the majority, Judge Torruella accorded too much weight to a few lines in the legislative history and overlooked the fact that when Congress otherwise intended to grant bankruptcy courts the ability to "equitably" craft exceptions to rules set forth in the Bankruptcy Code, "it did so in the statute itself" (citing sections 365(d)(5), 502(j), 552(b)(1), 557(d)(2)(D), 723(d), 1113(c), and 1114(g)).

Moreover, the majority emphasized, even if the court were in a position to legislate from the bench, it would not embrace "a case-specific, equitable approach." It found "unappealing the prospect of saddling bankruptcy proceedings with the added cost and delay of attempting to draw fact-sensitive and unreliable distinctions between greater and lesser burdens" borne by the parties. Instead, the First Circuit majority wrote, "we favor the categorical approach of leaving trademark licenses unprotected from court-approved rejection, unless and until Congress should decide otherwise."

Outlook

The First Circuit’s effective retrenchment to the Lubrizol approach in Tempnology is anything but welcome news for trademark licensees. In the five years since Sunbeam was decided, only a handful of reported decisions have discussed the impact of the rejection of a trademark license on the licensee’s ability to use the licensed trademarks, and only one court (other than the bankruptcy court and the appellate panel in Tempnology) has actually decided the issue. In In re Crumbs Bake Shop, Inc., 522 B.R. 766 (Bankr. D.N.J. 2014), the bankruptcy court followed Sunbeam in ruling that trademark licensees are entitled to the protections of section 365(n) of the Bankruptcy Code, notwithstanding the omission of trademarks from section 101(35A)’s definition of "intellectual property." The court also held that a sale of assets "free and clear" under section 363(f) does not trump or extinguish the rights of a third-party licensee under section 365(n), unless the licensee consents. See also Interstate Bakeries, 751 F.3d at 963 (a trademark license agreement was not executory and thus could not be assumed or rejected); Harrell v. Colonial Holdings, Inc., 923 F. Supp. 2d 813, 818 n.4 (E.D. Va. 2013) (noting the disagreement between Lubrizol and Sunbeam, but also that the parties had not raised the issue of the impact which the debtor’s rejection of a trademark license had on the licensee’s rights). Tempnology undermines any sense of security that Sunbeam and Crumbs offered to trademark licensees considering the ramifications of a licensor’s bankruptcy filing and subsequent rejection of a trademark license.

The First Circuit’s ruling highlights that there are limits to a bankruptcy court’s equitable powers. Guided by U.S. Supreme Court precedent, most courts recognize that, considerations of fairness aside, a bankruptcy court’s broad equitable discretion is not a mandate to depart from the plain meaning of the Bankruptcy Code. Reformation of the statute is left to Congress.

Despite its refusal to review Sunbeam in 2012, the U.S. Supreme Court may finally agree to weigh in on this important issue due to the widening circuit split created by Tempnology.

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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