Every article, blog post, book chapter or court decision this blogger has ever read about Section 365(n) of the Bankruptcy Code and the treatment of trademark licenses thereunder has always been either dizzyingly abstruse, deadly boring, or both. We make no guarantees as to the latter, but a recent decision by the First Circuit Court of Appeals provides a possible opening to a new clarity in discussing Section 365(n).

Let’s start with some background. When a company enters Chapter 11 bankruptcy, section 365(a) of the Bankruptcy Code permits the trustee (or debtor-in-possession) to reject certain executory contracts which the trustee deems may hinder the debtor’s reorganization. An executory contract is one where there are still duties to perform on both sides, and it’s consistent with the purposes of Chapter 11 to permit a debtor to shed those obligations which would otherwise impede its recovery. Reorganization in bankruptcy would be pointless if the debtor were still left saddled with onerous obligations (which may have contributed to the bankruptcy to begin with).

That all seems reasonable enough. But there will be collateral damage. Suppose you are a licensee of certain intellectual property, the use of which is critical to your business. What happens if your licensor declares bankruptcy and rejects your license. Suddenly, through no fault of your own, are you left without the right to use the IP assets necessary for your own operations (and possibly survival)?

This was the question confronting the Court in Lubrizol Ents., Inc. v. Richmond Metal Finishers, Inc. (756 F.2d 1043 (4th Cir. 1985)). Section 365(g) of the Code provides that the rejection of a contract shall be deemed a pre-petition breach of the contract. The Lubrizol Court held that a rejection under § 365(a) constituted a termination of the license, and the only remedy for that breach would be a claim for damages. To compel the debtor’s specific performance would frustrate the core purpose of Section 365(a). The licensee was left unable to continue using the licensed IP.

This seemed like a harsh outcome for licensees, and Congress stepped up not long afterward, amending Section 365 to add a new subsection (n). Section 365(n) provides that if a debtor/licensor rejects an IP license agreement; the licensee shall have the option of either (a) accept the termination of the agreement and whatever damages claim might apply; or (b) to continue using the licensed IP under the agreed upon terms for the duration of the agreement.

Again, straightforward enough… except the Bankruptcy Code’s definition of “intellectual property” as referenced in section 365(n) does not include trademarks. Congress, in its wisdom, opted to allow case law to develop with respect to trademark licenses and so they very intentionally omitted trademark licenses from the protection of section 365(n).

As night follows day, a Congressional decision to let case law develop led eventually to a circuit split. Thus, while Lubrizol remains good law in the Fourth Circuit, the Court of Appeals in the Seventh Circuit, in a case arising after the enactment of Section 365(n) reached a different result. In Sunbeam Products, Inc. v. Chicago Amer. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012), the court reasoned that it would be inequitable for the bankrupt licensor to “vaporize” the licensee’s rights completely, and so concluded that while rejection under section 365 removed the debtor’s duty to perform its obligations under a trademark license, it did not affect the licensee’s rights to continue using the licensed trademarks.

Now we come to Mission Product Holdings, Inc. v. Tempnology LLC (In re Tempnology LLC), Case No. 16-9016 (1st Cir., January 12, 2018). Mission was the licensee in an agreement granting it (a) certain broad license rights to a number of patents and other know-how; (b) an exclusive distributorship for sale of goods in the United States; and (c) a more limited license to certain trademarks. Tempnology filed its Chapter 11 petition and promptly moved to reject the agreement with Mission. On appeal, the parties agreed that the patent license was covered by Section 365(n), and the Court concluded without much heavy lifting that the distributorship right was not a “intellectual property” right within the ambit of that section.

But as for the trademark license, a divided panel of the Court declined to follow the Seventh Circuit’s approach in Sunbeam and concluded instead that (consistent with Lubrizol) that the rejection of the license agreement effectively terminated the license leaving Mission with only a damages claim for pre-petition breach of contract. In an opinion notable for its clarity, the Tempnology court reasoned that permitting the licensee to keep using the mark would place continuing obligations on the debtor/licensor – effectively a specific performance that section 365 is designed to avoid. The Court noted the unique characteristics of a trademark license, specifically the obligation of a licensor to establish, monitor and enforce quality standards for use of the marks – a measure essential to preserve the validity of the licensed marks themselves. Forcing a debtor/licensor to continue to shoulder this quality control burden was both inconsistent with the goals of reorganization, it was also impractical in situations where the relationship between the parties was already frayed if not hostile. The efforts of the Sunbeam court, and of the Tempnology dissent, to fashion some sort of equitable compromise for the benefit of the licensor were just too far outside both the language and the intent of Section 365.

The Tempnology decision thus crystalizes the circuit split on the treatment of trademark licenses in bankruptcy. While Sunbeam was arguably in conflict with Lubrizol, Lubrizol pre-dated the enactment of Section 365(n). Now there are divergent decisions from two circuits assessing the issue in light of Section 365(n). There are compelling interests on both sides of the question: the need for the debtor to be able to start over without being burdened by unfavorable pre-petition contracts, and the interests of the (presumably faultless) licensee whose contractual right to use critical assets is suddenly taken away. It will be interesting to see how other Circuit Courts of Appeal come down.

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