The United States Supreme Court has agreed to address “[w]hether, under §365 of the Bankruptcy Code, a debtor-licensor’s ‘rejection’ of a license agreement—which ‘constitutes a breach of such contract,’ 11 U.S.C. §365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law.” The appeal arises from a First Circuit decision, Mission Prod. Holdings, Inc. v. Tempnology, LLC, holding that the plain language and policy of the Bankruptcy Code necessitated a finding that Tempnology, LLC’s (the “Debtor”) rejection of a marketing and distribution agreement (the “Agreement”) with Mission Product Holdings, Inc. (“Mission”) “left Mission with only a pre-petition damages claim in lieu of any obligation by Debtor to further perform under . . . the trademark license[.]”
As noted by Mission in its cert petition, “[t]he First Circuit’s decision openly chooses sides—rejecting the Seventh Circuit’s position and aligning itself with the Fourth Circuit—in a longstanding circuit split on a fundamental bankruptcy question: the effect of a debtor’s rejection of an executory contract, and, in particular, an agreement to license intellectual property.” A decision by the Supreme Court, therefore, should resolve the conflict among circuits and provide guidance as to whether licensees’ rights under trademark agreements are either terminated or continue post-rejection.
Rejection of Executory Contracts under the Bankruptcy Code
Under section 365 of the Bankruptcy Code, a debtor may reject executory contracts, i.e. contracts on which performance is due to some extent on both sides. The Bankruptcy Code treats the rejection as a pre-petition breach and grants the counterparty an unsecured claim for damages. The rejection of a license agreement under which the debtor is a licensor is governed by section 365(n)(1), which provides licensees of intellectual property rights a choice between treating the license as terminated and asserting a damages claim or retaining its intellectual property rights under the license. The Bankruptcy Code defines “intellectual property” to include, inter alia, trade secrets and patent applications, but not trademarks.
The Split between the Fourth and Seventh Circuits
In 1985, the Fourth Circuit held in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. that a debtor-licensor’s rejection of an agreement to license intellectual property terminated the licensee’s right to continue to use the intellectual property, thereby allowing the debtor to sell or license it to a third party without any limitations. The court reasoned that section 365(g) only provided for a damages remedy and, therefore, that the licensee “could not seek to retain its contract rights in the technology by specific performance even if that remedy would ordinarily be available upon breach of this type of contract [outside of bankruptcy].” In response to Lubrizol, Congress enacted section 365(n) to govern the rejection of licenses of certain types of intellectual property. Courts, however, remain divided on the effect of rejection of trademark rights, with some courts applying Lubrizol’s holding to such rights.
In 2012, the Seventh Circuit in Sunbeam Prods., Inc. v. Chicago Am. Mfg. rejected Lubrizol’s holding as applied to trademarks and held that the rejection of a trademark license does not terminate a licensee’s right to use a debtor’s trademarks. The court reasoned that section 365 is not an avoiding power; rather, as evidenced by section 365(g)’s treatment of rejection as a breach, section 365 relieves a debtor of its obligations under a rejected contract while the other party’s rights remain in place as they would under non-bankruptcy law: “outside of bankruptcy, [the debtor] could not have ended [the licensee’s] right to sell the [trademarked goods] by failing to perform its own duties.” Consequently, the debtor could not terminate the licensee’s right to sell the trademarked goods by rejecting the agreement in bankruptcy. Notably, section 365(n) did not influence the Seventh Circuit’s analysis because the court reasoned that the “limited definition [of ‘intellectual property’] in the Bankruptcy Code means that § 365(n) does not affect trademarks one way or the other.”
The First Circuit’s Decision in Mission Prod. Holdings, Inc. v. Tempnology, LLC
Prior to the bankruptcy, the Debtor granted Mission a “non-exclusive, non-transferable, limited license . . . to use [Debtor’s] trademark and logo.” Thereafter, the parties became embroiled in a dispute regarding the termination of the Agreement, with both parties seeking to terminate the Agreement, and Mission’s ongoing rights to use the Debtor’s trademarks. The dispute was brought before an arbitrator, who determined that Mission was contractually entitled to retain its trademark rights for a two-year wind-down period. Shortly thereafter, the Debtor commenced its bankruptcy case and moved to reject the Agreement.
The Bankruptcy Court approved the rejection, subject to Mission’s rights under section 365(n). However, the Bankruptcy Court “concluded that Mission’s election pursuant to section 365(n) did not preserve either the exclusive distribution rights or the trademark license” because “Congress’s decision to leave trademarks off the definitional list of intellectual properties in 11 U.S.C. § 101(35A) left the trademark license unprotected from rejection.”
On appeal, the First Circuit upheld the Bankruptcy Court’s ruling and disagreed with the Seventh Circuit’s approach in Sunbeam. While the court addressed the absence of “trademark licenses” from the protective ambit of section 365(n), the court cited the underlying policy of allowing a debtor to reject executory contracts as determinative of the issue.
The court rejected Sunbeam’s “unstated premise that it is possible to free a debtor from any continuing performance obligations under a trademark license even while preserving the licensee’s right to use the trademark” because “the effective licensing of a trademark requires that the trademark owner . . . monitor and exercise control over the quality of the goods sold to the public under cover of the trademark.” Noting that “failure to monitor and exercise this control results in a so-called ‘naked license,’ jeopardizing the continued validity of the owner’s own trademark rights,” the First Circuit concluded that the holding in Sunbeam “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 . . . . Such a restriction on Debtor’s ability to free itself from its executory obligations, even if limited to trademark licenses alone, would depart from the manner in which section 365(a) otherwise operates.” Accordingly, the First Circuit determined that trademark licenses are unprotected from court-approved rejection, “unless and until Congress should decide otherwise.”
The Supreme Court
As previously discussed on this site, the uncertain treatment of trademarks under the Bankruptcy Code has troubled courts and parties on a wide variety of issues for decades. The Supreme Court, however, is now poised to end 30 years of uncertainty around at least one issue—the status of trademark rights when a debtor rejects a license agreement in bankruptcy. If the Court agrees with the Seventh Circuit, debtors could be in the untenable position of having to monitor trademark usage at a time when financial wherewithal may make that effort futile. If the Court sides with the First Circuit, licensees could see their businesses destroyed. Regardless of how the Court decides, Congress may wade back into the fray and revisit whether “trademarks” should be included as “intellectual property” under the Bankruptcy Code.