Quinn Emanuel Urquhart & Sullivan, LLP

Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019): The Supreme Court Protects Trademark Licensees, But Raises New Questions About The Effect Of Rejecting Executory Contracts

The Supreme Court has resolved a significant Circuit split concerning whether a trademark licensee can continue to use a mark notwithstanding rejection of the license agreement in bankruptcy.  In an 8-1 decision, the Court found in favor of the trademark licensee, holding that the debtor’s rejection of the license merely constitutes a breach , rather than a termination, and thus the non-debtor licensee may continue to exploit the debtor’s trademark notwithstanding rejection.  See Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019).  While this may be a good outcome for trademark licensees, the decision may have implications for bankruptcy practice far beyond the world of trademark licenses. 

Bankruptcy Code Section 365(a) (11 U.S.C. § 365(a)) provides that a Chapter 11 debtor may assume or reject any executory contract, subject to bankruptcy court approval.  A contract is “executory” when some performance remains due on both sides, such that the non-performance of one party will result in a breach of that agreement.  Section 365(g) states that “the rejection of an executory contract [ ] constitutes a breach of such contract” immediately before the filing date of the bankruptcy.  The practical consequences of this are (1) the debtor is no longer required to perform, and (2) the non-bankrupt counterparty is entitled to a claim for damages, but that claim can be discharged in bankruptcy, and the counterparty may only receive cents-on-the dollar for its damage claim (or in some cases nothing at all).

But what if the non-bankrupt counterparty still wants to receive the benefits of the rejected contract?  In most cases the non-bankrupt party is out of luck – the debtor cannot be compelled to perform following rejection.  There are, however, limited statutory exceptions.  For example, Section 365(n) provides that a licensee of certain intellectual property (principally copyrights and patents) can continue to use such intellectual property as long as it continues to fulfil its obligations under the license, including the payment of royalties.  Trademarks, however, are excluded from the Bankruptcy Code’s definition of “intellectual property” and therein lied the problem for the non-bankrupt trademark licensee in Mission Product.   Can the licensee continue to use the debtor’s trademark notwithstanding the debtor’s rejection of the license?

Factual Background and Procedural History

Mission held licenses from Tempnology to distribute activewear products.  Tempnology, however, filed for Chapter 11 and sought to reject the licenses.  Tempnology also sought a declaration from the bankruptcy court that rejection of the  licenses not only allowed it to stop performing but also terminated Mission’s rights to use the trademarks.  The bankruptcy court agreed. 

The Bankruptcy Appellate Panel (“BAP”) for the First Circuit reversed, relying on  Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC 686 F.3d 372, 376-77 (7th Cir. 2012).  The Sunbeam court focused on Section 365(g)’s direction that rejection of a contract constitutes a breach not a rescission.  While rejection converts a debtor’s breach of the contract to a prepetition damages claim, it does not “vaporize” the counterparty’s rights. 

The First Circuit Court of Appeals reversed.  Relying on unique features of trademark law, the Court held that allowing a licensee to retain its rights after rejection could jeopardize the continued validity of the trademark because the debtor would no longer be monitoring and exercising quality control over goods associated with the marks.  Requiring the debtor to do so would frustrate “Congress’s principal aim in providing rejection” to “release the debtor’s estate from burdensome obligations.”  The Supreme Court granted certiorari to resolve this conflict between the Seventh and First Circuits. 

The Supreme Court Resolves the Circuit Split

Justice Kagan authored the Court’s opinion holding that rejection of an executory contract operates as a breach giving rise to a prepetition damages claim, but it does not rescind the agreement.  The Court adopted the Seventh Circuit’s reasoning in Sunbeam and looked to non-bankruptcy contract law to determine whether a breach should be treated as a termination.  As Justice Kagan noted, outside of bankruptcy, the non-breaching party gets to decide whether to continue performing its own obligations under the agreement.  The breaching party, here the debtor, has no ability to terminate the agreement.

In preserving the rights of the non-debtor party to a rejected contract, Section 365 reflects the general bankruptcy rule that the estate cannot possess anything more than the debtor itself had outside of bankruptcy.  In other words, the same counterparty rights that survive a breach outside of bankruptcy survive a rejection inside of bankruptcy.

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The Court rejected Tempnology’s “negative inference” argument that a debtor’s rejection of a contract terminates a counterparty’s rights unless the contract falls within the express statutory exceptions of Section(n) which as noted only protects certain types of intellectual property licenses (principally copyrights and patents).. While Section 365(n) certainly addresses specific post-rejection rights, and may indeed limit, ever so slightly, the applicability of Section 365(g), the Court found that just because trademark licenses are not covered by Section 365(n), that does not abrogate Section 365(g)’s application to all executory contracts, including trademark licenses. 

The Court also rejected Tempnology’s remaining arguments, including that the value of a debtor’s trademarks will be significantly denigrated if the debtor is unable to monitor the use of those marks.  The Court reasoned that, by allowing a debtor to reject all future contractual obligations, Section 365 “does not grant the debtor an exemption from all the burdens of generally applicable law-whether involving contracts or trademarks,” nor does it relieve the debtor of the need to make economic decisions about preserving the estate’s value, even if it means investing resources to preserve the marks (and potentially significantly increasing the cost of Chapter 11). 

Practical Implications

Trademark licensees can now take comfort in knowing that they retain the same post-rejection rights to exploit the marks that they would have had if the breach had occurred outside of bankruptcy.  Licensees cannot demand future affirmative performance from the debtor (such as the debtor’s protection of the mark), but they otherwise can elect to continue utilizing onthe mark on the same terms they did pre-rejection.  Indeed, trademark licensees may have somewhat broader post-rejection rights than patent and copyright licensees, who are restricted to the post-rejection rights delineated in Section 365(n). 

The Mission decision arguably is not limited to trademark licenses.  The Court discussed general contract principles and the applicability of Section 365(g) to all executory contracts.  The decision thus raises the question of whether (and to what extent) it has diminished the power of rejection in bankruptcy and made it more difficult for a debtor to shed burdensome obligations. As Justice Kagan noted, “[t]he Code of course aims to make reorganizations possible.  But it does not permit anything and everything that may advance that goal.”  Mission thus may create more obstacles to achieving a successful reorganization..  Although the general principle that “rejection is a breach and not a termination” is a long-standing one, Mission may encourage parties to rejected contracts to assert their rights to continue to use the debtor’s tangible or intangible personal property post-rejection.

Take, for example, parties who lease equipment from a debtor.  Mission suggests that those parties may be allowed to retain possession of the leased property, notwithstanding the debtor’s rejection of the lease.  Indeed, the Court used a hypothetical involving a copy machine leased by a debtor to a law firm, and the ensuing breach when the debtor fails to service the copier.  The Court noted that outside of bankruptcy, the lessee can excuse the breach and still keep possession of the copier through the term of the lease.  According to Mission, that result should be the same both inside and outside of bankruptcy.  If the copier lessor files for Chapter 11 and decides to reject its agreement with the law firm, the rejection is merely a breach, not a termination.  The debtor can stop servicing the copier, but it cannot regain possession of the copier if the law firm wants to keep using it during the lease term.  In other words, the law firm has an option about how to respond—continue the contract, or walk away and file a claim in the bankruptcy for damages. 

Mission thus may hinder the ability of some debtors and their creditors to maximize the value of a bankruptcy estate. 

Although Mission has clarified the rights of trademark licensees in bankruptcy, it also has potentially raised new questions about the effect of rejection in other contexts.

 

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