A long-running issue concerning the treatment of trademark licenses in bankruptcy has seen a new milestone with the January 12 decision of the First Circuit in Mission Product Holdings, Inc. v. Tempnology, LLC.[1]  The issue was implicit in the Bankruptcy Code from the time of its adoption in 1978 and flared into the open with the decision of the Fourth Circuit in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc.[2]  Congress rejoined the fray when it enacted the Intellectual Property Bankruptcy Protection Act of 1987, P.L. 100-506, in 1988.[3]  Then, in 2012, the Seventh Circuit jumped in with its decision in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC.[4]  I’m going to let an excerpt from our 2012 Sunbeam Client Alert provide the background and tee up the issue:

The U.S. Court of Appeals for the Seventh Circuit in Chicago has issued a decision with significant implications for licensees of trademarks whose licensors become debtors in bankruptcy. In Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, the Court considered whether rejection of a trademark license in bankruptcy deprives the licensee of the right to use the licensed mark.¹  Disagreeing with the holding of the Court of Appeals for the Fourth Circuit in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc.,² the Court concluded that a licensee could continue to use the licensed mark notwithstanding the rejection of the license agreement.  The decision may have important implications also for other types of intellectual property licenses and, indeed, all other kinds of contracts, licenses and leases as well.

Lubrizol and Congressional Response

Lubrizol held that, when an IP license is rejected in the bankruptcy case of the licensor, the licensee “could not seek to retain its contract rights in the [IP] by specific performance.”  746 F.2d at 1048.  Lubrizol was universally understood to mean that the licensee loses the right to use any licensed IP following rejection of the license agreement.  The licensee’s sole remedy under the Bankruptcy Code following rejection of its license agreement, Lubrizol explained, is a claim for damages.  Id.

Lubrizol created a dilemma for IP licensees.  They could spend years and huge sums of money developing and marketing a new drug or electronic device based upon a compound or technology licensed from the patent holder, but they would always be at risk of losing the right to use the patented compound or technology if the license were to be rejected in the bankruptcy case of the patent-holding licensor and be left with nothing to show for its investment but an unsecured claim for damages.

Congress responded to these concerns, expressed with particular vigor by the computer and pharmaceutical industries, by enacting Section 365(n) of the Bankruptcy Code.³  Passed into law expressly to overrule Lubrizol, subsection (n) permits a licensee of “intellectual property” to elect to retain the right to use the licensed IP after rejection of a license agreement, as long as it continues to perform its obligations under the license (e.g., make all required royalty payments).⁴  However, the definition of “intellectual property” that was added to the Bankruptcy Code as part of the 1987 Act did not include trademarks.⁵  While it was clear after the enactment of the 1987 Act that rejection of an IP license in the licensor’s bankruptcy would not interfere with the licensee’s right to use copyrights and patents (along with trade secrets, plant varieties and mask works) if a licensee so elected, the effect of rejection on a licensee’s right to use trademarks post-rejection was unaffected.

Sunbeam

More than 25 years after Lubrizol, another Court of Appeals has offered a starkly different understanding of the effect of rejection on a trademark licensee who, by congressional omission, is unable to make a continuing use election under Section 365(n). . . . 

* * * *

As an initial matter, the Sunbeam Court rejected the notion that Congress approved the Lubrizol decision with respect to trademarks by excluding them from the definition of “intellectual property” added by the 1987 Act.  “Some bankruptcy judges have inferred from the omission that Congress codified Lubrizol with respect to trademarks, but an omission is just an omission.  The limited definition in §101(35A) means that §365(n) does not affect trademarks one way or the other.”⁸

The Sunbeam Court then turned its analysis to the effect of the trustee’s rejection of the trademark license on [the licensee’s] rights.  The Court explained that, under Section 365(g) of the Bankruptcy Code, rejection constitutes a breach of the contract, not a termination . . . .  A “licensor’s breach does not terminate a licensee’s right to use intellectual property [. . . ] outside of bankruptcy,” the Court explained, and Section 365(g) preserves that result in bankruptcy.  Id. at 376.⁹

1.-3.  [footnotes omitted].

4.  A Section 365(n) election comes with some additional baggage.  In addition to continued performance, the licensee must waive any setoff claim arising under the license agreement and any claim for an administrative expense under Section 503(b) arising from its performance under the license agreement.  See Section 365(n)(2)(C).

5.  Tradenames and service marks are also excluded. See Bankruptcy Code § 101(35A) (definition of “intellectual property”).  Congress believed that trademark licenses--

raise issues beyond the scope of this legislation. In particular, trademark, trade name and service mark licensing rela­tionships depend to a large extent on control of the quality of the products or services sold by the licensee. Since these matters could not be addressed without more extensive study, it was determined to postpone congressional action in this area and to allow the development of equitable treatment of this situation by bankruptcy courts. Senate Report on P.L. 100-505, at 5.

“[P]ostpone” suggests that Congress intended to revisit the issue of trademarks, but, in the nearly 25 years since enactment of the 1987 Act, it has never done so.

6.  Sunbeam, 686 F.3d at 374.

7.  It was undisputed that [the licensee] could elect to retain its rights to use the patents under Section 365(n).

8.  Id. at 375.  According to Sunbeam, the legislative history of Section 365(n) indicates that “the omission [of trademarks from the “intellectual property” definition] was designed to allow more time for study, not to approve Lubrizol.”  Id.  See also n.5, supra.

9.  The Court was clear that, unlike the Bankruptcy Court, it did not base its holding on equitable notions of fairness to [the licensee] but rather a straightforward explication of the Bankruptcy Code.  See id. at 376.  It thus declined the Senate’s invitation to “develop[] equitable treatment of this situation . . . .”

The conclusion that Section 365(g) saves a rejected trademark license from termination was completely rejected by the majority in Tempnology:

[T]he approach taken by Sunbeam entirely ignores the residual enforcement burden [under trademark law] it would impose on the debtor just as the [Bankruptcy] Code otherwise allows the debtor to free itself from executory burdens.  The [Sunbeam] approach also rests on a logic that invites further degradation of the debtor’s fresh start options. . . .  [W]e favor the categorical approach of leaving trademark licenses unprotected from court-approved rejection, unless and until Congress should decide otherwise.[5]

The Sunbeam and Tempnology approaches are, in effect, two materially different answers to the fundamental question of what is the effect of the rejection of any executory contract, not limited to trademark licenses, for which a different answer is not specified by the Bankruptcy Code.[6]  Does rejection convert all of the non-debtor party’s rights under the rejected contract into a pre-petition monetary claim and otherwise terminate all such rights (Tempnology), or does rejection have only the effects that would result under non-bankruptcy law from a pre-petition breach by the debtor, which do not necessarily include termination, with the non-debtor party’s damages remedies converted into a pre-petition monetary claim (Sunbeam)?  Why hasn’t such a basic question been settled long ago in the 40-year life of the Bankruptcy Code?  These issues have an uncanny way of avoiding resolution.  This one is likely to remain open and contested “unless and until Congress”--or the Supreme Court--“should decide otherwise.”[7]

[5]  Tempnology at *33-34.  Although the Court did not mention it, the Sunbeam approach also ignores the potential to erode the value of the debtor’s IP of allowing a counterparty (apparently at its sole option) to treat a trademark license as continuing notwithstanding rejection even without regard to “the residual enforcement burden” that it does mention.

[6]  I.e., an executory contract for which special treatment is not otherwise authorized or required, such as real property leases (§ 365(h)(1)(A)), contracts for the sale of real property or timeshare interests (§ 365(i)(1)) and licenses of IP other than trademarks (§ 365(n)(1)).

[7]  Tempnology at *34.