When a debtor-licensor files a bankruptcy to reject an outbound license of the debtor's trademarks to a third party licensee, what happens to the licensee's right to use the marks after rejection?2 That question has ostensibly been open to interpretation since 1988, when Congress amended Section 365 of the U.S. Bankruptcy Code3 to overrule the U.S. Court of Appeals for the Fourth Circuit's holding in Lubrizol Enterprises v. Richmond Metal Finishers, Inc.4In Lubrizol, the Fourth Circuit held that rejection of a technology licensee in the licensor's bankruptcy terminated the licensee's rights to use the debtor's intellectual property.5 Troubled by that result, Congress drafted Section 365(n)6 to clarify that rejection of a contract "under which the debtor is a licensor of a right to intellectual property" does not terminate the license outright. Rather, the licensee may elect at its sole discretion to either "treat such contract as terminated by such rejection" or else to "retain its rights" for the duration of the license term. Congress was unequivocal in declaring that Section 365(n) was intended to ensure that "rights of an intellectual property licensee to use of the licensed property cannot be unilaterally cut off" upon rejection of a license.7
In nearly all respects, the addition to Section 365 was celebrated as a significant victory for those that rely on inbound intellectual property licenses as part of their own business ventures. Expressly excluded from the intellectual property subject to Section 365(n), though, were "trademarks."8 The Senate committee report indicates that this omission was to allow more time for study, not as an approval of Lubrizol, but in the intervening three decades, Congress failed to complete that study or otherwise broaden the construct of Section 365(n). Trademarks remain beyond the scope of the Bankruptcy Code's definition of "intellectual property." They also make up the largest branch of registered intellectual property, over patents and copyrights.9
This perceived ambiguity in the Bankruptcy Code's treatment of trademark licenses has made it possible for debtor-licensors to successfully argue that they should be extricated from burdensome trademark licenses, pointing to the "negative inference" in the Code that a trademark licensee's rights terminate upon rejection since omitted from Section 365(n). Judicial relief for some licensees came in 2012 when the U.S. Court of Appeals for the Seventh Circuit considered the impact of rejection on trademark licenses and concluded that the exclusion of trademarks from Section 365(n) was not dispositive, since a trademark licensee's rights survive rejection by virtue of Section 365(g).10 Yet, outside the Seventh Circuit, debtor-licensors have continued to rely on Lubrizol and favorable lower-court precedent to successfully rescind trademark licensee rights through contract rejection in bankruptcy.
Just such a scenario found its way to the First Circuit in the case of Mission Product Holdings Inc. v. Tempnology LLC (In re Tempnology LLC)(Mission Products)11 on appeal of an order of the U.S. Bankruptcy Court for the District of New Hampshire challenged by a trademark licensee.12 In Mission Products, the First Circuit held that since Section 365(n) does not provide trademark licensees with the ability to retain their rights following rejection of the underlying license, the licensee's (Mission Product Holdings Inc.) right to use the trademarks did not survive rejection of the license. Put another way, the First Circuit was convinced that any and all rights once granted in favor of a trademark licensee are converted by Section 365(g)'s provisions to a claim for damages flowing from that breach to compensate for the loss of trademark use. The majority in Mission Products reasoned that it was not "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," as rejection is intended to accomplish, since a debtor would be required to "monitor and exercise control over the quality of the goods" produced by the licensee to protect the "continued validity" of its trademarks.13 The First Circuit's holding14 specifically rejected the Seventh Circuit's earlier decision in Sunbeam Products.15
Against this backdrop, in October 2018, the U.S. Supreme Court granted the petition for writ certiorari filed by the trademark licensee in Mission Products to consider one lone but crucial issue of Bankruptcy Code interpretation relating to the Circuit split: What effect rejection of the parties' license agreement in Mission Products had on the licensee's rights under the subject agreement with regard to trademarks.16 The Supreme Court had no trouble finding the answer to this question that has plagued so many other courts and practitioners for so long in a Code provision that has been staring us in the face the whole time, Section 365(g). In the Supreme Court's decision issued on May 20, 2019 (the Opinion), Justice Elena Kagan wrote:
[B]ecause rejection 'constitutes a breach,' §365(g), the same consequences follow in bankruptcy. The debtor can stop performing its remaining obligations under the agreement. But the debtor cannot rescind the license already conveyed. So the licensee can continue to do whatever the license authorizes.
– Mission Product Holdings Inc. v. Tempnology LLC,
587 U.S. __, (2019).17
The Supreme Court's analysis started (and ended) with "the text of the Code's principal provisions on rejection – and [found] that it does much of the work."18 Section 365(g) describes what rejection means, clearly treating that act as amounting to "breach" and not termination. The Court reasoned that " 'breach' is neither a defined nor a specialized bankruptcy term, it means in the Code what it means in contract law outside bankruptcy."19 Using a hypothetical copy machine lease as an example of how breach would impact a contract outside of bankruptcy, the Court pointed out that it is the non-breaching contract party that holds the ability to terminate a contract, not the party that committed the breach in the first instance. Similarly, rejection, the Court noted, does not terminate a contract in bankruptcy, but rather, the counterparty's contractual rights survive rejection. Since Sections 365(a) and (g) speak broadly, to "any executory contract[s]," and an intellectual property licensor's breach does not terminate a licensee's right to use the licensed intellectual property outside of bankruptcy, breach of a trademark license "does not revoke the license or stop the licensee from doing what it allows." The Court, therefore, rejected the "rejection-as-rescission" approach taken by the First Circuit so as to prevent debtors from using Section 365 as a means to avoid prepetition transfers of their property without complying with the statutory prerequisites contained in Chapter 5 of the Code.
In its analysis of the interplay between Section 365(n) and 365(g), the Court "reject[ed] the competing claim that by specifically enabling the counterparties in some contracts to retain rights after rejection, Congress showed that it wanted the counterparties in all other contracts to lose their rights."20 In so holding, the Court dismissed any "negative inference" that Congress was endorsing the Lubrizol logic for trademarks by excluding them from the Bankruptcy Code's definition of "intellectual property." Rather, despite the "mash-up of legislative interventions" found in Section 365, "Congress did nothing in adding Section 365(n) to alter the natural reading of Section 365(g)—that rejection and breach have the same results. "21
The Court was also not moved by the First Circuit's and licensor's urging that not relieving the debtor of the "burden" of monitoring a licensee's use of its trademarks in order to preserve quality and value even after rejection would impede a debtor-licensor's reorganization.22 The Court found that to permit concerns associated with tasks imposed upon a debtor for one particular type of contract among the many that are within the scope of Section 365(g) to influence interpretation of that provision would improperly enable the "tail to wag the Doberman."23 In any event, while through rejection the debtor can escape all of its future contractual obligations, Section 365 does not grant the debtor an exemption from the burdens that applicable law – whether involving contracts or trademarks – imposes on property owners. The Court was convinced that "Congress weighed (among other things) the legitimate interests and expectations of the debtor's counterparties" when it drafted Section 365, and while the "resulting balance" may indeed impede some reorganizations, "Section 365's edict that rejection is breach expresses a more complex set of aims" than the debtor-licensor would admit.24
Based on its interpretation of Section 365, the Supreme Court reversed the First Circuit's holding in Mission Products and in doing so, held that its construction of Section 365 means that "the debtor-licensor's rejection cannot revoke the trademark license."25 Its holding far goes beyond intellectual property licenses, though, to all executory contracts that might someday intersect with Section 365. The Court ruled, broadly, that:
A debtor's rejection of an executory contract in bankruptcy has the same effect as a breach of that contract outside bankruptcy. Such an act cannot rescind rights that the contract previously granted.
– Opinion at p. 1
As the dust settles and the trademark bar's victory lap concludes, it remains to be seen whether the Opinion will indeed provide trademark licensees with assurance that if they develop a business model around use of trademarks and other intellectual property, a licensor's intervening bankruptcy will not impact their own company's survival over the term of the license agreement.
Perhaps one lesson that can be learned from this result is that the contractual quality control obligations on the licensee should be robust and clear – if the licensee's rights to use a licensed trademark survive rejection in bankruptcy, so too do the licensee's obligations with regard to such use. If a licensor desires to ensure protection of its brand in the unfortunate event the licensor finds itself in bankruptcy, such considerations must play a role in the drafting and negotiation of the trademark license.
Along these lines, both trademark licensors and licensees may leverage this ruling to negotiate more favorable licensing terms – while licensors may push for terms that enhance brand protection, that reflect greater brand value and that seek to ensure a revenue stream in the event of bankruptcy, licensees may try for terms that better define rights and obligations to avoid uncertainty in the event of bankruptcy. As Justice Sonia Sotomayor pointed out in her concurring opinion, the Court did not decide that "every trademark licensee has the unfettered right to continue using licensed marks postrejection."26 The true extent of what a licensee may retain depends in large part on the terms of the underlying contract, or perhaps state law, and remains fluid.
Though the Court's Opinion may make a licensee's rights in bankruptcy less tenuous, it leaves unresolved certain questions regarding the implications of the ruling. Justice Sotomayor also observed that by excluding trademarks from the Code's definition of "intellectual property" subject to the requirements of Section 365(n), it is unclear if trademark licensees, like patent licensees, are required to continue making royalty payments with no right to deduct damages from their payments even if they otherwise could have done so under nonbankruptcy law – or if such a deduction is indeed available to a trademark licensee electing to retain its rights to use a mark. As Justice Sotomayor posited, such an outcome "leaves Congress with the option to tailor a provision for trademark licenses, as it has repeatedly in other contexts."
Until then, we expect the clarity will be short-lived.
1 For a more detailed discussion of the concepts discussed herein, see Holland & Knight's alert, "First Circuit: Trademark Licensee Doesn't Retain Rights After Rejection by Bankrupt Licensor," May 11, 2018, by Lynne B. Xerras and John J. Monaghan.
2 Under Section 365 of the U.S. Bankruptcy Code (the Code or Bankruptcy Code), a debtor may seek to shed by moving to "reject" certain burdensome contracts and licenses under a "business judgment" standard. 11 U.S.C. §365(a); see NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531–32 (1984)(discussing treatment of executory contracts).
3 Section 365 deals with treatment of "executory" contracts, permitting a debtor to assume or reject them. A contract is executory if "performance remains due to some extent on both sides." NLRB v. Bildisco & Bildisco, 465 U.S. at 522, n. 6 (internal quotation marks omitted).
4 756 F.2d 1043 (4th Cir. 1985).
5 In its decision, the court acknowledged that the decision "could detrimentally affect a licensor's willingness to enter into a contract with potentially financially unstable parties, but found that such equitable considerations were irrelevant in light of Congress' decision to allow executory contract rejection." 756 F.2d at 1048.
6 The act was called the Intellectual Property Bankruptcy Protection Act of 1988.
7 See S. Rep. No. 100-505.
8 See 11 U.S.C. §101(35A) (detailing the statutory definition of intellectual property).
9 World Intellectual Property Organization, World Intellectual Property Report: Brands—Reputation And Image In The Global Marketplace 9 (2013).
10 Sunbeam Prods., Inc. v. Chi. Am. Mfg., LLC, 686 F.3d 382 (7th Cir. 2012).
11 879 F.3d 389 (1st Cir. 2018).
12 The Bankruptcy Court order was first appealed to the Bankruptcy Appellate Panel, with that court holding that rejection does, in fact, convert unfulfilled obligations to an unsecured claim for damages; but, it does not "vaporize" a licensee's rights. In Re Tempnology LLC, 559 B.R. 809, 820 (B.A.P. 1st Cir. 2016).
13 In doing so, the majority followed the Fourth Circuit's decision in Lubrizol Enterprises v. Richmond Metal Finishers, Inc., supra.
14 In 2018, the U.S. Bankruptcy Court for the District of Connecticut examined the effects and relevance of the First Circuit's holding in Mission Products in In re SIMA International, Inc., finding it to be flawed. 2018 WL 2293705, at *7–8 (Bankr. D. Conn. May 17, 2018).
15 In dissent in Mission Products, Judge Juan Torruella criticized the majority for "treat[ing] a debtor's rejection as a contract cancellation, rather than a contractual breach." 879 F.3d at 405–07 (Torruella, J., dissenting).
16 The Supreme Court also held that the appeal was not "moot" even though the licensee chose not to continue to sell products bearing the licensed marks, with Justice Neil Gorsuch dissenting on this part of the decision.
17 Opinion at p. 10.
18 Opinion at p. 8.
19 Opinion at p. 10.
20 Opinion at p. 8.
21 Opinion at p. 14.
22 Absent those efforts to keep up quality, the mark will naturally decline in value and may eventually become altogether invalid. See 3 J. McCarthy, Trademarks and Unfair Competition §18:48, pp. 18–129, 18–133 (5th ed. 2018).
23 Opinion at p. 15-16.
24 Opinion at 16.
25 Opinion at p. 17.
26 Sotomayor, J. concurring.
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