Insights

Connecticut Bankruptcy Court Adds Fuel to the Fire in Debate Over Effect of Rejection of Trademark License

In In re SIMA Int'l, Inc., 2018 WL 2293705 (Bankr. D. Conn. May 17, 2018), the U.S. Bankruptcy Court for the District of Connecticut ruled that a chapter 7 trustee's rejection of an intellectual property license agreement did not deprive the licensee of the continuing right to use the licensed intellectual property, including a trademark, because the licensee made a timely election under section 365(n) of the Bankruptcy Code. According to the court, rejection of the agreement, of which the trademark license was an integral component, resulted in a nonmaterial breach, rather than termination, and the section 365(n) election "indisputably" preserved the licensee's exclusive right to use the intellectual property during the remaining term of the license agreement.

In so ruling, the bankruptcy court embraced the approach articulated by the U.S. Court of Appeals for the Seventh Circuit in Sunbeam Prods., Inc. v. Chicago Am. Manuf., LLC, 686 F.3d 372 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012), and rejected the contrary view endorsed by the Fourth and First Circuits—the only other circuit courts of appeals that have directly addressed the issue—in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985), and Mission Product Holdings, Inc. v. Tempnology, LLC (In re Tempnology, LLC), 879 F.3d 389 (1st Cir. 2018).

The widening rift among the courts on this issue may be an invitation to U.S. Supreme Court review.

Special Rules Governing Rejection of Certain Intellectual Property Licenses in Bankruptcy

Absent special statutory protection, the rejection of an intellectual property ("IP") license by a chapter 11 debtor-in-possession ("DIP") or a bankruptcy trustee can have a severe impact on the licensee's business and leave the licensee scrambling to procure other IP to keep its business afloat. This concern was heightened by the Fourth Circuit's 1985 ruling in Lubrizol. In that case, the court held that, if a debtor rejects an executory IP license, the licensee loses the right to use any licensed copyrights, trademarks, and patents. The court also concluded that the licensee's only remedy was to file a claim for money damages, since the licensee could not seek specific performance of the license agreement.

In order to better protect such licensees, Congress amended the Bankruptcy Code in 1988 to add section 365(n). Under section 365(n), licensees of some (but not all) IP licenses have two options when a DIP or trustee rejects the license. The licensee may either: (i) treat the agreement as terminated and assert a claim for damages; or (ii) retain the right to use the licensed IP for the duration of the license (with certain limitations). By adding section 365(n), Congress intended to make clear that the rights of an IP licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license.

However, notwithstanding the addition of section 365(n) to the Bankruptcy Code, the legacy of Lubrizol endures—since by its terms, section 365(n) does not apply to trademark licenses and other kinds of "intellectual property" outside the Bankruptcy Code's definition of the term. In particular, trademarks, trade names, and service marks are not included in the definition of "intellectual property" under section 101(35A) of the Bankruptcy Code. Because of this omission, courts continue to struggle when determining the proper treatment of trademark licenses in bankruptcy.

Sunbeam Gives Trademark Licensees a Glimmer of Hope

In Sunbeam, the Seventh Circuit expressly rejected the Lubrizol court's approach to trademark licenses. Focusing on the impact of section 365(g) of the Bankruptcy Code (which specifies the consequences of rejection), the Seventh Circuit explained that, outside bankruptcy, a licensor's breach does not terminate a licensee's right to use IP. According to the court, "What § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party's rights remain in place." The debtor's unfulfilled obligations under the contract are converted to damages, which, if the contract has not been assumed, are treated as a prepetition obligation. "[N]othing about this process," the court remarked, "implies that any rights of the other contracting party have been vaporized." Instead, rejection "merely frees the estate from the obligation to perform and has absolutely no effect upon the contract's continued existence" (internal quotation marks and citation omitted).

The Seventh Circuit reasoned that lawmakers' failure to include trademark licenses among the "intellectual property" protected by section 365(n) should not be viewed as an endorsement of any particular approach regarding rejection of a trademark license agreement. Rather, the Seventh Circuit wrote, the legislative history indicates that "the omission was designed to allow more time for study, not to approve Lubrizol."

The Third and Eighth Circuits also have had the opportunity to weigh in on the validity of the Lubrizol approach but declined to reach the issue for a variety of reasons. See Lewis Bros. Bakeries Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 751 F.3d 955 (8th Cir. 2014) (ruling that a license agreement was not executory and thus could not be assumed or rejected because the license was part of a larger, integrated agreement which had been substantially performed by the debtor prior to filing for bankruptcy); In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010) (sidestepping the issue and concluding that a trademark license agreement was not executory; in a concurring opinion, Judge Ambro noted that Congress's decision to leave treatment of trademark licenses to the courts signals nothing more than Congress's inability, when it enacted section 365(n), to devote enough time to consideration of trademarks in the bankruptcy context).

First Circuit Takes Opposite Approach in Tempnology

A divided First Circuit rejected the Sunbeam approach in Tempnology. According to the First Circuit majority, the "unstated premise" of Sunbeam is flawed because freeing a debtor from any continuing performance obligations under a trademark license, while preserving the licensee's right to use the trademark, simply does not comport with Congress's principal aim in providing for rejection of a contract—namely, to "release the debtor's estate from burdensome obligations that can impede a successful reorganization" (citing NLRB v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984)).

The majority explained that the effective licensing of a trademark requires the trademark owner (or any purchaser of its assets) to monitor and exercise control over the quality of the goods sold to the public under cover of the trademark, failing which the trademark owner would be left with a "naked license" that would jeopardize the continued validity of its trademark rights. The Sunbeam approach, the majority emphasized, would allow the licensee to retain the use of licensed trademarks "in a manner that would force the company to choose between performing executory obligations under the license or risk the permanent loss of its trademarks."

Such a restriction on the licensor's ability to free itself from its executory obligations, even if limited to trademark licenses, the majority wrote, "would depart from the manner in which section 365(a) otherwise operates."

In a dissenting opinion, circuit judge Juan R. Torruella disagreed with the majority's "bright-line rule that the omission of trademarks from the protections of section 365(n) leaves a non-rejecting party without any remaining rights to use a debtor's trademark and logo." Instead, Judge Torruella would follow Sunbeam in concluding that a licensee's rights to use the licensed trademark "d[o] not vaporize" because of rejection of the agreement.

The First Circuit majority was critical of the dissent, writing that "our dissenting colleague seems to reject [Sunbeam's] categorical approach in favor of what Sunbeam itself rejected—an 'equitable remedy' that would consider in some unspecified manner the 'terms of the Agreement, and non-bankruptcy law' " (quoting Sunbeam, 686 F.3d at 375–76). According to the majority, the dissent accorded too much weight to a few lines in the legislative history and overlooked the fact that when Congress otherwise intended to grant bankruptcy courts the ability to "equitably" craft exceptions to rules set forth in the Bankruptcy Code, "it did so in the statute itself" (citing sections 365(d)(5), 502(j), 552(b)(1), 557(d)(2)(D), 723(d), 1113(c), and 1114(g)).

Other Recent Case Law

In the six years since Sunbeam was decided, only a handful of reported decisions have discussed the impact of the rejection of a trademark license on the licensee's ability to use licensed trademarks. In addition to the First Circuit (and lower courts) in Tempnology, only two courts have actually decided the issue.

In In re Crumbs Bake Shop, Inc., 522 B.R. 766 (Bankr. D.N.J. 2014), the U.S. Bankruptcy Court for the District of New Jersey followed Sunbeam in ruling that trademark licensees are entitled to the protections of section 365(n) of the Bankruptcy Code, notwithstanding the omission of trademarks from section 101(35A)'s definition of "intellectual property." The court also held that a sale of assets "free and clear" under section 363(f) does not trump or extinguish the rights of a third-party licensee under section 365(n) unless the licensee consents. See also Interstate Bakeries, 751 F.3d at 963 (a trademark license agreement was not executory and thus could not be assumed or rejected); Harrell v. Colonial Holdings, Inc., 923 F. Supp. 2d 813, 818 n.4 (E.D. Va. 2013) (noting the disagreement between Lubrizol and Sunbeam, but also that the parties had not raised the issue of the impact which the debtor's rejection of a trademark license had on the licensee's rights).

Another bankruptcy court recently joined the fray in SIMA Int'l.

SIMA Int'l

SIMA International, Inc. ("SIMA") owns certain copyrights, trademarks, and other IP relating to a process that analyzes motivational patterns to assist individuals and employers in making career and employment decisions. Prior to filing a chapter 7 petition on November 17, 2017, in the District of Connecticut, SIMA, in exchange for royalties, licensed the process, including associated trademarks, to various parties under agreements that allowed the licensees or sublicensees to use the IP to create or develop derivative works, modifications, adaptations, or other improvements relating to the technology.

Such a license agreement with Marlys Hanson, Inc. ("MHI") provided in relevant part that the licensed technology "includes but is not limited to the [scheduled] trademarks and copyrights" in relation to product adaptations developed by MHI, and the agreement required SIMA's approval for any usage of the license in connection with adaptations. The agreement also provided that any licensed products must carry an attribution statement indicating SIMA's ownership of the technology.

Shortly after entering into the license agreement, MHI developed valuable software incorporating the licensed technology.

SIMA's chapter 7 trustee moved to reject the license agreement with MHI in December 2017. MHI objected and filed a notice pursuant to section 365(n) of its election to retain its rights under the license agreement. The parties did not dispute that the license agreement was an executory contract or that rejection of the agreement would benefit SIMA's estate by enhancing the value of the IP in a bankruptcy sale.

Instead, the parties disputed whether: (i) the section 365(n) election entitled MHI to the continued use of the licensed trademark; and (ii) the election preserved MHI's exclusive rights under the license agreement to develop and sell products using the licensed technology.

The Bankruptcy Court's Ruling

After examining the language of section 365(n), its historical context, and relevant case law, the bankruptcy court noted that "[t]his Court, like many others, does not endorse the reasoning in Lubrizol and is not alone in concluding that its reasoning is flawed" (citing Sunbeam, 686 F.3d at 377–78).

Instead, the bankruptcy court aligned itself "with the plain language reading of Section 365(g) advanced" by the Seventh Circuit in Sunbeam. First, the court explained, under section 365(g), the rejection of a contract constitutes a breach rather than termination of the contract. Under Connecticut law (the law governing the license agreement), a counterparty is relieved of continued performance under a contract if the breach is material. In this case, the court concluded, the "rejection breach" was not material. Because "the Section 365(n) election indisputably preserves MHI's right to the intellectual property and exclusivity, ... the core of the bargain and substantial purpose of the License Agreement [have] been preserved."

Second, the bankruptcy court noted, the use of the trademark was "directly imbedded within, supplemental to, and integral to the intellectual property license."

Finally, the court explained, the chapter 7 trustee conceded that he was more concerned about the bid-chilling impact of the license agreement's exclusivity provisions than MHI's use of the trademark, as he understood that the trademark was intertwined with the IP license.

On the basis of these findings, the bankruptcy court ruled that MHI's section 365(n) election entitled it to the continued use of the trademark throughout the duration of the license agreement. In addition, because of the plain language of section 365(n), the court held that: (i) the election preserved MHI's exclusive rights to prevent the development of competing products; and (ii) all royalty and payment provisions due under the license agreement remained in full force and effect.

Outlook

After the alarm bells resulting from Tempnology, the bankruptcy court's ruling in SIMA Int'l is welcome news to trademark licensees, even if the decision does not carry the same weight as the First Circuit's ruling. To be sure, the unsettled state of the law on this important issue is not a positive development for trademark licensors or licensees. As the case law currently stands, to the extent a potential licensor has a choice of venue for a bankruptcy filing, that choice can have significant consequences for the fate of licensed trademarks.

Despite its refusal to review Sunbeam in 2012, the U.S. Supreme Court may finally agree to weigh in on this important issue because of the widening rift in lower and appellate courts.

On June 14, 2018, Mission Product Holdings Inc. ("MPH") filed a petition for a writ of certiorari requesting that the Supreme Court review the First Circuit's January 2018 ruling in Tempnology. According to the petition filed by MPH, which was stripped of its right to use licensed trademarks by rejection of its license agreement, the First Circuit "worsen[ed]" the circuit split on this issue, and its decision undermined the effectiveness of a provision that Congress enacted to protect licensor rights, "cast[ing] a cloud of uncertainty over significant commercial transactions that are central to our nation's system for encouraging and rewarding innovation."

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