The U.S. Supreme Court Rules That Rejection of a Trademark License Agreement in Bankruptcy Does Not Strip the Licensee of Its Right to Use the Trademark
In Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 652, 2019 WL 2166392 (U.S. May 20, 2019), the U.S. Supreme Court ruled that the rejection in bankruptcy of a trademark license agreement, which constitutes a breach of the agreement under section 365(g) of the Bankruptcy Code, does not terminate the rights of the licensee that would survive the licensor’s breach under applicable non-bankruptcy law. In the eagerly anticipated ruling, the Court’s 8-1 majority ended a long-running dispute among bankruptcy and appellate courts regarding the ramifications of a trademark license agreement’s rejection by a bankruptcy trustee or a chapter 11 debtor-in-possession ("DIP").
The issue is of crucial importance to both trademark licensors and licensees. It rose to prominence when Congress added special protections to the Bankruptcy Code for licensees of rejected "intellectual property" licenses in 1988, yet omitted trademarks from the definition of that term. This left the courts to determine the impact of rejection of a trademark license; the inconsistent outcomes eventually resulted in a split among the circuit courts of appeals. The Supreme Court’s ruling has now resolved that dispute in a welcome development for trademark licensees, but it leaves some important questions unanswered.
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 bankruptcy trustee or DIP 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 Enterprises, Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985). 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 endured—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 continued to struggle when determining the proper treatment of trademark licenses in bankruptcy.
Sunbeam Gives Trademark Licensees a Glimmer of Hope
In Sunbeam Products, Inc. v. Chicago Am. Manuf., LLC, 686 F.3d 372 (7th Cir. 2012), 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 provides that the rejection of an unassumed executory contract or unexpired lease constitutes a prepetition breach of the contract or lease), 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 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 that 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).
A handful of lower courts have also adopted the Sunbeam approach or have ruled that section 365(n) protects trademark licensees. See In re SIMA Int’l, Inc., 2018 WL 2293705 (Bankr. D. Conn. May 17, 2018) (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); In re Crumbs Bake Shop, Inc., 522 B.R. 766 (Bankr. D.N.J. 2014) (ruling that trademark licensees are entitled to the protections of section 365(n), notwithstanding the omission of trademarks from section 101(35A)’s definition of "intellectual property").
The First Circuit Takes the Opposite Approach in Tempnology
Cold-weather clothing innovation company Tempnology LLC (the "debtor") entered into a marketing and distribution agreement (the "Agreement") with Mission Product Holdings, Inc. ("Mission") that included, among other things, a license of certain of the debtor’s trademarks.
The debtor filed for chapter 11 protection in 2015 in the District of New Hampshire. It then moved to reject the Agreement. Mission objected, arguing that, notwithstanding rejection, by making an election under section 365(n), Mission retained its rights under the trademark license and that it could continue to exercise those rights without interference from the debtor or any purchaser of its assets in the bankruptcy case.
Relying on Lubrizol and "negative inference," the bankruptcy court ruled that, because trademarks are not expressly protected by section 365(n) or any similar provision in the Bankruptcy Code (e.g., sections 365(h) and 365(i), which protect tenants and timeshare interest holders), Mission lost its trademark license rights upon rejection.
A bankruptcy appellate panel reversed the trademark ruling on appeal. The panel found that the bankruptcy court’s reliance on Lubrizol was flawed, noting that "Lubrizol … is not binding precedent in this circuit and, like the many others who have criticized its reasoning … , we do not believe it articulates correctly the consequences of rejection of an executory contract under § 365(g)." Instead, the panel wrote, "We adopt Sunbeam’s interpretation of the effect of rejection of an executory contract under § 365 involving a trademark license."
A divided three-judge panel of the First Circuit reversed the bankruptcy appellate panel’s ruling.
According to the First Circuit majority, the "unstated premise" of Sunbeam was 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 N.L.R.B. 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." Judge Torruella stated that instead, he 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.
On October 26, 2018, the Supreme Court agreed to review the First Circuit’s ruling to resolve the split between the First and Seventh Circuits.
The Supreme Court’s Ruling
The Supreme Court adopted the Seventh Circuit’s reasoning, reversed the First Circuit’s decision, and remanded the case below.
Writing for the 8-1 majority, Justice Kagan wrote that "both Section 365’s text and fundamental principles of bankruptcy law" mandate the "rejection-as-breach" approach rather than the "rescission approach turning on the distinctive features of trademark licenses." The majority rejected the argument 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."
Justice Kagan explained that section 365(g) provides that rejection constitutes a "breach," but the Bankruptcy Code does not define the term. Therefore, "breach" means in the Bankruptcy Code "what it means in contract law outside bankruptcy." According to the majority, this means that, upon rejection of a trademark license agreement, the debtor-licensor can stop performing its remaining obligations under the agreement, but "the debtor cannot rescind the license already conveyed," meaning that "the licensee can continue to do whatever the license authorizes."
Justice Kagan noted that the "rejection-as-breach" rule comports with the general bankruptcy rule that the "estate cannot possess anything more than the debtor itself did outside bankruptcy." Conversely, she explained, the "rejection-as-rescission" approach would circumvent the Bankruptcy Code’s stringent limits on "avoidance" actions under the powers given to a trustee under sections 544 to 553. Whereas those powers may be invoked in only "narrow circumstances," the "power of rejection may be exercised for any plausible economic reason." According to the majority, "If trustees (or debtors) could use rejection to rescind previously granted interests, then rejection would become functionally equivalent to avoidance … subvert[ing] everything the Code does to keep avoidances cabined."
The majority rejected the debtor’s "negative inference" argument. That argument, Justice Kagan wrote, "pays too little heed" to section 365(g)’s directive that rejection constitutes breach and too much attention to the "mash-up of legislative interventions" embodied in sections 365(h), 365(i), and 365(n). Moreover, she noted, Congress has consistently expressed its disapproval of the view that rejection terminates all contractual rights.
The majority specifically rejected the "negative inference" argument predicated on section 365(n):
Congress’ repudiation of Lubrizol for patent contracts does not show any intent to ratify that decision’s approach for almost all [other intellectual property agreements]. Which is to say that no negative inference arises. 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.
Finally, the majority rejected the debtor’s contention that the rejection-as-breach rule should not apply in this case because of special features of trademark law, including the licensor’s duty to monitor and exercise quality control over licensed goods and services. The debtor’s "plea to facilitate trademark licensors’ reorganizations," Justice Kagan wrote, "cannot overcome what Sections 365(a) and (g) direct."
Justice Sotomayor filed a concurring opinion in which she noted that: (i) the Court did not decide whether every trademark licensee has the right to continue using licensed marks post-rejection because certain licensees’ rights might not survive a breach under applicable non-bankruptcy law; and (ii) the Court’s holding confirms that trademark licensees’ post-rejection rights and remedies may be more expansive than the rights of intellectual property licensees covered by section 365(n).
Justice Gorsuch dissented, observing that he would have dismissed the appeal as improvidently granted. Because Mission did not assert a claim for damages arising from the rejection of its trademark license, Justice Gorsuch deemed the appeal moot and would not have considered the merits.
Tempnology is a welcome development for trademark licensees. However, it now shifts the inquiry from whether a trademark licensee is entitled to the rights explicitly set forth in section 365(n) for other intellectual property licensees to the consequences of breach under applicable non-bankruptcy law. Therefore, unlike with respect to other intellectual property licenses, bankruptcy courts still do not have a clear road map defining the post-rejection rights of trademark licensees.
The impact of Tempnology in contexts other than trademark licenses has already been manifested in the courts. For example, in In re Roberson, 2019 WL 2320809 (B.A.P. 6th Cir. May 30, 2019), a Sixth Circuit bankruptcy appellate panel cited Tempnology in affirming a bankruptcy court’s determination that a landlord had no undischarged post-rejection claim against the debtors as holdover tenants. Because rejection of the lease in that case breached, but did not terminate, the lease, the appellate panel ruled that the bankruptcy court correctly concluded that the landlord was not entitled to damages under either the terms of the lease or applicable non-bankruptcy (Ohio) law.
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