Rejected Trademark Licenses in Bankruptcy: Giving the Licensor a Fresh Start

Friday, March 2nd, 2018 at 11:25 am by Abraham Bane

Introduction:

The United States Court of Appeals for the First Circuit recently issued a ruling which has significant implications for trademark licensees. Reversing a decision by the First Circuit Bankruptcy Appellate Panel, the court held that a trademark licensor in bankruptcy may reject a trademark licensing agreement contained in an executory contract, and in such instances the trademark licensee loses the right to continue to use the trademark.[1] The First Circuit explicitly noted that this decision rejects a contrary decision by Judge Easterbrook of United States Court of Appeals for the Seventh Circuit which found that while a debtor-licensor may reject such a contract under Section 365(a) of the Bankruptcy Code, the licensee continues to retain the trademark license for the duration of the contract.[2]

Background:

Under Section 365(a) of the Bankruptcy Code, a debtor in bankruptcy may choose to assume or reject an executory contract. An executory contract is generally defined as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”[3] When a debtor chooses to reject an executory contract, Section 365(g)(1) provides that the damage claim is deemed to be a pre-petition claim together with all pre-petition unsecured debt, even though the breach may occur post-petition. A debtor rejection also functions to “release the debtor’s estate from burdensome obligations that can impede a successful reorganization” by limiting the contractual breach remedies to monetary damages and give the debtor a “fresh start” by freeing the debtor from continued specific performance obligations.[4]

In 1985, the Fourth Circuit in Lubrizol Enterprises, Inc. v. Richmond Metal Finishes, Inc. held that under Section 365(a) a patent licensee loses its right to continue to use a patent when a debtor-licensor rejects a patent licensing agreement in an executory contract.[5] The Fourth Circuit held that a Section 365(a) rejection constitutes a “statutory breach” of the executory contract which terminates the licensing contract completely. Congress soon recognized that the Lubrizol decision would have a chilling effect on the development of new technology as licensees would be reluctant to contract for intellectual property with licensors who are at risk of declaring bankruptcy and consequently the potential innovation to be gained from use of such intellectual property would be squandered. Congress therefore enacted Section 365(n) which allows a licensee of “intellectual property” to retain the right to continue to utilize the license for the duration of the contract irrespective of a debtor licensor’s rejection of the license. While the Bankruptcy Code in Section 101(35A) outlines various types of licenses which are defined as “intellection property” (patents, trade secrets, etc.), the Bankruptcy Code conspicuously omits trademarks.  The Senate Report explained that Congress intentionally postponed action and left open the question of whether a licensee of a rejected trademark may continue to use a licensed trademark “to allow the development of equitable treatment of this situation by bankruptcy courts” due to trademarks’ unique features such as need of licensor quality control over the trademark.[6]

Sunbeam and In re Tempnology:

The courts in both Sunbeam and In re Tempnology rejected the Senate Report’s suggestion that judges should decide trademark licensing questions solely on equitable grounds and argued that judges should adjudicate by looking to the Bankruptcy Code and “[w]hat the Bankruptcy Code provides, a judge cannot override by declaring that enforcement would be inequitable.”[7] Likewise, the courts agree that Section 365(n) does not protect a trademark licensee to allow the licensee to retain the license as trademarks are not included the Section 101(35A) definition of intellectual property.[8]

Yet, Judge Easterbrook in Sunbeam argued that while a trademark licensee is not protected from licensor rejection under Section 365(n), the licensee still retains the continued right to use the trademark for the duration of the contract. Easterbrook points to Section 365(g) of the Bankruptcy Code which provides that a licensor rejection of an executory contract constitutes a contractual breach. In contrast to the Fourth Circuit Lubrizol decision which construed “breach” to mean that the entire agreement is terminated, Judge Easterbrook argues that the debtor’s rejection only ensures that the debtor will not be subject to an order of specific performance; the creditor’s rights, however, remain in place as such rights would for any common law breach outside of bankruptcy. Consequently, a trademark licensee continues to retain the right to utilize the trademark license even after the debtor licensor rejects an executory contract which contains a trademark agreement.

The recent First Circuit’s decision In re Tempnology disagreed with Judge Easterbrook’s analysis. The court reasoned that allowing a licensee to continue to use a licensed trademark despite the debtor licensor’s rejection would run afoul with the purpose of Section 365(a) which aims to release the debtor from any continued obligations and provide the debtor with a fresh start. Under trademark law, a trademark owner must monitor and exercise control over the quality of trademarked goods sold to the public to ensure that the public is not deceived as to the quality of such goods. Failure of a trademark owner to monitor and exercise reasonable control over the trademarked goods is a “naked license” which can cause the owner to lose trademark rights. The First Circuit therefore argued that allowing the licensee to continue to utilize a trademark during a licensor’s bankruptcy would force the debtor to choose between risking permanent loss of its trademark or continue its obligations of monitoring and exercising control over the quality of the goods which would run contrary to the primary aim that Section 365(a) intends to serve.[9] Therefore, the First Circuit held that upon debtor rejection a trademark licensee loses the right to continue to use the trademark.

Interestingly, the International Trademark Association recommended in November 2012 that Section 365(n) be amended to apply to trademark licenses (similar to other types of intellectual property licenses) and further noted that it should “be amended to explicitly state that the statute does not relieve debtor licensors from any existing contractual obligations or authority to monitor and control the quality of licensed products bearing a licensed trademark.”[10]

Conclusion:

This clear and unambiguous circuit split concerning a question of federal Bankruptcy Code statutory interpretation presents a matter ripe for the Supreme Court to grant certiorari.[11] The Supreme Court should decide as a threshold matter whether to adopt the Lubrizol understanding of rejection as termination or the Sunbeam position that rejection means breach. If the Supreme Court accepts the latter position, the First Circuit’s recent rejection of the Sunbeam remains unconvincing. Had the First Circuit adopted the Lubrizol understanding of rejection as termination, dismissal of Judge Easterbrook’s analysis in Sunbeam would be warranted. But assuming (as Judge Easterbrook does based on Section 365(g)) that a debtor rejection only constitutes a breach and does not terminate the licensing agreement, it is unclear how the First Circuit’s policy argument about the primary aim of Section 365(a) and its tension with licensee’s continued use of trademark impacts this statutory interpretation of the Bankruptcy Code (which construes rejection as breach for all executory contracts). Nowhere in the Bankruptcy Code is it implied that a debtor’s rejection under Section 365(a) only constitutes a breach when such a breach will fulfill Congress’s aim.

Moreover, under the Sunbeam holding a trademark licensor would not be contractually obligated to fulfill any executory obligations. As the First Circuit correctly noted, a debtor licensor may be forced to choose to continue to monitor the licensee in fear of losing trademark rights, but such performance is not an executory contract obligation that Section 365 addresses. While the First Circuit’s concern resonates, it would be best resolved through a legislative amendment to the Bankruptcy Code.

[1] In re Tempnology, LLC, 879 F.3d 389 (1st Cir. Jan. 12, 2018).

[2]  Sunbeam Products, Inc. v. Chicago American Mfg., LLC, 686 F.3d 372 (7th Cir., 2012).

[3] See Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439 (1973).

[4] In re Tempnology, 879 F.3d at 402.

[5] 756 F.2d 1043 (4th Cir., 1984).

[6] S. Rep. No. 100-505, at 5.

[7] In re Tempnology, 879 F.3d at 401; Sunbeam, 686 F.3d at 375.

[8] In re Tempnology, 879 F.3d at 401; Sunbeam, 686 F.3d at 375.

[9] In re Tempnology, 879 F.3d at 402.

[10] See also James M. Wilton & Andrew G. Devore, Trademark Licensing in the Shadow of Bankruptcy, 68 Bus. Law. 739, 770–71 (2013).

[11] See generally Karen M. Gebbia, Certiorari and the Bankruptcy Code: The Statutory Interpretation Cases, 90 Am. Bankr. L.J. 503 (2016).