July 01, 2018 Landslide

Trademarks Are Not Intellectual Property in Bankruptcy Cases, So Circuits Are Split on What Happens upon Rejection of Trademark Licenses

By John R. Knapp, Jr.

Words have meaning. In federal statutes, Congress gets to define them. And in the world of federal bankruptcy law, intellectual property does not mean trademarks. Congress intentionally excluded trademarks from the definition of the term as it is used in the Bankruptcy Code.1 Intellectual property is only any “(A) trade secret; (B) invention, process, design, or plant protected under title 35 [United States Code]; (C) patent application; (D) plant variety; (E) work of authorship protected under title 17 [United States Code]; or (F) mask work2 protected under chapter 9 of title 17 [United States Code]; to the extent protected by applicable nonbankruptcy law.”3

What does this omission mean for licensees of trademarks that are licensed to them by debtors who file for bankruptcy and then reject the license? Federal courts of appeal are split. In the Seventh Circuit, the Bankruptcy Code does not specify what rejection means for trademark licensees, and it is up to the court to fashion an equitable remedy for the licensee. But as decided in early 2018, in the First Circuit, following the Fourth Circuit’s line of reasoning from 1985 and rejecting the Seventh Circuit’s equitable approach, the licensee’s rights in the trademark are categorically transformed (if not exactly terminated) upon rejection, leaving the licensee with merely an unsecured, nonpriority, prepetition claim for damages.

Nonexclusive Licenses Are Executory Contracts

Turn back the clock 30 years: Nonexclusive licenses for the use of intangible personal property like patents, copyrights, or trademarks did not receive any special attention, treatment, or protection under the Bankruptcy Code. They were just plain old executory contracts.

Executoriness is important because it means the debtor may reject that contract under § 365 of the Bankruptcy Code. Of course, the Bankruptcy Code does not define “executory.” Bankruptcy courts most often cite the definition developed by Professor Vern Countryman for whether a contract is executory. Under the Countryman definition, a contract is executory where both the debtor and the nondebtor parties have unperformed obligations such that failure of either to complete performance would constitute a material breach excusing the performance of the other.4

As a rule, nonexclusive licenses are considered executory contracts, whereas exclusive licenses are not.5 Whether sufficient performance remains due on both sides for the contract to be executory can vex the courts. But negative covenants have been determined to be sufficient to make a contract executory.6 Even a simple provision prohibiting the parties from suing for infringement has been construed as sufficient for a license agreement to remain executory.7

A debtor (or the debtor’s trustee) who is the licensor of intellectual property gets a special ability upon filing for bankruptcy: the power to reject a nonexclusive license pursuant to § 365 of the Bankruptcy Code. Through rejection, the debtor might relieve itself of the burdens as a licensor of intellectual property.8 Ideally for the debtor-licensor, rejection would not only leave the licensee with just a prepetition claim for damages against the debtor, it would also deprive the licensee of the right to use that intellectual property despite all the bargaining the licensee did for it. The debtor could thereby become free to strike new deals for the licensing or sale of its trademarks.

Fourth Circuit (Lubrizol)

In 1985, in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., the Fourth Circuit ruled that, as an executory contract, a license agreement for the nonexclusive right to use a metal coating process technology (apparently not patented although potentially subject to patent infringement claims) could be rejected by the debtor-licensor as long as the rejection would be advantageous to the debtor in its sound business judgment.9 The court held that the debtor’s decision to reject the license agreement was within its sound business judgment because the technology was the debtor’s principal asset, and by freeing it from the license agreement, the debtor would be able to sell the technology on more advantageous terms to other potential licensees. The court further held that it would be inappropriate to substitute the court’s own business judgment for that of the debtor, despite the serious harm done to the licensee as a result of the rejection:

It cannot be gainsaid that allowing rejection of [intellectual property licenses] as executory imposes serious burdens upon contracting parties such as Lubrizol. Nor can it be doubted that allowing rejection in this and comparable cases could have a general chilling effect upon the willingness of such parties to contract at all with businesses in possible financial difficulty. But under bankruptcy law . . . Congress has plainly provided for the rejection of executory contracts, notwithstanding the obvious adverse consequences for contracting parties thereby made inevitable. . . . [N]o comparable special treatment is provided for technology licensees such as Lubrizol. They share the general hazards created by § 365 for all business entities dealing with potential bankrupts in the respects at issue here.10

Lubrizol gave rise to wailing and gnashing of teeth among technology licensees about the unfairness of this result and the possible chilling effect that this result could have on commercial activity, including the development of new intellectual property or the products of such property. Licensees sought salvation, and Congress enacted § 365(n) of the Bankruptcy Code to remedy the inequity.11 As the legislative history makes clear, Congress’s intentions in enacting § 365(n) were to clarify that the rights of an intellectual property licensee to use the licensed property cannot be cut off unilaterally as a result of the rejection of the license by a debtor/licensor.12 In granting protection to intellectual property licensees, Congress recognized that intellectual property is unique and, unlike most other assets, is not fungible and cannot be replaced by another party because that party may not have the same knowledge, intellectual property rights, or expertise as the licensor.13

Now, pursuant to § 365(n), if a debtor/licensor rejects an intellectual property license, the licensee has two options: (1) treat the license as terminated and assert a claim for breach of contract damages, or (2) retain its rights under the intellectual property license as they existed prior to the filing of the bankruptcy petition, with the exception of the right to compel specific performance. If the licensee chooses the latter, the Bankruptcy Code requires the licensee to continue to make all royalty payments due to the debtor under the license agreement, waive all rights of setoff against the debtor, including any setoffs against royalty payments, and waive any administrative expense claims against the debtor related to the license agreement. These options hinge on the license involving “intellectual property” as defined in the Bankruptcy Code. But Congress left trademarks out of that definition and thus out of the clarification about what exactly happens to the licensee’s rights upon rejection of the license. Are they terminated, or do they survive? The courts are left with having to make the decision in this life-or-death situation, and have taken their time in doing so.

Seventh Circuit (Sunbeam)

Two dozen years after the enactment of § 365(n), the Seventh Circuit, in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, went the route of providing some protection for trademark licensees.14 Despite a trustee’s rejection of a trademark license under § 365(n) on behalf of the licensor, Chief Judge Frank Easterbrook stated that the licensee, who manufactured box fans for the licensor, could continue using the licensed trademark at issue.15 In support, Judge Easterbrook noted that while trademarks are excluded from the Bankruptcy Code’s definition of intellectual property, the omission “does not affect trademarks one way or the other.”16 The language of § 365(g) broadly applies to rejection of executory contracts, where treatment is not otherwise specified under the Bankruptcy Code, as with “intellectual property” under § 365(n). Section 365(g) simply says that “the rejection of an executory contract . . . of the debtor constitutes a breach of such contract.”

According to the Seventh Circuit: “Outside of bankruptcy, a licensor’s breach does not terminate a licensee’s right to use intellectual property.”17 The result should be no different in bankruptcy: Rejection leaves the licensee’s rights in place. The only exception is when it comes to damages, which are paid (if at all) only in accordance with bankruptcy priorities. Otherwise, rejection does not mean “to vaporize.” It is not avoidance, abrogation, rescission, nullification, or annihilation. Rejection “‘merely frees the estate from the obligation to perform’ and ‘has absolutely no effect upon the contract’s continued existence.’”18 Based on this analysis, the Seventh Circuit parted ways with Lubrizol, expressly noting the creation of a circuit split, and upheld the bankruptcy court’s judgment in favor of the licensee to allow it to continue to make and sell fans with the debtor’s trademark.19

First Circuit (Tempnology)

In January 2018, almost a half-dozen years after Sunbeam, the First Circuit arrived to reinforce the appellate split, but on the side of Lubrizol. In Mission Product Holdings, Inc. v. Tempnology, LLC (In re Tempnology, LLC), the court held that rejection of a trademark license left the licensee “with only a pre-petition damages claim in lieu of any obligation by Debtor to further perform under either the trademark license or the grant of exclusive distribution rights.”20 This decision disregarded the conclusion of the First Circuit Bankruptcy Appellate Panel, which had followed Sunbeam in reversing the bankruptcy court’s determination that rejection extinguished the licensee’s trademark and exclusive distribution rights. The First Circuit first held that exclusive distribution rights that go along with licensed patents died upon rejection because they were not de facto intellectual property or an embodiment of such intellectual property within the meaning of § 365(n). Although the parties agreed that the licensee did retain rights under § 365(n) with respect to the patent license, distribution is an independent right that is unprotected upon rejection.21

Moving on to the trademark license, the First Circuit noted that trademarks are not included in the definition of intellectual property as the term is used in § 365(n). In the context of the rejected trademark license, the court considered the ongoing use of the trademark to be a demand by the licensee to continue using the debtor’s property. While the First Circuit observed that the legislative history for § 365(n) explained the at least temporary omission of trademarks from the definition as being in order “to allow the development of equitable treatment of this situation by bankruptcy courts,” the bankruptcy courts could not go beyond the bounds of the Bankruptcy Code in determining what is equitable.22 Apparently demanding use of property that belongs to the debtor who rejected the executory contract governing that property would not be within those parameters. Ultimately, the First Circuit gave no weight to the legislative history, because in its view § 365(n) was not ambiguous, and in any event Congress did not provide any statutory language to activate some kind of equitable power, such as through the ability to enter orders at odds with the Bankruptcy Code or to simply balance the equities for a particular purpose. Congress knows how to do that when it means to.23

The First Circuit next considered what rejection means. It did not view rejection as vaporizing rights, but converting them into a prepetition claim for damages. The purpose of rejection is to free the debtor from burdensome obligations that impede successful reorganization. The panel could not accept Sunbeam’s “unstated premise that it is 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.”24 Rather than seeing a trademark as just something inert that the licensee could continue to use without any obligation by the debtor, the First Circuit held that a debtor would have to monitor and exercise quality control with respect to the goods sold under cover of the trademark, in order to serve the purpose of avoiding public deception as to the nature and quality of the goods sold. The license agreement itself recognized that if the debtor did not carry out the required review and approval of use, it could end up abandoning the trademarks. This would result in lost value to debtors and the creditors of their estates—contrary to the Bankruptcy Code’s policies favoring reorganization or even maximization through sale.25 Until Congress decides otherwise, the rule that rejection by the licensor only gives rise to prepetition damages for the licensee is simple and reduces the cost of and delay associated with fashioning equitable remedies and creating public confusion about trademarked goods.26

Venue Considerations

In light of the circuit split, debtors who are trademark licensors and anticipate rejecting licenses in their bankruptcy cases will need to be cognizant of the scope of that power, depending on where their cases are pending. For cases with venue in the bankruptcy courts of the Seventh Circuit, rejection of the license will not limit the licensee’s remedy to a prepetition claim for damages. Instead, the licensee will retain the opportunity to assert that it retains some amount of rights to the trademark under its license agreement, in addition to any prepetition claim it may have against the debtor’s bankruptcy estate. In bankruptcy courts in the Fourth and First Circuits, debtors can expect that they will be relieved of their performance obligations as licensors under the trademark licenses they reject. There, licensees will not be able to assert any rights to use the trademarks, and their only recourse will be to their pro rata share of available funds as prepetition creditors through the bankruptcy claims process.

If rejection of trademark licenses is of crucial importance to business reorganization or asset maximization prospects, debtors will need to be aware of which venues are available to them. A debtor may only commence a bankruptcy case in the federal district

(1) in which the domicile, residence, principal place of business in the United States, or principal assets in the United States, of the person or entity that is the subject of such case have been located for the one hundred and eighty days immediately preceding such commencement, or for the longer portion of such one-hundred-and-eighty-day period than the domicile, residence, or principal place of business, in the United States, or principal assets in the United States, of such person were located in any other district; or

(2) in which there is pending a case under title 11 concerning such person’s affiliate, general partner, or partnership.27

In other words, a debtor cannot simply file a bankruptcy case in a bankruptcy court in the First or Fourth Circuit just because it likes how rejection works there. The debtor has to be eligible for venue and must plan accordingly. By the same token, licensees will need to be vigilant and seek to enforce the propriety of the debtor’s choice of bankruptcy court in the event it has significance to the breadth of their remedies.

For licensees, it is worth considering the options that may be available prior to the rejection of the license agreement. Lubrizol, Sunbeam, and Tempnology all address the impact of rejection after it has already occurred. They do not address the protections that the licensee may seek from the bankruptcy court with respect to its license rights before or in connection with opposing a debtor’s request for rejection. After all, rejection is not a foregone conclusion just because the debtor asks for it. The debtor must show that rejection reflects good business judgment.

Timing is important. Section 365(n) governs intellectual property rights only after rejection, and it explicitly excludes trademarks from its protection. But before rejection, the court may be willing to balance the equities and deny rejection of the agreement if the trademarks are integrally linked to other intellectual property that would be protected by § 365(n). If the license agreement has already been rejected, it may be too late.28

Endnotes

1. 11 U.S.C. §§ 101 et seq.

2. For the casual intellectual property enthusiast or curious reader, “mask work” is defined as “a series of related images, however fixed or encoded—(A) having or representing the predetermined, three-dimensional pattern of metallic, insulating, or semiconductor material present or removed from the layers of a semiconductor chip product; and (B) in which series the relation of the images to one another is that each image has the pattern of the surface of one form of the semiconductor chip product.” 17 U.S.C. § 901(a)(2). This definition is incorporated into the Bankruptcy Code. See 11 U.S.C. § 101(39).

3. 11 U.S.C. § 101(35A).

4. Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439 (1973); see also In re Texscan Corp., 976 F.2d 1269 (9th Cir. 1992); In re Coast Trading Co., 744 F.2d 686, 692 (9th Cir. 1984); In re Select-A-Seat Corp., 625 F.2d 290 (9th Cir. 1980).

5. In re Golden Books Family Entm’t, 269 B.R. 300 (Bankr. D. Del. 2001).

6. See, e.g., In re Rovine Corp., 5 B.R. 402 (Bankr. W.D. Tenn. 1980) (covenant not to compete sufficient); Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985) (technology licensor’s duty to defend intellectual property rights, indemnify licensee, and maintain confidentiality sufficient); Select-A-Seat, 625 F.2d 290 (exclusive licensor’s duty not to further license held sufficient). But see In re Stein & Day, Inc., 81 B.R. 263 (Bankr. S.D.N.Y. 1988) (nondebtor author’s duty to indemnify publisher and offer future books for publication insufficient); In re Monument Record Corp., 61 B.R. 866 (Bankr. M.D. Tenn. 1986) (employment contract in which nondebtor artists had no further obligation to record insufficient). A license boils down to the “mere waiver of the right to sue.” In re Spansion, Inc., Nos. 11-3323, 11-3324, 2012 WL 6634899, at *3 (3d Cir. Dec. 21, 2012) (quoting De Forest Radio Tel. Co. v. United States, 273 U.S. 236, 242 (1927)).

7. In re Access Beyond Techs., Inc., 237 B.R. 32, 43–44 (Bankr. D. Del. 1999) (citing Everex Sys., Inc. v. CadTrak Corp. (In re CFLC, Inc.), 89 F.3d 673, 677 (9th Cir. 1996)).

8. “[T]he trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.” 11 U.S.C. § 365(a). In a reorganization case filed by a debtor under chapter 11 of the Bankruptcy Code, the debtor becomes a debtor in possession. “Subject to any limitations on a trustee serving in a case under [chapter 11], and to such limitations or conditions as the court prescribes, a debtor in possession shall have all the rights, other than the right to compensation under section 330 of [the Bankruptcy Code], and powers, and shall perform all the functions and duties, except the duties specified in sections 1106(a)(2), (3), and (4) of [the Bankruptcy Code], of a trustee serving in a case under [chapter 11].” 11 U.S.C. § 1107(a).

9. 756 F.2d at 1047. The Fourth Circuit noted that application of this standard is similar to the test applied by courts in connection with assessing the reasonableness of the decisions of corporate directors. Id. at 1046.

10. Id. at 1048. Other courts faced with similar situations as the Fourth Circuit in Lubrizol also have held that rejection of an intellectual property license agreement pursuant to § 365(a) of the Bankruptcy Code was expressly permitted. See In re Chipwich, Inc., 54 B.R. 427 (Bankr. S.D.N.Y. 1985) (holding that intellectual property license could be rejected under rationale of Lubrizol); In re Petur U.S.A. Instrument Co., 35 B.R. 561, 563 (Bankr. W.D. Wash. 1983) (holding that license agreement could be rejected under § 365(a) but rejection would not be permitted because the debtor could not demonstrate that rejection was beneficial to its estate and creditors).

11. 134 Cong. Rec. H9484 (daily ed. Oct. 4, 1988).

12. Id.

13. Noreen M. Wiggins, Note, The Intellectual Property Bankruptcy Protection Act: The Legislative Response to Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 16 Rutgers Computer & Tech. L.J. 603, 616 (1990) (citing S. Rep. No. 100-505, at 4 (1988)).

14. 686 F.3d 372 (7th Cir. 2012).

15. Id.

16. Id. at 375.

17. Id. at 376.

18. Id. at 377 (quoting Thompkins v. Lil’ Joe Records, Inc., 476 F.3d 1294, 1306 (11th Cir. 2007)).

19. Id. at 377–78.

20. 879 F.3d 389, 392 (1st Cir. 2018). The license agreement included patent, trademark, and exclusive distribution rights with respect to specialized products such as towels, socks, headbands, and other accessories designed to remain at low temperatures even when used during exercise. See id.

21. Id. at 398–401.

22. Id. at 401.

23. See id. at 403–04.

24. Id. at 402 (citing Sunbeam, 686 F.3d at 377).

25. Id. at 402–03.

26. Id. at 404.

27. 28 U.S.C. § 1408.

28. Raima UK Ltd. v. Centura Software Corp. (In re Centura Software Corp.), 281 B.R. 660, 671–72 & n.19 (Bankr. N.D. Cal. 2002) (finding that the licensee had already stipulated to rejection and the court had no business judgment of the debtor to evaluate, only the impact of § 365(n)); see also In re Matusalem, 158 B.R. 514, 521 (Bankr. S.D. Fla. 1993) (refusing to authorize rejection upon finding that rejection of franchise agreement that included exclusive right to make and market rum using the debtor’s secret formula and trade name would render no economic benefit to the debtor’s estate and was certain to destroy the licensee’s business).

John R. Knapp, Jr. is a partner at Miller Nash Graham & Dunn LLP in Seattle, Washington. He regularly advises licensors and other parties to executory contracts and unexpired leases on their rights in bankruptcy cases.