The Ripple Effect of Rejecting Trademark Licenses

The Fourth Circuit's Lubrizol decision is at the root of longstanding confusion about the trademark licensee's rights after rejection. Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985). In its decision, the Fourth Circuit upheld the rejection of a technology licensing agreement, addressing only very briefly, in a single paragraph, the effect of rejection.

The Fourth Circuit acknowledges that §365(g) of the Bankruptcy Code treats rejection as a breach but, drawing on its reading of the legislative history, concludes that the purpose of the provision is to provide only a damages remedy for the debtor's counterparty under the rejected contract. Introducing the concept of a “statutory breach” — presumably to distinguish it from a common law breach — the court concludes “the statutory 'breach' contemplated by §365(g) controls, and provides only a money damages remedy for the non-bankrupt party.” 756 F.2d at 1048. In the court's view, this damages remedy must obtain as the sole remedy even if outside bankruptcy the licensee ordinarily would be able to retain its rights to the technology.

Section 365(n)

In 1988, three years after Lubrizol, Congress responded to industry concerns by enacting §365(n) to ensure the rights of an intellectual property licensee cannot be cut off by rejecting the contract providing the license. Section 365(n) allows the licensee “to elect to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of the contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable nonbankrupcy law).” 11 U.S.C. §365(n)(1).

In exchange, the licensee must make all royalty payments due under the contract and is deemed to waive any right of setoff and any administrative claim related to the contract. Id. §365(n)(2); see, e.g., In re CellNet Data Sys., Inc., 327 F.3d 242 (3d Cir. 2003); In re Prize Frize, Inc., 32 F.3d 426 (9th Cir. 1994).

In enacting §365(n), Congress purposefully did not include trademarks within the definition of intellectual property in §101(35A) of the Bankruptcy Code. In the legislative history, Congress explained that trademark, trade name, and service mark licensing relationships raise unique issues and, in particular, “depend to a large extent on control of the quality of the products or services sold by the licensee.” Since those matters required more extensive study, Congress decided to postpone any action and “allow the development of equitable treatment of this situation by bankruptcy courts.” Congress further cautioned that no inference should be drawn about treatment of executory contracts not related to intellectual property. S. Rep. No. 100-505, at 5, reprinted in 1988 U.S.C.C.A.N. 3200, 3204.

Approaches to Rejection of Trademark Licenses

In the wake of Lubrizol and Congress's continuing abstention, most courts have deprived the trademark licensee of the right to use licensed trademarks after the debtor's rejection of the license. These courts reason by negative inference that the omission of trademarks from the protection of §365(n) means Lubrizol is intended to control, and so licensees have no right to continue to use trademarks after rejection. See, e.g., In re Old Carco LLC, 406 B.R. 180 (Bankr. S.D.N.Y. 2009); In re Dynamic Tooling Sys., Inc., 349 B.R. 847 (Bankr. D. Kan. 2006); In re HQ Holdings, Inc., 290 B.R. 507 (Bankr. D. Del. 2003); In re Centura Software Corp., 281 B.R. 660 (Bankr. N.D. Cal. 2002); In re Blackstone Potato Chip Co., 109 B.R. 557 (Bankr. D.R.I. 1990). (Several courts have managed to duck this sticky issue on finding the trademark license was part of a larger, integrated non-executory agreement. See, e.g., In re Interstate Batteries Corp., 751 F.3d 955 (8th Cir. 2014); In re Exide Techs., 607 F.3d 957 (3d Cir. 2010).)

Judge Ambro criticized this reasoning in his concurrence in Exide. Judge Ambro reviewed the history of §365(n), including its legislative history, and explained it was inconsistent with drawing any negative inference. After emphasizing rejection only serves to relieve the estate from its obligations to perform and has no effect on the contract's continued existence, he concluded “the Courts here should have used, I believe, their equitable powers to give Exide a fresh start without stripping EnerSys of its fairly procured trademark rights.” 607 F.3d at 965-67.

A few courts have relied on this analysis to allow a licensee to continue to use licensed trademarks after rejection. See, In re Crumbs Bake Shop, Inc., 522 B.R. 766 (Bankr. D.N.J. 2014); In re Lakewood Eng'g & Mfg. Co., 459 B.R. 306 (Bankr. N.D. Ill. 2011), aff'd sub nom. on other grounds, Sunbeam Prods., Inc. v. Chicago Am. Mfg, LLC, 686 F.3d 372 (7th Cir. 2012).

Departing somewhat from Judge Ambro's approach, the Seventh Circuit in Sunbeam concluded that rejection does not deprive a trademark licensee of its rights under the rejected license. Rejecting the notion a court can use equitable powers to override the Bankruptcy Code, the court focused instead on the limited effect of rejection under §365(g). It reasoned that since rejection is only a prepetition breach of contract, the contract's continued existence is not affected and the parties' rights remain in place. Rejection serves only to relieve the debtor from having to perform its obligations, converting them to damages. Consequently, a trademark licensee retains and can continue to exercise its rights to use a trademark after rejection. 686 F.3d at 375-78.

Facts in Tempnology

Debtor Tempnology, LLC made specialized products designed to stay cold during exercise and marketed them under Coolcore and Dr. Cool brands. In November 2012, Debtor and Mission Products Holdings, Inc. entered into a Co-Marketing and Distribution Agreement granting Mission various product distribution rights and licenses.

After two years of losses, Debtor filed a Chapter 11 bankruptcy in September 2015 and moved to reject the agreement with Mission. Debtor explained the agreement had stymied other marketing and distribution opportunities, and faulted Mission and the agreement's grant of exclusive distribution rights for its bankruptcy.

The bankruptcy court granted rejection subject to Mission's election under §365(n) to retain its rights. Debtor then moved for a determination that Mission's election covered only its non-exclusive license to use Debtor's intellectual property and not its exclusive distribution rights or non-exclusive trademark license. The bankruptcy court agreed with Debtor. In re Tempnology, LLC, 541 B.R. 1 (Bankr. D.N.H. 2015). On appeal, the bankruptcy appellate panel agreed §365(n) does not cover exclusive distribution rights or trademark licenses, but followed Sunbeam to hold rejection of the trademark license did not have the effect of eliminating rights to use Debtor's trademarks. In re Tempnology, LLC, 559 B.R. 809 (1st Cir. BAP 2016).

Analysis of First Circuit in Tempnology

The First Circuit had before it two issues. Did Mission's rights to use Debtor's trademarks remain intact after rejection of the agreement's trademark licenses? And, did Mission's election under §365(n) cover Mission's exclusive distribution rights under the agreement? Because the agreement had already terminated, the court's rulings, practically speaking, would determine whether Mission was entitled to pre or postpetition status for any damages caused by Debtor's failure to perform. 879 F.3d at 397.

Rejection Analysis

After concluding the Bankruptcy Code does not allow “for unfettered 'equitable' dispensations from section 365(a) rejection,” id. at 401, the court examined the rationale of Sunbeam, but rejected it in favor of an approach very much like Lubrizol's. The court reasoned that while rejection does not terminate a party's contract rights, it converts those rights into a prepetition claim for damages. Id. at 402.

The court also took particular issue with the “unstated premise” in Sunbeam that the debtor could be freed from unperformed obligations under a trademark license while the licensee's rights were preserved. For effective licensing of a trademark, the trademark owner must continuously monitor and control the quality of the goods sold under the trademark. In fact, the failure to do so results in a “naked license” that may result in abandonment of the trademark and the loss of its validity. Id.

In this regard, the parties' agreement reserves for Debtor the right to review and approve uses of its trademarks, a right the First Circuit equates with an obligation of Debtor in light of the need to maintain quality and avoid abandonment. Since the principal aim of Congress in providing for rejection was to relieve the debtor from burdensome obligations, rejection of a trademark license should end the licensee's right to use the trademark and so relieve the debtor from the ongoing burden of monitoring and controlling the trademark's use. The court concludes: “[W]e favor the categorical approach of leaving trademark licensee's unprotected from court-approved rejection, unless and until Congress should decide otherwise.” Id. at 402-04.

Exclusive Distribution Rights Analysis

In holding that Mission's exclusive distribution rights were not covered by §365(n)(1) and so not retained after rejection, the court construed the scope of the licensee's rights under the statute “to enforce any exclusivity provision of such contract” and to “any embodiment of such intellectual property.” Although these phrases are quite broadly worded, the First Circuit relied on the language of the statute and the legislative history to construe them narrowly.

Since §365(n), on its face, covers only the subset of executory contracts “under which the debtor is a licensor of a right to intellectual property” and operates only to allow the debtor to “retain its rights … under such contract,” the exclusivity rights must grant exclusive use of an intellectual property right to fall within the statute. As a result, the statute protects “an exclusive license to use a patent, but does not protect an exclusive right to sell a product merely because that right appears in a contract that also contains a license to use intellectual property.” Id. The legislative history supports this reading. It makes clear §365(n) was intended only to preserve the licensee's intellectual property rights and describes the protected exclusivity rights as rights to exclusive use of the license. Id. at 397-98.

The court also rejected the notion that the right to “any embodiment” of the intellectual property supported retention of exclusive distribution rights. After explaining that “embodiment” is a term of art, the court summarized the characteristics of a protected embodiment. The parties' contract must give the licensee access to the embodiment. The embodiment must be a tangible object existing prepetition and be inherently limited in number — a prototype or example of a product but not all products produced using the intellectual property. And finally, access to the embodiment must be necessary to allow the licensee to exploit its right to the underlying intellectual property. No such embodiment was implicated by Mission's rights. Id. at 399-400.

The Dissent

Judge Torruella in dissent agreed § 365(n) did not protect Mission's exclusive distribution rights or nonexclusive trademark license. But he disagreed with the majority's bright line rule that rejection of the trademark license left the licensee without any remaining rights to use the trademarks. He would instead follow Sunbeam and the BAP in finding Mission's rights to use the trademarks remained intact after rejection. He would then examine the terms of the contract and other non-bankruptcy law to determine the appropriate equitable remedy for Debtor's breach of contract through rejection. Id. at 405-07.

Upshot of Tempnology

More than 30 years later, Tempnology comes full circle back to the much-criticized Lubrizol decision. The Tempnology court's views on the effect of rejection are inconsistent with almost every other appellate court since Lubrizol to consider the issue. These courts recognize that after rejection the contract and the parties' contract rights remain in place, but the debtor is relieved of its future performance obligations with §365(g) operating to give the other party a prepetition claim for any damages from the debtor's non-performance. See, e.g., Sunbeam; In re Shelbyville Road Shoppes, LLC, 775 F.3d 789, 796-97 (6th Cir. 2015); Thompkins v. Lil'l Joe Records, Inc., 476 F.3d 1294, 1306-08 (11th Cir. 2007); In re Pomona Valley Med. Grp., Inc., 476 F.3d 665, 671, 672-73 (9th Cir. 2007); A & L Labs., Inc. v. Bou-Matic LLC, 429 F.3d 775, 779 (8th Cir. 2005); In re Lavigne, 114 F.3d 379, 386-87 (2d Cir. 1997); In re Flagstaff Realty Assocs., 60 F.3d 1031, 1034 (3d Cir. 1995).

Indeed, the First Circuit's own decision in In re Ground Round, Inc., 482 F.3d 15 (1st Cir. 2007), recognizes that the other party's rights survive rejection, allowing specific performance against the debtor of rights to return of personal property, although the Tempnology court construes the decision narrowly to its facts. 879 F.3d at 401. On the other hand, the result in Tempnology is in line with the majority of courts to consider the issue, which reason by negative inference that trademark rights do not survive rejection.

Sunbeam is also not without issues. As the Tempnology court emphasizes, allowing the licensee to retain its trademark rights effectively means the debtor must continue to review and control the use of its trademarks. That is inconsistent with the purpose of rejection. In addition, the terms of the post-rejection use are not clear. Presumably, as implied in Sunbeam, 686 F.3d at 376-77 (discussing rights under UCC), the decision to continue to use the trademarks constitutes an affirmance of the contract so the contract terms govern that use. But what about the setoff rights of the licensee? And the right to file an administrative claim? Would the licensee retain those rights after rejection? If so, ironically, it would be better off than a licensee of intellectual property electing under §365(n) to retain its rights, since those rights are deemed waived if that election is made. *****

Mark W. Page is of counsel at Massey & Gail LLP in Chicago. He may be reached at [email protected] or 312-379-0720.