Section 365(c)(1) of the Bankruptcy Code limits a debtor’s ability to assume or assign a contract where “applicable law” excuses a non-debtor counterparty from accepting performance from a third party.  Circuits currently are split on whether this section prohibits a debtor from assuming an intellectual property license without the consent of the licensor.  Courts on one side of the issue apply the “actual test,” which permits a debtor to assume a license as long as the debtor does not intend to assign it.  On the other side, courts apply the “hypothetical test,” which prohibits a debtor from assuming a license regardless of the debtor’s intent to assign it.  In a decision that discusses in detail what type of “applicable law” is relevant in the 365(c)(1) analysis, the United States Bankruptcy Court for the District of Delaware issued a reminder in In re Trump Entertainment Resorts, Inc. that the hypothetical test is alive and well in the Third Circuit. 

Trademark License Agreement

Prepetition, Donald and Ivanka Trump entered into a perpetual Trademark License Agreement with the debtors and assigned their rights under the agreement to Trump AC Casino Marks, LLC.  The license agreement provided for three uses of the Trumps’ names, likenesses, and other marks in connection with the operation of certain casinos located in Atlantic City: “current uses,” which covered a “wide range of products and activities” relating to casino operations and for which the debtors did not need prior approval; “similar uses,” which were similar to the “current uses” and were subject to a 10-day right to object by Trump AC (although the debtors needed no prior approval for use); and “proposed uses,” for which the debtors were required to obtain approval.  The license agreement required Trump AC’s prior written consent to any assignment by the Debtors, although the licensor separately agreed to the assignment of the debtors’ license rights to their first lien lender in the event of an enforcement action under state law by the first lien lender.  Before the debtors’ chapter 11 filing, Trump AC commenced an action in state court to terminate the Trademark License Agreement due to certain breaches by the debtors.  Once the debtors entered bankruptcy, Trump AC filed a motion seeking relief from the automatic stay to proceed with the state court action.  The debtors, whose proposed chapter 11 plan contemplated assumption of the Trademark License Agreement, objected to the motion.   Notably, the chapter 11 plan contemplated a debt for equity swap under which the first lien lender would acquire the equity of the reorganized debtors.

Rexene Fails, but West Electronics Prevails

Trump AC sought modification of the automatic stay under section 362(d)(1) of the Bankruptcy Code, which requires bankruptcy courts to grant relief from the stay “for cause.” Delaware generally applies the balancing test established in Izzarelli v. Rexene Prods. Co. (In re Rexene Prods. Co.) to determine whether “cause,” which is not defined in section 362, exists.  Bankruptcy Judge Gross found that Trump AC was not entitled to relief from stay under Rexene because it failed to show that it would suffer a significant hardship from maintenance of the stay and because the state court action would impose a substantial burden on the debtors’ efforts to reorganize.

Although the court would not grant relief under Rexene, it did consider Trump AC’s argument that cause existed under In re West Electronics.  In that case, the Third Circuit adopted the hypothetical test, holding that where an executory contract is subject to the limitation created by section 365(c)(1), the non-debtor counterparty is entitled to relief from the automatic stay to seek termination.  Judge Gross stated that the plain language of section 365(c)(1) creates the hypothetical test because it limits a debtor’s ability to assume a contract based on its ability – not its intent – to assign.  He also noted, however, the importance of reading section 365(c)(1) in conjunction with section 365(f)(1), which provides that a debtor may assign a contract notwithstanding any “applicable law” that prohibits, restricts, or conditions the assignment.  To resolve this apparent inconsistency, the court followed the Ninth Circuit’s approach of characterizing section 365(f)(1) as a broad rule overriding general bans on assignment and section 365(c)(1) as an exception to that rule.  Accordingly, the court held that section 365(c)(1) applies only where the applicable law “specifically states that the contracting party is excused from accepting performance from a third party under circumstances where it is clear from the statute that the identity of the contracting party is crucial to the contract.”

Application to Trademarks

The court determined that the “applicable law,” federal trademark law, provides that licenses are not assignable without express authorization from the licensor.  This general ban exists because trademarks are meant to identify a good or service of a particular, consistent quality, making the identity of licensees crucial to licensors.  The parties did not intend to contract around this rule in the Trademark License Agreement.  Additionally, the licensor’s consent to assignment to the first lien lender was not enough to overrule the default rule of non-assignability because it was only effective with respect to an “isolated assignee” in the context of a state enforcement action that was unlikely to ever occur once the bankruptcy case was commenced.  The section 365(c)(1) hypothetical test was thus satisfied, and the court held that Trump AC was entitled to relief from the automatic stay under West Electronics.

Implications

Trump Entertainment Resorts highlights one of the ironies under the Bankruptcy Code.  Although section 365(n) of the Bankruptcy Code expressly protects non-debtor licensees of intellectual property and the Third Circuit seems to want to extend such protection to trademark licenses, the hypothetical test adopted by the Third Circuit remains an obstacle for debtors that simply wish to keep their intellectual property licenses.  The Trump opinion, however, hints at the role section 365(f)(1) can play in limiting the reach of the hypothetical test.  By only applying section 365(c)(1) where the identity of the assignee is “crucial” to the contract, courts can more frequently provide debtors with the ability to continue operating under their prepetition contracts and, in turn, contribute to successful reorganizations.

The Trump decision also highlights the importance of prepetition planning whenever debtors have valuable contract rights that may be affected by the hypothetical test.  As popular as Delaware is as a venue for chapter 11 cases, the hypothetical test adopted by the Third Circuit may make Delaware less attractive in certain circumstances.  Was another venue outside the Third Circuit available to the debtors?  Could the debtors have structured the debt for equity swap so that the first lien lender effectively exercised its state law enforcement rights to achieve the same result?  In those situations covered by the hypothetical test, it is important to scrutinize the consent provisions carefully and determine whether the debtors should take steps prepetition or postpetition in structuring their chapter 11 plan to fit within the situations in which the contract permits assignment.