A recent decision by a New Jersey bankruptcy court scrambles the law regarding rejected trademark licenses.1 Crumbs was a multi-location bakery that also licensed its trademarks and trade secrets to third parties. In July of 2014 Crumbs filed a Chapter 11 reorganization case and in August of 2014 the court entered an order selling substantially all of the assets of Crumbs to LFAC2 free and clear of liens, claims, encumbrances, and interests. LFAC did not purchase the licenses, which were initially to be rejected by Crumbs pursuant to § 365 of the Bankruptcy Code. When it was asserted that the licensees could elect to retain their rights under § 365(n), Crumbs withdrew the rejection, but the parties sought a determination by the court of their respective rights.

The court delineated the genesis of § 365(n) as a reaction to the much criticized Fourth Circuit decision inLubrizol3 and noted that trademarks are not defined as intellectual property for purposes of § 365(n).4Disagreeing with the reasoning in Lubrizol, the court concluded that it could apply equitable principles to decide whether the licensees could retain rights listed under § 365(n). Mentioning that many bankruptcy cases principally benefit only secured and administrative claimants, the court found no basis to yield the rights of third parties to the goal of maximizing the bankruptcy estate in a liquidation.

The court then cited the decision of the Seventh Circuit in Sunbeam5 where the court correctly noted that rejection under § 365 only constitutes a breach by the debtor, not a termination of the contract. In the event of a breach by a licensor outside of bankruptcy, the licensee does not lose its rights under the license. Although LFAC argued that if the licensees retained their rights, then LFAC could not control the quality of the products and services provided by the licensees, the court found that LFAC would have sufficient protections under trademark infringement, unfair competition, warranty, and other theories. In addition, the court discussed recent prospective legislation to include trademarks within the protection of § 365(n).6

Turning to the sale free and clear provisions of § 363(f), the court concluded that the specific provisions of § 365(n) controlled and that the licensees had not implicitly consented to the termination of their trademark rights since notice was inadequate. The notice provided constituted a “labyrinth of cross-referenced definitions and a complicated network of corresponding paragraphs with annexed schedules.” It was unclear what was being sold and the license agreements were included on a schedule of “Excluded Assets,” adding to the confusion. The licensees had no apparent reason to believe that an objection would be necessary in order to retain their rights. The proposed sale order contained a mere ten words indicating that the sale would be free and clear of the rights of the licensees buried in a twenty-nine page proposed order affixed to a filing totaling one hundred and twenty-nine pages.

Given that the licenses in question had not been rejected, and had not been sold to LFAC, the court ruled that the debtors could continue to collect the royalties from the licensees since the royalties were directly linked to the contract, not to the intellectual property that had been sold to LFAC. However, the court surmised that only LFAC could actually perform the obligations of the licensor under the license agreements and determined that rejection was necessary. The court concluded that the licensees were protected by § 365(n), that the sale free and clear under § 363(f) did not extinguish the licensees’ rights under § 363(n), and that the royalties generated by the use of the intellectual property by the licensees could be collected by the debtors “because the agreements themselves have not been assumed, assigned or rejected, and thus continue to be Debtors’ property.”7

The Crumbs court got to the right results for the wrong reasons. Trademarks were specifically excluded from the definition of intellectual property in the bankruptcy code because of the ongoing obligations of a licensor regarding trademarks. As a result, § 365(n) is not applicable to trademarks and the licensees have no rights under § 365(n). Fortunately, the analysis of Sunbeam is correct and rejection by a debtor only constitutes a breach and does not terminate the rights of the trademark licensee. In a non-bankruptcy context, breach by the licensor does not deprive the licensee of its rights to use the trademark. Since § 365(n) is inapplicable to trademarks, the court’s “specific controls the general” analysis breaks down, but its conclusion that the rights of the licensees were not terminated by the § 363 sale free and clear is not only the equitable result, but is also supported by the court’s conclusions regarding lack of notice. Had appropriate notice been provided, the licensees would have been entitled to adequate protection by § 363(e).