The Bottom Line:

Intellectual property licenses are often crucial components of licensees' businesses, and despite Congress's adoption of section 365(n) of the Bankruptcy Code and its provision that licensees can continue to use licensed intellectual property after a license is rejected by a debtor, a licensor's fall into bankruptcy still raises serious concerns on behalf of non-debtor licensees.  The Seventh Circuit, however, may have provided some comfort to licensees by more definitively limiting the ability of a debtor-licensor's rejection power and the ability to deprive non-debtor licensees of their right to continued use of licensed property. In Sunbeam Prods., Inc. v. Chicago Am. Manuf., LLC, the Seventh Circuit considered the effect on a trademark licensee of the rejection of the intellectual property license by the bankrupt licensor.  No. 11-3920 (7th Cir. July 9, 2012).  While section 365(n) provides that licensees of patents and copyrights can continue to use the intellectual property post-rejection, the statute is silent as to the treatment of trademarks.  The Seventh Circuit held that, despite pre-section 365(n) precedent from the Fourth Circuit (Lubrizol), rejection does not rescind or terminate the underlying agreement itself, and, therefore, the rights of licensees under the license remain intact post-rejection.

What Happened:

Lakewood Engineering & Manufacturing Co. ("Lakewood") contracted with Chicago American Manufacturing, LLC ("CAM") to manufacture Lakewood brand fans.  Under the agreement, Lakewood would order a certain number of fans to be manufactured by CAM in order to satisfy the customer orders that Lakewood expected to receive.  The agreement included an intellectual property license permitting CAM to practice Lakewood's patents and to place Lakewood's trademark on the finished products.  In order to assure CAM of its ability to pay for the first year's order of fans, Lakewood agreed that CAM would be permitted to sell for its own account any manufactured fans that Lakewood did not purchase.

Several months after entering the agreement, Lakewood was forced into bankruptcy by its creditors, and the court-appointed trustee sold Lakewood's assets, including its patents and trademarks, to Sunbeam Products, Inc. ("Sunbeam").  Sunbeam rejected the agreement under section 365(a) of the Bankruptcy Code.  Despite the rejection of the agreement, CAM continued to sell the Lakewood fans it had acquired in inventory for its own account under the agreement with Lakewood, and Sunbeam initiated an adversary action against CAM. 

After a trial, the bankruptcy court first found that CAM was permitted under the agreement to manufacture and sell the full number of fans that Lakewood estimated it would need for the first year and rejected Sunbeam's argument that the agreement required CAM to stop manufacturing and selling fans once Lakewood stopped needing them for itself.  The bankruptcy court next had to determine the effect of the rejection of the contract on CAM's rights with respect to the licensed intellectual property.

By way of legal background, in 1985, the Fourth Circuit held in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), that a rejection of an intellectual property license terminated the licensee's rights to use any licensed intellectual property, including copyrights, trademarks and patents.  Congress responded by enacting section 365(n) of the Bankruptcy Code, which provides that a licensee under a rejected license agreement has the right to continue to use licensed "intellectual property" after rejection, provided certain conditions are met.  The definition of "intellectual property" under the Bankruptcy Code includes patents, copyrights and trade secrets, but does not explicitly include trademarks.

The bankruptcy court stated that the omission of trademarks from section 365(n) did not necessarily imply that Congress intended Lubrizol to control in the case of trademarks, but determined that it did not have to decide the issue because CAM should be allowed to continue to use the trademarks on equitable grounds due to its substantial investment in manufacturing Lakewood fans.

On appeal, first, the Seventh Circuit rejected the notion that a court can override a provision of the Bankruptcy Code solely on grounds of equity.  The Seventh Circuit agreed with the bankruptcy court, however, that the omission of trademarks from section 365(n) did not indicate that Lubrizol had the imprimatur of Congress with respect to treatment of trademarks and, instead, the Court turned to the Bankruptcy Code to determine whether Lubrizol was correctly decided.  Section 365(g) provides that "the rejection of an executory contract or unexpired lease constitutes a breach of such contract or lease."  The Court noted that, outside of bankruptcy, basic principles of contract law dictate that breach of an intellectual property license by the licensor does not terminate the licensee's right to use the intellectual property at issue "any more than a borrower could end the lender's right to collect just by declaring that the debt will not be paid."  The Court held, therefore, that section 365(g) merely codified, with respect to rejection in bankruptcy, the basic premise of contract law that the rights of the non-breaching party to a contract remain intact upon a breach by the other party, and that rejection merely relieves a debtor of its continuing obligation to perform; however, rejection does not abrogate or rescind the contract itself.  According to the Seventh Circuit, Lubrizol misapprehended the nature of rejection and, irrespective of any rights conferred under section 365(n), non-debtor intellectual property licensees (including trademark licensees) have a right to continue to use licensed property after a license is rejected by a debtor-licensor.

Why the Case is Interesting:

The Fourth Circuit's holding in Lubrizol rattled the intellectual property market, spurring Congress into action.  Despite the adoption of section 365(n), however, concerns have persisted over the ability of debtor-licensor to disrupt the ongoing business operations of non-debtor licensees by rejecting license agreements in bankruptcy, particularly with respect to the licensing of trademarks.  The Seventh Circuit's opinion (rejecting Lubrizol) puts trademark licensees on the same footing as other intellectual property licensees protected by section 365(n), despite Congress's omission of trademark licensees from the statute itself.  More broadly, the Court's characterization of the nature of a debtor's rejection power implies that section 365(n) may not even be necessary for licensees to continue to use intellectual property post-rejection.