On October 31, 2014, Bankruptcy Judge Kaplan of the District of New Jersey addressed two issues critically important to intellectual property licensees and purchasers: (i) can a trademark  licensee use section 365(n) of the Bankruptcy Code to keep licensed marks following a  debtor-licensor’s rejection of a license agreement?; and (ii) can a “free and clear” sale of  intellectual property eliminate any rights retained by a licensee? In re Crumbs Bake Shop, Inc., et  al., 2014 WL 5508177 (Bankr. D.N.J. Oct. 31, 2014). He concluded that section 365(n) protects  trademark licenses, notwithstanding the omission of trademarks from the Bankruptcy Code’s  definition of protected “intellectual property,” and that a “free and clear” sale does not  extinguish a licensee’s section 365(n) rights, absent clear and knowing consent by the licensee.

Background

Crumbs was a specialized retailer of cupcakes and other baked goods that stopped operating in early  July 2014.  The company and its affiliates filed for chapter 11 and tried to sell substantially all  of their assets in a section 363 sale. On August 27, 2014, the court approved the sale of those  assets to the debtors’ existing lender, free and clear of all liens, claims, encumbrances and  interests.

Soon after entry of the sale order, the debtors moved to reject executory contracts the purchaser  had not acquired, including various trademark licensing agreements for the use of the Crumbs  trademark and trade secrets. A third party—a brand licensing servicer of the licenses for the  Crumbs trademarks— responded that licensees could retain their rights to the trademarks pursuant to  section 365(n) of the Bankruptcy Code. The debtors withdrew their motion to the extent it related  to the trademark licenses in favor of a later determination of the effect of the sale order on  rights to the Crumbs trademark.

Section 365(n) & Trademark Licenses

Under section 365(n) of the Bankruptcy Code, a non-debtor licensee may retain the right to use  “intellectual property” under a rejected license. In essence, this provision allows the licensee to  “reject” the debtor’s rejection if, among other things, the licensee continues to pay the royalties  due under the license.

Congress enacted section 365(n) after a 1985 Fourth Circuit ruling that a debtor’s rejection of a  patent license extinguished the licensee’s rights in the patented technology. Lubrizol Enters.,  Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985).  Congress was concerned that  the harsh result in Lubrizol would adversely impact the technology industry as a whole. 

Section 365(n), however, only applies to certain types of “intellectual property.”  See 11 U.S.C. §  101(35A). Trademarks are not among the enumerated categories of protected intellectual property and the  legislative history indicates that their absence was intentional. See In re Exide Techs., 607 F.3d  957, 966-7 (3d Cir. 2010), citing S. Rep. No. 100-505, at 5. Thus, the legal consequences of  trademark license rejection for trademark licensees remain unclear. Some courts impose the Lubrizol  result— the debtor’s rejection of a trademark license extinguishes the licensee’s rights. See e.g.  In re HQ Global Holdings, Inc., 290 B.R. 507, 513 (Bankr. D. Del. 2003). Others have declined to  apply Lubrizol, reasoning that rejection is nothing more than a breach of the agreement and that  breach alone does not terminate a licensee’s rights. See Sunbeam Prods., Inc. v. Chicago Mfg., LLC,  686 F.3d 372, 277-8 (7th Cir. 2012) (rejection did not terminate counterparty’s right to continue  to manufacture and sell trademarked fans); see also In re Exide Techs., 607 F.3d 957, 964-8 (3d  Cir. 2010) (Judge Ambro, concurring).1

In Crumbs, Judge Kaplan held that section 365(n) applies to Crumbs’ trademark licenses,  notwithstanding that the Bankruptcy Code’s definition of protected “intellectual property” does not  expressly include trademarks. He maintained that “Congress intended the bankruptcy courts to  exercise their equitable powers to decide, on a case by case, whether trademark licensees may  retain the rights listed under §365(n),” (2014 WL 5508177 at *4), and that, given the facts at  hand, it would be inequitable to strip the licensees of their rights for the benefit of the  purchaser. Id., citing favorably to Judge Ambro’s concurrence in Exide, 607 F.3d at 967-8 (“Courts  may use 365 to free a bankrupt trademark licensor from burdensome duties that hinder its  reorganization. They should not… use it to let a licensor take back trademark rights it bargained  away.”). Separate and apart from equitable considerations, he agreed with Sunbeam that rejection of  a trademark license should not eliminate the counterparty’s rights. Id. at *4-5. He also noted that  legislation is currently pending that would remedy the omission of trademarks from the definition of “intellectual property” covered by section 365(n). Id. at *5.

Section 365(n) in a Sale Context Having determined that section 365(n) applies to and protects trademark licenses, Judge Kaplan next  addressed section 365(n)’s operation in the context of a 363 sale.

First, the court considered whether section 363(f) trumps licensees’ rights under section 365(n).  Under specified circumstances, section 363(f) allows a purchaser to take assets “free and clear” of  any other property interest. Would that include section 365(n) rights? Judge Kaplan said “no,” that  section 363(f) does not extinguish section 365(n)’s protections, absent the informed consent of the  counterparty.  2014 WL 5508177 at *8.   As a matter of statutory construction, the specific protections provided by  section 365(n) trump the general “free and clear” language of section 363(f). Id. at *9. In so holding, the  court declined to follow a Seventh Circuit ruling to the contrary regarding a similar provision,  section 365(h). Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003).  There, the Court of Appeals concluded that a sale under section 363(f) stripped a lessee of its  rights under section 365(h).

Judge Kaplan also rejected the purchaser’s argument that the licensees had “impliedly consented” to  the termination of their section 365(n) rights by failing to object to the sale motion. He found  that the notice provided to Crumbs’ licensees—one which neither identified clearly the assets being  sold, nor informed the licensees that their rights might be extinguished—was inadequate. Given  that, Judge Kaplan decided that the counterparties’ failure to object to the sale could not be  construed as informed consent. Id. at *6- 7.

Second, Judge Kaplan considered an additional consequence of his decision arising from the fact  that the underlying trademarks, but not the license agreements, had been transferred to the  purchaser. Because the agreements remained with the debtors, Judge Kaplan concluded that  post-closing royalties under the agreements were owed to the debtors, not the purchaser of the trademarks. Id. at *11.

Consequence for Purchaser

The Crumbs decision places the burdens of trademark license issues squarely on the purchaser. Judge  Kaplan acknowledged that the continuation of trademark licenses under section 365(n) that are not  assumed by the debtor and acquired by the purchaser resulted in the purchaser – now, owner of the  trademarks – never becoming party to the rejected agreements and, thus, unable to enforce their  terms (such as quality control standards). Id. at *5. He suggested that existing infringement and  anti-fraud laws constituted sufficient incentives for the counterparties to maintain the quality of  the trademarks (id.), but these are incentives for the licensee to comply with quality control  standards, and not remedies available to a trademark owner. Such incentives do not address  circumstances that arise during the course of a licensing arrangement, including how to apply and  enforce quality control standards in the face of emerging technologies and media available to a  licensee, such as social media. This separation of ownership of the trademarks from the ability to  enforce and police their use could diminish the value of the trademarks purchased in a sale  transaction as a result of potential “naked licensing.” Perhaps recognizing this, Judge Kaplan  ventured that purchase price adjustments might be necessary to compensate the purchaser. Id. at *5.

Conclusion

The ultimate impact of the decision—particularly Judge Kaplan’s application of section 365(n) to  trademark licenses—remains to be seen. However, given the evolving case law regarding section  365(n) and the legal effect of rejecting a trademark license, buyers should understand that a  debtor may not be  able to deliver intellectual property—including trademarks—“free and clear” of the burdens of  existing licenses. Thus, buyers should consider including language in purchase agreements to protect against  adverse intellectual property decisions (e.g., providing for a purchase price adjustment, the  transfer of all royalties or section 365(n) payments associated with purchased assets, an  assignment of enforcement rights, a license “back” from the purchaser to the debtor to permit the  debtor to sublicense the trademarks to the licensees and enforce purchaser’s rights, and the like).