What is the impact of a bankruptcy filing on the ability of a franchisee to continue utilizing the trademarks of the franchisor?  

Title 11 of the United States Code, better known as the “Bankruptcy Code”, allows companies to not only restructure their debts, but to modify current contractual obligations by rejecting contracts.  Debtors have the ability to reject contracts when there are continuing contractual obligations for both parties.  It follows that a bankrupt franchisor could potentially reject a franchise and license agreement, leaving the franchisee without ability to use trademarks and other intellectual property of the bankruptcy franchisor.  

Section 365(n) of the Bankruptcy Code affords protection to licensees of intellectual property.  If a bankruptcy licensor rejects a license agreement, section 365(n) allows a licensee to retain its rights to the intellectual property so long as the licensee continues making royalty payments to the licensor.  Sound good, right?  But not so fast!  There are limits to the protections afforded to licensees.  The Bankruptcy Code limits these protections to “intellectual property”, a specific defined term in the Bankruptcy Code.  The real question is, what is “intellectual property”.  The Bankruptcy Code’s definition of “intellectual property” includes, among other things, inventions, patents, trade secrets and copyrights.   The definition specifically does not include trademarks.

So what happens if a licensor attempts to reject a trademark license granted under a franchise agreement?  For years, most courts followed the Fourth Circuit Court of Appeals decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985).  The Fourth Circuit determined that after rejection by a debtor-licensor, a licensee would lose the right to use the trademark, and would only hold a damages claim against the debtor-licensor.

Twenty-five years later, the Seventh Circuit Court of Appeals revisited this issue in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372 (7th Cir. 2012).   The Seventh Circuit rejected the Lubrizol decision, and held that a licensee utilizing the trademarks of a debtor-licensee is protected, and can continue using the trademarks even if the license agreement is rejected by the licensor-debtor.

The Sunbeam decision is a positive development for franchisees operating in the states of  Illinois, Indiana and Wisconsin, which are governed by court decisions by Seventh Circuit.  Until there is a further ruling, possibly by the United States Supreme Court, Franchisees in those states may retain the ability to use trademarks even if the license agreement governing the franchise relationship is rejected in the bankruptcy of the licensor.  It is unclear whether this decision will be followed in courts outside of the Seventh Circuit; nonetheless, it is a significant win for franchisees, especially if courts in other judicial circuits adopt the reasoning of the Seventh Circuit.