In Mission Products Holdings, Inc. v. Tempnology, LLC, the U.S. Supreme Court resolved a question that vexed the lower courts and resulted in a circuit split: does the rejection by a debtor-licensor of a trademark license agreement terminate the licensee’s rights under the rejected license?
The Fourth Circuit in Lubrizol and the First Circuit in Tempnology (the case for which certiorari was granted) held that the rejection terminates the licensee’s rights under the license; the Third Circuit in Sunbeam, held that it does not. The Supreme Court adopted what has become the minority view among the lower courts—rejection is a breach, not an avoidance power. As such, the debtor-licensor’s rejection of the trademark license does not strip the licensee of its rights under the license. In the words of the Supreme Court: “The question is whether the debtor-licensor’s rejection of that contract deprives the licensee of its rights to use the trademark. We hold that it does not. A rejection breaches a contract but does not rescind it.”
The Supreme Court gave a vivid example to demonstrate why a contrary holding would lead to an untenable result: assume a debtor-lessor leases copiers to a law firm. Upon the bankruptcy filing, the debtor seeks to reject the lease for the copiers. Is the law firm, as the non-breaching party, required to return the copiers to the debtor-breaching party? No says the Supreme Court.
So What Happens when the Non-debtor Retains its Rights?
The rule established by the Supreme Court in Tempnology appears simple enough and, since it is based on the long standing principle of executory contracts that a rejection is a breach by the debtor but not a termination of the contract, is applicable to all executory contracts except for those where the bankruptcy code establishes special rejection rules: “[W]e reject an argument for the rescission approach turning on the distinctive features of trademark licenses. Rejection of a contract-any contract-in bankruptcy operates not as a rescission but as a breach.”
But examining the contracts for which the bankruptcy code does provide special rejection rules, teaches us that there are far from simple lingering issues. As to each “special” category of contracts for which the bankruptcy code includes special rejection rules, the code provides for a detailed regime governing the rights of the parties should the non-debtor party choose to retain its rights under the rejected contract or license.
For “intellectual property licenses” (which, as that term is defined under the Bankruptcy Code, do not include trademark licenses), Section 365(n) allows the non-debtor party to treat the license as terminated and file a pre-petition rejection claim, or elect to retain its rights under the license for the duration of the license and any extensions provided therein, and if it so elects, requires the debtor or trustee to allow the licensee to exercise its licensed rights, provide the licensee any intellectual property or embodiment thereof held by the trustee, not interfere with the licensee’s rights, and requires the licensee to pay the royalty provided for in the license while deeming the licensee to have waived any setoff rights and any administrative expense claim arising from the performance by the debtor/trustee of the contract post-petition. Similar provisions (that vary in their specificity) apply to real property leases (section 365(h)(1)), time share interests (section 365(h)(2)) and real estate sales contracts (section 365(i)).
Which leads to the obvious question-what are the rights of the non-breaching party under rejected contracts for which the bankruptcy code does not specify these “special” rules? Are they required to continue paying the lease payments provided in the lease? Do they waive setoff rights? Can they exercise extension rights? A possible answer might be that the parties are left to whatever rights are provided under the state law applicable to the contract or lease at issue, as Justice Sotomayor suggested in her concurring opinion. But many of these state law rights might run head on into fundamental bankruptcy protections, not the least of which, are the automatic stay (section 362) and setoff rules (section 553) of the bankruptcy code.
In addition, an important policy issue remains. As the Supreme Court recognized, under trademark law, the licensor has a duty to police the mark, absent which its value would decline and eventually the trademark will become invalid. While the Court did not find that unique feature of trademark law sufficient to justify a different result, it potentially leaves the debtor-licensor with an economic leverage. Rather than threaten rejection in order to obtain better terms, the debtor may threaten to abandon the mark, leaving the licensee with a trademark that is declining in value and destined to become invalid.
The Supreme Court provided much required clarity on the treatment of trademark licenses in bankruptcy by resolving the Circuit split, and holding that notwithstanding that trademark licenses were omitted from the special protections in Section 365(n), a trademark licensee is otherwise protected from the loss of its license in the event that the bankrupt licensor rejects the license agreement. The Supreme Court’s resolution, however, would appear to shift the litigation over to what enforceable rights and obligations remain for contracts for which the bankruptcy code does not provide “special” rejection rules.