In Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372, the United States Court of Appeals for the Seventh Circuit held that a debtor-licensor’s rejection of an executory trademark license does not terminate the licensee’s right to use the trademark. The decision creates a circuit-level split that may invite Supreme Court review. However, no final resolution is likely soon. The Supreme Court declined to hear the case, denying a petition for a writ of certiorari in December of 2012. Thus, most bankruptcy courts will continue to grapple with the difficult issue of whether rejecting a trademark will terminate a licensee’s right to use that trademark.

Legal Background

In 1985, the Fourth Circuit Court of Appeals issued its opinion in the Lubrizol Enterprises, Inc. case. See 756 F.2d 1043. That decision held that when an intellectual property license is rejected by a debtor in bankruptcy, the licensee loses the ability to use any licensed copyrights, trademarks and patents. For many, such a result seemed grossly unfair and improper. For example, under the holding of Lubrizol, a debtor’s rejection could negate the right of a software user to use software provided by a debtor during the middle of the contract term, at great expense to the software user. However, the Fourth Circuit was not to have the last word on this issue, or at least on a substantial part of this issue.

In response to criticism of Lubrizol, Congress soon added Section 365(n) to the Bankruptcy Code. That provision (now about 25 years old) provides that licensees can elect to continue to use “intellectual property,” after a debtor rejects an intellectual property license, for the remaining period of that contract so long as the licensee continues to fulfill all of its obligations (including by making royalty payments) and certain other conditions are satisfied. While this change was effective in resolving the issue for most intellectual property-related issues, it did not resolve the question for trademarks. This is because the definition Congress created for “intellectual property” included only patents, copyrights and trade secrets. Trademark rejection was not addressed and was exactly the issue faced by the Seventh Circuit in the Sunbeam case.

The Facts

In 2008, an economically-distressed Lakewood Engineering & Manufacturing sought to enter into a contract with Chicago American Manufacturing under which Chicago American would manufacture box fans using Lakewood-patented designs and Lakewood trademarks. Lakewood was to take orders from retailers and relay those orders to Chicago American, who would ship the finished fans as directed. However, Chicago American was leery of entering into such a contract given Lakewood’s financial condition and the fact that gearing up for production of the required 1.2 million fans would be costly. Lakewood provided assurance by authorizing Chicago American to sell the year’s order for its own account if Lakewood did not purchase them.

Three months into the contract, Lakewood was forced into bankruptcy involuntarily. The trustee appointed to oversee Lakewood’s bankruptcy estate ultimately sold Lakewood’s business. (The sale was to Sunbeam Products, hence the name of the case.) After completing the sale, the trustee exercised its right under section 365 of the Bankruptcy Code to reject Lakewood’s contract with Chicago American.

Notwithstanding that rejection, Chicago American continued to manufacture Lakewood-branded fans. As a result, Lakewood’s successor sued Chicago American in bankruptcy court, arguing that the trustee’s rejection of Chicago American’s contract (which included the licenses that allowed Chicago American to use Lakewood’s patents and trademarks) terminated Chicago American’s right to manufacture Lakewood- branded fans.

The Decision

After a full trial on the merits, the bankruptcy court declined to decide the broader question of whether a debtor-licensor’s rejection of a trademark license terminates the license under principles of law. Instead, the bankruptcy court found that, because Chicago American had invested substantial capital with the expectation that it would manufacture Lakewoodbranded box fans for an extended period of time, equity required that Chicago American be permitted to retain its trademark license.

On appeal, the Seventh Circuit rejected the bankruptcy court’s equitable basis for permitting Chicago American to continue using Lakewood’s trademarks, recognizing that “[w]hat the Bankruptcy Code provides, a judge cannot override by declaring that enforcement would be ‘inequitable.’” Nevertheless, the court did not conclude that rejection of the contract terminated Chicago American’s trademark rights. Instead, the Seventh Circuit rejected the Fourth Circuit’s Lubrizol reasoning and held that a licensee’s rights under an executory trademark license survive rejection of the license by a debtor-licensor.

As the Seventh Circuit explained, bankruptcy courts have erred in concluding that, by omitting the word trademark from the definition of intellectual property protected by 365(n), “Congress codified Lubrizol with respect to trademarks . . . .[A]n omission is just an omission. The limited definition [of intellectual property] means that §365(n) does not affect trademarks one way or the other.” Accordingly, the court reasoned that the correct course was to apply principles of statutory interpretation – without reference to Lubrizol – in deciding whether Chicago American’s trademark license rights were terminated by the trustee’s rejection of its contract.

In addition, the Seventh Circuit stated that courts have erred in equating a debtor’s right to reject executory contracts with an avoidance power that provides a means for erasing substantive contract rights. Section 365(g) of the Bankruptcy Code provides that “the rejection of an executory contract . . . of the debtor constitutes a breach of such contract . . . .” Thus, contract rejection frees the debtor from specific performance of its unfulfilled obligations and converts those obligations to damages. However, “nothing about this process implies that any rights of the other contracting party have been vaporized.” Instead, to determine the effect of contract rejection in bankruptcy (save for excusing the debtor from specific performance), a court need only inquire what effect a breach of the contract at issue would have outside of bankruptcy.

As the Seventh Circuit observed, outside of bankruptcy, a licensor’s breach of a trademark license would not terminate a licensee’s right to use the trademark. Accordingly, “[w]hat § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party’s rights remain in place.” As a result, the Seventh Circuit ruled that Chicago American was entitled to retain its license to use the Lakewood trademarks.

Conclusion

The Sunbeam decision creates an important circuit-level split regarding trademark rights in bankruptcy. Unless and until the Supreme Court weighs in on this issue, there will be no clear rule of law across the country. As such, in most jurisdictions, trademark licensees can be expected to argue that their full spectrum of rights under any rejected license (except for those that require specific performance by the debtor) survive in full and licensors can be expected to argue that the rejection voids the trademark license completely.