Recently, the United States Bankruptcy Court for the District of Connecticut held that while a bankrupt licensor may reject a trademark licensing agreement, the trademark licensee may elect to retain its rights to the debtor’s trademark. The Bankruptcy Court noted that its ruling disagrees with a contrary decision issued by the First Circuit only a few months earlier.
Executory Contracts and the IP Exception
Section 365(a) of the Bankruptcy Code allows a trustee (or a chapter 11 debtor), to assume or reject any executory contract. While a rejected contract leaves the non-debtor party with a prepetition damages claim for breach of contract, the Bankruptcy Code generally does not prescribe the effect of rejection on property being used by the non-debtor party under the agreement with the debtor.
Under section 365(n), however, if the rejected contract is one under which the debtor is a licensor of IP, the licensee may elect to “retain its rights… to such intellectual property,” thereby preserving its ability to continue using the licensed IP, although, it must continue to pay royalties due under the agreement.
This IP exception was Congress’s reaction to the 1985 Fourth Circuit decision in Lubrizol, which held that rejection of an IP license agreement effectively terminates the licensee’s rights to use any licensed copyrights, trademarks, and patents. Congress professed that allowing section 365 to strip IP licensees of their rights “threaten an end to the system of licensing of intellectual property ... that has evolved over many years to the mutual benefit of both the licensor and the licensee and to the country's indirect benefits.”
In conjunction with the enactment of section 365(n)’s IP exception, Congress amended the definition of “Intellectual Property” to include: trade secret; invention, process, design, or plant; patent application; plant variety; a protected work of authorship; or protected mask work. Congress purposefully excluded trademarks in order to allow courts to develop the law in light of the unique nature of trademarks.
The Circuit Split
There is a circuit split as to whether a trademark licensee can continue to use the licensed trademark after rejection. Some bankruptcy courts have followed Lubrizol and concluded that, since trademarks are not covered by section 365(n), rejection of a trademark license extinguishes the licensee’s right to use the trademark.
Judge Ambro’s concurring opinion in the Third Circuit’s Exide Technologies opinion, however, disagreed with Lubrizol. Judge Ambro held that courts should use their equitable powers to give the debtor a fresh start without stripping the licensee of its trademark rights. This line of reasoning has been characterized as “the equities approach.”
In 2012, the Seventh Circuit in Sunbeam disagreed with the equities approach but arrived at the same result nonetheless. The Seventh Circuit held that the limited definition of “Intellectual Property” in section 101(35A) means that section 365(n) does not encompass, and therefore does not protect, trademarks. Focusing, however, on a plain language of section 365(g), the Seventh Circuit held that a trademark licensee is entitled to continue using the trademark because rejection of an executory contract is a breach, not termination, and therefore the contractual use rights of the licensee do not evaporate upon the licensor’s breach (aka rejection).
Most recently, in Tempnology, the First Circuit, agreeing with the Fourth Circuit, held that the rejection of a trademark by a debtor licensor stripped the licensee of its right to use the trademark. The court found that allowing the licensee to continue to use the trademark would impose on the licensor the undue burden of monitoring the use of the trademark, and would thereby undercut the purpose of the rejection powers under the Bankruptcy Code.
In re SIMA
SIMA International, Inc. (“SIMA”) was the sole and exclusive owner of certain copyrights, trademarks and other IP relating to a System for Identifying Motivated Abilities (“SIMA®”). SIMA entered into licensing agreements allowing third parties to utilize the IP to create or develop derivative works, modifications, revisions, or other improvements relating to the technology. A license agreement between SIMA and Marlys Hanson, Inc. (“MHI”) provided that, in exchange for royalties, SIMA would license all IP associated with SIMA®, which included trademarks and copyrights, to MHI for purposes of developing “adaptions” of the SIMA® technology.
On November 17, 2017, SIMA filed a voluntary chapter 7 petition. The Trustee filed a motion seeking authorization to reject the license agreement between SIMA and MHI. MHI elected to retain its rights to the license agreement pursuant to section 365(n). The parties disagreed as to whether the section 365(n) election preserved MHI right to the continued use of the SIMA® trademark and to enforce the license’s exclusivity provision.
The Bankruptcy Court declined to follow Tempnology and found that the 365(n) election entitled MHI to continue to use the SIMA® trademark. The Bankruptcy Court further held that the 365(n) election preserved MHI’s exclusive rights to prevent the development of competing products.
First, under section 365(g), rejection of a contract constitutes a breach. Therefore, rejection frees the estate from its obligation to perform, but does not make the contract disappear. And, other than with respect of certain real estate contracts, section 365 does not provide for the termination of the licensee’s contract rights. Therefore, regardless of whether section 365(n) is applicable, there simply is no basis to terminate MHI’s rights in the licensed trademark.
Second, the Bankruptcy Court found that the use of the trademark was actually protected by section 365(n) because it was not only ancillary to the use of the IP, it was directly embedded within, supplemental to, and integral to the IP license. In that respect the court’s opinion is consistent with other decisions protecting trademarks under section 365(n) when the trademark license was integral to the main purpose of an otherwise covered license.
Third, the court held that the license’s exclusivity provision survived rejection since section 365(n) explicitly so provide for contracts falling within its coverage. In that respect the Bankruptcy Court rejected the Trustee’s broad reliance on the First Circuit’s decision in Tempnology as inapposite. The exclusivity issue in Tempnology related to exclusive distribution rights, not the exclusive rights to exploit the debtor’s IP under section 365(n). In fact, the First Circuit held that “[a]n exclusive right to sell a product is not equivalent to an exclusive right to exploit the product’s underlying intellectual property.” Accordingly, the Bankruptcy Court held that MHI’s election preserved its exclusive rights to prevent the development of competing products as defined in the license agreement. The court, however, did not analyze the issue assuming that the license was outside the section 365(n) protection. We can only speculate whether the exclusivity provision remains enforceable notwithstanding rejection under the rational that rejection is a breach, not a termination.
Conclusion and Implications
In SIMA, the Bankruptcy Court positioned itself on the Sunbeam side of the circuit split and rejected the holding and reasoning in Tempnology. This ruling, if appealed, may therefore become a vehicle for the Second Circuit to speak on a question upon which the First, Third, Fourth and Seventh Circuit Courts of Appeals have already spoken. Moreover, this circuit split concerns a question of federal Bankruptcy Code statutory interpretation and presents a matter that is ripe for Supreme Court review. In the meantime, absent a Supreme Court decision or amendments to the Bankruptcy Code, the question of whether a licensee’s trademark rights are protected upon the licensor’s bankruptcy filing will continue to depend on where the case is filed.