What happens to the a licensee’s right to use a trademark if the licensor files for bankruptcy? This critically important question was recently addressed by the First Circuit Court of Appeals in Tempnology. Bucking the current trend of case law, the First Circuit held that a debtor-licensor’s rejection of a trademark license agreement terminates the licensee’s rights to use the mark. The First Circuit reaffirmed that section 365(n) of the Bankruptcy Code does not provide special protections to trademark licensees. Widening the existing circuit split on this important issue, Tempnology presents an attractive case for the Supreme Court’s review and some considerations for licensees of trademarks.
Rejection of Intellectual Property Executory Contracts in Bankruptcy
Section 365(a) of the Bankruptcy Code permits bankrupt debtors to reject executory contracts that, in their business judgment, are a burden to their estate. Rejection of an executory contract, under section 365(g), constitutes a statutory breach of the contact and is treated as if the agreement was breached as of the date immediately prior to the filing of the debtor’s bankruptcy petition. Such rejection generally entitles the non-breaching party to a prepetition, unsecured claim for breach damages.
While debtors are no longer required to perform post-rejection, section 365(n) provides certain protections to licensees in connection with the rejection of intellectual property contracts. In the event a debtor-licensor rejects its intellectual property license, section 365(n) grants the licensee discretion to elect to either (1) treat the rejection as a termination and assert a prepetition claim for monetary damages; or (2) retain its rights under the license—and related supplements to the contract—for the duration of the contract. In connection with its enactment of section 365(n), Congress concurrently amended the Bankruptcy Code’s definition of “intellectual property” to include six categories of property, including trade secrets, patents, and copyrights. Trademarks, however, are not included. Despite this clear omission, courts have taken differing approaches as to whether trademark licensees are entitled to retain their rights under the license following rejection.
The Tempnology Case
The Debtor, formerly known as Tempnology, LLC, was a designer and manufacturer of specialized athletic apparel products—marketed under the Coolcore and Dr. Cool brands. In 2012, the Debtor executed a co-marketing and distribution agreement, pursuant to which the Debtor granted Mission Product Holdings, Inc., among other things, licenses to use its patents and trademarks. On September 1, 2014, the Debtor filed a voluntary chapter 11 petition and promptly moved to reject the Agreement.
Mission objected to the proposed rejection, arguing that section 365(n) of the Bankruptcy Code permitted its continued use of the intellectual property licenses notwithstanding rejection. The parties agreed that rejection did not affect Mission’s rights under the Patent License, but disagreed as to the Trademark License. Ultimately, the bankruptcy court sided with the Debtor, holding that because Congress did not include “trademarks” under the Bankruptcy Code’s definition of intellectual property, section 365(n) does not apply to trademark licenses and Mission’s rights under the Trademark License terminated upon rejection.
On appeal to the Bankruptcy Appellate Panel for the First Circuit, the BAP affirmed the ruling that section 365(n) does not apply to trademark licensees, but held that the lower court “erred in ruling that Mission’s rights in the [Trademark License] terminated upon . . . rejection[.]” Instead, the BAP found that Mission may retain its rights to use the Trademark License if it were permitted to do so following the Debtor’s breach under the Agreement and non-bankruptcy law. The BAP reasoned that section 365(g) simply provides that rejection of an executory contract constitutes a breach and that the section’s plain language does not restrict the non-breaching party’s remedy to a claim for monetary damages.
Although the First Circuit affirmed the lower courts’ conclusions that the Bankruptcy Code excludes trademark licenses from section 365(n), the circuit court disagreed as to the effect of a section 365(g) breach on rejection of the Trademark License. The First Circuit found that because a debtor-licensor’s rejection of a trademark license terminates the debtor’s obligation to perform under the license, the licensee’s remedy is limited to a prepetition claim for monetary damages. The BAP’s decision was based the “unstated premise that it is possible to free a debtor from any continuing performance obligations under a trademark license even while preserving the licensee’s right to use the trademark.” Rejecting this premise, the First Circuit reasoned that trademarks, unlike other types of intellectual property, are “public-facing messages to consumers” that “signal uniform quality and protect a business from competitors who attempt to profit from its developed goodwill.” Thus, to preserve a mark’s value, licensors have an ongoing need to monitor and control their licenses’ use to ensure that the public is not deceived by a misuse of the mark. “[F]ailure to monitor and exercise this control results in a so-called ‘naked license,’ jeopardizing the continued validity of the owner’s own trademark rights.” The First Circuit further noted that to conclude otherwise “invite[s] further leakage”; if a licensee’s trademark rights survive rejection under this theory, other rights also may also survive.
As a result, under the Tempnology decision, the rejection of a trademark license leaves the licensee with the sole remedy of asserting a claim for monetary damages.
The Third and Seventh Circuits’ Approaches
The First Circuit’s opinion in Tempnology is the first circuit-level decision to hold that a trademark licensee’s right to use a mark under the licenses do not survive rejection since Congress’ adoption of section 365(n) in 1988. The ruling counters earlier decisions by the Third and Seventh Circuits, which each held that a non-debtor licensee’s rights to use a trademark may survive rejection. Although the Third and Seventh Circuits came to similar results, they were based on different rationale.
Third Circuit Judge Ambro opined, in his concurrence in Exide Technologies, that Congress intended bankruptcy judges to exercise their equitable powers to determine if, on a case-by-case basis, trademark licensees should be permitted to preserve their rights under the license notwithstanding its rejection. Judge Ambro looked beyond the plain language of the Bankruptcy Code, which clearly excluded trademarks from intellectual property, to section 365(n)’s legislative history. Trademark licensing agreements, Congress observed, “depend to a large extent on control of the quality of the products or services sold by the licensee.” Since it could not address trademark licenses “without more extensive study,” Congress chose to “postpone congressional action” and allowed “the development of equitable treatment of this situation by bankruptcy courts.” While the Third Circuit’s equitable rule is not binding, it is highly persuasive and has been employed by lower courts throughout the Third Circuit.
The Seventh Circuit, in its Sunbeam decision, expressly rejected Judge Ambro’s reasoning as providing too much discretion to bankruptcy judges. Instead, the Seventh Circuit established a rule that permits trademark licensees to retain their rights under the license notwithstanding its rejection for the same reasons asserted by the BAP in Tempnology. The Seventh Circuit concluded that section 365(n) does not apply to trademark licenses. Despite the inapplicability of section 365(n), a trademark licensee’s continued right to use a mark may survive rejection if the licensee is entitled to continued use of the license following the licensor’s breach under non-bankruptcy law since section 365(g) merely provides that rejection of an executory contract “constitutes a breach of such contract.” Because a licensor’s breach of a license outside of bankruptcy does not terminate the licensee’s rights under the license, a section 365(g) breach (rejection), likewise does not vaporize the innocent licensee’s rights under the license.
Conclusion, Practice Points and Thoughts to Consider
While the reasoning differed, prior to the ruling in Tempnology the circuit courts addressing the rejection of trademark agreements held that a non-debtor licensee’s rights to use a trademark license may survive the debtor’s rejection of the license. Under the First Circuit’s Tempnology decision, however, non-debtor trademark licensees are only entitled to a prepetition, unsecured claim for monetary breach damages. Other circuits, such as the Second Circuit, have yet to take a position.These polar opposite results invite forum shopping. Until the Supreme Court decides to intercede, companies burdened by cumbersome trademark licenses are incentivized to seek bankruptcy protection in the First Circuit. Trademark licensees, however, may be motivated to move to transfer venue to a jurisdiction where there rights are protected.
From a business perspective, the circuit split creates uncertainty for trademark licensees when the debtor-licensor rejects a trademark license because the right or protection depends on where the debtor-licensor files for bankruptcy. Licensors of trademarks may start to utilize the bankruptcy process to shed below market or burdensome trademark licenses. On the other side, trademark licensees, or lenders and providers of financing for whom such trademark licensees are pledged as collateral, should consider structuring transactions in a manner to prevent the loss of trademarks under license agreements in the event a licensor files for bankruptcy protection. For example, parties can build in protections that reduce the risk of rejection in bankruptcy, including, placing the trademarks in a separate bankruptcy protected or remote entity and/or obtaining a lien in the actual trademark as separate from a license or lien in the assignment. Despite the recent ruling, careful planning and creativity can reduce the risk of losing the rights to trademark use in bankruptcy.