The economic value of IP rights in US bankruptcy proceedings has risen rapidly. Due to Congress's unique view of trademark licenses, appellate courts are increasingly divided on the ability both of debtor-owners to freely reject them, and of licensees to continue to use them. In In re Tempnology LLC,1 the Supreme Court has been asked to provide much-needed certainty on these issues.
There has been a remarkable commercialization of intellectual property in recent years. Market studies reveal that close to 80 percent of a company's market capitalization may come in the form of intangible assets, including intellectual property assets such as patents, trademarks, copyrights and other business knowledge and know-how. By way of example, the trademark applications growth rate is the highest since 2000—there are now twice as many applications being filed across the globe than 18 years ago.
Commensurate with its tremendous commercialization, the ever-increasing influence of intellectual property on local and regional economies, as well as on global commerce, cannot be overstated. Intellectual property touches almost every industry, supporting at least 45.5 million US jobs and contributing nearly US$7 trillion to the US GDP.
Because no enterprise that owns intellectual property outright can fully exploit every aspect of such ownership, the use of licenses, as well as sublicenses and cross-licenses, often provides an opportunity to derive the greatest value from intellectual property. A "license" is simply a legally binding permission that the owner of specific intellectual property grants to another party to use the owner's intellectual property without transferring ownership outright. As the global economy continues to expand, the popularity of licensing rights has grown, both in healthy businesses and distressed ones. In fact, the global retail of licensed merchandise will soon reach US$300 billion, and with the continued expansion of e-commerce (at a growth rate of 15 percent), these figures are sure to increase substantially.
Intellectual property issues are particularly significant in distressed situations, where many companies seeking bankruptcy protection under chapter 11 find significant, if not complete, value for stakeholders through the sale of intellectual property rights. The list of large chapter 11 cases where value is realized from these intellectual property sales is long and getting longer: Nortel (US$4.5 billion), Kodak (US$550 million), Nine West (US$348 million), Aeropostale (US$242 million), Polaroid (US$88 million) and American Apparel (US$86 million), among others.
The ability to monetize these intellectual property rights derives from several unique provisions of the United States Bankruptcy Code (the “Bankruptcy Code”). Historically, intellectual property licenses were not expressly covered by the prior version of the Bankruptcy Code, and, therefore, US bankruptcy courts treated them simply as executory contracts,2 subjecting them to section 365 of the Bankruptcy Code. This allowed the agreements to be rejected, assumed, or assumed and assigned. If a debtor is reorganizing its business, intending to emerge from bankruptcy as a viable going concern, the debtor may want to assume its license agreements, in which case it must cure any prepetition and postpetition defaults. Frequently, if a debtor is selling or otherwise liquidating its business, in whole or in part, it may attempt to monetize its intellectual property rights by choosing to assign its licensing agreements, often as part of a sale of substantially all of the debtor's assets under section 363 of the Bankruptcy Code. Before an agreement can be assigned to a third party, however, the debtor must assume it and cure any existing defaults, and the buyer must provide to the nondebtor-counterparty adequate assurance of the assignee’s future performance.
Due to significant concern over the impact rejection would have on licensees, Congress amended the Bankruptcy Code to include section 365(n). If a licensor rejects a license agreement, then section 365(n)(1) of the Bankruptcy Code meaningfully protects the licensee from automatically losing its licensing rights by allowing the licensee to choose either to (a) treat the license agreement as terminated or (b) retain its rights to intellectual property under the licensing agreement (including a right to enforce any exclusivity and confidentiality provisions, but excluding any right to specific performance) to the extent such rights existed immediately before the bankruptcy filing, for the duration of the agreement and any period for which it may be extended by the licensee as of right under applicable nonbankruptcy law. If the licensee elects to retain its rights under the licensing agreement, the debtor must provide to the licensee any intellectual property it holds and cannot interfere with the rights of the licensee as provided in the agreement. In turn, the licensee must pay all royalties that become due under the license agreement and automatically relinquishes any right of setoff it may have with respect to the agreement.
Interestingly, the Bankruptcy Code does not provide the same rights to a trademark licensee because the statutory definition of "intellectual property" does not include trademarks.3 The different treatment of trademark licenses may be attributable to their unique nature—they require continuous supervision and control by the licensor, which would simply be logistically impossible after the debtor-licensor rejects the trademark license. In fact, the affirmative duty of the licensor to approve the quality of products bearing the licensed trademark directly conflicts with section 365(n) of the Bankruptcy Code, which allows a licensee to use the license post-rejection without the licensor's involvement. Indeed, trademark licenses are equated to personal agreements based on the identity of the licensees because the licensor relies upon the good standing of the licensee, which can significantly affect the value of the brand, and expects the quality of the licensee to be of a certain caliber.
US courts have struggled with the import of this exclusion of trademarks from the definition of intellectual property in interpreting section 365(n) of the Bankruptcy Code. For example, the U.S. Courts of Appeals for the Third and Eighth Circuits4 have held that, when considered as part of a set of related transaction agreements and parties' performance, trademark licenses were not executory contracts and, thus, not subject to rejection.5 Other courts have held that trademark licenses are executory, because performance is required by each party. Within these courts, however, there is a divergence: some courts hold that licensee's rights to licensed trademarks are preserved following rejection of the license, reasoning that rejection does not constitute termination and does not obviate the contract6; other courts strictly interpret Bankruptcy Code section 365(n), such that a debtor-licensor's rejection of an executory trademark license terminates all licensee's rights to use the licensed trademarks (and none of the protections available under section 365(n) apply). 7Yet, one court has held that Bankruptcy Code section 365(n) applies to trademark licenses.8
Needless to say, this split of authorities has created significant uncertainty. First, debtors may seek to "forum-shop" to ensure that trademark licenses can terminate without residual burdens. In those jurisdictions where the license is not an executory contract, there is a risk that the debtor cannot assume and assign the lease to a third-party purchaser, potentially destroying considerable value for the estate. Further, in those courts where the licensee has a residual right of usage, the debtor-licensor is left with the difficult choice of abandoning control over potentially valuable intellectual property rights or continuing to operate under the license, which can be difficult for a chapter 11 debtor.
Owing to this uncertainty, the licensee in Tempnology has asked the US Supreme Court to clarify what, if any, rights under a trademark license survive rejection in chapter 11. As this article makes clear, the Supreme Court's review of this issue to address an issue of growing uncertainty is a matter of global economic significance.