The United States Court of Appeals for the Seventh Circuit (the “Seventh Circuit”) recently ruled that rejection of a trademark license as an executory contract did not terminate the licensee’s right to use the trademark. Specifically, the Seventh Circuit’s decision (Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, July 9, 2012) establishes that the rejection of the trademark license constitutes a breach of contract and relieves the estate from the obligations under the license, but such breach does not eliminate the existence of the license or the non-breaching party’s rights under the license.  

The Contract and the Adversary Proceeding

Lakewood Engineering & Manufacturing Co. (“Lakewood”) made and sold a variety of consumer products, including box fans, and all of the products were covered by Lakewood’s patents and trademarks. Lakewood entered into a contract (the “Contract”) with Chicago American Manufacturing, LLC (“CAM”) whereby CAM would practice Lakewood’s patents and put Lakewood trademarks on completed fans. The contract further provided that CAM could sell the 1.2 million fans estimated for 2009 on its own account directly to specified retailers if Lakewood did not purchase them from CAM.

In February 2009, shortly after Lakewood entered the Contract with CAM, several of Lakewood’s creditors filed an involuntary bankruptcy petition against it in the United States Bankruptcy Court for the Northern District of Illinois (the “Bankruptcy Court”). The Bankruptcy Court appointed a trustee (the “Trustee”) who sold Lakewood’s business to Sunbeam Products, Inc. d/b/a Jarden Consumer Solutions (“Jarden”).

While Jarden did not purchase the completed fans in CAM’s inventory, it did object to CAM selling the Lakewood-branded fans in direct competition with Jarden. The Trustee rejected the executory portion of the Contract. Notwithstanding the Trustee’s rejection of the Contract, CAM continued to manufacture and sell Lakewood-branded fans pursuant to the terms of the Contract, and the Trustee filed an adversary proceeding1 seeking, among other things, to enjoin CAM from selling the Lakewood-branded fans and for disgorgement of all of CAM’s profits from the sale of such fans.

The Bankruptcy Court ruled on equitable grounds that CAM should be permitted to continue to manufacture and sell Lakewood-branded fans pursuant to the terms of the Contract.2 The Seventh Circuit, while rejecting the Bankruptcy Court’s reasoning that equity should determine the case, nonetheless affirmed the Bankruptcy Court’s ruling.3

Section 365 of the Bankruptcy Code4

Section 365(n) of the Bankruptcy Code establishes that a licensee of intellectual property has two choices when the license is rejected by a trustee: 1) it may treat the license as terminated if the rejection amounts to such a breach as would otherwise entitle the licensee to treat it as terminated under its own terms or applicable nonbankruptcy law, or 2) it may retain its rights to such intellectual property as the rights existed before the bankruptcy case commenced for the duration of the contract. At first glance, this section of the bankruptcy code might appear to resolve the issue in favor of CAM, but the Seventh Circuit describes why resolution of the issue is not so simple.

The term “intellectual property” is a defined term under the Bankruptcy Code and includes patents, copyrights, and trade secrets.5 Conspicuously missing from this definition is trademarks, which are the subject of Jarden’s adversary proceeding against CAM. Because trademarks are not included in the definition of “intellectual property” under the Bankruptcy Code, section 365(n) is inapplicable.

Effect of the Rejection

Because it found that section 365(n) is not controlling over trademarks, the Seventh Circuit was required to determine the effect of the Trustee’s rejection of the Contract without regard to that section. The Seventh Circuit noted that “[o]utside of bankruptcy, a licensor’s breach does not terminate a licensee’s right to use intellectual property.”6

The Seventh Circuit hypothesized that if Lakewood had breached its obligations under the Contract prior to bankruptcy by failing to provide the motors for the fans, CAM would have been entitled to either treat the breach as ending its own obligations or cover Lakewood’s breach by purchasing the motors from an alternative source and charge the added cost to Lakewood.7 Moreover, CAM would have been entitled to the benefit of its bargain to sell Lakewood-branded fans on its own account if Lakewood defaulted outside of bankruptcy.

The Seventh Circuit evaluated section 365(g) of the Bankruptcy Code to determine the effect of the Trustee’s rejection.8 Section 365(g) establishes that, except in certain situations not applicable to the Contract, the rejection of an executory contract constitutes a breach of such contract. As is the case outside of bankruptcy, a breach by one party does not abrogate the other party’s rights.

Because CAM’s rights under the Contract remained intact, the Seventh Circuit affirmed the Bankruptcy Court’s ruling that CAM was permitted to make and sell Lakewood-branded fans on its own account for the number of fans that Lakewood had estimated it would need for 2009.9

It should be noted that the Seventh Circuit’s decision is in conflict with Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc.10 Lubrizol, which was decided before Congress added Section 365(n) to the Bankruptcy Code, holds that, when an intellectual-property license is rejected in bankruptcy, the licensee loses the ability to use any licensed copyrights, trademarks, and patents. In response to the Lubrizol decision, Congress added section 365(n) to the Bankruptcy Code to protect the rights of licensees of certain intellectual property such as patents, copyrights and trade secrets. But, because trademark licenses are not within the scope of 365(n), Lubrizol may remain persuasive in some circuits—or controlling in the case of the Fourth Circuit—regarding the rejection of a trademark license. Nevertheless, the Seventh Circuit’s decision serves as key support for the argument that rejection of an executory contract is a breach of such contract rather than a rescission.

The Takeaway

The Seventh Circuit’s ruling is significant in two respects. First, it reminds us of the importance of defined terms under the Bankruptcy Code because trademarks, while commonly understood to be intellectual property in most respects, are not intellectual property as that term is defined by the Bankruptcy Code.

Second, and more importantly, it provides key guidance on how bankruptcy courts may view rejections of contracts by trustees, generally. That is, rejection by a trustee of an executory contract, except in certain circumstances, is treated by some circuits as a breach of the contract as opposed to termination or rescission, and the non-breaching party retains the same rights under the contract as it would have had if the breach occurred outside of bankruptcy. While often the remedy for breach is damages, which in bankruptcy would result in a claim for the non-breaching party against the estate, in some circumstances, other remedies might be available to the non-breaching party.

Parties to executory contracts should take care to properly evaluate available remedies following rejection by trustee. In addition, potential purchasers of a debtor’s business that is subject to executory contracts must also take care to properly evaluate the risks that those executory contracts pose to the assets being purchased. Only when the risks presented by executory contracts are fully understood can parties make informed decisions as to the proper course of action regarding those contracts.