The Bottom Line

The Bankruptcy Court for the District of Connecticut in In re Sima Int’l, Inc., Case No. 17-21761, 2018 WL 2293705 (Bankr. D. Conn. May 17, 2018), recently held that rejection of a license agreement did not terminate the licensee’s right to use the trademarks or enforce its exclusivity rights. In so holding, the court adopted a plain language reading of Section 365(g) and 365(n) of the Bankruptcy Code and found, respectively, that rejection of an executory contract is a breach, not a termination, and therefore the contractual rights of the trademark licensee remained in place post-rejection and the licensee’s exclusivity rights were preserved. The case adds to the split among courts over whether the Bankruptcy Code’s protections of “intellectual property” rights extend to “trademarks” which are not expressly included in the Code. With the increased prominence of the potential value of intellectual property rights in bankruptcy cases – such as liquidating retailers with well-known brands – this decision underscores the potential limitations on capturing that value through seeking to assign trademarks to new parties.

What Happened?

The Debtor was the sole and exclusive owner of certain copyrights, trademarks and other intellectual property relating to a unique System for Identifying Motivated Abilities (“SIMA®”). The Debtor entered into licensing with various parties, allowing those parties to use the intellectual property to create or develop derivative works, modifications, revisions or improvements. Pursuant to the Licensing Agreement between the Debtor and Marlys Hanson, Inc. (“MHI”), the Debtor would license, inter alia, all intellectual property associated with SIMA®, which included the trademarks and copyrights therein, to MHI for purposes of developing “adaptations.” In exchange, the Debtor would receive royalties from MHI’s gross revenues generated from the developed product. Under the License Agreement, MHI maintained an exclusive right to develop software involving the SIMA® technology and neither the Debtor nor any third party could engage in upgrading or improving the software.

The Debtor filed for Chapter 7 bankruptcy and shortly thereafter, the Chapter 7 Trustee filed a motion seeking to reject the Licensing Agreement pursuant to Section 365 of the Bankruptcy Code. The Trustee contended that the continuing obligations under the License Agreement were burdensome and rejection would likely enhance the value of the license in a bankruptcy sale. MHI objected, seeking to retain its rights to the License Agreement under Section 365(n)(1)(B) of the Bankruptcy Code. The parties disagreed on (a) whether Section 365(n) entitled MHI to the continued use of the SIMA® trademark and (b) whether MHI’s election preserved its exclusive rights under Section 6 of the License Agreement, which limits the parties’ ability to sell or enter into any agreement with any other person for developing, manufacturing or selling a competing product.

Section 365(n) of the Bankruptcy Code limits a debtor’s ability to terminate intellectual property licenses. Specifically, when the contract to be rejected is one “under which the debtor is a licensor of a right to intellectual property,” the licensee may elect to “retain its rights . . . to such intellectual property,” thereby continuing the debtor’s duty to license the intellectual property. 11 U.S.C. § 365(n)(1).

The court first considered the legislative history behind Section 365(n), noting that it was enacted in response to Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), which held that upon rejection, a licensee could not retain any of its contractual rights under a technology license and thus, the licensee was stripped of all rights of use it previously held under the agreement. The court noted that Section 365(n) was enacted to allow a licensee to retain its licensed rights for the rejected contract’s duration, as such rights existed immediately prior to the bankruptcy.

As an initial matter, the court found that the Trustee’s business judgment was entitled to deference and approved the motion to reject. The court next found that MHI had properly elected to retain its rights under Section 365(n) by filing its responsive pleading. The court then turned to whether MHI’s Section 365(n) election entitled it to use the SIMA® trademark post-rejection. A key aspect of the dispute was whether the protection of Section 365(n) extends specifically to “trademarks.” Section 365(n) protects the interests of a licensee of “intellectual property.” “Intellectual property,” in turn, as defined by the Bankruptcy Code – Section 101(35A) – does not expressly include trademarks; instead, it includes patents, copyrights and trade secrets. To address whether the protection should be expanded to include “trademarks,” the court noted the circuit split over whether a trademark licensee can continue to retain the license post-rejection of the agreement. On the one hand, the Seventh Circuit, in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372 (7th Cir. 2012), employed a “plain language reading” approach, and held that a licensee is allowed to retain rights to the debtor’s trademark post-rejection. On the other, the First Circuit recently held in In re Tempnology, LLC, 879 F.3d 389 (1st Cir. 2018), that the rejection by a debtor-licensor of a trademark stripped the licensee of its right to use the trademark post-rejection. The decision reviews the various cases across the circuits (which we won’t belabor here) examining a trademark licensee’s rights post-rejection. After reviewing various decisional authority, the court here aligned itself with the Seventh Circuit and agreed with Judge Turruella’s dissent in Tempnology, stating that the First Circuit’s statutory construction was contrary to Congress’ explicit efforts to “rebalance affected rights on intellectual property and leave Section 365(g) to answer otherwise unresolved trademark issues.” Under Section 365(g), the rejection of a contract not previously assumed constitutes a breach. To determine the parties’ rights regarding the License Agreement and the breach, the court looks to applicable state law. Under Connecticut law, a counter-party is relieved of continued performance under a contract if the breach is material. A material breach has been defined as one that would justify the other party to suspend his own performance of the contract. Here, the court found that under Connecticut state law, the estate’s rejection breach was not material and thus, the counter-party was not relieved of continued performance under the contract. In doing so, the court reasoned that the “Section 365(n) election indisputably preserves MHI’s right to the intellectual property and exclusivity, therefore, the core of the bargain and substantial purpose of the License Agreement has been preserved. Neither Section 365(g) applying state law, nor Section 365(n), provide a basis to terminate MHI’s equally central and bargained-for rights in the SIMA® trademark.”

Finally, the court concluded that Section 365(n)(1)(B) allowed MHI to retain its exclusivity rights to prevent the development of “competing products.” The court found that by its own terms, Section 365(n)(1)(B) allows MHI “to retain its rights (including a right to enforce any exclusivity provision of such contract) . . . under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property to the extent protected by applicable non-bankruptcy law).” 11 U.S.C. § 365(n). The court distinguished the First Circuit’s holding in Tempnology on this issue as inapposite stating that there, the issue was an exclusive distribution argument by the non-debtor. In contrast, here, the License Agreement embodies precisely the kind of exclusive intellectual property rights that are protected by 11 U.S.C § 365 (n)(1)(B).

Why This Case Is Interesting

The court declined to follow the recent First Circuit ruling in In re Tempnology, and aligned itself with the Seventh Circuit in permitting the trademark licensee to retain rights post-rejection. As noted in a prior blog article on the First Circuit’s ruling in In re Tempnology, trademarks can be a valuable right for certain distressed businesses. The Bankruptcy Code is often a balancing act – sometimes advancing rules that allow the estate to unlock value from assets limited as a matter of non-bankruptcy law and other times protecting the investment of non-debtors who transact with debtors and risk losing their investment in their property interest. This latest decision sides with the trademark licensee and prevents the debtor’s estate from walking away from pre-bankruptcy licenses and entering into new post-petition agreements. For some debtors (like retailers or other well-known product branded owners), trademarks can be a valuable asset. The impact of prepetition license arrangements on that value may be key to whether these marks can be a potential recovery source for creditors. It will be interesting to see whether the Second Circuit gets an opportunity to rule on this issue and take a side.