In February, following oral argument before the U.S. Supreme Court in Mission Product Holdings, Inc. v. Tempnology, LLC, we wrote about the hugely important trademark law issue presented by this case, namely: If a bankrupt trademark licensor “rejects” an executory trademark license agreement, does that bankruptcy action terminate the licensee’s right to continue using the licensed trademark for the remaining term of the agreement?
On May 20, 2019, the Supreme Court issued its decision. In a resounding 8-1 majority opinion, it declared that rejection of a trademark license under Section 365 of the Bankruptcy Code does not terminate the licensee’s right to continue using the licensed mark. The opinion points to Section 365(g) , which provides that rejection of an executory contract constitutes a “breach” of that contract by the bankrupt debtor. The Court concludes – with what appears to be unassailable logic – that a breach of a license agreement by the licensor cannot deprive the innocent licensee of its rights under the agreement. As Justice Kagan’s energetic opinion summarizes: “A rejection breaches a contract but does not rescind it. And that means all the rights that would ordinarily survive a contract breach … remain in place.”
The reason this seemingly obvious conclusion had generated so much judicial uncertainty is found in a series of additional sub-parts that Congress had appended to Section 365 over a span of 50 years. Each of these provisions addresses the impact of bankruptcy rejection on the non-bankrupt counterparty in certain specific types of agreements – leases, timeshare contracts and intellectual property licenses, among others – and each affirms that the counterparty’s rights remain enforceable post-rejection, as Section 365(g) would indicate. The Court stresses that each of these legislative additions to Section 365 was a Congressional rejection of judicial decisions that produced a contrary outcome.
In the case of Section 365(n), the trigger for Congressional response was Lubrizol Enterprises v. Richmond Metal Finishers, in which the Fourth Circuit held that a debtor’s rejection of an executory contract worked to revoke its grant of a patent license. As Justice Kagan recounts, “Congress sprang into action” with Section 365(n), overruling Lubrizol and declaring that rejection does not terminate the patent licensee’s remaining license rights. And it went further, extending the same mandate for post-rejection survival of licensed intellectual property rights to agreements covering copyrights, trade secrets, plant varieties and mask works.
The only broad category of IP rights omitted from Section 365(n) is trademark licenses. Presumably, Congress had a reason for this exclusion. In the 30 years since Section 365(n) was enacted, many commentators have opined that the rationale lies in the different social and commercial reasons to protect patents and copyrights, as distinguished from trademarks. Patents and copyrights encourage and reward intellectual innovation. Trademarks, in contrast, do not fundamentally reward innovation, but rather serve to assure the public that the products and services marketed under an established brand will provide the benefits and advantages associated with that brand. This requires that a trademark licensor monitor and police the quality, consistency and other material attributes of the goods or services offered by the licensee. Where a bankrupt licensor elects to reject an executory trademark license, allowing the licensee to continue using the mark will require the debtor to either continue policing the mark – which may impose burdens that hinder its financial reorganization – or allow unsupervised use of the mark (known as a “naked license”), which could tarnish or even invalidate the brand.
Tempnology argued strenuously that, by purposefully leaving trademark licenses out of Section 365(n), Congress must have intended that rejection of a trademark license would result in revocation of the licensed rights, arguing further that this different result makes sense in light of the different attributes and licensor burdens of trademark licenses in a bankruptcy situation.
But Justice Kagan, speaking for an eight-person majority, with equal vigor rejected this argument. She reasoned that any negative inference said to follow from the exclusion of trademarks from Section 365(n) could not overcome the direct, overarching mandate of Section 365(g), which states that rejection of an executory contract constitutes the bankrupt debtor’s breach of that contract, which cannot be expanded into a rescission or revocation of the counterparty’s rights. The opinion stresses that Section 365(n), as well as Sections 365(h) and (i) before it, were created precisely to counteract judicial interpretations that treated rejection as resulting in termination of the non-bankrupt counterparty’s executory rights.
The opinion goes on to emphasize that nowhere in Section 365 is there any specific mention of trademark agreements. There is only Section 365(g), stating the rule generally applicable to all types of executory contracts – that is, rejection is a breach, not a rescission. Then there are the other sub-parts noted above, each of which reinforces that the same outcome applies in the context of certain types of agreements, where court decisions had reached a different result.
But, if Tempnology’s argument is accepted, that is, that by omitting trademarks from Section 365(n), Congress intended that “rejection” of a trademark license would operate as a complete revocation of the license agreement, it would follow that all contracts except those carved out by Sections 365(h), (i) and (n) would, upon rejection, similarly be revoked. In practical effect, this would functionally delete Section 365(g), which has always been understood as the general rule on the effect of rejection, from the statute. The decision makes clear that such a wholesale reinterpretation of Section 365 cannot be sustained on nothing more than a “negative inference” drawn from what was left out of Section 365(n). As Justice Kagan comments, such an interpretation “would allow the tail to wag the Doberman.”
The opinion gives similar short shrift to the argument that the special “quality control obligations” imposed on a trademark licensor require that rejection of such a license must also result in termination of the licensee’s continuing right to use the licensed mark, so as not to complicate the bankrupt licensor’s reorganization plan. The opinion points out: “The Code of course aims to make reorganization possible. But it does not permit anything and everything that might advance that goal.” Rather, the rejection power gives the debtor a powerful tool with which to escape undesirable contractual obligations, but it does not “relieve the debtor of the need … to make economic decisions about preserving the estate’s value – such as whether to invest the resources needed to maintain a trademark.”
The opinion does not offer any suggestion about why Congress chose to omit trademarks from Section 365(n), nor does it acknowledge that its decision requires any such explanation. But the fact that trademarks are indeed omitted from Section 365(n) will have potentially profound commercial implications on trademark licenses rejected in bankruptcy going forward.
This is highlighted in the concurring opinion authored by Justice Sotomayor. Justice Sotomayor “join[s] the Court’s opinion in full.” But her concurring opinion goes on to note that, because Section 365(n) does not cover trademark licenses, trademark licensees whose license is rejected will enjoy a valuable right specifically denied by Section 365(n) to those IP licensees covered by that statute. Specifically, under generally applicable contract law, if a licensor breaches a license agreement, the licensee may offset the resulting damages against royalties otherwise owing to the licensor. Section 365(n) provides that a covered licensee who chooses to continue exercising the licensed rights post-revocation must continue to pay all associated royalties and fees, but may not offset any damages caused by the licensor’s breach against those payments. Because trademark licenses are not mentioned in Section 365(n), this prohibition against damage offsets will not affect trademark licensees when their license is rejected.
This becomes economically significant because the “breach of contract” caused by the debtor licensor’s rejection of the license is deemed to have occurred immediately prior to the filing of the bankruptcy case. Therefore, the damages suffered by the licensee as a result of the rejection/breach will be treated as an unsecured pre-bankruptcy claim against the debtor. In most bankruptcy reorganizations, the unsecured pre-petition claimants will receive only pennies on the dollar for whatever nominal damages can be proven. For those types of licenses covered by Section 365(n), the licensee’s recovery will be limited to that diminished payout, with no right to offset the actual damage amount against royalties otherwise owing.
But trademark licensees will not be precluded from offsetting, under generally applicable non-bankruptcy law, the entire amount of damages caused by the rejection/breach from the royalties accrued by the continued use of the licensed mark. Depending on the economic circumstances of any given situation, this means that a trademark licensee may be able to fully recoup the entire amount of monetary loss caused by the license rejection, in stark contrast to the “pennies on the dollar” recovery of the licensees covered by Section 365(n).
Now that the impact of rejection on trademark licenses is unambiguously resolved, it will be up to trademark practitioners, particularly those representing trademark licensors, to attempt to fashion contractual mechanisms that may preserve some greater measure of licensor control over the licensees’ post-rejection activities while surviving scrutiny under bankruptcy as well as general contract law. It will also be interesting to see whether Congress will take any action in light of this ruling, for example, addressing the “royalty offset” disparity that now exists between trademark versus other IP licensees. However that may be, the “most significant open question in trademark law” is now closed.