As previously discussed here and heresection 365(n) of the Bankruptcy Code offers special protection for licensees of intellectual property. When a debtor-licensor rejects an intellectual property license, section 365(n) allows the licensee to elect to retain its rights under the license without binding the licensor to any continuing obligations.

The Bankruptcy Code expressly defines what constitutes “intellectual property” in section 101(35A). Congress’s exclusion of trademarks from such definition has led a number of courts to ask whether a trademark licensee is entitled to the same rights and protections that are afforded to licensees of “intellectual property” that fall within the statutory definition. Did Congress intend for this result? Resolution of this dispute often leads courts beyond these specific questions to a broader bankruptcy issue: What is the effect of rejection of an executory contract? Can/should rejection of any type of executory contracts strip the non-debtor party of its contractual rights, or does rejection simply release the debtor from performance of its contractual obligations?

Add in to the mix yet another layer of analysis: Notwithstanding a licensee’s rights, may a debtor nevertheless sell its property free and clear of such rights under section 363(f) of the Bankruptcy Code?

The icing on the cake is the issue of who gets to keep the royalties if the licensee is permitted, and elects, to retain its rights under a rejected license – the debtor’s estate or the purchaser of its assets?

In a recent decision, In re Crumbs Bake Shop, Inc., the Bankruptcy Court for the District of New Jersey attempted to come up with a recipe for addressing these questions.

Background

Crumbs Bake Shop entered into licensing agreements with various third party licensees prior to bankruptcy. These licensees were able to use the Crumbs trademark and trade secrets, as well as sell cupcakes, baked goods, and beverages under the Crumbs brand. After the Crumbs debtors ceased operations and closed their bake shops, they filed for chapter 11 protection. Marcus Lemonis’s joint venture, Lemonis Fischer Acquisition Company, stepped in, provided financing for the debtors, and then entered into an asset purchase agreement with the debtors pursuant to which Lemonis would credit bid its loan to purchase substantially all of the debtors’ assets, free and clear of liens, claims, encumbrances, and interests.

The day after the bankruptcy court approved the sale, the debtors filed a motion to reject certain executory contracts and unexpired leases, including the trademark license agreements. The licensees elected to retain their rights under the license agreements pursuant to section 365(n).

Analysis

Should Trademarks Fall Under the Protection of Section 365(n)?

Prior to Congress’s enactment of section 365(n), the controlling case on the topic of trademark licenses was Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. In that case, the Fourth Circuit held that when a debtor-licensor rejects a trademark license pursuant to section 365(a) of the Bankruptcy Code, the licensee may no longer continue to use the licensed trademarks. The rejection, however, would constitute a breach, entitling the licensee to monetary damages under section 365(g). In response to Lubrizol, Congress enacted section 365(n), which allows the licensee of a rejected license of intellectual property to elect either to treat the license as terminated or to retain its rights under the license (other than any rights to enforce performance by the debtor other than as to exclusivity provisions) and continue to pay royalties under the license.

The Crumbs court was faced with determining the effect of rejection of the trademark licenses. In concluding that the rejection could not deprive the trademark licensees of their rights, the court adopted two different approaches – one that, based upon Judge Ambro’s concurring opinion in In re Exide Technologies, relies upon “equity” to expand the scope of the definition in section 101(35A), and one that adopts the Seventh Circuit’s narrow view of the effect of rejection, as set forth in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC.

From an “equity” perspective, the Crumbs court first examined the Senate committee reporton the amendments to section 365(n). In that bill, Congress stated that it wanted to allow for the development by the bankruptcy courts of equitable treatment of trademark rejection and retention of rights. The Crumbs court shared Judge Ambro’s opinion that Congress, therefore, intended for bankruptcy courts to exercise their equitable powers, on a case by case basis, to decide whether trademark licensees may retain the rights listed in section 365(n). The Crumbs court found it inequitable to strip trademark licensees of their rights. Taking a swipe at lenders, the court noted that bankruptcy estates already benefit from the ability to assume or reject executory contracts, and no reason exists to augment such benefits at the expense of third parties:

[I]n sale cases, which currently dominate the retail Chapter 11 landscape, monetary recoveries primarily benefit the pre-petition and post-petition lenders and administrative claimants. Minimal distributions to general unsecured creditors are the norm. It is questionable that Congress intended to sacrifice the rights of licensees for the benefit of the lending community.

In what may be characterized as two bites at the apple (tart), the Crumbs court then goes on to rely upon the reasoning of Sunbeam Products. Interestingly, though, the Seventh Circuit in Sunbeam Products expressly rejected the equitable expansion of section 101(35A) advocated by the Crumbs court. The definition of “intellectual property” does not use the word “includes” and instead uses “means.” The court in Crumbs characterized the definition as creating only a “negative implication” that trademarks are not within the protection of section 365(n), whereas the Seventh Circuit held that the “[w]hat the Bankruptcy Code provides, a judge cannot override by declaring that enforcement would be inequitable.”

Why, then, did the Seventh Circuit in Sunbeam Products protect trademark licenses? The court was troubled by the use of the rejection power to strip away a licensee’s vested rights. Indeed, the Third Circuit majority in Exide expressed the same concern when it concluded that rejection could not affect the trademark license rights that were part of an otherwise completed transaction, and, therefore, no executory contract subject to rejection existed. In the Interstate Bakeries case, the Eighth Circuit also concluded that a license agreement that was part of a completed sale transaction was not an executory contract subject to rejection.

The Seventh Circuit, though, was not faced with the type of perpetual, royalty-free license that the Third and Eighth Circuits had before them. Instead, it held that a trademark licensee that had a rejected supply agreement with the debtor coupled with a rejected trademark license could continue to sell products under the debtor’s trademark. The Seventh Circuit in Sunbeam Properties noted that the effect of rejection is simply a breach. That breach frees the debtor’s estate from its performance obligations, but does not “vaporize” the rights of the trademark licensee. The Crumbs court supported its analysis by adopting the Seventh Circuit’s reasoning.

Licensee Consent Is Required in a Sale Under Section 363(f)

The Crumbs court also discussed whether the sale “free and clear” under section 363(f) could nevertheless extinguish the licensee’s rights. Here, the court held that, unless the licensee consents to the release of its rights in a 363 sale, section 363 cannot trump the rights created under section 365. (Although unclear, this part of the analysis appears to rely upon the court’s conclusion that section 365(n) applies to protect the trademark license rights.)

Consent, however, does not need to be express, and the court concluded that consent may be implied from a failure to object to the sale free and clear. If the seller and purchaser are going to rely upon such implied consent, however, the licensee must receive adequate notice of the sale. This is where the cookie crumbled.

In Crumbs, the court described the notice of the sale as a “labyrinth of cross-referenced definitions and a complicated network of corresponding paragraphs.” In fact, the court noted that the reference to the licenses was a mere ten words in a 29-page document. Therefore, again relying on principles of equity, the court found that it would inequitable to strip the licensees of their rights in the sale, based on their lack of adequate notice. The court also assumed that had the licensees received adequate notice regarding the extinguishment of their rights, they would have objected to the sale, and the court would have found that their rights under section 365(n) were intact.

Who Gets to Keep the Royalties?

Because the licensees were able to retain their trademark license rights, they also were required to continue paying royalties. The debtor and the purchaser, however did not contemplate that the licensees might be able to retain their rights and had listed the trademark licenses as “Excluded Assets” in the asset purchase agreement. Notwithstanding that the trademark licenses were “Excluded Assets,” the purchaser argued that it, and not the debtor’s estate, should receive the royalties as the parties did not contemplate that the trademark licensees actually would retain their rights and continue to pay royalties. This argument, however, did not measure up, and the court concluded that the debtor’s estate – and not the purchaser – had the right to receive the ongoing royalties from the trademark licensees.

Conclusion

The Crumbs decision may be considered a big win for trademark licensees, but it must be taken with a pinch of salt. The notion that a bankruptcy court may use its equitable powers to expand the definition of “intellectual property” in section 101(35A) is by no means widely accepted. Courts increasingly are viewing license rights as vested rights, but the analysis is far simpler when the trademark licenses are perpetual, royalty-free licenses granted as part of a larger, completed transaction. How far other courts will take the Sunbeam Propertiesreasoning – that a trademark licensee may continue to retain its rights notwithstanding the rejection of a license that clearly is executory – remains to be seen, especially if the reasoning starts to get applied to other types of contracts.

From the perspective of debtors and asset purchasers, though, the decision certainly serves up a sweet reminder about some of the necessary ingredients for a successful asset sale – thoughtfully drafted agreements that do not assume away the issues (i.e., that take into account what happens if a licensee is able to retain its rights) and well-designed and implemented notice to alert licensees of the prospect that a sale will extinguish their rights.

Under any facts, licensees must continue to be vigilant in protecting their rights so they are not left trying to pick up the crumbs after the fact.