In one of the first decisions issued this year by the United States Court of Appeals for the First Circuit, the court addressed an issue of first impression. In Mission Products Holdings, Inc. v. Tempnology, LLC, n/k/a Old Cold LLC, No. 16-9016 (1st Cir. Jan. 12, 2018), the First Circuit held that the omission of trademarks from the definition of “intellectual property” in Section 101(35A) of the Bankruptcy Code, as incorporated by Section 365(n), leaves a trademark licensee with nothing more than a claim for damages upon the rejection of its license under Section 365(a). In so holding, the First Circuit joined the majority of bankruptcy courts that have addressed the issue and rejected the view adopted by the United States Court of Appeals for the Seventh Circuit.

Background on Section 365 and Trademarks

Subject to court approval, Section 365(a) of the Bankruptcy Code permits a debtor-in-possession to reject an executory contract. However, Section 365(n) affords special protection to licensees of “intellectual property,” as that term is defined by Section 101(35A), in the event of rejection, provided they meet certain requirements and conditions set forth therein.

Section 365(n) was enacted in response to the Fourth Circuit’s 1985 decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), which held that that rejection of an intellectual property license under Section 365(a) terminated all of the licensee’s rights under the license agreement and provided only for a money damages claim. In conjunction with enacting Section 365(n), Congress also amended the definition of intellectual property set forth in Section 101(35A) to include: trade secrets, patents and patent applications, plant varieties, copyrights and mask work protected under chapter 9 of title 17. It does not include trademarks. The legislative history indicates that trademarks were intentionally omitted, and congressional action “postponed,” in order to allow for further study that was deemed necessary.

A majority of bankruptcy courts have inferred that the omission of trademarks from the definition of intellectual property in Section 101(35A) suggests that Congress intended not to extend the protections afforded by Section 365(n) to trademarks, thereby codifying Lubrizol with respect to trademarks. 

In Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372 (7th Cir. 2012), the Seventh Circuit, however, took a different approach from the majority. In Sunbeam, the court reasoned that the omission of trademarks from the definition set forth Section 101(35A) “means that Section 365(n) does not affect trademarks one way or the other” and, rather than vaporizing a licensee’s rights upon rejection, it is more appropriate to apply Section 365(g), which classifies rejection as a breach, excusing the estate’s continued performance but leaving the licensee’s trademark rights in place.

History of In re Tempnology Case

Tempnology was an athletic textiles company that developed a chemical-free cooling fabric used to produce “Coolcore” performance apparel and accessories. In 2012, Tempnology entered into a marketing and distribution agreement with the appellant, Mission Product Holdings, Inc., which granted Mission exclusive distribution rights with respect to certain of Tempnology’s products, a non-exclusive license to Tempnology’s intellectual property (expressly excluding trademarks), and a non-exclusive license to use the Coolcore trademark and logo for the limited purpose of performing Mission’s obligations under the agreement.

Immediately after commencing its chapter 11 bankruptcy in 2015, the debtor filed a motion seeking to reject certain executory contracts under Section 365(a), including the agreement with Mission. Mission objected and expressly reserved its rights under Section 365(n), which lead to a fight over the scope of Mission’s rights protected by Section 365(n). The debtor argued that Mission’s election under Section 365(n) was limited to its non-exclusive intellectual property license (which it conceded was protected), whereas Mission asserted that its distribution and trademark rights were also protected.

The Bankruptcy Court for the District of New Hampshire held that neither Mission’s exclusive distribution rights, nor its rights to use the debtor’s trademark and logo, fell within the scope of rights Mission could elect to retain under Section 365(n). The bankruptcy court reasoned that the exclusive distribution rights amounted to nothing more than the right to sell and distribute certain of the debtor’s products, which did not rise to the level of a license in intellectual property that could survive rejection. With respect to Mission’s trademark rights, the bankruptcy court followed the majority of courts that have held by negative inference that the omission of “trademarks” from the definition of “intellectual property” set forth in Section 101(35A) renders trademark rights outside the protections afforded by Section 365(n), and, therefore, held that Mission did not retain its trademark rights post-rejection.

On appeal, the Bankruptcy Appellate Panel (the “BAP”) affirmed the bankruptcy court’s ruling with respect to the exclusive distribution rights, but rejected its analysis and application of Lubrizol to Mission’s trademark rights the BAP elected instead to follow the Seventh Circuit’s approach in Sunbeam, finding that the bankruptcy court had erred in ruling that Mission’s trademark rights had terminated upon rejection. The BAP determined that Mission’s post-rejection rights were governed by the terms of the agreement and applicable non-bankruptcy law. [Read our Alert, “First Circuit Bankruptcy Appellate Panel Latest to Warm Up to Protections for Trademark Licensees in Bankruptcy.”]

First Circuit Rejection of Sunbeam

The First Circuit affirmed the bankruptcy court’s ruling with respect to Mission’s exclusive distribution rights, agreeing that “[a]n exclusive right to sell a product is not equivalent to an exclusive right to exploit the product’s underlying intellectual property.”

However, the First Circuit rejected the approach taken by both the BAP and the Seventh Circuit in Sunbeam, instead favoring a “categorical approach of leaving trademark licenses unprotected from court-approved rejection, unless and until Congress should decide otherwise.” Accordingly, the First Circuit affirmed the bankruptcy court’s ruling that all of Mission’s rights to the debtor’s trademarks were terminated upon rejection.

In its analysis of Section 365(n)’s application to trademarks, the First Circuit examined the legislative history and concluded that, in omitting trademarks from Section 101(35A), Congress did not intend for bankruptcy courts to take an equitable approach in determining the effect of rejection on a trademark license. The court identified seven sections of the Bankruptcy Code where Congress had expressly “grant[ed] bankruptcy courts the ability to ‘equitably’ craft exceptions to the Code’s rules,” and noted that such an express grant of authority was absent from Section 365(n).

The First Circuit also criticized the Seventh Circuit’s approach in Sunbeam as founded on an erroneous premise that a debtor-licensor could be freed from continuing performance obligations under a trademark license, while at the same time allowing a licensee to retain its right to use the trademark. The court reasoned that a trademark licensor is required to continuously “monitor and exercise control over the quality of the goods sold to the public under cover of the trademark” to prevent public deception and protect against competition. Noting that a licensor’s failure to do so could jeopardize both the trademark’s validity and value, the First Circuit reasoned that the Sunbeam approach would force a debtor to either accept such risks or continue to perform executory obligations that it had rejected, which runs counter to the policy underlying Section 365(a). The court determined that in most instances the “residual enforcement burden” on the debtor would be greater than the burden on a licensee of having its trademark rights converted to a prepetition damages claim.

The First Circuit concluded that the best approach was a categorical one and that the protections of Section 365(n) should not be extended to trademark licenses “unless and until Congress should decide otherwise.”

The First Circuit’s Tempnology decision omits any reference to the Bankruptcy Court for the District of New Jersey’s decision in In re Crumbs Bake Shop, Inc., in which that court held that “Congress intended the bankruptcy courts to exercise their equitable powers to decide, on a case by case basis, whether trademark licensees may retain the rights listed under Section 365(n).”  522 B.R. 766, 772 (Bankr. D.N.J. 2014). [Read our Alert, “New Jersey Bankruptcy Court Upholds Trademark Licensees’ Rights to Use Trademark Despite Licensor’s Bankruptcy.”] However, the First Circuit seemed to expressly reject that approach in its rejection of the dissent’s equitable approach.

The Dissent

Judge Juan R. Torruella dissented in part, disagreeing with the majority’s bright-line rule that rejection of a trademark license under Section 365(a) eliminates the licensee’s right to use the trademark post-rejection in contravention of congressional intent. The dissent acknowledged the majority’s concerns with respect to the potential “residual enforcement burden” on a debtor-trademark owner to “monitor and exercise control over the quality of the goods sold to the public” post-rejection, but noted that licensees also have quality control obligations that may be enforced. The dissent suggested that Mission’s post-rejection rights should be governed by the terms of the agreement and applicable non-bankruptcy law “to determine the appropriate equitable remedy of the functional breach of contract.”

No notice of appeal or petition for rehearing had been filed as of the date of this Alert.