- Rejection of a contract in bankruptcy does not rescind rights that the contract previously granted to the non-breaching counterparty.
- Despite debtor’s rejection of trademark agreement in bankruptcy, the non-breaching party retains non-bankruptcy contract rights, such as the ability to continue to perform under the license agreement and use the trademark.
In a major victory for trademark licensees, the Supreme Court of the United States recently held that a debtor’s rejection of a trademark agreement in bankruptcy does not revoke a licensee’s right to use the mark. In so holding, the Supreme Court reversed the First Circuit’s holding that rejection of a license agreement effectively amounts to rescission of the agreement rather than a breach. Meanwhile, the Court upheld the Seventh Circuit’s view that rejection instead constitutes a breach, one that leaves the non-breaching party with non-bankruptcy contract rights, including the ability to continue to perform under the license agreement and use the trademark.
Section 365 of the Bankruptcy Code permits a debtor in bankruptcy to reject any “executory contract” – meaning a contract that neither party has finished performing. The rationale behind the rejection doctrine is to provide a bankrupt entity a better opportunity to reorganize and survive bankruptcy by granting it the ability to shed burdensome contracts that provide little benefit to the bankruptcy estate. Section 365(g) provides that rejection “constitutes a breach.” However, the term “breach” is not defined in the statute; nor is it a specialized bankruptcy term. The general bankruptcy rule, upon breach, is that the debtor is no longer obligated to perform under the contract and the counterparty is left with a prepetition damage claim against the debtor’s estate. Such prepetition claims are often only paid pennies on the dollar, leaving the counterparty with a fraction of what it would have received absent the rejection.
There are exceptions to this general rule. These include those contained in sections 365(h), (i), and (n), namely, exceptions for leases of real property, contracts for sale of real property, and intellectual property licenses, respectively. These exceptions permit counterparties to retain specified rights – such as continued use of the underlying asset – after rejection. Thus, if a debtor rejects a patent assignment agreement, the counterparty may still continue to use the patent (if it continues to perform its contractual obligations) despite the rejection.
Prior to the Supreme Court’s decision in Mission Product Holdings, Inc. v. Tempnology, LLC, two Courts of Appeals reached different conclusions as to whether trademarks are afforded the same intellectual property protections as patents.
Pre-Mission Circuit Split Over Trademarks
In one of these cases, the First Circuit Court of Appeals declined to extend section 365’s exceptions to include trademarks, reasoning that “trademarks” are not explicitly enumerated in the 365 exceptions. It then observed that a debtor-licensor would be required to monitor and exercise quality control over the trademark, which would “frustrate Congress’s principal aim in providing for rejection: to release the debtor’s estate from burdensome obligations.”
In another case, the Seventh Circuit Court of Appeals reached a different conclusion, instead focusing on a non-breaching party’s rights outside of bankruptcy. Outside of bankruptcy, a breach does not “terminate the contract” or “vaporize” the non-breaching party’s rights. Rather, in the non-bankruptcy context, a non-breaching party could elect to perform under the contract and retain its rights. Accordingly, the Seventh Circuit held that a licensee could continue to use a trademark even after the debtor-licensor’s rejection of the license agreement.
Mission Product Holdings Decision
In resolving the circuit split, the Supreme Court sided with the Seventh Circuit, stating that section 365’s “text and fundamental principles of bankruptcy law command” that a licensee may continue to use the trademark after rejection. As mentioned, the Court first noted that “breach” is neither a defined term nor a specialized bankruptcy term and, as a result, it must be ascribed its ordinary contract law meaning outside of the bankruptcy context. A breach outside of bankruptcy gives the non-breaching party two options. First, the non-breaching party may continue performing under the contract and then sue for recovery of damages resulting from the breach; or, alternatively, the non-breaching party may stop performing and sue for recovery of damages resulting from the breach. In either case it is the non-breaching party’s decision whether to continue performance after the breach.
Extrapolating this example to bankruptcy, the Supreme Court held that the non-breaching counterparty must also retain the decision to either (i) perform under the license agreement (i.e., continue to make payments to the debtor and use the trademark) and file a claim for prepetition damages; or (ii) not perform under the license agreement (i.e., stop making payments and discontinue use of the trademark) and file a larger claim for damages. As in instances of a breach of contract outside of bankruptcy, the ultimate decision rests with the non-breaching counterparty; otherwise, debtors would enjoy greater contract rights within a bankruptcy proceeding than under non-bankruptcy law.
For these reasons, the Court held that under section 365, a debtor’s rejection of an executory contract “has the same effect as a breach outside bankruptcy,” and such an act cannot rescind rights already granted under the contract. Accordingly, under section 365, a debtor-licensor’s rejection of a trademark agreement does not revoke the counterparty’s license to use the mark.
The Mission decision specifically permits a trademark licensee to continue performing under a license agreement and to use the trademark even after the debtor-licensor’s rejection. The decision, however, may have implications beyond contracts involving trademarks and potentially provide non-breaching parties to any executory contract with more options if their contract is rejected in bankruptcy.