Lewis Brothers Bakeries Incorporated and Chicago Baking Company v. Interstate Brands Corporation (In re Interstate Bakeries Corporation, et al.), Bk. Case No. 04-45818-11-JWV (W.D. Mo. March 21, 2011)

CASE SNAPSHOT

Interstate Bakeries entered into an agreement, pursuant to which Interstate agreed to license certain of its trademarks to certain licensees. Two years after receiving the licensees’ final payment, Interstate filed a chapter 11 petition and sought to reject the licensing agreement as an executory contract. The licensees objected on the grounds that the agreement was effectively a “sale,” had been fully performed, and there were no outstanding material obligations. The Bankruptcy Court disagreed, looking to the agreement’s provision requiring licensees to maintain the quality of the licensed products. This provision expressly stated that it was a “material” obligation, and the agreement permitted Interstate to terminate the agreement upon its breach. The Bankruptcy Court held that this provision effectively created a perpetually executory contract, ruling that Interstate could, thus, reject the agreement. On appeal, the District Court affirmed.

FACTUAL BACKGROUND

In 1996, Interstate Bakeries licensed certain of its trademarks in the Chicago area to Lewis Brothers Bakeries and Chicago Baking Company, after being ordered to do so pursuant to certain antitrust rulings against Interstate. The license was “perpetual,” and final payment for the license was made to Interstate in 2002. Although the license agreement had many of the markings of a sale, several provisions in the license agreement made clear that Interstate retained full and exclusive ownership of the trademarks.

The license agreement gave Interstate the right to terminate the agreement upon a material breach. In relevant part, “material breach” was defined as, “a failure of LBB to maintain the character and quality of goods sold under the Trademarks….”  

In 2004, Interstate Bakeries and its subsidiaries filed petitions for chapter 11 protection. In 2008, Lewis Brothers and Chicago Baking filed an adversary action, seeking a declaratory judgment that the license agreement was not executory. On cross-motions for summary judgment, the Bankruptcy Court found that the agreement was executory, and granted Interstate’s motion. The licensees appealed.  

COURT ANALYSIS

Section 365 of the Bankruptcy Code authorizes a debtor to assume or reject any executory contract. While the Code does not define “executory contract,” courts define it, under the Countryman Standard, as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far underperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” Courts in the Eighth Circuit, as in many others, look at whether any material obligations remain unperformed, and define a “material obligation” as any important or substantial obligation.

Arguing that there were no outstanding material obligations, the licensees relied heavily on In re Exide Technologies, 607 F.3d 957 (3rd Cir. 2010), in which the court found that there were no unperformed material obligations (i.e., no executory contract) in a licensing agreement where the licensee had already paid the full purchase price of the license.

However, in the Interstate case, the question of materiality was an easy one that did not require the sort of detailed materiality analysis conducted in Exide. The agreement expressly provided that the failure of licensees to maintain the character and quality of the goods sold under the trademarks constitutes a “material” breach, giving Interstate the right to terminate the agreement. “The parties agreed and acknowledged that this obligation was material in 1996 when they entered the License Agreement.”

In short, because material obligations permitting termination of the agreement would perpetually exist in the license agreement, the agreement was, therefore, perpetually an executory contract subject to rejection under section 365 of the Bankruptcy Code.

The licensees argued that they fully paid under the agreement, which was effectively a sale. Additionally, the quality control provision set forth no actual quality control standards and Interstate never checked the quality of the products. Most importantly, the agreement provided a cure period that allowed the licensees to easily cure any quality deficiencies, and thus no actual breach would ever realistically occur. The court set aside these arguments, stating that the issue was simply a legal one: if the term was breached (regardless of whether the scenario was realistic), Interstate could terminate the agreement. Thus, the contract was executory on its face.

The District Court upheld the Bankruptcy Court’s grant of Interstate’s motion for summary judgment.

PRACTICAL CONSIDERATIONS

Generally, trademark license agreements are found to be executory contracts. The exception is where the trademark license agreement looks more like a sale, as was the case in Exide. (For a discussion of Exide, please view the September 2010 CR&B Alert on the Reed Smith website). However, as is often the case in contract cases, the express terms of the contract will bind the parties. Unwitting licensees may purchase and fully pay for a “perpetual” license without considering that the licensor’s bankruptcy may permit the licensor to later reject the contract despite already being paid in full. Licensees should seek legal advice from bankruptcy counsel to determine whether their “perpetual” license will actually remain effective perpetually, even in bankruptcy