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Can Bankruptcy Terminate Intellectual Property Licenses?

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After filing for Chapter 11 bankruptcy, a company may request court approval to “reject” any outstanding executory contracts. 11 U.S.C. §§ 365(a), 1107(a). If the bankruptcy court approves the rejection, the other party to the contract may pursue a claim for damages because of the “breach” of the contract but cannot compel future performance. 11 U.S.C. § 365(g). The Supreme Court has held “the authority to reject an executory contract is vital to the basic purpose to a Chapter 11 reorganization, because rejection can release the debtor’s estate from burdensome obligations that can impede a successful reorganization.” N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 528 (1984). In many situations, monetary damages provide adequate compensation for the rejection. However, in situations involving contracts for specialized services or goods, monetary compensation—and likely reduced monetary compensation due to the insolvency of the rejecting party—may leave the other party in an undesirable position. When the contract in question is a license to intellectual property rights, the rejection of said contract by a bankrupt intellectual property owner may have devastating impacts on the licensee’s business if it relies heavily on the licensed intellectual property rights, and on income from the license that may assist in the reorganization of the bankrupt intellectual property licensor.

Accordingly, many have argued that the licensee of intellectual property rights should be able to retain its rights to the intellectual property even if the licensor rejects the contract. As discussed in greater detail below, Congress addressed this very issue with regard to certain intellectual property rights, but others remain open to further debate and treatment by the courts. In In re Tempnology, LLC, 879 F.3d 389 (1st Cir. 2018), the First Circuit affirmed the bankruptcy court’s finding that licensee Mission Products Holdings, Inc. (“Mission”) did not have the right to the continued use of Tempnology, LLC’s (“Tempnology”) trademark rights, nor did it retain the exclusive distribution rights to certain products covered by Tempnology’s patents. Id. at 405. On October 26, the Supreme Court granted Mission’s petition for certiorari to address the circuit split on these issues. Mission Prod. Holdings, Inc. v. Tempnology, LLC, No. 17-1657, 2018 WL 2939184 (U.S. Oct. 26, 2018). Specifically, the Supreme Court certified the following question for review: “[w]hether, under § 365 of the Bankruptcy Code, a debtor-licensor’s ‘rejection’ of a license agreement—which ‘constitutes a breach of such contract,’ 11 U.S.C. § 365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable non-bankruptcy law.” Id.; Petition at (i). Trademark licenses were explicitly excluded by Congress when it amended the statute because such agreements raise unique issues not present with respect to other intellectual property licenses, such as the trademark owner/licensor’s obligation to control the quality of any licensed products and services; Congress thought it best to leave it to the equitable determination of the bankruptcy courts to resolve these types of issues. See S. Rep. No. 100-505, at 5 (1988).

I. Lubrizol and Congressional Amendment
The issue presently before the Supreme Court is largely one of statutory interpretation. However, § 365 of the Bankruptcy Code—the statutory framework in question—underwent substantial amendments in response to a 1985 decision by the Fourth Circuit. In Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), the Fourth Circuit addressed whether the licensee to patented technology may continue to practice the patent under the terms of a license agreement even after the licensor rejects the contract. Id. at 1045. The Fourth Circuit held that the phrase “executory contract”—as found in § 365(a)—encompassed intellectual property licenses. Id. at 1045; see also 11 U.S.C. § 365(a) (“the trustee, subject to the court's approval, may assume or reject any executory contract”). Therefore, the court held “the statutory ‘breach’ contemplated by § 365(g) controls and provides only a money damages remedy for the non-bankrupt party.” Id. at 1048. The court reasoned that allowing the licensee to retain its contract rights in the intellectual property “would obviously undercut the core purpose of rejection under § 365(a).” Id. Applying the Lubrizol holding allows debtors to completely terminate a licensee’s rights to continue use of the debtor’s intellectual property with court approval.

The Fourth Circuit’s decision faced instant criticism, prompting Congress to amend the bankruptcy code in 1988 to include § 365(n) “to make clear that the rights of an intellectual property licensee to use the licensed property cannot be unilaterally cut off as a result of the rejection of the license pursuant to [§] 365.” S. Rep. No. 100-505, at 3200. Congress explained they “never anticipated that … the licensee would lose not only any future affirmative performance required of the licensor under the license, but also any right of the licensee to continue to use the intellectual property as originally agreed in the license agreement.” Id. at 3201-3202. Section 365(n) provides that when a debtor rejects a contract “under which the debtor is a licensor of a right to intellectual property,” the licensee may elect either to treat the contract as terminated or to “retain its rights (including a right to enforce any exclusivity provision of such contract …) under such contract … to such intellectual property.” 11 U.S.C. § 365(n). At the same time, Congress amended the bankruptcy code definitions to include the term “intellectual property” that covers, among other things, patents, copyrights, and trade secrets. 11 U.S.C. § 101(35A). The definition of “intellectual property” did not, however, include trademarks.

II. Seventh Circuit: Sunbeam Prod. v. Chicago Am. Mfg. LLC
The Seventh Circuit was the first circuit court to address the issue of rejected trademark licenses after Lubrizol and the subsequent amendments to § 365. See Sunbeam Prod., Inc. v. Chicago Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012). The court found that rejection of a trademark license does not terminate the licensee’s right to use the debtor’s trademarks, thereby refusing to adopt the reasoning presented by the Fourth Circuit in Lubrizol that the goals of Chapter 11 bankruptcy would be best served by termination of a licensee’s intellectual property rights. Id. at 376–78. Specifically, the court asserted that the decision was “mistaken” and did not “correctly underst[an]d §365(g).” Id. at 376. In the Seventh Circuit’s view, Lubrizol incorrectly equated a trustee’s or debtor-in-possession’s rejection of the license to an “avoiding power” rather than merely a breach as governed by § 365(g). Id. at 376–77. The court explained “[o]utside of bankruptcy, a licensor's breach does not terminate a licensee's right to use intellectual property.” Id. at 376. “What § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party's rights remain in place.” Id. at 377. In other words, according to the Seventh Circuit, whether trademarks are covered by § 365(n) has no effect on the licensee’s ability to continue using the trademarks post-rejection.

III. First Circuit: Mission Products Holdings Inc., v. Tempnology, LLC
In In re Tempnology, LLC, the First Circuit reached a different conclusion from the Seventh Circuit and created the circuit split now facing the Supreme Court. 879 F.3d 389. On November 21, 2012, Mission and Tempnology executed a Co-Marketing and Distribution Agreement, which serves as the focal point of the dispute. Id. at 394. The agreement granted Mission several rights, including patent licenses, trademark licenses, and exclusive distribution rights to certain patented products. Id. On September 1, 2015, Tempnology filed for Chapter 11 bankruptcy and, the following day, moved to reject its agreement with Mission. Id. Mission invoked § 365(n) in an attempt to retain the intellectual property rights granted by the agreement, but the bankruptcy court found that this exemption only applied to the patent rights, not the exclusive distribution or trademark rights. Id. “With respect to trademarks, the court reasoned that Congress’s decision to leave trademarks off the definitional list of intellectual properties in 11 U.S.C. § 101(35A) left the trademark license unprotected from rejection.” Id. Mission appealed to the Bankruptcy Appellate Panel for the First Circuit who affirmed the court’s order with respect to the exclusive distribution rights, but instead applied the Sunbeam holding to trademark rights. Id. at 395.

Specifically, the First Circuit agreed with the original bankruptcy court, reversing the Bankruptcy Appellate Panel’s decision on the trademark issue. Id. In doing so, the court applied the reasoning from Lubrizol that “[e]ven though § 365(g) treats rejection as breach, the legislative history of § 365(g) makes clear that the purpose of the provision is to provide only a damages remedy for the non-bankrupt party.” Id. at 396 (quoting Lubrizol, 756 F.2d at 1048). The court argued that Congress recognized this to be the case by choosing to add § 365(n) rather than amending § 365(a) or (g) to clarify that the “breach” was no different than those occurring outside of bankruptcy. Id. at 397–98. Moreover, the First Circuit reasoned that this was consistent with the goal of bankruptcy—to reduce burden on a debtor—because, unlike other forms of intellectual property, trademarks require the owner “monitor and exercise control over the quality of the goods sold to the public under cover of the trademark. Id. at 402. Requiring this monitoring and control of the trademarks, the court asserted, would “diminish[] their value to Debtor, whether realized directly or through an asset sale.” Id. at 403.

In its petition for certiorari, Mission asks the Supreme Court to overturn the decision below from the First Circuit and, instead, adopt the Sunbeam rule that “rejection does not ‘impl[y] that any rights of the other contracting party have been vaporized.’” Petition at 22 (quoting Sunbeam, 686 F.3d at 377). Mission explains “[t]he trustee or debtor-in-possession in bankruptcy does have an ‘avoiding’ power that enables it to undo certain pre-bankruptcy transactions, but it is a limited power found elsewhere in the Bankruptcy Code.” Id. at 23. Mission further argues “[t]he omission of trademarks from the Code’s definition of ‘intellectual property’ does not create any inference that trademark rights do not survive rejection.” Id. at 27. Specifically, Mission argues that “rather than endorsing Lubrizol’s result for trademarks, the Senate Report emphasized that, while ‘it was determined to postpone congressional action’ on trademarks, ‘rejection [of trademark licenses] [was] of concern because of the interpretation of [§] 365 by the Lubrizol court.’” Id. (quoting S. Rep. No. 100-505, at 3204). Several amicus curiae briefs were filed supporting Mission’s arguments, including one from The International Trademark Association. That brief refutes the First Circuit’s findings of the diminished value of a trademark by explaining “[t]rademark licensors also would benefit from this regime where licensees, knowing their rights will be more valuable in any eventual bankruptcy proceeding, are incentivized to pay more for those rights in pre-bankruptcy negotiations.” INTA Brief at 23.

The opposition focuses its substantive arguments on the assertion that “[t]rademarks are deeply different from other forms of intellectual property subject to the application of section 365(n), because the value inheres in conveying a message of continued monitoring and quality control by the originator (and not just the licensees).” Opposition at 6. Tempnology reasons “[t]he unique characteristics of trademarks support a holding that licensees cannot continue to use trademarks after a debtor rejects a trademark license under section 365 because continued use necessarily imposes costs and burdens on the debtor licensor.” Id. at 13–14. The opposition argues that Congress recognized this fundamental difference associated with trademarks by expressly considering their inclusion in, but subsequently leaving them out of, its bankruptcy definitions and § 365(n). Id. at 7. Tempnology argues Congress should handle “through legislative action what this Court cannot” if it feels that change is necessary. Id. at 9.

IV. Conclusion
The International Trademark Association noted that “[i]n 2014, trademarks accounted for $6.1 trillion in value added to the U.S. gross domestic product.” INTA Brief at 24 (citing Economics and Statistics Administration & United States Patent and Trademark Office, INTELLECTUAL PROPERTY AND THE U.S. ECONOMY: 2016 UPDATE 22 (2016)). Moreover, trademark licensing “provides a significant stream of revenue for trademark licensors, not to mention extensive commercial opportunities.” Id. at 25 (citing Irene Calboli, The Sunset of “Quality Control” in Modern Trademark Licensing, 57 AM. U. L. REV. 341, 343 (2007)). Thus, the commercial significance of the Supreme Court’s forthcoming decision is clear. The Supreme Court’s decision in this case should, regardless of the outcome, provide some clarity for parties considering trademark licenses in the face of potential bankruptcy. Improved clarity will allow negotiating parties to assign proper value to the trademarks, and potentially other intellectual property rights, in question. For example, § 365(n)’s protections only apply explicitly to license agreements. If the Supreme Court agrees adopts the Sunbeam standard, the decision could have broader impact on other types of contracts involving intellectual property rights, such as covenants not to sue and exclusive distribution/sales agreements.

 

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