The US Supreme Court has reversed the First Circuit’s ruling in Mission Products (Mission Prod. Holdings v. Tempnology, LLC (In re Tempnology, LLC), 879 F.3d 389 (1st Cir. 2018)), thereby allowing the trademark licensee in that case to continue using the licensed trademark despite the debtor trademark licensor’s rejection of the underlying trademark agreement in its bankruptcy case.
The decision, written by Justice Kagan, provides a solid analysis of section 365 of the Bankruptcy Code. A philosophical debate exists within the US bankruptcy community about what the purpose of a debtor’s rejection of a contract is — is it simply to free a debtor from the burdens associated with the contract, or does it also have the effect of eviscerating the non-debtor contract counterparty’s rights? Except with respect to certain types of contracts marked for particular treatment (such as intellectual property licenses under section 365(n) of the Bankruptcy Code), the Bankruptcy Code is pretty laconic about the effect of rejection: “the rejection of an executory contract constitutes a breach of such contract,” with such breach being deemed to have occurred “immediately before the date of the filing of the [bankruptcy] petition.”
Much of the focus of the debate has centered on the rights of trademark licensees following rejection of a trademark license by the debtor licensor. Because trademarks are not within the scope of intellectual property that is expressly protected under section 365(n) of the Bankruptcy Code, courts and parties have struggled with how to deal with the effects of rejection of a trademark license, with some courts even trying to squeeze trademarks into the definition of “intellectual property” under section 101(35A) of the Bankruptcy Code. The two sides of the philosophical debate about the effects of rejection resulted in a circuit court split. The First Circuit in Tempnology held that the effect of the debtor licensor’s rejection of the trademark license was to terminate the licensee’s rights to continue to use the licensed trademark. In contrast, the Seventh Circuit, in Sunbeam Products, held that rejection of a trademark license only constitutes a breach by the debtor and relieves the debtor of its obligations, but does not necessarily eliminate the licensee’s right to use the trademark. Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012). (Notably, both the First and the Seventh Circuits agreed that trademark licenses do not fall within the protections of section 365(n).)
The Supreme Court sided squarely with the Seventh Circuit and noted that a debtor’s rejection may give the non-debtor contract counterparty the right to terminate the contract, but does not confer that right on the breaching party (the debtor). The Supreme Court distinguished the concept of rejection from the avoidance powers a debtor has (such as to avoid a transfer of property as a fraudulent transfer) and noted that an interpretation of the effect of rejection that allows a debtor to take away prepetition vested rights of the non-debtor contract counterparty is tantamount to treating a debtor’s rejection power like an avoidance power.
It is worth noting, by the way, that the Supreme Court did not hold that trademark licenses are within the scope of section 365(n) of the Bankruptcy Code. In light of the Tempnology holding, however, some licensees might wonder whether the special provisions in section 365(n) of the Bankruptcy Code are still relevant or whether they are even better. Justice Sotomayor’s concurring opinion highlights this issue. For example, Justice Sotomayor notes that section 365(n) requires intellectual property licensees to continue making royalty payments, without deduction for damages, if they want to retain their license rights post-rejection. It remains to be seen how these issues will apply to licensees under rejected trademark licenses. Justice Sotomayor, however, also notes that the Tempnology decision is focused squarely on the limited issue of “whether rejection ‘terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law’” and that the decision does not mean that “every trademark licensee has the unfettered right to continue using licensed marks postrejection” because what would happen upon breach under applicable non-bankruptcy law remains the baseline inquiry for determining rights under rejected trademark licenses.
With its limited holding, the Supreme Court left open other issues that might affect a trademark licensee, including how to treat a licensee’s exclusive right to use a trademark within a given territory or field of use. Section 365(n) clearly preserves a licensee’s exclusivity rights. It is not clear, though, even in light of Tempnology, whether a debtor would be free to breach its agreement to maintain exclusivity in the context of a rejected trademark license.
Moreover, section 365(n) also expressly allows a licensee to retain its intellectual property rights for any extensions that are at its option. Presumably, this will be the case with trademark licenses, but this is another open area in which debtors may seek to test the boundaries of Tempnology.
Tempnology does not even purport to address the broader issue of how a party’s equitable remedies in other contexts, such as a right of specific performance, a right of first refusal, or a covenant not to compete, should be treated following the debtor’s rejection of its contract. The Seventh Circuit, in dicta, broadly stated in Sunbeam Products that the effect of rejection is to convert a debtor’s unfulfilled obligations into a prepetition damages claim. Section 101(5) of the Bankruptcy Code recognizes that certain equitable remedies can be converted into a monetary damages claim that is dischargeable in bankruptcy and that, as Justice Kagan recognized, might receive “only cents on the dollar” in a bankruptcy case. Not all equitable rights, however, are even dischargeable, and section 101(5)(B) of the Bankruptcy Code only converts an equitable remedy for breach of performance into a dischargeable “claim” “if such breach gives rise to a right to payment.” The Supreme Court did not address this issue, and this question may become the new focus of the debate over the effects of rejection of an executory contract.