No Refuge for Licensees: The First Circuit Takes a Hard Line on Trademark License Rejection & Bankruptcy Code Section 365(n)

18 January 2018 Bankruptcy Talk Publication

The First Circuit Court of Appeals in the recent case Mission Product Holdings, Inc. v. Tempnology, LLC refused to recognize certain protections for trademark licensees when the licensor files bankruptcy and seeks to reject the license. Rejection is a bankruptcy term of art and refers to the ability of a debtor, pursuant to Bankruptcy Code section 365, to free itself of obligations in agreements including licenses. Normally, the non-debtor party to a rejected agreement retains no post-rejection enforcement rights. Section 365(n) acts as an exception to the general rule by providing certain post-rejection enforcement rights to licensees of rejected intellectual property licenses. The practical effect of the January 12, 2018 Tempnology decision is that in the First Circuit, and in any other jurisdiction choosing to follow the case, the 365(n) protections are not afforded to trademark licensees. Thus, a trademark licensor may use a bankruptcy filing to effectively erase the bargained-for rights granted under the license to the licensee. The decision adopts a harder line than a handful of recent decisions in other jurisdictions and provides a great deal of pre-bankruptcy negotiating leverage to a trademark licensor where the relationship between the licensor and licensee has become strained. Trademark licensees should take heed that the strategic alternatives available to a licensor are not necessarily limited to the terms found in the licensing agreement.

The Tempnology case involved Tempnology, LLC, a company that manufactured athletic sportswear and licensed related rights. In 2012, Tempnology entered into a Co-Marketing and Distribution Agreement (the “Agreement”) with Mission Product Holdings, LLC that provided Mission with a number of different rights in relation to Tempnology’s products and intellectual property. The rights included: (i) manufactured product distribution rights; (ii) a nonexclusive, irrevocable, perpetual license to Tempnology’s intellectual property, with a specific exclusion of trademark rights; and (iii) a much more limited nonexclusive trademark license. The Agreement permitted termination without cause by either party. In 2014, Mission exercised the termination clause and initiated a two-year “wind-down” period. Tempnology responded by immediately terminating the agreement for cause, based on Tempnology’s allegations that Mission violated a restrictive covenant in the Agreement by hiring Tempnology’s former president. The parties took the matter to arbitration, resulting in a decision in favor of Mission. Therefore, under the wind-down provisions, Mission retained distribution and trademark licensing rights until July 1, 2016 and retained other nonexclusive intellectual property rights in perpetuity.

Tempnology’s next move was to file Chapter 11 bankruptcy on September 1, 2015 and immediately seek rejection of the Agreement under section 365 of the Bankruptcy Code. Section 365 permits any debtor to either assume or reject agreements such as licenses. If the debtor elects to assume, it must pay past due amounts owing under the agreement and must commit to performing under the agreement going forward. If a debtor choses rejection, the debtor frees itself of the contractual obligations. Generally speaking, a debtor seeking to reject an agreement need only file a motion stating that the agreement is burdensome to the debtor’s bankruptcy estate and asking the bankruptcy court to enter an order providing for its rejection. Following rejection, the non-debtor party’s remedies are limited to filing a general unsecured claim asserting the monetary damages related to the debtor’s breach and failure to perform under the agreement. Depending on the case, general unsecured claimants may receive much less than the face value of their claims.

Section 365(n) sets forth an exception to the general rule that non-debtor parties to rejected license agreements have no post-rejection enforceable rights against the debtor. The section states that for certain intellectual property licenses, the licensee may elect to retain rights under the agreement, including the enforcement of exclusivity provisions, for the remaining term of the agreement. Prior to the enactment of section 365(n) in 1988, a licensor had the power to essentially run a licensee out of business by filing bankruptcy and rejecting the license. This was precisely the result in a 1985 Fourth Circuit patent licensor case, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. Congress took note of the harsh licensee outcome in the Lubrizol case and further recognized that licensees of intellectual property often build their entire business around the licensing rights. The section 365(n) protections were designed as a response to adjust the balance of power between licensors and licensees.

The statute is tied to licenses of “intellectual property,” as that term is defined in the Bankruptcy Code. The Bankruptcy Code definition broadly includes a number of different types of intellectual property, such as patents and copyrights. The statutory definition does not, however, include trademarks. The legislative history of the statute indicates that this was a purposeful omission, based on a determination that trademarks serve different purposes and otherwise operate differently than other types of intellectual property. For example, while trademarks provide economic benefits to a licensor (just as copyrights and patents provide licensor economic benefits), trademarks also serve a public purpose by indicating the quality and consistency of a product. In addition, trademark licensing requires the licensor to remain actively involved by monitoring and exercising control over the quality of the trademarked goods.

In the Tempnology case, Mission argued that section 365(n) allowed for the post-rejection enforcement of both its distribution rights and its trademark licensing rights. The bankruptcy court disagreed, holding that the distribution rights were not intellectual property rights under the facts of the case and also holding that 365(n) did not apply to trademarks under the terms of the statute. Mission appealed to the First Circuit Bankruptcy Appellate Panel (the “BAP”). The BAP affirmed the bankruptcy court’s decision regarding the distribution rights. As to the trademark licensing rights, however, the BAP followed the reasoning from a 2012 Seventh Circuit case, Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC. The Sunbeam court recognized that 365(n) by its terms did not apply to trademark licenses, but the court did not end its analysis at that point. The court pointed out the well-accepted view that a license rejection acts as a legal breach, not a termination, of the agreement. In the words of the Sunbeam court, rejection does not “vaporize” a licensee’s rights and the non-debtor licensee thus may retain certain enforcement rights. To that point, outside of the bankruptcy context, a licensor’s breach of a trademark license agreement does not mean that the licensee no longer has any rights in the license. In fact, state law provides a number of licensee remedies short of termination. The same logic set forth in the Sunbeam case was also set forth in a concurring opinion by Third Circuit Judge Thomas Ambro in the 2010 case, In re Exide Technologies. Based on this reasoning, the BAP therefore reversed the bankruptcy court’s decision that Mission no longer had any post-rejection enforcement rights under the trademark license.

Tempnology thereafter appealed to the First Circuit. The court took up both the issues of whether the exclusive distribution rights and the trademark licensing rights were the types of rights protected under 365(n). Mission noted in its arguments that the language of section 365(n) specifically states that the rights preserved include “a right to enforce any exclusivity provision” in a license of intellectual property. The First Circuit, however, pointed out that the exclusivity at issue in the case related to exclusive distribution rights, rather than exclusive licensing rights. The fact that the distribution rights were found within the same agreement as other intellectual property licensing rights was not relevant to the court. Because the exclusivity related to the sale of products, as opposed to the licensing of intellectual property related to the products, the First Circuit agreed with the bankruptcy court and the BAP that 365(n) did not provide Mission with any post-rejection right to enforce such rights.

As to the trademark license, the First Circuit refused to follow the reasoning set forth in the Sunbeam case. The First Circuit disagreed with the characterization that refusing to apply section 365(n) would “vaporize” a trademark licensee’s rights. The licensee continued to have rights, the court noted, but the rights were limited to filing a claim for rejection damages. The court further noted that the purpose of rejection under the Bankruptcy Code is to free a debtor of costly obligations and that this purpose would be thwarted if a trademark licensor debtor were required to deal with post-rejection assertions of rights by the licensee. The First Circuit also held that Congress clearly left trademark licenses out of the rights protected under section 365(n) and that it was not a court’s place to essentially write such protections into the statute. Mission therefore was left with no enforceable distribution or trademark licensing rights under the Agreement.

Rejection of a license agreement under section 365 of the Bankruptcy Code only is available to a licensor if the licensor files for bankruptcy. Bankruptcy can be chaotic and unpredictable. The myriad of other financial matters at issue may not reasonably allow a licensor to choose bankruptcy solely as a means to free the licensor of its obligations under a trademark license agreement. But, it does happen. The debtors in both the Lubrizol and the Tempnology cases appear to have been primarily motivated by the desire to reject a license. Trademark licensees should therefore be aware that licensor bankruptcy represents a realistic threat to the licensee’s ability to continue to enforce its valuable rights. In the First Circuit (covering the states of Maine, New Hampshire, Massachusetts, and Rhode Island), the Tempnology case seems to settle the issue. It should be noted, however, that the Tempnology case included a dissent from Judge Juan Torruella where he sided with the logic set forth in the Sunbeam and Exide cases. In other words, reasonable and sophisticated minds continue to differ on the important issue of post-rejection enforceability of trademark licenses. Licensees outside of the First Circuit may find that point useful in both negotiation and litigation contexts.

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