Section 365(a) Trumped by Inability to Assign Trademark Under Nonbankruptcy Law

Trump Entertainment Resorts Trump AC Casino Marks, LLC (the “licensee/debtor”) filed voluntary petitions for chapter 11 relief on Sept. 9, 2014. On Aug. 5, 2014, Trump Marks, LLC sought to terminate the royalty-free trademark license previously granted to the licensee/debtor. This trademark license provided for the use of Trump Marks’s names, likenesses and other enumerated marks in connection with the operation of three Atlantic City hotel casinos[1] in a six-state territory,[2] subject to the parties’ enumerated termination rights. In a state court complaint, Trump Marks alleged that the licensee/debtor “failed a Quality Assurance Review and failed to cure any deficiencies, as well as other breaches of the Trademark License Agreement.”[3]

The licensee/debtor’s proposed chapter 11 plan contemplated assumption of the trademark license, and on Sept. 24, 2014, Trump Marks filed its motion for relief from the automatic stay pursuant to § 362(d)(1) of the Bankruptcy Code to proceed with its trademark license termination action. Section 362(d)(1) states that a creditor shall be granted relief from the automatic stay for cause; however, cause is not defined by the Bankruptcy Code.[4] Nevertheless, Trump Marks argued, and the U.S. Bankruptcy Court for the District of Delaware agreed, that cause existed to grant relief because, according to nonbankruptcy law, the licensee/debtor was not authorized to assign the trademark license without the permission of Trump Marks, and therefore pursuant to § 365(c)(1),[5] the trademark license — which was deemed to be an executory contract[6] — was not assumable (or assignable) by the licensee/debtor.[7]

In reaching this conclusion, the bankruptcy court applied the “hypothetical test” contained in West Electronics,[8] a Third Circuit case, which provides that an executory contract cannot be assumed in a chapter 11 case where the debtor is unable to assign the same executory contract without consent from the licensor, irrespective of whether the debtor actually intends to do so. Here, the licensee/debtor did not intend to assign the trademark license; nevertheless, the licensee’s/debtor’s inability to unilaterally assign the trademark license prevented assumption of the same and therefore constituted cause to grant relief under § 362(d)(1).[9] As such, under the hypothetical test, a debtor “may not assume an executory contract over the nondebtor’s objection if applicable law would bar assignment to a hypothetical third party, even where the debtor in possession has no intention of assigning the contract in question to any such third party.”[10] The applicable nonbankruptcy law — trademark law — unquestionably states that in the absence of authority from the licensor, a trademark license cannot be assigned by a licensee[11] because the purpose of trademark law is to protect the consumer’s connection between a brand and the source and quality associated with that brand’s products or services, all of which will be circumvented if the owner of the trademark cannot control its trademark licensee(s).[12]

There is a circuit split on the application of § 365(c)(1) in that some circuits apply the “hypothetical test,” while others apply the “actual test,” or a slightly modified version of the actual test, and some circuits are undecided. Circuits that apply the hypothetical test follow the reasoning above in West Electronics. The Third Circuit is joined by the Fourth Circuit,[13] the Ninth Circuit[14] and the Eleventh Circuit[15] in the adoption of the hypothetical test. The circuits that apply the actual test permit a debtor to assume a trademark license that the debtor does not intend to assign. The First Circuit[16] has adopted the actual test, and there is authority in favor of the actual test, either from or within, the Fifth Circuit,[17] the Sixth Circuit[18] and the Eighth Circuit.[19] In the Second Circuit,[20] there is authority for a position that is similar to the actual test in that the Southern District of New York has espoused a “literal” reading of § 365(c)(1) that excludes the term “debtor” or “debtor in possession” from the definition of “trustee” and thus permits a debtor in possession to assume an executory contract that it does not intend to assign. There does not appear to be a prevailing case on point from the Seventh Circuit,[21] and it does not appear as though this issue has ever been raised in the Tenth or D.C. Circuits.

In circuits where the hypothetical test prevails, it is clear that the interests of nondebtors are paramount as both licensor, as seen in this case, and as licensee as dictated by § 365(n). Licensors in the future may need to be cautious about entering into trademark license agreements with potential licensees with contacts in jurisdictions where the actual test controls. Likewise, there may be implications on future debtors and the jurisdiction in which they choose to file their bankruptcy petition. For example, perhaps there was another jurisdiction where licensee/debtor could have filed their voluntary petitions.

The IP/bankruptcy community has already been put on alert that the U.S. Supreme Court believes that it should resolve whether the actual or hypothetical test should be employed when the proper question is presented. Specifically, Justice Kennedy joined by Justice Breyer, stating that “[t]he division in the courts over the meaning of § 365(c)(1) is an important one to resolve for bankruptcy courts and for businesses that seek reorganization. This petition for certiorari, however, is not the most suitable case for our resolution of the conflict…. In a different case the Court should consider granting certiorari on this significant question.”[22] As such, until certiorari is granted on this issue, pre-petition planning in chapter 11 cases involving trademark licenses must consider the implications of the hypothetical test and the actual test.