Can You Lose a Licensed Mark in Bankruptcy? Reality and Considerations

What happens to a licensee’s right to use a trademark if the licensor files for bankruptcy? This critically important question was recently addressed by the First Circuit Court of Appeals in Tempnology.^[1] Bucking the current trend of case law, the First Circuit held that a debtor-licensor’s rejection of a trademark license agreement terminates the licensee’s rights to use the mark.^[2] Widening the existing circuit split on this important issue, Tempnology presents an attractive case for the Supreme Court’s review and some considerations for licensees of trademarks.

Rejection of Intellectual Property Executory Contracts in Bankruptcy

Rejection of an executory contract pursuant to § 365(a) of the Bankruptcy Code generally relieves the debtor of its obligations to perform under the executory contract. Under § 365(g), the rejection is treated as a breach and the nonrejecting party is entitled to a claim for breach damages.

Section 365(n), however, provides certain protections to licensees in connection with the rejection of intellectual property contracts. In the event a debtor-licensor rejects its intellectual property license, § 365(n) grants the licensee discretion to elect to either (1) treat the rejection as a termination and assert a pre-petition claim for monetary damages^[3], or (2) retain its rights under the license — and related supplements to the contract — for the duration of the contract.^[4] In connection with its enactment of § 365(n), Congress concurrently amended the Code’s definition of “intellectual property” to include six categories of property, including trade secrets, patents and copyrights.^[5] Trademarks are not included in this definition.^[6] Despite this clear omission, courts have taken differing approaches as to whether trademark licensees are entitled to retain their rights under the license following rejection.

The Tempnology Case

The debtor, formerly known as Tempnology, was a designer and manufacturer of specialized athletic apparel products. In 2012, the debtor executed a co-marketing and distribution agreement, pursuant to which the debtor granted Mission Product Holdings, Inc., among other things, licenses to use its trademarks. On Sept. 1, 2014, the debtor filed a voluntary chapter 11 petition and promptly moved to reject the agreement.^[7]

Mission objected to the proposed rejection, arguing that § 365(n) of the Code permitted its continued use of the trademark license notwithstanding rejection.^[8] Ultimately, the bankruptcy court sided with the debtor, holding that because Congress did not include “trademarks” under the Code’s definition of intellectual property, § 365(n) does not apply to trademark licenses, and Mission’s rights under the trademark license terminated upon rejection.^[9]

On appeal to the First Circuit Bankruptcy Appellate Panel (BAP), the BAP affirmed the ruling that § 365(n) does not apply to trademark licensees, but held that the lower court “erred in ruling that Mission’s rights in the [Trademark License] terminated upon ... rejection[.]”^[10] Instead, the BAP found that Mission may retain its rights to use the trademark license if it were permitted to do so following the debtor’s breach under the agreement and nonbankruptcy law. The BAP reasoned that § 365(g) simply provides that rejection of an executory contract constitutes a breach and that the section’s plain language does not restrict the nonbreaching party’s remedy to a claim for monetary damages.^[11]

Although the First Circuit affirmed the lower courts’ conclusions that the Code excludes trademark licenses from § 365(n),^[12] the circuit court disagreed as to the effect of a § 365(g) breach on a rejection of the trademark license. The First Circuit found that because a debtor-licensor’s rejection of a trademark license terminates the debtor’s obligation to perform under the license, the licensee’s remedy is limited to a pre-petition claim for monetary damages.^[13] The BAP’s decision was based the “unstated premise that it is possible to free a debtor from any continuing performance obligations under a trademark license even while preserving the licensee’s right to use the trademark.”^[14] Rejecting this premise, the First Circuit reasoned that trademarks, unlike other types of intellectual property, are “public-facing messages to consumers” that “signal uniform quality and protect a business from competitors who attempt to profit from its developed goodwill.”^[15] Thus, to preserve a mark’s value, licensors have an ongoing need to monitor and control their licenses’ use to ensure that the public is not deceived by a misuse of the mark.^[16] “[F]ailure to monitor and exercise this control results in a so-called ‘naked license,’ jeopardizing the continued validity of the owner’s own trademark rights.”^[17] The First Circuit further noted that to conclude otherwise “invite[s] further leakage”; if a licensee’s trademark rights survive rejection under this theory, other rights also may also survive.^[18]

As a result, under the Tempnology decision, the rejection of a trademark license leaves the licensee with the sole remedy of asserting a claim for monetary damages.

The Third and Seventh Circuits’ Approaches

The First Circuit’s opinion in Tempnology is the first circuit-level decision to hold that a trademark licensee’s right to use a mark under the licenses has not survived rejection since Congress’ adoption of § 365(n) in 1988. The ruling counters earlier decisions by the Third and Seventh Circuits, which each held that a nondebtor licensee’s rights to use a trademark may survive rejection. Although the Third and Seventh Circuits came to similar results, they were based on a different rationale.

Third Circuit Judge Ambro opined, in his concurrence in Exide Technologies,^[19] that Congress intended bankruptcy judges to exercise their equitable powers to determine if, on a case-by-case basis, trademark licensees should be permitted to preserve their rights under the license notwithstanding its rejection.^[20] Judge Ambro looked beyond the plain language of the Code, which clearly excluded trademarks from intellectual property, to § 365(n)’s legislative history.^[21] Trademark licensing agreements, Congress observed, “depend to a large extent on control of the quality of the products or services sold by the licensee.”^[22] Since it could not address trademark licenses “without more extensive study,” Congress chose to “postpone congressional action” and allowed “the development of equitable treatment of this situation by bankruptcy courts.”^[23] While the Third Circuit’s equitable rule is not binding,^[24] it is highly persuasive and has been employed by lower courts throughout the Third Circuit.^[25]

The Seventh Circuit, in its Sunbeam decision,^[26] expressly rejected Judge Ambro’s reasoning as providing too much discretion to bankruptcy judges.^[27] Instead, the Seventh Circuit established a rule that permits trademark licensees to retain their rights under the license notwithstanding its rejection for the same reasons asserted by the BAP in Tempnology.^[28] The Seventh Circuit concluded that § 365(n) does not apply to trademark licenses. Despite the inapplicability of § 365(n), a trademark licensee’s continued right to use a mark may survive rejection if the licensee is entitled to continued use of the license following the licensor’s breach under nonbankruptcy law, because § 365(g) merely provides that rejection of an executory contract “constitutes a breach of such contract.”^[29] Since a licensor’s breach of a license outside of bankruptcy does not terminate the licensee’s rights under the license, a § 365(g) breach (rejection) likewise does not vaporize the innocent licensee’s rights under the license.^[30]

Conclusion, Practice Points and Thoughts to Consider

While their reasonings differed, the circuit courts addressing the rejection of trademark agreements prior to Tempnology held that a nondebtor licensee’s rights to use a trademark license may survive the debtor’s rejection of the license. Under the First Circuit’s Tempnology decision, however, nondebtor trademark licensees are only entitled to a pre-petition, unsecured claim for monetary-breach damages. Other circuits have yet to take a position.^[31]

These polar opposite results invite forum-shopping because the right or protection depends on where the debtor-licensor files for bankruptcy. Until the Supreme Court decides to intercede, companies burdened by cumbersome trademark licenses are incentivized to seek bankruptcy protection in the First Circuit to shed below-market or burdensome trademark licenses. Trademark licensees, however, may be motivated to move to transfer venue to a jurisdiction where their rights are protected. Additionally, trademark licensees, or lenders for whom trademark licensees are pledged as collateral, should consider structuring transactions in a manner to prevent the loss of trademark license agreements in the event a licensor files for bankruptcy protection.

Parties can build in protections that reduce the risk of rejection in bankruptcy, including placing the trademarks in a separate bankruptcy protected or remote entity and/or obtaining a lien in the actual trademark as separate from a license. Despite the recent ruling, careful planning and creativity can reduce the risk of losing the rights to trademark use in bankruptcy.