Trademarks Licenses and Bankruptcy: Certain Uncertainty

In the recent case of Mission Product Holdings Inc. v. Tempnology LLC,[1] the U.S. Court of Appeals for the First Circuit added to the already uncertain fate of trademark licenses in bankruptcy cases.

By way of background, in bankruptcy cases, intellectual property licenses most often fall into the category of executory contracts. Many courts rely on the definition of executory contracts contained in Vern Countryman’s 1973 Article, “Executory Contracts in Bankruptcy: Part I.” Professor Countryman defined an executory contract as a contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.[2]

The Bankruptcy Code allows a debtor to reject an executory contract in order to be relieved from the burden of performance. The Bankruptcy Code treats the rejection as a “breach.” Any claim of a nondebtor party for damages arising from that breach is treated under the Bankruptcy Code as a pre-petition unsecured claim.

For a nondebtor licensee of intellectual property, receiving money damages is a hollow remedy. For example, if a nondebtor licensee has built a business model on the practice of a patent, losing access to patent rights would destroy the licensee’s business. Recognizing this, Congress amended the Bankruptcy Code to add § 365(n), which permits rejection of an intellectual property license but requires the debtor to allow the nondebtor to retain its rights in the license until the termination of the license.[3] Section 365(n) contemplates that the debtor/licensor can be passive and merely allow the licensee to continue using the intellectual property for the life of the license while collecting royalties and license fees.

The fate of trademark licenses, however, has always been a sore spot. The problem arises from the fact that the Bankruptcy Code does not include trademarks in the definition of intellectual property for the purposes of § 365(n).[4] The sparse legislative record addressing this omission recognizes that the unique aspects of trademark law require trademarks to be treated differently from other intellectual property. Trademark law protects the consumer’s right to rely on the quality of goods and services identified by a trademark. Therefore, in order to maintain rights in a trademark, the trademark owner must monitor and control the use of the trademark. If the trademark owner licenses the trademark, the licensee’s use inures to the benefit of the licensor as long as the owner/licensor monitors its licensee’s use of the trademark. The licensor could lose rights in the trademark if a licensee were permitted to continue to use a trademark without quality control over the goods or services connected with the trademark. Therefore, unlike licensors of other types of intellectual property, the debtor/licensor of a trademark cannot be passive and merely collect royalties and license fees.

Many courts have decided that the omission of trademarks was an oversight or statutory drafting issue that should be remedied. For instance, in Sunbeam Products Inc. v. Chicago American Manufacturing LLC, the Seventh Circuit held that a trademark licensee retains basic contractual rights to use a debtor’s trademarks post-rejection.[5]

The First Circuit’s opinion in Tempnology held the opposite.

In Tempnology, the debtor granted a license to the licensee to distribute products and to license the debtor’s trademark and logo. The debtor rejected the license. The licensee appealed to the Bankruptcy Appellate Panel for the First Circuit (BAP). The BAP also agreed that § 365(n) does not apply to trademarks because the definition of “intellectual property” under the Bankruptcy Code does not include trademarks. Following Sunbeam, the BAP determined that the debtor’s rejection does not necessarily terminate the licensee’s right to license the trademarks. The debtor appealed to the First Circuit.

The First Circuit rejected the BAP’s support of Sunbeam, which rested on the notion that it is possible to free a debtor from any continuing performance obligations under a trademark license even while allowing a licensee to continue to use the trademark. The First Circuit recognized that trademarks, unlike patents, required monitoring and control to maintain the goodwill associated with the trademark. Sunbeam’s approach would allow the licensee to retain the use of the debtor’s “trademarks in a manner that would force the Debtor to choose between performing executory obligations arising from the continuance of the license or risking the permanent loss of its trademarks, thereby diminishing the value….” The application of § 365(n) would result in destroying the viability of the trademark. Accordingly, the First Circuit concluded that trademark licenses are not protected by § 365(n).

The First Circuit joins the majority of courts that have found that a trademark licensee only has a claim for damages upon rejection of the license. This decision marks a split among the circuits. The remedy for the split may lie in amending § 365(n) to balance the debtor’s need to protect its trademarks with a nondebtor/licensee’s interest in the continued use of the trademark. Until a remedy can be legislated or determined by the U.S. Supreme Court, the trademark licensee faces risk when entering into a trademark license. If the licensor files for bankruptcy, the licensee could lose a valuable component of its business model.