From Sunbeam to In re Tempnology: Solving the Trademark Puzzle with a Burden-Shifting Framework

Editor’s Note: The following article, “From Sunbeam to In re Tempnology: Solving the Trademark Puzzle with a Burden-Shifting Framework” won the prize for second place in the Tenth Annual ABI Bankruptcy Law Student Writing Competition. Mr. Li is a recent graduate of  Cornell Law School in Ithaca, NY He will begin clerking at the SDNY Bankruptcy Court later this year. Thank you to Wolcott | Rivers | Gates for sponsoring this prize.

In January 2018, the First Circuit Court of Appeals issued its decision in In re Tempnology, the most recent attempt by a federal appellate court to clarify post-rejection protections for licensees of executory trademark agreements.[1] Acknowledging the Seventh Circuit’s contrary view in Sunbeam Products, the First Circuit decided that the debtor-licensor’s rejection of a trademark license terminated the nondebtor-licensee’s rights.[2]

The current circuit split centers on the effect of a debtor-licensor’s rejection of trademark agreement: whether a licensee can continue to use the trademark or only has a claim for monetary damages as a general unsecured creditor. This article argues that neither the Sunbeam nor In re Tempnology decisions prove satisfactory: The Sunbeam approach, which allows a trademark licensee to retain rights post-rejection,[3] does not recognize the uniqueness of trademark licensing and may impede a debtor’s reorganization efforts with a residual duty to police trademark usage, but on the other hand, the In re Tempnology[4] decision overemphasizes the burden of a debtor-licensor’s monitoring duty, making “bankruptcy more a sword than a shield, putting debtor-licensors in a catbird seat they often do not deserve.”[5]

This article will begin by reviewing the Fourth Circuit’s Lubrizol[6] decision and the enactment of § 365(n). Then it will illustrate the circuit split by discussing and critiquing Sunbeam and In re Tempnology. After placing cases involving rejections of trademark agreement on a continuum, the article will propose a burden-shifting framework, where courts can more accurately assess a debtor’s post-rejection burden of exercising quality control.

Lubrizol and the Enactment of § 365(n)

In Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., the Fourth Circuit held that a debtor-licensor’s rejection of a technology licensing agreement would leave the licensee with a right to monetary damages, but no right to continue to use the technology.[7] By looking to the legislative history of § 365(g), the court explained that Congress intended to provide only a damages remedy for the nondebtor licensee.[8] Although the result could chill “the willingness of ... parties to contract at all with businesses in possible financial difficulty,” a remedy of specific performance, which would have preserved the licensee’s rights to continue its use of the licensed technology, would defeat the purpose underlying § 365(a).[9] In addition, the court pointed to the more favorable treatment accorded to collective bargaining contracts and reasoned that, by negative inference, the Bankruptcy Code did not allow licensees of intellectual property to retain their rights post-rejection.[10] The court noted that Congress, not the courts, should provide the desired relief to licensees of intellectual property.[11]

In response, Congress enacted § 365(n) of the Bankruptcy Code, establishing the rights of debtor-licensors and nondebtor licensees upon rejection of intellectual property licenses.[12] Under § 365(n), despite a debtor-licensor’s rejection, a licensee can choose to retain rights to intellectual property while continuing to fulfill its contractual obligations by making royalty payments to the licensor.[13] However, Congress did not include trademark in the definition of “intellectual property.”[14] This “omission” set the stage for disagreement between the First and Seventh Circuit.

Sunbeam and the Uniqueness of Trademark Licensing

In Sunbeam Products Inc. v. Chicago American Manufacturing LLC, the Seventh Circuit disagreed with the Lubrizol court and held that a trademark licensee could retain rights to the trademark after the debtor-licensee had rejected the contract.[15] The Sunbeam court based its reasoning on § 365(g), explaining that rejection constituted a pre-petition breach and thus was not the equivalent of rescission, where the licensee’s rights would vaporize.[16]

The court then wrote that, outside of bankruptcy, “a licensor’s breach does not terminate a licensee’s right to use intellectual property.”[17] The court reasoned that if rejection didn’t terminate the licensee’s rights, then the licensee could continue to use the trademark.[18] This line of reasoning is flawed, however. First, the Uniform Commercial Code sections the court cited provide that a buyer may cover by purchasing goods to substitute for those due from the seller, not that a licensee may choose to retain the rights to a trademark despite a debtor’s rejection of the trademark agreement;[19] second, the court’s reliance on § 365(g) is mistaken. The legislative history of § 365(g)(1) clarifies that claims arising out of rejections are treated as general unsecured claims.[20] Although a general unsecured creditor may only receive a pro rata payout, receiving such a payout does not vaporize a licensee’s rights.

In the relatively short opinion, the Sunbeam court failed to address the primary difference between a trademark and the enumerated categories of intellectual property in § 101(35A), namely, the relational aspect of trademark licensing. “A trademark license commonly embodies and documents an active relationship, not a conveyance of property.”[21] The validity of a trademark license is predicated on the debtor-licensor’s continued performance of the affirmative duty to police the use of the trademark to ensure its quality.[22] While critical to the continued validity of a trademark, such a duty may impede a debtor’s effective reorganization. Furthermore, although the Sunbeam court cautioned against imposing specific performance on the debtor,[23] the court’s decision to allow the licensee to retain its rights requires the debtor-licensor to continue to perform its monitoring duties.

In re Tempnology

In In re Tempnology, the First Circuit reached the opposite result, holding that a debtor-licensor’s rejection terminated a licensee’s right to continue to use a trademark.[24] Unlike the Sunbeam court, the First Circuit acknowledged the relational aspect of trademark licensing: Without monitoring the use of licensed trademark, the licensor risks abandoning the trademark altogether.[25] The First Circuit also noted that Congress’s principal aim in providing for rejection was to “release the debtor’s estate from burdensome obligations that can impede a successful reorganization.”[26] To allow a licensee to continue its use of a trademark imposes a residual enforcement burden on the debtor-licensor, which is tantamount to ordering specific performance that would undermine Congress’s principal aim in enacting § 365(g).[27]

However, allowing rejection without preserving the licensee’s rights does not necessarily relieve the debtor-licensor of its duty to maintain quality control. When a debtor-licensor threatens to reject the trademark agreement as leverage to renegotiate the terms of the contract, the debtor would continue to discharge its monitoring duty if such a negotiation is successful. If the renegotiation is unsuccessful, the debtor-licensor will likely re-license the same trademark for higher royalty payments. In a new licensing agreement, the debtor-licensor would also need to perform its monitoring duty to preserve the validity of the trademark. Furthermore, if the monitoring duty with respect to the current licensee is too burdensome for the debtor-licensor, the duty may turn out to be just as burdensome, or even more so, if the debtor is unfamiliar with the prospective licensee.

While the First Circuit upholds one “principal aim” of Congress, it did not conduct the inquiry into whether a debtor’s residual duty, when a licensee retains rights to a trademark, would indeed constitute a burden on the reorganization. Therefore, the court risks deserting another principal aim of Congress underlying the enactment of § 365(n). In adopting the categorical approach of leaving trademark licenses unprotected from rejection, the First Circuit contravened congressional intent to “allow the development of equitable treatment of this situation by bankruptcy courts.”[28] By definition, equitable treatment eschews a categorical approach that favors the debtor while leaving the nondebtor unprotected.

The Business Judgment Test and Where It Falls Short

Trademark licensing contracts can be viewed as being along a continuum. At one end of the continuum, where a debtor-licensor’s duty to police the use of trademarks is the least burdensome, a court’s concern with imposing a residual duty on the debtor is at its weakest. Courts have employed the test for executory contracts to ferret out trademark agreements, whereas a debtor-licensor’s monitoring duty is minimal, thus the trademark agreement would not constitute an executory contract. For example, in In re Exide Technologies, the Third Circuit defined an executory contract as one where “both parties have unperformed obligations that would constitute a material breach if not performed.”[29] Thus, a prepaid, exclusive and perpetual trademark license failed the test for executory contract because the contract deemphasized the relational aspect of trademark licensing and resembled a complete transfer of property.[30]

At the other end of the continuum, where a debtor-licensor’s monitoring duty is the most burdensome, a court’s concern with imposing a residual duty on the debtor is at its strongest. Less extreme and thus more difficult cases congregate near the midpoint of the continuum, where the residual duty is not trivial but may not be so substantial as to interfere with the debtor’s reorganization. After determining whether a contract is executory, courts typically employ the business judgment test in reviewing a debtor’s decision to reject executory contracts.[31] In applying the test, a majority of courts approve rejection unless the “conclusion that rejection would be advantageous is so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.”[32] Because this test is deferential to a debtor’s judgment, it is unlikely to yield accurate results in the more difficult cases.[33] In other words, the decisions would be sound only in extreme cases, where a debtor-licensor’s monitoring duty is the most burdensome.

The ‘Burdensome’ Standard Proposal

Notwithstanding the prevalence of the business judgment test, courts have used a “burdensome” standard.[34] As the Second Circuit observed in In re Minges, “[I]t is accepted that to justify rejecting an executory contract, it must at least be shown to be burdensome, since the power to reject derives from the long-held doctrine that the bankrupt estate may abandon burdensome property.”[35] Under the “burdensome” standard, it is not necessary that “continued performance under the contract [will] result in an actual loss to the estate.”[36] Thus, a profitable trademark licensing contract does not preclude a debtor from rejecting a truly burdensome license.

Furthermore, courts can more accurately assess a debtor’s burden of exercising quality control by adopting the following burden-shifting framework, which involves two steps. First, the debtor-licensor bears the initial burden to show that if the court disapproves the debtor’s rejection, the residual burden will have a substantial adverse effect on its reorganization. If the debtor carries this burden, the burden then shifts to the nondebtor-licensee to offer countervailing evidence, demonstrate how the debtor’s monitoring duty can be discharged in a substantially less burdensome manner, or argue that approving the rejection would not materially reduce the debtor’s monitoring duty because the debtor’s attempt at rejection is a pretext for renegotiating the agreement or relicensing the same trademark for higher revenue. If the debtor-licensor fails to carry the burden in the first step or the licensee carries the burden in the second step, a court should disapprove the debtor’s rejection. On the other hand, a court would approve rejection if the debtor-licensor carries the burden in the first step or the licensee fails to carry the burden in the second step. Once rejection is approved, a licensee would have a pre-petition claim for monetary damages, but not the right to retain the licensed trademark.

Here, the proposed ‘burdensome’ test intended the exclusion of any balancing test, where a court would weigh the debtor’s residual burden against the nondebtor’s loss (if debtor’s rejection terminates the nondebtor’s rights to trademark). First, a balancing test without the support of statutory language is more freight than § 365(n)’s legislative history can bear; when Congress intended equitable dispensation from the Code’s rules, it reflected the intention with explicit statutory language.[37] Second, hundreds of bankruptcy judges may have “many different ideas about what is equitable in any given situation.”[38]An equitable approach “has the added drawback of imposing increased uncertainty and costs on the parties in bankruptcy proceedings.”[39]

Unlike the burden-shifting approach, a hard-and-fast rule cannot accommodate trademark licenses that often differ in parameter and purpose. In addition, the burden-shifting framework can address the fluid nature of a debtor-licensor’s policing duty. A debtor’s duty tends to be most burdensome at the beginning of a contract, where the debtor lacks confidence and active monitoring of a licensee’s use of trademark would increase such confidence. Since a debtor’s need and duty in monitoring the use of a trademark may fluctuate overtime, the burden-shifting framework would allow the courts to examine the degree of a debtor’s monitoring duty.

Conclusion

Courts might well welcome an amendment of § 365(n), provided that Congress gives clear guidance on the effects of the rejection of trademark licenses. In the meantime, courts should adopt the “burdensome” standard, which can deliver better results by complementing the test for executory contract and the business judgment test. Any categorical approach would either ignore or overemphasize the relational aspect of trademark agreements. Rather than expanding the equitable power of bankruptcy courts, the burden-shifting framework strikes the right balance between ad hoc equitable administrations and one-sided categorical rules. The proposed “burdensome” standard does not change the outcome; courts will either approve or disapprove a debtor’s rejection of an executory trademark agreement. However, it is the process of making the decision that matters. The “burdensome” standard would help courts understand the relational aspect of trademark licensing and meaningfully assess the degree of a debtor’s residual duty.