O’Melveny Worldwide

Rights of the Rejectee: High Court to Address Circuit Split over Trademark Licenses in Bankruptcy Rejections

December 13, 2018

The Supreme Court has granted certiorari to resolve whether rejection of a trademark license in the licensor’s bankruptcy terminates the licensee’s rights to use the mark.1 Though Congress determined 30 years ago that holders of copyright and patent licenses would be protected from rejection, it left trademark licenses outside that safety. Circuit courts applying general rules of bankruptcy law have split on whether those rules protect the trademark licensee or leave the mark at risk, and the grant of certiorari invites a decision with important implications.

The issue underlying this split has been brewing for decades. The ability to reject executory contracts is one of the key powers afforded to a bankruptcy estate, as rejection permits the bankruptcy estate to escape performing burdensome contract obligations. By doing so, it can maximize the value of the estate available for creditors. However, this maximization must balance the rights of parties who dealt with the debtor. In 1988, Congress adopted Bankruptcy Code Section 365(n), specifying that following rejection a copyright or patent licensee might continue to practice the licensed technology in return for continued royalty payments. At the same time, Section 365(n) absolves the licensor/debtor of affirmative obligations such as developing or improving technology.2 The legislation was in express reaction to the well-known Fourth Circuit Lubrizol decision that rejection terminated the licensee’s rights.3 In adopting Section 365(n), Congress reached back to the purpose of copyright and patent—to encourage innovation. Congress reasoned that allowing copyright and patent licenses to be at risk in bankruptcy would threaten the very schemes that innovation demands, particularly in the technology industry. However, Congress excluded trademarks from Section 365(n). Although there is little discussion of the choice, trademarks are different from the copyright and patent. Rather than personal property of the owner, trademarks protect consumer expectations by insuring that a particular good has the quality that the consumer associates with the mark. Thus, a falsely marked good unfairly frustrates the consumer’s expectation. Congress indicated that the courts would develop appropriate rules for rejected trademark licenses.

Relying on first principles of bankruptcy law, and in the absence of express guidance from Section 365(n), courts developed two conflicting answers to what happens to a rejected trademark license. Each line relies on a well-established, though non-statutory, rule of bankruptcy. The first rule is that rejection entitles the estate to cease all future performance, and specific performance will not be ordered. The second rule is that rejection does not undo performance already rendered. How to apply these rules to licensing agreements has confounded courts because of two different conceptual models of a license. One model sees a license as a completed transfer. Upon entry, rights are “granted” to the licensee. Rejection would not permit a licensor to “undo” the completed transfer; thus, the licensee may continue to enjoy the intellectual property after rejection. The other model relies on authority that a license is simply an agreement to forebear from asserting infringement. Under this view, rejection absolves the licensor from continuing to forebear; thus, the licensee’s rights terminate upon rejection, as the owner is free to enforce its exclusive rights. Although various courts have picked each model, and seen the outcome as simple once the model is in place, almost none have expressly considered that two models coexist and lead to different conclusions.4

For 30 years following adoption of Section 365(n), a majority of lower courts found the exclusion of trademarks from Congress’s definition of intellectual property controlling and ruled that because trademarks were not within Section 365(n)’s “safe harbor,” the Lubrizol rule applied. They found self-evident that rejection terminated the licensee’s rights. Practitioners resorted to various alternative means to protect trademark licenses from rejection. Then, in 2012, the Seventh Circuit reached a different conclusion.5 Applying the agreed-on principle that rejection does not undo performance already rendered, the Seventh Circuit held that the rights of a trademark licensee survived rejection. The court gave remarkably little attention to the competing model of a license, and simply did not consider how to reconcile its decision with the adoption of Section 365(n) or its exclusion of trademarks. Though not stated, the Seventh Circuit fundamentally found Section 365(n) to be unnecessary because Lubrizol is wrong.6

Last year the First Circuit disagreed. Adopting the “continuing forbearance” model of a license, the First Circuit ruled that rejection terminated the obligation to forebear, that exclusion of trademarks from Section 365(n) was compelling, and that the rejected trademark licensee no longer enjoyed rights in the mark.

The Supreme Court will now decide. Because the split turns not only on narrow statutory construction issues—does omission of trademarks from 365(n) imply that a different result applies—but also upon fundamental understanding of licenses and rejection, the Court’s decision will determine not only the fate of trademark licenses in bankruptcy, but may define rejection more broadly. Briefing is underway with oral argument in the coming term.

1 Mission Prod. Holdings, Inc. v. Tempnology LLC (In re Tempnology LLC), 879 F. 3d 389 (1st Cir. 2018), cert. granted Oct. 26, 2018.

2 Under Section 365(n), the licensee electing to enjoy the rights must make royalty payments without setoff for deficient performance such as excused future obligations to upgrade or improve the technology.

3 Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc. (In re Richmond Metal Finishers, Inc.), 756 F.2d 1043 (4th Cir. 1985), cert. denied, 475 US 1057 (1986).

4 The Lubrizol case itself illustrates the two views. The lower court in Lubrizol found it readily apparent that rejection of a copyright license would not “undo” the license. In reversing, the Fourth Circuit adopted a different model. It ruled that the licensor’s obligation to forebear was an executory one not fully performed and that rejection ended the licensor’s obligation to allow enjoyment of the property.

5 Sunbeam Products, Inc. v. Chicago American Mfg., LLC (In re Sunbeam), 686 F.3d 372, (7th Cir. 2012).

6 In stating the “general rule” that rejection does not undo performance rendered, the Seventh Circuit curiously cited a special rule for real property leases found in the Bankruptcy Code. That rule was, in fact, the model for Congress’s adoption of Section 365(n). Before the 1978 Bankruptcy Code was adopted, much the same debate raged over real property leases. Once property was “delivered,” what remaining obligations did the landlord have? Was the lease even executory? Did rejection divest the tenant of its rights? Congress resolved this dispute by edict; Section 365 applies to “executory contracts and unexpired leases,” and a special rule was codified permitting the rejected tenant to remain in possession.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Evan Jones, an O’Melveny partner licensed to practice law in California and the District of Columbia, and John Rapisardi, an O’Melveny partner licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

© 2018 O’Melveny & Myers LLP. All Rights Reserved. Portions of this communication may contain attorney advertising. Prior results do not guarantee a similar outcome. Please direct all inquiries regarding New York’s Rules of Professional Conduct to O’Melveny & Myers LLP, Times Square Tower, 7 Times Square, New York, NY, 10036, T: +1 212 326 2000.