Seventh Circuit Opinion Holds Trademark License Survives Rejection in Bankruptcy, Suggests that Special Statute Protecting Intellectual Property Licenses Unnecessary

July 17, 2012


In a decision that could reshape the way bankruptcy courts across the country treat trademark licenses, the Seventh Circuit has ruled that a licensee can continue to use a trademark even when the license itself is rejected in the bankruptcy of the licensor. The unanimous July 9 Sunbeam opinion addresses two facets of intellectual property law that have stirred debate for a quarter-century: it breaks with the Fourth Circuit’s notorious 1985 Lubrizol decision, which held that rejection of a patent license in bankruptcy terminated the licensee’s rights to the patent, and it plugs a hole in Section 365(n) of the Bankruptcy Code, which Congress enacted in 1987 to protect intellectual property licensees from the threat of Lubrizol.

Although Section 365(n) permits licensees (with some important limitations) to retain their intellectual property rights even after rejection in bankruptcy, Congress excluded trademarks from its definition of “intellectual property,” thus leaving trademark licenses under a cloud of uncertainty. Sunbeam marks the first time in 27 years that a federal appellate court has directly disagreed with Lubrizol—“Lubrizol does not persuade us,” Chief Judge Frank H. Easterbrook wrote—and in doing so, the decision creates a split among the circuits that could require Supreme Court intervention.

Sunbeam could also have a counterintuitive effect on the relative rights of those protected by and those not protected by Section 365(n). The Seventh Circuit found that Congress’s omission of trademark protections was “just an omission”—that Section 365(n) “does not affect trademarks one way or the other.” Because intellectual property licensees “protected” by Section 365(n) have to adhere to certain conditions to retain their licensing rights, they may in some circumstances actually have fewer rights than the trademark licensees that Congress chose to ignore in Section 365(n).

Although the Bankruptcy Code permits a debtor’s estate to “reject” “executory contracts,” Congress curiously chose to define neither executory contracts nor the effects of rejection. However, three basic principles were reasonably well-established even prior to enactment of the Bankruptcy Code in 1978. First, an executory contract is one where material obligations remain on both sides such that breach by one party would excuse the other’s performance. Second, rejection entitles the bankruptcy estate to cease future performance. Third, rejection is not a rescission of the contract and cannot undo performance already rendered.[1] Application of these simple rules is not always simple, and may turn on how one conceives the agreement in question. For example, prior to adoption of the Bankruptcy Code, authorities struggled with how to apply these paradigms to real property leases; once the landlord delivered the property has it fundamentally performed such that the right to occupy is a “completed transfer” that survives rejection, or is the covenant of quiet enjoyment a continuing obligation that – along with the right to occupy – could be terminated by rejection? Congress statutorily resolved these questions in 1978 by providing that executory contracts and “unexpired leases” might be rejected, thus evading the fundamental question of whether a lease should be classified as “executory.” At the same time, it adopted special provisions in Section 365(h) permitting a tenant under a rejected real property lease to continue occupancy, while expressly excusing additional affirmative performance by the rejecting landlord.

Unfortunately, Congress did not expressly address license agreements in 1978, and uncertainties led to significant litigation. The two conflicting approaches turned on an almost metaphysical analysis of the nature of a license agreement. One view found a license a delivery of property such that the hornbook rule that rejection did not “undo” or “rescind” performance applied. The other view conceived the license as a continuous tolerance by the property owner of the licensee’s use of the property with either an express or implicit covenant not to disturb the use and often to permit the use on an exclusive basis. This struggle arose both in cases analyzing whether an intellectual property license was executory as well as in cases addressing the impact of rejection. On the question of “executoriness,” courts endorsing the “transfer” paradigm flyspecked the contract for continuing obligations of the licensor.

This often led to courts’ dubious analysis of materiality, ruling for example that the obligation of the licensor to cooperate in patent infringement actions rendered the licensor’s obligations executory. On the other hand, a line of cases starting in the Ninth Circuit and well established by the 90’s concluded that the continuing obligation to provide “quiet enjoyment,” while a negative covenant, was sufficiently material to make the licensor’s obligations fundamentally executory. These cases suggested an entirely different model of the license from the “completed transfer” model.

The parallel argument over the result of rejection contrasted the “transfer” approach’s conclusion that rejection could not “undo” a “completed” license with the view that rejection terminates the covenant of non-disturbance, and thus the licensee could no longer use the intellectual property following rejection.[2] In the notorious Lubrizol decision, the Fourth Circuit addressed the effects of rejection of a patent license in the licensor’s bankruptcy. Implicitly adopting a “continuing tolerance” model of the license, the Fourth Circuit ruled that following rejection the licensee could no longer practice the patent. In response, Congress quickly enacted Section 365(n), which permits a licensee of defined “intellectual property” to continue to enjoy its rights notwithstanding rejection.[3] In doing so, Congress expressly chose to exclude trademarks from the definition of intellectual property. The legislative history states that Congress left the rules for trademark licenses to be developed by the equitable powers of the courts.

This state of affairs continued for nearly 25 years, with disputes flaring regarding both the general rules applicable to executory contracts and Congress’ specific exclusion of trademarks from Section 365(n). At least one court held early on that a trademark license attendant to a predominant “intellectual property” license would also be protected by Section 365(n).[4] Other courts held that upon rejection of a pure trademark license, the licensee’s rights are terminated because they are not protected by 365(n). In 2010, the Third Circuit touched on these issues in Exide, when it addressed a fully paid trademark license.[5] The bankruptcy and district courts ruled that the contract could be rejected as executory, and that because trademark licenses are not within the safe harbor of Section 365(n) the licensee had no rights following rejection. The Third Circuit reversed, finding no material demands remaining on the licensee after payment of the upfront license fee[6]. If the contract is not executory it cannot be rejected and thus the result of rejection need not be addressed. In a prescient concurrence, Judge Ambro (a former bankruptcy practitioner), suggested that the protections of Section 365(n) aren’t necessary as rejection would never “undo” a completed transfer (implicitly adopting the transfer model of understanding the license). Judge Ambro found Lubrizol’s conclusion on the effects of rejection fundamentally flawed, and any negative inference on the survival of a trademark license following rejection arising from omission of trademarks from 365(n) too speculative.

This state of uncertainty came to a head in Sunbeam. In this case the licensee manufactured fans, holding both a patent license clearly protected by Section 365(n) and the right to use the debtor’s mark on the fans. The licensee had invested heavily in manufacturing facilities, and when the licensor entered bankruptcy and rejected the agreement, the licensee was left with a warehouse full of fans marked with the debtor’s marks. The bankruptcy court noted the legislative history of Section 365(n), indicating that Congress did not specify treatment of trademark licenses but rather left them for development by the courts applying equitable principles. The bankruptcy court found that on the facts before it equity required that the trademark license follow the patent license and also be protected under Section 365(n).

On appeal, writing for a unanimous Seventh Circuit panel, Judge Easterbrook rejects this approach as far too nebulous. He notes that “there are hundreds of bankruptcy judges, who have many different ideas about what is equitable in any given situation…. Rights depend, however, on the what the Code provides rather than on notions of equity.” Nevertheless, the court sustains the decision on an entirely different theory. In a remarkably short opinion, with little citation other than to Lubrizol and Judge Ambro’s concurrence in Exide, the Seventh Circuit cites hornbook law that rejection is not a rescission and cannot “undo” what has been done under a contract. Thus, without the need to weigh any equities or specific facts, the Seventh Circuit concludes that rejection of a trademark license cannot terminate the licensee’s rights to use the mark. In doing so, the court implicitly adopts the “completed transfer” understanding of the license, without recognizing the conflicting “continuing tolerance” model. Nor does the court consider the implication of its ruling, that Congress’ enactment of Section 365(n) and the earlier provisions regarding real property leases were unnecessary.[7]

The Sunbeam opinion notes both that it creates inter-circuit conflict with the Fourth Circuit’s Lubrizol decision and that not a single judge in the Seventh Circuit supported en banc review. Ultimately, it creates the odd potential result that licensees “protected” by Congress’ enactment of Section 365(n) may in fact enjoy lesser rights following rejection than if Congress had never enacted Section 365(n). As noted above, Section 365(n) expressly conditions the licensee’s continued rights on payment of all royalty obligations. Absent this express requirement, the license might well survive a non-material royalty default.[8] Similarly, Section 365(n) requires a licensee retaining its rights to waive any setoffs. While set-offs are limited in bankruptcy, this waiver of set-off might not apply absent Section 365(n). Finally, Section 365(n) expressly limits the licensee’s rights based upon the state of the license at the moment of bankruptcy. If rejection of an intellectual property license is merely a breach by the licensor as the Seventh Circuit holds, it is hard to see why such a limitation would result absent Section 365(n). However, protection by Section 365(n) may not be all for the worse. One of the specific rights protected by that provision is the right to enforce exclusivity. While a trademark licensee subject only to rules of general applicability could presumably reduce royalty payments by damages suffered from termination of exclusivity (a right perhaps denied to a licensee protected by 365(n)[9]  a rejected trademark licensee may not be able to directly enforce exclusivity.[10]

The Seventh Circuit’s ruling that a trademark license is protected from rejection in bankruptcy will be well received by many. However, the decision in Sunbeam suggests that an area of bankruptcy law that was thought largely settled, the treatment of an intellectual property license following rejection, and perhaps the much larger fundamental understanding of executory contracts and rejection will continue to evolve in future decisions.

[1]The Bankruptcy Code specifies that rejection is a breach and any damage claim arising upon rejection would be deemed to arise immediately before commencement of the bankruptcy case.
[2]Very few cases actually address the existence of two competing models -- tending to pick one as obvious. Similarly, few cases consider that the selection will have an impact on both whether the contract is executory and the effects of rejection, typically only addressing one issue or the other.
[3]The rights are subject to requirements to pay all royalties, waive set-offs and limits to the status of the license at commencement of the case. There is varying authority whether this last requirement focuses on the state of the intellectual property upon commencement -- such that the licensee has no rights in developments and improvements after the case begins -- or upon the state of the license itself -- such that the license may not “spring” into existence after the case begins. Each view has been adopted in reported decisions without expressly addressing the other line.
While the licensee electing to retain its rights must make all royalty payments, the debtor licensor is relieved of much future performance.
[4]The court addressed whether or not a party licensed to use the secret process to make Old Matusalem rum might so label the resulting concoction.
[5]In re Exide Technologies, Inc., 607 F.3d 957 (3d Cir. 2010).
Curiously, the court does not consider any requirement to maintain quality of the manufactured goods, without which the mark could well be abandoned as a matter of law. Such a requirement would be expected in a trademark license.
[6]As the parties had never adopted a schedule of quality control standards contemplated by the agreement, the court did not find them material. This may be an anomaly as failure of the mark’s owner to enforce quality standards can result in abandonment of the mark and such requirements are thus normally a key part of a license agreement.
[7]The court cites the rule on real property leases as reflecting general effects of rejection without noting that it is an express safe-harbor.
[8]The courts have interpreted royalty obligations quite broadly.
[9] Demonstrating the lack of certainty that continues to apply to Section 365(n) itself, the provision requires the licensee to make payments "without set-off." However, set-off in bankruptcy is generally understood to apply to claims arising from a different contract or set of dealings, while obligations arising from the same contract or set of dealings are technically "recoupments." No court has ruled whether this distinction applies to Section 365(n) and thus whether royalty payments may be reduced by unperformed obligations of the licensor under the license itself.
[10] Adding to the uncertainty, a rejected trademark licensee may in fact be able to enforce exclusivity by injunctive relief. While the discharge in bankruptcy terminates the debtors liability for all "claims," it does not address true equitable obligations. The Seventh Circuit has accordingly held that a covenant of non-competition may be specifically enforced following rejection. It is unclear whether enforcement of trademark exclusivity would be permitted under this approach.