In bankruptcy proceedings, contracts which are “executory” can be “rejected” by the debtor. A contract is executory if both parties have continuing obligations and a failure of either party to perform would be a material breach excusing the other’s performance. Rejection of an executory contract relieves the debtor of its obligations under the contract and is treated as a breach of the contract by the debtor “immediately before the date of filing” of the bankruptcy. The practical impact of rejection on the non-debtor party is to create an unsecured claim against the debtor which will receive little if any payment from the bankruptcy estate.
Over thirty years ago a court held rejection in bankruptcy revoked a patent license previously granted by the debtor. Lubrizol Enterprises v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985). Congress reacted by amending bankruptcy law to provide protection for licensees of patents and certain other “intellectual property”. Congress provided that the debtor in bankruptcy could not revoke the grant in an intellectual property license; instead, the rejection would be treated as a breach and the licensee (rather than the debtor/licensor) would have the right to either: (1) revoke the license; or (2) retain the license and continue to pay the license royalties. 11 USC §365(n).
Trademark licenses are not included in the definition of “intellectual property” and therefore are not included within the protections of Section 365(n). Consequently, courts have disagreed over how to treat trademark licenses in bankruptcy. Some courts treated rejection of a trademark license granted by the debtor as a rescission – terminating the whole agreement along with all rights it conferred. On May 20, 2019 the US Supreme Court held instead that rejection of a trademark license granted by a debtor has the same effect as a breach of a contract outside bankruptcy – the licensee has a claim for damages and can retain trademark rights granted under the contract (subject to payment of the royalties). Mission Product Holdings, Inc. v. Tempnology, LLC, No. 17-1657 (U.S., May 20, 2019) The licensee also may have the option to rescind the license under state law, but the bankrupt debtor has no right to rescind. To rescind, the debtor must satisfy the more stringent requirements for avoidance – typically by proving a fraudulent transfer.
PRACTICAL CONSEQUENCES TO A TRADEMARK LICENSEE
First, Offsetting Damages Against Royalties. To maintain trademark rights, the licensee must continue to make royalty payments under the contract. Section 365(n) regarding licenses of other intellectual property specifically provides that damages resulting from rejection cannot be used to offset ongoing royalty payments. Because trademark rights are not included in Section 365(n), a trademark licensee may argue there is a right to offset the damages against continuing royalty payments. A provision in the trademark license authorizing or prohibiting an offset for damages would impact that argument. Consequently, licensors and licensees will now negotiate more aggressively regarding any offset rights.
Second, Ongoing Trademark Enforcement. The bankrupt debtor can stop performing its obligations under the contract after rejection. Trademark law generally imposes the burden of enforcing trademarks on the licensor. Licensees should consider license terms to allow enforcement by the licensee if the licensor is bankrupt. Therefore, the trademark licensee can argue the debtor has to continue enforcing the trademark against infringers. But a bankrupt licensor may not have the resources to perform the enforcement obligation. Eventually, if a trademark is not enforced, then trademark rights are lost. The trademark licensee might prefer to at least have the option to enforce the trademark if the bankrupt licensor does not. This is especially important where the licensee does not have exclusive rights (and would not have standing to enforce the trademark itself). Consequently, the enforcement provisions in the license are likely to be more aggressively negotiated.
What if the licensee has exclusive rights and the bankrupt licensor seeks to reject the exclusivity provision? Section 365(n) provides for the retention of a licensee’s right to exclusivity, but trademark licenses are not included. Some commentators have suggested rejection could effect the exclusive rights granted a licensee – perhaps preventing enforcement by the licensee and permitting the bankrupt debtor to obtain additional revenue by entering into additional licenses. Generally, the rule under Tempnology is the licensee retains trademark rights granted under the contract (subject to payment of the royalties). So if the license gives the licensor the right to terminate trademark exclusivity in the event of bankruptcy without rejecting the contract (in return for a lower royalty), maybe that contract provision can be enforced. Consequently, licensees should watch for and oppose any such provision.
Third, Breach by the Licensee. While the bankrupt debtor cannot revoke trademark license simply by rejecting it under the bankruptcy statutes, the license can be revoked for a material breach by the licensee. Consequently, licensors will more aggressively negotiate the licensee’s duties of quality control to enable the licensor to assert a breach by the licensee and pursue the termination option when advantageous to do so.
In light of the Supreme Court’s recent decision, trademark licenses should be reviewed to determine if the parties are comfortable with the potential effects of rejection in bankruptcy. If not, the terms of the trademark license should be renegotiated now or upon renewal.