On May 20, 2019, the U.S. Supreme Court issued a long-awaited and important decision in Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. __ (2019) (the Supreme Court decision), resolving a split amongst various Circuit courts concerning the impact of rejection of trademark licenses by debtor-licensors in a bankruptcy case.
As we predicted in a client alert earlier this year summarizing the First Circuit's decision in Mission Product Holdings Inc. v. Tempnology, LLC, 879 F.3d 389 (1st Cir. 2018) and the Supreme Court's oral argument that took place in February 2019, the Supreme Court has now determined that a trademark licensee may retain its rights under a trademark license even after a Chapter 11 debtor-licensor rejects the trademark license between the parties.
Licensees of trademarks finally have some much-needed clarity regarding their now favorable rights in the event of rejection of a trademark license. On the other hand, the Supreme Court decision makes it more difficult for debtor-licensors to terminate a trademark license.
A more detailed summary of the background of the case and the Supreme Court decision, along with its significant implications, follows below.
Relevant Background and Lower Court Decisions
The debtor, Tempnology, LLC, produced clothing that remained cool during exercise and marketed these products using the COOLCORE and DR COOL trademarks. Tempnology entered into a co-marketing and distribution agreement with Mission Product Holdings, Inc. in which it granted, among other things, a non-exclusive license to use Tempnology's trademarks on products that Mission sold to its customers. Further, the agreement granted Mission an exclusive license to sell certain of Tempnology's products bearing its trademarks in the United States.
Disputes arose under the agreement, leading to an arbitration in Mission's favor allowing it to retain its distribution and trademark rights under the agreement until July 1, 2016.
After the arbitrator's ruling, in September 2015, Tempnology filed a Chapter 11 bankruptcy petition in the Bankruptcy Court for the District of New Hampshire. Immediately thereafter, Tempnology filed a motion to reject the agreement pursuant to section 365(a) of the Bankruptcy Code, which provides, in relevant part, that a trustee (or a debtor in possession in a Chapter 11 case) may reject executory contracts in which a debtor is a party.
Mission filed an objection to the proposed rejection, arguing that section 365(n) of the Bankruptcy Code provides certain protections to non-debtor licensees of certain intellectual property such as allowing them to retain their intellectual property rights under a license rejected by the debtor-licensor.
In reaction to a Fourth Circuit decision, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers Inc., 756 F.3d 1043 (4th Cir 1985), which allowed a debtor-licensor to reject a patent license and deprive such non-debtor licensee of all rights, section 365(n) was added to the Bankruptcy Code, along with a definition of "intellectual property."
Interestingly, while trademarks are generally considered a form of intellectual property outside of bankruptcy, the definition of "intellectual property" under the Bankruptcy Code includes, among other things, patents and copyrights, but not trademarks. The legislative history in 1988 behind the intellectual property definition and section 365(n) reveals that Congress was solely reacting to the Lubrizol decision and purposely left trademarks out of the intellectual property definition, thereby "postpon[ing] action on trademark licenses to allow the development of equitable treatment of this situation by bankruptcy courts." S. Rep. No. 100-505, at 5.
After reviewing the relevant case law, the statutory text and legislative history, the bankruptcy court determined that Mission did not have a right to retain its rights under the license after rejection. Mission appealed the Bankruptcy Court's decision to the Bankruptcy Appellate Panel for the First Circuit (the BAP), which reversed the Bankruptcy Court's decision, finding instead that a trademark licensee did not lose all rights under the license upon rejection by a debtor-licensor.
In reaching its decision, the BAP relied on the Seventh Circuit's decision in Sunbeam Products, Inc. v., Chicago American Manufacturing, LLC, 686 F.3d 372, 377 (7th Cir. 2012), which had held that rejection does not preclude the continued use of a trademark - "nothing about this process implies that any other rights of the other contracting party have been vaporized." In other words, the Seventh Circuit determined that rejection constituted a contractual breach and not a termination and thus, whatever post-rejection rights Mission retained in the debtor's trademark and logo were governed by the terms of the agreement and applicable non-bankruptcy law.
Tempnology appealed the BAP's decision to the First Circuit, making it the third court in the Tempnology case to weigh in on this important legal issue. The First Circuit disagreed with the reasoning of the BAP and consequently, the Seventh Circuit's decision in Sunbeam, finding that rejection of the trademark license meant that Mission was limited to a claim for damages and that it retained no further rights in the trademark license after rejection, focusing on the exclusion of trademarks as protected intellectual property under section 365(n). The First Circuit also reasoned that requiring a debtor-licensor to continue to comply with its obligations under the trademark, such as the obligation to monitor and exercise control over the quality of the goods, would be too burdensome.
Mission filed a petition for certiorari to the Supreme Court, which granted the petition, in order to resolve this important conflict amongst the Circuits. The Supreme Court heard oral argument from the parties on February 20, 2019, and issued its opinion on May 20, 2019.
The Supreme Court's Decision Resolving Circuit Court Conflict
In the 8-1 Supreme Court Decision authored by Justice Kagan, the Supreme Court sided with Mission, the trademark licensee.
The Supreme Court began by analyzing the general provisions of the Bankruptcy Code governing rejection of executory contracts and the consequences of such rejection. The Supreme Court determined that a debtor-licensor's rejection of an executory contract such as a trademark license under section 365(a) of the Bankruptcy Code has the same effect as a breach of that contract outside of bankruptcy. Section 365(g) of the Bankruptcy Code provides that rejection constitutes a "breach" which is not defined in the Bankruptcy Code, thus requiring bankruptcy courts to look to applicable state contract law to determine the consequences of a breach. The parties agreed that Tempnology's breach could certainly give rise to money damages in favor of Mission, the licensee, which would merely mean that the licensee would have an unsecured claim that is usually paid a fraction of its value in a bankruptcy case. The issue centered on whether Mission, the licensee, also had the remedy of retaining the continued use of the trademark under such license.
The Supreme Court found that outside of bankruptcy, a licensor's breach cannot revoke continuing rights given to a licensee under a contract, assuming no special contract term or state law. Thus, in other words, rejection of a trademark license in a bankruptcy case by the licensor should not give the debtor-licensor more rights than if the licensor breached its obligations outside of a bankruptcy case. This is the principal holding of the Supreme Court decision.
In reaching its conclusion, the Supreme Court rejected Tempnology's argument that there should be a negative inference drawn by Congress's determination to leave trademarks out of the "intellectual property" definition under the Bankruptcy Code. As explained, section 365(n) makes it clear that upon rejection by a debtor-licensor, those licensees of intellectual property (such as patents or copyrights) have a right to retain the benefits of a license even after a debtor-licensor rejects the license. In this regard, the Supreme Court followed the reasoning of the Seventh Circuit decision in Sunbeam and the BAP's decision in the Tempnology case as the better view of the law, stating that when enacting section 365(n) in response to the Lubrizol decision (dealing with patents), Congress did not intend to alter the natural reading of section 365(g) of the Bankruptcy Code, which merely means that rejection constitutes a "breach."
The Supreme Court also rejected Tempnology's policy argument that rejection of a trademark license must mean termination because otherwise, a debtor-licensor would essentially be required to continue monitoring the goods sold under the license (which may be a burdensome obligation on the licensor) to avoid losing the trademark. Tempnology had argued a contrary result would affect a debtor's ability to reorganize its affairs, a fundamental policy of chapter 11 of the Bankruptcy Code. The Supreme Court acknowledged the Bankruptcy Code's goal of reorganization but noted that "it does not permit anything and everything that might advance that goal." The Supreme Court noted that since rejection of a trademark, like other executory contracts, is governed by section 365(a), if Tempnology's policy argument (which was specific to trademarks) was accepted by the Supreme Court, counterparties to executory contracts would also raise similar policy considerations, thereby allowing "the tail to wag the Doberman."
Justice Sotomayor joined in the Supreme Court decision but issued a concurring opinion noting two important observations.
First, Justice Sotomayor noted that while the Supreme Court decision makes clear that rejection does not terminate rights of the licensee under applicable nonbankruptcy law, "special terms in a licensing contract or state law could bear on that question in individual cases." It is important to note that, under applicable state law, if the license is not terminated, then the licensee must comply with the terms of the license; subject to such compliance, the goods provided by the licensee will then be considered licensed goods. Failure to comply with the license terms might result in an action against the licensee for trademark infringement. El Greco Leather Prods. Co. v. Shoe World, Inc., 806 F.2d 392, 395 (2d Cir. 1986).
Second, Justice Sotomayor pointed out that the Supreme Court's ruling makes clear that section 365(n) does not cover trademarks and as a result, the rights of trademark licensees may now actually be more expansive than those rights of licensees of other intellectual property defined under the Bankruptcy Code (such as patents and copyrights). For instance, upon rejection of a copyright or patent by the debtor-licensor, the copyright or patent licensee can retain its rights under section 365(n) but must also make all royalty payments to the debtor-licensor while also losing the right to set-off its damages from its payments, even if it could have done so under nonbankruptcy law. The Supreme Court decision provides no similar requirement for trademark licensees to make royalty payments, leading Justice Sotomayor to conclude that it "leaves Congress with the option to tailor a provision for trademark licenses, as it has repeatedly in other contexts."
Conclusion and Potential Implications
The Supreme Court decision finally resolved a very contentious legal issue that has confused lower courts for years and led to inconsistent rulings. In this regard, the clarity provided by this decision is a positive development. On the other hand, this decision may have unintentionally given trademark licensees more rights than other holders of intellectual property by not burdening trademark licensees with the same obligations as other licensees of intellectual property upon rejection. As a result, this could lead Congress to act in the future to finally include trademarks in the "intellectual property" definition under the Bankruptcy Code.
It also appears that the Supreme Court's decision in this case enhances the negotiating leverage of trademark licensees as debtor-licensors no longer have the ability to treat the license as "revoked" upon rejection of a trademark license. As a result, it is more likely that more trademark licenses will be assumed and/or assigned, as opposed to rejected, in the future. This is especially so since, on the one hand, the Supreme Court seemed to indicate that a licensor's duties may cease upon rejection, but, on the other hand, noted that rejection does not "relieve the debtor of the need...to make economic decisions about preserving the estate's value." Incidentally, a trademark licensee seeking financing of its operations may now have more favorable lending options (and hence, negotiating leverage) as its "contract rights" have arguably enhanced in value as a result of this decision.
Further, this decision may be construed broadly by counterparties to other types of executory contracts, which may now argue they are entitled to retain the benefits of a rejected executory contract. Indeed, the Supreme Court cites to an example of a lessor's rejection of a photocopier lease to a law firm client, concluding that, upon rejection, the law firm is not limited to money damages but may be entitled to keep the photocopier under applicable law (assuming no contrary contract term or state law).
Finally, in reaction to the Supreme Court decision in Mission v. Tempnology, it is anticipated that parties to trademark licenses will now negotiate specific contract provisions in their favor in hopes of protecting themselves from the consequences of rejection of a trademark license in a bankruptcy setting. At the negotiating table, the licensor and licensee may consider whether to set forth different levels of quality control, which would apply pre-bankruptcy and post-bankruptcy, keeping in mind that the value of the trademark (and thus, in part, of the bankrupt estate) may rise or fall depending on the manner of the licensee's continued use of the trademark post-bankruptcy.
For instance, if one of the licensee's obligations under the license is to design a certain number of new products that cannot be marketed without the licensor's approval, the parties may consider what type of approval mechanism might work post-bankruptcy. If the license also includes patents (for instance, design patents for those new products), then section 365(n) may apply such that if the licensee retains its rights under the rejected license, it must continue to pay royalties and any right of set-off under the license is waived. The manner in which quality control is exercised is up to the licensor and licensee and is an essential provision of the trademark license. Prior to license negotiations, the licensee with a long track record may also be more selective, choosing licensors who are financially stable; entrepreneurs who are entering the market may find that their balance sheet is just as important as their new brand when negotiating licenses.
We will keep abreast of the changing landscape in this area and advise our clients and friends in the future of any new circumstances or trends that develop in response to this landmark case.