A New Twist on Trademark Licenses in Bankruptcy

August 16, 2012, 8:36 AM

What happens when a company takes a license to manufacture and sell a product under anothers mark, only to discover later that the licensor has entered bankruptcy? Can the bankrupt estate reject the license and deny the licensee the ability to continue using the mark in its business? The problem can arise, and sometimes has, to the detriment of trademark licensees. Yet, a recent Seventh Circuit decision takes an interesting new approach to the problem. In the short term the decision creates uncertainty, but it opens the door to reconsideration of the effects of a licensors bankruptcy on IP licenses.

Some historical background will help to understand the problem and the Seventh Circuits solution. Bankruptcy is intended in large part to free the bankrupt estate of debts (giving it a fresh start) and to maximize the value of the bankrupt estate for the benefit of its creditors. To these ends, Section 365 of the Bankruptcy Code allow a trustee in bankruptcy, subject to the courts approval, to assume, assign or reject any executory contract. (An IP license may or may not qualify as an executory contract, which is a topic unto itself). A trustee in bankruptcy may thus want to reject an IP license to free itself from ongoing obligations under a license and/or in order to sell the IP, free of the license, for a greater return. The resulting legal question has been whether rejection of a license effectively ends the licensees rights.

A 1985 Fourth Circuit decision, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., held that a trustees rejection of a license does deprive the licensee of the right to continue using the licensed intellectual property. The decision aroused great concern among licensees, and Congress subsequently adopted Section 365(n) of the Bankruptcy Code to allow licensees of Intellectual Property, as defined by the Code, to continue to use the IP it held by license, albeit subject to several limitations.

Congress excluded trademarks from the Codes definition of Intellectual Property, however, believing trademarks posed special issues that required further study. Thus, when trademark licensors enter bankruptcy, the consensus in the bar has been that its licensees do not enjoy the protection of Section 365(n), that Lubrizol applies, and therefore, trustee rejection deprives the licensee of continuing rights. The hardship of that result is well illustrated In re Exide Technologies, where an exclusive trademark licensee was denied for years the right to use a mark on which it built a business and for which it paid $133 million. (After nearly ten years of litigation, in 2010 the Third Circuit overturned the result, holding that the license at issue was not executory after all and thus not subject to rejection).

The story brings us to Judge Easterbrooks recent opinion in Sunbeam Prods., Inc. v. Chicago American Mfg., LLC, No. 11-3920 (7th Cir., July 9. 2012). The facts were straightforward: Lakewood granted to Chicago American a license of patents and marks to manufacture and sell box fans, later entered involuntary bankruptcy, and then rejected the license so as to sell the intellectual property through bankruptcy to Sunbeam (which did not want to take the IP subject to a license).

The Seventh Circuit deemed Section 365(n) inapplicable and came to a different conclusion than Lubrizol on the effects of rejection under Section 365 generally. The court of appeals concluded that the exclusion of trademarks from the Codes definition of Intellectual Property was just an omission. While a deliberate exclusion, it did not follow that Congress legislated that licensees could not use marks when a bankrupt licensor rejects the license. Instead, the exclusion simply meant that Section 365(n) does not apply and the court must decide whether to follow the Fourth Circuits rule in Lubrizol. Lubrizol, Easterbrook concluded, does not persuade us. The Seventh Circuit looked to Section 365(a) and (g) of the Code, noted that rejection constitutes a breach by the licensor for which damages may be sought, not termination, and stated (without citation to any authority) that outside of bankruptcy a licensors breach does not terminate the license. (The licensee could cover to mitigate its damages, for example, and continue to use the IP). From this the court of appeals concluded that Lubrizol wrongly concluded that rejection cut off the licensees rights to the IP.

Sunbeam represents one solution to a rare but serious problem. The implications are unclear. Two courts of appeal facing the same situation now have reached opposite conclusions. What results will obtain in other jurisdictions remain to be seen. Licensees in the Seventh Circuit apparently have more breathing room today, but in the Fourth Circuit (which includes Virginia) Lubrizol presumably remains good law. Since the reasoning of Sunbeam did not rely at all on Section 365(n), it raises the possibility that, at least within the Seventh Circuit, Section 365(n) was and is unnecessary. Since Sunbeam appears to permit the licensee unrestricted exploitation of its licensed rights (while allowing the bankrupt licensor to avoid other obligations of its agreement), the question arises of whether the restrictions on continued use in Section 365(n) continue to apply to non-trademark licensees. If so, the curious result obtains that trademark licensees can use their licensed mark without restriction while technology licensees are subject to the statutory limits of Section 365(n).

The split in authority also forces the question of which course is more sound. Judge Easterbrook is a wonderful writer, with a way of making his logic seem inexorable. Yet, while the Lubrizol rule is both suspect and indisputably harsh, Sunbeams approach is not clearly more cogent. Sunbeam does not squarely confront the question of why a licensors allowing ongoing use of its IP is not a form of performance that it is entitled to avoid pursuant to rejection. In particular, a trademark license is more than a one-time grant: the licensor has an ongoing obligation, for its own benefit as well as its licensees, to monitor and enforce the quality of goods and services sold under the mark. This is why Congress thought trademarks required further study. If a bankrupt trademark licensor is freed of this ongoing obligation, unless an early sale of the IP with the license is arranged, continued use by an exclusive licensee might amount to more or less a conveyance of the mark for no value, a result inconsistent with the goals of bankruptcy. In the context of a nonexclusive trademark license, continued use by multiple licensees without any quality control arguably results in abandonment of the mark, to the possible detriment of the bankrupt licensor, its creditors and even its licensees. No doubt such issues will be sorted out in future decisions.

Christopher Mugel practices intellectual property law from Kaufman & Canoles Richmond, Virginia office. He spoke on how IP licensors and licensees can deal with the risks of bankruptcy at the 2009 annual meeting of the AIPLA. --Christopher Mugel