A recent Bankruptcy Court decision in New Jersey took an unusual approach in determining  the rights of the debtors’ trademark licensees following the debtors’ rejection of the licenses as executory contracts. In In re Crumbs Bake Shop, Inc., Case No. 14-24287 (10/31/14), Judge Michael Kaplan held that the debtors’ licensees were protected by Section 365(n) of the Bankruptcy Code and could continue to use the licensed marks notwithstanding the rejection, even though that section  – which expressly protects licensees of other types of intellectual property —  makes no mention of trademarks. The decision has been appealed to the Third Circuit. If affirmed, the holding would diverge from the Fourth and Seventh Circuit’s approaches to the same issue and could lead to either a Supreme Court review or legislative action by Congress.

Debtors sold baked goods through a chain of retail shops. Through a licensing agent, the debtors licensed certain of their trademarks and trade secrets to six different licensees. Debtors filed bankruptcy in July 2014.  In August, the Court approved the sale of substantially all of the debtors’ assets to Lemonis Fischer Acquisition Company LLC (the “Buyer”), free and clear of liens and other encumbrances, pursuant to Section 363(f) of the Bankruptcy Code. Following the sale, the Buyer moved to reject the trademark license agreements. In response, the licensing agent asserted that the licensees could elect to retain their rights under Section 365(n).

This subsection was added to the Bankruptcy Code in 1988 with the express purpose of overruling Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985). Lubrizol had held that when any intellectual property license is rejected in bankruptcy, the license is terminated and the licensee loses the ability to exercise the right granted by the license. Section 365(n) permits a licensee of “intellectual property” to continue exercising its rights notwithstanding the rejection of the license contract by the trustee for a debtor licensor.

The subsection’s definition of  “intellectual property” includes patents,  copyrights and trade secrets, but does not include trademarks. This was intentional. As noted in the legislative history, trademark licensing relationships – unlike licenses for patents or copyrights — “depend to a large extent on control of the quality of the products or services sold by the licensee.”[1] There were concerns about whether debtor-licensors would have the means or incentive to exercise this function, as well as a reluctance to impose any additional obligations on trustees. “Since these matters could not be addressed without more extensive study,” said the Senate Report,  “it was determined to postpone congressional action in this area and to allow the development of equitable treatment of this situation by bankruptcy courts.”

Since then, courts have treated debtors’ rejections of trademark licenses in a variety of ways. In most cases, the licensee’s rights are simply extinguished. See, e.g., In re Global Holdings, Inc.,  290 B.R. 507, 513 (Bankr. Del. 2003). In some exceptional cases, licensees were able to obtain relief by showing that their businesses would be virtually destroyed and/or that rejection would be of little benefit to the state and the creditors.

The Seventh Circuit took an entirely different approach in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC 686 F.3d 372 (7th Cir. 2012). Sunbeam held that that because Section 365(g) characterizes the rejection of an executory contract as a breach — not a rescission voiding the contract — “nothing about this process implies that any rights of the other contracting party have been vaporized.” The rejection “merely frees the estate from the obligation to perform” but has no effect on the contract’s continued existence. Therefore, the Seventh Circuit’s position is that, even without the protection afforded by Section 365(n), a trademark licensee retains its rights to use the licensed mark notwithstanding the rejection of the license by the debtor licensor.

In Crumbs, Judge Levine followed the reasoning previously articulated by Judge Ambro’s concurrence in In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010). He agrees with Judge Ambro (as well as the Seventh Circuit)  that the mere absence of “trademarks” from the list of intellectual property in Section 365(n) does not prohibit a judge from granting “equitable treatment” to trademark licensees, as envisioned by the legislative history. Judge Levine went on to hold that “it would be inequitable to strip the within Licensees of their rights in the event of a rejection, as those rights had been bargained away by Debtors.”

The Buyer argued that these equitable considerations are irrelevant where, as here, the debtors sold their assets, to a bona fide purchaser, under Section 363(f). Judge Levine disagreed. He saw no reason to augment the already considerable benefit of allowing bankruptcy estates to assume or reject executory contracts at the expense of third parties. Noting that monetary recoveries in Chapter 11 cases primarily benefit pre- and post-petition lenders and administrative claimants rather than unsecured creditors, he held that “[i]t is questionable that Congress intended to sacrifice the rights of licensees for the benefit of the lending community.”

The Court also rejected Buyer’s argument that, because the licensees failed to object to the sale, the asset sale under Section 363(f)  was a free and clear conveyance of the trademark rights, unencumbered by the licenses. It held that, in the absence of consent, a Section 363(f) sale does not trump the Section 365(n) rights owned by the licensees. The failure to object in this case was not an implicit consent in this case, said the Court, because the sale of IP rights in the Asset Purchase Agreement was so convoluted and impenetrable that the licensees had no reasonable notice. The court posited “that the content of the Sale Motion was a calculated effort to camouflage the intent to treat the License Agreements as vitiated without raising the specter of §365(n) rights. Thus, it would be inequitable for this Court to find that the Licensees consented to termination of their rights.”

Judge Levine glossed over the Buyer’s concerns that it would have little ability to control the quality of products or services sold by licensees, as the law of trademark licensing demands. It cited only to a law review article which discussed the licensees’ incentive to maintain quality, and to a pending bill in the House of Representatives which would add “trademarks” to Section 365(n) and also provide that bankruptcy trustees must not be relieved of any contractual obligation to monitor and control quality.

The shotgun marriage of the Buyer and the licensees is made even more awkward by the Court’s holding that, since the license agreements were excluded from the asset sale, post-closing royalties generated by the licensees are owed to the Debtors, not the Buyer. In support of this holding, the Court cited In re Cellnet Data Sys., Inc., 327 F.3d 242 (3d Cir. 2003), which reached the same result. But CellNet involved patent licenses, which require no ongoing business relationship between licensor and licensee. It is anomalous, to say the least, to have one party be responsible for quality control while another party collects the royalties. That said, the Buyer will have a motive to undertake this obligation, since its failure to do so would threaten the validity of the trademarks themselves – assets the Buyer paid for and presumable wishes to preserve.

The Buyer has filed a notice of appeal to the Third Circuit. If the decision is affirmed, the Third Circuit would join the Seventh in holding that the exclusion of “trademarks” from the definition of intellectual property in Section 365(n) does not, by “negative inference,” preclude a court from granting protection to licensees under that subsection. A reversal, however, would put the circuits in conflict. While this decision should give some comfort to trademark licensees of debtor companies, their status will remain highly uncertain so long as the statute is silent. Ideally, Congress will finally clarify the statute and finish the job it “postponed” 25 years ago.

[1] Senate Report No. 100-505, 100th Cong., 2d Sess. (Sept. 14, 1988)