Restructuring

Article Contributed by Christopher Linden
Section 365(n) of the Bankruptcy Code affords special protection to a licensee of intellectual property when a debtor-licensor rejects its licensing agreement pursuant to section 365(a) of the Bankruptcy Code.  Essentially, section 365(n) allows a licensee of intellectual property to retain its rights under the license post-rejection, if it so elects and continues to perform its obligations under the license (e.g., royalty payments).  Congress added section 365(n) to the Bankruptcy Code in 1988 to assuage licensee concerns stemming from the Fourth Circuit’s Lubrizol decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. which permitted a debtor-licensor to reject an intellectual property licensing agreement.  The Lubrizol decision made clear that pursuant to section 365(g) of the Bankruptcy Code, the licensee could only seek monetary damages as a result of the debtor-licensor’s breach resulting from rejection; i.e., the licensee had no right to retain its rights under the license through the remedy of specific performance.  Lubrizol’s practical result, and what kept the licensee community up at night, was that the debtor-licensor’s rejection stripped the licensee of the right to use the licensed intellectual property going forward.  Put another way, Lubrizol was most troubling not for its holding that the licensing agreement could be rejected, but the effect of such rejection.
More than 25 years after Lubrizol the Seventh Circuit, in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, No. 11-3920, 2012 WL 2687939 (7th Cir. July 9, 2012), has rejected Lubrizol’s holding regarding the effect of rejection on a licensee’s rights to use the licensed intellectual property going forward.  The debtor-licensor in Sunbeam licensed certain patents and trademarks relating to the manufacture of box fans as part of a manufacture and supply agreement with the licensee.  The agreement authorized the licensee to manufacture and sell box fans using the licensor’s patents and bearing licensor’s trademarks.  Three months into the agreement, the debtor-licensor was pushed into bankruptcy by several of its creditors and a trustee was appointed to administer the estate.  The trustee moved quickly to liquidate the estate and began selling the debtor’s inventory.  Around the same time, the trustee also rejected the supply agreement because of concerns that the continued sale of the fans by the licensee might hurt the debtor’s brand and/or confuse the marketplace.  Despite the rejection of the supply agreement, the licensee continued to sell box fans bearing the licensor’s trademarks and the trustee was forced to initiate an adversary proceeding to enforce the estate’s rights.
Realizing that a piecemeal liquidation of the estate was impractical (especially in light of the licensee’s continued use of the intellectual property), the trustee decided to sell at auction substantially all of the estate assets.  After a traditional auction process, which included a stalking horse bidder and two other potential purchasers, the assets (including the trademarks and patents) were sold to the highest bidder.  The purchaser, having no interest in allowing the licensee to continue producing box fans bearing the trademarks it had just acquired, joined the adversary proceeding initiated by the trustee earlier in the case.  The bankruptcy court held a six-day trial in the adversary proceeding, ultimately determining that the licensee could continue using the debtor-licensor’s trademarks and patents despite the rejection of the supply agreement.  Sunbeam Prods., Inc. v. Chi. Mfg..  The bankruptcy court reasoned that section 365(n) required it to allow the licensee to continue using the debtor’s patents.  Although it recognized that trademarks are not expressly included in the definition of “intellectual property” in section 101(35A) of the Bankruptcy Code, and thus not protected by section 365(n), the bankruptcy court nevertheless held that equity required it to permit the licensee to continue using the debtor’s trademarks.  The purchaser appealed the bankruptcy court’s decision directly to the circuit court.
The Seventh Circuit agreed with the bankruptcy court’s holding that the licensee’s right to use the debtor’s patents was protected by section 365(n).  The court, however, disagreed with the bankruptcy court’s decision respecting the trademarks, finding that “[w]hat the Bankruptcy Code provides, a judge cannot override by declaring that enforcement would be inequitable.”  Despite this disagreement, the Seventh Circuit affirmed the lower court’s decision on different grounds, i.e., that pursuant to section 365(g) of the Bankruptcy Code, rejection of the supply agreement had no effect on the licensee’s right to use the trademarks going forward.  After explaining that the “limited definition in section 101(35A) means that section 365(n) does not affect trademarks one way or the other,” Chief Judge Easterbrook framed the issue as “whether Lubrizol correctly understood [section] 365(g), which specifies the consequences of a rejection under [section] 365(a).”
Noting that no other circuit has agreed or disagreed with Lubrizol on this point, the court began its analysis by explaining that rejection pursuant to section 365(a) of the Bankruptcy Code merely constitutes a breach of the underlying agreement.  A breach outside of bankruptcy, the court noted, does not terminate the licensee’s right to use intellectual property.  As a result, “[w]hat § 365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party’s rights remain in place.”  The only right of the counterparty abrogated as a result of rejection is the right to require performance from the debtor; in place of such performance, the counterparty must settle for a monetary award.  The court emphasized that nothing in section 365(g) suggests that rejection “vaporize[s]” the counterparty’s rights.  Such a result would be to confuse rejection with rescission.  Quoting an Eleventh Circuit decision, Thompkins v. Lil Joe Records, Inc., the court concluded that rejection “‘merely frees the estate from the obligation to perform’ and ‘has absolutely no effect on the contract’s continued existence.’”
One thing is clear from the Sunbeam decision: trademark licensees in the Seventh Circuit should be less concerned about not being afforded section 365(n) protection.  Following the Third Circuit’s decision in In re Exide Technologies, the protection of the rights of trademark licensees in a licensor’s bankruptcy seems to be gathering momentum.  The Sunbeam decision, however, also raises a statutory issue: what is the purpose of section 365(n) if a debtor-licensor’s rejection of an intellectual property license has no effect on the licensee’s ability to use the licensed property?  Isn’t that the reason the provision was added to the Bankruptcy Code in the first place?
Of course, one thing section 365(n) makes clear is the extent to which the debtor is freed from its obligation to perform following rejection of an intellectual property license.  If the licensee elects to retain its license rights (as opposed to assert a damages claim), then the only obligation the debtor retains is to respect the exclusivity provisions of the license.  Will the debtor (or its successors) still be required to respect exclusivity provisions under a theory in which the estate is freed from any obligation to perform?  Moreover, while Sunbeam is undoubtedly helpful to trademark licensees and other contract counterparties that might seek to retain rights under a rejected contract, the parameters of what types of rights may be retained remains to be seen.  One thing that is clear, though, is that the Seventh Circuit once again has issued a thought-provoking opinion that very well may change not only how courts address trademark licenses in chapter 11, but also how counterparties under other types of rejected contracts seek to enforce their rights.