Court Rules That Trademark Licensees Are Protected by Section 365(n) and That Licensees’ Rights Cannot Be Extinguished by Sale Free and Clear Absent Consent

Protections added to the Bankruptcy Code in 1988 that give some intellectual property ("IP") licensees the right to continued use of licensed property notwithstanding rejection of the underlying license agreement do not expressly apply to trademark licenses. As a consequence, a trademark licensee faces a great deal of uncertainty concerning its ability to continue using a licensed trademark if the licensor files for bankruptcy. This uncertainty has been compounded by inconsistent court rulings addressing the ramifications of rejection of an executory trademark license by a chapter 11 debtor-in-possession ("DIP") or a bankruptcy trustee.

In a positive development for trademark licensees, a New Jersey bankruptcy court ruled in In re Crumbs Bake Shop, Inc., 2014 BL 309030 (Bankr. D.N.J. Oct. 31, 2014), that trademark licensees are entitled to the protections of section 365(n) of the Bankruptcy Code, notwithstanding the omission of "trademarks" from the Bankruptcy Code definition of "intellectual property." The court also held that a sale of assets "free and clear" under section 363(f) does not trump or extinguish the rights of a third-party licensee under section 365(n), unless the licensee consents.

Special Rules Governing Rejection of Certain IP Licenses in Bankruptcy

Absent special statutory protection, the rejection by a DIP or trustee of an IP license, particularly a license of IP that is critical to a licensee's business operations, could have a severe impact on the licensee's business and leave the licensee scrambling to procure other IP to keep its business afloat. This concern was heightened by the Fourth Circuit's ruling in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), that if a debtor rejects an executory IP license, the licensee loses the right to use any licensed copyrights, trademarks, and patents.

In order to better protect such licensees, Congress amended the Bankruptcy Code in 1988 to add section 365(n). Under section 365(n), licensees of some (but not all) IP licenses have two options when a DIP or trustee rejects the license. The licensee may either: (i) treat the agreement as terminated and assert a claim for damages; or (ii) retain the right to use the licensed IP for the duration of the license (with certain limitations). By adding section 365(n), Congress intended to make clear that the rights of an IP licensee to use licensed property cannot be unilaterally cut off as a result of the rejection of the license.

However, notwithstanding the addition of section 365(n) to the Bankruptcy Code, the legacy of Lubrizol endures—since by its terms, section 365(n) does not apply to trademark licenses and other kinds of "intellectual property" outside the Bankruptcy Code's definition of the term. In particular, trademarks, trade names, and service marks are not included in the definition of "intellectual property" under section 101(35A) of the Bankruptcy Code. Due to this omission, courts continue to struggle when determining the proper treatment of trademark licenses in bankruptcy.

Circuit Courts Weigh In on Trademark Licenses After Lubrizol

Several federal courts of appeal have had the opportunity during the last few years to weigh in on how rejection in bankruptcy of a trademark license impacts the rights of the nondebtor licensee.

For example, in In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010), a Third Circuit panel could have considered but sidestepped the issue, concluding that a trademark license agreement was not executory because the nondebtor licensee had materially completed its performance under the agreement prior to the debtor's bankruptcy filing. Thus, the court held that the agreement could not be assumed or rejected at all. As a consequence, the Third Circuit never addressed whether rejection of the agreement (had it been found to be executory) would have terminated the licensee's right to use the debtor's trademarks.

However, in a separate concurring opinion, circuit judge Thomas L. Ambro took issue with the bankruptcy court's conclusion that rejection of a trademark license agreement necessarily terminates the licensee's right to use the debtor's trademark. Congress's decision to leave treatment of trademark licenses to the courts, Judge Ambro argued, signals nothing more than Congress's inability, at the time it enacted section 365(n), to devote enough time to consideration of trademarks in the bankruptcy context; no negative inference should be drawn by the failure to include trademarks in the Bankruptcy Code's definition of "intellectual property." The judge wrote that "it is simply more freight than negative inference will bear to read rejection of a trademark license to effect the same result as termination of that license."

In Sunbeam Prods., Inc. v. Chicago Am. Manuf., LLC, 686 F.3d 372 (7th Cir. 2012), cert. denied, 133 S. Ct. 790 (2012), the Seventh Circuit held as a matter of first impression that when a trademark license is rejected in bankruptcy, the licensee does not lose the ability to use the licensed IP. In so ruling, the Seventh Circuit expressly rejected Lubrizol. The Seventh Circuit reasoned that lawmakers' failure to include trademark licenses within the ambit of section 365(n) should not be viewed as an endorsement of any particular approach regarding rejection of a trademark license agreement, observing that "an omission is just an omission."

Skirting the issue of the effect of rejection of a trademark license agreement, the Eighth Circuit (in a decision similar to the Third Circuit's holding in Exide Technologies) ruled in Lewis Bros. Bakeries, Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 751 F.3d 955 (8th Cir. 2014), that a license agreement was not executory and thus could not be assumed or rejected because the license was part of a larger, integrated agreement which had been substantially performed by the debtor prior to filing for bankruptcy. In a footnote, the Eighth Circuit remarked that "[b]ecause the agreement is not executory, we need not address whether rejection of a trademark-licensing agreement terminates the licensee's rights to use the trademark."

Free and Clear Bankruptcy Sales

Section 363(f) of the Bankruptcy Code authorizes a trustee to sell property "free and clear of any interest in such property of an entity other than the estate" under any one of five specified conditions. These include, among other things, if the holder of the interest consents, if applicable nonbankruptcy law permits a sale free and clear, if the sale price exceeds the aggregate value of all liens encumbering the property, or if the interest is in bona fide dispute.

Section 363(f) does not define "interest." Although generally acknowledged to encompass liens and security interests, the term would appear to be much broader, taking into account both the language of the provision and its underlying purpose. Broadly applied, however, section 363(f) arguably conflicts with certain other provisions of the Bankruptcy Code.

One of those provisions is section 365(h)(1). Section 365(h)(1) provides that, if the trustee rejects an executory real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign) has the option to retain its rights under the lease for the balance of the lease term. Courts disagree as to whether the rights of a lessee or sublessee under section 365(h)(1) are effectively extinguished if the leased real property (or the lease itself) is sold free and clear of any "interest" under section 363(f). Compare Precision Industries, Inc. v. Qualitech Steel SBQ, 327 F.3d 537 (7th Cir. 2003) (sale free and clear extinguishes nondebtor lessee's leasehold interest), and In re Spanish Peaks Holdings II, LLC, 2014 BL 64226 (Bankr. D. Mont. Mar. 10, 2014) (same), with Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014) (section 363(f) sale cannot extinguish nondebtor lessee's rights under section 365(h)(1)), and In re Zota Petroleums, LLC, 482 B.R. 154 (Bankr. E.D. Va. 2012) (same).

In Zota Petroleums, for example, the court explained that the rationale underlying decisions prohibiting the extinguishment of a nondebtor sublessee's section 365(h) rights through a section 363 sale "has been based in part upon the statutory construction principle that the more specific provision should prevail over the general." Id. at 161. According to this reasoning, because Congress decided that lessees should have the option under section 365(h)(1) to remain in possession, "it would make little sense to permit a general provision, such as Section 363(f), to override its purpose," which, according to the legislative history of section 365(h), is to protect the rights of a debtor's tenants. Id. at 162.

Finding limited guidance on point, the court in Crumbs Bake Shop applied the Zota Petroleums court's reasoning in examining the interplay between sections 363(f) and 365(h) in a different context—whether a sale free and clear under section 363(f) can extinguish a nondebtor IP licensee's rights under section 365(n).

Crumbs Bake Shop

Crumbs Bake Shop, Inc. ("Crumbs"), a specialty retailer of baked goods and beverages, sold its wares through retail stores, an e-commerce division, catering services, and a wholesale distribution business. In addition, Crumbs entered into licensing agreements with third parties that allowed the licensees to use the Crumbs trademark and trade secrets and to sell products under the Crumbs brand. To maximize licensing revenues, Crumbs entered into an agreement with Brand2 Squared Licensing ("BSL") under which BSL, on Crumbs' behalf, procured license agreements (the "License Agreements") with various licensees (collectively, the "Licensees").

Crumbs ceased operating on July 7, 2014. The company filed for chapter 11 protection in the District of New Jersey on July 11, 2014. Three days afterward, Crumbs sought court authority to sell substantially all of its assets free and clear of liens, claims, and encumbrances to secured creditor Lemonis Fischer Acquisition Company, LLC ("LFAC") in accordance with the terms of an asset purchase agreement under which LFAC proposed to credit bid its claims. After no alternative bidder submitted a competing offer, the bankruptcy court approved the sale transaction.

Crumbs then filed a motion to reject certain executory contracts and unexpired leases, including the License Agreements. BSL submitted a response in which it asserted that the Licensees were entitled to the protections of section 365(n) and that, if the Licensees were to elect to continue using the licensed property, Crumbs was entitled to royalties under the License Agreements.

The Bankruptcy Court's Ruling

Trademark License Agreements Are Covered by Section 365(n)

The bankruptcy court ruled that the "protective scope" of section 365(n) extended to the License Agreements even though trademarks are not explicitly included in the Bankruptcy Code's definition of "intellectual property." Characterizing Lubrizol as "discredited" (and in any case nonbinding), the court agreed with circuit judge Ambro's reasoning in his concurring opinion in Exide Technologies. According to the Crumbs Bake Shop court, "reasoning by negative inference" that the omission of trademarks from the definition of IP indicates that Congress intended Lubrizol to control when a debtor rejects a trademark license "is improper in the context of trademark licenses."

For support, the bankruptcy court cited to the legislative history of section 365(n), which states in relevant part, "[Since] trademark, trade name and service mark licensing relationships . . . could not be addressed without more extensive study, it was determined to postpone congressional action in this area and to allow the development of equitable treatment of this situation by bankruptcy courts." S. Rep. No. 100-505, at 5 (1988) (emphasis added). Like Judge Ambro in Exide Technologies, the Crumbs Bake Shop court concluded that Congress intended the bankruptcy courts to exercise their equitable powers to decide, on a case-by-case basis, whether trademark licensees are entitled to the protections of section 365(n).

The court concluded that it would be inequitable to strip the Licensees of their rights under the License Agreements in the event of rejection, "as those rights had been bargained away" by Crumbs. The court rejected LFAC's arguments that: (i) equitable considerations should not apply in cases where, as here, the debtor sells its assets to a bona fide purchaser; (ii) if, upon rejection of the License Agreements, the Licensees were to elect under section 365(n) to continue using the trademarks, "LFAC would be placed in a licensor-licensee arrangement that it never intended to assume"; and (iii) allowing the Licensees to make such an election would leave LFAC with little ability to control the quality of products or services, a notably important aspect of trademark licensing.

According to the court, "While some courts have suggested that § 365(n) rights of third parties should succumb to the interests of maximizing the bankruptcy estate in liquidation contexts, this Court finds no basis for such a distinction." The court wrote, "It is questionable that Congress intended to sacrifice the rights of licensees for the benefit of the lending community." The court further emphasized that LFAC entered into the sale transaction "with eyes wide-open, after engaging in due diligence, and can adjust [its] purchase price to account for such existing License Agreements." Finally, the court explained that "there are protections in place, outside of bankruptcy, that give rise to the incentive for Licensees to maintain a certain standard of quality in using the licensor's trademark."

The bankruptcy court took judicial notice of a bill recently passed by the U.S. House of Representatives (Innovation Act of 2013, H.R. 3309, 113th Cong. (2013)) that would add trademarks to the definition of IP in section 101(35A) of the Bankruptcy Code and add language to section 365(n) providing that "in the case of a trademark . . . the trustee shall not be relieved of a contractual obligation to monitor and control the quality of a licensed product or service." Although not dispositive to its decision, the court noted, the fact that the legislation is pending "suggests that Congress is aware of the prejudice to trademark licensees from the approach espoused by LFAC, and is attempting to remedy the omission of ‘trademarks' from its definition of ‘intellectual property.' "

Sale Free and Clear Does Not Extinguish Licensee's Rights Under Section 365(n)

The bankruptcy court ruled that the interests of the Licensees in the licensed trademarks were not extinguished by the sale free and clear to LFAC because "in the absence of consent, a sale under § 363(f) does not trump the rights granted to Licensees by § 365(n)."

The court rejected LFAC's argument that the Licensees impliedly consented to the vitiation of their section 365(n) rights by failing to object to the sale motion. According to the court, because it was not clear exactly what was being sold pursuant to the asset purchase agreement, and because the sale motion pleadings said nothing about the impact the sale would have on the rights of the Licensees, the Licensees "had no apparent reason to believe that an objection would be necessary in order to retain their rights under § 365(n)." In fact, the court posited, "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."

The court adopted the reasoning articulated in Zota Petroleums and other decisions interpreting the apparent conflict between sections 363(f) and 365(h), concluding that "the general provision of § 363(f) does not wipe away the rights granted to Licensees by § 365(n)." It accordingly ruled that, because the Licensees did not consent to the sale of the trademarks free and clear of their interests (and no alternative condition allowing a sale free and clear under section 363(f) was satisfied), the sale to LFAC did not extinguish the Licensee's rights under section 365(n).

Outlook

Crumbs Bake Shop is undeniably a positive development for entities that license trademarks from financially troubled licensors which may end up filing for bankruptcy. Even so, because other courts have ruled to the contrary, nondebtor licensees still face a great deal of uncertainty concerning their ability to continue to use licensed trademarks in the event that the debtor-licensor rejects the license in bankruptcy or sells the trademarks in a sale free and clear under section 363(f).

On an encouraging note for trademark licensees, among the recommendations in a long-anticipated report issued on December 8, 2014, by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 are proposals that: (i) U.S. trademarks, service marks, and trade names, as well as foreign patents, copyrights, and trademarks, should be included within the Bankruptcy Code's definition of IP and therefore entitled to the protections set forth in section 365(n), with certain modifications, in the event that a license of such IP is rejected; and (ii) the sale of a debtor's assets free and clear of executory contracts and unexpired leases should be governed by section 365. Under the Commission's proposal, a sale free and clear of an executory contract or unexpired lease would be permitted only if the contract or lease is rejected in accordance with section 365 and the trustee is permitted by section 365 to recover the property free and clear of the nondebtor's right to use or possess such property. Accordingly, a free and clear sale order under section 363(f) could not trump the rights of a third-party licensee under section 365(n), absent the licensee's consent. It remains to be seen whether lawmakers will act on these recommendations.