Protecting intellectual property rights is a top priority among businesses throughout the world. When intellectual property rights stem from a financially weak counterparty, it becomes substantially more difficult to protect those rights. For years, trademark licensees have faced the prospect of losing their intellectual property rights if their licensor filed for federal bankruptcy protection. At least in one circuit, however, the tide has shifted. In Sunbeam Products v. Chicago American Manufacturing , 2012 U.S. App. LEXIS 13883 (7th Cir. Jul. 9, 2012), the U.S. Court of Appeals for the Seventh Circuit recently held that rejection of a trademark license agreement simply constitutes a contract breach occurring at the time immediately prior to bankruptcy. As a result, the nondebtor’s rights under the contract do not “vaporize,” but rather remain as they would have under the contract and applicable nonbankruptcy law. In so ruling, the Sunbeam decision runs directly contrary to the Fourth Circuit’s decision in Lubrizol Enterprises v. Richmond Metal Finishers , 756 F.2d 1043 (4th Cir. 1985), as it relates to trademarks.

In Lubrizol , the Fourth Circuit held that a nondebtor licensee’s intellectual property rights terminate upon rejection of the technology licensing agreement. The issue in Lubrizol was whether the Bankruptcy Code allowed the debtor licensor to reject an executory technology licensing agreement, and subsequently whether that rejection terminated the licensee’s right to use the technology. The court found that it was an exercise of sound business judgment for the debtor to reject the contract because the debtor’s continued obligations to the licensee, Lubrizol Enterprises, would hinder its prospective ability to sell or license the technology under more advantageous terms to other licensees. The court reasoned that the debtor’s rejection was to be treated by Lubrizol as a breach of contract and could seek money damages. It could not, however, retain its technology rights through a demand for specific performance, even if specific performance ordinarily would have been available upon breach of the contract. The court also reasoned that entitling Lubrizol to continue using the technology would undercut the purpose of rejection, which is to allow a debtor to avoid contracts when such obligations place too great a burden on the estate.

Lubrizol represented a devastating precedent for intellectual property licensees. Congress partially fixed the problem by subsequently enacting 11 U.S.C. §365(n), which offers licensees the option to continue using the intellectual property, despite the debtor’s rejection of the underlying license agreement. The wrinkle, however, is that when Congress defined “intellectual property” in Section 101(35A) of the Bankruptcy Code, it excluded trademarks. After Lubrizol and the enactment of Section 365(n), whether a licensee had the right to use a trademark subject to a rejected license agreement remained an unanswered question.

In Sunbeam , Lakewood Engineering & Manufacturing Co. contracted with Chicago American Manufacturing (CAM) to manufacture consumer fans for Lakewood. As part of the deal, Lakewood licensed to CAM its patents and trademarks. Instead of prepaying CAM for the production costs, Lakewood assured CAM that should Lakewood not purchase the fans back from CAM, CAM would be authorized to sell the products with Lakewood’s mark. Before Lakewood purchased the fans, however, its creditors filed an involuntary bankruptcy petition against it, according to the opinion. The bankruptcy trustee sold Lakewood’s business, including its intellectual property rights, to Sunbeam Products. Sunbeam declined to purchase the Lakewood inventory from CAM, and objected to CAM’s sale of the fans with the trademark that Sunbeam now owned.

11 U.S.C. §365(a) authorizes a trustee, upon court approval, to assume or reject executory contracts held by the debtor. An executory contract, as referred to in the code, is one in which neither party has substantially performed and the failure of either one of the parties to complete its obligations would constitute a material breach and excuse the nonbreaching party’s performance. Because neither CAM nor Lakewood had substantially performed, the trustee was authorized to reject the contract. The trustee did so in an effort to invalidate CAM’s license of the Lakewood mark. When CAM continued to manufacture and sell Lakewood-branded fans in spite of the rejection, Sunbeam filed an adversary proceeding against CAM, according to the opinion.

Although finding CAM entitled to continue manufacturing the fans through the selling season, the bankruptcy court did not decide whether the trustee’s rejection terminated CAM’s right to use the trademark. Rather, the court resolved the issue on equitable grounds by permitting CAM to continue selling fans adorned with the Lakewood mark because it had already invested significantly in producing them.

The bankruptcy court decision was certified for direct appeal. Although the Seventh Circuit affirmed the lower court decision, it criticized its underlying reasoning. The fact that the licensee had invested significantly in the finished product had no bearing on the Seventh Circuit’s decision. Chief Judge Frank Easterbrook noted that the Bankruptcy Code cannot be superseded by one judge’s subjective views of equity. When determining rights, there is little room for public policy to displace the Bankruptcy Code. Sunbeam communicates the message that bankruptcy court judges should avoid deciding and justifying decisions on public policy grounds and equitable considerations when such decisions violate the statutory language of the Bankruptcy Code. Either the rejection of the contract terminated CAM’s license rights or it didn’t; the fact that CAM would lose a substantial investment if its rights were terminated was irrelevant.

Grounding its decision upon statutory rather than equitable considerations, the Seventh Circuit determined that the rejection of a trademark licensing agreement itself does not discontinue the licensee’s right to use the trademark. The court pointed out that 11 U.S.C. §365(g) clarifies the effects of a contract rejected under §365(a): the rejection constitutes a breach of that contract. While the trustee attempted to nullify CAM’s trademark license, the act of rejecting the underlying contractual provisions did nothing of the sort. The code treated the contract rejection as if Lakewood had breached its contract with CAM immediately prior to the bankruptcy filing. CAM could have viewed Lakewood’s nonperformance as a substantial breach and sued for damages, or could have continued to market the Lakewood-marked products and mitigated its damages. Either way, CAM preserved its right to market its products with the Lakewood mark. The trustee’s rejection — which was nothing more than a court-sanctioned breach of the contract — failed to alter or “vaporize” that right.

Post-Section 365(n), an intellectual property licensee (other than a trademark licensee) faced with a rejected executory contract is permitted to either treat the rejection as if it terminated the corresponding license or affirm its license and continue asserting its property rights. According to the Seventh Circuit, the legislative history behind §365(n) signified that Congress sought neither to codify nor reject the Lubrizol holding as it related to trademarks.

Trademark licensees, at least in the Seventh Circuit, can breathe a bit easier, especially in times of financial instability, according to Sunbeam . In the event that one’s licensor winds up bankrupt and the underlying contract is rejected, intellectual property rights are not automatically destroyed. For licensees who have based their entire business model around products bearing a licensed trademark, the Sunbeam decision is welcome news and a positive step toward securing investment-backed expectations.

Although the Bankruptcy Code permits debtors to reject burdensome contracts that may prevent the debtor from successfully reorganizing, Sunbeam weakens a debtor licensor’s ability to cancel licensing agreements and terminate the licensee’s rights in the hopes of capitalizing on a more profitable licensing venture. For licensors contemplating bankruptcy, the fact that one might not be able to nullify current trademark licenses may affect the approach to reorganization and the selling of one’s assets, as well as the decision of whether to file bankruptcy itself. With the knowledge that a potential licensee may be able to preserve its trademark rights notwithstanding a licensor’s bankruptcy filing, parties may be more willing to consider negotiating with trademark owners holding less than perfect financial portfolios.

Going forward, other circuits faced with this issue may follow the same views as expressed by the Sunbeam court, particularly in light of the barrage of criticism focused toward Lubrizol (as noted in the Sunbeam opinion). It may also be time for either Congress or the Supreme Court to resolve the circuit split, given the need for uniformity and predictability when adjudicating intellectual property rights in bankruptcy proceedings nationwide. •

Francis J. Lawall , a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice in national bankruptcy and reorganization matters. He routinely lectures to various creditor groups concerning general bankruptcy issues, including preferences, reclamation, the role of creditors committees and related issues.

Lesley S. Welwarth is an associate in the firm’s Detriot office, where she concentrates her practice in national bankruptcy and reorganization matters.