The recent decision of the U.S. Court of Appeals for the Seventh Circuit in Sunbeam Products v. Chicago American Manufacturing, 2012 U.S. App. LEXIS 13883 (7th Cir. filed July 9, 2012), has engendered much attention by holding that a licensee of a rejected trademark license can continue to use the licensed intellectual property. This marks a divergence from the Fourth Circuit’s holding in Lubrizol Enterprises v. Richmond Metal Finishers, 756 F.2d 1043, 1048 (4th Cir. 1985), that rejection of a license agreement by a licensor terminated the licensee’s rights to continue to use intellectual property.

The Lubrizol decision sent shock waves throughout the business community, raising concerns that innovation would be stifled, creating a chilling effect on business development because of the newfound uncertainty surrounding the effects of a bankruptcy on the continued use of licensed technology. This issue was so serious that Congress amended the Bankruptcy Code in 1988 by enacting §365(n) to protect licensees of rejected patent, copyright, and trade secret licenses from Lubrizol‘s effects. In essence, §365(n) explicitly permits a licensee to elect to continue to use licensed intellectual property for the term of the license, notwithstanding rejection, conditioned on, among other things, continued payment of royalties. In enacting §365(n), Congress included a limited definition of intellectual property to the Bankruptcy Code that did not include trademarks.1 This left open the question of how to treat the rejection of a trademark license.

While Lubrizol‘s holding has been widely criticized, many bankruptcy courts nonetheless reasoned that Congress’ exclusion of trademark licenses from §365(n) evinced an intent that Lubrizol‘s holding must be applied in the trademark context, giving debtors the ability to terminate by rejection a licensee’s rights in a trademark license. Although the Sunbeam decision should be welcomed by trademark licensees, the Seventh Circuit did agree with Lubrizol‘s holding that rejection eliminates the remedy of specific performance. Thus, existing uncertainty surrounding the availability of specific performance remedies in rejected contracts, often addressed in the context of covenants not to compete, may have been compounded. As Sunbeam is only binding authority in the Seventh Circuit, it remains to be seen whether other courts will follow Sunbeam‘s holding. What is clear is that the stage is now set for the U.S. Supreme Court to resolve the split between the Seventh and Fourth circuits and provide certainty to counterparties of rejected licenses.

Factual Background of ‘Sunbeam’

In 2008, Lakewood Engineering and Manufacturing, a consumer products manufacturer, contracted with Chicago American Manufacturing (CAM) to manufacture box fans using patents and trademarks owned by Lakewood. Lakewood would take orders from its customers, and CAM would ship fans directly. Because of Lakewood’s financial distress, the contract authorized CAM to sell fans for its own account if Lakewood did not purchase them. Three months after the contract was signed, Lakewood found itself the subject of bankruptcy proceedings. Sunbeam Products purchased Lakewood’s assets, including the patents and trademarks that had been licensed to CAM. Lakewood’s trustee rejected the CAM contract including the patent and trademark licenses.

Because Sunbeam did not want CAM to sell fans in competition with other products, Sunbeam and the Lakewood Trustee commenced an adversary proceeding seeking to enjoin CAM from continuing to sell fans and damages for trademark infringement, claiming that trademarks were not within the definition of “intellectual property” that can be used under §365(n) of the Bankruptcy Code notwithstanding rejection. Accordingly, the Lakewood Trustee’s rejection resulted in the termination of CAM’s right to use the trademarks it had licensed from Lakewood in accordance with Lubrizol.

Bankruptcy Court Decision

After a lengthy discussion of the factual disputes regarding the scope and length of the license granted to CAM, the Bankruptcy Court turned to the legal effect of the rejection. First, the Bankruptcy Court held §365(n) applied to CAM’s patent license rights that survived rejection. (The court did not address whether the sale of Lakewood’s patents to Sunbeam could have been effectuated “free and clear” of §365(n) rights under §363(f) in a manner similar to a sale of real property free and clear of a tenant’s rights under §365(h) to retain possession notwithstanding rejection. See Precision Industries v. Qualitech Steel SBQ, 327 F.3d 537 (7th Cir. 2003)).

Then the Bankruptcy Court turned to the effect of the license rejection on CAM’s trademark rights. The Bankruptcy Court agreed with prior decisions that §365(n) did not apply to a trademark license. The Bankruptcy Court grappled with Lubrizol, which it believed would compel the inequitable result of CAM losing its substantial investment as a result of a default by Lakewood, not because of any action CAM took. The court therefore declined to “mechanically follow[] the line of cases which state that Lubrizol controls on the effect of rejection of a license to use trademarks.” In re Lakewood Eng’g & Mfg., 459 B.R. 306, 343 (Bankr. N.D. Ill. 2011). The Bankruptcy Court found it had sufficient authority to fashion an appropriate remedy relying on the legislative history to §365(n), which provides that Congress was deferring to bankruptcy courts to address trademark licenses in an equitable manner.

The court also found support for an equitable result that provided protection to CAM in Judge Thomas L. Ambro’s2 concurrence in the case of In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010). In Exide, the debtor moved to reject an integrated agreement containing a trademark license in an effort to regain the trademark for its own use. The Third Circuit reversed the lower court decisions approving the rejection because the agreements were no longer executory and therefore §365 could not be used to recapture the licensed rights. Ambro concurred in the result, but wrote an opinion expressing the commonly held view applied outside of intellectual property licenses that a contract rejection does not result in a termination, but operates as a breach of the contract by the debtor. Further, he stated, it would be inequitable to allow §365 to be utilized to allow a licensor to recapture trademark rights it bargained away, and that the lower court’s error was permitting Exide to “extinguish” the licensee’s rights through rejection.

The Bankruptcy Court in Sunbeam noted that Ambro took pains to distinguish between rejecting a license and rescinding or terminating it. Persuaded by Ambro’s reasoning and relying on Congress’ delegation of authority to the bankruptcy courts in the legislative history of §365(n), the Bankruptcy Court used its equitable powers to “ensure that CAM is not stripped of its “fairly procured trademark rights” by allowing CAM to continue to sell Lakewood box fans to third parties. This decision sets the stage for a conflict with the Fourth Circuit’s Lubrizol decision.

Seventh Circuit Decision

The Bankruptcy Court decision was directly appealed to the Seventh Circuit. The only aspect that remained in dispute on appeal was the Bankruptcy Court’s treatment of the trademark license. The Seventh Circuit began its legal analysis by discussing Lubrizol‘s application to trademark licenses. Noting that no other circuit court has directly addressed the issue, the Seventh Circuit rejected the reasoning employed by some lower courts that this exclusion was a congressional adoption in the trademark context of Lubrizol‘s holding that a licensor’s rejection of a license results in termination of a licensee’s rights, simply stating that “an omission is just an omission.”

While ultimately agreeing with the results of the Bankruptcy Court decision, the circuit court rejected the Bankruptcy Court’s reliance on equitable principles to reach its holding. The Seventh Circuit stated that bankruptcy court decisions should not be predicated solely on notions of equity that could leave rights of parties subject to varying individual views of hundreds of bankruptcy judges, and that decisions in bankruptcy cases must be based on construction of the Bankruptcy Code.

Turning to the substantive issues, the Seventh Circuit explicitly repudiated the Fourth Circuit’s holding in Lubrizol that rejection terminates a licensee’s rights. The court relied on the portions of Bankruptcy Code §365(g) that specify that a rejection “constitutes a breach of such contract,” not a termination. The court emphasized that the rejection process does not rescind a contract or “vaporize” the counterparty’s rights. This is consistent with non-bankruptcy law. Under applicable non-bankruptcy law—here, the Uniform Commercial Code—when there is a breach of a supply contract, the counterparty can elect to treat its obligations as terminated or could cover in the market and bill the breaching party for the additional cost. The circuit court stated that when there is a rejection, unfulfilled obligations are converted to damages, but that the other party’s rights to the contract remain intact.

However, the court did agree with Lubrizol respecting specific performance remedies, stating that “after rejecting a contract, a debtor is not subject to an order of specific performance.” Although the Sunbeam court rejected Lubrizol, its endorsement of Lubrizol‘s conclusion that specific performance was no longer an available remedy is surprising. In fact, in a case outside the executory contract context, the Seventh Circuit reached the opposite conclusion. In re Udell, 18 F.3d 403 (7th Cir. 1993). In Udell, a debtor had entered into a covenant not to compete with his employer. The debtor breached this covenant by working for a competitor and filed a bankruptcy petition. The lower courts held that the debtor’s former employer was not entitled to specific performance of the non-compete covenant because such covenant was a dischargeable “claim” as defined in the Bankruptcy Code.

The Seventh Circuit reversed the lower court, noting that for an obligation to be subject to discharge it must fit within the meaning of a “claim.” Because the Bankruptcy Code definition included only equitable remedies that give rise to a right to payment, and because specific performance was available to the employer under non-bankruptcy law, specific performance rights survived the bankruptcy filing.

The fact that specific performance is available under an executory contract should not affect the result in Udell. In re Walnut Assocs., 145 B.R. 489, 494 (Bankr. E.D. Pa. 1992) (if state law authorizes specific performance under a rejected executory contract, the non-debtor should be able to enforce the contract against the debtor irrespective of rejection); see also Fellerman & Cohen Realty v. Clinical Plus (In re Hirschhorn), 156 B.R. 379, 381-82 (Bankr. E.D.N.Y. 1993) (“Section 365(g) is intended to affect only the monetary rights of creditors. Section 365(g) does not disturb the equitable non-monetary rights arising from the breach of contract”). Thus, it is unclear whether Udell or Sunbeam would control if there was a covenant in a rejected executory contract that was enforceable by specific performance. Perhaps the unavailability of specific performance should be limited to affirmative obligations, as opposed to negative covenants. Other circuit courts will also have to wrestle with the lasting effects of Lubrizol, now revitalized to some extent by Sunbeam.

This is unfortunate, as Lubrizol was erroneously decided in the first instance. The Lubrizol court, in concluding that rejection eliminates specific performance, referred to a House Report for §365(g) that the purpose of that subsection is to treat rejection damages as prepetition “claims.” However, when the House Report relied on by the Lubrizol court was issued, the version of the Bankruptcy Code being considered by Congress included specific performance remedies in its definition of a claim. This was changed in the Bankruptcy Code enacted by Congress, such that only a remedy that is associated with a right to payment is considered a claim. Martin J. Bienenstock, “Recent Developments Affecting Chapter 11 Cases,” Prepared for Task Force on Current Developments of Business Bankruptcy Subcommittee of the Section of Business Law of the American Bar Association, Fall Meeting, Oct. 13, 2011, Tampa, Fla.

‘Kemata’ Decision

In another significant decision, Judge Christopher S. Sontchi of the U.S. Bankruptcy Court for the District of Delaware reached a similar conclusion to the Sunbeam court in In re Kemata, 470 B.R. 304 (Bankr. D. Del. 2012). In that case, the court held that a prepetition breach by a licensor did not terminate a licensee’s rights, so that the license remained an executory contract and the licensee could still take advantage of §365(n) protections.

In the Kemata case, prior to the bankruptcy filing, the debtor granted Invoy Technologies an exclusive license to use patents regarding medical technology for measuring chemical species or analyses in breath. Prior to the filing date, the debtor had breached its agreement, and the state court issued a preliminary injunction enforcing Invoy’s license based on the debtors violation of the exclusivity provisions, among other things. Invoy moved to compel Kemata’s trustee to comply with §365(n).

The Chapter 7 trustee and Kemata’s secured lender opposed the motion on the grounds that Kemata’s prepetition breaches rendered the license nonexecutory, as Invoy was under no obligation to perform based on the prepetition breaches. They argued that, like the trademark license in Exide, if the contract was not executory, §365(n) would not apply. However, although the breach excused Invoy’s obligation to perform, the breach did not effect a contract termination and the continuing obligations on each side rendered the contract executory. Thus, Invoy was entitled to continued possession and use of the intellectual property under §365(n).

However, the court required Invoy to make royalty payments, rejecting an argument that Invoy may “recoup” its damages from its royalty obligations. In an apparent case of first impression, the court held that set-off rights were waived by Invoy’s §365(n) election and recoupment was inapplicable, as the “same transaction” requirement of recoupment was not satisfied. Invoy’s obligations to pay royalties no longer arose from the license, but arise from §365(n) itself.

Conclusion

While the Sunbeam decision has clear implications for trademark licensees in the Seventh Circuit, the broader implications remain to be seen, perhaps creating more questions than answers. For example, how does a licensee under a rejected agreement effectively enforce exclusivity provisions if specific performance is not available? The decision also calls into question the utility and future application of §365(n) itself, i.e., do licensees have a right to maintain the use of intellectual property such that they would not have to comply with the more burdensome provisions of that section, such as the payment of royalties or the forfeiture of set off rights? The law surrounding the rights and obligations of both licensees and licensors under rejected intellectual property licenses has been uncertain for many years. Perhaps the Seventh Circuit’s recent entrance into the fray will provide the impetus for a final determination on this important issue.

Jeffrey W. Levitan is a partner in Proskauer Rose’s business solutions, governance, restructuring and bankruptcy group.

Endnotes:

1. Trademark licenses depend on licensor quality control to be effective. Once a license agreement has been rejected, there is no effective quality control by the licensor, and any retained rights by the licensee could constitute an improper “naked” license, resulting in abandonment of the trademark.

2. This is not the first time a minority opinion by Judge Thomas L. Ambro, (a former bankruptcy practitioner) in a bankruptcy matter has become influential. Ambro’s views on credit bidding in a sale pursuant to a plan of reorganization expressed in the dissent in In re Phila. Newspapers, 599 F.3d 298 (3d Cir. 2010) were embodied in the decision of the U.S. Supreme Court in RadLAX Gateway Hotel v. Amalgamated Bank, 132 S.Ct. 2065 (2012).