One of the tools of the debtor filing bankruptcy is the ability to assume contracts or reject burdensome contracts. When a franchisor files bankruptcy, it may choose to reject the undesirable franchise agreements and cause the franchisee to change its name. This is an extraordinary option for the franchisor because it can shape the franchise system when it undergoes corporate renewal. The franchisor can also use this tool to ready itself for sale within the bankruptcy, for example, by jettisoning geographies it no longer desires to support. A recent case suggests that this tool may no longer be available for debtor-franchisors.

The bankruptcy code provides in most instances that, where a contract is rejected by the debtor, the counterparty can no longer avail itself of the benefits of the contract. When the debtor is the franchisor, that would mean that the franchisee might be required to de-identify the business. Special rules apply in intellectual property contracts that allow the licensee to retain the intellectual property rights but not require the debtor to provide services. The same retention rights work similarly where the rejecting debtor is a landlord because the bankruptcy code allows the tenant retention rights without landlord services. This statutory system of retention rights, however, does not apply to trademark licenses.

Trademarks are not “intellectual property” as defined by the Bankruptcy Code and the code does not address whether retention rights are automatically granted or denied. To the contrary, the legislative history suggests, and the cases support, looking at each individual case and deciding the outcome on the individual facts. This protocol has been rejected by the U.S. Court of Appeals for the Seventh Circuit.

The Seventh Circuit has split ways with the landmark Fourth Circuit decision in Lubrizol Enterprises v. Richmond Metal Finishers, 756 F.2d 1043 (4th Cir. 1985), by holding that a licensor’s rejection of a licensing contract in bankruptcy does not deprive the trademark licensee of its right to the debtor-licensor’s trademark. See Sunbeam Products v. Chicago American Mfg., No. 11-3920 (7th Circ. July 9, 2012). Congress or the U.S. Supreme Court may need to resolve the gap.

The debtor in Sunbeam, Lakewood Manufacturing, sold a variety of consumer products covered by its patents and trademarks. Facing financial difficulty, it outsourced manufacturing and shipping for its box fan business to defendant Chicago American Manufacturing (CAM). Per the contract, Lakewood would take orders and CAM would directly ship to Lakewood’s customers. The contract authorized CAM to put Lakewood’s trademarks on the fans. Because Lakewood was in financial distress, the contract also provided CAM with the assurance that CAM could sell the 2009 run of box fans for its own account in the event that Lakewood did not purchase them. Three months into the contract, in February 2009, Lakewood’s creditors filed an involuntary bankruptcy petition against it and the court appointed a trustee who sold Lakewood’s business to plaintiff Sunbeam Products. The trustee also rejected the executory portion of the CAM contract under 11 U.S.C. §365(a). When CAM continued to make and sell Lakewood-branded fans, Sunbeam filed suit.

In Lubrizol, the Fourth Circuit had held that when an intellectual property license is rejected in bankruptcy, the licensee loses the ability to use any licensed copyrights, trademarks and patents. Three years after the decision, Congress responded by adding §365(n) to the Bankruptcy Code, which allowed licensees to continue using intellectual property after rejection. “Intellectual property” as defined in the code, however, only included patents, copyrights and trade secrets, without mention of trademarks. The Sunbeam court ruled that the absence of the word merely indicated that Congress intended to leave the question of trademarks open, and did not codify Lubrizol with regard to trademarks.

The court then went on to explicitly reject the reasoning of the Fourth Circuit in Lubrizol by characterizing it as having incorrectly interpreted the implications of §365(g) of the Bankruptcy Code, which holds that the rejection of an executory contract by the debtor amounts to breach of that contract. The court held that although breach by the debtor may affect some of its own obligations under the rejected contract, it does not necessarily abrogate the contractual rights of a nondebtor contracting party. The court thus concluded that CAM is entitled to exercise the trademark rights it had contracted for despite Lakewood’s trustee’s rejection of the contract.

Sunbeam promises franchisees protection (which they did not have under §365(n)) of their licensed trademarks in the event of their franchisors’ bankruptcy. Protection of a franchisee’s licensed trademark could translate into protection of its whole business and into the ability to continue franchise operations in spite of a rejection of the franchising contract by an insolvent franchisor. From the franchisor’s perspective, the insolvent franchisor will no longer be able to terminate a franchisee’s use of its trademark toward assigning the franchise to a more profitable party. On a broader level, the debtor-franchisor may not be able to obtain as high a value from sale of its trademark upon bankruptcy, but lenders to franchisees no longer need to be concerned about the rejection risk.

The decision is, of course, currently only binding within the Seventh Circuit. The fact that it split the circuits may make it a likely candidate for review by the Supreme Court, or by Congress, but until that point we shall have to observe which circuit’s decision is followed by other federal courts on the issue. •

Craig R. Tractenberg is chair of the global franchise and distribution practice at Nixon Peabody. He is a former editor of the ABA Franchise Law Journal. He can be reached at tractenberg@nixonpeabody.com.