Alvin Benton is an Associate in Holland & Knight's Dallas office
Robert Labate is a Partner in Holland & Knight's Chicago office
Arthur Rosenberg is a Partner in Holland & Knight's New York office

"Free and Clear" Sale of a Trademark or Intellectual Property License Under Section 363 Does Not Trump Rights of Third Party Licensees under Section 365

HIGHLIGHTS:

  • The U.S. Bankruptcy Court for the District of New Jersey issued an opinion in In re Crumbs Bake Shop, Inc., that provides significant protections for trademark licensees. The opinion was issued on Oct. 31, 2014.
  • Trademark licensees cannot be deprived of their rights to use a licensed mark by a debtor's license rejection notwithstanding the omission of "trademarks" from the definition of "intellectual property" that is afforded protection under Section 365(n) of the Bankruptcy Code.
  • A "free and clear" sale of a debtor-licensor's assets pursuant to Section 363(b) and (f) of the Bankruptcy Code does not trump or extinguish the rights of third-party licensees to continue use of the mark.
  • Should a trademark licensee exercise its Section 365(n) right to continue use of a licensed mark after a debtor's rejection of the underlying license, the licensor/debtor is entitled to collect royalties in consideration of the licensees' continued use of the intellectual property.

The United States Bankruptcy Court for the District of New Jersey issued an opinion in In re Crumbs Bake Shop, Inc., No. 14-24287-MBK that provides significant protections for trademark licensees. The opinion was issued on Oct. 31, 2014. In the Crumbs case, the court held that:

  1. Trademark licensees cannot be deprived of their rights to use a licensed mark by a debtor's license rejection notwithstanding the omission of "trademarks" from the definition of "intellectual property" that is afforded protection under Section 365(n) of the Bankruptcy Code.
  2. A "free and clear" sale of a debtor-licensor's assets pursuant to Section 363(b) and (f) of the Bankruptcy Code does not trump or extinguish the rights of third-party licensees to continue use of the mark.
  3. Should a trademark licensee exercise its Section 365(n) right to continue use of a licensed mark after a debtor's rejection of the underlying license, the licensor/debtor is entitled to collect royalties in consideration of the licensees' continued use of the intellectual property.

Rejection of Intellectual Property License

Crumbs Bake Shop rode a cupcake wave from a mom-and-pop bakery on Manhattan's Upper West Side to a 79-location publicly traded company that sold cupcakes, baked goods and beverages through retail stores, an e-commerce division, catering and wholesale distribution. The expansion beyond the New York market was accomplished, in part, through license deals, with Crumbs entering into licensing agreements with third parties that allowed those parties to use the Crumbs trademark and trade secrets to produce and sell products under the Crumbs brand. Due to various factors, liquidity constraints drove Crumbs to cease operation and to file a Chapter 11 bankruptcy petition on July 14, 2014.

In its Chapter 11 case, Crumbs entered into an asset purchase agreement under which it agreed to sell substantially all of its assets to Lemonis Fischer Acquisition Company, LLC (LFAC). Crumbs sought bankruptcy court authority for the sale through a motion seeking approval of the sale free and clear of all claims, liens and encumbrances under Section 363 of the Bankruptcy Code. On Aug. 27, 2014, the court entered an order approving the sale.

A day later, on Aug. 28, 2014, Crumbs also filed a motion to reject certain executory contracts and unexpired leases, including the license agreements it had entered into with the various operators of the Crumbs' locations. A counterparty to a representation and branding agreement filed a response, asserting that, as a licensee, it could elect, under Section 365(n) of the Bankruptcy Code, to retain its rights under its license agreement, and also asserting an entitlement to continue to pay royalties in the event that the licensee elected to continue using the debtors' intellectual property. The debtors eventually withdrew their motion to reject the license agreements, leaving the court to determine whether the "free and clear" provisions of the order approving the sale to LFAC negatively impacted the licensees' rights – with the purchaser asserting that it had purchased the Crumbs name and intellectual property free and clear of the licensees' rights to use those assets.

In its decision, the Crumbs court addressed the following issues:

  • whether trademark licensees to rejected intellectual property licenses fall under the protective scope of 11 U.S.C. §365(n), notwithstanding that "trademarks" are not explicitly included in the Bankruptcy Code definition of "intellectual property"
  • whether a "free and clear" sale of a debtors' assets pursuant to 11 U.S.C. §§363(b) and (f) trumps and extinguishes the rights of third-party licensees under §365(n)
  • to the extent there are continuing obligations under the license agreements, which party is entitled to the collection of royalties generated as a result of third-party licensees' use of licensed intellectual property

Congressional Intent Provides the Answer

In Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), the Fourth Circuit determined under Section 365 of the Bankruptcy Code as then in effect a Chapter 11 debtor/licensor's rejection of an intellectual property license that stripped the licensee of all of its rights under the license agreement. Three years later, Congress enacted 11 U.S.C.§365(n), which sought to make clear that the rights of an intellectual property licensee to use licensed property cannot be unilaterally cut off as a result of rejection of the license.

Section 365(n) reads as follows:

  1. If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect –

    1. to treat such contract as terminated by such rejection if such rejection by the trustee amounts to such a breach as would entitle the licensee to treat such contract as terminated by virtue of its own terms, applicable nonbankruptcy law, or an agreement made by the licensee with another entity; or
    2. to retain its rights (including the right to enforce any exclusivity provision of such contract, but excluding any other right under applicable nonbankruptcy law to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property ... as such rights existed immediately before the case commenced for –

      1. the duration of such contract; and
      2. any period for which such contract may be extended by the licensee as of right under applicable nonbankruptcy law
  2. If the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, under such contract –

    1. the trustee shall allow the licensee to exercise such rights
    2. the licensee shall make all royalty payments due under such contract for the duration of such contract and for any period described in paragraph (1)(B) of this subsection for which the licensee extends such contract

In enacting Section 365(n), Congress provided licensees the option to make an election if the debtor-licensor rejects the intellectual property license to either continue using the licensed intellectual property or to treat the license as terminated. When it defined the scope of intellectual property rights protected by Section 365(n), however, Congress failed to include the term "trademarks," leaving some courts1 to conclude that Congress intended for Lubrizol to control when a debtor/licensor rejects a trademark license.

The Crumbs court rejected the continuing applicability of Lubrizol to trademark license rejections, ruling that the legislative history of Section 365 indicated congressional intent that bankruptcy courts exercise their equitable powers to decide whether trademark licensees may retain their licensed rights as though protected under Section 365(n). The court held that it would be inequitable to strip the licensees of their rights upon rejection.

Election Does Not Imply Lack of Protection

The Crumbs court cited a Seventh Circuit decision in Sunbeam Products, Inc. v. Chicago Am. Mfg. LLC, 686 F.3d 372 (7th Cir. 2012). In Sunbeam, the Seventh Circuit focused on the text of Section 365(g) and addressed the statutory protections granted to licensees of trademarks as similar to real estate lessees whose leases are rejected by debtor/lessors. The court in Sunbeam noted that "a lessor that enters bankruptcy could not, by rejecting the lease, end the tenant's right to possession and thus re-acquire premises that might be rented out for a higher price,"2 before holding that the licensee of a trademark should be entitled to similar protections for their license rights. The Crumbs court essentially held that the same rationale applies to licensees under trademark licenses.

The Crumbs court noted that nothing about the election process implies that the trademark licensee's rights have been vaporized. The court recognized that there are protections in place for the licensor, such as potential actions for infringement or unfair competition, which provide incentives for licensees to maintain a certain standard of quality in using the debtor-licensor's trademark despite the rejection of the underlying license.

Key Points Regarding Consent, Notice and Clarity

Next, the Crumbs court addressed LFAC's assertions that its purchase of Crumbs' assets free and clear of trademark rights trumped or extinguished the rights of all third-party licensees. LFAC asserted that the licensees' failure to object to the "free and clear" language in the order constituted implicit consent to the sale free and clear of their license rights.

The Crumbs court held that adequate notice is essential in determining whether the licensees impliedly consented to the vitiation of their Section 365 rights by failing to object to LFAC's sale motion. The court candidly admitted that it had difficulty in following the definitional maze of the asset purchase agreement. The court found that it was unclear what was being sold to LFAC; there was no clear discussion of what rights were purportedly being taken away as a result of the sale; thus, the licensees were not provided with adequate notice that their rights were at risk of being stripped away as a consequence of the sale.

Nowhere in Crumbs' sale motion or supporting submissions was anything stated about the treatment of the licensees in particular, or the effect that the sale would have on their rights. The Crumbs court ultimately held that: "Debtors' moving papers collectively failed to direct attention specifically to the proposition that the sale would strip licensees of their rights or to bring such consequences to licensees' attention."

Section 363(f) vs. Section 365

In discussing whether Sections 363(b)3 and (f)4 of the Bankruptcy Code trumped or extinguished the rights of third-party licensees under Section 365, the court also formed its conclusion based on two factors:

  1. the principle of statutory construction that the specific governs the general
  2. review of the legislative history of Section 365

The court observed similarities between Section 365(h) and Section 365(n) in that Section 365(h) grants a particular set of clearly stated rights to lessors of rejected leases that are similar to rights afforded intellectual property licenses under 365(n). The Crumbs court held that subsection (n) is specific in granting certain rights to licensees of rejected intellectual property licenses and that nothing in Section 365(n) should not be overcome by the general "free and clear" text of Section 363(f).

The court also used the legislative history of Section 365(h) to further its point that a sale of real property free and clear of a leasehold interest would permit the debtor to achieve under Section 363 what it was proscribed from achieving under Section 365(h). The legislative history of Section 365(h) provided that "under the terms of §365(h), the tenant will not be deprived of his estate for the term for which he bargained." The legislative history also clarified that lessees cannot have their rights stripped away if a debtor rejects its obligation as a lessor in bankruptcy. The court determined that the same rationale applied to Section 365(n).

LFAC relied on the Seventh Circuit case of Precision Indust., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003); however, the Crumbs court was not persuaded by the reasoning set forth by the Seventh Circuit.

Royalties Generated by Licenses

The Crumbs court was clear that, although Crumbs' trademark, as well as its other intellectual property, was sold to LFAC, the license agreements between Crumbs and its licensees were expressly excluded from the scope of the assets sold the LFAC. Since the license agreements were not sold or otherwise transferred to LFAC in the transaction, LFAC did not receive any rights under the license agreements. Accordingly, the post-closing royalties for the licensees' use of the Crumbs trademark and other intellectual property would be due and owing to Crumbs, and not to LFAC.

For this holding, the Crumbs court relied on the Third Circuit's decision in In re CellNet Data Sys., Inc., 327 F.3d 242 (3d Cir. 2003). In CellNet, the Third Circuit held that Section 365(n)(2)(B)5 links a licensee's post-rejection obligation to pay royalties, should it opt to continue to use the rights granted to it under the rejected license, directly to the rejected contract – not to the intellectual property itself. The primary mechanism for determining where royalties flow, therefore, was the rejected contract or license agreement. Because the Crumbs licenses had not been rejected or assumed and assigned, it was even clearer that royalties would be payable to Crumbs because the agreements themselves continued to be Crumbs' property.

Based on this and other recent decisions, notwithstanding the exclusion of trademarks from the specific protections provided to licensees under Section 365(n), licensees of trademarks where the licensor becomes bankrupt may be protected under certain circumstances. Similarly, any attempt to sell a trademark or similar intellectual property "free and clear" in a Section 363 sale will need to provide clear and specific notice to any licensees of such property in order to be able to terminate such license rights.

Footnotes

1. In re Global Holdings, Inc., 290 B.R. 507, 513 (Bankr. Del. 2003).

2. Sunbeam, 686 F.3d at 377

3. Section 363(b) states that "[t]he trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate, except that if the debtor in connection with offering a product or a service discloses to an individual a policy prohibiting the transfer of personally identifiable information about individuals to persons that are not affiliated with the debtor and if such policy is in effect on the date of the commencement of the case, then the trustee may not sell or lease personally identifiable information to any personunless – (A) such sale or such lease is consistent with such policy; or (B) after appointment of a consumer privacy ombudsman in accordance with section 332, and after notice and a hearing, the court approves such sale or such lease – (i) giving due consideration to the facts, circumstances, and conditions of such sale or such lease; and (ii) finding that no showing was made that such sale or such lease would violate applicable nonbankruptcy law."

4. Section 363(f) states that "[t]hetrustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if – (1) applicable nonbankruptcy law permits sale of such property free and clear of such interest; (2) such entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; (4) such interest is in bona fide dispute; or (5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest."

5. Section 365(n)(2)(B) provides that "[i]f the licensee elects to retain its rights, as described in paragraph (1)(B) of this subsection, under such contract –(B) the licensee shall make all royalty payments due under such contract for the duration of such contract and for any period described in paragraph (1)(B) of this subsection for which the licensee extends such contract ... ."

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