On July 9, 2012, the U.S. Court of Appeals for the Seventh
Circuit issued a decision that could have far-reaching implications
for licensees of trademarks, and more generally for all licensees
of intellectual property, who find their licensors in bankruptcy.
In Sunbeam Products, Inc. v. Chicago American Manufacturing,
LLC,1the Seventh Circuit affirmed the decision of
the U.S. Bankruptcy Court for the Northern District of Illinois
(the "Bankruptcy Court") that a trademark licensee whose
licensor rejected the license agreement in bankruptcy could
nevertheless continue to use the licensed trademark. In the
proceedings below, the Bankruptcy Court based its holding on
"equitable grounds," effectively extending the
protections for intellectual property licensees under section
365(n) of the Bankruptcy Code to trademarks, while recognizing that
the statute (which protects patent and copyright licenses) does not
include trademarks within those protections. The Seventh Circuit
affirmed the Bankruptcy Court's judgment, but based its
decision on a different analysis. Like the Bankruptcy Court, the
Seventh Circuit reexamined the Fourth Circuit's landmark
decision in Lubrizol Enterprises, Inc. v. Richmond Metal
Finishers, Inc.,2 in which the Fourth
Circuit, prior to the enactment of section 365(n), found that a
patent licensee loses its license rights when the licensor rejects
the patent license in bankruptcy. But, rather than relying on
"equitable grounds" to part company with
Lubrizol, the Seventh Circuit concluded that the Fourth
Circuit in Lubrizol reached the wrong result in
interpreting the effects of rejection under section 365(g) of the
Bankruptcy Code.
The Seventh Circuit started with the fundamental proposition that
"rejection" of a contract in bankruptcy means simply that
the debtor breached the contract (which, for the purposes of
allowance of a licensee's claim, is deemed to occur as of the
day immediately before the bankruptcy filing). But the
licensee's rights to use the trademark should not necessarily
be terminated simply because the debtor has "rejected,"
and is deemed to have breached, the license agreement. Accordingly,
in the Seventh Circuit at least, a trademark licensor may
effectively get the same protections as section 365(n), without
being covered by the statute the rights may not be compromised by
rejection in the first place. The Seventh Circuit's decision
examines once again the scope of a licensee's rights after
rejection of a license agreement by the licensor, and the effect of
a counterparty's rejection of an executory contract more
generally. And the Seventh Circuit's decision creates a circuit
split with the Fourth Circuit in Lubrizol, albeit one
where the decisions are separated by a distance of 27 years.
Background
In 1985, the U.S. Court of Appeals for the Fourth Circuit issued its decision in Lubrizol. The Fourth Circuit held that a licensee of intellectual property (in this case, patents) may not continue to use the licensed property after the licensor rejects the license in bankruptcy. In response, Congress swiftly enacted section 365(n) to the Bankruptcy Code in 1988. Section 365(n) prevents a licensor from unilaterally terminating the rights of a licensee under an "intellectual property" license by rejecting the license under section 365(a) of the Bankruptcy Code if the licensee elects to continue its rights and pay royalties as they become due. Although U.S. patents and copyrights are expressly included in the Bankruptcy Code's definition of "intellectual property," trademarks are notably absent.3 The legislative history of the enactment of section 365(n) makes clear that Congress intentionally excluded trademarks from the scope of the section's protections because of the unique concerns inherent to trademark licensing relationships, namely that such relationships depend on the licensor's ability to control the quality of the products or services sold by the licensee. The legislative history provides that: "Since these matters 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."4
The exclusion of trademarks from the definition of
"intellectual property" led a number of courts, including
bankruptcy courts in the Southern District of New York and in
Delaware, to conclude that Congress intended the effects of
Lubrizol that a licensee would lose its rights upon
rejection to apply to trademark licenses.5 Others,
like Judge Ambro of the U.S. Court of Appeals for the Third Circuit
in his concurring opinion in In re Exide
Technologies,6 believed it inappropriate to
conclude by negative inference that rejection of a trademark
license triggers the same result as termination of that license.
Instead, Judge Ambro believed that, in certain circumstances,
courts should use their equitable powers to preserve a
licensee's fairly-procured trademark rights. According to Judge
Ambro, to do otherwise would "make bankruptcy more of a sword
than a shield, putting debtor-licensors in a catbird seat they
often do not deserve."7
The Lakewood
Bankruptcy Court Decision: "Equitable Grounds"
for Protection
Lakewood Engineering & Manufacturing Co.
("Lakewood") was one of the largest manufacturers of box
fans in the United States. In 2008, Lakewood entered into a supply
agreement with its manufacturer, Chicago American Manufacturing
("CAM"), under which CAM would use Lakewood's patents
and trademarks to produce and distribute box fans for Lakewood in
accordance with forecasted amounts set forth in the supply
agreement. Because Lakewood was already experiencing financial
difficulty at the time it entered into the supply agreement,
Lakewood granted to CAM in the supply agreement a license to
continue to use Lakewood's patents and trademarks for the
purpose of selling fans that Lakewood had forecasted, but could not
purchase.
Three months into the contract, Lakewood's creditors placed it
into involuntary bankruptcy. In bankruptcy, the chapter 7 trustee
for Lakewood rejected Lakewood's contract with CAM under
section 365(a) of the Bankruptcy Code and sold Lakewood's
assets, including its patents and trademarks, to an affiliate of
Sunbeam Products. After the sale of Lakewood's assets and
rejection of Lakewood's agreement with CAM, CAM continued to
manufacture and sell box fans. Sunbeam and Lakewood's
bankruptcy trustee filed suit against CAM, asserting that CAM was
not entitled to continue producing and selling the fans using the
Lakewood patents and trademarks. The Bankruptcy Court held that CAM
retained its license to use Lakewood's patents based
on Lakewood's election of its rights under section 365(n) of
the Bankruptcy Code. The Bankruptcy Court also held that CAM's
right to use Lakewood's trademarks survived the
rejection of the supply agreement, notwithstanding the omission of
trademarks from the scope of section 365(n) of the Bankruptcy Code.
The Bankruptcy Court, relying heavily on Judge Ambro's
concurring opinion in Exide, based its decision on
"equitable grounds" rather than on any particular
provision of the Bankruptcy Code.8
The Seventh Circuit's Decision in
Lakewood: Protection under
Section 365(g)
The Seventh Circuit affirmed the Bankruptcy Court's
decision, but on different grounds. The Seventh Circuit called the
Bankruptcy Court's reliance on its equitable powers
"untenable," because "what the Bankruptcy Code
provides, a judge cannot override by declaring that enforcement
would be inequitable."9 Nevertheless, the Seventh
Circuit proceeded to reexamine the Fourth Circuit's landmark
decision in Lubrizol, which spawned section 365(n) in the
first place. The Seventh Circuit concluded that the
Lubrizol court was mistaken in its analysis of the
consequences of rejection of an executory contract.
Focusing on section 365(g) of the Bankruptcy Code, which governs
the consequences of rejection of an executory contract, the Seventh
Circuit emphasized that rejection of a contract merely constitutes
a breach of such contract by the debtor. The Seventh Circuit noted
that outside of bankruptcy, a licensor's breach does not
terminate a licensee's right to use the licensed intellectual
property.10So too, in bankruptcy, a licensee's
rights should remain intact despite rejection by the licensor. The
Seventh Circuit explained that the consequence of rejection is
simply that the debtor cannot be forced to perform its unfulfilled
obligations are instead converted to damages. Nothing about section
365(a), however, implies that any rights of the licensee have been
"vaporized."11 The court contrasted sections
of the Bankruptcy Code that may be used to eliminate contractual
rights like the Bankruptcy Code's avoidance powers with section
365, which is not an avoidance power. The Seventh Circuit concluded
that the Fourth Circuit in Lubrizol confused rejection
with the use of an avoidance power or the remedy of rescission.
Accordingly, the Seventh Circuit rejected the Lubrizol
approach and upheld the Bankruptcy Court's decision.
The Bottom Line
The Seventh Circuit's decision provides some comfort to
trademark licensees, who have long faced the possibility that their
rights were unprotected in the event of a rejection of their
license by the licensor, and who were dependant on the equitable
powers of bankruptcy judges for the protection of those rights. The
extent of the comfort that they draw from Lakewood may
depend in part on the terms of the licensee's rights under the
applicable agreement.12
But the Seventh Circuit's critique of Lubrizol goes
much further. By clarifying that rejection is not the same as
termination, the Seventh Circuit calls into question whether
section 365(n) is the exclusive protection available to
intellectual property licensees in the event of rejection by a
licensor. Indeed, it calls into question the need for section
365(n) in the first place, or for its sister section that provides
protection for real estate lessees, section 365(h). For example,
the Seventh Circuit's decision could mean that a licensee's
rights in foreign patents (which may not be covered by section
365(n)) survive rejection as well, even if such rights could, like
trademarks, be interpreted to be outside the scope of section
365(n).
But a trademark licensee may not be home free in the Seventh
Circuit. Although the issue was apparently not raised by Sunbeam, a
purchaser of assets could argue that a "free and clear"
sale under section 363 of the Bankruptcy Code eliminates the rights
of licensees. The Seventh Circuit itself has found that section 363
may effect a sale "free and clear" of unasserted section
365(h) rights with respect to a commercial
lease.13 Might section 363 also free a trademark
purchaser from the continuing rights of a licensee such as
CAM?
Accordingly, while the Lakewood decision may favor trademark
licensees in some respects, it also raises questions that may have
implications for both trademark licensees and others when contract
counterparties enter bankruptcy.
Footnotes
1. Case No. 11-3920 (7th Cir. Jul. 9, 2012). The
case is referred to as "Lakewood" based on the
name of the Bankruptcy Court debtor.
2. 756 F.2d 1043 (4th Cir. 1985).
3. 11 U.S.C. § 101(35A).
4. S. Rep. 100-505, at 5, reprinted in 1988
U.S.C.C.A.N. at 3204.
5. In re Old Carco LLC, 406 B.R. 180, 211 (Bankr.
S.D.N.Y. 2009) ("Trademarks are not
â€Üintellectual property' under the
Bankruptcy Code . . . [, so] rejection of licenses by [a] licensor
deprives [the] licensee of [the] right to use [a] trademark . . .
."); In re HQ Global Holdings, Inc., 290 B.R. 507,
513 (Bankr. D. Del. 2003) ("[S]ince the Bankruptcy Code does
not include trademarks in its protected class of intellectual
property, Lubrizol controls and the Franchisees' right
to use the trademark stops on rejection.").
6. 607 F.3d 957 (3d Cir. 2010).
7. Exide, 607 F.3d at 967-68 (Ambro, J.,
concurring).
8. Sunbeam Products, Inc. v. Chicago American
Manufacturing, Inc. (In re Lakewood Engineering & Manufacturing
Co., Inc.), 459 B.R. 306, 345 (Bankr. N.D. Ill.
2011).
9. Sunbeam, Case No. 11-3920, slip op. at
4-5.
10. Id. at 7.
11. Id. at 8.
12. Before even reaching the issue of whether rejection
terminated CAM's rights to use the trademarks, the Bankruptcy
Court held as a matter of contract interpretation, and the Seventh
Circuit agreed, that one of CAM's remedies for breach of the
supply agreement by Lakewood was that CAM would have a trademark
license to sell the fans that were the subject of the agreement.
This focus on the contractual terms suggests that there could have
been a different result had the parties agreed to different
remedies.
13 Precision Industries, Inc. v. Qualitech Steel
SBQ LLC, 327 F.3d 537 (7th Cir. 2003).
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