United States: Trademark Licensees Beware: The Hypothetical Test Lives On In The Third Circuit

Last Updated: May 29 2015
Article by Mark G. Douglas

Trademark licensees that file for bankruptcy protection face uncertainty concerning their ability to continue using trademarks that are crucial to their businesses. Some of this stems from an unsettled issue in the courts as to whether a licensee can assume a trademark license without the licensor's consent. In In re Trump Entertainment Resorts, Inc., 2015 BL 44152 (Bankr. D. Del. Feb. 20, 2015), a Delaware bankruptcy court reaffirmed that the ongoing controversy surrounding the "actual" versus "hypothetical" test for assumption of a trademark license has not abated. Applying the hypothetical test, the court granted a trademark licensor's motion for relief from the automatic stay to pursue termination of the license agreement because the license could not be assumed or assigned by the debtor under sections 365(c)(1) and 365(f)(1) of the Bankruptcy Code.

Limitations on the Ability to Assume or Assign Certain Contracts and Leases in Bankruptcy

Section 365(a) of the Bankruptcy Code allows a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume or reject most kinds of executory contracts and unexpired leases. This broad power, however, is limited with respect to certain kinds of contracts. For example, section 365(c)(1)(A) of the Bankruptcy Code provides that a trustee or DIP may not "assume or assign" an executory contract or unexpired lease if "applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession" and such party does not consent to assumption or assignment.

Courts have applied this provision to a wide variety of contracts. Among these are personal service contracts, including employment agreements; contracts with the United States government, which cannot be freely assigned under federal law; certain kinds of franchise agreements; and licenses of intellectual property, which generally cannot be assigned without consent under federal intellectual property law. Thus, many debtors (especially those in the technology industry) find that their rights with respect to certain executory contracts are significantly limited.

The Statutory Muddle

Section 365(c)(1) prevents a trustee or DIP from assigning a contract without the nondebtor's consent if applicable law prevents the contract from being assigned outside bankruptcy without consent. Section 365(c)(1), however, uses the distinctive phrase "assume or assign," as opposed to "assume and assign," which would seem to mean that a trustee or DIP cannot even assume such a contract and agree to perform under it, even if the trustee or DIP has no intention of assigning the contract to a third party.

Some courts construe the "assume or assign" language to mean that the statutory proscription applies to a trustee or DIP who seeks either: (i) to assume and render performance under the agreement; or (ii) to assume the agreement and assign it to a third party. Under this literal interpretation, the court posits a hypothetical question: Could the debtor assign the contract to a third party under applicable nonbankruptcy law? If the answer is no, the trustee or DIP may neither assume nor assign the contract. This approach is commonly referred to as the "hypothetical test." The Third, Fourth, Ninth, and Eleventh Circuits have adopted this approach. See In re West Elecs. Inc., 852 F.2d 79 (3d Cir. 1988); Resort Computer Corp. v. Sunterra Corp (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004); Perlman v. Catapult Entm't, Inc. (In re Catapult Entm't, Inc.), 165 F.3d 747 (9th Cir. 1999); City of Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534 (11th Cir. 1994).

Other courts, having determined that the phrase "may not assume or assign" should be read to mean "may not assume and assign," apply the statutory proscription only when the trustee or DIP actually intends to assign the contract to a third party. This approach is commonly referred to as the "actual test." Its adherents include the First Circuit and the vast majority of lower courts considering the issue. See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997), abrogated by Hardemon v. City of Boston, 1998 WL 148382 (1st Cir. Apr. 6, 1998), superseded by 144 F.3d 24 (1st Cir. 1998); Summit Inv. & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995); In re Jacobsen, 465 B.R. 102 (Bankr. N.D. Miss. 2011) (citing and listing cases). In addition, the Fifth Circuit has applied the actual test in construing section 365(e)(2)—the Bankruptcy Code's exception to the prohibition against enforcement of "ipso facto" clauses that act to terminate or modify a contract as a consequence of a bankruptcy filing. See Bonneville Power Admin. v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238 (5th Cir. 2006).

In In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005), the court adopted a slightly different test predicated upon the legal distinctions between the debtor and the DIP, on the one hand, and the bankruptcy trustee, on the other. The court reasoned that the term "trustee" in section 365(c)(1) should not automatically be read (as it is in many other provisions "as a matter of simple logic and common sense") to be synonymous with the term "debtor-in-possession." Instead, the proscription of assumption and assignment is limited to situations where a trustee, rather than a DIP, seeks to assume an executory contract. Under the Footstar approach, the DIP would be permitted to assume the contract because, unlike a bankruptcy trustee, the DIP is not "an entity other than" itself; nevertheless, the DIP would be precluded from assigning a qualifying contract because assignment would force the nondebtor contracting party to accept performance from or render performance to an entity other than the debtor. In contrast, under Footstar, a trustee would be permitted neither to assume nor to assign such a contract.

Depending on the contracts involved, whether a bankruptcy court applies the hypothetical test or the actual test can profoundly impact a DIP's ability to stay in business. Application of the hypothetical test can prevent a DIP from continuing to exercise its rights under a nonassignable contract, such as a patent, copyright, or trademark license, which generally cannot be assigned without the licensor's consent. Without such contracts, some DIPs may be incapable of reorganizing under chapter 11. In Trump Entertainment, the bankruptcy court considered section 365(c)(1) in the context of a trademark licensor's motion for relief from the automatic stay to continue state court litigation in which the licensor was seeking to terminate a trademark license agreement with the debtor.

Trump Entertainment

In 2010, Donald and Ivanka Trump entered into a perpetual trademark license agreement with Trump Entertainment Resorts, Inc., and its affiliates (collectively, "TER") that granted TER a royalty-free license to use the Trumps' names, likenesses, and other marks in connection with the operation of three hotel casinos located in Atlantic City. The Trumps subsequently assigned their rights under the agreement to Trump AC Casino Marks, LLC ("Trump AC").

The license agreement required Trump AC's prior written consent to any assignment by TER. On the same day that TER executed the license agreement, the Trumps, TER, and one of TER's secured lenders entered into a Consent Agreement whereby Trump AC (as the Trumps' assignee) agreed that TER's rights under the license agreement could be assigned to the lender "upon and following the enforcement" by the lender of its rights under its credit agreement with TER.

On August 5, 2014, Trump AC sued TER in state court, seeking to terminate the license agreement due to TER's alleged breach of the agreement. That action was stayed when TER filed for chapter 11 protection in the District of Delaware on September 9, 2014. TER later proposed a chapter 11 plan pursuant to which the secured lender's claims would be exchanged for equity in a reorganized entity recapitalized to continue the business of TER's one remaining operating casino, the Trump Taj Mahal Casino Resort. The plan also contemplated assumption of the trademark license agreement.

On September 24, 2014, Trump AC filed a motion for relief from the automatic stay to proceed with the state court action to terminate the license agreement.

The Bankruptcy Court's Ruling

At the outset of its analysis, the court explained that, in accordance with Izzarelli v. Rexene Prods. Co. (In re Rexene Prods. Co.), 141 B.R. 574 (Bankr. D. Del. 1992), Delaware bankruptcy courts typically apply a balancing test in assessing whether "cause" to lift the stay exists under section 362(d) of the Bankruptcy Code to allow pending nonbankruptcy litigation to continue. Under this three-pronged test, the court considers:

  1. Whether continuation of the nonbankruptcy litigation will cause great prejudice to either the estate or the debtor;
  2. Whether any hardship to the nondebtor arising from continuation of the stay considerably outweighs the hardship to the debtor; and
  3. The probability that the nondebtor will prevail on the merits.

The court found that Trump AC failed to demonstrate that any significant hardship would result from maintenance of the stay. It also found that continuation of the state court litigation "would impose a substantial burden on [TER's] reorganization efforts." The court therefore concluded that Trump AC was not entitled to relief from the automatic stay under the traditional Rexene analysis.

The court noted, however, that "cause" under section 362(d)(1) "is a flexible concept and not confined solely to the Rexene factors." In particular, the court agreed with Trump AC's position that, in accordance with the Third Circuit's ruling in West Electronics, "cause" to modify the stay existed because the trademark license agreement was not assignable absent Trump AC's consent and thus could not be assumed or assigned by TER under section 365(c)(1). In West Electronics, the Third Circuit ruled that, where an executory contract is subject to the limitation on assumption or assignment set forth in section 365(c)(1), the nondebtor contracting party is entitled to relief from the automatic stay to seek termination of the contract.

In Trump Entertainment, the bankruptcy court explained that, pursuant to the binding precedent in West Electronics, courts in the Third Circuit are obligated to apply the hypothetical test to determine whether a contract can be assumed. Thus, the court concluded, a DIP may not assume an executory contract over the nondebtor's objection if applicable law would bar assignment to a hypothetical third party, "even where the [DIP] has no intention of assigning the contract in question to any such third party" (quoting Catapult, 165 F.3d at 750).

Nonetheless, the court cautioned that section 365(c)(1) must be read in conjunction with section 365(f)(1), which provides that:


Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection (emphasis added).

Thus, the general rule in section 365(f)(1) invalidating anti-assignment clauses in contracts or leases as well as overriding nonbankruptcy laws that prohibit assignment is expressly subject to any alternative rule provided in section 365(b) or 365(c). As discussed, section 365(c)(1) provides that a contract may not be assumed or assigned if assignment is prohibited by applicable nonbankruptcy law.
According to the Trump Entertainment court, the inconsistency between these provisions has been "persuasively reconciled" by a number of courts, including the Sixth and Ninth Circuits. In particular, in In re Magness, 972 F.2d 689 (6th Cir. 1992), the Sixth Circuit found that sections 365(c)(1) and 365(f)(1) do not conflict because "each subsection recognized an 'applicable law' of markedly different scope." As described by the Ninth Circuit in Catapult, section 365(f)(1) broadly provides that a law which "prohibits, restricts, or conditions the assignment" of an executory contract is trumped by section 365(f)(1). Section 365(c)(1), on the other hand, "states a carefully crafted exception to the broad rule—where applicable law does not merely recite a general ban on assignment, but instead more specifically 'excuses a party . . . from accepting performance from or rendering performance to an entity' different from the one with which the party originally contracted, the applicable law prevails over subsection (f)(1)." Catapult, 165 F.3d at 752.

Finding this reasoning persuasive, the bankruptcy court in Trump Entertainment concluded that, for section 365(c)(1) to apply, the applicable law must specifically provide that the nondebtor contract party "is excused from accepting performance from a third party under circumstances where it is clear from the statute that the identity of the contracting party is crucial to the contract" (citing In re ANC Rental Corp., 277 B.R. 226, 236 (Bankr. D. Del. 2002)).

Initially, the bankruptcy court determined that the "applicable law" in this context is federal trademark law. Under trademark law, the bankruptcy court noted, "the substantial weight of authority" indicates that trademark licenses are not assignable in the absence of some kind of express authorization by the licensor, such as a clause in the license agreement itself (citing In re XMH Corp., 647 F.3d 690 (7th Cir. 2011); Miller v. Glenn Miller Prods., Inc., 454 F.3d 975 (9th Cir. 2006)). Even so, the bankruptcy court explained that it is not sufficient alone to recognize a general ban on assignment under applicable nonbankruptcy law—the court must determine why the law in question bans assignment.

Federal trademark law generally bans assignment of trademark licenses without the licensor's consent because trademarks are meant to identify a good or service of a particular, consistent quality, making the identity of licensees crucial to licensors. Although the parties to a license agreement are free to contract around this general rule, the court in Trump Entertainment found no indication that the Trumps (and by extension Trump AC) and TER intended to do so in the trademark license agreement.

Moreover, the court found that notwithstanding the Consent Agreement, Trump AC did not consent to assignment of the trademark because the consent provided was effective only with respect to an "isolated assignee" in the context of a state enforcement action that was unlikely to occur once the bankruptcy case was commenced. Therefore, the bankruptcy court ruled that the hypothetical test under section 365(c)(1) was satisfied and, accordingly, under West Electronics, that Trump AC was entitled to relief from the automatic stay.

Outlook

Recent rulings from courts in the Third Circuit concerning the treatment of trademark licenses in bankruptcy are a decidedly mixed bag. On the one hand, the court in In re Crumbs Bake Shop, Inc., 522 B.R. 766 (Bankr. D.N.J. 2014), held that trademark licensees are entitled to the protections of section 365(n) of the Bankruptcy Code, even though the Bankruptcy Code does not include "trademarks" in the definition of "intellectual property." Furthermore, on the basis of circuit judge Thomas L. Ambro's concurring opinion in In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010), the Third Circuit may be receptive to this approach, which would be a positive development for trademark licensees. On the other hand, Trump Entertainment indicates that the hypothetical test is alive and well in the Third Circuit and that a trademark licensee may not be able to retain its rights under an executory license agreement, even if it has no intention of assigning the agreement. These issues create uncertainty for licensees considering a bankruptcy filing in any district in the Third Circuit.

Lawmakers had an opportunity to end this uncertainty when Congress amended the Bankruptcy Code in 2005, yet they failed to do so. The U.S. Supreme Court similarly declined the opportunity to resolve the circuit split over the "hypothetical test" versus the "actual test" in 2009, when it denied certiorari in N.C.P. Marketing Group, Inc. v. BG Star Productions, Inc., 556 U.S. 1145 (2009) (concluding that the division in the courts over the interpretation of section 365(c)(1) is "an important one to resolve" but that the case in question was "not the most suitable case for our resolution of the conflict").

The final report issued on December 8, 2014, by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11 recommended that the Bankruptcy Code be amended in several respects to address these issues. First, the Commission recommended that trademarks, service marks, and trade names be included in the Bankruptcy Code's definition of "intellectual property." The Commission also recommended that a trustee or DIP should be able to assume an intellectual property license notwithstanding applicable nonbankruptcy law or a provision to the contrary in the license or any related agreement. Finally, the Commission recommended that a trustee or DIP should be able to assign an intellectual property license to a single assignee in accordance with section 365(f), notwithstanding applicable nonbankruptcy law or a provision to the contrary in the license or any related agreement. However, if a trustee or DIP were seeking to assign an intellectual property license to a competitor of the nondebtor licensor, the court could deny the assignment if it were to determine that the harm to the nondebtor licensor resulting from the proposed assignment would significantly outweigh the benefit to the estate derived from the assignment.

It remains to be seen whether Congress will take action to implement these recommendations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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