Choose Site

LawFlash

Rejecting Lubrizol, Seventh Circuit Expands Licensee Protections in Bankruptcy

July 19, 2012

On July 9, 2012, the United States Court of Appeals for the Seventh Circuit became the first federal appeals court to extend protections to licensees of debtor-owned trademarks whose license agreements are rejected in bankruptcy.1 The decision represents an important win for licensees of trademarks whose licensors become insolvent and, conversely, may substantially affect the value obtainable by a debtor for its trademarks through a bankruptcy sale.

Background

Sunbeam involved a debtor that licensed certain intellectual property to Chicago American Manufacturing (“CAM”) that allowed CAM to make and sell box fans under the debtor’s patents and with the debtor’s trademarks. After the debtor was forced into involuntary bankruptcy proceedings, the trustee sold the debtor’s assets, including the patents and trademarks that CAM licensed. As a condition for purchasing the intellectual property rights, the purchaser required that the trustee reject the license agreement with CAM. Following rejection, CAM continued to use the trademarks, and the purchaser brought suit against CAM for infringement. The Bankruptcy Court found that while section 365(n) (which, by its terms, protects only holders of patents, copyrights and certain other intellectual property) did not afford any protection to trademark licensees, CAM could continue to use the trademarks based upon considerations of equity. On appeal, the issue was the effect of the trustee’s rejection of the trademark license agreement and CAM’s ability to continue selling the fans with the trademark.

11 U.S.C. §365(n) and Lubrizol

Section 365(n) of the Bankruptcy Code allows an intellectual property licensee to continue to exercise rights after rejection of a license agreement. Congress enacted section 365(n) in response to a Fourth Circuit decision, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), which held that an intellectual property licensee would lose the right to use the licensed intellectual property upon rejection of the underlying agreement. The Lubrizol court held that a non-exclusive patent licensee, whose patent license was rejected as an executory contract in the bankruptcy proceeding, could not rely on provisions within its license agreement for continued use of the technology at question. The Lubrizol court determined that section 365(g) was only a damages remedy for the non-bankrupt party and not a specific performance remedy. The Lubrizol court then held that when a debtor rejected a contract, the licensee lost its rights under the license — in essence, rejection of a contract resulted in termination of the contract.

In reaction to the Lubrizol decision, Congress added section 365(n) to the Bankruptcy Code to expressly permit intellectual property licensees to retain their rights to the use of the licensed property if certain statutory conditions were met. However, Congress omitted trademarks from the definition of “intellectual property” in the Bankruptcy Code when it enacted section 365(n). As a result, trademark licensees have not been afforded protection under section 365(n).

Court of Appeals Analysis

The Seventh Circuit analyzed the consequences of contract rejection as set forth in section 365(g) of the Bankruptcy Code and determined that CAM could continue to use the debtor’s trademarks. But rather than rely on broad notions of equity to support its decision as the lower court had done, the Seventh Circuit relied on the text of section 365(g) itself, which provides that rejection constitutes a breach of a contract. Turning to non-bankruptcy law to ascertain the consequence of a licensor’s breach, the court reasoned that a breach by the licensor should not terminate the licensee’s right to use intellectual property any more than a debtor’s breach of a loan agreement would terminate the lender’s right to be repaid. While the Bankruptcy Code does provide a means for eliminating rights under some contracts (for example, through the avoidance of preferential transfers under section 547), no such statutory exception applied here.

The court was not persuaded by the Lubrizol decision or the omission of trademark protection in section 365(n). The Seventh Circuit rejected Lubrizol and joined many in criticizing Lubrizol for confusing rejection, which is a breach of contract, with avoidance, which is nullification. With respect to the omission of “trademarks” from the definition of “intellectual property,” the court cited to the legislative history of section 365(n) for the proposition that the omission was designed to allow more time for study, not to approve Lubrizol. The court found that the “omission is just an omission” and the limited definition does not affect trademarks one way or the other. Further, rejection “merely frees the estate from the obligation to perform and has absolutely no effect upon the contract’s continued existence.”

Implications

Sunbeam is the first appellate level decision to expressly reject Lubrizol, and potentially has ramifications that go beyond its specific facts. For example, it appears that Sunbeam will have an immediate and direct impact on the rights of non-debtor franchisees whose franchisors are in bankruptcy. Franchise agreements are often trademark license agreements first and foremost, and the franchisee’s right to continue to use those trademarks generally is essential to the continued existence of the franchise. The flip side of the same coin is that under Sunbeam, debtor-franchisors no longer would have the ability to reject a franchise agreement in the hope of assigning the franchise to a third party that might be willing to pay more for the use of the relevant trademarks.

Outside the trademark context, the reasoning of Sunbeam suggests that other non-monetary provisions of rejected executory contracts may be enforceable as well including, for example, non-competition provisions of employment or consulting agreements, particularly where the rejecting debtor is the employee.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Wilamowsky-Steven
Carter-Christopher

1 Sunbeam Products, Inc. v. Chicago American Mfg., LLC, No. 11-3920 (7th Cir. July 9, 2012) (“Sunbeam”)

This article was originally published by Bingham McCutchen LLP.