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First Circuit Bucks Developing Trend; Favors Trademark Owners Over Their Licensees in Bankruptcy – In re Tempnology, LLC

Litigation & Dispute Resolution Alert Kevin Grzebielski, Christopher Combest

In a recent decision, the First Circuit Court of Appeals ruled that the rejection by a licensor of a trademark license stripped the licensee of its right to use the trademark post-rejection, reversing a decision by the intermediate bankruptcy appellate panel (BAP) and reinstating the bankruptcy court’s original judgment. In re Tempnology, LLC, 2018 WL 387621 (1st Cir. Jan. 12, 2018), reversing in part 559 B.R. 809 (B.A.P. 1st Cir. 2016). The First Circuit did, however, affirm that the rejection stripped the licensee's exclusive product distribution rights.

Debtors in bankruptcy have the power under bankruptcy law to "reject" many types of contracts – that is, to walk away from the obligations imposed by those contracts. When licensors rejected IP licenses and repudiated their obligations to permit use of the licensed IP, the result could be disastrous for licensees who had built businesses around the rights granted under the licenses.

Therefore, Congress enacted Section 365(n) of the Bankruptcy Code, which allows a non-debtor licensee to retain its rights to use licensed intellectual property for the duration of a rejected license and any permitted extensions, provided that the licensee continues to make all royalty payments due.

However, while the Bankruptcy Code's definition of the term intellectual property includes patents, copyrights, and trade secrets, it is silent as to trademarks. There is a split between circuit courts of appeal on whether trademark licensees are protected under Section 365(n):

Lubrizol Approach – Licensee loses rights to IP when licensor rejects license

Before the enactment of Section 365(n), in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., the Fourth Circuit Court of Appeals held that a licensee was stripped of its contractual rights to use a debtor-licensor's IP when the licensor rejected the license.

In response, Congress added Section 365(n) (described above). However, because the definition of "intellectual property" does not include trademarks, many courts have held that Lubrizol still applies to trademark licenses and that, therefore, post-rejection, a licensee loses its rights to use licensed trademarks.

The Sunbeam Products Approach – Licensee retains right to use trademarks, despite rejection of license

In Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC, the Seventh Circuit – 27 years after Lubrizol – became the first circuit court to split from Lubrizol’s interpretation of the effect of rejection and, based on the language of Section 365(g) of the Bankruptcy Code, concluded that rejection of a trademark license does not eliminate the license, but merely constitutes a breach of the license by the debtor-licensor. Because outside of bankruptcy, the licensee could not be deprived of its rights by a licensor's breach, so in bankruptcy, the licensee should also retain its rights to use the licensed trademarks.

First Circuit rejects Sunbeam Approach for Trademarks, Ruling that Licensee Loses License for Trademark and Exclusive Distribution Rights

In the Tempnology trilogy, the bankruptcy court ruled that the debtor-licensor’s rejection of a distribution and marketing agreement, which included a trademark license, left the licensee with only a pre-petition damages claim in lieu of any obligation by the debtor-licensor to further perform under either the trademark license or the grant of exclusive distribution rights. 

The First Circuit BAP then reversed the bankruptcy court on the trademark license issue, adopting the Sunbeam Products approach.

However, the First Circuit has now reversed the First Circuit BAP on the trademark license issue holding that the rejection of the agreement stripped the licensee's right to use the trademark. The First Circuit relied on the reasoning behind the ability to reject a contract - to "free[] the estate from the obligation to perform.”  A trademark license requires the licensor to monitor and exercise control over the quality of the goods sold to the public under the trademark. Therefore, allowing the licensee to continue to use the trademark would impose on the licensor the burden of monitoring the use of the trademark, thereby undercutting the purpose of the rejection powers under the Bankruptcy Code. 

Regarding the exclusive distribution rights, the First Circuit agreed with the bankruptcy court and the First Circuit BAP that the exclusive distribution rights were not themselves licensed intellectual property protected under the Bankruptcy Code, and the rejection of the agreement eliminated those distributions rights.

The First Circuit's decision deepens the divide in the Circuit Courts of Appeal regarding whether trademark licensees are protected from the loss of their rights in their licensors' bankruptcy cases, an issue only the Supreme Court now can finally resolve.

For questions, please contact Kevin Grzebielski at (608) 283-2634/ [email protected], Christopher Combest at (312) 715-5091/[email protected], or your Quarles & Brady attorney.