Client Alert. Circuit Courts Weigh In on Treatment of Trademark License Agreements in Bankruptcy

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1 Number 1438 December 12, 2012 Client Alert Latham & Watkins Finance Department Circuit Courts Weigh In on Treatment of Trademark License Agreements in Bankruptcy Recent bankruptcy appellate rulings have addressed the issue as to what rights a trademark licensee has after a debtorlicensor rejects its trademark license in bankruptcy. These cases have significantly shifted the bankruptcy legal landscape in favor of trademark licensees. Recent bankruptcy appellate rulings have addressed the issue of what rights a trademark licensee has after a debtor-licensor rejects its trademark license in bankruptcy. The Third Circuit in the Exide Technologies case and the Eighth Circuit in the Interstate Bakeries case recently considered whether certain trademark license agreements that were executed in connection with asset sale transactions several years before the commencement of the licensors bankruptcy cases were executory contracts. Additionally, the Seventh Circuit in the Sunbeam Products case and a concurring opinion in the Exide Technologies case recently opined on what rights a licensee would have after a debtor-licensor rejects a trademark license. This Alert addresses these cases. When a company enters bankruptcy in the US, it enjoys a broad right to assume, assign or reject its executory contracts (contracts with material performance obligations remaining on both sides) and unexpired leases. This right extends to executory contracts relating to intellectual property rights (such as patent, copyright and trademark licenses), regardless of whether the debtor is the licensor or the licensee of those rights. The US Bankruptcy Code further provides that a debtor s rejection of an executory contract or unexpired lease constitutes a breach by the debtor of that contract or lease that is deemed to have occurred immediately before the filing of the bankruptcy case. 1 Bankruptcy courts have often held that as a consequence, counterparties to executory contracts and unexpired leases that are rejected are entitled only to assert claims for damages relating to the rejection of those agreements. Those claims would be classified as pre-petition claims that may receive much less than a full recovery. A threshold question in evaluating an intellectual property license agreement in a bankruptcy case is whether it is an executory contract at all. If a contract is not executory, it is merely an asset or obligation of the debtor s estate, and it cannot be assumed or rejected in a bankruptcy case. Intellectual property licenses that are not executory are normally viewed as transfers of ownership interests in the intellectual property. If the debtor rejects an executory contract under which it is the licensor of a right to intellectual property as defined in section 101(35A) of the Bankruptcy Code, section 365(n) of the Bankruptcy Code 2 provides certain protections to licensees. 3 Specifically, if a debtor-licensor rejects such a contract, the licensee may treat the Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and as affiliated partnerships conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Salman M. Al-Sudairi. In Qatar, Latham & Watkins LLP is licensed by the Qatar Financial Centre Authority. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2012 Latham & Watkins. All Rights Reserved.

2 contract as having been terminated if the debtor-licensor s rejection amounts to such a breach as would entitle to the licensee to treat the contract as terminated under the terms of the contract, applicable non-bankruptcy law or an agreement between the licensee and a third party. Alternatively, the licensee may retain certain of its rights under the contract (except for the right to specific performance), so long as the licensee continues to pay all royalties required under that agreement. 4 Importantly, section 365(n) of the Bankruptcy Code applies only to executory contracts under which the debtor is a licensor of a right to intellectual property, as that term is defined in section 101(35A) of the Bankruptcy Code. While trademarks are commonly considered intellectual property, section 101(35A) of the Bankruptcy Code does not include trademarks. Thus, when a debtor-licensor rejects an executory contract giving rise to a trademark license, the licensee cannot avail itself of section 365(n) of the Bankruptcy Code. Until the recent slate of appellate cases discussed herein, there was a widespread perception that a trademark licensee would not retain any rights under the license after it is rejected. These recent cases have significantly shifted the bankruptcy legal landscape in favor of trademark licensees. Whether a Particular Trademark License Agreement is an Executory Contract In re Exide Technologies 5 In 1991, Exide Technologies sold substantially all of its industrial battery business to EnerSys Delaware, Inc. (then known as Yuasa Battery (America), Inc.). In connection with that sale the parties executed nearly two dozen different agreements, including an Asset Purchase Agreement, a Trademark and Trade Name License Agreement, an Administrative Services Agreement and a letter agreement (the Four Agreements). Under the Four Agreements, Exide Technologies granted EnerSys a perpetual, exclusive, royalty-free license to use the Exide trademark in the industrial battery business (Exide Technologies continued using the Exide trademark outside of the industrial battery business). In 2000, Exide Technologies returned to the North American industrial battery market by purchasing another company. In connection with its return to that market, Exide Technologies made several attempts to regain the trademark from EnerSys, but was rebuffed. As a result, Exide Technologies had to compete against EnerSys in the industrial battery market, but it was EnerSys that was selling its products with the Exide mark. In 2002, Exide Technologies commenced its chapter 11 case in the United States Bankruptcy Court for the District of Delaware. Exide Technologies moved to reject the Four Agreements during that bankruptcy case. In 2006, the Bankruptcy Court ruled that the Four Agreements were executory contracts that could be rejected by Exide Technologies, and that as a result of the rejection, EnerSys s rights and Exide Technologies obligations under the Four Agreements terminated. 6 The District Court affirmed the Bankruptcy Court s ruling. 7 EnerSys appealed to the Third Circuit, arguing that the District Court and Bankruptcy Court erred in holding that the Four Agreements were executory and in holding that rejection resulted in the termination of EnerSys s rights and Exide Technologies obligations under the Four Agreements. 2 Number 1438 December 12, 2012

3 On appeal, the Third Circuit held that the Four Agreements were not executory contracts, and accordingly were not subject to rejection. In its analysis, the Third Circuit applied the often-used Countryman definition of the term executory contract, which provides that an executory contract is one under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other. 8 Relying on the Countryman definition, the Third Circuit held that unless both parties have unperformed obligations that would constitute a material breach if they are not performed, the contract cannot be executory. 9 The Third Circuit also stated that (a) the party seeking to reject a contract (typically the debtor) bears the burden of demonstrating that the contract is executory and (b) the time for testing whether there are material unperformed obligations by both parties is the date the bankruptcy petition is filed. 10 Because the Four Agreements were governed by New York law, the Third Circuit looked to New York contract law to determine whether there was at least one obligation for both parties (at the time Exide Technologies filed its bankruptcy case in 2002) that would constitute a material breach if not performed. The Third Circuit noted that under New York law, a material breach is one that is so substantial as to defeat the purpose of the entire transaction. 11 However, New York contract law also provides that when a breaching party has substantially performed under the contract before breaching, the other party s performance is not excused. 12 In the Exide Technologies case, the Third Circuit held that EnerSys had substantially performed under the Four Agreements, which formed a part of a complex integrated transaction that closed more than 10 years before Exide Technologies filed its bankruptcy case. Specifically, the Third Circuit noted that EnerSys had paid the full purchase price under the 1991 sale agreement, assumed Exide Technologies liabilities relating to the industrial battery business, and had been operating under the Four Agreements for more than 10 years as of Because EnerSys had substantially performed its obligations under the entire sale transaction of which the Four Agreements constituted a part, the Third Circuit held that the Four Agreements were not executory and thus could not be rejected. In re Interstate Bakeries Corp. 14 In connection with the US Department of Justice s antitrust challenge of Interstate Bakeries Corporation s acquisition of Continental Baking Company, Interstate Bakeries was required to divest itself of certain rights and assets in order for the acquisition to close. To effectuate the required divestiture, Interstate Brands Corporation (IBC), a subsidiary of Interstate Bakeries Corporation, entered into an asset purchase agreement and a license agreement with Lewis Brothers Bakeries (LBB) in The license agreement granted LBB a perpetual, royalty-free, transferable and exclusive license to use various trademarks in certain locations in Illinois. In 2004, IBC commenced a chapter 11 case in the United States Bankruptcy Court for the Western District of Missouri. Four years later, LBB commenced an adversary proceeding that sought a declaratory judgment that the license agreement was not an executory contract. The Bankruptcy Court held that the license agreement was executory, finding that IBC maintained numerous obligations under the license agreement, such as the obligations to defend the marks, notify LBB of any threatened infringement of the marks, refrain from suing LBB for infringement or using the marks in the relevant territories, and indemnify LBB against certain claims. The Bankruptcy Court also 3 Number 1438 December 12, 2012

4 found a number of continuing obligations on LBB s part, including the duties to maintain the character and quality of goods sold under the marks, refrain from sublicensing or registering the marks, notify IBC of any threatened infringement of the marks, and assist IBC in infringement litigation. The District Court affirmed the Bankruptcy Court s decision, holding the License Agreement was an executory contract because a material obligation remained since the failure to maintain the character and quality of goods sold under the trademarks would constitute a material breach. 15 On appeal to the Eighth Circuit, LBB contended that the license agreement was similar to the Four Agreements in Exide Technologies. In particular, LBB argued that the license agreement was an integral part of a completed acquisition transaction, that the acquisition was fully or substantially performed, and that any ongoing obligations of LBB and IBC under the license agreement were either minor or conditional. 16 The Eighth Circuit rejected LBB s arguments and held that the license agreement was an executory contract. Critical to the Eighth Circuit s analysis were the specific provisions in the license agreement itself, wherein LBB and IBC agreed that LBB s failure to maintain the character and quality of goods sold under the marks (which was a continuing obligation of LBB) would be a material breach. The Eighth Circuit distinguished Exide Technologies on its facts, noting that in Exide Technologies, the parties had never contemplated or discussed any quality standards, so Third Circuit could not have held that the maintenance of quality standards was a material obligation. In the license agreement between LBB and IBC, however, the parties specifically agreed that a breach of the obligation to maintain quality standards would be material. 17 The Eighth Circuit also noted that IBC continued to have material obligations under the license agreement, including obligations of notice and forbearance with regard to the marks. 18 In a dissenting opinion, one Judge concluded that the license agreement between LBB and IBC was part of an integrated agreement that also included an asset purchase agreement, and that the integrated agreement was not executory because IBC substantially performed its obligations thereunder. 19 Whether a Licensor s Rejection of a Trademark License Deprives the Licensee of the Right to Use the Mark Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC 20 In the Sunbeam Products case, the Seventh Circuit held that a trademark licensee could continue to use a trademark after the license was rejected by the debtorlicensor, even though the protections of section 365(n) of the Bankruptcy Code do not extend to licensees of trademarks. In that case, Lakewood Engineering & Manufacturing Co. (Lakewood) entered into a contract with Chicago American Manufacturing (CAM), whereby CAM was authorized to manufacture box fans and to put Lakewood s trademarks on the box fans that CAM manufactured. Three months after that contract was executed, several of Lakewood s creditors filed an involuntary petition against Lakewood. Lakewood s bankruptcy trustee sold Lakewood s business (including Lakewood s patents and trademarks) to Sunbeam Products. The bankruptcy trustee also moved to reject the contract with CAM, which the Bankruptcy Court approved. When CAM continued to make and sell Lakewood-branded fans under the rejected contract, Sunbeam Products brought an adversary proceeding against CAM. The Bankruptcy Court did not decide 4 Number 1438 December 12, 2012

5 whether the Bankruptcy Code provided for the termination of CAM s right to use the trademarks upon rejection, but it permitted CAM to continue using the mark on equitable grounds because of the substantial resources CAM invested in making Lakewood-branded box fans. 21 The Seventh Circuit rejected the Bankruptcy Court s equitable basis for permitting CAM to continue using the mark, but it held that the Bankruptcy Code permitted CAM to continue using the mark. The Seventh Circuit observed that pursuant to section 365(g) of the Bankruptcy Code, once a debtor rejects an executory contract, it is no longer subject to an order of specific performance. The debtor s unfulfilled obligations under that contract are converted to damages, which are treated as a pre-petition obligation. But nothing about this process implies that any rights of the other contracting party have been vaporized. 22 In other words, rejection has absolutely no effect upon the contract s continued existence. 23 In its opinion, the Seventh Circuit also criticized the Fourth Circuit s 1985 decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 24 which had held that when an intellectual property license is rejected by a debtor-licensor, the licensee loses its right to retain its contract rights in the technology, but rather only has a claim for money damages. The Seventh Circuit stated that the Lubrizol decision confused contract rejection (which is not the equivalent of rescission) with avoidance powers (which could be used to completely eliminate a non-debtor s right to property). 25 The Seventh Circuit also concluded that Congress s decision to omit trademarks from the purview of section 365(n) of the Bankruptcy Code (which was enacted after the Lubrizol decision specifically to overrule that decision with respect to intellectual property ) was not an implicit codification of Lubrizol with respect to trademarks; rather it was simply an omission designed to allow more time for Congressional study. 26 In his concurring opinion in Exide Technologies, Judge Ambro applied a very similar analysis as the Seventh Circuit did in Sunbeam Products to conclude that a debtorlicensor s rejection of a trademark license agreement does not deprive the licensee of its rights in the mark. 27 Potential Strategies to Protect the Rights of Trademark Licensees In light of the current uncertainty surrounding the rights of trademark licensees when a debtor-licensor seeks to reject the underlying license agreements in bankruptcy, licensees may wish to consider strategies to protect their rights. Such strategies may include: If the trademark license forms a part of a larger transaction, include a provision in the trademark license agreement and the other transaction documents that provides that the trademark license agreement and the other transaction documents form a single integrated agreement. Bundle trademark rights with copyright or patent licenses, which are protected under section 365(n). Explicitly establish a transition period in the trademark license agreement. Obtain and perfect a security interest in the trademark. 5 Number 1438 December 12, 2012

6 Endnotes 1 This is the case unless the contract or lease was previously assumed during the bankruptcy case in which case the breach would be deemed to have occurred on a later date. See 11 U.S.C. 365(g). 2 Id U.S.C. 365(n). Section 365(n) of the Bankruptcy Code was enacted in response to the Fourth Circuit s decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), which held that when an intellectual property license is rejected by a debtor-licensor, the licensee loses its right to retain its contract rights in the intellectual property, but rather only has a claim for money damages. 4 These rights include: (a) continued use of the intellectual property as it existed at the time of the filing of the bankruptcy case for the duration of the executory contract plus any period for which the license may be extended by the licensee as of right under applicable non-bankruptcy law, and (b) the ability to enforce exclusivity provisions against the debtor and any successor entity contained in the executory contract. The licensee would not have the right to specific performance of the executory contract by the debtor-licensor after the contract is rejected. See 11 U.S.C. 365(n)(1)(B). 5 In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010). 6 See In re Exide Technologies, 340 B.R. 222 (Bankr. D. Del. 2006). Prior to that decision, the Bankruptcy Court ruled that the Four Agreements constituted a single integrated agreement, a ruling that neither Exide Technologies nor EnerSys challenged on appeal. 7 See In re Exide Technologies, No , 2008 U.S. Dist. LEXIS (D. Del. Feb. 27, 2008). 8 Vern Countryman, Executory Contracts in Bankruptcy: Part 1, 57 Minn. L. Rev. 439, 460 (1973). 9 See In re Exide Technologies, 607 F.3d at See id. 11 See id., citing Lipsky v. Commonwealth United Corp., 551 F.2d 887, 895 (2d Cir. 1976). 12 See id., citing Hadden v. Consolidated Edison Co., 34 N.Y.2d 88 (N.Y. 1974). 13 The Third Circuit rejected Exide Technologies assertion that certain ongoing obligations on the part of EnerSys were substantial enough to cause a material breach if unperformed. For example, the Third Circuit stated that EnerSys s obligation not to use the Exide mark outside the industrial battery business was not a material obligation, but rather was a condition subsequent that required EnerSys to use the mark in accordance with the terms of the trademark license. The Third Circuit also stated that EnerSys s obligation to observe a quality standards provision in the Four Agreements was minor, because it required EnerSys simply to meet the standards of the mark for each battery produced, and the provision did not relate to the sale of the industrial battery business itself. See id. at In re Interstate Bakeries Corp., 690 F.3d 1069 (8th Cir. 2012). 15 See In re Interstate Bakeries Corp., 447 B.R. 879 (W.D. Mo. 2011). 16 See In re Interstate Bakeries Corp., 690 F.3d at See id. at See id. 19 See id. at Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372 (7th Cir. 2012). 21 See id. at See id. at See id. 24 Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985). 25 See Sunbeam Products, 686 F.3d at See id. at See In re Exide Technologies, 607 F.3d at Number 1438 December 12, 2012

7 If you have any questions about this Client Alert, please contact one of the authors listed below or the Latham attorney with whom you normally consult: Peter M. Gilhuly Los Angeles Michael Riela New York Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney with whom you normally consult. A complete list of our Client Alerts can be found on our website at If you wish to update your contact details or customize the information you receive from Latham & Watkins, visit to subscribe to our global client mailings program. Abu Dhabi Barcelona Beijing Boston Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong Houston London Los Angeles Madrid Milan Moscow Munich New Jersey New York Orange County Paris Riyadh* Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. * In association with the Law Office of Salman M. Al-Sudairi 7 Number 1438 December 12, 2012