The following is an update of a decision by the U.S. Supreme Court involving contracts and bankruptcy.
Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. ___, 139 S.Ct. 1652, 203 L.Ed.2d 876, 2019 U.S. LEXIS 3544, 2019 WL 2166392 (May 20, 2019)
Although a debtor-licensor’s rejection of a trademark licensing agreement under the Bankruptcy Code breaches the contract, such action does not rescind it. Accordingly, the United States Supreme Court held, in an 8-1 decision, rejection of the license in bankruptcy does not deprive the licensee of its rights to use the trademark. In so ruling, the Supreme Court reversed the decision of a divided First Circuit and resolved a circuit split. The opinion can be found here.
Using clear and concise language, Justice Kagan authored the majority opinion for the Court. Section 365 of the Bankruptcy Code (Title 11, U.S.C.) enables a debtor to “reject any executory contract”, which means a contract that neither party has finished performing. Under §365(g), a debtor’s rejection of a contract “constitutes a breach of such contract,” and such breach gives rise to a prepetition claim against the bankruptcy estate for damages resulting from the debtor’s nonperformance.
The debtor in the present case, Tempnology, LLC, argued that its rejection of the contract also terminated the rights it had granted to the licensee, Mission Product Holdings, Inc. (“Mission”), to use its trademark for “Coolcare” athletic apparel. In rejecting that argument, the Court determined that “breach” – which is neither defined in the Bankruptcy Code nor a specialized bankruptcy term – shall be interpreted to have the same meaning under the Code that it has outside bankruptcy. Thus, the rejection of a contract under § 365 by a debtor or bankruptcy trustee has the same consequence as a breach of contract occurring outside bankruptcy. Under the Court’s holding, the non-breaching party (here, Mission) has a claim for damages and retains the rights it has received under the trademark license agreement with Tempnology.
The decision is useful not just for bankruptcy attorneys, but for all lawyers whose practices include the resolution of disputes arising from contracts. The Court succinctly summarized: the history of the dispute, in which three lower courts had issued decisions; the split that had existed between the First and Seventh Circuits concerning rejection of trademark licenses in bankruptcy; and the important legal issues presented by intellectual property rights, including such rights in trademark license agreements, and application of section 365’s governing subdivisions, including (a), (g)-(i), and (n). Subdivision (n) of section 365 specifically concerns the rejection of an executory contract “under which the debtor is a licensor of a right to intellectual property”. However, intellectual property, as defined in the Bankruptcy Code, does not include trademarks. This fact supported the “negative inference” argument that Tempnology had used to prevail in the Bankruptcy Court and First Circuit.
Before addressing the negative inference argument, legislative history of section 365, core principles of bankruptcy, and so-called “special features of trademark law”, Justice Kagan used an analogy involving another type of executory contract – between a law firm and photocopier leasing company – to suggest an apparently broad view of rights held by the counterparty if the debtor rejects the contract. Justice Kagan wrote:
” … A dealer leases a photocopier to a law firm, while agreeing to service it every month; in exchange, the firm commits to pay a monthly fee. During the lease term, the dealer decides to stop servicing the machine, thus breaching the agreement in a material way. The law firm now has a choice (assuming no special contract term or state law). The firm can keep up its side of the bargain, continuing to pay for use of the copier, while suing the dealer for damages from the service breach. Or the firm can call the whole deal off, halting its own payments and returning the copier, while suing for any damages incurred. (Citation) But to repeat: The choice to terminate the agreement and send back the copier is for the law firm. By contrast, the dealer has no ability, based on its own breach, to terminate the agreement. Or otherwise said, the dealer cannot get back the copier just by refusing to show up for a service appointment. The contract gave the law firm continuing rights in the copier, which the dealer cannot unilaterally revoke.
[¶] And now to return to bankruptcy: If the rejection of the photocopier contract ‘constitutes a breach,’ as the Code says, then the same results should follow (save for one twist as to timing). Assume here that the dealer files a Chapter 11 petition and decides to reject its agreement with the law firm. That means, as above, that the dealer will stop servicing the copier. It means, too, that the law firm has an option about how to respond—continue the contract or walk away, while suing for whatever damages go with its choice. (Here is where the twist comes in: Because the rejection is deemed to occur ‘immediately before’ bankruptcy, the firm’s damages suit is treated as a pre-petition claim on the estate, which will likely receive only cents on the dollar. […]) And most important, it means that assuming the law firm wants to keep using the copier, the dealer cannot take it back. A rejection does not terminate the contract. When it occurs, the debtor and counterparty do not go back to their pre-contract positions. Instead, the counterparty retains the rights it has received under the agreement. As after a breach, so too after a rejection, those rights survive.”
The use of this example supports the Court’s interpretation that section 365’s (a) and (g) “speak broadly to ‘any executory contract[s].'” The Court acknowledged that Congress had taken the opportunity to draft specific rules within section 365 to govern real property leases [subdivision (h)] and patent licenses [(n)], but explained that these provisions are therefore “not redundant of Section 365(g): Each sets out a remedial scheme embellishing on or tweaking the general rejection-as-breach rule.”
In reaching its conclusion, the Court rejected Tempnology’s arguments based on the negative inference and special features of trademark law. Further, the Court explained that its decision was consistent with the general bankruptcy rule that the estate cannot possess anything more that the debtor did outside bankruptcy and that, to hold otherwise, would circumvent the Code’s stringent limits on “avoidance” actions, i.e., the exceptional cases in which debtors may unwind pre-bankruptcy transfers that undermine the bankruptcy process.
Under 11 U.S.C. Section 365, a debtor’s rejection of an executory contract in bankruptcy has the same effect as a breach outside bankruptcy; and such act of rejection cannot rescind rights that the contract previously granted. For Mission, this construction of Section 365 means that Tempnology’s rejection cannot revoke the trademark license. For all counterparties whose contracts are rejected in bankruptcy, they may now look to state law, in addition to Section 365, to assert their rights.
These materials were written by the Business Litigation Committee by Peter L. Isola of Hinshaw & Culbertson LLP (PIsola@hinshawlaw.commailto:email@example.com). The author is a former Co-Chair of the Business Litigation Committee. Editing contributions were provided by Neil J Wertlieb of Wertlieb Law Corp (Neil@WertliebLaw.com).