The Supreme Court reminded bankrupt debtors on Monday that mere rejection of a contract does not turn back the clock to avoid contractual obligations. This was the thrust of its holding in Mission Product Holdings, Inc. v. Tempnology, LLC, which held that a rejection of an executory contract—in this case, a trademark license—under Section 365(a) constitutes a breach of the contract, not a rescission. Accordingly, in addition to a claim for damages in the bankruptcy case, the creditor may still be entitled to certain benefits under the contract terms, despite the rejection.
Rejecting Contracts under Bankruptcy
Mission Product addresses one of the debtor’s key bankruptcy rights—the power to reject executory contracts. Section 365(a) of the Bankruptcy Code allows the trustee (or in Chapter 11 cases like Mission Product, the debtor-in-possession) to freely assume or reject any “executory contract.” An executory contract is one in which both parties have future obligations to the other party. For example, a sales contract where both goods and payment are to be exchanged in the future would be deemed executory. Section 365(g) generally states that the rejection of a contract is to be treated as a breach that occurred the day before the bankruptcy filing, which results in the opposing contract party having a general unsecured claim in the case.
Is a Rejected Trademark License a Breach or Rescission?
This would all seem fairly straightforward, but for the monkey wrench presented by the particular contract in this case.
Notably, under non-bankruptcy law, trademark licensing agreements typically provide that the licensee’s rights may survive despite the licensor’s breach. Namely, the non-breaching party has a choice. It can cease performance and terminate the agreement, or it can continue to enjoy the rights granted—as such may be enjoyed despite the breach by the other party. In either case, the non-breaching party can also sue for damages.
Mission Product Holdings (MPH) had entered into an agreement with Tempnology to distribute clothing and accessories for keeping cool during exercise under the brand name COOLCORE. The same agreement also granted MPH a nonexclusive, worldwide right to use the COOLCORE trademarks in the course of its distribution activities. When Tempnology filed Chapter 11, it rejected its distribution and license agreement with MPH. In addition to suing for damages for the breach arising out of the rejection of the agreement, MPH also sought to retain its licensed right to use the COOLCORE trademarks.
Bankruptcy law regarding rejection of intellectual property agreements distinguishes trademark contracts from other intellectual property licenses. In contrast to the default treatment for executory contracts under Section 365(g), special protections in bankruptcy under Section 365(n) provide specialized treatment for rejected patent and copyright licenses. This specialized treatment allows the creditor-licensee to continue using the licensed intellectual property according to the licensed terms in exchange for paying any fees specified by the contract for the licensed rights. In other words, Section 365(n) expressly allows a licensee to retain its licensed rights under certain conditions—but this provision conspicuously excludes trademark licenses from its scope. Therefore, a trademark license is treated under the general rule for rejected contracts set forth in Section 365(g), whereby the agreement is deemed to be breached by the debtor-licensor. Applying Section 365(g), Tempnology’s rejection of the distribution agreement and trademark license would mean that MPH was entitled to sue for damages from breach of contract and also entitled to continue using the trademark rights granted by the agreement.
Under trademark law, this presents a problem for Tempnology. Trademark owners must monitor their licensees and enforce quality control standards over the use of the licensed trademarks. Failure to do so can result in degradation or even loss of the trademark rights by law. Tempnology rejected the contract, seeking to escape the presumably burdensome contract with MPH. However, the rejection of the contract (even though deemed a breach by Tempnology) would not necessarily block MPH from using the trademarks. This result would frustrate Tempnology’s ability to control the licensed trademarks and potentially jeopardize its rights in them.
Instead, Tempnology sought a ruling that rejecting the trademark license amounted to a rescission of the contract, not a breach. Rescinding the contract would return the parties to their pre-contract status, with no trademark rights conferred. First, it argued that by excluding trademarks from the right to continue using licensed intellectual property rights under Section 365(n), there was a “negative inference” that trademark licensees were not entitled to continue using licensed trademarks from a rejected license (Section 365(g) notwithstanding). Second, it argued that the imperatives of trademark law to monitor and control licensed uses of trademarks should entitle trademark licensor-debtors to a special rule (again, Section 365(g) notwithstanding). The First Circuit adopted Tempnology’s arguments, and MPH appealed to the Supreme Court.
Creditor-Licensee’s Rights to Use Trademarks Protected
In an 8-1 opinion for the Supreme Court, Justice Kagan deftly swatted away both of Tempnology’s arguments and reversed the holding of the First Circuit. Regarding the exclusion of trademarks from the treatment afforded other intellectual property licenses under Section 365(n), Justice Kagan held that no such “negative inference” arises. “Congress,” Justice Kagan wrote, “did nothing in adding Section 365(n) to alter the natural reading of Section 365(g),” which plainly states that rejection of a contract is to be deemed a breach. The opinion went on to note: “Outside bankruptcy, a licensor’s breach cannot revoke continuing rights given to a counterparty under a contract (assuming no special contract term or state law). And because rejection ‘constitutes a breach,’ the same result must follow from rejection in bankruptcy.”
With respect to the second argument, Justice Kagan acknowledged that while a creditor-licensee’s ongoing use of trademarks under a rejected contract could raise “serious … trademark-related concerns,” Sections 365(a) and (g) were “general provisions that speak, well, generally.” There is no special trademark provision that applies. Justice Kagan concluded, “[i]n thus delineating the burdens that a debtor may and may not escape, Congress also weighed (among other things) the legitimate interests and expectations of the debtor’s counterparties.”
While a trademark licensee thus has the right to continue using the licensed trademarks under a rejected contract, the Supreme Court made clear that trademarks are not being made subject to the provisions in Section 365(n) for other intellectual property contracts. That is, the licensee’s rights arise naturally from the breach itself under Section 365(g). This does mean that trademark licenses are treated somewhat differently from other intellectual property licenses. For example, under basic principles of contract law, the non-breaching party may deduct damages caused by the breach from any amounts owed to the breaching party. This would be allowed for a trademark licensee, but a patent or copyright licensee under Section 365(n) is not entitled to this form of legal self-help.
What Should Licensors and Licensees Do?
In the wake of Mission Product, trademark licensors should strongly consider defining how trademark rights may be treated in the event of bankruptcy or other conditions during contract negotiations. As Justice Sotomayor notes in her concurrence, “special terms in a licensing contract or state law could bear” on whether trademark rights survive a breach of other conditions in a contract that terminate rights. A trademark licensor could tie the trademark license to certain other rights or obligations that may cease in the event of bankruptcy (for example, requiring that all printed materials displaying the mark be purchased from the licensor), which as a practical matter would result in the licensee being prevented from using the marks. Another option would be to include a termination of the trademark rights under certain conditions, including bankruptcy. But as prospective licensors seek ways to prevent the trademark license from continuing, prospective licensees may try to do the opposite.
Once a licensor-debtor is in bankruptcy, the result of Mission Product demonstrates that the licensor-debtor should carefully consider the downstream effects of rejecting a contract. Continued control and rights over a trademark may outweigh the financial or contractual burdens of a particular deal.