Protecting Trademark Rights in Bankruptcy—Part 1

“It was the best of times, it was the worst of times….” Charles Dickens, A Tale of Two Cities. These words seem an apt description for the divided experiences of retailers in today’s COVID-19 world. Some retailers in the United States, such as Target, Best Buy, and Dick’s Sporting Goods, are experiencing record sales, profits, and market capitalizations. Others are fighting for survival with no clear path to recovery. With few options left, some retailers look to bankruptcy, either to reorganize or to sell their assets and liquidate. Well-known U.S. retailers that have sought bankruptcy protection since the onset of COVID-19 include Neiman Marcus, Brooks Brothers, and J. Crew.

Bankrupt retailers are frequently party to contracts involving trademark licenses, either as the licensor or licensee. Congress excluded trademarks, including related rights such as service marks and trade names, from the U.S. Bankruptcy Code’s definition of intellectual property (IP); furthermore, the rules that apply to treatment of other IP may not always apply in the case of trademarks. 11 U.S.C. § 101(35A) (defining “intellectual property” as “(A) trade secret; (B) invention, process, design, or plant protected under title 35; (C) patent application; (D) plant variety; (E) work of authorship protected under title 17; or (F) mask work protected under chapter 9 of title 17; to the extent protected by applicable nonbankruptcy law.”).

Trademark licensors and licensees should be aware of the risks that can arise if they or their license counterparty files for bankruptcy. This two-part series addresses the rights and remedies of trademark licensors and licensees in bankruptcy cases in the United States, as well as strategies that can be used to protect license rights and important considerations for potential purchasers of trademark rights in bankruptcy cases. In this series, the party in bankruptcy is referred to as the debtor, and the non-debtor counterparty either as the licensor or the licensee, as applicable.

Types of Bankruptcy

A potential debtor may file for bankruptcy under different chapters of the Bankruptcy Code depending on its ultimate goals for the bankruptcy case. When a retailer seeks bankruptcy protection, it will most likely file under Chapter 11 of the Bankruptcy Code. Chapter 11 is known as the reorganization chapter and provides flexibility for a debtor to either (i) reorganize and restructure its debts and exit bankruptcy or (ii) sell its assets, distribute the proceeds, and liquidate. In Chapter 11 cases, the debtor typically remains in control of its assets as a “debtor in possession,” unless a trustee is appointed for cause (e.g., in the case of fraud, misconduct, incompetence, or gross mismanagement of the business by current management).

Chapter 7 is known as the liquidation chapter. In a Chapter 7 liquidation, a trustee is automatically appointed to take control over and liquidate the debtor’s assets, displacing management. The proceeds of the liquidated assets are used to pay creditors. For purposes of this article, the debtor and trustee are synonymous, and the concepts discussed generally apply in both Chapter 11 and Chapter 7. Chapter 9 (municipality), Chapter 12 (family farmer), and Chapter 13 (individuals with income) bankruptcy cases are not discussed here.

Chapter 15 of the Bankruptcy Code is a separate procedure designed for U.S. recognition of foreign insolvency proceedings. Chapter 15 allows for cooperation among courts in multinational insolvency cases to address cross-border insolvency issues. Issues unique to U.S. licensors and licensees seeking to protect their rights in a Chapter 15 bankruptcy case are discussed in Part 2 of this series of articles.

Regardless of which chapter a debtor files under, one thing is common: the filing of the bankruptcy petition operates as a stay of all actions against a debtor or its property. 11 U.S.C. § 362. Accordingly, after a debtor files for bankruptcy, a licensor or licensee cannot take any action to terminate the debtor’s rights under a trademark license, which is considered property of the estate, without obtaining court permission to do so. The automatic stay does not just prohibit termination of the license, but also other actions seeking to enforce the licensor’s or licensee’s rights against the debtor, such as demands for payments due under the license.

It is important to consult counsel immediately upon a counterparty’s bankruptcy filing to understand how the bankruptcy may affect license rights and what actions might be taken to protect those rights. While this assessment will depend on the facts and circumstances of a particular license, we describe the general rules below.

A Debtor’s Options in Bankruptcy: Assumption

Once a debtor files for bankruptcy, it will usually have discretion to determine the disposition of its trademark licenses, subject to approval of the bankruptcy court. Until the license’s disposition is determined, the licensor or licensee counterparty must continue to perform its obligations under the agreement.

The debtor’s treatment of a contract to which it is a party will be affected by whether that contract is classified as an “executory” contract or “non-executory” contract. A trademark license typically will be considered an executory contract. See e.g., In re Trump Entertainment Resorts, Inc., 526 B.R. 116, 121 (Bankr. D. Del. 2015) (“[T]his Court has previously found patent and copyright licenses to be executory contracts within the meaning of Section 365. [citations omitted]. The reasoning in those decisions with respect to whether an intellectual property license is an executory contract applies with equal force in the context of a trademark license.”). An executory contract is a contract that has not been fully performed by either party. Most courts have generally defined an executory contract as “a contract under which the obligation of both the bankrupt [debtor] 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 the performance of the other.” Countryman, “Executory Contracts in Bankruptcy: Part I,” 57 Minn. L. Rev. 439, 460 (1973). Similarly, the legislative history of Section 365(a) indicates that Congress intended the term to mean a contract “on which performance remains due to some extent on both sides.” H. R. Rep. No. 95-595, at 347 (1977).

Trademark licenses are typically considered executory contracts because the licensor and the licensee generally have significant ongoing obligations under the license. This may include a licensee’s obligations to make royalty payments, comply with restrictions on the use of the licensed trademark, or maintain the quality of products offered pursuant to that trademark, or a licensor’s obligations to protect the trademark against infringement by third parties, monitor the quality of products or services offered under the trademark, or pay maintenance or renewal fees.

However, under certain circumstances, courts have found that perpetual, royalty-free, exclusive trademark licenses were not executory contracts—for example, where a trademark license was granted in connection with a broader transaction, such as the purchase of a business as a going concern. See, e.g., In re Interstate Bakeries Corp., 751 F.3d 955, 963–964 (8th Cir. 2014); In re Exide Techs., 607 F.3d 957, 964 (3d Cir. 2010). Accordingly, it is important to “first identify what constitutes the agreement at issue” before determining whether a license is an executory contract. In re Interstate Bakeries Corp., 751 F.3d at 961.

Section 365(a) of the Bankruptcy Code sets forth the general rule for a debtor’s treatment of executory contracts. Subject to bankruptcy court approval, Section 365(a) allows the debtor to choose between two main options: keeping the contract (known as assumption), or no longer performing under the contract (known as rejection). 11 U.S.C. § 365(a). An assumed contract can be assigned, or sold, in the bankruptcy. The debtor can assume, assign, or reject an executory contract either by filing a motion with the court or through a provision in its plan of reorganization. 11 U.S.C. § 365(a); 11 U.S.C. § 1123(b)(2).

A debtor must assume or reject a contract in its entirety—that is, the debtor cannot pick and choose which provisions of a license it will comply with going forward. In re Physiotherapy Holdings, Inc., 538 B.R. 225, 229 (D. Del. 2015) (“[A] debtor can only assume a contract cume onere—accepting the benefits along with the burdens.” (citing In re Fleming Cos., 499 F.3d 300, 308 (3d Cir. 2007))). Bankruptcy is not an opportunity for a debtor to rewrite or modify its contracts and licenses.

In the following section, the authors discuss the implications of assumption and the bases for licensor or licensee objections. Rejection and assignment, as well as the bases upon which a licensor or licensee may object to the debtor’s proposed treatment of its license will be discussed in Part 2 of this series.

Assumption of the License

To keep or “assume” a contract or license, the debtor must (i) cure any outstanding defaults; (ii) compensate the counterparty for any past defaults; and (iii) provide adequate assurance that the debtor will be able to perform under the contract in the future. 11 U.S.C. § 365(b)(1). Compensation is usually an amount of money, such as unpaid royalties. Under an assumed contract, the counterparty will have a claim in the bankruptcy for outstanding obligations under the contract, regardless of whether they arose before or after bankruptcy. Such claims will be “administrative claims,” a type of claim in bankruptcy that is entitled to a higher priority in the distribution of assets to a debtor’s creditors, and thus are more likely to be paid in full than other claims (such as general unsecured claims). Holders of administrative claims generally are entitled to be paid in full in a Chapter 11 bankruptcy. See 11 U.S.C. § 1129(a)(9)(A) (“the holder of such claim will receive on account of such claim cash equal to the allowed amount of such claim”).

The assumption process requires the debtor to send an assumption notice to its counterparty, setting forth the proposed cure, any compensation for damages caused by the debtor’s default, and adequate assurance. A licensor or licensee that is content with the terms of the assumption notice need take no further action. In the absence of an objection, a debtor’s request to assume a contract is routinely granted by the bankruptcy court.

On the other hand, a licensor or licensee may have an issue with the proposed cure or adequate assurance, or may want to use the bankruptcy process to force the debtor to reject the contract. In that case, absent a consensual resolution with the debtor, the licensor or licensee must assert a timely objection to the debtor’s proposed assumption of its license. There may be several grounds on which it can object to the debtor’s proposed assumption of a trademark license.

First, a counterparty may be able to object to any assumption of its license without consent. Specifically, in certain Circuits that follow what is called the “hypothetical test,” a counterparty licensor’s consent may be required for a debtor to assume a license regardless of the proposed terms of the assumption. Under the hypothetical test, where non-bankruptcy law precludes the assignment of a trademark license absent the consent of the licensor, the debtor will not be allowed to assume the license without its counterparty’s consent. This is the case even if the debtor seeking to assume the license has no intention of selling or assigning the license to a third party. This is largely based on the theory that the “debtor-in-possession,” that is, the debtor during the bankruptcy, is a different entity than the pre-bankruptcy company that filed the bankruptcy case. The federal Circuits that follow the hypothetical test are the Third, Fourth, Ninth, and Eleventh Circuits. See Resort Computer Corp. v. Sunterra Corp (In re Sunterra Corp.), 361 F.3d 257, 265–271 (4th Cir. 2004); Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 749–750 (9th Cir. 1999); City of Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534, 537 (11th Cir. 1994); In re West Elec. Inc., 852 F.2d 79, 83 (3d Cir. 1988). A licensor whose licensee files for bankruptcy in these Circuits thus may have significant negotiating power in dealing with the debtor regarding treatment of the trademark license in bankruptcy.

Other federal Circuits, including the First and Fifth Circuits, as well as lower courts in other Circuits, do not mandate such consent. These courts follow what is called the “actual test.” In re Mirant Corp., 440 F.3d 238 (5th Cir. 2006); Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997); Cajun Elec. Members Comm. v. Mabey (In re Cajun Elec. Power Co-op., Inc.), 230 B.R. 693, 705 (Bankr. M.D. La. 1999); In re Lil’ Things, Inc., 220 B.R. 583, 587 (Bankr. N.D. Tex. 1998); In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005). In these courts, non-bankruptcy law restrictions on assignment come into play only if the debtor actually intends to assign the contract to a third party. Accordingly, under the actual test, the debtor may not need the consent of its counterparty to assume the license, as long as the debtor satisfies the cure, compensation, and adequate assurance requirements for assumption. 11 U.S.C. § 365(b)(1).

Second, a trademark counterparty may object to the adequacy of the debtor’s proposed cure of outstanding defaults. If a debtor assumes a trademark license, the debtor must cure monetary and nonmonetary defaults. In the trademark context, non-monetary defaults could exist whether the debtor is a licensor (e.g., failure to police the mark) or a licensee (e.g., selling product beyond the scope of the license). If the debtor’s nonmonetary defaults are material (e.g., if the debtor never had any right to the mark it licensed), that is an additional basis upon which the counterparty licensor or licensee can object to the debtor’s proposed assumption. The debtor is excused from curing defaults solely relating to the debtor’s insolvency or bankruptcy filing. 11 U.S.C. § 365(b)(2).

Third, a licensor or licensee can object on the basis that it disagrees with the debtor’s proposed compensation for past defaults (also known as a “cure amount”). For example, a debtor may set forth a cure amount of US $50,000. If a licensor or licensee believes the debtor owes it US $200,000, the licensor or licensee should file a timely objection.

Finally, a counterparty may object that the debtor has not provided adequate assurance that the debtor will be able to perform under the contract going forward. For example, if the debtor’s defaults are continuing or defaults are anticipated in the future, the licensor or licensee can object on the basis that the debtor is unable to provide adequate assurance it will be able to perform under the license’s terms in the future. 11 U.S.C. § 365(b)(1)(C); see also In re Travelot Co., 286 B.R. 447, 462 (Bankr. S.D. Ga. 2002); In re Jennifer Convertibles, Inc., 447 B.R. 713, 718–719 (Bankr. S.D.N.Y. 2011). In making this determination, a bankruptcy court may examine the debtor’s history of payment or other performance under the license, whether the debtor has cured or will cure all outstanding defaults, the debtor’s financial outlook, and whether there is a guarantor for payments under the contract.

The other options for a debtor are rejection and assignment of the executory contract, which will be discussed in Part 2 of this series. Part 2 will also address Chapter 15 of the Bankruptcy Code and strategy tips for licensors and licensees during bankruptcy proceedings.

Read Part 2 of this series.

Although every effort has been made to verify the accuracy of this article, readers are urged to check independently on matters of specific concern or interest.

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