"Rejection as Breach" Analysis Resolves Circuit Split and Sets Precedent in Supreme Court's Recent Bankruptcy Ruling in Mission Product Holdings Inc. v. Tempnology LLC

On May 20, 2019, the United States Supreme Court issued its decision in Mission Product Holdings Inc. v. Tempnology LLC (In re Tempnology) ("Tempnology"), 587 U.S. ___, 2019 WL 2166392 (U.S. May 20, 2019), which finally resolved an issue that has created confusion and uncertainty for more than 30 years regarding the consequences flowing from a debtor licensor's rejection of a trademark license in bankruptcy. The Supreme Court considered whether a trademark licensor's rejection of a trademark license terminates the non-debtor licensee's rights to use the trademark or simply constitutes a breach of such agreement, entitling the licensee to assert a claim for damages. Specifically, Section 365(g) provides that "the rejection of an executory contract … constitutes a breach of such contract … immediately before the date of the filing of the petition."¹ While the term "breach" is not defined in the Bankruptcy Code, the Supreme Court noted that it has the same meaning as used "in contract law outside bankruptcy."² This is generally defined as a contract party's failure to perform its contractual obligations, giving the non-breaching party a claim for damages or other relief.³ However, Congress accorded special treatment to licensees of "intellectual property" under Section 365(n) of the Bankruptcy Code, which grants licensees of a rejected license of intellectual property the option either to treat the license agreement as terminated (and to assert a pre-petition damages claim) or to retain the intellectual property under the license for the remainder of the license term, subject to its obligation to pay ongoing royalties under the terms of the license. While Section 365(n) addresses how patent and copyright licenses, and other intellectual property licenses, are treated upon rejection in bankruptcy, trademarks are expressly excluded from the definition of intellectual property. As a result, it was uncertain until now how trademark licenses would be treated upon rejection in bankruptcy.

The Supreme Court held that rejection of a trademark license under Section 365 of the Bankruptcy Code constitutes a breach of the license agreement entitling the licensee to damages and whatever remedies were negotiated by the licensee under the terms of the license or available under applicable non-bankruptcy law, but does not automatically result in termination of the license. Equally important, the Supreme Court's ruling will have reverberations far beyond trademark licenses and will affect what remedies are available to counterparties to all executory contracts if their agreements are rejected in bankruptcy. As discussed below, counterparties to such contracts including trademark licenses must, more than ever, consider whether and how to structure their agreements to preserve post-rejection remedies. The import of Tempnology is briefly discussed below.

Case Background and Procedural History

In Tempnology, the debtor Tempnology LLC ("Debtor") licensed clothing and accessories "designed to stay cool when used in exercise."⁴ The Debtor granted Mission Product ("Mission") a non-exclusive license to use the Debtor's "Coolcore trademarks," which was set to expire in July 2016.⁵ The Debtor commenced a Chapter 11 bankruptcy petition in September 2015, and sought to "reject" the trademark license under Section 365 of the Bankruptcy Code in order "to free itself from Mission's rights under the Agreement, which it claimed had 'hinder[ed] [its] ability to derive revenue by other marketing and distribution opportunities.'"⁶ The Debtor also sought to "market and sell its products to third parties in Mission's exclusive territory."⁷ Mission objected to the motion and elected to retain its rights to intellectual property under Section 365(n) of the Bankruptcy Code, which gives licensees of "intellectual property" the option either to treat the license agreement as terminated (and to assert a pre-petition damages claim), or to retain the intellectual property under the license for the remainder of the license term, subject to its obligation to pay ongoing royalties under the terms of the license. Notably, the Bankruptcy Code's definition of "intellectual property" includes trade secrets, patents, patent applications, copyrights, mask works, and plant varieties, to the extent protected by applicable non-bankruptcy law.⁸ However, trademarks are not included in the definition of intellectual property. In response, the Debtor requested that the Bankruptcy Court determine what rights Mission would retain after the Debtor's rejection of the license.

The Bankruptcy Court found that rejection of the trademark license terminated the licensee's rights under the license. As a result, Mission sought to sell substantially all of the Debtor's assets, including intellectual property, to the Debtor's controlling shareholder, which agreed to pay all unsecured claims against the Debtor in full, except certain disputed claims, including Mission's rejection damages claim. During the course of the bankruptcy, the trademark license expired in accordance with its terms. Mission filed a claim for more than $4 million in breach of contract damages.

On appeal, the First Circuit Bankruptcy Appellate Panel (the "BAP") reversed in part, holding that rejection did not result in termination of the license:

Outside bankruptcy, . . . the breach of an agreement does not eliminate rights the contract had already conferred on the non-breaching party [citation omitted]. So neither could a rejection of an agreement in bankruptcy have that effect. A rejection "convert[s]" a "debtor's unfulfilled obligations" to a pre-petition damages claim. [citation omitted]. But it does not "terminate the contract" or "vaporize[ ]" the counterparty's rights. . . . Mission could continue to use the Coolcore trademarks.⁹

The First Circuit Court of Appeals reversed the BAP, holding that Mission's rights under the license were terminated upon rejection.¹⁰ Mission filed a petition for certiorari, which was granted.

Rejection of a Trademark License Constitutes a Breach and Not a Termination of the License

The Supreme Court reversed the First Circuit and held in an 8-1 decision authored by Justice Kagan that a debtor licensor's rejection of a trademark license constitutes a breach of the license, rather than a termination, and does not revoke the licensee's rights previously transferred under the trademark license. This decision resolves a circuit split between the First Circuit in In re Tempnology, LLC, supra, which concluded that rejection under Section 365(g) of the Bankruptcy Code results in termination of the licensee's rights under the trademark license, and the Seventh Circuit Court of Appeals in Sunbeam Product, supra, which held that a rejection does not automatically cancel the trademark licensee's rights.¹¹

The Court was unpersuaded by the Debtor's contention "that by specifically enabling the counterparties in some contracts to retain rights after rejection, Congress showed that it wanted the counterparties in all other contracts to lose their rights."¹² According to the Court, "[t]he debtor can stop performing its remaining obligations under the agreement. But the debtor cannot rescind the license already conveyed. So the licensee can continue to do whatever the license authorizes."¹³ Similarly, the Court was unpersuaded by the First Circuit's rationale that "special features of trademark law counsel against allowing a licensee to retain rights to a mark after the licensing agreement's rejection. Under that body of law, . . . , the trademark owner's '[f]ailure to monitor and exercise [quality] control' over the goods associated with the trademark 'jeopardiz[es] the continue validity of [its] own trademark rights.'"¹⁴ Section 365 does not "relieve the debtor of the need, against the backdrop of [trademark law], to make economic decisions about preserving the estate's value – such as whether to invest the resources needed to maintain a trademark. In 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."¹⁵ The Court further noted that "[t]he rejection-as-breach rule" prevents the debtor "from recapturing interests it had given up" upon rejection, whereas the "rejection-as-rescission" approach would "circumvent the [Bankruptcy] Code's stringent limits on 'avoidance' actions – the exceptional cases in which trustees . . . may indeed unwind pre-bankruptcy transfers that undermine the bankruptcy process."¹⁶

To make its point that a debtor should not be permitted to use its breach to deny the non-debtor contract counterparty's rights under a contract, the Court posed the following hypothetical involving a copy machine lease: A law firm leases a copy machine from a dealer, and the lease requires the dealer to provide monthly service and the law firm to pay a monthly fee. The dealer later breaches the agreement by refusing to provide service. The law firm faces a choice (assuming no special contract term or state law applies): (A) the law firm could retain the copier, continue to make the service payments, and sue the dealer for damages; or (B) the law firm could cease making payments, return the copier to the dealer, and sue for damages.¹⁷ As the Court observed, the law firm must decide whether to terminate the lease and return the copier. The dealer cannot unilaterally terminate the lease and recover the copier, because the breach is deemed to have occurred immediately before bankruptcy.¹⁸ Similarly, if the dealer files Chapter 11 bankruptcy, it would not be able to use rejection to terminate the lease and to recover the copier. The Court reasoned that to do otherwise would be to grant the debtor avoidance powers that are not set forth in the Bankruptcy Code. As the Court noted: "If trustees (or debtors) could use rejection to rescind previously granted interests, then rejection would become functionally equivalent to avoidance. Both, that is, would roll back a prior transfer. And that result would subvert everything the Code does to keep avoidances cabined."¹⁹

The Court applied a "plain meaning" interpretation of the Bankruptcy Code to reach its conclusion that a debtor licensor's rejection of a trademark license constitutes a breach of the license rather than a termination. The Court held that no negative inferences arise from the fact that trademark licenses do not fall within the definition of intellectual property governed by Section 365(n) "to alter the natural reading of Section 365(g) . . . that rejection and breach have the same results."²⁰ The Court further reasoned that this decision is consistent with long-standing case law holding that bankruptcy does not provide a debtor with greater rights than it would otherwise have under non-bankruptcy law: "A debtor's property does not shrink by happenstance of bankruptcy, but it does not expand, either."²¹ According to the Court, non-bankruptcy law generally provides that the licensee may continue to pay for and use the trademark in the event of breach in the absence of any contract term or state law to the contrary. However, the Court also made clear that debtors may not escape certain burdens associated with such contracts under applicable non-bankruptcy law:

Through rejection, the debtor can escape all of its future contract obligations, without having to pay much of anything in return. . . . But in allowing rejection of those contractual duties, Section 365 does not grant the debtor an exemption from all the burdens that generally applicable law—whether involving contracts or trademarks—imposes on property owners. See 28 U.S.C. § 959(b) (requiring a trustee to manage the estate in accordance with applicable law). Nor does Section 365 relieve the debtor of the need . . . to make economic decisions about preserving the estate's value—such as whether to invest the resources needed to maintain a trademark. In 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.²²

But Tempnology suggests that trademark licensees may have greater rights than licensees of intellectual property governed by Section 365(n). As Justice Sotomayor stated in her concurrence, "the Court's holding confirms that trademark licensees' post-rejection rights and remedies are more expansive in some respects than those possessed by licensees of other types of intellectual property [governed by Section 365(n)]."²³ The result of the majority's decision is that while the licensee of a rejected patent or copyright who chooses to retain its rights must pay royalties, the licensee of a rejected trademark license may be able to set off post-petition royalties against damages, because such licenses are neither protected nor limited by Section 365(n), which gives licensees of copyrights, patents, and other intellectual property certain retention rights in the event their licenses are rejected. According to Justice Sotomayor, while a licensee of intellectual property covered by Section 365(n) "has no right to deduct damages from its payments even if it otherwise could have done so under nonbankruptcy law," to the extent trademark licensees are granted greater rights, "that outcome leaves Congress with the option to tailor a provision for trademark licenses, as it has repeatedly in other contexts."²⁴

Implications of Tempnology for the Rights of Parties to Executory Contracts

Although the Tempnology decision specifically addresses the narrow issue of whether a trademark licensee retains the same post-rejection rights as other licensees of intellectual property, the Supreme Court made it clear that its "rejection as breach" analysis applies to all executory contracts,²⁵ including trademark licenses. As a result, a debtor may be able to retain or sell the benefits conferred on it under an executory contract, leaving the non-breaching party solely with a breach of contract claim against the debtor's bankruptcy estate in the absence of contractual remedies or applicable non-bankruptcy law to the contrary. In light of the Tempnology decision, counterparties to executory contracts including trademark licenses should consider whether to negotiate provisions in their agreements that give them post-rejection remedies, such as, among other things, the right to terminate an agreement for breach or the right to seek injunctive relief to prevent the debtor from using the rights conferred under the contract once it is rejected.

As Justice Sotomayor noted, Bankruptcy Courts will need to look at license agreements on a case-by-case basis to determine whether the debtor can retain such rights granted to it under a rejected trademark license.²⁶ As a result of the Supreme Court's ruling in Tempnology, debtors will need to carefully review each executory contract to determine what, if any, rights and remedies have been conferred on non-debtor counterparties upon breach, which will undoubtedly impact a debtor's decision to assume or reject a particular executory contract. Furthermore, debtors who seek to retain such post-rejection rights will likely buy themselves additional litigation regarding the scope of those rights, which will lead to increased administrative expenses. Contract counterparties should make clear their intentions regarding the rights conferred under the agreement and remedies available upon breach. Finally, contract counterparties may have greater leverage in negotiating with distressed companies that are contemplating filing a Chapter 11 bankruptcy.

1. 11 U.S.C. § 365(g)(1).
2. Mission Prod., 2019 WL 2166392, at *5.
3. See, e.g., In re Allegheny Imaging Institute, 69 B. R. 932, 936 (Bankr. W.D. Penn. 1987) ("It is axiomatic that a breach of contract occurs whenever one party to the contract fails to perform any contractual duty of immediate performance, or violates an obligation or duty. When a contract calls for performance by both parties and one party fails to so perform, the other contracting party is entitled to consider the agreement breached.") (citations omitted); Black's Law Dictionary, Breach of Contract (10th ed. 2014), available at Westlaw BLACKS.
4. Mission Prod., 2019 WL 2166392, at *2.
5. Id.
6. Pet. Br., at 9.
7. Id. (citation and internal quotation marks omitted).
8. 11 U.S.C. § 101(35A).
9. Id. at *3 (quoting In re Tempnology, LLC, 559 B. R. 809, 820-23 (B.A.P. 1st Cir. 2016) (citing Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC, 686 F. 3d 372, 376-77 (7th Cir. 2012)).
10. Id.
11. As a threshold issue, the majority rejected Justice Gorsuch's assertion as set forth in his lone dissent that the appeal was moot because the license expired in accordance with its terms during the bankruptcy case, and all assets have been distributed, leaving nothing to satisfy Mission's claim. Because the Bankruptcy Court held that Mission could not use the trademarks after rejection of the license, the majority agreed with Mission's assertion that Mission would have brought more legal trouble on itself by doing so, even in the absence of an injunction. The majority found that the possibility of Mission's ability to unwind "prior distributions to get its fair share of the estate" was a sufficient basis to keep the appeal alive, even though the lawsuit "'may not make [Mission] rich,' or even better off." Id. at *5 (quoting Chafin v. Chafin, 568 U. S. 165, 172, 133 S.Ct. 1017, 1017 (2013)).
12. Id. at *5.
13. Id. at *3.
14. Id. at *4 (quoting In re Tempnology, LLC, 879 F.3d at 402).
15. Id. at *8.
16. Id. at *6.
17. Id. at *5.
18. Id. at *6.
19. Id.
20. Id. at *7.
21. Id. (citing D. Baird, Elements of Bankruptcy 97 (6th Cir. ed. 2014)).
22. Id. at *8
23. Id. at *9 (Sotomayor, J., concurring).
24. Id.
25. Interestingly, the Supreme Court defined the term, "executory contract," as a contract where "performance remains due to some extent on both sides." Id. at *2 (quoting NLRB v. Bildisco & Bildisco, 465 U.S. 513, 522 n. 6 (1984)) (emphasis added). While the Bankruptcy Code does not define the term, "executory", the legislative history of Section 365 refers with approval to the definition articulated by Professor Vern Countryman, who defined an "executory" contract as "[a] contract 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." Most courts have accepted this definition (or a substantially similar definition) of the term "executory." The Supreme Court's definition of "executory" in Tempnology may have inadvertently removed the "materiality" requirement, such that creative attorneys may argue that any obligation that remains unperformed on both sides makes a contract executory. If a Bankruptcy Court applies this broader definition, such contracts with unperformed obligations that may not rise to the level of materiality must be either assumed or rejected under Section 365. Although dictum, this definition could have unintended consequences in cases where a debtor wishes to retain the benefits conveyed under a contract without any material obligations remaining on each side; a debtor must cure all monetary and non-monetary defaults if it wishes to assume such contracts that previously did not satisfy Professor Countryman's definition of an executory contract.
26. Id. ("But the baseline inquiry remains whether the licensee's rights would survive a breach under applicable nonbankruptcy law. Special terms in a licensing contract or state law could bear on that question in individual cases.")