The COVID-19 pandemic has caused unprecedented economic disruption, creating sudden financial distress across industries. Companies are now facing impacts ranging from a dramatic decline in revenue of uncertain duration, to potential setbacks to M&A transactions, to delayed or canceled financing rounds.

With even some previously well-performing companies potentially entering the so-called zone of insolvency, it’s important to review the fiduciary duties owed by directors and officers and how discharging those duties may change in the face of financial distress.

A Refresher On Fiduciary Duties. Let’s start with a high-level overview of the fiduciary duties of directors and officers of a Delaware corporation. This primer is not a substitute for specific legal advice but may help provide context for discussions with counsel.

  • The Key Duties. Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty.
    • The duty of due care requires directors and officers to make informed decisions in good faith and in the best interests of the company.
    • The duty of loyalty requires directors and officers not to engage in self-dealing and to put the interests of the company ahead of their own.
  • Solvency. Under Delaware law, when a company is solvent, the directors and officers owe their fiduciary duties of due care and loyalty to the corporation and to the stockholders.
    • This remains true even for a company in the zone of insolvency (more on that concept below).
    • Stockholders of a solvent company have standing to bring derivative claims for breach of fiduciary duty against directors and officers.
  • Insolvency. When a company is insolvent, meaning it’s not able to pay its creditors in full, the directors and officers still owe their fiduciary duties of due care and loyalty to the corporation.
  • Zone of Insolvency. The zone of insolvency is a term used to describe a company that is still solvent but is approaching insolvency.
    • For a number of years the courts suggested that if a company entered the zone of insolvency, fiduciary duties expanded to include creditors (as well as shareholders).
    • That’s no longer the case. The Delaware Supreme Court clarified that the key inflection point for fiduciary duties is actual insolvency, not the zone of insolvency. Upon actual insolvency, fiduciary duties are still owed to the corporation (rather than being expanded to include creditors) but creditors gain the right to bring derivative claims for breach of fiduciary duty.
    • However, it can be challenging to determine whether a company is still solvent or has already crossed into actual insolvency. The zone of insolvency concept therefore can serve as a useful “caution flag” for directors and officers assessing the issue.
  • Discharging Fiduciary Duties in Insolvency. With that refresher in mind, how should directors and officers best discharge fiduciary duties for a company that has become insolvent? This is a very fact-intensive analysis, and directors and officers should seek specific legal advice for their company’s particular situation, but here are some issues to consider.
    • Generally, the focus should be on maximizing enterprise value without taking undue risk, which will maximize recovery for creditors as the new residual rights holders.
    • Maximizing value may also benefit stockholders but care should be taken if pursuing an upside for stockholders puts creditor recoveries at greater risk.
    • Directors should assess all aspects of the company’s business, seek input from legal and financial advisers where helpful, hold Board meetings as often as needed, follow good corporate process, and continue to avoid conflicts of interest.
    • This will allow directors to enjoy the protection of the business judgment rule, which provides that courts will not second guess a director’s good faith business judgment made with due care.
    • Many companies may have to make immediate or longer-term reductions in expenses and cash burn in an attempt to extend the runway for a turnaround, financing, or sale transaction.
    • If the company has borrowed money from a bank or other secured lender, it’s also critical to assess the lender’s rights, potential remedies, and prospects for a restructuring.
    • Even in difficult situations, maximizing value may mean continuing operations — even though that burns cash — for a limited period to allow the company to complete a sale that the directors believe is likely to close and produce significant value for creditors.
    • In other cases, it may mean winding down (or even shutting down) operations quickly to conserve cash, especially if any asset sale is not expected to generate more than the cash required to pursue it.
    • Restructuring and wind-down alternatives, including Chapter 11 bankruptcy and assignments for the benefit of creditors, may need to be considered as well.

The Unique Impact of COVID-19. The COVID-19 pandemic and government orders precluding non-essential business operations have produced widespread financial impacts.

  • Companies that have been performing well previously, but are now experiencing financial distress primarily because of COVID-19, may need to assess factors that go beyond those of a traditional distressed company.
  • These could include, among others: financial contingency planning based on the possible duration of the pandemic and stay-at-home or similar orders; negotiations with lenders for short or near-term debt service extensions, additional liquidity, or a restructuring of loan facilities; and potential changes in customer preferences or supplier availability once the pandemic eases.
  • In addition, COVID-19 has prompted federal, state, and local governments to consider assistance programs for specific industries and potentially for businesses across the economy.
  • If these programs are enacted, companies will have to assess whether they are eligible for financial assistance, the conditions placed on receiving assistance, and how long it could take before relief would actually be received.

Conclusion. The COVID-19 pandemic has disrupted businesses across the economy and caused unexpected and immediate financial impacts. Directors and officers faced with managing through these issues will benefit from specific legal advice about their fiduciary duties and how best to discharge them in these newly uncertain times.

 

 

Photo by Drew Beamer on Unsplash

Each year amendments are made to the rules that govern how bankruptcy cases are managed — the Federal Rules of Bankruptcy Procedure. The amendments address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others. The rule amendments are ultimately adopted by the U.S. Supreme Court and technically subject to Congressional disapproval.

Only A Few Rule Amendments This Year. Unlike previous years, there are only four rule amendments expected to take effect on December 1, 2019. Here they are:

  • Rule 4001(c) has been amended to clarify that Rule 4001(c), governing the obtaining of credit, does not apply in Chapter 13 cases.
  • Rule 6007 has been amended to specify who needs to be served with a motion to abandon, to provide that the objection deadline is within 14 days of service of the motion unless otherwise fixed by the court, and to clarify that a court’s order granting the motion itself effects the abandonment without need for further notice.
  • Rule 9036 has been revised to confirm that both notice and service to a registered electronic filing system user can be done by filing the pleading with the court’s electronic filing system. This, however, does not apply to service requirements under Rule 7004.
    • The Advisory Committee states that the “use and reliability of electronic delivery have increased since the rule was first adopted” and so Rule 9036 is being amended to make “a party who registers [ ] subject to service by filing with the court’s system unless the court provides otherwise.”
    • Likewise, service may be made to any person who has consented to service electronically, at least to the extent of the consent.
    • Service or notice is complete upon filing or sending unless the filer or sender gets notice that it did not reach the intended person.
  • Rule 9037 has been amended to add a subsection (h) setting forth procedures for motions seeking to redact previously filed documents otherwise protected under Rule 9037(a). Rule 9037(a) protections cover social security numbers, birth dates, names of minors, and financial account numbers.
    • A belated motion under the new subsection can be filed by the original filer or anyone else.
    • The new procedures include identifying the proposed redactions, attaching the document to be redacted, and specifying who is to be served. Courts are authorized to alter the national rule’s procedures, presumably through adoption of local rules.
    • The court is required to restrict from public access both the motion to redact and the previously available unredacted document. If granted, the redacted document is to be docketed. If denied, the restrictions must be lifted unless the court orders otherwise.

A Bonus: Federal Rule Of Appellate Procedure Change Impacting Bankruptcy Cases. In addition, although not a Federal Rule of Bankruptcy Procedure change, Rule 26.1(c) of the Federal Rules of Appellate Procedure has been revised to require certain disclosures in bankruptcy case appeals. Each debtor, including any debtors not named in the caption, must be identified. For each debtor that is a corporation, the Federal Rule of Appellate Procedure 26.1(a) disclosures must be provided regardless of whether the corporate debtor is named in the caption.

Give Me A Redline. If you’re like me, the best way to see the changes is to go through a redline. Follow the link in this sentence for the complete set of rule changes, including redlines showing the revisions made, as well as the Advisory Committee’s explanations for each amendment. The redline of the bankruptcy rule amendments starts at page 65 of the linked document. The change to Federal Rule of Appellate Procedure Rule 26.1(c) is found on page 32.

Is It December Already? These rule amendments are slated to take effect on December 1, 2019, a few weeks from now, so read through them to be ready when they do.

 

 

 

 

Photo by Kealan Burke on Unsplash

A Big Answer To A Big Question. After dividing the courts for a number of years, we finally have the answer to the big question of whether rejection of a trademark license by a debtor-licensor deprives the licensee of the right to use the trademark. Here’s the question on which the Supreme Court granted certiorari in the Mission Product Holdings, Inc. v Tempnology, LLC case:

Whether, under §365 of the Bankruptcy Code, a debtor-licensor’s “rejection” of a license agreement—which “constitutes a breach of such contract,” 11 U.S.C. §365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law.

On May 20, 2019, the Supreme Court issued is decision in Tempnology, diving deep into the meaning of rejection of executory contracts in bankruptcy and delivering the answer:

“We hold it does not. A rejection breaches a contract but does not rescind it. And that means all the rights that would ordinarily survive a contract breach, including those conveyed here, remain in place.”

Get Your Copy Of The Decision. Justice Kagan, for an 8-1 majority, wrote a very interesting and readable decision. Justice Sotomayor wrote a short concurring opinion while Justice Gorsuch was the lone dissenter. Follow the link for a copy of the full Supreme Court opinion. An analysis of the key aspects of the decision is below.

The Key Facts. Before going further, it’s important to review the main facts. Tempnology, LLC (“Tempnology”) and Mission Product Holdings, Inc. (“Mission”) were parties to a Co-Marketing and Distribution Agreement (“Agreement”).  In the Agreement, Tempnology granted Mission (1) a non-exclusive license to certain of Tempnology’s copyrights, patents, and trade secrets, (2) an exclusive right to distribute certain cooling material products that Tempnology manufactured, and (3) an associated trademark license.

After various disputes over the Agreement, Tempnology filed Chapter 11. One of its first motions in the bankruptcy case was to reject the Agreement and the focus quickly turned to the trademark license. Tempnology sought and obtained declaratory relief from the bankruptcy court holding that rejection terminated Mission’s rights under the trademark license.

The Long And Winding Road. Given its importance, this blog has followed the Tempnology case’s roller coaster ride for more than three years. You can relive those twists and turns and get more background on the case by clicking on the links below.

The Circuit Split. The case got to the Supreme Court because of a split between the First and Fourth Circuits on the one hand, and the Seventh Circuit on the other hand, on the impact of rejection on trademark licensees. A little history will help set the stage for the Supreme Court’s opinion:

The Supreme Court’s Majority Opinion. The Supreme Court’s decision first addressed whether the case was moot before moving on to the merits.

Mootness. The Court held the case was not moot because Mission made at least a plausible claim for money damages based on Tempnology’s rejection and Mission’s subsequent inability to use the trademarks. That was enough of a live controversy for the majority. Justice Gorsuch, who raised the mootness issue at oral argument, dissented. He believed it was unclear whether there was a real controversy and would dismiss the case as improvidently granted.

With mootness out of the way, the Court turned to Section 365’s provisions:

Section 365 of the Bankruptcy Code enables a debtor to “reject any executory contract”—meaning a contract that neither party has finished performing. 11 U. S.C. §365(a). The section further provides that a debtor’s rejection of a contract under that authority “constitutes a breach of such contract.” §365(g).

Executory Contract. The Court’s reference to an executory contract as “a contract that neither party has finished performing” is interesting in itself. That statement could be read as less demanding than the commonly cited “Countryman definition,” which focuses on whether a failure to complete performance would constitute a material breach. It’s unclear whether the Court meant to remove “material breach” from the definition but lawyers may well argue over it.

Breach Not Rescission. Turning to the main substance of the rejection issue, the Court framed, and then answered, the question as follows:

What is the effect of a debtor’s (or trustee’s) rejection of a contract under Section 365 of the Bankruptcy Code? The parties and courts of appeals have offered us two starkly different answers. According to one view, a rejection has the same consequence as a contract breach outside bankruptcy: It gives the counterparty a claim for damages, while leaving intact the rights the counterparty has received under the contract. According to the other view, a rejection (except in a few spheres) has more the effect of a contract rescission in the non-bankruptcy world: Though also allowing a damages claim, the rejection terminates the whole agreement along with all rights it conferred. Today, we hold that both Section 365’s text and fundamental principles of bankruptcy law command the first, rejection-as-breach approach. We reject the competing claim 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. And we reject an argument for the rescission approach turning on the distinctive features of trademark licenses. Rejection of a contract—any contract—in bankruptcy operates not as a rescission but as a breach.

Effect Of Rejection. Justice Kagan first examined Section 365(a), which gives a debtor the option to assume or reject an executory contract, and Section 365(g), which provides that rejection “constitutes a breach” of the executory contract.

  • The Court used an example of a law firm leasing a photocopier from a dealer that also agrees to service it, all for a monthly fee.
  • The “dealer cannot get back the copier just by refusing to show up for a service appointment” because the contract gave the law firm “continuing rights in the copier, which the dealer cannot unilaterally revoke.”
  • Concluding the same result applies in bankruptcy, the Court held that when it comes to a license agreement, “the debtor can stop performing its remaining obligations” upon rejection but “cannot rescind the license already conveyed” and the “licensee can continue to do whatever the license authorizes.”
  • Preserving those rights is also consistent with the bankruptcy principle that the bankruptcy estate cannot possess more than the debtor did outside of bankruptcy. A holding that rejection constitutes rescission rather than breach would circumvent the avoidance powers that allow a trustee or debtor, in specific circumstances, to unwind pre-bankruptcy transfers such as fraudulent conveyances.
  • Permitting a debtor or trustee to achieve the same result through rejection of an executory contract, and recovering the previously conveyed interest in a trademark or other property, would make rejection “functionally equivalent to avoidance.”

No Negative Inference. One of Tempnology’s main arguments was that enactment of statutory provisions such as Sections 365(h) and 365(n), allowing a counterparty to a real-property lease and intellectual property license to retain rights after rejection, creates a negative inference that in all other cases rejection revokes the counterparty’s rights. Otherwise, it argued, the general rule would swallow the exceptions.

The Court found that argument to be flawed in part because Tempnology viewed the statutory exceptions as a “neat, reticulated scheme” when “history reveals [them] to be anything but.”  Enacted over a fifty year period, “each responded to a discrete problem–as often as not, correcting a judicial ruling of just the kind Tempnology urges.” The Court found that “Congress enacted the provisions, as and when needed, to reinforce or clarify the general rule that contractual rights survive rejection.”

The opinion then includes Footnote 2, which states as follows:

At the same time, Congress took the opportunity when drafting those provisions to fill in certain details, generally left to state law, about the post-rejection relationship between the debtor and counterparty. See, e.g., Andrew, Executory Contracts in Bankruptcy, 59 U. Colo. L. Rev. 845, 903, n. 200 (1988) (describing Congress’s addition of subsidiary rules for real property leases in Section 365(h)); Brief for United States as Amicus Curiae 29 (noting that Congress similarly set out detailed rules for patent licenses in Section 365(n)). The 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.

Reviewing the history of Section 365(n), enacted in response to the Lubrizol decision involving patent licenses, Justice Kagan concluded it shows no intent by Congress to ratify Lubrizol’s result for all other agreements. That means no negative inference arises and Section 365(n) does not “alter the natural reading of Section 365(g)–that rejection and breach have the same results.”

No Trademark Exception. The final Tempnology argument addressed and dismissed was that the nature of trademark law, and the potential burdens on reorganization posed by exercising quality control over the trademarked goods, compels a different result. Although presented as a trademark issue, the Court found that Tempnology’s construction of Section 365 would “govern not just trademark agreements, but pretty nearly every executory contract. However serious Tempnology’s trademark-related concerns, that would allow the tail to wag the Doberman.” Instead, the Court held that while rejection allows a debtor to escape all future contract obligations, it does not grant an exemption from generally applicable law, including trademark law and its quality control obligations.

The Court concluded:

For the reasons state above, we hold that under Section 365, a debtor’s rejection of an executory contract in bankruptcy has the same effect as a breach outside bankruptcy. Such an act cannot rescind rights that the contract previously granted. Here, that construction of Section 365 means that the debtor-licensor’s rejection cannot revoke the trademark license.

Justice Sotomayor’s Concurrence. In a two-page concurring opinion, Justice Sotomayor wrote separately “to highlight two potentially significant features of today’s holding.”

  • First, she stated that “the Court does not decide that every trademark licensee has the unfettered right to continue using licensed marks postrejection.” The “baseline inquiry remains whether the licensee’s rights would survive a breach under applicable nonbankruptcy law,” and posits that “[s]pecial terms in a licensing contract or state law could bear on that question” in particular cases.
  • Second, “the Court’s holding confirms that trademark licensees’ postrejection rights and remedies are more expansive in some respects that those possessed by licensees of other types of intellectual property. Those variances stem from §365(n), one of several subject-specific provisions in the Bankruptcy Code that ’emellis[h] on or twea[k]’ the general rejection rule.”
    • Describing Section 365(n)’s requirements requiring royalty payments to be made and precluding the deduction of damages from those payments, she then states that “[t]his provision and others in §365(n) mean that the covered intellectual property types are governed by different rules than trademark licenses.”
    • She concludes that these “differences may prove significant for individual licensors and licensees” but do not alter the Court’s outcome in the Tempnology case.

Justice Sotomayor’s concurrence raises important questions regarding Section 365(n):

  • After Tempnology, are Section 365(n)’s provisions mandatory for the types of intellectual property licenses it covers in conjunction with Section 101(35A)’s definition, as Justice Sotomayor writes?
  • Footnote 2 of the Court’s majority opinion states that Section 365(n) is “not redundant,” and that Sections 365(n) and 365(h) are each a “remedial scheme embellishing on or tweaking the general rejection-as-breach rule,” but the Court’s opinion does not affirmatively state that those provisions are exclusive.
  • Does Justice Sotomayor’s concurrence accurately describe the majority opinion, in particular about the binding effect of Section 365(n), or assert a position the Court’s majority was not comfortable stating, even in a footnote?

Conclusion. The Supreme Court’s Tempnology decision definitively resolves the circuit split and ends the Lubrizol view that rejection under Section 365 terminates a counterparty’s rights. It answers the big question of the impact of rejection under Section 365, making it an important decision with significant implications for parties to trademark license agreements and other executory contracts.

 

 

Image Courtesy of Flickr by Tim Sackton

As discussed in an earlier post called “Moving Up: Bankruptcy Code Dollar Amounts Will Increase On April 1, 2019,” various dollar amounts in the Bankruptcy Code and related statutory provisions were increased for cases filed on or after today, April 1, 2019. This information sheet has a list of all of the dollar amount changes now in effect.

The official bankruptcy forms have also been revised to reflect these new dollar amounts.

Remember, the increased dollar amounts, now reflected on these forms, apply only to cases filed on or after April 1, 2019.

 

Image Courtesy of Flickr by Tom Bullock

The Supreme Court held oral argument earlier today in the Mission Products v. Tempnology case, on the issue of the effect of rejection by a licensor of a trademark license on the licensee’s rights. For the full background on the case and the arguments of the parties and amici, please read this post from last week. However, for quick reference, this is the question presented:

Whether, under §365 of the Bankruptcy Code, a debtor-licensor’s “rejection” of a license agreement—which “constitutes a breach of such contract,” 11 U.S.C. §365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law.

What follows are some initial impressions from the questions and comments by the Justices during oral argument. You can read the entire official oral argument transcript at this link.

  • Overview. Those looking for a clear signal how the Court will rule are going to be disappointed. Although all Justices other than Justices Thomas and Kavanaugh asked questions, it’s difficult to tell where the Court will come out on the key issue.
  • Mootness. The Justices asked a number of questions about Tempnology’s argument that the case is moot. If the questions are a guide, it appears that the Court may be inclined to hold that the case is not moot. Justice Gorsuch was quite focused on that issue but later in the oral argument asked whether the facts presented at least “an acorn of injury” for Article III purposes.
  • Quality Control. One important focus was the impact of the quality control requirement imposed on a trademark owner under trademark law. The Justices raised a number of questions centered on whether this obligation made trademarks, and therefore trademark licenses, different from other contracts. The parties had agreed that outside of bankruptcy a breach by a trademark owner as licensor would not terminate a trademark licensee’s rights, but at times the Justices seemed to question that premise.
  • General Rule v. Exceptions. Another major area of interest was whether the existence of exceptions in Section 365, such as Sections 365(n), 365(h)(2), and 365(i)(2), implied that the general rule of the effect of rejection was to terminate the rejected executory contract. In response to the argument that these subsections do not mean the general rule of Section 365 is termination, Justice Sotomayor commented that it “seems as all of these are exceptions by their nature, and that goes contrary to the general rule that if it’s an exception, the rule is different than the exception.” On several occasions she expressed concern that if the Sunbeam rule were followed, a trademark licensee would get more rights than would a licensee of other intellectual property under Section 365(n), given the trade-offs built into Section 365(n).
  • Rejection as Breach. A core issue discussed in the oral argument was whether rejection is just a pre-petition breach–or something more.
    • Justice Kagan noted that Section 365(g) states that rejection “constitutes a breach” and asked why a debtor or trustee could “unwind the entire deal” in bankruptcy upon rejection but not when a licensor breached outside of bankruptcy.
    • Justice Sotomayor, during the argument by the United States, observed that “rejection is not a contract term,” and described rejection instead as a “specialized term.”
    • Overall, the Justices seemed to be struggling with how to square Section 365(g)’s language that rejection “constitutes a breach” with that section’s use of a bankruptcy-specific term, “rejection.”

Conclusion. During an hour-long oral argument, the Justices raised questions about a number of bankruptcy and trademark law issues. What they did not do, however, was reveal any clear direction in how they will decide the case. Since no conservative/liberal split emerged, it would not be surprising to see an atypical combination of Justices voting together, assuming the decision is not unanimous. What that decision will ultimately be, and how the various Justices will vote, remains to be seen. Stay tuned.

Image Courtesy of Flickr by Matt Wade

An official notice from the Judicial Conference of the United States was just published announcing that certain dollar amounts in the Bankruptcy Code will be increased about 6.2% this time for new cases filed on or after April 1, 2019. Follow this link for the Federal Register page with a chart listing all of the updated dollar amounts.  Among the most meaningful increases for Chapter 11 and other business bankruptcy cases:

  • The employee compensation and employee benefit plan contribution priorities under Sections 507(a)(4) and 507(a)(5) both increase to $13,650 from $12,850;
  • The consumer deposit priority under Section 507(a)(7) rises to $3,025 from $2,850;
  • The total amount of claims required to file an involuntary petition rises to $16,750 from $15,775;
  • The dollar amount in the bankruptcy venue provision, 28 U.S.C. Section 1409(b), which requires that actions to recover for non-consumer, non-insider debt be brought against defendants in the district in which they reside, has increased to $13,650 from $12,850;
  • The minimum amount required to bring a preference claim against a defendant in a non-consumer debtor case, specified in Section 547(c)(9), rises to $6,825 from $6,425; and
  • The total debt amount in the definition of small business debtor in Section 101(51D) will rise to $2,725,625.

Other adjustments will affect consumers more than business debtors. For example, the debt limit for an individual to qualify for a Chapter 13 bankruptcy case will rise to $1,257,850 of secured debt, and certain exemption amounts will also increase.

Although the changes aren’t that large, be sure to keep them in mind when assessing cases filed after April 1, 2019. Official bankruptcy forms will likely be updated as April 1st draws near.

 

Image Courtesy of Flickr by Pictures of Money

The Big Question. What is the effect of rejection of a trademark license by a debtor-licensor? Over the past few years, this blog has followed the Tempnology case out of New Hampshire raising just that issue. The case has gone from the bankruptcy court, to the Bankruptcy Appellate Panel, and then to the First Circuit. Last August, I wrote about how the case could be headed to the Supreme Court. In late October, the Supreme Court granted review and has set oral argument for February 20, 2019.

Here’s the question on which the Supreme Court granted certiorari:

Whether, under §365 of the Bankruptcy Code, a debtor-licensor’s “rejection” of a license agreement—which “constitutes a breach of such contract,” 11 U.S.C. §365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law.

A Supreme Court Preview Article. In anticipation of next week’s oral argument, I wrote an article on the case and it’s just been published by the American Bar Association’s Supreme Court Preview publication, which as its name implies previews each pending case coming up on the Supreme Court’s calendar.

  • The new article discusses the key facts, issues, and arguments presented by the parties and amici to the Supreme Court, along with background on the legal context and potential significance of the case.
  • For a detailed look at the case and these issues, you can access the full article using this link.

The Circuit Split. The case seems likely to resolve the split between the First and Fourth Circuits on the one hand, and the Seventh Circuit on the other hand, on the impact of rejection of a trademark licensee.  Let’s review the history:

The Supreme Court Briefs. In addition to briefs from debtor-licensor Tempnology and licensee Mission Products, the case has attracted six amicus briefs, including from the United States. Four amici support the licensee and two support neither party. However, all six call for reversal of the First Circuit’s position that rejection of a trademark license terminates the licensee’s rights under the license. For your further reading pleasure, each of the briefs from the parties and the amici are at the links below:

Is Rejection Just A Breach Or Something More? Sifting through all the arguments, the key issue is what effect rejection of an executory contract under Section 365 has on the counterparty’s rights. Does rejection function merely as a breach that frees the estate from future affirmative performance obligations? Or, does it render the contract unenforceable by the counterparty—other than the right to file a pre-petition rejection damages claim under Section 502(g)—thereby terminating all other rights and remedies under the rejected contract absent a statutory exception like Section 365(n)? If the former, the Supreme Court will likely reverse and endorse the Sunbeam approach or something similar. If the latter, it will likely affirm and adopt the Tempnology/Lubrizol approach.

Oral Argument Is February 20th. At the February 20th oral argument, the two parties, and the United States, have been allocated time to argue. Stay tuned for what could be a very interesting oral argument—and of course, ultimately the Supreme Court’s decision.

Almost every year amendments are made to the rules that govern how bankruptcy cases are managed — the Federal Rules of Bankruptcy Procedure. The amendments address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others. The rule amendments are ultimately adopted by the U.S. Supreme Court and technically subject to Congressional disapproval.

Key Rule Amendments Have A Certain Appeal. This year almost all of the rule amendments are to the set of Federal Rules of Bankruptcy Procedure governing appeals, those related to appeals, and others involving electronic filing. They have been revised to reflect changes made to the Federal Rules of Appellate Procedure and also the Federal Rules of Civil Procedure. Most amendments are fairly technical but here are some to note:

  • Rule 3002 has been amended to address procedures for handling payment changes in home equity lines of credit in consumer cases.
  • Rule 5005 has been amended to require electronic filing absent good cause and to make that a national rule. As the Advisory Committee commented, “Electronic filing has matured” and “The time has come to seize the advantages of electronic filing by making it mandatory in all districts, except for filings made by an individual not represented by an attorney.” Almost all filings are electronic now anyway so this is more of the rule reflecting current practice than requiring actual changes.
  • Rule 7004(a) has been tweaked to pick up the accurate cross-references to Federal Rule of Civil Procedure 4.
  • Rule 7062 applies Federal Rule of Civil Procedure 62 to adversary proceedings but clarifies that the stay of proceedings to enforce a judgment is only for 14 days in an adversary proceeding and not the 30 days in a district court case.
  • Rule 8002 has been amended to clarify, among other items, time requirements for filing a notice of appeal.
  • Rule 8006 now allows the bankruptcy court to file a statement on the merits of direct certification to the court of appeals when the parties make a joint certification.
  • Rules 8007 and 8010 discard the term “supersedeas bond” and instead use “security provided to obtain a stay of judgment” to account for changes to Federal Rule of Civil Procedure 62.
  • Several rules, including Rules 8011, 8013, 8015, 8016, and 8022 have been amended to reflect electronic filing and to limit the size of briefs using word counts rather than page limits.
  • Rule 8017 has been revised to address amicus briefs and their potential impact on the disqualification of a judge.
  • Rule 8018.1 has been added to allow a district court to treat an appeal from a bankruptcy court judgment — if the district court concludes the bankruptcy court lacked constitutional authority to enter the judgment — as proposed findings of fact and conclusions of law.
  • Rule 9025 has been revised to reflect the different types of security for appeals and their providers.

Give Me A Redline. If you’re like me, the best way to see the changes is to go through a redline. Follow the link in this sentence for the complete set of rule changes, including redlines showing the revisions made, as well as the Advisory Committee’s explanations for each amendment. The redline of the bankruptcy rule amendments starts at page 141 of the linked document, and it also includes the changes to the other federal rules.

Is It December Already? These rule amendments take effect on December 1, 2018, which is only days away, so read through them now and you will be ready when they take effect.

The twists and turns of the In re Tempnology LLC bankruptcy case have been a frequent subject on this blog for good reason. The case addresses whether a trademark licensee, whose licensor files bankruptcy and rejects the license agreement, retains any rights to use the trademark — or instead is out of luck.

A Wild Ride. The licensee in that case, Mission Product Holdings, Inc. (“Mission”), has been on something of a roller coaster ride for the past few years:

The Circuit Split. Propelling Mission on this roller coaster ride has been a circuit split about the impact of rejection of a trademark licensee.

A Cert Petition. In the face of this major circuit split, in June 2018 Mission filed a petition for a writ of certiorari, asking the U.S. Supreme Court to review the First Circuit’s decision. (As a side note, the Supreme Court denied cert in the Sunbeam case.) Mission’s cert petition posed two questions:

  1. Whether, under §365 of the Bankruptcy Code, a debtor-licensor’s “rejection” of a license agreement—which “constitutes a breach of such contract,” 11 U.S.C. §365(g)—terminates rights of the licensee that would survive the licensor’s breach under applicable nonbankruptcy law.
  2. Whether an exclusive right to sell certain products practicing a patent in a particular geographic territory is a “right to intellectual property” within the meaning of §365(n) of the Bankruptcy Code.

It’s the first question that goes to the heart of the Lubrizol/Sunbeam/Tempnology circuit split: what is the effect of rejection on a trademark licensee’s rights?

A Friend Of The Court Emerges And The Supreme Court Shows Interest. This key issue drew an amicus curiae brief from the International Trademark Association in support of Mission. After Tempnology itself declined to respond to the cert petition, the Supreme Court requested that it file a response. Could the request be a hint that the Supreme Court will seriously consider granting cert and reviewing one or both of these questions? Tempnology has until September 7, 2018 to file its response and the case has been “distributed for conference” on September 24, 2018. Reading Supreme Court tea leaves is always uncertain, but we might learn whether the Supreme Court will hear the case after the September 24 conference.

Are More Than Just Trademark Licenses At Stake? Although the Tempnology case is first and foremost about a trademark license, if the Supreme Court were to hear the case and issue an opinion on the impact of rejection, that decision could have consequences beyond just trademark licenses.

  • If the Court were to follow Sunbeam and hold that rejection does not terminate a licensee’s rights, would that decision apply to patent, copyright, and trade secret licensees as well?
  • Would those licensees still need to follow Section 365(n)’s provisions, including the requirement for a licensee electing to retain its rights to the intellectual property to continue paying royalties, or could they argue that rejection was a material breach excusing royalty payment obligations?

Trademark licensees and those interested in the impact of rejection generally will want to stay tuned for further developments. If the Supreme Court grants cert, this could get interesting.

The Tempnology Trademark Saga. When it comes to decisions on bankruptcy and trademark licenses, the In re Tempnology LLC bankruptcy case is the gift that keeps on giving.

  • The Original. It all started in November 2015. Following Tempnology’s rejection of an agreement containing a trademark licensee, the New Hampshire Bankruptcy Court ruled that the licensee could no longer use the licensed trademarks.
  • The Sequel. Then, in November 2016, the First Circuit Bankruptcy Appellate Panel (“BAP”) became the first appellate court to follow the Seventh Circuit’s 2012 decision in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 382 (7th Cir. 2012) on the effect of rejection of a trademark license — namely, that rejection did not terminate the licensee’s rights to use the trademarks.
    • In Sunbeamthe Seventh Circuit had expressly rejected the Lubrizol decision and its analysis of the effects of rejection (follow the link for a full discussion of the Sunbeam decision).
    • The Sunbeam court held that rejection is a breach by the debtor and does not terminate the agreement or “vaporize” the rights of the non-breaching party. Critically, the Seventh Circuit allowed the non-debtor trademark licensee to continue using the licensed trademarks despite the debtor’s rejection of the trademark license.
    • The BAP’s decision to follow Sunbeam raised the prospect that other courts might follow suit and start a trend away from Lubrizol.
  • The Final Installment. Fast forward to January 12, 2018 when, on appeal from the BAP, the U.S. Court of Appeals for the First Circuit issued a 2-1 decision, reversing the BAP and affirming the Bankruptcy Court’s decision. Follow this link for a copy of the First Circuit’s full 34 page majority opinion and 7 page concurring and dissenting opinion.
  • Keep reading for the juicy details but, to cut to the chase, the First Circuit unequivocally sided with Lubrizol on the impact of rejection, deepening the circuit split created by the Seventh Circuit’s Sunbeam decision.

Before turning to the First Circuit’s decision, let’s set the stage with a brief review of the underlying facts, a few more highlights from the Bankruptcy Court’s original decision, and the BAP’s subsequent take on these important issues.

The Bankruptcy Court’s Decision. In November 2015, the New Hampshire Bankruptcy Court issued a decision involving the effects of rejection by the debtor, Tempnology LLC, of a Co-Marketing and Distribution Agreement (“Agreement”). In re Tempnology, LLC, 541 B.R. 1 (Bankr. D.N.H. 2015). In the Agreement, Tempnology had granted Mission Product Holdings, Inc. (“Mission”) (1) a non-exclusive license to certain of Tempnology’s copyrights, patents, and trade secrets, (2) an exclusive right to distribute certain cooling material products that Tempnology manufactured, and (3) an associated trademark license. With one of its first motions in the bankruptcy case, Tempnology rejected the Agreement.

  • The Bankruptcy Court held that the non-exclusive license to Tempnology’s copyright, patent, and trade secret rights was a license of “intellectual property” as defined in Section 101(35A) of the Bankruptcy Code, and that Mission’s right to continue to use that IP was protected under Section 365(n). However, the Bankruptcy Court held that Mission’s exclusive distribution rights were not “intellectual property” under Section 101(35A) and were not protected under Section 365(n).
  • The Bankruptcy Court also held that because trademarks were not included in Section 101(35A)’s definition of intellectual property, Mission’s trademark license rights were not protected by Section 365(n).
  • On the impact of rejection, the Bankruptcy Court followed the Lubrizol decision and held that the rejection of the Agreement meant that Mission lost both the exclusive distribution rights and the trademark license rights.
  • The details on the Bankruptcy Court’s decision are at this prior post, entitled “A Reminder Of The Limits Of Section 365(n)’s Licensee Protection.”

The Bankruptcy Appellate Panel Decision. Mission appealed the Bankruptcy Court’s decision to the BAP. On November 18, 2016, the BAP issued a decision affirming in part and reversing in part the Bankruptcy Court’s decision. In re Tempnology LLC, 559 B.R. 809 (1st Cir. BAP 2016).

  • The BAP affirmed the Bankruptcy Court’s holding that the exclusive distribution rights in the Agreement were not intellectual property as defined in the Bankruptcy Code and were not protected by Section 365(n).
  • The BAP also agreed that Section 365(n) did not protect Mission’s rights as a trademark licensee, ruling that the Bankruptcy Court had correctly held that Section 101(35A)’s definition of “intellectual property” excludes trademarks.
  • On the trademark point, Mission urged the BAP to follow the equitable approach that Judge Ambro suggested in his concurring opinion in the Third Circuit’s decision in In re Exide Techs., 607 F.3d 957 (3d Cir. 2010). That would let bankruptcy courts fashion equitable protections for rejected trademark licensees.
  • The BAP declined to follow either that approach or the one taken by the New Jersey Bankruptcy Court in In re Crumbs Bake Shop, 522 B.R. 766 (Bankr. D.N.J. 2014), which had effectively applied Section 365(n) to trademarks. (For more on the Crumbs Bake Shop and Exide Techs. decisions, take a look at this earlier post.)
  • The BAP then considered the Seventh Circuit’s Sunbeam decision and, in a major shift, followed its analysis on the effect of rejection on a trademark license agreement. It thus held that Mission could continue to use the licensed trademarks.
  • For more information on the BAP decision, you can read this prior post, entitled “A Beam Of Sun For Trademark Licensees: Another Appellate Court Holds Rejection Does Not Terminate A Trademark Licensee’s Rights.”

The Main Event: The First Circuit’s Decision. With the background covered, let’s dig into the First Circuit’s decision. The BAP made Sunbeam front and center, so a big question was whether the First Circuit would follow Sunbeam and affirm the BAP’s decision, follow Lubrizol and affirm the Bankruptcy Court’s decision, or perhaps go with the equitable approach discussed by Judge Ambro.

A Notable Section 365(n) Analysis. Before turning to Sunbeam, the First Circuit started with a fairly extensive Section 365(n) analysis, worth examining given how few circuit court decisions address Section 365(n) at all.

  • The Court first agreed with the BAP and the Bankruptcy Court that neither the exclusive distribution rights nor the trademarks are “intellectual property” under Section 101(35A) and therefore neither has Section 365(n) protections.
  • The First Circuit likewise concluded that the exclusivity rights protected by Section 365(n) are limited to IP license rights only and do not extend to distribution rights.
  • The Court also held that a licensee’s right to the “embodiment of such intellectual property” in Section 365(n)(1)(b) is a limited concept (and a term of art) that does not extend to all the goods Mission sought to distribute:

A few common themes appear in these explanations. First, the pre-petition agreement must give the licensee access to the embodiment of intellectual property. Second, an embodiment of intellectual property is a tangible or physical object that exists pre-petition. Third, an embodiment of intellectual property is something inherently limited in number — it is a prototype or example of a product, but does not include all products produced using the intellectual property. Finally, we can infer that the purpose of this provision is to allow the licensee to exploit its right to the underlying intellectual property.

The Negative Covenant Issue. The First Circuit dismissed Mission’s arguments that the case implicated the enforceability of all negative covenants. The Court commented that the Bankruptcy Code might protect from rejection some negative covenants such as confidentiality, but only if they do not materially restrict the debtor’s reorganization, are closely tied to the IP license, and are necessary to implement the terms of the IP license.

The Equitable Treatment Discussion. After agreeing with the BAP (and also Sunbeam) that Sections 101(35A) and 365(n) do not protect trademark licensees, the Court held that courts could not use equitable considerations to protect trademark licensees.

  • The majority opinion rejected the dissent’s contrary view, which was based on Congress’s decision to defer action on trademark licenses in Section 365(n) “to allow the development of equitable treatment of this situation by bankruptcy courts,” as the Senate Report had stated.
  • The First Circuit held that when Congress intended courts to use equitable powers, it included specific language in the text of the relevant Bankruptcy Code section, and it had not done that in Section 365(n).
  • The Court also believed it would be difficult to weigh the equities, given the long-term nature of a trademark license relationship, and courts could misjudge how those burdens might play out in the future.

Taking On Sunbeam. The First Circuit’s biggest divergence from the BAP was on the issue of the effect of rejection under Section 365(g). The Court’s main rationale for following Lubrizol and not Sunbeam was its view that the Sunbeam approach would burden the debtor, as trademark owner, with monitoring and controlling the quality of the trademarked goods — duties imposed under trademark law — despite having already rejected the trademark license. It is worth reviewing the First Circuit’s analysis on this crucial point at some length:

Of course, to be precise, rejection as Congress viewed it does not “vaporize” a right. Rather, rejection converts the right into a pre-petition claim for damages. Putting that point of vocabulary to one side, and leaving open the possibility that courts may find some unwritten limitations on the full effects of section 365(a) rejection, we find trademark rights to provide a poor candidate for such dispensation. Congress’s principal aim in providing for rejection was to “release the debtor’s estate from burdensome obligations that can impede a successful reorganization.” Bildisco & Bildisco, 465 U.S. at 528. Sunbeam therefore largely rests on the unstated premise that it is possible to free a debtor from any continuing performance obligations under a trademark license even while preserving the licensee’s right to use the trademark. See Sunbeam, 686 F.3d at 377. Judge Ambro’s concurrence in In re Exide Technologies shares that premise. See 607 F.3d at 967 (Ambro, J., concurring) (assuming that the bankruptcy court could allow the licensee to retain trademark rights even while giving the debtor “a fresh start”).

Careful examination undercuts that premise because the effective licensing of a trademark requires that the trademark owner — here Debtor, followed by any purchaser of its assets — monitor and exercise control over the quality of the goods sold to the public under cover of the trademark. See 3 J. Thomas McCarthy, McCarthy on Trademarks & Unfair Competition § 18:48 (5th ed. 2017) (“Thus, not only does the trademark owner have the right to control quality, when it licenses, it has the duty to control quality.”). Trademarks, unlike patents, are public-facing messages to consumers about the relationship between the goods and the trademark owner. They signal uniform quality and also protect a business from competitors who attempt to profit from its developed goodwill. See Societe Des Produits Nestle, S.A. v. Casa Helvetia, Inc., 982 F.2d 633, 636 (1st Cir. 1992). The licensor’s monitoring and control thus serve to ensure that the public is not deceived as to the nature or quality of the goods sold. Presumably, for this reason, the Agreement expressly reserves to Debtor the ability to exercise this control: The Agreement provides that Debtor “shall have the right to review and approve all uses of its Marks,” except for certain pre-approved uses. Importantly, failure to monitor and exercise this control results in a so-called “naked license,” jeopardizing the continued validity of the owner’s own trademark rights. McCarthy, supra, § 18:48; see also Eva’s Bridal Ltd. v. Halanick Enters., Inc., 639 F.3d 788, 790 (7th Cir. 2011) (“[A] naked license abandons a mark.”); Restatement (Third) of Unfair Competition § 33 (“The owner of a trademark, trade name, collective mark, or certification mark may license another to use the designation. . . . Failure of the licensor to exercise reasonable control over the use of the designation by the licensee can result in abandonment . . . .”).

The Seventh Circuit’s approach, therefore, would allow Mission to retain the use of Debtor’s trademarks in a manner that would force Debtor to choose between performing executory obligations arising from the continuance of the license or risking the permanent loss of its trademarks, thereby diminishing their value to Debtor, whether realized directly or through an asset sale. Such a restriction on Debtor’s ability to free itself from its executory obligations, even if limited to trademark licenses alone, would depart from the manner in which section 365(a) otherwise operates.

The Court also raised the specter of a slippery slope:

And the logic behind that approach (no rights of the counterparty should be “vaporized” in favor of a damages claim) would seem to invite further leakage. If trademark rights categorically survive rejection, then why not exclusive distribution rights as well? Or a right to receive advance notice before termination of performance? And so on.

The First Circuit concluded its Sunbeam analysis this way:

In sum, the approach taken by Sunbeam entirely ignores the residual enforcement burden it would impose on the debtor just as the Code otherwise allows the debtor to free itself from executory burdens. The approach also rests on a logic that invites further degradation of the debtor’s fresh start options. Our colleague’s alternative, “equitable” approach seems similarly flawed, and has the added drawback of imposing increased uncertainty and costs on the parties in bankruptcy proceedings. For these reasons, we favor the categorical approach of leaving trademark licenses unprotected from court-approved rejection, unless and until Congress should decide otherwise. See James M. Wilton & Andrew G. Devore, Trademark Licensing in the Shadow of Bankruptcy, 68 Bus. Law. 739, 771-76 (2013).

Where Does Tempnology Leave Trademark Licensees? The First Circuit’s decision is bound to cause trademark licensees to worry anew about the risks of a licensor bankruptcy, after what had seemed to be a trend toward protecting trademark licensees. Although the circuit split remains, and at least two circuit judges have written separate opinions to argue for protecting trademark licensees through a court’s equitable powers, the First Circuit’s decision is a forceful endorsement of Lubrizol and the complete termination of a licensee’s trademark rights upon rejection.

Is there any hope for trademark licensees?

  • Other circuits, notably the Second and Third Circuits where many business bankruptcy cases are filed, have yet to weigh in.
  • Congress has from time to time proposed changes to Sections 101(35A) and 365(n) that would give some Section 365(n) protection to trademark licensees, but to date all of those bills have stalled.
  • With a now more prominent circuit split, the U.S. Supreme Court might consider taking up the issue, possibly even in the Tempnology case if a certiorari petition were filed. That said, cert petitions are rarely granted so the split could remain for some time.

Conclusion. The First Circuit’s decision to follow Lubrizol and reject Sunbeam reinforces the existing circuit split. Will its extensive trademark analysis be more persuasive to subsequent courts? It will be interesting to see how other courts, especially Courts of Appeals, come down on the effects of rejection and the rights of trademark licensees. Stay tuned.

 

Image courtesy of Flickr by Blondinrikard Fröberg