Recent Developments

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Business Bankruptcy Issues Recent Developments

Ninth Circuit Opens The Door To Recharacterization Of Debt As Equity

In bankruptcy, prepetition loans made by insiders are often investigated, and sometimes challenged, by debtors, creditors’ committees, or trustees. The two most frequent challenges brought are that (1) the loans in question are not really debt and should be recharacterized as equity, and (2) the debt should be equitably subordinated below the claims of all or some other creditors. Recharacterization focuses on the intent of the parties (e.g., did the parties intend for the debt to be repaid or treated like equity) and the characteristics of the alleged debt instrument. Equitable subordination, on the other hand, generally requires, among other facts, a showing of inequitable conduct on the insider’s part. A successful challenge on either basis usually means the insider receives nothing on its claim since most debtors cannot pay all creditors in full. 

The Ninth Circuit BAP Had Rejected Recharacterization Claims. For the past 27 years, although recharacterization challenges have been advanced in cases elsewhere around the country, lower courts in the Ninth Circuit have largely rejected them. Instead, they have tended to follow the holding of a 1986 decision by the Ninth Circuit Bankruptcy Appellate Panel, In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986), which shut the door on recharacterization claims.

  • In Pacific Express, the Bankruptcy Appellate Panel held that the characterization of claims as equity or debt was governed exclusively by equitable subordination principles under Section 510(c) of the Bankruptcy Code.
  • This meant that no separate challenge based only on recharacterization of debt as equity could be pursued. 

The Ninth Circuit Opens The Door.  With a decision issued last week by the U.S. Court of Appeals for the Ninth Circuit, made at the Circuit level and not by the lower BAP court, those days are over. In its April 30, 2013 opinion in In the Matter of: Fitness Holdings Int’l, the Ninth Circuit held that recharacterization and equitable subordination address distinct concerns, and a recharacterization challenge separate from equitable subordination is permissible. (Follow the link in the prior sentence to read the opinion.) The Fitness Holdings court stated that recharacterization determines whether there is a claim to be paid at all while equitable subordination considers whether an allowed claim should be subordinated to other claims. The Ninth Circuit held that the Pacific Express court erred in holding that the characterization of claims as equity or debt is governed solely by Bankruptcy Code Section 510(c).

  • The case arose in the context of a fraudulent transfer claim originally brought on behalf of the bankruptcy estate by the creditors’ committee. The committee alleged that the debtor’s pre-bankruptcy repayment of a loan made by its sole shareholder was a constructively fraudulent transfer, a transfer made at a time when the debtor was insolvent or otherwise financially impaired and for which it did not receive "reasonably equivalent value."
  • Normally, repayment of a loan provides a debtor with reasonably equivalent value because it discharges an equal amount of debt owed by the debtor. However, the complaint sought to recharacterize the loan itself as an equity interest.  If recharacterized, the repayment would be treated as a distribution to equity for which the debtor received no value in return. 
  • In a footnote, the Ninth Circuit also called out the district court for erroneously holding that it, an Article III court, was bound by a decision of the Bankruptcy Appellate Panel.

State Law Applies To Recharacterization Claims. Having opened the door, the Ninth Circuit then determined how recharacterization claims should be considered. Specifically, the Court ruled that bankruptcy courts should look to state law to determine whether a challenged debt claim should be characterized as debt or equity. The Ninth Circuit followed the Fifth Circuit’s decision in In re Lothian Oil Inc., 650 F.3d 539 (5th Cir. 2011), which applied state law, rejecting the approach used in the Third and Sixth Circuits, which have developed their own set of factors based on a bankruptcy court’s general equitable authority under Section 105(a) of the Bankruptcy Code. This widened a split among the circuits but the Ninth Circuit held that Supreme Court authority, including Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007), requires state law to govern the substance of claims and, as a result, also the characterization of a claim as debt or equity. (Read this prior post for more information on the Travelers case.)  In Fitness Holdings, the Ninth Circuit did not reach the issue of whether the loan should actually be recharacterized, instead sending the case back to the lower courts for further proceedings.

Conclusion. The Fitness Holdings decision aligns the Ninth Circuit with most other courts around the country in permitting a claim to be challenged on grounds that it should be recharacterized as equity instead of a true debt. Although the case arose in the context of a fraudulent transfer claim, the holding that recharacterization claims may be made separately from equitable subordination claims seems likely to be applied outside of that context. That said, a recharacterization claim is not easy to establish, and not every insider loan will be susceptible to such a challenge. Also, recharacterization claims have not typically been brought in state court. It remains to be seen how application of state law, as opposed to the well-developed factors used by bankruptcy courts in other circuits, will impact the viability of recharacterization claims. Nevertheless, given Fitness Holdings, recharacterization is now an issue that major shareholders and other insiders, as well as debtors, creditors’ committees, and trustees, will need to keep in mind in bankruptcy cases in the Ninth Circuit.

Business Bankruptcy Issues Recent Developments

Spring 2013 Edition Of Bankruptcy Resource Now Available

The Spring 2013 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has now been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • The U.S. Supreme Court’s decision upholding a secured creditor’s right to credit bid;
  • Determining when a claim arises under the Bankruptcy Code;
  • How the assumption of an executory contract can protect a party from a preference claim; and
  • A recent Seventh Circuit decision applying the absolute priority rule in a Chapter 11 plan context.

This edition also reports on some of our recent representations, including for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others, and our work for Chapter 11 debtors. Recent committee cases include Mervyn’s Holdings, Appleseed’s Intermediate Holdings, Atari, Vertis Holdings, United Retail, and Urban Brands, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Business Bankruptcy Issues Recent Developments

Seventh Circuit Decision Gives Support To Protecting Buyers In Bankruptcy Sales From Successor Liability

Last week, the U.S. Court of Appeals for the Seventh Circuit addressed whether a buyer of assets outside of bankruptcy (in this case, from a receivership), takes on successor liability for federal Fair Labor Standards Act ("FLSA") claims made by the employees of the company whose assets it purchases. Although the case arose in a receivership, the Seventh Circuit’s opinion provides important insights into how these issues play out in bankruptcy sales of substantially all assets of a debtor.

Successor Liability Imposed. In Teed v. Thomas & Betts Power Solutions, L.L.C., the Seventh Circuit held that the buyer took on successor liability for the FLSA claims, even though the sale was made "free and clear" of all liabilities generally and of the FLSA claims in particular. The Seventh Circuit ruled that although those provisions would have protected the buyer, Thomas & Betts, under applicable Wisconsin state law, the FLSA is a federal statute and under federal common law, the buyer had successor liability for the FLSA claims. You can read a copy of the Seventh Circuit’s opinion, issued March 26, 2013, by clicking on the link in this sentence.

Contrast With Section 363 Bankruptcy Sales. As discussed in a recent post, when a debtor is facing major potential liabilities, the ability of a bankruptcy court to order the sale to the buyer "free and clear" of liabilities, including successor liability, can lead to a much higher price in a Section 363 sale. Cases discussing successor liability in bankruptcy therefore get the attention of those involved in distressed asset sales.

  • At first glance, the Seventh Circuit’s opinion seems to be troubling news for buyers of assets from distressed companies because the buyer in the Teed case was held to have successor liability for the FLSA claims at issue.
  • However, there appears to be more to the Seventh Circuit’s thinking. In its opinion, written by Judge Richard A. Posner, the Seventh Circuit concluded that "successor liability is appropriate in suits to enforce federal labor or employment laws–even where the successor disclaimed liability when it accepted the assets in question–unless there are good reasons to withhold such liability."  It was in examining possible "good reasons" not to impose successor liability that the Seventh Circuit specifically highlighted bankruptcy sales.

Seventh Circuit’s Analysis. Given that most bankrupt companies are insolvent, the Seventh Circuit noted that imposing successor liability on a buyer might allow unsecured FLSA claims against the seller (debtor) to become, effectively, senior to a secured creditor’s claim against the debtor if the buyer lowered its purchase price to account for such claims:

That is a good reason not to apply successor liability after an insolvent debtor’s default, whether its assets were sold in bankruptcy or outside (by a receiver, for example, as in this case): to apply the doctrine in such a case might upend the priorities of competing creditors. See In re Trans World Airlines, 322 F.3d 283, 290, 292-93 (3d Cir. 2003); Douglas G. Baird, The Elements of Bankruptcy 227-28 (5th ed. 2010). It’s an example of a good reason not mentioned in conventional formulations of the federal standard for not imposing successor liability. But it doesn’t figure in this appeal. Thomas & Betts has not urged it. It says that it didn’t discount its bid for Packard because of the workers’ claims; this both suggests that it didn’t anticipate successor liability and may explain why the bank has not complained about the imposition of that liability.

                                                *          *          *

Thomas & Betts argues finally, with support in Musikiwamba v. ESSI, Inc., supra, 760 F.2d at 751, that allowing the workers to enforce their FLSA claims against the successor, in a case such as this in which the predecessor cannot pay them, complicates the reorganization of a bankrupt. Seeing the handwriting on the wall and wanting to minimize the impact of the reorganization on them (in loss of employment or benefits), the workers might decide to file a flurry of lawsuits, whether or not well grounded, hoping to substitute a solvent acquirer for their employer as a defendant in the suits. The prospect thus created of increased liability might scare off prospective buyers of the assets. But there is no suggestion of such a tactic by workers in this case; if there were, it would be another good reason for denying successor liability. Still another concern is that an insolvent company, seeking to maximize its value, might decide not to sell itself as a going concern but instead to sell off its assets piecemeal, even if the company would be worth more as a going concern than as a pile of dismembered assets. In the latter case there would be as we said no successor liability, and successor liability depresses the going concern value of the predecessor, so the insolvent company might be better off even though it was destroying value by not selling itself as a going concern. Once a firm is in Chapter 7 bankruptcy (or in a Chapter 11 bankruptcy in which a trustee is appointed), or receivership, it is “owned” by the trustee (or receiver), whose sole concern is with maximizing the net value of the debtor’s estate to creditors (and maybe to other claimants—including shareholders, if the estate is flush enough to enable all the creditors’ claims to be satisfied in full). In re Taxman Clothing Co., 49 F.3d 310, 315 (7th Cir. 1995); In re Central Ice Cream Co., 836 F.2d 1068, 1072 (7th Cir. 1987). With immaterial exceptions, the trustee in a Chapter 7 bankruptcy (or, we assume, a receiver) must sell the debtor’s assets for the highest price he can get. 11 U.S.C. § 704(a)(1); In re Moore, 608 F.3d 253, 263 (5th Cir. 2010); In re Atlanta Packaging Products, Inc., 99 B.R. 124 (Bankr. N.D. Ga. 1988). He may not cut the price so that some junior creditor can enforce a claim not against the debtor’s assets but against a third party, the successor, in this case Thomas & Betts. The trustee would be required to sell the assets piecemeal if that would yield more money for the creditors as a whole (to be allocated among them according to their priorities) than sale as a going concern would, even if some creditors would be harmed because successor liability would have been extinguished, and even if economic value would have been destroyed.

But this is a theoretical rather than a practical objection. Since most firms’ assets are worth much more as a going concern than dispersed, successor liability will affect the choice between the two forms of sale in only a small fraction of cases. Lynn M. LoPucki & Joseph W. Doherty, “Bankruptcy Fire Sales,” 106 Mich. L. Rev. 1, 5 (2007).

Conclusion. Although the Court of Appeals did not find any of the potential "good reasons" applicable in the Teed case, its discussion of the problems with imposing successor liability in a bankruptcy sale is helpful.  Despite the holding, the decision’s analysis provides support for buyers seeking protection from successor liability in bankruptcy sales, even from liability under federal labor and employment statutes that might otherwise trump state law, and likewise for bankruptcy courts issuing orders granting buyers that protection. For that reason, it is an interesting and important opinion for buyers and sellers of distressed assets and the professionals that work with them.

Business Bankruptcy Issues Recent Developments

Official Bankruptcy Forms Revised To Reflect April 1, 2013 Dollar Amount Adjustments

As discussed in an earlier post called "Going Up: Bankruptcy Dollar Amounts Will Increase On April 1, 2013," various dollar amounts in the Bankruptcy Code and related statutory provisions were increased for cases filed on or after today, April 1, 2013. Now several official bankruptcy forms have been revised to reflect these new dollar amounts.

Remember, the increased dollar amounts reflected on these forms apply only to cases filed on or after April 1, 2013.

Business Bankruptcy Issues Recent Developments

Going Up: Bankruptcy Dollar Amounts Will Increase On April 1, 2013

It hasn’t gotten much publicity yet, but certain dollar amounts in the Bankruptcy Code will be increased for new cases filed on or after April 1, 2013. Follow this link for a chart listing all of the changes on this Federal Register page, which printed this month’s official notice from the Judicial Conference of the United States.

Among the most meaningful increases for Chapter 11 and other business bankruptcy cases:

  • The total amount of claims required to file an involuntary petition rises to $15,325 from $14,425;
  • The employee compensation and benefit plan contribution priorities under Sections 507(a)(4) and 507(a)(5) both increase to $12,475 from $11,725;
  • The consumer deposit priority under Section 507(a)(7) rises to $2,775 from $2,600;
  • 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 $12,475 from $11,725;
  • 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 from $6,225 from $5,475; and
  • The total debt amount in the definition of small business debtor in Section 101(51D) will rise to $2,490,925.

Other adjustments will affect consumers more than business debtors. For example, the debt limit for an individual to be able to qualify to file a Chapter 13 bankruptcy case will rise to $1,149,525 of secured debt, and certain exemption amounts will also rise.

Although the changes aren’t substantial, be sure to keep them in mind when assessing cases filed after April 1st.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Summer 2012 Edition Of Bankruptcy Resource Now Available

The Summer 2012 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has now been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

  • Decisions from courts in Delaware and California interpreting the Supreme Court’s 2011 Stern v. Marshall decision and its impact on the ability of bankruptcy courts to enter final judgments in fraudulent transfer and other cases;
  • The Section 546(e) defense to fraudulent transfer claims; and
  • Issues involving the recharacterization of a non-insider’s loans as equity.

This edition also reports on some of our recent representations, including our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Ritz Camera & Image, Blockbuster, Orchard Brands, Wave 2 Wave Communications, Signature Styles, Urban Brands, and Mervyn’s Holdings, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

Business Bankruptcy Issues Recent Developments

Seventh Circuit Bankruptcy Ruling Is Big Win For Trademark Licensees

On July 9, 2012, the U.S. Court of Appeals for the Seventh Circuit issued its decision in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, and in doing so handed a major victory to trademark licensees whose licenses are rejected in bankruptcy by trademark owners. A copy of the opinion is available through this link. However, before discussing the details of the opinion, it’s important to put it in context first. And for that, we need to journey back to the 1980s.

A History Of Rejection. Back in 1985, the U.S. Court of Appeals for the Fourth Circuit issued a decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985). The Fourth Circuit held that Lubrizol, a nonexclusive patent licensee whose patent license was rejected as an executory contract in the bankruptcy case of Lubrizol’s licensor, debtor Richmond Metal Finishers, could not "rely on provisions within its agreement with [the debtor] for continued use of the technology."  According to the Lubrizol court, when Congress enacted Section 365(g) of the Bankruptcy Code, governing the effect of rejection of an executory contract, "the legislative history of § 365(g) makes clear that the purpose of the provision is to provide only a damages remedy for the non-bankrupt party," and no specific performance remedy. The Fourth Circuit held that, as a result, when the debtor rejected the contract, Lubrizol, as the patent licensee, lost its rights under the license.

Congress Protects Certain IP Licensees. In reaction to the Lubrizol decision and the concerns of the decision’s potential impact on patent and other technology licensees, in 1988 Congress added Section 365(n) to the Bankruptcy Code, expressly permitting licensees of intellectual property to elect to retain their rights to the intellectual property. However, Congress also added to the Bankruptcy Code its own definition of "intellectual property" for Section 365(n) purposes, and decided not to include trademarks in Section 101(35A)’s definition. As a result, trademark licensees have none of the protections of Section 365(n). Follow the link for more on Section 365(n) and its protections for licensees.

Back To The Future. With that history in mind, it’s time to come back to the future, or at least the present. Lubrizol’s decision that a licensee cannot rely on the provisions of its license agreement for continued use of the intellectual property, together with the fact that Section 365(n)’s protections do not extend to trademark licenses, has for years left trademark licensees at great risk of losing all trademark rights if the license is rejected. That is, it seemed that way until just the past couple of years.

  • A 2010 decision from the U.S. Court of Appeals for the Third Circuit in the In re: Exide Technologies case held that when a trademark license was provided in connection with the sale of a business, and that sale had been substantially performed, the trademark license was no longer executory, could not be rejected, and the licensee could continue to use the trademarks.
  • In a concurring opinion in Exide Technologies, Judge Ambro went further, concluding that rejection of a trademark license should not deprive the licensee of all rights. In enacting Section 365(n) but leaving trademarks outside the definition of "intellectual property," Congress did not intend that Lubrizol’s result apply to trademark licenses and instead courts should use equitable powers to protect licensees.
  • Last year, in the case that led to the Seventh Circuit’s decision here, the bankruptcy court in In re Lakewood Engineering & Manufacturing Co., Inc, 459 B.R. 306 (Bankr. N.D. Ill. 2011), decided to "step into the breach," follow Judge Ambro’s reasoning, and begin the "development of equitable treatment" of trademark licensees that it concluded Congress had anticipated would occur. In so doing, it held that despite rejection of a manufacturing and supply agreement that included a trademark license, the licensee could continue to sell trademarked goods as it had been licensed to do.

The Seventh Circuit’s Decision. The bankruptcy court’s decision was taken up on appeal to the Seventh Circuit. In its July 9, 2012 opinion, written by Chief Judge Frank H. Easterbrook, the Seventh Circuit disagreed with the bankruptcy court’s analysis but ultimately affirmed its decision. In its opinion, however, the Seventh Circuit took aim directly at the Lubrizol decision and reasoning.

The facts of the Sunbeam case are fairly straightforward. Lakewood Engineering & Manufacturing Co. made various consumer products, including box fans, which were covered by its patents and trademarks. Lakewood contracted with Chicago American Manufacturing ("CAM") to make its fans for 2009, granting CAM a license to the relevant patents and trademarks. In recognition of both the investment CAM would have to make to manufacture the fans and Lakewood’s own distressed financial condition, the agreement authorized CAM to sell directly any of the 2009 production of box fans that Lakewood did not purchase. A few months after the agreement was signed, Lakewood was forced into involuntary bankruptcy and a trustee was appointed. The trustee sold Lakewood’s assets, including the patents and trademarks, to Sunbeam Consumer Products, which wanted to sell its own fans and not have to compete with CAM’s sales. The trustee rejected the CAM agreement and, when CAM continued to sell the remaining fans, Sunbeam sued CAM for infringement.

The issue on appeal was the effect of the trustee’s rejection of the CAM agreement, and specifically the trademark license, on CAM’s ability to sell the fans. The Seventh Circuit’s focus on the Lubrizol decision was apparent:

Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), holds that, when an intellectual-property license is rejected in bankruptcy, the licensee loses the ability to use any licensed copyrights, trademarks, and patents. Three years after Lubrizol, Congress added §365(n) to the Bankruptcy Code. It allows licensees to continue using the intellectual property after rejection, provided they meet certain conditions. The bankruptcy judge held that §365(n) allowed CAM to practice Lakewood’s patents when making box fans for the 2009 season. That ruling is no longer contested. But “intellectual property” is a defined term in the Bankruptcy Code: 11 U.S.C. §101(35A) provides that “intellectual property” includes patents, copyrights, and trade secrets. It does not mention trademarks. Some bankruptcy judges have inferred from the omission that Congress codified Lubrizol with respect to trademarks, but an omission is just an omission. The limited definition in §101(35A) means that §365(n) does not affect trademarks one way or the other. According to the Senate committee report on the bill that included §365(n), the omission was designed to allow more time for study, not to approve Lubrizol. See S. Rep. No. 100–505, 100th Cong., 2d Sess. 5 (1988). See also In re Exide Technologies, 607 F.3d 957, 966–67 (3d Cir. 2010) (Ambro, J., concurring) (concluding that §365(n) neither codifies nor disapproves Lubrizol as applied to trademarks). The subject seems to have fallen off the legislative agenda, but this does not change the effect of what Congress did in 1988.

Chief Judge Easterbrook’s opinion noted that the bankruptcy court had permitted CAM to continue using the trademarks on equitable grounds, but rejected that approach as going beyond what the Bankruptcy Code permits. The Seventh Circuit then directly addressed the Lubrizol decision:

Although the bankruptcy judge’s ground of decision is untenable, that does not necessarily require reversal. We need to determine whether Lubrizol correctly understood §365(g), which specifies the consequences of a rejection under §365(a). No other court of appeals has agreed with Lubrizol—or for that matter disagreed with it. Exide, the only other appellate case in which the subject came up, was resolved on the ground that the contract was not executory and therefore could not be rejected. (Lubrizol has been cited in other appellate opinions, none of which concerns the effect of rejection on intellectual-property licenses.) Judge Ambro, who filed a concurring opinion in Exide, concluded that, had the contract been eligible for rejection under §365(a), the licensee could have continued using the trademarks. 607 F.3d at 964–68. Like Judge Ambro, we too think Lubrizol mistaken.

After observing that outside of bankruptcy a licensor’s breach does not terminate a licensee’s right to use intellectual property, and Section 365(g) provides that rejection is breach, the Seventh Circuit turned to the impact of Section 365(g) and rejection in bankruptcy:

What §365(g) does by classifying rejection as breach is establish that in bankruptcy, as outside of it, the other party’s rights remain in place. After rejecting a contract, a debtor is not subject to an order of specific performance. See NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984); Midway Motor Lodge of Elk Grove v. Innkeepers’ Telemanagement & Equipment Corp., 54 F.3d 406, 407 (7th Cir. 1995). The debtor’s unfulfilled obligations are converted to damages; when a debtor does not assume the contract before rejecting it, these damages are treated as a pre-petition obligation, which may be written down in common with other debts of the same class. But nothing about this process implies that any rights of the other contracting party have been vaporized. Consider how rejection works for leases. A lessee that enters bankruptcy may reject the lease and pay damages for abandoning the premises, but rejection does not abrogate the lease (which would absolve the debtor of the need to pay damages). Similarly a lessor that enters bankruptcy could not, by rejecting the lease, end the tenant’s right to possession and thus re-acquire premises that might be rented out for a higher price. The bankrupt lessor might substitute damages for an obligation to make repairs, but not rescind the lease altogether.

The Court then distinguished rejection from avoidance powers, which might lead to rescission or termination of an agreement, observing that "rejection is not ‘the functional equivalent of a rescission, rendering void the contract and requiring that the parties be put back in the positions they occupied before the contract was formed.” Thompkins v. Lil’ Joe Records, Inc., 476 F.3d 1294, 1306 (11th Cir. 2007). It ‘merely frees the estate from the obligation to perform’ and ‘has absolutely no effect upon the contract’s continued existence’. Ibid. (internal citations omitted)." Follow the link for more background on the Thompkins decision.

The Seventh Circuit referenced scholarly criticism of the Lubrizol decision before turning back to the Fourth Circuit’s opinion: 

Lubrizol itself devoted scant attention to the question whether rejection cancels a contract, worrying instead about the right way to identify executory contracts to which the rejection power applies.

Lubrizol does not persuade us. This opinion, which creates a conflict among the circuits, was circulated to all active judges under Circuit Rule 40(e). No judge favored a hearing en banc. Because the trustee’s rejection of Lakewood’s contract with CAM did not abrogate CAM’s contractual rights, this adversary proceeding properly ended with a judgment in CAM’s favor.

A Significant Decision. The Seventh Circuit’s opinion in the Sunbeam case not only creates a circuit split that could potentially lead the Supreme Court to address the issue, but more significantly represents the first court of appeals decision in 27 years to challenge Lubrizol’s view of how rejection impacts an intellectual property license. Although binding only in the Seventh Circuit (much like, in theory, Lubrizol was binding only in the Fourth Circuit), the Sunbeam decision has the potential to impact licensee rights in cases across the country. Licensees, and especially trademark licensees, will be arguing that rejection does not terminate their license rights. Debtors and purchasers of trademarks may well argue otherwise. If followed by other courts, the Sunbeam decision and its potential interplay with Section 365(n) raises a number of questions, including:

  • Aside from the right to use the licensed trademarks, does the licensee keep other rights under its agreement, such as exclusivity if applicable?
  • How long does the right to the trademarks continue, the full term of the license agreement plus any extensions, or some shorter period?
  • If royalties are required under a trademark license, must the trademark licensee continue to pay them post-rejection to use the licensed trademarks, as an IP licensee covered by Section 365(n) is required to do, or can the trademark licensee argue that rejection is a material breach excusing that performance?
  • Since under Sunbeam rejection does not terminate trademark license rights, does the same analysis apply to intellectual property other than trademarks, including those covered by Section 365(n)?
  • Are licensees of patents, copyrights, or trade secrets, otherwise protected by Section 365(n), required to follow Section 365(n)’s statutory scheme to retain their rights, or can they rely on the Sunbeam decision’s analysis of the effect of rejection as an alternative approach? 
  • How will purchasers of trademarks and other assets react to the potential continued use of the marks by licensees under rejected trademark licenses?

Conclusion. As these questions suggest, the full impact of the Seventh Circuit’s Sunbeam decision is yet to be determined. It remains to be seen how other circuits — and bankruptcy courts in important venues such as Delaware and the Southern District of New York — will react. Given the circuit split now created, it’s possible the Supreme Court could address the issue, either in Sunbeam or a later case. In the meantime, however, a long-standing and often accepted view of the impact of rejection on intellectual property licenses, and especially on trademark licenses, has been upended. It will likely take courts, licensors, and licensees some time to sort through how the new, post-Sunbeam state of the law will play out. This could get interesting — stay tuned.