Tempnology decision eliminates bankrupt entities’ power to rescind most executory contracts
By George H. Singer and Aaron E. Brown
What is the consequence when a bankrupt exercises its statutory right to reject a contract in bankruptcy? This precise question has divided the courts since 1985, when the 4th Circuit held, in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., that a patent license agreement could be rejected by the debtor in bankruptcy and thereby result in the rescission of all rights granted to the licensee under the contract.1 Mass outrage over this decision and the impact the ruling had on licensees of intellectual property caused Congress to amend the Bankruptcy Code to allow nondebtor licensees to continue to use the contracted-for intellectual property irrespective of whether the debtor-licensor rejected the license agreement in its bankruptcy proceeding.2 But this amendment to the Bankruptcy Code did not expansively define “intellectual property” to include all categories of proprietary rights—leaving out of the definition trademarks and other types of intellectual property.3
In the intervening decades, courts have heard challenges to the idea that executory contracts may be not only rejected but also rescinded when the licensor files for protection in bankruptcy—the practical effect being that the nonbreaching party is no longer able to retain any of the benefits of the breached contract and must instead get in line with every other unsecured creditor. Several courts have, however, rejected the holding in Lubrizol and instead concluded that a rejection of a contract acts as a breach but not as a rescission of the entire agreement.4 Therefore, although the license agreement can be rejected and the debtor-licensor does not have to perform its own ongoing obligations under the contract, the licensor cannot rescind the contract and thereby terminate the licensee’s right to use the debtor’s trademark.
The United States Supreme Court, in Mission Product Holdings, Inc. v Tempnology, LLC,5 has resolved a circuit split with respect to the effect of a debtor’s rejection of an executory contract by concluding that rejection in bankruptcy cases breaches the agreement but does not rescind the entire contract.6 The 8-1 decision finally brought at least a little clarity to what the International Trademark Association characterized as “the most significant unresolved legal issue in trademark licensing.”
Factual background
In 2012, Tempnology entered into a license agreement with Mission Product Holdings. The license agreement allowed Mission to distribute Tempnology’s “Coolcore” brand of products—which consisted of clothing and accessories designed to allow the wearer to stay cool when exercising. The agreement also gave Mission a non-exclusive license to use the Coolcore trademark both in the United States and around the world.
A little less than a year before the agreement was set to expire, Tempnology filed for bankruptcy protection. After doing so, Tempnology asked the bankruptcy court to allow it to reject the licensing agreement under Section 365(a) of the Bankruptcy Code.7 The bankruptcy court approved the rejection of the license agreement, which as a matter of course allowed Tempnology to stop performing under the contract, and also allowed Mission to assert a pre-petition claim in the proceeding for damages relating to Tempnology’s breach. Tempnology also believed that a natural consequence of rejecting the licensing agreement was that the rejection would terminate the rights it granted to Mission to sell products using the Coolcore trademarks. Accordingly, Tempnology moved for a declaratory judgment in bankruptcy court to affirm its position.
Tempnology’s argument boiled down to a negative inference, with Tempnology pointing out that several subsections of Section 365 of the Bankruptcy Code compel the rejection-as-rescission theory. For example, Subsection 365(n) (the amendment Congress passed in response to the Lubrizol decision) allows a debtor-licensor to reject certain intellectual property licenses while allowing the non-debtor licensee to use the license so long as it makes the payments as provided by the contract. Another Subsection, 365(h), allows a debtor-landlord to reject a lease agreement but also allows the tenant to continue its tenancy and occupy the property until the lease term expires as long as the tenant pays the rent required under the contract. Because Section 365 covers these specific instances and provides what Tempnology argues is an exception to the “general” rule, Tempnology asserts that the debtor’s rejection must extinguish the rights that the agreement had granted.
The bankruptcy court agreed with Tempnology’s negative inference argument and concluded that Tempnology could reject and rescind the agreement, which terminated Mission’s rights to use the Coolcore trademarks in connection with the sale of goods.8 Mission appealed to the Bankruptcy Appellate Panel, and the panel reversed the lower court’s finding in favor of Mission. The panel did so by following a 7th Circuit opinion from 2012, Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC.9 In Sunbeam Products, the 7th Circuit rejected the negative-inference argument, and instead focused on Subsection (g) of Section 365, which states that rejection of the contract “constitutes a breach.”10 Moreover, outside the bankruptcy context, a breach of an agreement does not eliminate a right the contract confers on the nonbreaching party (such as the ability to continue to pay to receive the benefits of the contract). Breach is not defined in the Bankruptcy Code. Thus “breach” means the same thing under the Bankruptcy Code as it means in contract law outside the bankruptcy process.11 This allowed the 7th Circuit to determine that the rejection-as-rescission rule for executory contracts established in Lubrizol was incorrect.
After the Bankruptcy Appellate Panel’s ruling, Tempnology appealed the ruling to the Court of Appeals for the 1st Circuit, which reversed the Bankruptcy Appellate Panel’s decision and reinstated the bankruptcy court’s decision. With the 1st Circuit’s decision in Tempnology, a circuit conflict was created between the 7th and 1st Circuits, setting the stage for the Supreme Court to resolve an ongoing conflict that has troubled the courts for the past three decades.
Supreme Court decision
The Supreme Court ruled in favor of Mission and determined that Tempnology’s rejection of the contract did not operate to rescind the contract. The high court concluded that the plain text of the Bankruptcy Code resolves much of this issue. Section 365(a) gives the debtor the option to “assume or reject any executory contract.”12 Importantly, rejection “constitutes a breach of [an executory]13 contract” that occurs “immediately before the date of the filing of the petition.”14 Although breach is not defined in the Bankruptcy Code, its meaning in bankruptcy is the same as outside bankruptcy.15
Under contract law, if a party breaches an executory contract, then the nonbreaching party has the option of retaining the benefits of the bargain (in the present case, Mission would continue to pay for use of the trademark and sue for damages for Tempnology not servicing the trademark). Or the nonbreaching party can elect to terminate the contract and sue for all damages incurred because of the breach. The bottom line, though, is that the breaching party does not have the ability based on its own breach to terminate the agreement. Rather, the nonbreaching party retains the rights it has received under the agreement. And since this is equally true in the bankruptcy context as it is in contract law generally, the Supreme Court concluded that Tempnology’s breach did not terminate Mission’s rights to the trademarks. Although Tempnology can stop performing its remaining ongoing obligations under the agreement (e.g., protecting the trademark) by electing to reject the agreement, the license cannot be unilaterally terminated by the breaching party. Or, put another way, declaring bankruptcy does not grant the debtor more protections than it possessed before the case was commenced.
The Supreme Court reached this conclusion in spite of Tempnology’s argument, which centered around the negative-inference argument used in the lower courts and the idea that the 1988 licensing carve-out added by Congress to the statute in the shadow of Lubrizol created a specific intent not to protect trademarks. For its part, Congress did state that its omission of trademarks was very much intentional due to the lack of “extensive study” on the issue and the fact that “trademark licensing relationships depend to a large extent on control of the quality of the products or services sold by the licensee.”16 In the end, Congress concluded that it would “postpone” a decision on trademark’s inclusion under Section 365(n) and instead “allow the development of equitable treatment of [the] situation to bankruptcy courts.”17
Be that as it may, the high court noted that the inclusion of specific exceptions in the Bankruptcy Code should be seen as a legislative response to ensure that certain congressional rights survive rejection—and not a negative inference that others do not. Or, put differently, each of the exceptions highlighted by Tempnology were responses that took place over the span of a half century, and each exception “responded to a discrete problem—as often as not, correcting a judicial ruling of just the kind Tempnology urges.”18 As stated by the majority, “[t]he code of course aims to make reorganization possible. But it does not permit anything and everything that might advance that goal.”19
Conclusion
The Supreme Court in Tempnology provides a clear answer to the question of whether rejection’s breach under Section 365 of the Bankruptcy Code also terminates rights that the contract previously granted: Rejection breaches but does not rescind the contract.20 And that means all the rights that would ordinarily survive a breach of contract, including rights granted by a licensor to a licensee, remain in place.21
Importantly, the Supreme Court in Tempnology made multiple references to the general rule it was now pronouncing with the caveat that “no special contract term or state law” amend it. In the future, we expect the Tempnology ruling to force parties to specifically address the issue of termination of executory contracts in bankruptcy and whether such a termination will rescind the contract under the contract’s terms. This type of contractual provision could amend the general approach as articulated by the Supreme Court in Tempnology and provide the debtor party with much greater latitude. At a minimum, the broad, generalized pronouncements made by the Supreme Court regarding the effects and consequences of rejection under Section 365 may also result in nondebtor counterparties to contracts arguing that certain of their contractual rights continue notwithstanding the debtor’s rejection.
As courts have noted in the past, “[t]he effect of rejection is one of the great mysteries of bankruptcy law.”22 The Tempnology decision confronts the conceptual question in business bankruptcy cases of how one should think about a debtor’s contractual relations. The Supreme Court’s ruling makes it clear that a rejection does not mean a rescission or termination, but it remains to be seen what other types of contractual rights may be able to survive a debtor’s rejection. That question will likely need to work itself out in the coming years, but for now nondebtors can relish the fact that debtors will not be provided more rights in bankruptcy than they would have following a breach of contract outside of a bankruptcy.
Debtors can no longer, through rejection, stop licensees from using the licensor’s trademark assets in accordance with the terms of an otherwise enforceable license agreement. As a result, debtor licensors will be required to decide whether their trademark assets are valuable enough to justify continuing to incur the costs associated with maintaining quality controls over licensees and otherwise protecting their trademarks. As the Supreme Court summarized:
Through rejection, the debtor can escape all of its future contractual 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…. Nor does Section 365 relieve the debtor of the need, against the backdrop of that law, to make economic decisions about preserving the estate’s value—such as whether to invest the resources needed to maintain a trademark.23
Notes
1 756 F.2d 1043 (4th Cir. 1985).
2 See 11 U.S.C. §365(n).
3 See id. §101(35A) (defining “intellectual property”).
4 See, e.g., Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC, 686 F.3d 372, 376-77 (7th Cir. 2012).
5 203 L. Ed. 2d 878 (2019).
6 Id. at 881.
7 Section 365 of the Bankruptcy Code authorizes the debtor, subject to court approval, to assume or reject any executory contract. 11 U.S.C. §365(a). The Tempnology case is rooted in the fact that although bankruptcy affords the bankrupt debtor a virtually unqualified right to reject contracts in order to free itself of burdensome obligations, the Bankruptcy Code contains an exception for licenses of “intellectual property” as defined in the statute. 11 U.S.C. §§101(35A), 365(n).
8 See In re Tempnology, LLC, 541 B. R. 1 (Bankr. D.N.H. 2015).
9 686 F.3d 372, 376-77 (7th Cir. 2012).
10 Id.
11 See Field v. Mans, 516 U.S. 59, 69 (1995) (noting that when Congress uses terms that have accumulated settled meaning under the common law, a court should infer that Congress means to incorporate the established meaning of those terms unless a statute says otherwise).
12 Tempnology, 203 L. Ed. 2d at 886.
13 An executory contract is a contract that neither party has finished performing. Id. at 882
14 11 U.S.C. §365(g).
15 Id.
16 S. Rep. No. 100-505 at 3204 (1988).
17 Id.
18 Tempnology, 203 L. Ed. 2d at 889.
19 Id. at 891.
20 Id. at 881.
21 Id.
22 In re Henderson, 245 B.R. 449, 453 (Bankr. S.D.N.Y. 2000).
23 Tempnology, 203 L. Ed. 2d at 891.
GEORGE H. SINGER is a partner in the Minneapolis office of Ballard Spahr LLP and concentrates his practice on corporate and commercial law. He also currently serves as an adjunct professor of law at the University of Saint Thomas School of Law. Mr. Singer formerly served as an attorney on staff with the National Bankruptcy Review Commission and as a judicial law clerk to the Honorable Nancy C. Dreher, U.S. Bankruptcy Court for the District of Minnesota, and to the Honorable William A. Hill, U.S. Bankruptcy Court for the District of North Dakota.
AARON E. BROWN is an associate in the Minneapolis office of Ballard Spahr LLP and advises public and private companies on mergers, acquisitions, sales, regulatory compliance, and other day-to-day legal and business matters. Prior to joining Ballard Spahr, Mr. Brown was a judicial law clerk for the Minnesota Court of Appeals.