Effects of Executory Contract Rejection — At U.S. Supreme Court

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A Trademark (photo by Marilyn Swanson)

By: Donald L. Swanson

Here’s a case about the effects of executory contract rejection. While its focus is on “intellectual property” rights under § 365(n) [Fn. 1], the case also delves into the effects of rejection for all types of executory contracts under § 365(g) [Fn. 2].

And this case demonstrates the hazards of a failure to reach settlement in an early mediation.

The case is Mission Product Holdings, Inc. v. Tempnology, LLC, nka Old Cold LLC. It’s Petition for a Writ of Certiorari is pending at the U.S. Supreme Court (Case No. 17-1657), with Conference scheduled for September 24, 2018.

[Note: Prospects for granting certiorari appear favorable, due to a significant circuit split and two amici curae briefs on file.]

Debtor’s Explanations

We are “the global leader in chemical-free cooling fabrics,” says Debtor, with products such as towels, wraps, hoodies and bandanas. Our products “reduce surface fabric temperature up to 30 percent lower than skin temperature when moisture is present.”

Yet, Debtor goes from profits of $3.4 million in 2013 and $1.9 million in 2014 to a projected loss of $3.5 to $4.0 million in 2015. Debtor blames such change-in-fortunes on its “Co-Marketing and Distribution Agreement” with Distributor (the “Agreement”).

On June 30, 2014, Debtor exercises its termination rights under the Agreement. A year later (on June 10, 2015) after a failed mediation, an arbitrator declares the termination to be ineffective and that “the Agreement remains in full force and effect.”

In July of 2015, Debtor starts looking for a buyer of its business as a going concern.

On September 1, 2015, Debtor files Chapter 11 bankruptcy in New Hampshire (Case No. 15-11400).

Bankruptcy Context for Supreme Court Issues

In Debtor’s bankruptcy proceeding:

09/2/2015 – Debtor files a Motion to approve procedures for auction sale of “substantially all” of its assets, with a stalking horse bid (Doc. 34);

09/2/2015 – Debtor files a Motion to reject executory contracts, including the Agreement (Doc. 35);

09/11/2015 – Distributor provides notice of its “election to retain its rights in the Agreement pursuant to section 365(n) of the Bankruptcy Code” (Doc. 99, at ¶ 18);

10/2/2015 – Bankruptcy Court grant’s Debtor’s request to reject the Agreement, “subject to” Distributor’s election rights under 11 U.S.C. § 365(n) (Doc. 188);

10/8/2015 – Bankruptcy Court approves auction procedures for sale of Debtor’s assets (Doc. 194);

10/15/2015 – Debtor moves to clarify that Distributor’s § 365(n) election, (i) applies only to non-exclusive licenses under the Agreement, and (ii) has no application to trademarks or distribution arrangements (Doc. 211);

11/6/2015 – Debtor files “Notice” that an auction bid of $2,700,000 is “the highest and best bid” and that Distributor “elected to not serve as the Back-Up Bidder” (Doc. 235);

11/12/2015 – Bankruptcy Court rules in Debtor’s favor on the effect of Distributor’s § 365(n) election (Docs. 239 & 240)

[Note: this 11/12/2015 ruling is what’s on appeal to the U.S. Supreme Court];

11/12/2015 – Distributor files, (i) “Statement of Challenge” and an “Objection” (as unsuccessful bidder) to the auction sale saying, “the alleged ‘winner’ of the Auction is an insider of the Debtor” (Docs. 241, 244 & 246), and (ii) Notice of appeal of the Bankruptcy Court’s ruling on its § 365(n) election (Doc. 242);

11/16/2015 – Distributor files a proof of claim in the “estimated” amount of $4,160,000 (Claim # 6-1);

12/21/2015 – Debtor objects to Distributor’s proof of claim (Doc. 313);

12/18/2015 – Bankruptcy Court approves the proposed sale, based on an Examiner’s report (Docs. 306 & 307);

12/28/2015 – Distributor appeals the sale approval order (Doc. 333); and

02/03/2016 – A stipulated Order “stays” prosecution of disputes between Debtor and Distributor, until both pending appeals are resolved.

06/30/2016 – The Agreement expires.

[Note: Due to the Agreement’s expiration, the practical issue in the case become this—whether Distributor’s claims are entitled to an administrative or a general unsecured status.]

Bankruptcy Court Ruling on Issues Now at the Supreme Court

The Bankruptcy Court identifies this issue:

“Debtor seeks a determination that [Distributor’s § 365(n)] rights do not extend to the grant of certain exclusive distribution rights or to the use of the Debtor’s trademarks.”

And it rules in Debtor’s favor on both the “exclusive distribution rights” and “trademarks” issues.

–“Exclusive Distribution Rights” Issue

Bankruptcy Court rules that Distributor’s “exclusive distribution rights” do not qualify for protection as “intellectual property rights” under § 365(n). Here’s why:

A contract “can serve more than one purpose,” but § 365(n) protection for licensees “is solely limited to intellectual property rights”;

Distributor’s exclusive distribution rights are not “intellectual property rights”—they are, (i) nothing more than “the right to sell and distribute specified products,” and (ii) not an “embodiment of . . . intellectual property” under § 365(n)(1)(B); and

Distributor “has not cited any case” that applies § 365(n) as broadly as Distributor argues.

–“Trademarks” Issue

Bankruptcy Court rules that Distributor does NOT retain rights to Debtor’s trademarks under § 365(n). Here’s why:

The Bankruptcy Code definition of “intellectual property” (§ 101(35A)) specifies trade secrets, inventions, processes, designs, etc., but does NOT mention trademarks [Fn. 3];

A minority of courts “exercise their equitable powers” to decide whether trademarks qualify as “intellectual property”;

A majority of courts hold that rights under trademark licenses “are not afforded any protection under § 365(n); and

The Bankruptcy Court adopts the majority approach, ruling in Debtor’s favor on Distributor’s trademark rights.

Bankruptcy Appellate Panel Ruling

On appeal, the Bankruptcy Appellate Panel for the First Circuit (“BAP”) affirms the Bankruptcy Court’s ruling on the “exclusive distribution rights” issue.

But it reverses on the trademarks issue. Here’s its rationale:

It rejects both the minority and majority approaches identified by the Bankruptcy Court, in favor of an approach that focuses on § 365(g), instead of on § 365(n) [Fn. 4];

Under § 365(g), a debtor’s rejection of an executory contract is not a “termination” of the contract—instead, rejection is a mere “breach” of the contract that “frees the estate from the obligation to perform,” while “the non-rejecting party’s rights remain in place”; and

“Debtor’s rejection of the Agreement did not vaporize [Distributor’s] trademark rights,” and Distributor’s right to continue using Debtor’s trademarks continues in effect.

Ruling of the First Circuit Court of Appeals

On appeal, the U.S. First Circuit Court of Appeals affirms the Bankruptcy Court’s ruling on all counts and rejects the BAP’s partial reversal. It’s rejection of the BAP’s § 365(g) approach is explained in this summary:

The BAP’s approach “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 BAP’s approach “rests on a logic that invites further degradation of the debtor’s fresh start options,” since Distributor is demanding “to continue using the debtor’s property”; and

The alternative “equitable” approach “has the added drawback of imposing increased uncertainty and costs on the parties in bankruptcy proceedings.”

Potential for Broad Impact on Executory Contracts

Upon initial evaluation, the Mission v. Tempnology rulings appear specific to intellectual property rights under § 365(n), with little impact beyond that context.

Upon closer review, however, Mission v. Tempnology has the potential to affect every rejection of every executory contract in a wide variety of contexts—under § 365(g)!

Conclusion

Mission v. Tempnology looks like a good candidate for granting certiorari.

If certiorari is granted, the U.S. Supreme Court decision could result in a narrow-and-limited holding under § 365(n).

But the case also has a potential for becoming a watershed decision on the impact of executory contract rejections, generally, under § 365(g).

Can’t wait to see what happens!

Footnote 1: 11 U.S.C. § 365(n) provides in part:

“If the trustee rejects an executory contract under which the debtor is a licensor of a right to intellectual property, the licensee under such contract may elect— . . . to retain its rights (including a right to enforce any exclusivity provision of such contract, but excluding any other right . . . to specific performance of such contract) under such contract and under any agreement supplementary to such contract, to such intellectual property (including any embodiment of such intellectual property . . . ), as such rights existed immediately before the case commenced.”

Footnote 2: 11 U.S.C. § 365(g) provides in part:

“the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease.”

Footnote 3: 11 U.S.C. § 101(35A) provides:

The term “intellectual property” means–(A) trade secret; (B) invention, process, design, or plant protected under title 35; (C) patent application; (D) plant variety; (E) work of authorship protected under title 17; or (F) mask work protected under chapter 9 of title 17; to the extent protected by applicable nonbankruptcy law.

Footnote 4: The BAP is following the view expressed and applied in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 372 (7th Cir. 2012).

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