Contract Rejection Damages as Administrative Claims in Bankruptcy

By: Donald L. Swanson

What is at issue for these parties, practically speaking, is whether to classify as prepetition or post-petition liability any damages caused by Debtor’s failure to honor its executory obligations.

–U.S. First Circuit Court of Appeals in Mission Product Holdings v. Tempnology, LLC., Case No. 16-9016 (1/12/2018), at 14.

Current Posture

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A Trademark (photo by Marilyn Swanson)

Mission v. Tempnology is now before the U.S. Supreme Court, where it awaits decision—oral arguments occurred on February 20, 2019. The Supreme Court will address the legal question of what happens to a party’s trademark rights under a contract that is rejected by the counterparty in bankruptcy.

Practical Issue is Huge

The First Circuit’s practical issue, using common bankruptcy jargon, is this: do the counterparty’s contract rejection damages hold an administrative claim or a general unsecured claim status in the bankruptcy?

Here’s why that’s important: administrative claims are usually paid in full while general unsecured claims get, typically, only a few cents on the dollar—if anything.

–Keep in mind that the Bankruptcy Code dictates that rejection damages for a counterparty are general unsecured claims [Fn. 1]. The Mission v. Tempnology counterparty contends, nevertheless, that it holds an administrative claim.

Accordingly, this practical issue (i.e., prepetition v. post-petition / administrative claim v. general unsecured claim) is huge—for both the Mission v. Tempnology case and for many other cases too!

Practical Issue Gets Little Attention

Yet this practical issue is getting little, if any, attention—almost none! For example:

  1. The practical issue is not a formal part of the appeal to the U.S. Supreme Court, because the parties had already stipulated that the practical issue would not be addressed until after the Supreme Court rules [Fn. 2]; accordingly, no one is talking to the Supreme Court in their briefs about this practical issue—no one.
  2. Moreover, there is exceedingly-little discussion of the practical issue among commentators. To illustrate this lack-of discussion, I conducted an experiment on 2/23/2019 by:

Practical Issue Discussed in Oral Arguments

So . . . it is with some self-satisfaction [and considerable relief] that I can report of an actual discussion of the practical issue (i.e., prepetition v. post-petition / administrative claim v. general unsecured claim) in oral arguments on Mission v. Tempnology at the U.S. Supreme Court.

I must admit that such discussion comes at the end of oral arguments [it’s on pages 65, 66 & 67 of a 68 page transcript of oral arguments], and such discussion has the appearance of an afterthought that’s nearly forgotten. But the discussion is there, nonetheless.

And here it is:

JUSTICE SOTOMAYOR: . . . If you continue using the mark, do the damages that you incur after the filing of the bankruptcy — are they prepetition debt or postpetition debt? Are you going to get a priority for the damages that accrue after you declare bankruptcy — after bankruptcy had been declared?
MS. SPINELLI: In this case, Mission has an administrative claim stemming from the wrongful deprivation of its right to use the trademark post-rejection. The estate — it’s a claim against the estate that arose postpetition, which is an administrative claim.
JUSTICE SOTOMAYOR: So . . . you’re going to get more rights than (n) gives other intellectual property?
MS. SPINELLI: Yes.

Reading Tea Leaves

If I were to read my tea leaves surrounding the interchange quoted above, I’d say Justice Sotomayor is skeptical of an administrative status for Petitioner’s claim. After all, how can an licensee get more rights than those provided by § 365(n)? . . . But my tea leaves are often defective.

An Elaboration

Petitioner’s counsel elaborates (see pages 66-67 of the Transcript) on her “Yes” answer to Justice Sotomayor’s administrative status question like this:

“And let me explain why that’s exactly what should happen. Prior to bankruptcy — and this is just like a lease, Justice Breyer — prior to bankruptcy, the debtor conveyed the licensee an interest in its intellectual property. We don’t have to call that a property right. It doesn’t matter what we call it. But it’s a stick in the bundle of sticks, just the same way that a lease grants the tenant a leasehold interest in the landlord’s real property. And McCarthy makes this exact analogy. Once the license has been granted, the licensor no longer has that stick. And it’s uncontested that the licensor can transfer only what it has. Respondent doesn’t dispute that, outside bankruptcy, if the licensor sold the intellectual property, the buyer would take subject to the license. And we do have authority for this. It’s in the blue brief. And because of that, the licensor’s creditors also cannot access the value of the license for their claims against the debtor.”

Such an elaboration is not very persuasive in my book . . . but, then, my book isn’t exactly authoritative.

Conclusion

It will be interesting to see whether the practical issue (i.e., prepetition v. post-petition / administrative claim v. general unsecured claim) gets a mention in the Supreme Court’s opinion. Can’t wait to see!

——————————-

Footnote 1: 11 U.S.C. § 365(g)(1) says (italics added for emphasis): “(g) Except as provided in subsections (h)(2) and (i)(2) of this section, the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease—(1) if such contract or lease has not been assumed under this section or under a plan confirmed under chapter 9, 11, 12, or 13 of this title, immediately before the date of the filing of the petition.

Footnote 2: See Brief of Mission Products (at 11) to U.S. Supreme Court in Mission Product Holdings v. Tempnology, LLC (Supreme Court Case No. 17-1657). Additionally, Mission Product describes the status of the practical issue in a Bankruptcy Court filing (Pages 3-4 of Doc. 351, in Case No. 15-11400, in the New Hampshire Bankruptcy Court) (italics added for emphasis) like this: “The outcome of the 365(n) Appeal will not affect the existence or validity of the damages, but will affect whether those damages are general unsecured claims, as presently alleged, or whether a portion of those damages are administrative expense claims for post-petition willful breaches.”

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