In light of the recent COVID related wave of bankruptcies affecting fashion brands such as John Varvatos and True Religion, the article explores the trends and implications since the one-year anniversary of ‘Mission Product Holdings v. Tempnology.’
It is no secret that the fashion industry has been steering against a headwind of challenges. Beginning with the rise of e-commerce and the layering on of significant amounts of debt, the current global pandemic might be said to have simultaneously exacerbated these vulnerabilities while also posing new obstacles, such as unforeseen inventory, vendor and supply chain issues.
In the span of five months, apparel companies such as True Religion, John Varvatos, Lucky Brands, and Brooks Brothers have filed Chapter 11 cases, some hoping to reorganize but, more often than not, ultimately pursuing strategic sales of their assets or opting for wholesale liquidations.
These unprecedented challenges are not without opportunities for acquirers and investors as well as licensees of brands. Notably, the wave of bankruptcies also coincides with the one-year anniversary of the Supreme Court’s decision Mission Product Holdings, Inc. v. Tempnology, LLC, a ruling that has a direct impact on the rights of a trademark licensee following the bankruptcy of a debtor-licensor.
The Tempnology case will influence a debtor’s reorganization process and/or the bids made by potential acquirers of a debtor’s brand. Accordingly, it is important that industry stakeholders understand the impact of the Tempnology ruling. While the significance of the Tempnology decision may not be quantifiable yet, stakeholders should monitor the bankruptcy processes of current licensor-debtors while also implementing certain practice tips before entering into new trademark license agreements or renewals.
In Mission Product Holdings, Inc. v. Tempnology, LLC, the Supreme Court held that a debtor’s rejection of an executory contract (a contract where performance obligations remain due by both sides) under Section 365 of the Bankruptcy Code equates to a breach of contract rather than a termination of the contract. As the court explained, upon entering bankruptcy, the debtor or trustee is able to decide whether a contract is a good deal for the estate. If it is a good deal, the debtor will want to assume the contract and fulfill its obligations while continuing to enjoy the benefits. If it determines otherwise, it may “reject” the contract, repudiating any further performance of its duties, and therefore allowing the counter-party to sue for damages upon such breach. It is understood, however, that in the bankruptcy context, the non-breaching party will have to get in line with other unsecured creditors and that its recovery will likely be limited to cents on the dollar.
In light of the court’s holding in Tempnology, in structuring future licensing transactions, licensors and licensees may wish consider the consequences of a bankruptcy filing of the licensor. The following represents a sample of items to consider.
First, apart from the initial license grant, licensees typically have very few rights under a trademark license, often lacking even a right to terminate upon a licensor’s breach. In the context of the Tempnology holding, granting a licensee this right might benefit both parties. For example, a licensee may want to cease using the trademarks in question and paying the associated royalties and marketing fees.
If a licensee is able to exercise its termination right, the licensor’s estate will be relieved of continued quality control obligations and expenses. And, more critically, the debtor-licensor would be able to avoid complications that the existence of a license could create upon a sale of its brand under Section 363 of the Code (described below).
Second, Section 365(n) of the Code sets forth a “remedial scheme”—comprising certain rights and obligations of a licensee of a patent or copyright that desires to continue to exploit such rights post-rejection, but it does not apply to trademark licensees because trademarks are not included in the definition of “intellectual property” under the Code. Section 365(n) also limits these particular licensees’ rights by subjecting them to a corresponding waiver of any setoff rights they might have under non-bankruptcy law and the right to file administrative (i.e., priority) claims against the debtor’s estate.
The rights of trademark licensees are not subject to these limitations. For instance, a trademark licensee that sells goods to its licensor may continue to pursue set-off rights against royalties payable (if this was already permitted under the contract), and may also make administrative claims, if applicable, for any payments not made by a debtor-licensor in association with the delivery of such goods. Therefore, a licensee of a rejected trademark license might seek to avail itself of its statutory 365(n) rights and to make clear that upon rejection it is entitled to 365(n) rights in addition to any other rights and remedies available to licensee under the contract or law that are not available under Section 365(n).
Third, a licensee making significant investments may desire to negotiate for a right of first refusal to purchase the brand. It should be noted, however, that even assuming this right is not expressly tied to the bankruptcy of the licensor, courts are split as to whether these rights are valid in the context of a bankruptcy case, at times voiding them as a restraint on alienation of the property of an estate.
Fourth, the Brief for American Intellectual Property Law Association as Amicus Curiae submitted that it would be possible, without resorting to unenforceable ipso facto clauses (i.e., termination rights based on a bankruptcy filing or insolvency), to structure trademark licensing transactions so that the license does not survive in the event of a licensor breach. Therefore, a licensor can attempt to avoid continuation of the license by proposing that the agreement automatically terminate concurrently with any licensor breach that it is not an invalid ipso facto clause.
Finally, a licensee’s broad right to continue operating under a trademark license agreement post-rejection will make it problematic for licensor-debtors to sell their brands “free and clear” of any “interest” under Section 363(f) of the Code. In Precision Industries Inc. LLC v. In Re: Qualitech Steel Corporation, the U.S. Court of Appeals for the Seventh Circuit addressed this issue when it held that a sale order under Section 363(f) of the Code operated to extinguish a lessee’s possessory interest in a lease of the debtor estate’s real property. In its opinion, the court relied on Section 363(e), which “directs the bankruptcy court, on the request of any entity with an interest in the property to be sold, to ‘prohibit or condition such sale as is necessary to provide adequate protection of such interest (emphasis added).’”
After explaining that use of the term “interest” should be broadly construed, the court stated that the “adequate protection” remedy did not guarantee the lessee’s continued use of the property, but did provide that the lessee should be compensated for its interest. By analogy, a licensee may wish to consider expressly stating in its license agreements that it will have a right to seek adequate protection under Section 363(e), including parameters thereof, such that upon request, the bankruptcy court will be obligated to ensure that its interest is adequately protected in the event of a sale of substantially all of the assets of the estate. In addition, adequate protection rights may provide licensees additional leverage to re-negotiate on-going agreements arguing that the value of the brand has been impaired.
While at first blush it would appear that the “rejection is merely a breach” Tempnology holding would allow a licensee to operate under a license until the end of its term, it remains an open question whether, in accordance with the Qualitech holding, the brand could be sold free and clear of interests, thereby cutting short the licensee’s rights. If a licensee is entitled to adequate protection of its interest in a rejected trademark license, the cost of adequate protection would be passed on to a buyer of the brand—leaving bidders to evaluate whether they would prefer to acquire a brand subject to a current license or factor in the adequate protection costs to its bid.
It is also reasonable to assume that the Tempnology decision would render a debtor-licensor’s choice to assume or reject meaningless, because in either case the licensor will still bear the expenses and obligations surrounding quality control over the products produced by licensees.
However, licensors should be mindful that in the context of a sale of trademarks, each outstanding license agreement will increase the potential adequate protection costs and these costs can negatively impact the estate’s ability to sell its brand. Therefore, the language in a license agreement covering the party’s respective termination rights upon a breach of licensor becomes even more important.
In light of the current climate, all industry stakeholders should consider how the Tempnology holding will affect their business plans. Specifically, licensors and licensees should begin considering the implications of a licensor bankruptcy while negotiating a licensing deal and determining the amount of capital invested and resources allocated. Potential acquirers and investors in debtor brands should seek to understand all outstanding licensing arrangements in crafting their turnaround or liquidation plans and the potential costs of ongoing obligations under Section 365, the underlying contract, and adequate protection under Section 363(e).
Ilana Lubin is a partner in Crowell & Moring’s New York office with a focus on cross-border and domestic mergers & acquisitions and intellectual property transactions. Mark Lichtenstein is a partner in the bankruptcy and reorganization practice group of Akerman in New York.
Reprinted with permission from the August 28, 2020 edition of the “New York Law Journal” © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or firstname.lastname@example.org.