A Guide To Navigating Bankruptcy's Impact On IP Licenses

Editor's note: Authored by Bob Eisenbach and Evan Lazerowitz, this article was originally published in Law360.

With a potential recession on the horizon, licensees of intellectual property may increasingly find their licensors seeking protection under Chapter 11 of the Bankruptcy Code.

For many companies — particularly those in the life sciences and technology sectors — IP, including in-licensed IP, may be their most valuable asset.

It is therefore critical for IP licensors and licensees to understand how their licenses will be treated in bankruptcy and consider ways to protect their license rights should a bankruptcy be filed.

This article explores some of the significant issues left open by the U.S. Supreme Court's seminal 2019 decision in Mission Products Holdings Inc. v. Tempnology LLC,[1] holding that a debtor-licensor's rejection of an executory trademark license acts as a prepetition breach rather than as a rescission of the license.

The article also offers practical drafting considerations for licensors and licensees that may help address bankruptcy's impact on IP licenses.

The Bankruptcy Code's IP Licensee Protections

Section 365(n) of the Bankruptcy Code provides that, notwithstanding a licensor's rejection of an executory contract containing an IP license, the licensee can elect either to treat the contract as terminated by the rejection or to retain its IP rights and continue to use the IP for the remainder of the term of the contract.[2]

Section 365(n), however, is subject to one important limitation: It only applies to IP as specifically defined in Section 101(35A) of the Bankruptcy Code.[3]

That definition is limited to:

• A trade secret;
• An invention, process, design or plant protected under Title 35;
• A patent application;
• A plant variety;
• A work of authorship protected under Title 17; and
• A mask work protected under Chapter 9 of Title 17.

While many would expect trademarks to be included, U.S. Congress intentionally left trademarks out of the Bankruptcy Code's definition of IP. There are also questions about the extent of protection for foreign patents and possibly other types of IP.

The Supreme Court's Tempnology Decision

The issue of whether trademarks are protected from the effects of rejection in bankruptcy was the subject of extensive court decisions until ultimately being decided by the Supreme Court in Tempnology.

Because Section 101(35A) of the Bankruptcy Code does not mention trademarks, the federal courts of appeal had split over whether rejection of a trademark license terminated the trademark licensee's rights.

In Tempnology, the Supreme Court squarely held that, under Section 365(g),[4] a debtor-licensor's rejection of an executory trademark license acts only as a prepetition breach and not as a rescission of the license, and that the licensee retains whatever rights it had under the trademark license agreement prior to breach.[5]

In a two-page concurring opinion, Justice Sonia Sotomayor wrote separately "to highlight two potentially significant features" of the Supreme Court's holding, both of which raise questions that practitioners should carefully consider.

First, Justice Sotomayor stated that "the Court does not decide that every trademark licensee has the unfettered right to continue using licensed marks postrejection." The "baseline inquiry remains whether the licensee's rights would survive a breach under applicable nonbankruptcy law," and she posited that "[s]pecial terms in a licensing contract or state law could bear on that question" in particular cases.[6]

Second, Justice Sotomayor wrote:

The Court's holding confirms that trademark licensees' postrejection rights and remedies are more expansive in some respects that those possessed by licensees of other types of intellectual property. Those variances stem from [Section] 365(n), one of several subject-specific provisions in the Bankruptcy Code that "embellis[h] on or twea[k]" the general rejection rule.[7]

After describing Section 365(n)'s provisions that require royalty payments to be made and preclude offsetting damages against those payments, Justice Sotomayor stated, "[t]his provision and others in [Section] 365(n) mean that the covered intellectual property types are governed by different rules than trademark licenses," and noted that these "differences may prove significant for individual licensors and licensees" but do not alter the outcome in the Tempnology case.[8]

Where Does Tempnology Leave Licensors and Licensees?

Although Tempnology held that rejection does not terminate a trademark license, it left unresolved several issues important to licensors and licensees.

These include the licensee's rights and obligations after a trademark license is rejected, and whether Tempnology's reasoning applies to other types of intellectual property not covered by Sections 101(35A) and 365(n).

In enacting Section 365(n), Congress provided a relatively clear set of rules governing the rights and obligations of a licensee that elects to retain its license rights after rejection.

Specifically, the licensee retains its IP rights for both the term of the license and any extensions as of right, explicitly retains the right to enforce any exclusivity provisions in the license agreement and, to the extent provided in the license agreement or an agreement supplementary to the license, the right to request to receive the embodiment of the IP.

In return, the licensee must continue to make all required royalty payments due under the license agreement and waive the right to setoff and to any administrative claims based on the licensor's breach.[9]

Since Section 365(n) does not apply to trademarks, there are no such statutory rules in place for the post-rejection rights of a licensee of a trademark or of any other type of IP not covered under Section 101(35A). Instead, as the Tempnology majority opinion held, after rejection "the licensee can continue to do whatever the license authorizes."[10]

As a result, the key to understanding where Tempnology leaves licensees — and licensors and their bankruptcy estates — after rejection is the terms of the license agreement itself.

Put differently, Tempnology merely confirmed that rejection does not terminate a trademark licensee's rights; it did not answer the important question of what happens after rejection.

Practical Drafting Considerations After Tempnology

Given the Tempnology court's determination that the licensee's rights after rejection will be governed by whatever the license authorizes, practitioners drafting licenses of trademarks — and potentially licenses of other IP not covered by Sections 101(35A) and 365(n) — should carefully consider how the license agreement treats the licensee's rights, and obligations, after breach by the licensor.

This is of special concern in the trademark arena. In rejecting a trademark license, the trademark owner — or its bankruptcy trustee should the case start or end up in Chapter 7 — is expressly rejecting the licensor's obligations to continue to perform.

In light of the consumer protection and quality signifier functions of trademarks, the trademark owner's failure to perform could have significant consequences for the licensee.

Among the typical license obligations of a trademark owner are maintaining quality control over the mark, reviewing and approving new trademarked products that the licensee may be licensed to introduce to the market and, in some instances, supplying goods to the licensee that the licensor was obligated to manufacture.

Without such performance, the trademark licensee could find itself with materially different rights after rejection.

In a post-Tempnology world, the terms of the license will likely govern the parties' post-rejection relationship.

As courts have yet to grapple with the consequences of rejection, parties negotiating trademark licenses should carefully weigh how to address these risks through inclusion of post-breach provisions in the license agreement, potentially including adjustments to royalty or other payments after rejection.

Here are some concepts and provisions to consider.

Delegate quality control rights to the trademark licensee or others.

Under trademark law, if a trademark owner fails to exercise control over the quality of trademarked goods, the trademark could end up abandoned. Bankruptcy means there is a material risk that the trademark owner or licensor could cease operations, or otherwise fail to ensure quality control.

Parties drafting a trademark license agreement should consider specifying quality standards and, as part of a post-breach provision, assess whether the licensor's quality control obligations could be delegated to the licensee.

An exclusive licensee in particular may have the best incentive to maintain quality control.

Provide a mechanism for new product approval or other step-in rights.

The parties could specify that, after the licensor's breach, the licensee — or some other third party — would become responsible for new product approvals, using quality and other commercial standards set forth in the license agreement.

If other licensor obligations would remain unperformed after breach, provisions could be added to allow the licensee, perhaps in conjunction with other licensees of the same trademark where applicable, to step into the licensor's role in performing these functions.

Provide for alternatives to licensor-manufactured goods.

If the licensor is required to manufacture and provide licensed goods to the licensee to distribute or use, the parties should consider addressing what happens when the licensor fails to do so.

One approach would be another post-rejection step-in right, authorizing the licensee to contract with a third party to manufacture the goods or, if preferable, allow the licensee to manufacture the goods after rejection or other breach.

Contractually incorporate Section 365(n)'s core concepts.

Since Section 365(n)'s balancing of the licensee's rights and obligations are relatively clear under the statute, the parties to a trademark license could incorporate Section 365(n)'s key provisions directly into the trademark license agreement, adjusted as appropriate to address the impact of the licensor's nonperformance.

Address automatic stay considerations.

These step-in and related rights might be viewed as the licensee exercising control over the trademark.

Since the trademark would remain property of the bankruptcy estate, the licensee might consider requesting, as part of an order approving the rejection of the trademark license, that the automatic stay be lifted to permit the licensee to exercise all step-in and other rights in the license agreement.

Consider a post-rejection termination right for the licensor, despite Tempnology.

Although Tempnology held that rejection is breach and not rescission, the parties could contractually provide the licensor with a termination right, even if due to the licensor's breach by rejection in bankruptcy.

Potential licensees may find such a right unacceptable but Tempnology does not appear to prohibit such a termination right.

Include a wind-down period or other termination provisions.

The parties might also consider a provision implementing a wind-down period following rejection or other licensor breach, especially where the arrangement would become unworkable if the licensor filed bankruptcy or went out of business.

This could provide the licensee with license rights for a limited period of time to conclude the relationship, perhaps with reduced royalty or other financial obligations.

Tempnology's reasoning appears capable of extension outside the trademark area to other IP rights left unprotected by Sections 101(35A) and 365(n). These could include foreign patents — at least to the extent not protected under Title 35 — and perhaps data sets or other rights that may not be fully covered under the protections for trade secrets, patents or copyrights.

It stands to reason that since trademark licensees are protected from the consequences of rejection under Tempnology, licensees of other forms of intellectual property also outside of Section 101(35A)'s definition should be similarly protected to the extent the license authorizes those rights.

Parties drafting license agreements of such uncovered IP should likewise consider including provisions to address the post-rejection scenario.

Conclusion

Tempnology was a watershed decision at the intersection of IP and bankruptcy law, but it left open a number of issues with significant potential consequences for licensors and licensees.

Through careful drafting of trademark and other IP license agreements, parties can help anticipate, and hopefully avoid, the most disruptive impacts of rejection in bankruptcy.

[1] Mission Product Holdings, Inc. v. Tempnology, LLC , 139 S. Ct. 1652 (2019) ("Tempnology").

[2] 11 U.S.C. § 365(n).

[3] 11 U.S.C. § 101(35A).

[4] 11 U.S.C. § 365(g).

[5] Tempnology, 139 S. Ct. at 1661.

[6] Tempnology, 139 S. Ct. at 1666 (Sotomayor, J., concurring).

[7] Id.

[8] Id. at 1667.

[9] 11 U.S.C. §§ 365(n)(1)(B), (2)(B)-(C).

[10] Tempnology, 139 S. Ct. at 1663.

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