An Analysis of the Recent Supreme Court Case of Mission Product Holdings, Inc. v. Tempnology, LLC
In Mission Product Holdings, Inc. v. Tempnology, LLC, the United States Supreme Court confirmed the generally accepted operation of bankruptcy law – that rejection of executory contracts does not constitute termination of those contracts – while declining to recognize special additional, non-statutory protections for debtor-licensors that reject trademark license agreements.
First some bankruptcy basics. Section 365(a) of the Bankruptcy Code allows a debtor to either assume or reject its pre-petition executory contracts. A contract is “executory” if both the debtor and its counterparty have material future obligations to perform under the agreement. In other words, the contract represents both an asset (the performance owed to the debtor by the counterparty) and a liability (the performance owed by the debtor). For executory contracts that the debtor considers burdensome, rejection allows the debtor to declare its intention not to perform. Under Section 365(g), rejection constitutes a breach of the contract that is deemed to have occurred immediately prior to the bankruptcy petition date. This usually has the practical effect of leaving the counterparty with an unsecured claim for damages arising from such breach. Yet despite that rejection causes breach, the counterparty may retain and exercise other rights in the contract under applicable non-bankruptcy law.
Additional nuance arises from several amendments Congress has made to Section 365 over the years. These generally concern the effect of rejection for specific types of executory contracts, such as real property leases, timeshares, and certain intellectual property agreements (except trademarks, which are excluded from the definition of “intellectual property” for the purposes of the Bankruptcy Code). All of these cases, in one way or other, expressly provide a procedure for the counterparty to terminate (or not) the rejected contract. Interpretation of these specialty provisions played a central role in the arguments on both sides of the Mission Product case.
The facts are typical of a licensing deal turned sour. Tempnology owned and licensed certain athletic wear trademarks to Mission Product Holdings. Tempnology attempted to terminate the license agreement before the end of the contract term, which resulted in an arbitration proceeding where the panel ruled against Tempnology. Tempnology then filed a Chapter 11 bankruptcy petition, along with motions to sell its assets and reject certain executory contracts, including the Mission trademark agreement. Tempnology claimed its rejection terminated Mission’s license to the trademarks and allowed the estate to sell Tempnology’s intellectual property, including the trademarks licensed to Mission, free and clear of Mission’s rights of use. Mission objected, arguing that Tempnology’s rejection of the trademark agreement constituted a breach of the agreement, but such a breach did not automatically terminate the agreement or Mission’s contractual right to use the trademarks.
The bankruptcy court overruled Mission’s objection and confirmed the sale of Tempnology’s assets, including the trademarks, free and clear of Mission’s rights under the rejected licensing agreement. The First Circuit Bankruptcy Appellate Panel reversed, finding that Tempnology’s rejection did not terminate Mission’s rights in the trademarks, relying primarily on the Seventh Circuit’s decision in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC. That case applied the general bankruptcy principle that rejection does not rescind rights granted under a rejected trademark license agreement. Then the First Circuit Court of Appeals, creating a circuit split, reversed the bankruptcy appellate panel and reinstated the bankruptcy court’s decision. The First Circuit based its ruling on a finding that termination was necessary to relieve the debtor’s estate from the specific burdens of monitoring quality controls under the trademark agreement, which the First Circuit believed would hamper the debtor’s ability to reorganize. The First Circuit further interpreted the exclusion of trademarks from Section 365(n) – a provision allowing counterparties for other types of intellectual property license agreements to either terminate or continue to use the licensed intellectual property – as evidence of a negative inference that rejection of trademark contracts automatically terminates them. Because there was a circuit split, the Supreme Court granted cert.
In an 8-1 decision, the Supreme Court overturned the First Circuit and largely adopted the reasoning of the Seventh Circuit in Sunbeam, re-affirming the general principal set forth by Section 365(g) that rejection constitutes a breach and the effect of such a breach depends on the terms of the contract and applicable non-bankruptcy law. Section 365’s specialty provisions should be seen as elaborations on the general principle for specific types of contracts, not exclusionary exceptions that undercut the general applicability of the rule. The Supreme Court acknowledged the potential burden on a debtor’s estate from monitoring quality controls for pre-petition licensing agreements, but the Court held that the decision as to whether or not to expend resources to preserve or protect assets is part of the reorganization process and balancing of interests contemplated by the Bankruptcy Code.
For negotiations with a licensor at risk of bankruptcy, two lessons emerge from Mission Product. First, the agreement should expressly set forth the remedies each party has when the other breaches the agreement. For example, if the licensor breaches the agreement, the licensee may reserve the right to either terminate or, alternatively, continue to exercise its rights and bring an action for damages arising from the breach. In addition or alternatively, if the licensee has sufficient leverage, the license may be granted on a perpetual and irrevocable basis. Second, also consider whether the deal may be structured in a manner to avoid imposing material continuing obligations on the licensee that would make the license executory. See e.g., In re Exide Technologies, 607 F.3d 957, 964 (3rd Cir. 2010) (holding that four unperformed contractual obligations under a prepaid trademark agreement did not outweigh the licensee’s substantial performance and therefore the contract was not executory and could not be rejected under Section 365(a)).
In sum, the Supreme Court’s decision in Mission Product re-affirms the general bankruptcy rule that rejection equals breach, but nothing more, and the counterparty’s remedies in connection with such a breach (including the right to terminate the contract or not) is determined by applicable non-bankruptcy law.