Congress enacted the Intellectual Property Licenses in Bankruptcy Act (IPLBA) in 1988, adding an important provision to the Bankruptcy Code to protect licensees of intellectual property from losing their licensed rights after the licensor has filed a petition for bankruptcy. The protection afforded by the Act, codified as 11 U.S.C. §365(n), extends to all forms of intellectual property except trademarks.

While Congress determined that it would allow "the development of equitable treatment of this situation [protection of trademark licensees] by bankruptcy courts," S. Rep. No.100-505, at 6 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3204, the bankruptcy courts have declined to act on Congress's expressed intention.

As two recent cases conclusively demonstrate, because the plain language of the statute indicates that §365(n) does not include trademarks, trademark licensees continue to face post-petition rejection of trademark license agreements without consideration of equitable principles. See In re HQ Global Holdings Inc., 290 B.R. 507 (Bankr. D. Del. 2003); In re Centura Software Corp., 281 B.R. 660 (Bankr. N.D. Cal. 2002). This raises the question of whether the Code should be amended to include trademark licensees under §365(n).

Prior to IPLBA, licensees of intellectual property were at the mercy of their licensors, who could freely reject license agreements after filing for bankruptcy, thereby immediately extinguishing the licensees' rights to the intellectual property. Under the current state of the law, licensees are protected against rejection of the license by a debtor-licensor with respect to a trade secret, patent or copyright, but not a trademark. The bankruptcy courts' reluctance (or inability) to address and develop equitable rules of law to protect trademark licensees under the Code has propagated the uncertainty in these licensing transactions that the IPLBA was intended to eliminate.

Section 365(n)

Under §365 of the Code, a debtor-in-possession (DIP) or a trustee in bankruptcy can reject executory contracts of the debtor where the rejection benefits the estate. 11 U.S.C. §365; HQ Global Holdings, 290 B.R. at 511. Before enactment of IPLBA, debtors were able to reject intellectual property license agreements with relative ease under this provision. The courts have routinely held that intellectual property licenses are executory contracts, since license agreements typically contain continuing obligations by both parties, i.e., undertakings by the licensor to maintain the intellectual property and covenants by the licensee to pay royalties. See, e.g., In re New York City Shoes Inc., 84 B.R. 947, 960 (Bankr. E.D. Pa. 1988). The question of whether the rejection benefits the estate is governed by the lenient "business judgment standard," under which the courts will not interfere with a debtor's business judgment absent a showing of bad faith or abuse of business discretion. In re Bildisco, 682 F.2d 72, 79 (3d Cir. 1982), aff'd., 465 U.S. 513 (1984). Because the reversion of valuable property rights would nearly always "benefit" the estate, the courts rarely questioned a debtor's decision to reject an executory contract.

Essentially, debtors had free reign to reject intellectual property licenses as executory contracts under §365, with virtual impunity. (In the event of rejection of an executory contract, the holder of the contract is typically left with only a claim for damages against the estate for breach of the agreement. 11 U.S.C. §365 (g)). In the vast majority of cases, the debtor's decision to reject was rubber-stamped by the court without regard to the consequences to the licensee. The result was debilitating to U.S. businesses and unforeseen by Congress:

Congress never anticipated that the presence of executory obligations in an intellectual property license would subject the licensee to the risk that, upon bankruptcy of the licensor, the licensee would lose not only any future affirmative performance required of the licensor under the license, but also any right of the licensee to continue to use the intellectual property as originally agreed in the license agreement.

S. Rep. No. 100-505, at 3 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3201-02.

In the wake of several court decisions in which companies that depended on licensed technology were suddenly stripped of their rights, including one case in particular, Lubrizol Enterprises Inc. v. Richmond Metal Finishers Inc., 756 F.2d 1043 (4th Cir. 1985), Congress sought to rectify the problem. Explaining that the ebb of bankruptcy court decisions rejecting intellectual property licenses "threaten an end to the system of licensing of intellectual property that has evolved over many years," Congress enacted IPLBA. S. Rep. No. 100-505, at 3 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3202.

Under §365(n), if a debtor or trustee rejects an executory contract under which the debtor is a licensor of intellectual property, the licensee has a choice of electing to treat the contract as terminated or to retain its rights under the contract to use the licensed intellectual property for the duration of the contract and any period for which it may be extended, per the terms of the license agreement. 11 U.S.C. §365(n)(1). Congress defined "intellectual property" as trade secrets, patents and copyrights, but omitted trademarks. See 11 U.S.C. §101 (35A).

The reason that trademarks were excluded from §365(n) protection is that—unlike technology and copyright licenses—trademark licenses require the exercise of quality control over the licensee by the owner/licensor of the mark. S. Rep. No. 100-505, at 5 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3204. The licensor has an affirmative obligation to insure that the goods sold by its licensee under the licensed mark are of comparable quality to those sold by the trademark owner. See, e.g., Kentucky Fried Chicken Corp. v. Diversified Packaging Corp., 549 F.2d 368, 387 (5th Cir. 1977).

Trademarks, Licensingand Quality Control

The quality control requirement grew out of the advent of trademark licensing. The function of a trademark is to indicate the source of goods and to distinguish the goods from those of others. 15 U.S.C. §1127. In early trademark jurisprudence, only the owner of the trademark—that is, the entity that actually manufactured or produced the goods sold under the mark—could properly use the mark in commerce. 2 McCarthy, J. Thomas, Trademarks and Unfair Competition §18:39 (2003). However, this view of a trademark's function changed during the first half of the Twentieth Century as trademark owners began to permit other entities to use their marks under certain conditions. This practice ushered in an entirely new way of merchandising products: trademark licensing.

As trademark licensing became a recognized means of selling products, an expanded judicial view of the purpose and function of trademarks arose. Because trademarked goods no longer need emanate from the trademark owner, i.e., a licensee could produce the goods itself or purchase them from a third-party manufacturer, trademarks were seen as indicators not only of source, but also of quality. Consumers rely on the trademark owner's reputation when they select goods sold under the mark, regardless of the actual source of the goods. This imposes a duty on the licensor to insure the quality of the licensed goods, the theory being that if a trademark owner allows licensees to depart from its quality standards, the public will be misled, and the trademark will cease to have utility as an informational device. Kentucky Fried Chicken Corp, 549 F.2d at 387.

Hence, quality control by the licensor is a required element of a proper trademark licensing arrangement. Id. A trademark license without quality control by the licensor is an uncontrolled or "naked" license, which could cause a loss of trademark rights. Dawn Donut Co. v. Hart's Food Stores Inc., 267 F.2d 358, 367 (2d Cir. 1959).

In actuality, the courts have been reluctant to find a forfeiture of trademark rights based on naked licensing. Because forfeiture of a trademark would result in a loss of valuable property rights, equity imposes a high burden of proof to establish naked licensing. Kentucky Fried Chicken Corp, 549 F.2d 368 at 387. Accordingly, a minimal level of quality control will usually suffice. Some courts have refused to find a loss of trademark rights even where the licensor engaged in no quality control over the licensee's goods.¹

Although the quality-control requirement was intended to prevent confusion in the marketplace, it has caused great confusion in the courts. The problem is, the judicially created requirement has been subject to widely varying standards as to the type and amount of control necessary. The U.S. Court of Appeals for the Seventh Circuit noted that "[n]aked licensing law is full of contradictory strains, with some authorities requiring strict oversight by licensors and others taking a more lenient approach." TMT North America Inc. v. Magic Touch GmbH, 124 F.3d 876, 885 (7th Cir. 1997).

Indeed, some commentators have questioned the proprietariness of the quality-control requirement and have advocated its elimination: "the quality-control requirement should be abandoned as a legal fiction that lacks a sound theoretical foundation, has no practical benefits and is inconsistent with the realities of the modern market place." "'Naked' Is Not a Four-letter Word: Debunking the Myth of the 'Quality-control Requirement' in Trademark Licensing," 82 Trademark Rep. 531, 531 (1992). Nevertheless, as long as quality control remains a requirement of trademark licensing, it must be reckoned with in the context of bankruptcy.

Amendment to the Bankruptcy Code

The legislative history of IPLBA indicates that Congress had the same concern with the rejection of trademark, service mark and trade name licenses by debtor-licensors as it did with other intellectual property licenses. S. Rep. No. 100-505, at 5 (1988), reprinted in 1988 U.S.C.C.A.N. 3200, 3204. However, Congress indicated that the bill did not address the rejection of trademark licenses because of the quality-control requirement, which "could not be addressed without more extensive study." Id. Presumably, the issue was that in certain instances, such as where the debtor has ceased business operations, there would be no exercise of quality control over the licensee. However, the Bankruptcy Code can be amended to include §365(n) protection for trademark licenses notwithstanding the quality control requirement.

In the Centura Software case, the court noted and discussed Congress's intention to allow equitable treatment of the rejection of trademark licenses by the bankruptcy courts. 281 B.R. at 670. Nevertheless, the court concluded that the language of §365(n) is unambiguous; therefore, since the statute could be interpreted on its face, it was not necessary to delve into legislative history. Id. The court went further, concluding that it was not empowered to address equitable considerations concerning rejection of the trademark license: "Because Congress has unambiguously indicated that trademark licenses are to be excluded from §365(n), it does not allow the court to weigh the equities of this case." Id. at 670. The court recognized that the result "may appear harsh" because, once a license is rejected, the licensee may not continue to use the trademarks. Id. at 662.

Most recently, a licensee of a service mark under which its franchise business was operated lost its rights to use the mark upon rejection of its license agreement. HQ Global Holdings, 290 B.R. at 513. The court similarly found that, although licensees of intellectual property receive special treatment under §365(n), trademarks are expressly excluded from the definition of intellectual property. Id. at 512-13. The court approved of the rejection and it too characterized the outcome as "harsh." Id. at 513. Making matters worse, after having lost its rights to use the licensed service mark, the licensee requested that the court grant a transition period such that it could gradually phase out use of the mark, instead of the seemingly punitive requirement that use cease immediately. The court refused, finding that there is no authority for any transition period, and ordered the licensee to cease use of the service mark within 30 days. Id. at 514.

These cases demonstrate that the courts have declined to provide §365(n) protection to trademark licensees solely because of the plain language of the statute and not for any policy reason. On the contrary, the judicial consensus is that the present application of the statute results in "harsh" consequences for the licensee and is inequitable. Although Congress expressed a clear intent that the courts develop equitable treatment of the situation, the courts are bound by the statute's plain language—and thus, the conundrum.

Congressional intent, judicial favor (as expressed in dictum) and marketplace realities all support the notion that the Bankruptcy Code should be amended to protect trademark licensees from rejection of their license agreements. This could be accomplished by adding a clause to §365(n) that provides for the same options to licensees of trademarks, service marks and trade names as licensees of other intellectual property, where under the particular circumstances of the case, the court finds that there is reasonable control over the quality of the licensed product, such that there is no likelihood of public deception. The provision should expressly provide that the licensee's election to retain its rights under the contract is subject to principles of equity.

The equities would often favor the licensee, and thus provide the intended protection, for the following reasons: (1) in most chapter 11 cases, the debtor remains in possession of its business and therefore it has the ability to exert control over the quality of licensed goods to the same extent it did before the bankruptcy filing; (2) where the business seeking reorganization is under the administration of a trustee, the trustee could appoint an appropriate person to engage in a legally sufficient level of quality control over the licensee; and (3) licensees have as great an incentive to control the quality of their goods as the trademark owner itself since, if the licensee puts out shoddy products, consumers will not buy them. Therefore, if the court is satisfied that the licensee will maintain the quality of its goods at the level that had been previously approved by the licensor, there is no sound reason to force the licensee to stop using the licensed mark.

When a party is suddenly forced to stop use of a trademark that has become associated with a product and develop a new commercial identity, there will be an obvious detrimental impact on sales of the product. In some instances, such as where the trademark appears on the product, or rejection of the license occurs after the product has been packaged, the licensee may not be able to sell the goods at all. This will often affect not only the licensee's bank account, but also its reputation with distributors and retailers.

Trademark licensing represents a substantial segment of U.S. commerce. According to one trade publication, sales of licensed goods (not including technical licenses) in the United States were $70.3 billion in 2001. "The Licensing Letter," EPM Communications, March 4, 2002. The continued prospect that trademark licensees may suddenly lose their rights upon the bankruptcy of their licensors threatens the integrity of trademark licensing in the United States and poses a potential cloud on every licensee's rights. There is no reason to discriminate against trademark licensees; they should receive the same protection under §365(n) that licensees of other intellectual property have enjoyed for the past 15 years.

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Footnotes

¹ The bases for such judicial holdings include the licensee's history of trouble-free manufacture (see Syntex Laboratories Inc. v. Norwich Pharmacal Co., 315 F. Supp. 45 (S.D.N.Y. 1970), aff'd. on other grounds, 437 F.2d 566 (2d Cir. 1971)), the interrelationship of the licensor and licensee (see Taco Cabana Int'l. Inc. v. Two Pesos Inc., 932 F.2d 1113 (5th Cir. 1991), aff'd., 505 U.S. 763 (1992)), the failure of proof that alleged naked licensing actually caused the mark to lose its significance (see Exxon Corp. v. Oxxford Clothes Inc., 109 F.3d 1070 (5th Cir. 1997)), or even the mere existence of a contractual provision in the license agreement providing for quality control (notwithstanding that the licensor did not exercise it) (see Wolfies Restaurant Inc. v. Lincoln Restaurant Corp., 143 U.S.P.Q. 310 (N.Y. Sup. Ct. 1964)). Return to article