The Supreme Court, Tempnology and the Rejection of Executory Contracts in Bankruptcy

May 29, 2019

Mission Prod. Holdings, Inc. v. Tempnology, LLC

A Comment

 

I was among the crowd of lawyers sitting in Court Room 2, United States Bankruptcy Court for the District of New  Hampshire, on November 3, 2015, listening to the argument.  There was nothing extraordinary, just  technical arguments about the extent of an election under 11 U.S.C. §365(n)... and not a mention of 11 U.S.C. §363(g).  There was no mention of the fundamental concept of rejection and no arguments that the Court should rethink the meaning of rejection.  The Bankruptcy Court heard the technical arguments and entered the order (that seemed trivial at the time) that 11 U.S.C. §365(n), which does not mention trademarks, does not protect a licensee’s rights to trademarks. 

 

Three and a half years later, and almost three years after the license expired by its terms, the United States Supreme Court reversed, not by saying that §365(n) applies to trademarks (every appellate court that addressed the issue agreed it did not), but by overturning the understandings expressed by every lawyer in the Courtroom that day as to the meaning or effect of the rejection of an executory contract.  Mission Prod. Holdings, Inc. v. Tempnology, LLC, No. 17-1657, 2019 WL 2166392 (U.S. May 20, 2019).  This comment will argue that the decision is poorly decided because the Court ignores the distinction between the debtor and the bankruptcy estate and because the Court fails to inquire or require inquiry into whether the licensee has a property right in the controverted trademark.

 

Tempnology starts with a new technology start up story.  The company had patents for the design of athletic cooling fabric.  Mission agreed to purchase and distribute Tempnology products using Tempnology’s trademarks.  In their agreement, Mission obtained the exclusive right to sell Tempnology products in certain territories over certain time periods, a permanent non-exclusive license to the patented technology and a right to use the trade-marks during the term of the agreement and thereafter for two years - the windup period.  Mission terminated the agreement on June 30, 2014.[1]  Mission’s two year continued use period was to expire on July 1, 2016.  On September 1, 2015, Tempnology filed its petition under Chapter 11 of the Bankruptcy Code.

 

Tempnology proposed to sell all of its assets including its patents and trademarks.  As part of that process Tempnology also proposed to reject the agreement with Mission.  Mission bid at the sale, objected to the

sale, objected to the proposed rejection of the agreement and made an election under 11 U.S.C. §365(n).

In support of its attempt to reject the Mission contract, Tempnology moved for an order determining exactly what rights were protected by Mission’s Section 365(n) election.   Tempnology took the view that the election protected the license of the patent but not exclusive distribution rights and not the license of the trademarks. 

 

Mission asserted that the §365(n) election protected the license of the patent rights, the exclusive distribution rights and the license of the trademarks during the two year wind down.  The Bankruptcy Court ruled that the §365(n) election protected the license of the patent rights (as both parties agreed), but not the exclusive distribution rights and not the trademark license.

 

In the course of its order, the Court quite naturally, given the way the issues were framed, said,

 

[s]ection 101(35A) identifies six categories of intellectual property that will be subject to

protection under § 365(n), while trademarks were knowingly omitted. … the omission of

trademarks from the definition of intellectual property in § 101(35A) indicates that Congress

did not intend for them to be treated the same as the six identified categories. Therefore,

Mission does not retain rights to the Debtor's trademarks and logos post-rejection.

 

In re Tempnology, LLC, 541 B.R. 1, 7–8 (Bankr. D.N.H. 2015), aff'd in part, rev'd in part sub nom. In re Tempnology LLC, 559 B.R. 809 (B.A.P. 1st Cir. 2016), aff'd in part, rev'd in part sub nom. In re Tempnology, LLC, 879 F.3d 389 (1st Cir. 2018), rev'd and remanded sub nom. Mission Prod. Holdings, Inc. v. Tempnology, LLC, No. 17-1657, 2019 WL 2166392 (U.S. May 20, 2019), and aff'd, 879 F.3d 389 (1st Cir. 2018), and rev'd and remanded sub nom. Mission Prod. Holdings, Inc. v. Tempnology, LLC, No. 17-1657, 2019 WL 2166392 (U.S. May 20, 2019).

 

Every appellate judge has agreed with the Bankruptcy Court’s interpretation of Section 365(n): it provides no succor for Mission’s claim to either the exclusive distribution rights or the license of the trademarks. Nevertheless, the U.S. Supreme Court reversed and remanded.

 

The issue the Supreme Court addressed was not the subject of debate in the bankruptcy courtroom that November day.  It was not the (boring and technical) issue of the extent of the §365(n) election’s availability for trademarks as intellectual property but instead the Supreme Court ruled on the much more fundamental issue of the effect of any rejection of any executory contract. In sum, said Justice Kagan, “[r]ejection of a contract—any contract—in bankruptcy operates not as a rescission but as a breach.”  Tempnology, LLC supra at *5.

 

By setting the dichotomous choice as one between two contract remedial concepts, the Supreme Court has erred because it ignores the true dichotomy between the debtor and the estate and it ignores the effect of 11 U.S.C. § 541.  

 

The Supreme Court, of course, is correct to quote §365(g) that “the rejection of an executory contract[ ] constitutes a breach of such contract.” Id.  at *3.[2]  However, subsection (g) of Section 365 is not the entirety of what it means to assume or reject but merely one part.  The part that is §365(g) works in conjunction with §541 and it works upon the Trustee and the estate not the debtor.[3]

 

Justice Kagan reasoned from §365(g) that because rejection constitutes a breach, the consequences of rejection are the same as the consequences of a breach.  She uses the hypothetical of a copier lease.  Assuming a breach by the lessor, the lessee has (at least) two options: redeliver the copier and sue for damages or retain the copier, continue payment and sue for damages: “[t]he choice to terminate the agreement and send back the copier is for the [lessee]. By contrast, the dealer has no ability, based on its own breach, to terminate the agreement.” Tempnology, LLC, supra at *5. From that hypothetical, Justice Kagan finds the following rules on rejection:

 

A rejection does not terminate the contract. When it occurs, the debtor and counterparty

do not go back to their pre-contract positions. Instead, the counterparty retains the rights

it has received under the agreement. As after a breach, so too after a rejection, those

rights survive.

 

All of this, it will hardly surprise you to learn, is not just about photocopier leases. Sections

365(a) and (g) speak broadly, to “any executory contract[s].” Many licensing agreements

involving trademarks or other property are of that kind (including, all agree, the Tempnology-

Mission contract). The licensor not only grants a license, but provides associated goods or

services during its term; the licensee pays continuing royalties or fees. If the licensor breaches

the agreement outside bankruptcy (again, barring any special contract term or state law),

everything said above goes. In particular, the breach does not revoke the license or stop the

licensee from doing what it allows. … And because rejection “constitutes a breach,” § 365(g),

the same consequences follow in bankruptcy. The debtor can stop performing its remaining obligations under the agreement. But the debtor cannot rescind the license already conveyed.

So the licensee can continue to do whatever the license authorizes.  Id. at *6.

 

Justice Kagan’s language uses repeated inaccurate references to the “debtor” but the “debtor” is a party to these proceedings only in its capacity as trustee for the bankruptcy estate created by 11 U.S.C. §541.  Upon the happening of the bankruptcy proceeding, the debtor ceased “performing its remaining obligations” and the matters that §365 deals with are whether the bankruptcy estate will perform those obligations. 

 

The distinction between the debtor and the Trustee on behalf of the estate finds resonance in §541.  Per §541, upon the filing of the bankruptcy petition, the debtor no longer holds title to any of its property and all now belongs to the estate including all trademarks.  Justice Kagan, though, modifies the effect of §541 with the following:

 

[s]o if the not-yet debtor was subject to a counterparty’s contractual right (say, to retain a

copier or use a trademark), so too is the trustee or debtor once the bankruptcy petition has

been filed. The rejection-as-breach rule (but not the rejection-as-rescission rule) ensures

that result. By insisting that the same counterparty rights survive rejection as survive breach,

the rule prevents a debtor in bankruptcy from recapturing interests it had given up.  Id. at *6. 

 

That reasoning ignores the distinction between the estate and the debtor and it modifies §541.

 

Take a hypothetical, the two parties are the parties to an agreement for the sale and purchase of an automobile.  The Buyer agrees to pay $20,000.  The Seller agrees to find for the Buyer, sell and deliver a Bentley in exchange for the price.  Seller has made many similar bad business deals and files a bankruptcy petition.  Seller has found no Bentley.  Seller’s Trustee rejects the contract.  Do the same “counterparty rights” survive rejection as would survive breach?  Can the Buyer tender the $20,000.00 and demand the vehicle of the bankruptcy trustee even in the face of a rejection?  The words Justice Kagan uses suggest "yes" but that cannot be the result.  It is not the result because, having rejected, the estate is not bound.[4] 

 

The estate was never a party to the contract and by rejection did not become a party.  It only becomes a party to the contract if the contract is assumed.  Rejection of an executory contract means that neither the bankruptcy estate, the bankruptcy trustee nor the debtor in its capacity as debtor in possession are bound. The corporate debtor is bound, and, unless a discharge enters under 11 U.S.C. § 1141, will always be bound.  The Court’s language ignores the distinction between the debtor and the estate.

 

The Court’s reasoning modifies §541. §541 brings into the estate all property (including the trademark) and the Court’s ruling carves out from the reach of §541 contract limitations whether or not those contract limitations give rise to rights in property and whether or not those contract limitations are avoidable.

 

Take the same hypothetical, the two parties are the parties to an agreement for the sale and purchase of an automobile.  The buyer agrees to pay $20,000. This time the Seller has the Bentley in stock. Seller realizes he or she could sell it for $50,000.  Seller files a bankruptcy petition. Seller’s trustee rejects the contract.  Do the same “counterparty rights” survive rejection as would survive breach?  Can the Buyer tender the $20,000 and demand the vehicle even in the face of a rejection thereby forcing the trustee to convey and depriving Seller’s creditors of the $30,000?  The words of Justice Kagan say "yes".   But if the estate has rejected the contract it is not a party to the contract and ought not be bound simply because there is a contract that the debtor made but that is not binding on the estate.

 

The only way that Justice Kagan’s result makes sense is if the Buyer has, or may assert, an equitable title to the vehicle by virtue of the purchase and sale agreement. In that circumstance one could say that the property brought into the estate was the vehicle encumbered by the equitable title in another.  The equitable title in the counterparty may exist at the outset of the case but the transfer of that equitable title was a transfer of property of the Debtor pre-petition which, unless protected by certain formalities, would most likely be avoidable under 11 U.S.C. § 544(a).[5]

 

Applying the reasoning from those hypotheticals to the Tempnology license to Mission Products, one reaches the following conclusions:

  1. If the license was a property right that could be said to encumber the trademark rights of the Debtor, then the Trustee in bankruptcy cannot avoid that property right by rejection; however, the property right might be, and probably would be, vulnerable to challenge as an unperfected transfer. 

  2. If the license is not a property right encumbering the trademark rights but is, instead, merely a contract right arising out of the contract that was rejected, then the bankruptcy estate, not being a party to the contract, cannot be bound by the contract.

The Tempnology opinion does not address whether the license is a right in property, or merely a contract right or whether that distinction is important.  The Court leaves it open to future litigants to expand the kind of contract situations in which the non-debtor counterparty will claim “that the same counterparty rights survive rejection as survive breach” and that therefore, the “debtor” (but really meaning the bankruptcy estate) is bound. Id. at *6.

 

Edmond J. Ford

May 27, 2019

10 Pleasant Street

Suite 400

Portsmouth, NH  03801

603-373-1737

eford@fordlaw.com

 

 

 

 

[1]   Mission Product Holdings, Inc.,’s (I) Objection to Debtor’s – (A) Rejection Motion, (B) Sale Motion, and (C) DIP Financing Motion and (II) Notice of Election Pursuant to 11 U.S.C. §365(n)(1)(b) (And Incorporated Memorandum of Law),  United States Bankruptcy Court for the District of New Hampshire In re Tempnology, LLC, 15-11400-CJP  D.E. 99 ¶8,

 

[2]   Although such an observation omits §365(g)’s function to confirm that such a breach is a pre-petition breach.  E.g., 11 U.S.C. §365(g)(1).

 

[3] “[T]he trustee, subject to the court’s approval, may assume or reject any executory contract …of the debtor…”  11 U.S.C. §365(a) (emphasis added).  It is, of course, true that the debtor-in-possession is granted the powers of a trustee but, the debtor-in-possession is nevertheless still acting as trustee for the bankruptcy estate. 11 U.S.C. § 1107. 

 

[4] The seller remains bound unless a discharge enters.  If the seller is an entity there would be no discharge in Chapter 7 nor in a liquidating 11.

 

[5] The ordinary means of perfecting a security interest in a general intangible would be to record a UCC-1 Financing Statement in the applicable Secretary of State’s office.  Mission Products did not record such a UCC-1.  Mission Products did not file a secured proof of claim and thereby did not claim a property interest in the trademark. Old Cold, LLC,  15-11400-CJP, Claim 6-1.

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