The U.S. Supreme Court clarified a vexing bankruptcy issue causing conflicts between U.S. Circuit Courts of Appeal. In Mission Products Holding v. Tempnology (In re Tempnology), the court clarified the intersection of bankruptcy and trademark law, and held that rejection under Section 365 of the Bankruptcy Code “constitutes a breach” of an executory contract by the debtor. This reverses the decision of the U.S. Court of Appeals for the First Circuit which treated the rejection as a termination of the contract akin to a rescission. Justice Elena Kagan wrote for the majority, and was the most active questioner at oral argument.

The debtor, Tempnology, licensed clothing and accessories to Mission Products, and filed bankruptcy so that it could “reject” burdensome contract such as held by Mission Products. Section 365 of the Bankruptcy Code enables a debtor to “reject any executory contract—meaning a contract that neither party has finished performing” wrote Kagan. Tempnology rejected the license so that it could, as a business strategy, jettison this burdensome contract, or perhaps resell or renegotiate the license. Mission Products argued that that because rejection is considered a breach, traditional contract law would allow the nonbreaching party the options of retaining the rights granted by the breaching licensor, damages or both.

The Supreme Court held that absent bankruptcy, a licensor's breach cannot ipso facto revoke continuing rights given to the licensee. The court discussed how bankruptcy does not enlarge the debtor's assets or rights in those assets. The court noted that Congress gave certain avoiding powers in the Bankruptcy Code for fraudulent conveyances and voidable preferences in order to unwind transactions which could impair rehabilitation. Congress did not address the post-rejection rights of licensees of trademark rights. Sen. Joseph Biden, then the chair of the Judiciary Committee, stated that trademarks should not be treated as other intellectual property in the Bankruptcy Code and that the courts should sort such post-rejection issues out on an equitable basis. The court thought to hold otherwise would broaden Congress' limits on unwinding pre-bankruptcy transfers and undermine the bankruptcy process. The court did recognize that the debtor was not required to perform its obligations under the rejected contract and that too could create damages in favor of the rejected licensee. The court utilized an analysis of common law contract breach in deciding the possible remedies a rejected licensee of a trademark license might have.

The court rejected Tempnology's arguments that the substantive law of trademark compelled the treatment of rejected trademark licenses as rescission, ab initio. The court held that this remedy would be contrary to contract law and is not supported by the language of the Bankruptcy Code.

Perhaps the most interesting aspect of the decision was the concurrence by Justice Sonia Sotomayor, who remarked that not every trademark licensee has the unfettered right to continue using licensed marks post rejection. What remains undecided is whether under the facts and circumstances in each case a licensee's rights would survive a breach under applicable nonbankruptcy law. Sotomayor also noted that because trademarks are not defined as intellectual property in the Bankruptcy Code, trademark holders in bankruptcy might not be as limited as rejected patent holders might be. For example, rejected patent licensees who choose to retain their rights must pay royalties, but trademark holders may be able to set off postpetition royalties against damages because they are neither protected nor limited by Section 365(n), which ensures retention rights for rejected licensees of defined intellectual property.

Note that Justice Neil Gorsuch writes in dissent that the bankruptcy case was fully administered, there was no live case or controversy, and this was a moot decision which was not within the court's jurisdiction. The majority did address the mootness issue to show that this decision was not simply an academic exercise. It was quite interesting that the majority used a relatively small thread of live controversy to support jurisdiction. Aside from the bankruptcy and trademark issues, this case may be cited in the future on the limits of mootness.

So let's see how this decision might have affected the Chrysler bankruptcy reorganization. On May 14, 2009, Chrysler filed a motion to assume and sell 2,392 of its dealership agreements and to reject the contracts of 789 of its dealers. At the time, Chrysler said, “The unprecedented decline in the industry has had a significant impact on our sales and forced us to reduce production levels to better match the needs of the market. With the downsizing of operations after the sale and reduction of plants and production, similar reductions must be made to the size of the dealer body. We appreciate the support of our dealers and regret this painful action. We wish market conditions made it possible to keep everyone.”

With respect to the rejected agreements, “It is with a deep sense of sadness that we must take steps to end some of our sales and service dealer agreements,” said Steven Landry, executive vice president, North American Sales and Marketing, Global Service and Parts. “The decision, though difficult, was based on a data-driven matrix that assessed a number of key metrics. In total, 789 dealers, which represents 14% of our sales volume, will be rejected and, subject to the court approval, they will discontinue selling Dodge, Chrysler or Jeep vehicles on or about June 9. While difficult, the actions to restructure its dealer network are a necessary part of Chrysler's viability plan and are central to the proposed sale transaction. These actions will help ensure that both remaining dealers and the new company will be stronger and more profitable going forward.”

Would the Chrysler case have come out differently for the 789 rejected dealers? Probably so, because they could have sought to retain their rights, and as long as they were selling Chrysler, Jeep or Dodge vehicles, they probably could have continued to call themselves dealers. Chrysler would have been required to show how it could not have reorganized if the rejected dealers remained, or how the retention of rights would have hurt the licensor. Moreover, the damage claims may have been higher based on the damage theory explained by the Supreme Court, giving the rejected dealers even more leverage in the case. If car production had not been affected, the dealers with rejected contracts may have had the right to continue in operation notwithstanding rejection.

The case will require more pre-bankruptcy planning for licensors. In addition, it may be able to draft language in the license grant that might be helpful in determining post-rejection remedies.

Craig R. Tractenberg is a partner and co-chair of the franchise practice group at Fox Rothschild where he handles complex business disputes involving intellectual property, licenses, business torts and insolvency issues. He focuses his practice on franchise companies' development and expansion. Contact him at [email protected].