Trademark licensees that file for bankruptcy protection face uncertainty concerning their ability to continue using trademarks that are crucial to their businesses. Some of this stems from an unsettled issue in the courts as to whether a licensee can assume a trademark license without the licensor's consent. In In re Trump Entertainment Resorts, Inc., 2015 BL 44152 (Bankr. D. Del. Feb. 20, 2015), a Delaware bankruptcy court reaffirmed that the ongoing controversy surrounding the "actual" versus "hypothetical" test for assumption of a trademark license has not abated. Applying the hypothetical test, the court granted a trademark licensor's motion for relief from the automatic stay to pursue termination of the license agreement because the license could not be assumed or assigned by the debtor under sections 365(c)(1) and 365(f)(1) of the Bankruptcy Code.
Limitations on the Ability to Assume or Assign Certain Contracts and Leases in Bankruptcy
Section 365(a) of the Bankruptcy Code allows a bankruptcy
trustee or chapter 11 debtor-in-possession ("DIP") to
assume or reject most kinds of executory contracts and unexpired
leases. This broad power, however, is limited with respect to
certain kinds of contracts. For example, section 365(c)(1)(A) of
the Bankruptcy Code provides that a trustee or DIP may not
"assume or assign" an executory contract or unexpired
lease if "applicable law excuses a party, other than the
debtor, to such contract or lease from accepting performance from
or rendering performance to an entity other than the debtor or the
debtor in possession" and such party does not consent to
assumption or assignment.
Courts have applied this provision to a wide variety of contracts.
Among these are personal service contracts, including employment
agreements; contracts with the United States government, which
cannot be freely assigned under federal law; certain kinds of
franchise agreements; and licenses of intellectual property, which
generally cannot be assigned without consent under federal
intellectual property law. Thus, many debtors (especially those in
the technology industry) find that their rights with respect to
certain executory contracts are significantly limited.
The Statutory Muddle
Section 365(c)(1) prevents a trustee or DIP from assigning a
contract without the nondebtor's consent if applicable law
prevents the contract from being assigned outside bankruptcy
without consent. Section 365(c)(1), however, uses the distinctive
phrase "assume or assign," as opposed to "assume
and assign," which would seem to mean that a trustee
or DIP cannot even assume such a contract and agree to perform
under it, even if the trustee or DIP has no intention of assigning
the contract to a third party.
Some courts construe the "assume or assign" language to
mean that the statutory proscription applies to a trustee or DIP
who seeks either: (i) to assume and render performance under the
agreement; or (ii) to assume the agreement and assign it to a third
party. Under this literal interpretation, the court posits a
hypothetical question: Could the debtor assign the contract to a
third party under applicable nonbankruptcy law? If the answer is
no, the trustee or DIP may neither assume nor assign the contract.
This approach is commonly referred to as the "hypothetical
test." The Third, Fourth, Ninth, and Eleventh Circuits have
adopted this approach. See In re West Elecs. Inc., 852
F.2d 79 (3d Cir. 1988); Resort Computer Corp. v. Sunterra Corp
(In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004);
Perlman v. Catapult Entm't, Inc. (In re Catapult
Entm't, Inc.), 165 F.3d 747 (9th Cir. 1999); City of
Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable
Partners, L.P.), 27 F.3d 534 (11th Cir. 1994).
Other courts, having determined that the phrase "may not
assume or assign" should be read to mean "may not assume
and assign," apply the statutory proscription only
when the trustee or DIP actually intends to assign the contract to
a third party. This approach is commonly referred to as the
"actual test." Its adherents include the First Circuit
and the vast majority of lower courts considering the issue.
See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d
489 (1st Cir. 1997), abrogated by Hardemon v. City of
Boston, 1998 WL 148382 (1st Cir. Apr. 6, 1998), superseded
by 144 F.3d 24 (1st Cir. 1998); Summit Inv. & Dev.
Corp. v. Leroux (In re Leroux), 69 F.3d 608 (1st Cir. 1995);
In re Jacobsen, 465 B.R. 102 (Bankr. N.D. Miss. 2011)
(citing and listing cases). In addition, the Fifth Circuit has
applied the actual test in construing section 365(e)(2)—the
Bankruptcy Code's exception to the prohibition against
enforcement of "ipso facto" clauses that act to
terminate or modify a contract as a consequence of a bankruptcy
filing. See Bonneville Power Admin. v. Mirant Corp. (In re
Mirant Corp.), 440 F.3d 238 (5th Cir. 2006).
In In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y.
2005), the court adopted a slightly different test predicated upon
the legal distinctions between the debtor and the DIP, on the one
hand, and the bankruptcy trustee, on the other. The court reasoned
that the term "trustee" in section 365(c)(1) should not
automatically be read (as it is in many other provisions "as a
matter of simple logic and common sense") to be synonymous
with the term "debtor-in-possession." Instead, the
proscription of assumption and assignment is limited to situations
where a trustee, rather than a DIP, seeks to assume an executory
contract. Under the Footstar approach, the DIP would be
permitted to assume the contract because, unlike a bankruptcy
trustee, the DIP is not "an entity other than" itself;
nevertheless, the DIP would be precluded from assigning a
qualifying contract because assignment would force the nondebtor
contracting party to accept performance from or render performance
to an entity other than the debtor. In contrast, under
Footstar, a trustee would be permitted neither to assume
nor to assign such a contract.
Depending on the contracts involved, whether a bankruptcy court
applies the hypothetical test or the actual test can profoundly
impact a DIP's ability to stay in business. Application of the
hypothetical test can prevent a DIP from continuing to exercise its
rights under a nonassignable contract, such as a patent, copyright,
or trademark license, which generally cannot be assigned without
the licensor's consent. Without such contracts, some DIPs may
be incapable of reorganizing under chapter 11. In Trump
Entertainment, the bankruptcy court considered section
365(c)(1) in the context of a trademark licensor's motion for
relief from the automatic stay to continue state court litigation
in which the licensor was seeking to terminate a trademark license
agreement with the debtor.
Trump Entertainment
In 2010, Donald and Ivanka Trump entered into a perpetual
trademark license agreement with Trump Entertainment Resorts, Inc.,
and its affiliates (collectively, "TER") that granted TER
a royalty-free license to use the Trumps' names, likenesses,
and other marks in connection with the operation of three hotel
casinos located in Atlantic City. The Trumps subsequently assigned
their rights under the agreement to Trump AC Casino Marks, LLC
("Trump AC").
The license agreement required Trump AC's prior written consent
to any assignment by TER. On the same day that TER executed the
license agreement, the Trumps, TER, and one of TER's secured
lenders entered into a Consent Agreement whereby Trump AC (as the
Trumps' assignee) agreed that TER's rights under the
license agreement could be assigned to the lender "upon and
following the enforcement" by the lender of its rights under
its credit agreement with TER.
On August 5, 2014, Trump AC sued TER in state court, seeking to
terminate the license agreement due to TER's alleged breach of
the agreement. That action was stayed when TER filed for chapter 11
protection in the District of Delaware on September 9, 2014. TER
later proposed a chapter 11 plan pursuant to which the secured
lender's claims would be exchanged for equity in a reorganized
entity recapitalized to continue the business of TER's one
remaining operating casino, the Trump Taj Mahal Casino Resort. The
plan also contemplated assumption of the trademark license
agreement.
On September 24, 2014, Trump AC filed a motion for relief from the
automatic stay to proceed with the state court action to terminate
the license agreement.
The Bankruptcy Court's Ruling
At the outset of its analysis, the court explained that, in
accordance with Izzarelli v. Rexene Prods. Co. (In re Rexene
Prods. Co.), 141 B.R. 574 (Bankr. D. Del. 1992), Delaware
bankruptcy courts typically apply a balancing test in assessing
whether "cause" to lift the stay exists under section
362(d) of the Bankruptcy Code to allow pending nonbankruptcy
litigation to continue. Under this three-pronged test, the court
considers:
- Whether continuation of the nonbankruptcy litigation will cause great prejudice to either the estate or the debtor;
- Whether any hardship to the nondebtor arising from continuation of the stay considerably outweighs the hardship to the debtor; and
- The probability that the nondebtor will prevail on the merits.
The court found that Trump AC failed to demonstrate that any
significant hardship would result from maintenance of the stay. It
also found that continuation of the state court litigation
"would impose a substantial burden on [TER's]
reorganization efforts." The court therefore concluded that
Trump AC was not entitled to relief from the automatic stay under
the traditional Rexene analysis.
The court noted, however, that "cause" under section
362(d)(1) "is a flexible concept and not confined solely to
the Rexene factors." In particular, the court agreed
with Trump AC's position that, in accordance with the Third
Circuit's ruling in West Electronics,
"cause" to modify the stay existed because the trademark
license agreement was not assignable absent Trump AC's consent
and thus could not be assumed or assigned by TER under section
365(c)(1). In West Electronics, the Third Circuit ruled
that, where an executory contract is subject to the limitation on
assumption or assignment set forth in section 365(c)(1), the
nondebtor contracting party is entitled to relief from the
automatic stay to seek termination of the contract.
In Trump Entertainment, the bankruptcy court explained
that, pursuant to the binding precedent in West
Electronics, courts in the Third Circuit are obligated to
apply the hypothetical test to determine whether a contract can be
assumed. Thus, the court concluded, a DIP may not assume an
executory contract over the nondebtor's objection if applicable
law would bar assignment to a hypothetical third party,
"even where the [DIP] has no intention of assigning the
contract in question to any such third party" (quoting
Catapult, 165 F.3d at 750).
Nonetheless, the court cautioned that section 365(c)(1) must be
read in conjunction with section 365(f)(1), which provides
that:
Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection (emphasis added).
Thus, the general rule in section 365(f)(1) invalidating
anti-assignment clauses in contracts or leases as well as
overriding nonbankruptcy laws that prohibit assignment is expressly
subject to any alternative rule provided in section 365(b) or
365(c). As discussed, section 365(c)(1) provides that a contract
may not be assumed or assigned if assignment is prohibited by
applicable nonbankruptcy law.
According to the Trump Entertainment court, the
inconsistency between these provisions has been "persuasively
reconciled" by a number of courts, including the Sixth and
Ninth Circuits. In particular, in In re Magness, 972 F.2d
689 (6th Cir. 1992), the Sixth Circuit found that sections
365(c)(1) and 365(f)(1) do not conflict because "each
subsection recognized an 'applicable law' of markedly
different scope." As described by the Ninth Circuit in
Catapult, section 365(f)(1) broadly provides that a law
which "prohibits, restricts, or conditions the
assignment" of an executory contract is trumped by section
365(f)(1). Section 365(c)(1), on the other hand, "states a
carefully crafted exception to the broad rule—where
applicable law does not merely recite a general ban on assignment,
but instead more specifically 'excuses a party . . .
from accepting performance from or rendering performance to an
entity' different from the one with which the party originally
contracted, the applicable law prevails over subsection
(f)(1)." Catapult, 165 F.3d at 752.
Finding this reasoning persuasive, the bankruptcy court in
Trump Entertainment concluded that, for section 365(c)(1)
to apply, the applicable law must specifically provide
that the nondebtor contract party "is excused from accepting
performance from a third party under circumstances where it is
clear from the statute that the identity of the contracting party
is crucial to the contract" (citing In re ANC Rental
Corp., 277 B.R. 226, 236 (Bankr. D. Del. 2002)).
Initially, the bankruptcy court determined that the
"applicable law" in this context is federal trademark
law. Under trademark law, the bankruptcy court noted, "the
substantial weight of authority" indicates that trademark
licenses are not assignable in the absence of some kind of express
authorization by the licensor, such as a clause in the license
agreement itself (citing In re XMH Corp., 647 F.3d 690
(7th Cir. 2011); Miller v. Glenn Miller Prods., Inc., 454
F.3d 975 (9th Cir. 2006)). Even so, the bankruptcy court explained
that it is not sufficient alone to recognize a general ban on
assignment under applicable nonbankruptcy law—the court must
determine why the law in question bans assignment.
Federal trademark law generally bans assignment of trademark
licenses without the licensor's consent because trademarks are
meant to identify a good or service of a particular, consistent
quality, making the identity of licensees crucial to licensors.
Although the parties to a license agreement are free to contract
around this general rule, the court in Trump Entertainment
found no indication that the Trumps (and by extension Trump AC) and
TER intended to do so in the trademark license agreement.
Moreover, the court found that notwithstanding the Consent
Agreement, Trump AC did not consent to assignment of the trademark
because the consent provided was effective only with respect to an
"isolated assignee" in the context of a state enforcement
action that was unlikely to occur once the bankruptcy case was
commenced. Therefore, the bankruptcy court ruled that the
hypothetical test under section 365(c)(1) was satisfied and,
accordingly, under West Electronics, that Trump AC was
entitled to relief from the automatic stay.
Outlook
Recent rulings from courts in the Third Circuit concerning the
treatment of trademark licenses in bankruptcy are a decidedly mixed
bag. On the one hand, the court in In re Crumbs Bake Shop,
Inc., 522 B.R. 766 (Bankr. D.N.J. 2014), held that trademark
licensees are entitled to the protections of section 365(n) of the
Bankruptcy Code, even though the Bankruptcy Code does not include
"trademarks" in the definition of "intellectual
property." Furthermore, on the basis of circuit judge Thomas
L. Ambro's concurring opinion in In re Exide
Technologies, 607 F.3d 957 (3d Cir. 2010), the Third Circuit
may be receptive to this approach, which would be a positive
development for trademark licensees. On the other hand, Trump
Entertainment indicates that the hypothetical test is alive
and well in the Third Circuit and that a trademark licensee may not
be able to retain its rights under an executory license agreement,
even if it has no intention of assigning the agreement. These
issues create uncertainty for licensees considering a bankruptcy
filing in any district in the Third Circuit.
Lawmakers had an opportunity to end this uncertainty when Congress
amended the Bankruptcy Code in 2005, yet they failed to do so. The
U.S. Supreme Court similarly declined the opportunity to resolve
the circuit split over the "hypothetical test" versus the
"actual test" in 2009, when it denied certiorari in
N.C.P. Marketing Group, Inc. v. BG Star Productions, Inc.,
556 U.S. 1145 (2009) (concluding that the division in the courts
over the interpretation of section 365(c)(1) is "an important
one to resolve" but that the case in question was "not
the most suitable case for our resolution of the
conflict").
The final report issued on December 8, 2014, by the American
Bankruptcy Institute Commission to Study the Reform of Chapter 11
recommended that the Bankruptcy Code be amended in several respects
to address these issues. First, the Commission recommended that
trademarks, service marks, and trade names be included in the
Bankruptcy Code's definition of "intellectual
property." The Commission also recommended that a trustee or
DIP should be able to assume an intellectual property license
notwithstanding applicable nonbankruptcy law or a provision to the
contrary in the license or any related agreement. Finally, the
Commission recommended that a trustee or DIP should be able to
assign an intellectual property license to a single assignee in
accordance with section 365(f), notwithstanding applicable
nonbankruptcy law or a provision to the contrary in the license or
any related agreement. However, if a trustee or DIP were seeking to
assign an intellectual property license to a competitor of the
nondebtor licensor, the court could deny the assignment if it were
to determine that the harm to the nondebtor licensor resulting from
the proposed assignment would significantly outweigh the benefit to
the estate derived from the assignment.
It remains to be seen whether Congress will take action to
implement these recommendations.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.