SBA borrowers, particularly franchisees, have greater protection if their franchisor goes into bankruptcy under a recent 7th Circuit case. In Sunbeam Prod's Inc. v. Chicago Amer. Mfg. LLC, the 7th Circuit held that a licensee can continue to use trademarks, even if its licensor rejects the license agreement in bankruptcy. This decision fills a burdensome, yet intentional, gap in the Bankruptcy Code. The 7th Circuit dramatic expansion of intellectual property licensees' rights in bankruptcy, however, is sure to spur additional judicial or legislative activity before the issue is finally put to rest.

Debtors is bankruptcy have broad discretion to assume or reject most types of contracts. Contract rejection essentially cuts off the Debtor's obligation to perform and reduces the non-debtor party's damages to a pre-bankruptcy general unsecured monetary claim. General unsecured claims typically are paid pennies on the dollar in bankruptcy.

Congress, however, has enacted several exceptions to the debtor's rejection power to prevent perceived abuses. One exception was in direct response to the 4th Circuit decision Lubrizol Enters, Inc v. Richmond Metal Finishers. In Lubrizol, the debtor rejected an exclusive license it had granted to its licensee for certain metal coating technology. The licensee's business depended on use of this patented technology. The Debtor, however, rejected the license agreement and relicensed the same technology to another company for a much higher royalty. The rejection eviscerated the original licensee's otherwise healthy business. The 4th Circuit correctly upheld the rejection, despite the damage to the innocent original licensee.

Congress quickly responded to Lubrizol by enacting section 365 (a) of the Bankruptcy Code. Section 365 (a) still permits the rejection of intellectual property licenses in bankruptcy, but it gives the non-debtor licensee the right to continue using the licensed technology for the term of the license as long as it continues paying the royalties.

Section 365 (a), however, only applies to patents and copyrights. It does not apply to trademarks. So franchisees, whose businesses rely on the use of their franchisor's trademarks, could have their rights stripped away through the franchisor's bankruptcy. That is, until the Sunbeam decision.

In Sunbeam, the 7th Circuit held that contract rejection does not cut off the non-debtor party's ability to assert its rights under the contract, including the right to continued use of licensed trademarks. The court recognized that rejection only cuts off the Debtor's obligation to perform.

The problem with the Sunbeam court's reasoning is that the debtor's rejection power only applies to executory contracts (meaning material performance remains from both sides). In the trademark context, the licensor's essential material performance is permitting the licensee's continued use of the trademarks. So the Sunbeam court is saying that while the Debtor is excused from performing under a rejected executory contract, it is also saying that a non-debtor ID licensee can nevertheless assert its right to continued use.

The Sunbeam Court further muddied its analysis by using a lessee's right to remain in possession of real property after the debtor-landlord rejects the lease as an example of the non-debtor retaining rights under a rejected contract. The Sunbeam decision, however, ignores the fact that a lessee's right to continued possession exists because of a separate, special exception to the rejection power in section 365 of the Bankruptcy Code.

For now, trademark licensees have the added protection of the Sunbeam decision. The apparent flaws in the Sunbeam court's reasoning certainly will reject additional judicial or legislative action. Until then, the decision stands as a "win" for trademark licensees.

For more information regarding banker's protection to IP licenses or Creditors' Rights, please contact Greg at (215) 542-7070 or at GKupniewski@StarfieldSmith.com.