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One of the most powerful tools a chapter 11 debtor has is the ability to assume or reject executory contracts under section 365 of the Bankruptcy Code.  In bankruptcy parlance, when a debtor “rejects” an executory contract, it is considered as though the debtor breached the agreement as of the date it filed for bankruptcy and sheds the debtor’s obligation to perform under the rejected contract.  The non-debtor party receives a claim for damages arising from the debtor’s breach; however, in many cases, it will be worth only pennies on the dollar.  The converse of rejection is “assumption.”  When a debtor assumes a contract, it pays the non-debtor counterparty any monies due under the agreement and requires the non-debtor party to comply with the contract’s terms regardless of whether the non-debtor would rather terminate the agreement.  In addition, a debtor may assign an assumed contract to another party without the counterparty’s consent, subject to certain limited exceptions, so long as the assignee can assure the non-debtor party that it is financially capable of performing its obligations under the agreement.

A debtor’s ability to assume or reject an executory contract raises particular concern for licensors or licensees of intellectual property because trademark, copyright, patent and similar licenses are generally considered executory contracts under the Bankruptcy Code, the assumption or rejection of which may run counter to the non-debtor’s intentions when entering into the license.  Moreover, assumption or rejection of an intellectual property license may occur years after its execution so long as the court considers the agreement “executory.”  So long as both parties have material obligations remaining under the license or agreement in question, it will be considered “executory” for purposes of assumption or rejection.

The Interstate Bakeries Corporation’s chapter 11 caseprovides a clear illustration of how proper diligence and careful drafting is of paramount importance when entering into a license agreement of intellectual property.  The Eighth Circuit Court of appeals upheld a debtor-licensor’s rejection of a trademark license decade’s after its execution.  The practical effect of this rejection was to relieve the debtor of any remaining obligations under the contract, including its requirement to maintain and defend the licensed marks.

The Court affirmed that the perpetual royalty-free trademark license was an executory contract for purposes of section 365 of the Bankruptcy Code and thus subject to assumption or rejection.  The Court reasoned that this was because material obligations remained unperformed by the parties..  The Eight Circuit’s holding creates a circuit split, as it runs counter to the Third Circuit’s decision in In re Excide Technologies, 607 F.3d 957 (3d. Cir. 2010), where a similar agreement was not found to be an executory contract.  The Interstate decision relied primarily on specific provisions of the agreement that the parties conceded were material and serves as an example of how licensors and licensees of intellectual property must take care in drafting their licenses to account for a subsequent bankruptcy.

Under the majority view affirmed by Court, a contract is executory “when the obligation of both the bankrupt and the other party to the contract are so far underperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.”  The contract at issue here was an asset purchase agreement between Interstate and Lewis Brothers Bakeries (“LBB”) in which LBB paid Interstate $20 million for Interstate’s Butternut Bread business.  Under the agreement, Interstate also granted LBC a “perpetual, royalty-free, assignable, transferable, exclusive license” (the “License”) to use the Butternut mark in the Chicago area.  The License was executed at the same time as the asset purchase agreement.  Fourteen years after the sale to LBB, Interstate filed for bankruptcy in September, 2004.

As part of its bankruptcy case, Interstate moved to reject the License as an executory contract.  LBB objected to the motion, arguing that the neither party had any material obligations remaining under the License so that it could not be rejected.  Both the bankruptcy and district courts, however, pointed to specific provisions of the agreement, which required ongoing performance by the parties to make the License an executory contract.

The Eighth Circuit agreed, pointing specifically to section 5.2 of the License, which provided, in relevant part, that “a failure of [the parties] to maintain the quality and character of the goods sold under the Trademarks. . .” shall constitute a “material breach” giving Interstate the right to terminate the License.  In reaching its decision, the court drew a distinction between the license at issue in the Excide case, which did not contain any materiality provisions and section 5.2 of the License.  The court also focused on the fact that Interstate too had material obligations remaining under the License, including an obligation to maintain and defend the relevant trademarks. 

Although the Interstate decision may be read on the surface as a mere exercise in contract interpretation, the holding illustrates the importance of careful drafting and diligence when contemplating a trademark license agreement.  Despite the fact that the License was perpetual, royalty-free and part of a comprehensive sale, the court looked almost exclusively to the provisions of the License itself in affirming the lower courts.  Thus, if the provisions of a license agreement are recognized by the parties to be material, and unperformed obligations still exist, a court will hold the license to be susceptible to assumption or rejection even if the bankruptcy occurs years after the license was executed.

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The Need for Careful Diligence in Drafting License Agreements Reinforced By Eighth Circuit Affirmation That a Perpetual, Royalty-Free Trademark License is an “Executory Contract”