Franchisor Wins IP Dispute

In bankruptcy, the debtor is entitled to reject (not perform) burdensome contracts. For franchise agreements that contain trademark licenses, the effects of rejection are decided on a case-by-case basis. Sometimes the licensees of the trademarks can continue to use the trademarks over the objection of the franchisor and sometimes not. This issue arose in the Crumbs Bake Shop case in connection with the sale of its assets.

The franchisees (called licensees) of baked goods retailer Crumbs Bake Shop Inc. can continue to use the Crumbs trademark and sell products under the Crumbs brand for the remainder of their licenses' terms, even though the retailer, acting as debtor-in-possession, had moved to reject the licenses following the court's approval of the sale of the business's assets, in In re Crumbs Bake Shop, No. 14-24287, Bankr. N.J. (Oct.31, 2014, Kaplan, M.). The licensees could elect, under 11 U.S.C. Section 365(n), to retain their rights under their respective licenses even though “trademarks” were not included in the Bankruptcy Code definition of “intellectual property.” In addition, sale of the retailer's assets pursuant to 11 U.S.C. Sections 363(b) and (f) did not affect the rights of third-party licensees under Section 365(n). The court held royalties generated as a result of this use were payable to the retailer, because the agreements themselves had not been assumed, assigned, or rejected, and thus continued to be the retailer's property.

Background

Crumbs specialized in the retail sales of cupcakes, baked goods and beverages. Crumbs entered into licensing agreements with third parties, allowing for the use of the Crumbs mark for the sale of products. To maximize licensing revenues, Crumbs entered into a representation agreement with Brand2 Squared Licensing (BSL). The latter agreed to provide services to Crumbs, including the provision of brand licensing services related to license agreements. BSL procured licenses with several licensees for use of Crumbs' trademark and trade secrets.

Crumbs ceased operations July 7, 2014, and filed voluntary petitions for relief pursuant to Chapter 11 of the Bankruptcy Code, but managed the business as a debtor-in-possession. On the petition date, Crumbs entered into a credit bid asset purchase agreement with Lemonis Fischer Acquisition Co. LLC (LFAC) for the sale of substantially all of Crumbs' assets. A sale order was entered by the court and approved Aug. 27, 2014.

The next day, Crumbs filed a motion to reject certain executory contracts and unexpired leases, including the intellectual property licenses. BSL filed a response asserting that the licensees could elect, under Section 365(n), to retain their rights under their respective license agreements. BSL also sought entitlement to royalties in the event the licensees elected to continue using the licensed intellectual property.

Crumbs then withdrew its rejection motion only to the extent that it related to the license agreements. The court entered an order authorizing the rejection of a number of executory contracts, unexpired leases and licenses, but excluding those involving the intellectual property licensees. The parties sought a determination of the effect of the sale order on their respective rights.

Retention Rights of 365(n)

Under 11 U.S.C. Section 365(n), licensees are protected from unilateral termination upon rejection of intellectual property contracts. When a licensor rejects an intellectual property license, the licensee is permitted to elect to retain its license, and the licensor then must continue to license, but is not bound by any other continuing obligations.

The definition of “intellectual property” is found in Section 101(35A) of the code. This definition lists trade secrets; inventions, processes, designs, or plants protected under Title 35; patent applications; plant varieties; works of authorship protected under Title 17; and mask works protected under Chapter 9 of Title 17, but it does not include trademarks. There was a split among authorities as to whether this omission indicated Congress's intention that trademark licensees are not protected by Section 365(n), such that rejection of a license deprived the trademark licensee of the rights previously granted under the agreement.

The court held that Congress intended the bankruptcy courts to exercise their equitable powers to decide, on a case-by-case basis, whether trademark licensees may retain the rights listed under Section 365(n). In this case, the court found that it would be inequitable to strip the licensees of their rights in the event of a rejection, as those rights had been bargained away by Crumbs.

LFAC argued that these equitable considerations should not come into play because Crumbs sold its assets to a bona fide purchaser. Some authorities have suggested that Section 365(n) rights of third parties should succumb to the interests of maximizing the bankruptcy estate in liquidation contexts. However, the court found no basis for such a distinction. Bankruptcy estates, whether reorganizing or liquidating, already benefit from the ability to assume or reject executory agreements. “There is no reason to augment such benefits at the expense of third parties and a licensing system which Congress sought to protect by means of preserving certain rights under Section 365(n),” the court said.

LFAC argued that allowing the licensees to make an election under Section 365(n) to continue using the trademarks would place LFAC in a licensor-licensee arrangement that it never intended to assume. However, the court reasoned, LFAC came into this transaction with eyes open, after engaging in due diligence, and could adjust its purchase price to account for existing trademark license agreements.

Accordingly, the court held that trademark licensees to rejected intellectual property licenses fell under the protective scope of 11 U.S.C. Section 365(n).

Effect of Asset Sale

Next, the court held that a sale of a bankrupt debtor's assets pursuant to 11 U.S.C. Sections 363(b) and (f) did not alter the rights of third-party licensees under Section 365(n), in the absence of consent. The court rejected LFAC's contention that the sale of Crumbs' assets pursuant to Sections363(b) and (f) effectuated a free and clear conveyance of the licensees' trademark rights to LFAC, such that Section 365(n) no longer applied.

Finally, the court held that Crumbs was the only party entitled to the collection of royalties generated as a result of licensees' use of licensed intellectual property. There was no question that the Crumbs trademark, among other intellectual property, was sold to LFAC. However, explicitly excluded from the sale were the license agreements between Crumbs and the trademark licensees, and the contract between Crumbs and BSL. The license agreements were not themselves sold, and they were not assumed or assigned; LFAC did not receive any rights under the agreements. Therefore, the rights as to the license agreements remain with Crumbs.

As a result, the brand survives, the franchisees continue to operate and the buyer gets the marks and the goodwill. Another perfect outcome under the Bankruptcy Code.

Craig R. Tractenberg is the team leader of the franchise practice at Nixon Peabody. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.

In bankruptcy, the debtor is entitled to reject (not perform) burdensome contracts. For franchise agreements that contain trademark licenses, the effects of rejection are decided on a case-by-case basis. Sometimes the licensees of the trademarks can continue to use the trademarks over the objection of the franchisor and sometimes not. This issue arose in the Crumbs Bake Shop case in connection with the sale of its assets.

The franchisees (called licensees) of baked goods retailer Crumbs Bake Shop Inc. can continue to use the Crumbs trademark and sell products under the Crumbs brand for the remainder of their licenses' terms, even though the retailer, acting as debtor-in-possession, had moved to reject the licenses following the court's approval of the sale of the business's assets, in In re Crumbs Bake Shop, No. 14-24287, Bankr. N.J. (Oct.31, 2014, Kaplan, M.). The licensees could elect, under 11 U.S.C. Section 365(n), to retain their rights under their respective licenses even though “trademarks” were not included in the Bankruptcy Code definition of “intellectual property.” In addition, sale of the retailer's assets pursuant to 11 U.S.C. Sections 363(b) and (f) did not affect the rights of third-party licensees under Section 365(n). The court held royalties generated as a result of this use were payable to the retailer, because the agreements themselves had not been assumed, assigned, or rejected, and thus continued to be the retailer's property.

Background

Crumbs specialized in the retail sales of cupcakes, baked goods and beverages. Crumbs entered into licensing agreements with third parties, allowing for the use of the Crumbs mark for the sale of products. To maximize licensing revenues, Crumbs entered into a representation agreement with Brand2 Squared Licensing (BSL). The latter agreed to provide services to Crumbs, including the provision of brand licensing services related to license agreements. BSL procured licenses with several licensees for use of Crumbs' trademark and trade secrets.

Crumbs ceased operations July 7, 2014, and filed voluntary petitions for relief pursuant to Chapter 11 of the Bankruptcy Code, but managed the business as a debtor-in-possession. On the petition date, Crumbs entered into a credit bid asset purchase agreement with Lemonis Fischer Acquisition Co. LLC (LFAC) for the sale of substantially all of Crumbs' assets. A sale order was entered by the court and approved Aug. 27, 2014.

The next day, Crumbs filed a motion to reject certain executory contracts and unexpired leases, including the intellectual property licenses. BSL filed a response asserting that the licensees could elect, under Section 365(n), to retain their rights under their respective license agreements. BSL also sought entitlement to royalties in the event the licensees elected to continue using the licensed intellectual property.

Crumbs then withdrew its rejection motion only to the extent that it related to the license agreements. The court entered an order authorizing the rejection of a number of executory contracts, unexpired leases and licenses, but excluding those involving the intellectual property licensees. The parties sought a determination of the effect of the sale order on their respective rights.

Retention Rights of 365(n)

Under 11 U.S.C. Section 365(n), licensees are protected from unilateral termination upon rejection of intellectual property contracts. When a licensor rejects an intellectual property license, the licensee is permitted to elect to retain its license, and the licensor then must continue to license, but is not bound by any other continuing obligations.

The definition of “intellectual property” is found in Section 101(35A) of the code. This definition lists trade secrets; inventions, processes, designs, or plants protected under Title 35; patent applications; plant varieties; works of authorship protected under Title 17; and mask works protected under Chapter 9 of Title 17, but it does not include trademarks. There was a split among authorities as to whether this omission indicated Congress's intention that trademark licensees are not protected by Section 365(n), such that rejection of a license deprived the trademark licensee of the rights previously granted under the agreement.

The court held that Congress intended the bankruptcy courts to exercise their equitable powers to decide, on a case-by-case basis, whether trademark licensees may retain the rights listed under Section 365(n). In this case, the court found that it would be inequitable to strip the licensees of their rights in the event of a rejection, as those rights had been bargained away by Crumbs.

LFAC argued that these equitable considerations should not come into play because Crumbs sold its assets to a bona fide purchaser. Some authorities have suggested that Section 365(n) rights of third parties should succumb to the interests of maximizing the bankruptcy estate in liquidation contexts. However, the court found no basis for such a distinction. Bankruptcy estates, whether reorganizing or liquidating, already benefit from the ability to assume or reject executory agreements. “There is no reason to augment such benefits at the expense of third parties and a licensing system which Congress sought to protect by means of preserving certain rights under Section 365(n),” the court said.

LFAC argued that allowing the licensees to make an election under Section 365(n) to continue using the trademarks would place LFAC in a licensor-licensee arrangement that it never intended to assume. However, the court reasoned, LFAC came into this transaction with eyes open, after engaging in due diligence, and could adjust its purchase price to account for existing trademark license agreements.

Accordingly, the court held that trademark licensees to rejected intellectual property licenses fell under the protective scope of 11 U.S.C. Section 365(n).

Effect of Asset Sale

Next, the court held that a sale of a bankrupt debtor's assets pursuant to 11 U.S.C. Sections 363(b) and (f) did not alter the rights of third-party licensees under Section 365(n), in the absence of consent. The court rejected LFAC's contention that the sale of Crumbs' assets pursuant to Sections363(b) and (f) effectuated a free and clear conveyance of the licensees' trademark rights to LFAC, such that Section 365(n) no longer applied.

Finally, the court held that Crumbs was the only party entitled to the collection of royalties generated as a result of licensees' use of licensed intellectual property. There was no question that the Crumbs trademark, among other intellectual property, was sold to LFAC. However, explicitly excluded from the sale were the license agreements between Crumbs and the trademark licensees, and the contract between Crumbs and BSL. The license agreements were not themselves sold, and they were not assumed or assigned; LFAC did not receive any rights under the agreements. Therefore, the rights as to the license agreements remain with Crumbs.

As a result, the brand survives, the franchisees continue to operate and the buyer gets the marks and the goodwill. Another perfect outcome under the Bankruptcy Code.

Craig R. Tractenberg is the team leader of the franchise practice at Nixon Peabody. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.