The United States Court of Appeals for the Eighth Circuit recently ruled that a perpetual, royalty-free, and exclusive trademark licensing agreement qualified as an executory contract subject to assumption or rejection under section 365 of the Bankruptcy Code. The decision creates new uncertainty for licensees under similar agreements, who may suddenly find that intellectual property rights they had taken for granted are at risk of termination in the event of a bankruptcy filing by the licensor. Lewis Bros. Bakeries Inc. v. Interstate Brands Corp. (In re Interstate Bakeries Corp.), 690 F.3d 1069 (8th Cir. 2012).
In 1995, Interstate Bakeries Corporation announced its acquisition of Continental Baking Company, the owner of the Wonder Bread and Hostess brands and trademarks. Following an anti-trust action by the United States Department of Justice requiring Interstate to divest itself of certain rights and assets, Interstate sold its Butternut Bread and Sunbeam Bread baking operations and assets to Lewis Brothers Bakeries. In connection with the sale, Interstate and Lewis entered into a license agreement pursuant to which Interstate granted Lewis a perpetual, royalty-free, assignable, transferable, exclusive license for the Butternut and Sunbeam trademarks within a delineated territory.
In 2004, Interstate and certain of its affiliates filed voluntary petitions for chapter 11 relief in the Bankruptcy Court for the Western District of Missouri. Four years later, in 2008, Interstate filed an amended plan of reorganization in which it proposed to treat the license agreement with Lewis as an executory contract, meaning that Interstate would have the power to assume or reject the agreement pursuant to section 365 of the Bankruptcy Code. Although Interstate initially indicated its intent to assume the license agreement, Lewis was concerned that Interstate might ultimately reject it. Such a rejection would have terminated Lewis’ licensing rights and allowed Interstate to sell or re-license the trademarks.
Accordingly, to protect its rights as licensee, Lewis filed an adversary proceeding seeking a declaratory judgment by the Bankruptcy Court that the license agreement was not an executory contract and, thus, not subject to assumption or rejection under section 365 of the Bankruptcy Code. A majority of courts, including those in the Eighth Circuit, assess whether a contract is executory under the so-called “Countryman” test, which provides that a contract is executory if the obligations of both the debtor and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other. See Vernon Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439, 460 (1973). Lewis contended that both parties had substantially completed the performance of their obligations under the license agreement, rendering the agreement non-executory. However, the Bankruptcy Court found that both parties had material unperformed obligations outstanding. Following an unsuccessful appeal to the District Court, Lewis appealed to the Eighth Circuit Court of Appeals.
As in the Bankruptcy Court and District Court proceedings, the central issue before the Eighth Circuit was whether the license agreement constituted an executory contract. Accordingly, applying the Countryman test, the Court began its analysis by identifying any material unperformed obligations under the agreement with respect to both Lewis and Interstate.
Focusing its attention first on licensee Lewis, the Court noted that the District Court had identified a “quality standards provision” in the agreement as the primary source of Lewis’ unperformed obligations. This provision expressly stated that Lewis’ failure to maintain the character and quality of goods sold under the relevant trademarks would constitute a material breach, entitling Interstate to terminate the license agreement.
In an attempt to overcome the finding of the District Court below, Lewis cited a recent Third Circuit case, In re Exide Technologies, 607 F.3d 957 (3d Cir. 2010), to argue that the quality standards provision did not create any obligations sufficiently material to render the contract executory. In Exide, the Third Circuit held that a perpetual, royalty-free, and exclusive licensing agreement between two companies involved in the battery trade did not qualify as an executory contract. Like the license agreement at issue in Interstate, the Exide licensing agreement contained a quality standards provision, but the Third Circuit concluded that the obligations created by this provision would not give rise to a material breach if not performed. Significantly, the parties in Exide had never, in fact, discussed any specific quality standards, and the Third Circuit concluded that it was impossible to find a provision material “when the parties themselves act as if they did not know of its existence.”
The majority of the Eighth Circuit panel rejected Lewis’ comparison to Exide, however, finding that the case was distinguishable. First, unlike the parties in Exide, who had not even discussed quality standards, Interstate and Lewis memorialized the applicable quality standards in an explicit provision of the license agreement. Furthermore, unlike in Exide, the plain language of the quality standards provision at issue in Interstate specified that a breach would be material. Following the District Court’s lead, the Court concluded that it was proper to consider the parties’ own agreement as to which provisions qualified as “material” in deciding whether a contract was executory.
Turning its attention to Interstate, the majority of the Eighth Circuit panel found that Interstate, too, had material unperformed obligations. Specifically, Interstate had obligations of notice and forbearance with regard to the trademarks, as well as obligations to maintain and defend the marks against infringement. Because the majority of the panel concluded that both Interstate and Lewis had material unperformed obligations, the Court held that the license agreement qualified as executory contract and, therefore, was subject to assumption or rejection under section 365 of the Bankruptcy Code.
The Interstate decision may come as a shock to licensees under perpetual licensing agreements, who may tend to view their rights as secure even in the event of the licensor’s bankruptcy. Arguably, however, the unpleasant surprise that the licensee experienced in this case was at least partially of its own making. The Eighth Circuit’s ability to distinguish this case from Exide – and thus its ability to rule that the license agreement was executory – hinged largely on the express language of the agreement stating that a breach of the quality standards provision would constitute a material breach. To avoid Lewis’ fate, prospective licensees negotiating similar agreements should keep in mind that a bankrupt licensor’s ability to later reject an agreement may well depend on which provisions the parties have decided to describe as “material.”