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 Eighth Circuit’s ruling is seemingly at odds with a 2010 decision by the Third Circuit which found an extremely similar licensing agreement to be non-executory. These decisions may signal a circuit split on the issue, and in any event, create uncertainty for licensees who have acquired perpetual licenses in connection with an asset sale, and have otherwise been operating under the licensing agreement post-closing without incident. 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. Following an anti-trust action by the United States Department of Justice, 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 licensing agreement granting 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 commenced chapter 11 proceedings in the Bankruptcy Court for the Western District of Missouri. These cases were the forerunner to Hostesses pending chapter 11 cases, which we have covered here. In 2008, Interstate sought to confirm a plan of reorganization in which it proposed to treat the licensing agreement with Lewis as an executory contract. Characterizing the licensing agreement as an executory contract meant that Interstate could assume or reject the agreement pursuant to section 365 of the Bankruptcy Code. Although Interstate initially indicated its intent to assume the licensing agreement, Lewis was concerned that Interstate might ultimately reject it. Rejection would have terminated Lewis’ licensing rights and allowed Interstate to sell or re-license the trademarks.
To protect its rights as licensee, Lewis requested a declaratory judgment from the Bankruptcy Court that the licensing 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, find contracts to be executory if both the debtor and the non-debtor counterparty have material unperformed obligations under the contract. Lewis contended that both parties had substantially performed their obligations under the licensing 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 licensing agreement constituted an executory contract. Accordingly, 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 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 licensing agreement.
In an attempt to overcome the finding of the District Court below, Lewis cited a 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. Although bankruptcy courts often find licensing agreements to be executory, Exide appeared to create an exception for perpetual licenses arising in the context of an asset sale. At issue in Exide was the sale of Exide’s industrial battery business to EnerSys. As part of the larger sale transaction, Exide granted EnerSys a perpetual license that included a duty to maintain quality standards. Following the sale closing in 1991, the parties operated under the licensing agreement without incident until Exide’s bankruptcy in 2002. The Third Circuit held that this type of perpetual, royalty-free licensing agreement was not executory, because there were no material obligations left unperformed by the parties. Specifically, the Third Circuit concluded that the quality standard obligations imposed on EnerSys through the licensing agreement were insignificant in the context of the overall transaction (i.e., the sale), which was focused not on the characteristics of individual products but rather the transfer of the Exide’s entire industrial battery business.
The majority of the Eighth Circuit panel rejected Lewis’ comparison to Exide, finding that the case was distinguishable. First, unlike the parties in Exide, who had not discussed specific quality standards, Interstate and Lewis memorialized the applicable quality standards in an explicit provision of the licensing 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 licensing agreement qualified as an executory contract and, therefore, was subject to assumption or rejection under section 365 of the Bankruptcy Code.
Not all members of the Eighth Circuit panel agreed that Interstate was distinguishable from Exide. Circuit Judge Steven Colloton dissented, arguing that the majority should not have considered the licensing agreement in isolation, but rather as an integrated part of the asset purchase agreement that conveyed Interstate’s Butternut and Sunbeam operations to Lewis. Judge Colloton found that the essence of this larger, integrated agreement was the sale of Interstate’s Butternut and Sunbeam operations in specific territories, not merely the licensing of Interstate’s trademark. On this basis, Judge Colloton concluded that Interstate in particular had “substantially performed” all of its material obligations under the integrated agreement, by transferring the purchased assets to Lewis, executing the licensing agreement, and receiving the purchase price from Lewis.
In the majority’s view, Interstate’s most significant outstanding obligation was to maintain and defend the trademark. On Judge Colloton’s reading, however, the licensing agreement imposed no such obligation, but instead merely gave Interstate the right to defend the mark at its discretion. Interstate’s other outstanding obligations, as identified by the majority, were in Judge Colloton’s view too minor to be “material” when viewed in the context of entire sale transaction. Accordingly, Judge Colloton believed that the Eighth Circuit should have followed Exide and ruled that the Interstate licensing agreement was non-executory.
More often than not, bankruptcy courts consider licensing agreements “executory”. The Third Circuit’s Exide decision appeared to create an exception to this general rule with respect to “perpetual” licensing agreements executed in connection a larger sale transaction. The Eighth Circuit’s decision in Interstate seems to run counter to Exide, and may indicate a split among the circuits. Insofar as it creates uncertainty surrounding the executory status of perpetual licensing agreements, Interstate may come as an unpleasant surprise for licensees under such agreements, who likely assumed that their rights were secure even in the event of the licensor’s bankruptcy.
Arguably, however, the unfavorable outcome the licensee experienced in Interstate 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 licensing agreement was executory – hinged largely on the express contractual language 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 turn on which provisions the parties have decided to describe as “material.”
In addition, where a perpetual licensing agreement forms part of a larger asset sale, licensees may want to include language expressly identifying the licensing agreement as an “integrated” part of the other transaction documents. Including an integration clause in the licensing agreement increases the likelihood that a court will find that the parties have substantially performed their obligations under the transaction documents viewed as a whole, and that any minor outstanding obligations under the licensing agreement are immaterial.