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The Delaware Bankruptcy Insider is a premier blog designed to bring its readers a comprehensive analysis of the latest Delaware corporate bankruptcy news and rulings. Brought to you by Ashby & Geddes, P.A.
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- “Straddling the Line”: Delaware Bankruptcy Court Rules That Not All Tax Liabilities Incurred During a Debtor’s Petition Year are Eligible for Administrative Expense Priority
On a Mission: Supreme Court Clarifies Effect of Rejection of Executory Contract
In Mission Prod. Hldgs., Inc. v. Tempnology, LLC, the United States Supreme Court resolved a long-standing Circuit Court split in holding that a debtor’s rejection of an executory contract does not eliminate a contract counterparty’s right to use certain debtor trademarks provided thereunder. Rather, according to the Court, following the debtor’s rejection of such contract, the counterparty retains the rights it received pursuant to the terms of the underlying agreement and applicable nonbankruptcy law.
Generally, Mission Product Holdings, Inc. (“Mission”) entered into a contract with Tempnology, LLC (the “Debtor”) whereby, among other things, the Debtor granted Mission a license to use certain Debtor trademarks. Thereafter, the Debtor filed for chapter 11 relief and sought to reject its contract with Mission. The Bankruptcy Court approved the Debtor’s rejection and held that, as a consequence of rejection, Mission’s license to use Debtor trademarks terminated. The Bankruptcy Appellate Panel reversed and found that while a rejection of an executory contract constitutes a breach of such contract, it does not terminate those rights that would survive a contract breach outside of bankruptcy. The First Circuit Court of Appeals rejected the Bankruptcy Appellate Panel’s ruling and reinstated the Bankruptcy Court’s decision. The Supreme Court granted certiorari.
In reaching its decision that the rejection of an executory contract results in nothing more than a breach of that contract (and not a termination thereof), the Supreme Court analyzed the effect of a breach under state law against the language and history of Section 365 of the Bankruptcy Code. To that end, the Supreme Court first looked to non-bankruptcy contract law and “how the law of breach works outside of bankruptcy”. Writing for the majority, Justice Kagan, explained that if a party breaches a contract, the counterparty has the option to continue or cease performance thereunder. If the non-breaching party wishes to continue utilizing its rights under the contract, it may do so. The breaching party, however, does not enjoy such a choice. Therefore, the Court reasoned, if a rejection constitutes a breach, as is the case under Section 365(g) of the Bankruptcy Code, the same result should follow in bankruptcy. That is, in bankruptcy the non-breaching party may elect its remedies following the rejection – and breach – of the contract.
Justice Kagan further explained that Section 365 of the Bankruptcy Code reflects the general bankruptcy principle that the estate cannot possess anything more than the debtor possessed outside of bankruptcy. As a result, if the pre-petition debtor entity was subject to a counterparty’s contract right, then the post-petition debtor must be as well. To find otherwise and allow rejection to serve as a termination or rescission of an agreement, the Court explained, would functionally transform rejection into avoidance – an approach that would circumvent the Bankruptcy Code’s “stringent” limits on avoidance actions.
The Court rejected the Debtor’s principal textual argument that because Section 365 of the Bankruptcy Code identifies specific categories of contracts under which a counterparty may retain contract rights (including Section 365(n) addressing licensing contracts of certain “intellectual property”, which does not include trademarks), trademark licenses are not entitled to the general rights and protections that Section 365 and the rejection-as-breach approach confers. That argument, according to the Court, pays too little heed to the main provisions governing rejection generally, and ascribes too much weight to the specific exceptions for certain executory contracts rejected in bankruptcy. The Court also shot down the Debtor’s policy argument, which contended that if rejection of a trademark licensing agreement did not terminate the counterparty’s right to use the mark, the debtor would have to choose between using its scarce resources on preserving the quality of the mark or risk losing the mark altogether. Either choice, argued the Debtor, would impede a debtor’s ability to reorganize. The Court rejected this argument and found that while a debtor’s rejection power is significant tool, a debtor is not exempt from the burdens of generally applicable law. The Court ruled that nothing in Section 365 of the Bankruptcy Code relieves a debtor of the responsibility to make difficult economic decisions concerning the preservation of the estate’s value. For a debtor to gain certain benefits under the Bankruptcy Code (such as contract rejection), there may be inescapable burdens arising from interests and expectations of non-debtor counterparties. This strive for balance runs throughout the Bankruptcy Code and, as acknowledged by the Supreme Court in the Mission decision, is reflected in Section 365’s “edict” that rejection is breach.
Takeaway: The import of the Mission holding is significant and cannot be overstated. Though framed as a question concerning the rejection of trademark licenses, the Supreme Court’s ruling has far-reaching implications for all executory contracts in bankruptcy. Because non-debtor contract counterparties may choose to continue performance and retain rights following the rejection of the underlying agreement, Debtors will need to assess the relative value (and cost) associated with the prospect of such continued performance before seeking rejection. Failure to carefully consider the ramifications of a prospective rejection may yield unintended (and costly) consequences to the estate.