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Third Circuit’s Hypothetical Test Wins The Day As Bankruptcy Court Grants Donald And Ivanka Trump Relief From The Automatic Stay

In re Trump Entm’t Resorts, Inc., No. 14-12103 (KG), WL (Bankr. D. Del. Feb. 20, 2015)

On February 20, 2015, the Honorable Kevin Gross granted relief from the automatic stay so that Donald and Ivanka Trump (the “Trumps”) may continue their action against Trump Entertainment Resorts, Inc. and certain affiliated debtors (the “Debtors”) seeking to terminate a trademark license agreement (the “Trademark License Agreement”) and remove, among other things, the “Trump” name from the Debtors’ buildings.  Following Third Circuit precedent, Judge Gross ruled that under the “hypothetical test” the Trademark License Agreement could not be assumed or assigned by the Debtors under Bankruptcy Code section 365(c)(1), and therefore, “cause” existed under section 362(d)(1) to grant stay relief.

Under the Trademark License Agreement, which was assigned by the Trumps to Trump AC, a royalty-free, exclusive, and perpetual license to use the Trumps’ name and likeness was granted to the Debtors.  The agreement prohibits the Debtors from assigning their rights under the agreement without the prior written consent of Trump AC.  Notwithstanding, the Trumps, the Debtors, and the Debtors’ first lien lender entered into a subsequent Consent Agreement, which allows for the transfer of the Debtors’ licensee rights under the Trademark License Agreement “upon and following” the first lien lender instituting an enforcement action to pursue its collateral under its prepetition credit agreement with the Debtors.

Prior to the petition date, Trump AC initiated an action in state court seeking to terminate the Trademark License Agreement following the Debtors’ alleged breaches thereof.  When the Debtors filed their Chapter 11 petitions, the automatic stay halted the state court litigation.  Thereafter, Trump AC filed its motion seeking relief from the automatic stay.  The Debtors have opposed the motion and proposed a plan contemplating the assumption of the Trademark Licensing Agreement.

As an initial matter, the Bankruptcy Court found that Trump AC did not meet the three-pronged Rexene balancing test relied upon by courts in this Circuit to determine whether “cause” exists to lift the automatic stay under section 362(d)(1).  Izzarelli v. Rexene Prods. Co. (In re Rexene Prods. Co.), 141 B.R. 574, 576 (Bankr. D. Del. 1992) (balancing prejudice, hardship, and the probability of success).  According to the Court, Trump AC failed to demonstrate significant hardship from a continued stay while the continuation of the state court litigation would impose a substantial burden on the Debtors’ reorganization.  Nevertheless, the Court found cause existed to grant Trump AC stay relief because the Trademark License Agreement was not able to be assumed by the Debtors during the bankruptcy proceedings absent Trump AC’s consent (which was not given).  See In re West Elecs. Inc., 852 F.2d 79, 83 (3d Cir. 1988) (holding that lack of assumability gives rise to cause).

The right of a debtor to assume an executory contract is subject to applicable law that excuses a non-debtor contract counterparty from rendering performance to an entity other than the debtor.  See 11 U.S.C. § 365(c)(1).  More specifically, if applicable law exists prohibiting the assignment of an executory contract to a non-debtor third party, then under section 365(c)(1), a debtor may not assume the contract absent consent of the non-debtor contract counterparty.  Interestingly, under the plain language of the Bankruptcy Code, such prohibition applies even if a debtor has no intention of assigning the executory contract to a third party.  In the Third Circuit, this rule has been dubbed the “hypothetical test”—if a debtor hypothetically cannot assign a contract, it may not assume it over the counter-party’s objection.  West Elecs. Inc., 852 F.2d at 83; see also In re Catapult Entm’t, Inc., 165 F.3d 747, 750 (9th Cir. 1999); but see Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997) (holding that the “actual test” is a better reading of section 365(c)(1), which turns on whether the debtor actually intends to assign the contract).

It is important to note also that if an applicable law exists that prohibits assignment (thereby necessitating consent of the non-debtor), bankruptcy courts in Delaware require that “the applicable law…specifically state that the contracting party is excused from accepting performance from a third party under circumstances where it is clear from the statute that the identity of the contracting party is crucial to the contract[.]”  In re ANC Rental Corp., 277 B.R. 226, 236 (Bankr. D. Del. 2002).  Thus, a court must ask why the applicable law prohibits the assignment and determine that it does so because the identity of the contracting party is material to the subject agreement.  See Catapult, 165 F.3d at 752.  The necessity for such an analysis stems from the inconsistency between section 365(f)(1) (subject to section 365(b) and (c), providing for the broad prohibition of contract provisions and applicable laws that prevent, restrict, or condition assignment) and section 365(c)(1) (as noted above, prohibiting assumption or assignment when applicable law excuses a party from accepting performance from or rendering performance to a new third party absent consent).  See generally id.

Applying the aforementioned rubric, the Court in Trump found that under applicable federal trademark law, “trademark licenses are not assignable in the absence of some express authorization from the licensor, such as a clause in the license agreement itself.”  Op. at *12.  Additionally, Judge Gross found that federal trademark law generally bans assignment of trademark licenses to ensure that all products bearing a licensor’s trademark are of uniform quality and that, therefore, the identity of the licensee is “crucially important.”  Moreover, the Court determined that, under the terms of Trademark Licensing Agreement, the parties expressly agreed that the Debtors could not assign their rights thereunder absent consent of Trump AC, which was not given.  And while Trump AC signed the Consent Agreement, the Court held that such agreement was contingent on future events and isolated to a specific identified assignee—the first lien lender.  Accordingly, under the section 365(c)(1) and the hypothetical test, the Debtors were not permitted to assume the Trademark Licensing Agreement and thus, Trump AC was entitled to relief from the automatic stay to pursue its action in state court.

For those readers interested in the hypothetical versus actual test under section 365(c)(1), the Supreme Court has taken notice.  N.C.P. Mktg. Grp., Inc. v. BG Star Prods., Inc., 556 U.S. 1145, 1145 (2009).  While the High Court denied certiorari in N.C.P. Marketing Group, Inc., it stated that “the meaning of § 365(c)(1) is an important one to resolve for bankruptcy courts and for businesses that seek reorganization” and the Supreme Court “should consider granting certiorari on this significant question.”  Id.