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On February 22, 2018, the Ninth Circuit Court of Appeals – sitting en banc – issued an opinion, S&H Packing & Sales Co., Inc. v. Tanimura Distributing, Inc., where the court analyzed competing rights and obligations related to the Perishable Agricultural Commodities Act (“PACA”) and purportedly secured transactions. The court held that labeling an accounts receivable transfer as a “factoring agreement” does not ultimately determine whether the accounts receivable were actually sold for the purposes of applying the PACA statutory trust. Rather, a court is obligated to look behind the label and study the substance of the transaction, including the important issue of whether the transferee assumed the risk of non-collection. The PACA statutory trust provides powerful protection to produce growers, allowing them to collect in full even where there are insufficient funds to pay secured creditors. While the S&H Packing case did not involve a bankruptcy filing, the decision has significant implications for creditors in a bankruptcy case of a purchaser or producer of fresh fruits and vegetables.

PACA is a federal law creating a “nonsegregating floating trust” in favor of produce growers. By operation of the statute, purchasers of wholesale-quantity fresh fruits and vegetables hold proceeds for the sale of produce in trust for the benefit of growers. Trust law provides that money held in trust is the property of the trust beneficiary, and if the party holding the money (the trustee) disposes of the money in breach of the trust, the trustee is liable to the beneficiary for damages. The distinction between being a creditor versus a trust beneficiary takes on great significance when there are insufficient funds to pay all creditors. A PACA trust beneficiary can successfully argue that the debtor is holding property (that is, the proceeds of the produce sales) actually belonging to the trust beneficiary, and that the property must be handed over to the beneficiary. In contrast, a creditor can make demands to be paid, but cannot argue that the debtor is holding property belonging to the creditor. Ownership of the property likewise has implications on the rights of secured creditors. If the proceeds belong to the growers – by virtue of the PACA trust – the proceeds do not belong to the debtor. It follows that any lien held by a secured creditor cannot attach to the proceeds. For these reasons, PACA trust beneficiaries are entitled to be paid in full before secured creditors. In addition, if the debtor breached the PACA trust by using PACA proceeds to pay a secured creditor, the PACA beneficiary (under certain circumstances) is entitled to demand payment of such misdirected funds from the secured creditor.

Courts have recognized that produce purchasers (i.e., PACA trustees) are entitled to sell PACA trust property under certain circumstances without breaching the PACA trust. It is well-accepted that if a PACA trustee sells produce on credit, the resulting accounts receivable become PACA trust assets. It is also well-accepted that if such accounts receivable are sold to a third party (a factor) for cash at a discount, the transaction is not a breach of the PACA trust. In that situation, the factor takes the accounts receivable free and clear of the PACA trust, which attaches to the proceeds of the accounts receivable sale. The situation changes, however, if the factor is deemed a lender who provided money to the PACA trustee and took a security interest in the accounts receivable to secure re-payment of the loan. Such accounts receivable remain subject to the PACA trust. The difference between a factor and a secured lender, and the resulting implications under PACA, were the issues presented to the court in the S&H Packing court.

In the S&H Packing case, certain growers sold produce on credit to distributor Tanimura Distributing, Inc. Tanimura sold the produce on credit to third parties, thereby generating accounts receivable. The accounts receivable were transferred by Tanimura to AgriCap Financial under an agreement labeled a “Factoring Agreement.” Pursuant to the Factoring Agreement, AgriCap provided cash to Tanimura at a significant discount from the face value of the accounts receivable. The transaction had other indications that, considered in the aggregate, indicated it was more than a mere factoring arrangement. AgriCap took a security interest in the accounts receivable and in all other assets of Tanimura, with the exception of inventory. In addition, AgriCap was entitled to force Tanimura to “repurchase” the accounts receivable in the event AgriCap was unable to collect.

Tanimura’s business later failed and it was unable to pay the growers in full. The growers sued AgriCap, arguing that the Factoring Agreement was actually a secured lending arrangement rather than a “true sale,” and that the accounts receivable therefore were subject to the PACA trust. AgriCap responded by citing to a 2001 Ninth Circuit case – Boulder Fruit Express & Heger Organic Farm Sales v. Transportation Factoring, Inc. – where the court held that a PACA trustee may remove assets without breaching the trust as long as the transaction was commercially reasonable. The Boulder Fruit case was notable because it did not require an analysis of whether a true sale actually occurred before analyzing whether the transaction was commercially reasonable. This was in contrast to decisions in the Second, Fourth, and Fifth Circuits where the courts required such an initial true sale analysis.

Based on its commercially reasonable argument, AgriCap prevailed on summary judgment at the district court and at a three-judge panel of the Ninth Circuit. The growers requested that the Ninth Circuit hear the matter en banc, based on the circuit split in the law. The Ninth Circuit agreed and the matter was heard before eleven Ninth Circuit judges. The court noted the Boulder Fruit decision, but determined that “the weight of authority and reasoning” required that true sale and transfer of risk “considerations should be assessed before considering the commercial reasonableness when considering the propriety of a transfer of trust assets.” The court set forth a multi-step analysis that is illustrated by the following flow chart:

PACA Chart

The court cited to the following factors for analyzing the transfer of risk: “(1) the right of the creditor to recover from the debtor any deficiency if the assets assigned are not sufficient to satisfy the debt, (2) the effect on the creditor’s right to the assets if the debtor were to pay the debt from independent funds, (3) whether the debtor has a right to any funds recovered from the sale of assets above that necessary to satisfy the debt, and (4) whether the assignment itself reduces the debt.”

The majority of the S&H Packing court (eight judges) concluded that such a true sale analysis must be conducted prior to analyzing the commercial reasonableness of the transaction, thus overruling the Boulder Fruit decision and aligning the Ninth Circuit with the Second, Fourth, and Fifth Circuits. The matter was remanded back to the district court to conduct the analysis.

Factors, asset-based lenders, and other creditors should each take heed of the required analysis in the S&H Packing case and the potential implications if a PACA trustee files bankruptcy. The absolute priority rule is a fundamental tenet of bankruptcy law and requires that higher priority creditors must be paid in full before any money flows down to junior creditors. The claim priority hierarchy is: secured claims (up to the value of the collateral), administrative expense claims, priority claims, general unsecured claims, and equity interests. As discussed above, trust fund law allows a trust beneficiary to sidestep the entire claim priority hierarchy and demand payment based on the argument that the debtor/trustee is holding the beneficiary’s property. Secured creditors who believed that the value of the collateral exceeded the loan balance may in fact find there is much less non-trust cash to make them whole. General unsecured creditors may discover that, although the debtor appears to be a going concern enterprise, it lacks the assets to pay anything at all on their claims. In the case of a factoring agreement, this important issue will not turn on the words in the title of the agreement. Rather, the matter will turn on the substance of the agreement, and whether the accounts receivable were truly sold.

For more information on PACA and statutory trust fund claims in bankruptcy, please see the full-length law review article co-authored by Jason Binford, Farmer Favoritism: Statutory Protections for Creditors in Agricultural Bankruptcy Cases, 46 Tex. Tech. L. Rev. 337 (2014).

The First Circuit Court of Appeals in the recent case Mission Product Holdings, Inc. v. Tempnology, LLC refused to recognize certain protections for trademark licensees when the licensor files bankruptcy and seeks to reject the license. Rejection is a bankruptcy term of art and refers to the ability of a debtor, pursuant to Bankruptcy Code section 365, to free itself of obligations in agreements including licenses. Normally, the non-debtor party to a rejected agreement retains no post-rejection enforcement rights. Section 365(n) acts as an exception to the general rule by providing certain post-rejection enforcement rights to licensees of rejected intellectual property licenses. The practical effect of the January 12, 2018 Tempnology decision is that in the First Circuit, and in any other jurisdiction choosing to follow the case, the 365(n) protections are not afforded to trademark licensees. Thus, a trademark licensor may use a bankruptcy filing to effectively erase the bargained-for rights granted under the license to the licensee. The decision adopts a harder line than a handful of recent decisions in other jurisdictions and provides a great deal of pre-bankruptcy negotiating leverage to a trademark licensor where the relationship between the licensor and licensee has become strained. Trademark licensees should take heed that the strategic alternatives available to a licensor are not necessarily limited to the terms found in the licensing agreement.

The Tempnology case involved Tempnology, LLC, a company that manufactured athletic sportswear and licensed related rights. In 2012, Tempnology entered into a Co-Marketing and Distribution Agreement (the “Agreement”) with Mission Product Holdings, LLC that provided Mission with a number of different rights in relation to Tempnology’s products and intellectual property. The rights included: (i) manufactured product distribution rights; (ii) a nonexclusive, irrevocable, perpetual license to Tempnology’s intellectual property, with a specific exclusion of trademark rights; and (iii) a much more limited nonexclusive trademark license. The Agreement permitted termination without cause by either party. In 2014, Mission exercised the termination clause and initiated a two-year “wind-down” period. Tempnology responded by immediately terminating the agreement for cause, based on Tempnology’s allegations that Mission violated a restrictive covenant in the Agreement by hiring Tempnology’s former president. The parties took the matter to arbitration, resulting in a decision in favor of Mission. Therefore, under the wind-down provisions, Mission retained distribution and trademark licensing rights until July 1, 2016 and retained other nonexclusive intellectual property rights in perpetuity.

Tempnology’s next move was to file Chapter 11 bankruptcy on September 1, 2015 and immediately seek rejection of the Agreement under section 365 of the Bankruptcy Code. Section 365 permits any debtor to either assume or reject agreements such as licenses. If the debtor elects to assume, it must pay past due amounts owing under the agreement and must commit to performing under the agreement going forward. If a debtor choses rejection, the debtor frees itself of the contractual obligations. Generally speaking, a debtor seeking to reject an agreement need only file a motion stating that the agreement is burdensome to the debtor’s bankruptcy estate and asking the bankruptcy court to enter an order providing for its rejection. Following rejection, the non-debtor party’s remedies are limited to filing a general unsecured claim asserting the monetary damages related to the debtor’s breach and failure to perform under the agreement. Depending on the case, general unsecured claimants may receive much less than the face value of their claims.

Section 365(n) sets forth an exception to the general rule that non-debtor parties to rejected license agreements have no post-rejection enforceable rights against the debtor. The section states that for certain intellectual property licenses, the licensee may elect to retain rights under the agreement, including the enforcement of exclusivity provisions, for the remaining term of the agreement. Prior to the enactment of section 365(n) in 1988, a licensor had the power to essentially run a licensee out of business by filing bankruptcy and rejecting the license. This was precisely the result in a 1985 Fourth Circuit patent licensor case, Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. Congress took note of the harsh licensee outcome in the Lubrizol case and further recognized that licensees of intellectual property often build their entire business around the licensing rights. The section 365(n) protections were designed as a response to adjust the balance of power between licensors and licensees.

The statute is tied to licenses of “intellectual property,” as that term is defined in the Bankruptcy Code. The Bankruptcy Code definition broadly includes a number of different types of intellectual property, such as patents and copyrights. The statutory definition does not, however, include trademarks. The legislative history of the statute indicates that this was a purposeful omission, based on a determination that trademarks serve different purposes and otherwise operate differently than other types of intellectual property. For example, while trademarks provide economic benefits to a licensor (just as copyrights and patents provide licensor economic benefits), trademarks also serve a public purpose by indicating the quality and consistency of a product. In addition, trademark licensing requires the licensor to remain actively involved by monitoring and exercising control over the quality of the trademarked goods.

In the Tempnology case, Mission argued that section 365(n) allowed for the post-rejection enforcement of both its distribution rights and its trademark licensing rights. The bankruptcy court disagreed, holding that the distribution rights were not intellectual property rights under the facts of the case and also holding that 365(n) did not apply to trademarks under the terms of the statute. Mission appealed to the First Circuit Bankruptcy Appellate Panel (the “BAP”). The BAP affirmed the bankruptcy court’s decision regarding the distribution rights. As to the trademark licensing rights, however, the BAP followed the reasoning from a 2012 Seventh Circuit case, Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC. The Sunbeam court recognized that 365(n) by its terms did not apply to trademark licenses, but the court did not end its analysis at that point. The court pointed out the well-accepted view that a license rejection acts as a legal breach, not a termination, of the agreement. In the words of the Sunbeam court, rejection does not “vaporize” a licensee’s rights and the non-debtor licensee thus may retain certain enforcement rights. To that point, outside of the bankruptcy context, a licensor’s breach of a trademark license agreement does not mean that the licensee no longer has any rights in the license. In fact, state law provides a number of licensee remedies short of termination. The same logic set forth in the Sunbeam case was also set forth in a concurring opinion by Third Circuit Judge Thomas Ambro in the 2010 case, In re Exide Technologies. Based on this reasoning, the BAP therefore reversed the bankruptcy court’s decision that Mission no longer had any post-rejection enforcement rights under the trademark license.

Tempnology thereafter appealed to the First Circuit. The court took up both the issues of whether the exclusive distribution rights and the trademark licensing rights were the types of rights protected under 365(n). Mission noted in its arguments that the language of section 365(n) specifically states that the rights preserved include “a right to enforce any exclusivity provision” in a license of intellectual property. The First Circuit, however, pointed out that the exclusivity at issue in the case related to exclusive distribution rights, rather than exclusive licensing rights. The fact that the distribution rights were found within the same agreement as other intellectual property licensing rights was not relevant to the court. Because the exclusivity related to the sale of products, as opposed to the licensing of intellectual property related to the products, the First Circuit agreed with the bankruptcy court and the BAP that 365(n) did not provide Mission with any post-rejection right to enforce such rights.

As to the trademark license, the First Circuit refused to follow the reasoning set forth in the Sunbeam case. The First Circuit disagreed with the characterization that refusing to apply section 365(n) would “vaporize” a trademark licensee’s rights. The licensee continued to have rights, the court noted, but the rights were limited to filing a claim for rejection damages. The court further noted that the purpose of rejection under the Bankruptcy Code is to free a debtor of costly obligations and that this purpose would be thwarted if a trademark licensor debtor were required to deal with post-rejection assertions of rights by the licensee. The First Circuit also held that Congress clearly left trademark licenses out of the rights protected under section 365(n) and that it was not a court’s place to essentially write such protections into the statute. Mission therefore was left with no enforceable distribution or trademark licensing rights under the Agreement.

Rejection of a license agreement under section 365 of the Bankruptcy Code only is available to a licensor if the licensor files for bankruptcy. Bankruptcy can be chaotic and unpredictable. The myriad of other financial matters at issue may not reasonably allow a licensor to choose bankruptcy solely as a means to free the licensor of its obligations under a trademark license agreement. But, it does happen. The debtors in both the Lubrizol and the Tempnology cases appear to have been primarily motivated by the desire to reject a license. Trademark licensees should therefore be aware that licensor bankruptcy represents a realistic threat to the licensee’s ability to continue to enforce its valuable rights. In the First Circuit (covering the states of Maine, New Hampshire, Massachusetts, and Rhode Island), the Tempnology case seems to settle the issue. It should be noted, however, that the Tempnology case included a dissent from Judge Juan Torruella where he sided with the logic set forth in the Sunbeam and Exide cases. In other words, reasonable and sophisticated minds continue to differ on the important issue of post-rejection enforceability of trademark licenses. Licensees outside of the First Circuit may find that point useful in both negotiation and litigation contexts.

Creditors lacking liens to secure their claim can fare poorly in a bankruptcy case. The “absolute priority rule” is a bedrock principle of bankruptcy law and provides that a creditor at a particular rung of the claim priority hierarchy must be paid in full before any money flows down to junior creditors. Secured creditors reside near the top of the hierarchy, followed by administrative expense claimants, priority claimants and general unsecured creditors. In many cases, there is insufficient money to pay secured creditors in full, thus leaving general unsecured creditors with no recovery at all. In other cases, the funds flowing to general unsecured creditors are sufficient to pay only pennies on the dollar. Because of this dynamic, creditors are incentivized to argue that their claim should be classified as high up the hierarchy as possible. There are, however, exceptions to the claim hierarchy rules. Bankruptcy Code section 503(b)(9) provides an administrative expense claim to vendors for the value of goods they delivered to the debtor within 20 days prior to the bankruptcy filing. The case In re SRC Liquidation, LLC, decided in July 2017 by the Bankruptcy Court for the District of Delaware, makes clear that section 503(b)(9) claim rights will be strictly construed to goods that are physically provided to the debtor.

In order for any Chapter 11 plan to be confirmed, administrative expense claims must be paid in cash in full. Generally speaking, administrative expense claims are claims related directly to administering the bankruptcy case. Examples include fees payable to the United States Trustee and fees payable to professionals such as debtor counsel and creditor committee counsel. However, Congress has also used administrative expense claims as a tool for pulling certain types of unsecured claims to the top of the claim hierarchy. This includes section 503(b)(9) claims. Unless otherwise ordered by the court, suppliers of the applicable 20-day goods are not required to file a notice or to take any other action. Rather, they automatically are entitled to be paid in full for such 503(b)(9) claims.

The prospect of paying in full in cash for all 20-day goods can be daunting for a cash poor debtor. This is especially the case for large retailers where the total amount owed on account of such goods can be a very large amount. In addition, paying 503(b)(9) claims in full may mean that there is much less available to pay other creditors. Therefore, both the debtor and other parties in interest may be highly motivated to argue that certain creditors asserting 503(b)(9) claims do not, in fact, qualify under the statute. These dynamics were squarely in play in the SRC Liquidation case. The case involved a debtor who had purchased goods from vendor International Imaging Materials, Inc. (“IIMAK”). In the ordinary course of the debtor and IIMAK’s business, IIMAK would ship certain goods directly to the debtor, and would “drop ship” other goods by sending them directly to the debtor’s customers. The dropped shipped goods were sent via common carrier UPS.

IIMAK asserted that it was entitled to a 503(b)(9) administrative expense claim for all goods shipping within 20 days prior to the debtor filing bankruptcy. Another party in the case, Standard Register, Inc. (“SRI”) argued that the $44,439.78 worth of drop shipped goods did not qualify under section 503(b)(9) because the debtor never actually took possession of the goods. In other words, the good were not “delivered to” the debtor, as that term is used in the statute. IIMAK argued in response that the debtor was in constructive receipt of the goods and also that the court should consider issues related to when title to the goods passed, rather than whether or not a debtor took physical possession.

The court began its analysis by noting that administrative claims such as 503(b)(9) claims are “discrete exceptions to the general equality principal” that similarly situated creditors (i.e., unsecured creditors) should be treated the same. Because these claims are exceptions to the general rule, the court reasoned, they must be “strictly construed and be clearly authorized by Congress.” The court noted that section 503(b)(9) claims were created in 2005 by the Bankruptcy Abuse Prevent and Consumer Protection Act, in conjunction with amendments to reclamation rights under section 546(c). Thus, the concept of whether goods are “received” for the purposes of reclamation bears directly on the same issue for section 503(b)(9) claims. Reclamation, in turn, is based on Article 2 of the Uniform Commercial Code; specifically, U.C.C. § 2-705(2). The court noted that the well-accepted view under the U.C.C. is that goods must be in a party’s physical possession to be received. For the same reason, the court held that passage of title was not relevant. The court stated that “the U.C.C. does not rely on the concept of title for the purposes of establishing rights of buyers and sellers: possession is the key.” Finally, the court analyzed whether providing the goods to a common carrier could be considered passage to the debtor under the argument that the common carrier was the debtor’s agent. The court did not accept that argument given prior Third Circuit law that common carriers cannot qualify as debtor agents for the purposes of section 503(b)(9).

Section 503(b)(9) claims, like reclamation claims, are designed in part to provide assurances to vendors in an attempt to prevent a bankruptcy filing in the first place. That is, if a vendor has some degree of assurance that it will be paid, the vendor may not take drastic action such as requiring its customer to make payment in advance of shipping the goods. Alternatively, without such assurances, financially troubled companies would be driven quickly into bankruptcy by vendors who refuse to extend any credit. The SRC Liquidation case provides some additional guidance to vendors on when they will, and when they will not, be entitled to the protection of administrative expense priority. Clearly, concerned vendors should be wary of drop shipment. In addition, if it is commercially unreasonable to avoid drop shipments, a vendor might consider exploring the use of a private (rather than common) carrier who could legitimately be considered an agent of the debtor. Being aware of this issue, and taking proactive steps, could make a significant difference between being paid in full versus being left with little to no recovery.

A recent decision by the Ninth Circuit Court of Appeals has fanned the smoldering dispute among courts regarding the scope of asset sales in bankruptcy. In the In re Spanish Peaks Holdings II, LLC decision, the Ninth Circuit affirmed a lower court’s holding that sale of commercial real estate can, in certain circumstances, be free and clear of all liens, claims, encumbrances, and interests, including a leasehold interest. In other words, a tenant of a bankrupt landlord could find itself with no interest in the property following the sale. The case addresses apparent tension between two different sections of the Bankruptcy Code. Bankruptcy Code section 363(f) permits free and clear sales, subject to certain important requirements that must be established by the moving party. Bankruptcy Code section 365(h) provides protections to non-debtor tenants, including allowing tenants to retain possession of the property following a bankrupt landlord’s rejection of the lease. For commercial tenants, the Spanish Peaks case reinforces one of the oldest and most important adages in bankruptcy law: timely assert your rights, or risk losing your money and/or your property.

The Spanish Peaks case involved Spanish Peaks Holdings, LLC (“SPH”), a private resort in Montana that filed Chapter 7 bankruptcy in October of 2011. Among SPH’s assets were developed parcels of real estate that SPH leased to other entities (the “tenants”) for operation of two restaurants. SPH’s principal was also an officer of both tenant entities and the leases were very favorable to the tenants, including rent that was a fraction of the market rate. The real estate was fully encumbered by the lien of a bank, which was significantly undersecured.

The Chapter 7 Trustee sought to sell the real estate free and clear of “any and all liens, claims, encumbrances, and interests.” It was clear based on the pleadings that the Trustee included the leasehold among the interests that would be shed upon the closing of the sale. The tenants objected to the sale, arguing that section 365(h) protected their possessory interests in the property. Importantly, no memorandum of lease was recorded in the real property records and the leases, by their terms, were not protected from foreclosure by virtue of subordination or non-disturbance agreements. After a two-day hearing on the matter, the bankruptcy court authorized the sale free and clear, on the grounds that the Trustee had met the applicable requirements under section 363(f). The bankruptcy court also noted that the tenants had not requested adequate protection of their leasehold interests, as they were entitled to do under Bankruptcy Code section 363(e).

The district court affirmed. On appeal to the Ninth Circuit, the tenants argued that section 365(h), rather than 363(f), should govern their rights with respect to the real estate. The tenants separately argued that none of the subsections of 363(f) applied to these facts. The Trustee responded that section 365(h) did not apply because the Trustee was seeking to sell, rather than to reject, the lease. Furthermore, the Trustee argued that section 363(f)(1) authorized a free and clear sale. Specifically, section 363(f)(1) states that such a sale will be permitted if “applicable nonbankruptcy law permits sale of such property free and clear of such interest.” The Trustee pointed out that if the bank had foreclosed on the real estate under state foreclosure law, it would have terminated the lease.

The court analyzed decisions from other jurisdictions and noted the view of a majority of courts is that section 365(h) would protect a tenant’s possessory interests in these circumstances. The only other Circuit Court to address the issue, however, was the Seventh Circuit in the 2003 decision Precision Industries, Inc. v. Qualitech Steel SBQ, LLC.  The Qualitech Steel court held that section 363, not section 365, governed and that therefore a sale could be free of a leasehold interest, as long as one of the elements of section 363(f) is established. The Qualitech Steel case also made clear that, while this result may appear to treat a non-debtor tenant harshly, the tenant can protect itself by demanding adequate protection under section 363(e).

The Spanish Peaks court adopted the “minority” approach as set forth in the Qualitech Steel case.  The court noted that no party was seeking to reject the lease, and therefore section 365 did not apply. The court also agreed that foreclosure law could be relied upon to meet the section 363(f)(1) free and clear sale requirement. In addition, the court pointed out that section 363(e) provides a “powerful check on potential abuses of free-and-clear sales” and that, depending the circumstances, adequate protection could include permitting the tenant to remain in the premises. In this case, however, the tenants did not raise the issue of adequate protection until the appeal.

It should be noted that, while the Spanish Peaks and Qualitech Steel positions on this issue remain among the minority of courts to consider it, none of the majority viewpoint courts are circuit courts. This raises the interesting issue of how a bankruptcy court outside the Ninth or Seventh Circuit should consider the issue when presented with a motion to sell real estate and the real estate happens to be located within one of those circuits. Such a scenario would not be unusual due to the national nature of many retail bankruptcy cases. Given the well-accepted Supreme Court precedent (from Butner v. United States, among others) that state law governs property interests in bankruptcy cases, such a bankruptcy court would probably be on solid legal ground to consider state real property law in interpreting section 363(f), rather than relying on the Spanish Peaks or Qualitech Steel analysis.

It should be further noted that, given only a few changes in the facts, the Spanish Peaks case likely would have turned out very differently. Clearly, if the tenants had raised the issue of adequate protection at the trial (bankruptcy court) level, the tenants would have received something on account of their interest, up to and including remaining in possession. Also, if memoranda of the leases were recorded, or if the leases included subordination or non-disturbance agreements, then the Trustee likely would have been unable to use section 363(f)(1) to sell the real estate free and clear. In that circumstance, however, the Trustee may still have been able to sell the property free and clear under section 363(f)(4) by arguing that the self-dealing nature of the leases made them subject to a bona fide dispute.

The very significant issue in both the Spanish Peaks case and the Qualitech Steel case was that the tenants did not timely assert all of their rights under the Bankruptcy Code. Bankruptcy sales can move very quickly. Tenants are well advised to pay close attention and to make each and every argument available to protect their valuable leasehold interests.

Last week, the United States Supreme Court issued a decision dealing with the doctrine of “patent exhaustion.”  The case dealt with the sale of a patented product and the degree of control a patent holder (known as a patentee) can, or cannot, exercise over the product following the initial sale.  The case did not involve a patent license, but the Supreme Court discussed patent exhaustion in the context of licensing as well.  While the case dealt with the rather prosaic issue of printer cartridge sales, the broader issue of patentee control has wide-ranging implications on supply chain commerce.  The case did not involve bankruptcy law.  But, because this is a bankruptcy law blog, the case provides an opportunity to explore the issue of how intellectual property rights are affected by a bankruptcy filing.

The case, Impression Products, Inc. v. Lexmark International, Inc., involved printer manufacturer Lexmark.  Lexmark is the patentee of patents related to printer cartridges.  The U.S. Patent Act granted Lexmark, as with any patentee, the right to exclude others from using, offering for sale, or selling its invention.  Patent restrictions are designed to temporarily provide a patentee with “monopoly” powers in order to allow the patentee to maximize its profits.  The prospect of being able to profitably exclude others from using an invention (typically for a period of twenty years) theoretically encourages parties to spend their time, effort, and money on new and useful innovations.

Lexmark’s profitable cartridge sale venture was being undercut, however, by third parties known as remanufacturers.  Remanufacturers would purchase empty cartridges from Lexmark customers, refill the cartridges, and sell them as “refurbished” for less than the cost of a new cartridge.  Lexmark sought to restrict this practice by enacting a “Return Program” that allowed a customer to buy cartridges at a lower price, in exchange for contractually agreeing not to transfer empty cartridges to anyone other than Lexmark.  Lexmark also installed a microchip in the cartridges that physically prevented reuse.  The remanufacturers developed methods to disable the microchip and Return Program customers continued to sell them the empty cartridges.  Lexmark responded by suing certain of the remanufacturers, including Impression Products, for patent infringement, arguing that the remanufacturers’ tinkering with the empty cartridges violated the terms of the Patent Act because it made use of the product in express violation of Lexmark’s prohibitions.  Lexmark also argued that the remanufacturers’ importation into the United States of cartridges purchased abroad violated the Patent Act.

Impression Products filed a motion to dismiss in the district court, which was granted as to domestic cartridge sales, but denied as to imported cartridges.  On appeal to the Federal Circuit, the court (sitting en banc) ruled in favor of Lexmark on both issues, stating that a patentee who clearly communicates restrictions can reserve the right to enforce its patent following a sale.  The issue of patent exhaustion was then taken up to the Supreme Court.  The Court noted that the doctrine of patent exhaustion has existed for over 160 years.  The doctrine provides that a “patentee is free to set the price and negotiate contracts with purchasers, but may not, by virtue of his patent, control the use or disposition of the product after ownership passes to the purchaser.”  Put another way, a patentee may restrict use of the product to the party who initially purchases the product.  But, once that initial purchaser sells the product to a third party, the patent restrictions are “exhausted” and the patentee cannot use patent law to restrict how the third party uses the product.

The policy reasoning behind the doctrine is that if a patentee were permitted to exercise its restrictive patent rights beyond the first sale, it “would clog the channels of commerce, with little benefit from the extra control that the patentees retain.”  The Supreme Court held that the application in the case was fairly simple because it was undisputed that Lexmark sold a patented product to customers and that the customers thereafter sold the product to third parties.  The fact that the second sale was contrary to the terms of the contract between Lexmark and its customers was not an issue of patent law.  Lexmark likely had a viable breach of contract claim against its customer (a claim Lexmark was unlikely to ever pursue).  But, as to its rights as a patentee under the Patent Act, which was the issue before the Court, Lexmark had no claim against the remanufacturers.  The Court therefore ruled in favor of Impression Products with respect to both the domestic and international issues.

Selling a patented product is not the only means for a patentee to maximize profits.  The patentee could, instead, enter into a license agreement whereby something less than full ownership is conveyed by the licensor/patentee to the other party (the licensee).  Licenses typically convey rights upon a licensee for a limited period of time.  The licensee agrees to use the product only in a specified way and to make royalty payments to the licensor during the term of the license.  Once again, while the Impression Products, Inc. v. Lexmark International, Inc. case involved the sale of a patented product, rather than a patent license, the Court nevertheless took the opportunity to discuss patent exhaustion in the context of licensor/licensee rights.  The Court made clear that a license is different than a sale because a patent licensor “is exchanging rights, not goods, [and thus] is free to relinquish only a portion of its bundle of patent protections.”  Therefore, if a licensee violates the terms of a patent license by, for example, selling the product in a manner prohibited by the license, the licensor can bring a patent infringement action not only against the licensee, but also against any party who knowingly violated the restrictions.  But, if the license contemplates sale of the product and the licensee sells the product in compliance with the license, the sale is considered authorized by the licensor and the patent exhaustion doctrine applies.

The Court provided the following example to illustrate patent exhaustion with respect to licenses: assume a patent licensor has licensed the manufacture and sale of computers to a licensee on the condition that the computers only be sold for commercial use.  The licensee requires all purchasers to sign a contract stating that they will only use the purchased computer for commercial purposes.  The licensee thus is in compliance with the license as each sale is made.  In other words, the law views each sale as authorized by the licensor.  Thereafter, if a customer who purchased the computer violates his contract with the licensee by making non-commercial use of the computer, the licensor has no recourse under patent law against the customer because the licensor’s patent rights were exhausted by the authorized sale.  The licensee would have a breach of contract claim against the customer, but no viable patent infringement claim would exist.

The Impression Products, Inc. v. Lexmark International, Inc. case did not involve a bankruptcy filing or otherwise involve the application of bankruptcy law to intellectual property rights.  Because bankruptcy and intellectual property law issues are complicated, and subject to a number of different exceptions to the general rules, the matter deserves its own blog post (coming soon).  That said, the case should lead patentees to carefully review their sale agreements and licenses to determine what restrictions may and may not be enforceable under patent law.  As part of that review, patentees, as well as other owners of other intellectual property (including copyrights and trademarks), should also be mindful of how a bankruptcy filing may affect intellectual property rights, including the licensor’s ability to control the use and assignment of their property.

Bankruptcy cases very often deal with the going concern sale of a business free and clear of all liens, claims, and encumbrances under Bankruptcy Code section 363.  In fact, obtaining the clean title associated with such “free and clear” sales can be the primary motivation for a company (known as the “debtor”) to file bankruptcy.  Bankruptcy provides a forum for parties to assert rights in the debtor’s property, such as lien rights or rights under intellectual property law to restrict the use or assignment of the property.  Intellectual property issues arise just about every time a business is sold substantially intact.  These issues affect every industry, from computer software licenses to oil refinery processes.  While the intersection of bankruptcy and intellectual property law can give rise to many and complicated matters, a few important issues stand out.

First, a licensor cannot simply contract around the problem of a bankruptcy filing by including a term stating that the license automatically terminates upon the licensee filing bankruptcy.  Such clauses are deemed “ipso facto” clauses and they are unenforceable under bankruptcy law.  Second, bankruptcy law has the potential to affect the licensor’s ability to prevent the assignment of the license.  The general rule under bankruptcy law is that clauses prohibiting assignment are not enforceable in bankruptcy.  There is a significant exception to the general rule providing that if “applicable law” allows the non-bankrupt party to refuse to accept services under the agreement from anyone other than the original party, then the non-bankrupt party can prohibit an assignment.  Licensors of patents, copyrights, and trademarks have generally been successful at citing to federal intellectual property law statutes (the Patent Act, the Copyright Act, and the Lanham Act) as applicable law that allows the licensor to prevent assignment by a bankrupt licensee to another party.  But, depending on the jurisdiction, the case law is not entirely clear on the point.  In addition, a licensor must assert its rights in order to enforce the restrictions.  Bankruptcy cases can move quickly and a licensor who does not understand the issue and who does not raise it quickly, can find itself bound by bankruptcy court order to a license with an undesirable assignee.

The assignment issue also has the potential to provide licensors with incredible leverage over a bankrupt licensee, even if the licensee has no intention of assigning the license.  Due to a linguistic ambiguity in the Bankruptcy Code, courts in a number of jurisdictions have held that if applicable law would prohibit assignment of a license, then the license cannot be assumed in the bankruptcy case, even if the licensee never sought to assign the license in the first place.  Assumption is a bankruptcy law term of art meaning that the bankrupt party has agreed to comply with the terms of an agreement (such as a license) going forward.  Depending on the facts, a licensee prohibited from assuming a license may be unable to reorganize in bankruptcy and essentially would be driven out of business for that reason alone.

As to the issue of control, the Impression Products, Inc. v. Lexmark International, Inc. case tips the scales against patentees, at least with respect to using patent law to enforce rights against subsequent purchasing parties.  In the context of a bankruptcy filing, control – and therefore leverage – has the potential to swing back and forth between the bankrupt and non-bankrupt party, depending on things such as applicable non-bankruptcy law, where the case was filed, and the degree of engagement by the respective parties.  The ultimate lesson of the case is that paying attention to and understanding these issues is critically important in order to maximize a party’s rights under the law.

A financially distressed company seeking refuge in Chapter 11 bankruptcy can take advantage of rights and remedies that are unavailable anywhere else. Need to stop a state court lawsuit in its tracks? Bankruptcy and the imposition of the automatic stay can do that. Need to force a lender or a trade creditor to accept worse treatment that what was originally agreed? Confirm a “cram down” plan of reorganization over the other party’s objection and emerge from bankruptcy with a new and enviable balance sheet. Need a particular agreement to effectively operate your business, but the counterparty terminated the agreement prior to the bankruptcy filing? If the agreement truly was terminated, then a bankruptcy filing will offer the debtor no succor. The power of Chapter 11 may heal the financially lame, but it cannot resurrect a dead contract.

A debtor’s ability to continue operating under the terms of an agreement can make the difference between whether a Chapter 11 bankruptcy makes sense in the first place. Understanding a few basic bankruptcy concepts and terms is necessary to set the stage. First, an agreement between a debtor and non-debtor party that has material unperformed obligations by both parties as of the date of the bankruptcy filing is called an “executory contract.” Bankruptcy provides debtors with the ability to either assume or reject an executory contract or a lease. Assumption and rejection is a very important part of most every bankruptcy case. Consider, for example, a retailer that is party to supply agreements vendors in several different regions of the country. Business is great in one region, and terrible in another region. The retailer may decide to make use of Chapter 11 by seeking to assume the supply agreements in the good region and rejecting the agreements in the bad one. Assumption of the agreements will require the debtor to pay the non-debtor party any past due amounts and further to provide each non-debtor party with adequate assurance of future performance. Essentially, the debtor must demonstrate to the other party that it will have the financial wherewithal to perform going forward. As to the rejected agreements, the non-debtor party will have a claim related to the lost income it expected to receive over the remaining life of the agreement (in other words, breach of contract damages). But, such damages are deemed to be merely unsecured claims and in many cases unsecured claims are paid at pennies on the dollar. Generally speaking, the same rules apply to real property lease assumptions and rejections, although there is a statutory cap that limits lease rejection damages to the greater of one year of rent or 15% of the remaining lease term rent, not to exceed three years’ worth.

A debtor is not required to make the assumption/rejection decision immediately following the bankruptcy filing. Rather, in a Chapter 11 case, the debtor can delay the decision until confirmation of a plan. Depending on the case, plan confirmation make time quite some time. During the period prior to assumption or rejection, the non-debtor party is required to continue performance. The debtor, for its part, is not strictly required to perform under the agreement, but is required to pay the non-debtor party the value for the benefits provided to the bankruptcy estate. While the benefit to the estate is not necessarily the same as the payment terms under the agreement, in practice debtors typically continue to pay the non-debtor party under those terms.

During the pre-assumption/rejection time period, the non-debtor party is therefore protected from the standpoint of continuing to receive payments. However, the non-debtor party must deal with the uncertainty associated with not knowing whether it will remain in a long term contractual relationship with the debtor. If such uncertainty is causing actual damage to the non-debtor party’s business (as opposed to merely nervousness or inconvenience), the non-debtor party’s remedy is to seek an order from the bankruptcy court compelling the debtor to decide whether to assume or reject the agreement. In addition, the Bankruptcy Code provides additional “safe harbor” rights to non-debtor parties (which will be the subject of a future blog post) in relation to certain types of financial and commodity agreements. Safe harbor provisions allow the non-debtor party to terminate or otherwise enforce agreement terms in a manner unavailable to non-debtor parties of typical executory contracts.

Only executory contracts that are property of a debtor’s bankruptcy estate are subject to assumption or rejection. An agreement becomes property of the estate if the debtor had any interest in the agreement as of the bankruptcy filing. Thus, for example, if the non-debtor party sends the debtor a default letter with a ten day cure period and the debtor files bankruptcy on day nine, the bankruptcy filing stops the clock and the agreement becomes part of the bankruptcy estate. Likewise, if the agreement has a provision that it automatically terminates upon a bankruptcy filing, it still becomes part of the estate because such “ipso facto” clauses are not enforceable in bankruptcy.

If, however, the debtor files on day eleven following a ten day cure period, then the agreement terminated according to its terms prior to the bankruptcy filing and it does not become property of the bankruptcy estate. The debtor will have no rights under the agreement and the non-debtor party will not be bound by the automatic stay (although many non-debtors in such a situation nevertheless seek stay relief out of an abundance of caution). Note, however, that the situation may not be as clear-cut as it seems. For example, if the non-debtor party continued to act as though an agreement existed following the termination, a bankruptcy court could find that some sort of enforceable agreement between the parties existed as of the filing date. The non-debtor party should also be mindful of a waiver argument. That is, if the termination date passes and the non-debtor party takes no action to enforce the termination, then the debtor may argue that the non-debtor waived its rights and the agreement remained in existence at the time of the filing.

This dynamic gives rise to a number of strategic considerations. On the debtor side, quickly filing bankruptcy before the non-debtor can effectuate a termination may be one of the best decisions a debtor makes. On the other side, a non-debtor seeking to avoid several months of dealing with a bankruptcy case will want to fully and finally terminate an agreement well before a prospective debtor wakes up to the severity of the situation. The party who realizes what is at stake and takes decisive and effective action likely will be the one with the upper hand. The general takeaway for debtors and non-debtors alike is to read and understand the contract, determine whether it may qualify for safe harbor protections, don’t sleep on your rights, and understand that delaying the exercise of your rights is risky business.