Trademark Licensees Beware: The Hypothetical Test Lives On In The Third Circuit

Trademark licensees that file for bankruptcy protection face uncertainty concerning their ability to continue using trademarks that are crucial to their businesses. Some of this stems from an unsettled issue in the courts as to whether a licensee can assume a trademark license without the licensor's consent. In In re Trump Entertainment Resorts, Inc., 2015 BL 44152 (Bankr. D. Del. Feb. 20, 2015), a Delaware bankruptcy court reaffirmed that the ongoing controversy surrounding the "actual" versus "hypothetical" test for assumption of a trademark license has not abated. Applying the hypothetical test, the court granted a trademark licensor's motion for relief from the automatic stay to pursue termination of the license agreement because the license could not be assumed or assigned by the debtor under sections 365(c)(1) and 365(f)(1) of the Bankruptcy Code.

Limitations on the Ability to Assume or Assign Certain Contracts and Leases in Bankruptcy

Section 365(a) of the Bankruptcy Code allows a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume or reject most kinds of executory contracts and unexpired leases. This broad power, however, is limited with respect to certain kinds of contracts. For example, section 365(c)(1)(A) of the Bankruptcy Code provides that a trustee or DIP may not "assume or assign" an executory contract or unexpired lease if "applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession" and such party does not consent to assumption or assignment. Courts have applied this provision to a wide variety of contracts. Among these are personal service contracts, including employment agreements; contracts with the United States government, which cannot be freely assigned under federal law; certain kinds of franchise agreements; and licenses of intellectual property, which generally cannot be assigned without consent under federal intellectual property law. Thus, many debtors (especially those in the technology industry) find that their rights with respect to certain executory contracts are significantly limited.

The Statutory Muddle

Section 365(c)(1) prevents a trustee or DIP from assigning a contract without the nondebtor's consent if applicable law prevents the contract from being assigned outside bankruptcy without consent. Section 365(c)(1), however, uses the distinctive phrase "assume or assign," as opposed to "assume and assign," which would seem to mean that a trustee or DIP cannot even assume such a contract and agree to perform under it, even if the trustee or DIP has no intention of assigning the contract to a third party. Some courts construe the "assume or assign" language to mean that the statutory proscription applies to a trustee or DIP who seeks either: (i) to assume and render performance under the agreement; or (ii) to assume the agreement and assign it to a third party. Under this literal interpretation, the court posits a hypothetical question: Could the debtor assign the contract to a third party under applicable nonbankruptcy law? If the answer is no, the trustee or DIP may neither assume nor assign the contract. This approach is commonly referred to as the "hypothetical test." The Third, Fourth, Ninth, and Eleventh Circuits have adopted this approach. See In re West Elecs. Inc., 852 F.2d 79 (3d Cir. 1988); Resort Computer Corp. v. Sunterra Corp (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004); Perlman v. Catapult Entm't, Inc. (In re Catapult Entm't, Inc.), 165 F.3d 747 (9th Cir. 1999); City of Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534 (11th Cir. 1994). Other courts, having determined that the phrase "may not assume or assign" should be read to mean "may not assume and assign," apply the statutory proscription only...