By: Donald L Swanson
Can non-compete and confidentiality protections in a rejected franchise agreement be discharged in bankruptcy?
The answer is, “No,” according to In re Empower Central Michigan, Inc.[Fn. 1]
Facts
Debtor is an automotive repair shop.
Debtor operates under a Franchise Agreement with Autolab Franchising, LLC. The Franchise Agreement has a non-compete provision, and there is a separate-but-related confidentiality agreement.
Debtor files a Subchapter V bankruptcy and a Subchapter V Plan (Doc. 84). The Plan explains that:
- Debtor’s Franchise Agreement with Autolab “is untenable” and will be rejected;
- Debtor receives “no tangible benefit” from the Franchise Agreement, because “the franchise is heavily skewed towards the Detroit market,” and Debtor “operates outside” that area; and
- a rejection of the franchise agreement “will increase the cash available to creditors significantly.”
Accordingly:
- Debtor moves to reject the Franchise Agreement with Autolab (Doc. 82); and
- Debtor’s plan provides for treatment of Autolab’s claim for rejection damages as part of the general unsecured class—i.e., to receive a small dividend and be discharged (Doc. 84, par. 2.3.5 & par. 4.2.1).
Autolab opposes Debtor’s rejection motion (see Doc. 90), arguing that the non-compete and confidentiality provisions survive rejection.
Autolab also objects to Debtor’s Plan as not-feasible (see Doc. 98), because the Plan provides for Debtor’s continued operations in violation of non-compete provisions in the Franchise Agreement.
- Debtor argues in response that “the non-competition provisions are dischargeable claims that have no negative impact on plan feasibility” (Doc. 106, ¶ 9); but
- As of this writing, no action has been taken by the Bankruptcy Court on Debtor’s Plan or Autolab’s objection thereto.
Court Ruling & Rationale
–Ruling
The Bankruptcy Court agrees with Autolab on rejection-and-discharge issues, entering an Order (Doc. 121):
- granting Debtor’s Motion to reject the Autolab Franchise Agreement; but
- declaring that:
- the non-compete clause in the Franchise Agreement “remains enforceable post-rejection”; and
- the confidentiality agreement “is not an executory contract subject to rejection” and “remains enforceable.”
–Rationale
The Bankruptcy Court explains its rationale as follows.
When there is a contract breach:
- a claim for damages is dischargeable in bankruptcy, even when an alternative equitable remedy exists; but
- the right to an equitable remedy is not a “claim” under § 101(5) and cannot be discharged in bankruptcy, when there is no money damages alternative.
“Most courts have concluded that a covenant not to compete, or at least the portion of such a contract giving a right to injunctive relief, is not a claim” under § 105.
In Kennedy v. Medicap Pharms., Inc., 267 F.3d 493 (6th Cir. 2001), debtors franchise agreement contains a covenant not to compete. The franchisor wants to pursue an injunction to enforce that covenant. In response:
- the Bankruptcy Court grants relief from the automatic stay so the franchisor can pursue its claim for injunctive relief in state court; and
- the Sixth Circuit affirms, because the right to injunctive relief does not “equate to being a claim” under § 105.
In the present case, both the non-compete and confidentiality provisions give rise to both monetary damages and equitable relief:
- monetary damages compensate Autolab for its lost royalties from rejection of the Franchise Agreement; and
- the payment of royalties “shall not affect Franchisor’s right to obtain appropriate injunctive relief” to enforce the Franchise Agreement.
Accordingly, there are two types of protections that are entirely separate and distinct:
- damages are compensation for lost royalties; and
- non-compete and confidentiality provisions are protections for proprietary intellectual property and customer goodwill.
Since the equitable protections cannot be reduced to a monetary claim under § 101(5), those protections cannot be discharged in bankruptcy. And they remain enforceable.
Conclusion
Here’s a “Thank you” to the Eastern Michigan Bankruptcy Court for this enlightening opinion on contract rejection and related discharge issues.
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Footnote 1. The In re Empower Central Michigan, Inc., opinion is in Case No. 23-31281 from the Eastern Michigan Bankruptcy Court (issued 4/26/2024, Doc. 121).
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