Enforcing Covenants Not to Compete After Rejection

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Sep 2001

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Under the laws of various states, parties to a contract may agree to an enforceable
covenant not to compete. The enforceability and limitations of such agreements are
governed by state law, but are generally accepted in employment agreements, franchise
agreements and, occasionally, as part of a security agreement.

Employment agreements and franchise agreements are often executory contracts subject
to rejection by a debtor in bankruptcy. In fact, circumstances may rise where a
party to a covenant not to compete may find such an agreement no longer beneficial,
thereby seeking to avoid such a covenant. The issue becomes, therefore, are covenants
not to compete subject to rejection by a bankrupt debtor? More importantly, what
implications does rejection have to the party seeking enforcement of that agreement?

<h3>Rejection of Executory Contracts</h3>

Pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(a)</a>, a trustee or debtor-in-possession
(DIP), subject to court approval, may assume or reject any executory contract—of
the debtor. Determining whether an agreement is an executory contract is often
determined by application of the Countryman definition. Specifically, an executory
contract is a contract under which the "obligations of both the bankrupt and the
other party to the contract are so far unperformed that failure of either to complete
performance would constitute a material breach excusing the performance of the other."
Countryman, Vern, "Executory Contracts in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Part 1," 57 Minn. L.
Rev. 439, 460 (1973)</a>. Thus, if only one party's obligations remain under
the agreement, the contract is not an executory contract and cannot be rejected.

Another principle of rejecting an executory contract is that an executory contract
must be rejected in its entirety or not at all. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Rovine, 6 B.R.
661, 666 (Bankr. W.D. Tenn. 1980)</a>. Based on this proposition, one
might argue that the covenant not to compete was a separate agreement for which
different consideration was given to avoid rejection thereof. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Annabel, 263 B.R. 19 (Bankr. N.D.N.Y. 2001)</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Noco
Inc., 76 B.R. 839 (Bankr. N.D. Fla. 1987)</a>.

In Annabel, a non-debtor party to a sales contract sought to enforce a covenant
not to compete and asserted that the covenant not to compete was a separate agreement,
citing Noco for authority. In Noco, a chapter 11 debtor rejected a franchise
agreement containing a covenant by the debtor not to compete with the franchisor. Upon
examining the obligation remaining from each party, the court concluded that the
franchise agreement was substantially complete with the debtor's covenant not to compete
being the only remaining obligation, which the debtor admitted was the motivation for
filing bankruptcy. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 76 B.R. at 840-41</a>. Consequently, the court
held that the agreement was not executory and not subject to rejection. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at
843</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Schneeweiss, 233 B.R. 28 (Bankr. N.D.N.Y.
1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Drake, 136 B.R. 325 (Bankr. D. Mass. 1992)</a>.

<blockquote><blockquote>
<hr>
<big><center>
While a debtor in bankruptcy may reject
agreements that contain covenants not to
compete, such rejection does not necessarily
prohibit the enforcement of the covenant.
</center></big>
<hr>
</blockquote></blockquote>

In Annabel, sufficient obligations remained between the parties to classify the
contract as executory. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 263 B.R. at 23</a>. In fact, the court
dismissed the severability argument due to the lack of authority therefore. See

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 263 B.R. at 23</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Carrere, 64 B.R. 156
(Bankr. C.D. Cal. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Rovine, 5 B.R. 402 (Bankr.
W.D. Tenn. 1980)</a>. Thus, little case law supports the assertion that a covenant
not to compete was a separate agreement. Facts could occur, however, that would
support such a finding. Otherwise, Countryman's analysis remains applicable, which could
result in a finding that the contract in issue is no longer executory.

Typically, however, parties to such an agreement do not intend for the covenant
not to compete to be separate from the rejected agreement, which results in the
rejection of the covenant not to compete as well. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Plants, Etc. Franchise
Systems Inc. v. Register (In re Register), 100 B.R. 360, 362
(Bankr. M.D. Tenn. 1989)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. TCBY Sys. Inc.
(In re JRT Inc.), 121 B.R. 314 (Bankr. W.D. Mich. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Lopez M.D.S.C., 93 B.R. 155 (Bankr. N.D. Ill. 1988)</a>.
Countryman's analysis remains applicable, which could result in a finding that the
contract in issue is no longer executory. When the contract is executory and rejected,
one must consider the consequences and enforceability post-rejection.

<h3>Enforcement After Rejection</h3>

The rejection of an executory contract and a corresponding covenant not to compete
does not mean that the covenant not to compete is unenforceable. In fact, the
rejection of an executory contract does not constitute a termination of that contract.
See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Annabel, 263 B.R. 19, 25 (Bankr. N.D.N.Y. 2001)</a>;
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Columbia Gas System Inc., 50 F.3d 233, 239 n. 8 (3d Cir.
1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of Austin Development Co., 19 F.3d 1077,
1082 (5th Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Modern Textile Inc., 900 F.2d
1184, 1191 (8th Cir. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Service Corp. v. First
Tennessee Bank Nat'l Ass'n, 826 F.2d 434, 436-37 (6th Cir.
1987)</a>. The rejection of an executory contract constitutes a breach of that contract
immediately prior to the petition date. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(g)</a>. Rejection does
not, however, affect the parties' substantive rights under the contract such as the
amount owing or the measure of the breach. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 263 B.R. at 25-6</a>;
citing 3 Collier on Bankruptcy, 15th ed., 365.09[1], at 365-73
(2000).

While a claim for monetary damages would constitute a general unsecured claim subject
to discharge, injunctive relief remains available to the non-debtor party. See
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 263 B.R. at 27</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Klein, 218 B.R. 787, 790-91
(Bankr. W.D. Pa. 1998)</a> (covenant not to compete in rejected franchise
agreement effective insofar as it was enforceable under applicable law); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Steaks
to Go Inc., 226 B.R. 35 (Bankr. E.D. Mo. 1998)</a> (even though
rejection constituted a rejection of the entire agreement, covenant not to compete in
rejected franchise agreement remained enforceable); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Don & Lin Trucking Co.,

110 B.R. 562, 566-68 (Bankr. N.D. Ala. 1990)</a>.

In fact, post-rejection rights and obligations of the debtor and non-debtor are
exactly the same as they would have been had the debtor first breached the contract
and then filed for bankruptcy. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Speedy Inc. v. Morse, 256 B.R.
657, 659 (D. Mass. 2000)</a>; citing Sharer, Jeffrey C., "Non-competition
Agreements in Bankruptcy; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… (Maybe) Not to Compete," 62 U. Chi. L.
Rev. 1549, 1553 (1995)</a>. The non-debtor party to the contract,
therefore, may seek the appropriate injunctive relief under the contract in issue. See
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Speedy Inc. v. Morse, 256 B.R. at 660</a>. More importantly, the
injunctive relief sought is not dischargeable as compared to monetary damages. See

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 263 B.R. at 27</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Wizard International Corp. v. Brown
(In re Brown), 237 B.R. 740 (Bankr. C.D. Cal. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Reppond, 238 B.R. 442 (Bankr. E.D. Ark. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v.
Herzog (In re Thomas), 133 B.R. 92 (Bankr. N.D. Ohio 1991)</a>.

Other courts, however, have held that the determination of whether
non-dischargeable injunctive relief is available hinges upon whether the breach and/or
obligation gives rise to a right of payment or whether injunctive relief is the only
remedy. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re May v. Charles Booher & Associates (In re May), 141
B.R. 940, 943 (Bankr. S.D. Ohio 1992)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Way
Associated Labels Inc. v. Mitchell, 249 B.R. 55 (Bankr. S.D.N.Y.
2000)</a>. Regardless, even discharge will not affect the enforcement of a covenant
not to compete where injunctive relief is available, but no claim to monetary damages
exists.

Yet another avenue of relief remains available in that the rejection of an executory
contract does not relieve a guarantor from its obligations. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Steaks to Go
Inc., 226 B.R. 35, 38 (Bankr. E.D. Mo. 1998)</a>; citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Modern Textile Inc., 900 F.2d 1184, 1191 (8th Cir. 1990)</a>.
Thus, relief may be sought from guarantors, as well as non-debtor officers,
directors, employees and agents of a corporate debtor, whether by injunctive or
monetary relief. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Steaks to Go Inc., 226 B.R. 35, 38
(Bankr. E.D. Mo. 1998)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Steaks to Go Inc., 226
B.R. 32, 33-4 (Bankr. E.D. Mo. 1998)</a>. Even after discharge,
however, additional breaches of the covenant not to compete would result in claims
arising subsequent to discharge, which are not subject to a previous discharge.

<h3>Conclusion</h3>

While a debtor in bankruptcy may reject agreements that contain covenants not to
compete, such rejection does not necessarily prohibit the enforcement of the covenant.
Indeed, mere rejection does not magically erase the contract and/or the covenant.
Instead, rejection creates a pre-petition breach, under which the parties' substantive
rights are not affected.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Saturday, September 1, 2001 - 12:00

Bankruptcy Rule

2001