A debtor’s covenant not to compete does not give rise to a claim and is not discharged in chapter 7, according to Bankruptcy Judge Robert E. Nugent of Wichita, Kan.
Before bankruptcy, the debtor sold his business. As part of the sale contract, he was employed by the buyer. The contract contained covenants preventing the debtor from competing for a number of years and barring him from disclosing proprietary information and soliciting customers. The contract included a liquidated damages clause calling for $50,000 in damages for each breach of the covenants.
The debtor filed a chapter 7 petition and received a discharge. After discharge, the buyer fired him. The following year, the buyer sued the debtor in state court and obtained an injunction enforcing the noncompetition clause.
The buyer filed a declaratory judgment action in bankruptcy court. In his July 26 opinion, Judge Nugent ruled that the noncompetition agreement was not a claim in the debtor’s bankruptcy and was not discharged in chapter 7. Consequently, continuation of the suit in state court for an injunction and damages was not in violation of the discharge injunction.
The Sixth Circuit already answered one of the tough questions. In Kennedy v. Medicap Pharmacies Inc., 267 F.3d 493 (6th Cir. 2001), the Sixth Circuit had held that breach of covenant not to compete is not a claim because it cannot be satisfied by money alone, since breach gives rise to an equitable remedy.
Judge Nugent acknowledged that some courts hold otherwise, where the plaintiff can choose either damages or injunctive relief. He said that the Sixth Circuit’s holding was buttressed by the Seventh Circuit, which has held there is no claim in a case where the plaintiff has the right to both damages and an injunction.
Because the covenant not to compete did not give rise to a claim, there was nothing to discharge. Even if the buyer had a claim, Judge Nugent went on to hold that the claim was not discharged under Section 727(b) because the events giving rise to the claim all occurred after the debtor’s chapter 7 filing.
The debtor argued that the covenants were executory contracts automatically rejected under Section 365(d)(1), giving the buyer no claim for relief based on actions that occurred after rejection.
Judge Nugent responded to the argument by saying that automatic rejection only relieves the trustee of any obligation to perform the contract, but does not provide “for the release of the debtor from any obligations.” In that regard, he cited a bankruptcy court decision from Maryland holding that a covenant not to compete survives a chapter discharge.
Judge Nugent dispensed with the executory contract argument on a second ground, noting that the Tenth Circuit has adopted the so-called Countryman test, which says there is an executory contract if the obligations of both parties are so far unperformed that the failure of either to perform would constitute a breach.
On the facts before him, Judge Nugent said that the buyer had no further duties under the contract given that the buyer had fired the debtor. The contract therefore was not executory and was not subject to rejection.
Alter the facts somewhat, though, and consider what the result might be. Assume that the debtor had violated the covenant before bankruptcy. Under Judge Nugent’s analysis, damages for breach before filing could be eligible for discharge, but the buyer presumably would still be entitled to an injunction precluding competition after bankruptcy.
But what if the covenant not to compete were part of a contract that was executory? A trustee likely would reject the contract in its entirety because black-letter law says that a trustee cannot pick and choose by assuming some portions of a contract and rejecting others. But would the covenant still survive bankruptcy following rejection? In the Sixth Circuit, the covenant seemingly would remain enforceable under Kennedy because it holds that a covenant not to compete is not a claim and survives discharge. The rationale is fuzzy, but the result makes sense as a matter of policy.