A state court’s preliminary injunction precluding the debtor from terminating a franchise agreement pendente lite does not bar the debtor from rejecting the agreement as an executory contract in a subsequent chapter 11 case, according to Bankruptcy Judge John P. Mastando, III of New York.
The debtor owned a hotel in Manhattan. Judge Mastando’s February 4 opinion insinuates that the debtor wanted out of the franchise agreement because it was too expensive. Before bankruptcy, both sides sued the other in state court.
The debtor claimed that the franchisor was in breach and wanted the state court to declare that the franchise had been terminated. The franchisor wanted monetary damages and an injunction barring the debtor from terminating the agreement.
Also before bankruptcy, the state court entered a preliminary injunction, or PI, barring the debtor from terminating the franchise agreement until the suit in state court was resolved. The state court said the PI was necessary to preserve the status quo. The PI was upheld on appeal in the intermediate state appellate court.
Next, the debtor filed a chapter 11 petition together with a plan to sell the hotel. The debtor also moved to reject the franchise agreement as an executory contract under Section 365, believing that the property was more valuable if the buyer could sign up with a franchisor of its choice.
The franchisor objected to the rejection motion, contending that the franchise agreement was no longer executory following the PI. Judge Mastando came down on the side of rejection.
Judge Mastando said that the Second Circuit has adopted the so-called Countryman definition of executory contracts, which says that a contract is executory if the obligations of both parties are so far unperformed that a failure by either to complete performance would constitute a material breach excusing performance by the other. He added that franchise agreements “are generally considered executory.”
Indeed, there were unperformed, material obligations imposed on both parties, typically rendering the franchise agreement executory and susceptible to rejection. The franchisor raised three arguments in opposition to the ordinary result.
The Effect of the Preliminary Injunction
Because the debtor had been enjoined by the state court from terminating the agreement, the franchisor said it was no longer executory. The franchisor relied on cases where an injunction meant that the contracts were no longer executory.
Judge Mastando said that the cases were “distinguishable because they all involve final orders, not preliminary injunctions.” In those cases, the debtors had been bound by final orders on the merits directing specific performance. By contrast, he said that the PI had been entered to preserve the status quo until the suit could be fully litigated.
Unlike a final order, Judge Mastando said that the PI “does not alter the parties’ contractual rights.” With material obligations remaining on both sides, he said that the “Preliminary Injunction thus does not render the License Agreement non-executory.”
Comity and Rooker-Feldman
The franchisor argued that rejecting the contract in the face of the PI would violate the principle of comity by overruling a state court order.
Judge Mastando said that the suit in state court and the rejection motion in the bankruptcy case were “wholly different proceedings.” In state court, the debtor wanted a declaration that the agreement had been terminated, but in bankruptcy court the debtor was seeking rejection under the Bankruptcy Code. “The relief sought is inherently different,” the judge said.
Judge Mastando held that “allowing the Debtor to reject the contract under Section 365 does not interfere with the [state court action] and does not violate principles of comity.”
Similarly, Judge Mastando found no violation of the Rooker-Feldman doctrine. He described the doctrine to mean that “lower federal courts lack subject matter jurisdiction to sit in appellate review of state court judgments.” He ruled that the doctrine did not apply because the bankruptcy court was “neither reviewing nor rejecting the Preliminary Injunction.”
Mutual obligations remaining, Judge Mastando granted the motion to reject the franchise agreement as an executory contract.
Observation
What if the state court had held a trial and entered a final order with a mandatory injunction compelling the debtor to continue performance under the franchise agreement? Would the agreement have ceased being an executory contract?
Let us know how you believe a court would rule.
A state court’s preliminary injunction precluding the debtor from terminating a franchise agreement pendente lite does not bar the debtor from rejecting the agreement as an executory contract in a subsequent chapter 11 case, according to Bankruptcy Judge John P. Mastando, III of New York.
The debtor owned a hotel in Manhattan. Judge Mastando’s February 4 opinion insinuates that the debtor wanted out of the franchise agreement because it was too expensive. Before bankruptcy, both sides sued the other in state court.
The debtor claimed that the franchisor was in breach and wanted the state court to declare that the franchise had been terminated. The franchisor wanted monetary damages and an injunction barring the debtor from terminating the agreement.
Also before bankruptcy, the state court entered a preliminary injunction, or PI, barring the debtor from terminating the franchise agreement until the suit in state court was resolved. The state court said the PI was necessary to preserve the status quo. The PI was upheld on appeal in the intermediate state appellate court.