iThe rejection of agreements under 11 U.S.C. § 365 isn’t always as straightforward as you might think. In an opinion issued in In re Empower Cent. Michigan, Inc., No. 23-31281-JDA, 2024 WL 1848504, (Bankr. E.D. Mich. Apr. 26, 2024), Judge Joel D. Applebaum of the U.S. Bankruptcy Court for the Eastern District of Michigan recently weighed in on a rare but not unusual issue that arises when confidentiality and non-compete provisions that are part of an executory contract survive the underlying contract’s rejection.
The debtor, a franchisee of an auto repair center in Fenton, Michigan, sought bankruptcy court approval to reject: (i) its franchise agreement with the franchisor, including (ii) non-compete and confidentiality provisions therein, and (iii) and separate, stand-alone confidentiality agreement, under section 365 of the bankruptcy code. Before the court ruled on the rejection motion, however, the debtor-franchisee began taking steps to sever its relationship with its franchisor that constituted material breaches of the applicable agreements. For instance, it had, without prior franchisor authorization, repainted the interior of its facility in a non-compliant color, it had stopped reporting sales to Auto-Lab as required under the agreement, and had posted a notice for its customers advising of its name change to “Fenton Car Care Center.” At the same time that it continued using the franchisor’s trademarks, the debtor-franchisee copied customer lists and other confidential intellectual property of the franchisor in taking steps to operate independently of the franchise agreement.
The debtor-franchisee explained that rejection under section 365 of the Bankruptcy Code was warranted because the agreements no longer provided any tangible benefit to it as a result of the costly, monthly franchise fees (i.e. royalties) it was obligated to pay to the franchisor.
Judge Applebaum disagreed and ultimately held that while the franchise agreement was indeed executory in nature and subject to rejection, neither the non-compete and confidentiality provisions included in the franchise agreement nor the separate confidentiality agreement were executory or subject to rejection under the Bankruptcy Code. Thus, while the Subchapter V debtor-franchisee could alleviate itself of the financial burden imposed by the royalties owed under the franchise agreement, it could not, however, rid itself of the obligations provided by the non-solicit and confidentiality obligations. As a result, the debtor-franchisee would ultimately be prohibited from, among other things, operating a competing auto care center from its Fenton location or using the franchisor’s confidential and proprietary information and intellectual property.
Why the Franchise Agreement was Rejected, but Not the Others
Judge Applebaum began his analysis by considering whether the franchise agreement, the non-solicit and confidentiality provisions therein, and/or the separate confidentiality agreement were “executory contracts” subject to the debtor’s rejection under 11 U.S.C. § 365. Citing the U.S. Supreme Court’s decision in NLRB v. Bildisco & Bildisco. 45 U.S. 513, 522, n.6 (1984), he explained that for a contract to be “executory” and thus, subject to rejection, performance by both parties must remain due “to some extent.” This concept is best understood if we look at such an agreement as both an asset and a liability of the debtor. Indeed, it is an asset to the extent that the debtor has a right under the agreement to the counterparty’s future performance, and it is a liability in the sense that the debtor is still obligated to future performance thereunder. Simply put, if an agreement is not “executory,” section 365 of the Bankruptcy Code does not apply. If an agreement is considered “executory,” the debtor may seek to reject same within the bounds of the business judgment rule.
In Empower, the franchise agreement, fit this bill because performance of both parties remained outstanding. But, as the court reasoned, neither the non-solicit and confidentiality clauses in the franchise agreement, nor the separate confidentiality agreement could be considered executory in nature because there were no “material continuing obligations remaining” where the franchisor had already performed by providing all trademarks, intellectual property and other proprietary confidential information to the debtor-franchisee. The court’s analysis, however, didn’t end here.
To fully answer the question of whether the debtor could reject the agreements in question, the court next looked at the nature of the counterparty’s damages that would arise from the debtor’s breach of the agreements vis-à-vis its rejection of same. This inquiry is crucial because, under section 365(g) of the Bankruptcy Code, the debtor’s rejection of an executory contract is considered to be a pre-petition breach of the agreement and as a result, provides the non-debtor counterparty with a claim against the debtor’s bankruptcy estate to compensate it for the debtor’s non-performance. As a result, the court had to consider the nature of damages arising from the debtor’s breach (by rejection) of the franchise agreement, the non-compete and confidentiality clauses therein, and the separate confidentiality agreement.
As Judge Applebaum explained, “a breach giving rise to money damages is a claim in [the] Debtor’s bankruptcy” under section 101(5)(A) of the Bankruptcy Code; but, “a breach giving rise to equitable relief (e.g. injunctive relief, specific performance, etc.) may or may not be a claim, depending on whether the right to equitable relief is ‘an alternative to payment or if compliance with the equitable order will itself require the payment of money.’” The court therefore looked to the damages provisions of each of the agreements at issue to answer the final question as to whether the debtor could reject the contracts.
On the one hand, because the franchise agreement contained a liquidated damages clause providing a formula to calculate the franchisor’s recoverable damages in the face of the debtor’s breach, the court determined that the debtor’s rejection could be reduced to a monetary claim in the debtor’s estate. On the other hand, the (i) non-compete and confidentiality clauses in the franchise agreement, and (ii) the separate confidentiality agreement, provided only for the franchisor’s equitable remedies for the debtor-franchisee’s breaches that could not be reduced to a monetary claim. In so holding, Judge Applebaum cited the Sixth Circuit’s rationale in Kennedy v. Medicap Pharms, Inc., 267 F.3d 493 (6th Cir. 2001), that equitable claims such as agreements not to compete, are not considered “claims” under section 101(5)(A) if it is merely an alternative to a right to payment. Hence, even if the non-compete and confidentiality provisions in the franchise agreement and separate confidentiality agreement were deemed executory in nature (they were not), the result would be the same because of the nature of the remedies for breaches thereof. That is, the non-compete and confidentiality provisions and separate agreement provided for both equitable and monetary claims (as opposed to in the alternative). The franchise agreement’s liquidated damages clause gave the franchisor a monetary claim for the franchisee’s breach in respect of its lost royalty payments, and expressly states that payment for such claim “shall not affect Franchisor’s right to obtain appropriate injunctive relief and other remedies to enforce this Agreement.” By comparison, the non-solicit and confidentiality provisions and separate agreement were intended to protect, among other things, the franchisor’s confidential and proprietary intellectual property. The court therefore concluded that these equitable protections were “entirely distinct from protections surrounding the stream of royalty payments,” and thus, were available to the franchisor in addition to, rather than in the alternative to same.
As a result, Judge Applebaum ultimately held that while the franchise agreement was executory and could be rejected by the debtor under section 365, neither the non-solicitation and confidentiality provisions therein nor the separate confidentiality agreement were executory, and even if they were, the debtor’s breach gave rise only to a claim for equitable relief and as such, could not be reduced to a claim in the debtor’s estate.
What Does this Ruling Mean for Businesses?
Non-solicitation and confidentiality agreements, whether in stand-alone agreements or incorporated into a broader contract that is executory in nature, survive rejection of the related agreement in a bankruptcy. For franchisors, the Empower ruling is a win, because it provides clarity and reassurance that business interests and intellectual property will be protected even after a franchise agreement is rejected. For debtor’s, it’s a reminder that not everything can be wiped clean in bankruptcy.
So, if you're navigating the tricky waters of bankruptcy, remember: noncompete and confidentiality agreements might just stick around longer than you'd think.
Final Thoughts
Judge Applebaum’s ruling in Empower underscores the importance of understanding and carefully crafting franchise and related agreements. While debtors might be able to rid themselves of the burdens of performing under some contracts in a bankruptcy, others, especially those protecting business secrets and competitive edges, may not be so easy to dispose or discharge in a bankruptcy.
