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Enforcing Covenants Not to Compete After Rejection

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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?

Rejection of Executory Contracts

Pursuant to 11 U.S.C. §365(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 Bankruptcy, Part 1," 57 Minn. L. Rev. 439, 460 (1973). 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 In re Rovine, 6 B.R. 661, 666 (Bankr. W.D. Tenn. 1980). 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., In re Annabel, 263 B.R. 19 (Bankr. N.D.N.Y. 2001); citing In re Noco Inc., 76 B.R. 839 (Bankr. N.D. Fla. 1987).

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 Noco, 76 B.R. at 840-41. Consequently, the court held that the agreement was not executory and not subject to rejection. Id. at 843; see, also, In re Schneeweiss, 233 B.R. 28 (Bankr. N.D.N.Y. 1998); In re Drake, 136 B.R. 325 (Bankr. D. Mass. 1992).


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.

In Annabel, sufficient obligations remained between the parties to classify the contract as executory. See Annabel, 263 B.R. at 23. In fact, the court dismissed the severability argument due to the lack of authority therefore. See Annabel, 263 B.R. at 23; citing In re Carrere, 64 B.R. 156 (Bankr. C.D. Cal. 1986); In re Rovine, 5 B.R. 402 (Bankr. W.D. Tenn. 1980). 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 Silk Plants, Etc. Franchise Systems Inc. v. Register (In re Register), 100 B.R. 360, 362 (Bankr. M.D. Tenn. 1989); see, also, JRT Inc. v. TCBY Sys. Inc. (In re JRT Inc.), 121 B.R. 314 (Bankr. W.D. Mich. 1990); In re Lopez M.D.S.C., 93 B.R. 155 (Bankr. N.D. Ill. 1988). 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.

Enforcement After Rejection

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 In re Annabel, 263 B.R. 19, 25 (Bankr. N.D.N.Y. 2001); In re Columbia Gas System Inc., 50 F.3d 233, 239 n. 8 (3d Cir. 1995); In the Matter of Austin Development Co., 19 F.3d 1077, 1082 (5th Cir. 1994); In re Modern Textile Inc., 900 F.2d 1184, 1191 (8th Cir. 1990); Leasing Service Corp. v. First Tennessee Bank Nat'l Ass'n, 826 F.2d 434, 436-37 (6th Cir. 1987). The rejection of an executory contract constitutes a breach of that contract immediately prior to the petition date. 11 U.S.C. §365(g). Rejection does not, however, affect the parties' substantive rights under the contract such as the amount owing or the measure of the breach. See Annabel, 263 B.R. at 25-6; 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 Annabel, 263 B.R. at 27; In re Klein, 218 B.R. 787, 790-91 (Bankr. W.D. Pa. 1998) (covenant not to compete in rejected franchise agreement effective insofar as it was enforceable under applicable law); In re Steaks to Go Inc., 226 B.R. 35 (Bankr. E.D. Mo. 1998) (even though rejection constituted a rejection of the entire agreement, covenant not to compete in rejected franchise agreement remained enforceable); In re Don & Lin Trucking Co., 110 B.R. 562, 566-68 (Bankr. N.D. Ala. 1990).

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 Sir Speedy Inc. v. Morse, 256 B.R. 657, 659 (D. Mass. 2000); citing Sharer, Jeffrey C., "Non-competition Agreements in Bankruptcy; Covenants (Maybe) Not to Compete," 62 U. Chi. L. Rev. 1549, 1553 (1995). The non-debtor party to the contract, therefore, may seek the appropriate injunctive relief under the contract in issue. See Sir Speedy Inc. v. Morse, 256 B.R. at 660. More importantly, the injunctive relief sought is not dischargeable as compared to monetary damages. See Annabel, 263 B.R. at 27; citing Dent Wizard International Corp. v. Brown (In re Brown), 237 B.R. 740 (Bankr. C.D. Cal. 1999); In re Reppond, 238 B.R. 442 (Bankr. E.D. Ark. 1999); Thomas v. Herzog (In re Thomas), 133 B.R. 92 (Bankr. N.D. Ohio 1991).

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 In re May v. Charles Booher & Associates (In re May), 141 B.R. 940, 943 (Bankr. S.D. Ohio 1992); see, also, Creator's Way Associated Labels Inc. v. Mitchell, 249 B.R. 55 (Bankr. S.D.N.Y. 2000). 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 In re Steaks to Go Inc., 226 B.R. 35, 38 (Bankr. E.D. Mo. 1998); citing In re Modern Textile Inc., 900 F.2d 1184, 1191 (8th Cir. 1990). 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 In re Steaks to Go Inc., 226 B.R. 35, 38 (Bankr. E.D. Mo. 1998); see, also, In re Steaks to Go Inc., 226 B.R. 32, 33-4 (Bankr. E.D. Mo. 1998). 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.

Conclusion

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 Date: 
Saturday, September 1, 2001

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