Rejection of a Non-Compete under 11 U.S.C. Section 365
Rejection of an executory contract under section 365 constitutes a breach of all future obligations under the contract, which breach is statutorily deemed to have occurred immediately prior to the petition date. See In re Annabel, 263 B.R. 19, 25 (Bankr. N.D.N.Y. 2001). Rejection does not cause the contract to be canceled, repudiated, rescinded, or terminated. See In re Printronics, Inc., 189 B.R. 995, 1000 (Bankr. N.D. Fla. 1995). Instead, rejection gives rise to a pre-petition breach of future performance but does not “affect the parties’ substantive rights under the contract . . . such as the amount owing or a measure of damages for breach.” In re Annabel, 263 B.R. at 26 (quoting Collier on Bankruptcy ¶ P365.09[1] (Richard Levin & Henry J. Sommer eds., 15th ed.)).
One line of cases holds that debtors continue to be obligated to perform under a non-compete even if the non-compete is part of an executory contract that is rejected under section 365. Annabel, 263 B.R. at 25–26; Sir Speedy Inc. v. Morse, 256 B.R. 657, 660 (D. Mass. 2000); In re Steaks to Go, Inc., 226 B.R. 35, 38 (Bankr. E.D. Miss. 1998); Printronics, Inc., 189 B.R. at 1000; In re Udell, 149 B.R. 898, 902 (Bankr. N.D. Ind. 1992); In re Don & Lin Trucking Co., 110 B.R. 562, 566–68 (Bankr. N.D. Ala. 1990); In re Klein, 218 B.R. 787, 790–91 (Bankr. W.D. Pa. 1986). These courts reason that, because rejection under section 365 does not cause a termination of the non-compete or change the measure of damages for breach, the plaintiff’s right to injunctive relief survives the rejection.
This line of cases misses a critical component of the effect of rejecting an executory contract under the Bankruptcy Code. It is true that rejection under section 365 does not cause a termination of the contract. However, rejection does create the legal fiction that all of the debtor’s future obligations under the contract were breached prior to the petition date. See In re Child World, Inc., 147 B.R. 847, 852 (Bankr. S.D.N.Y. 1992); In re Exec. Tech. Data Sys., 79 B.R. 276, 282 (Bankr. E.D. Mich. 1987). Accordingly, the plaintiff’s measure of damages is the relief it would be entitled to if the debtor had already breached the non-compete for its entire remaining term before the bankruptcy case was filed. Because section 365 forces the plaintiff to seek redress as if all of the debtor’s future obligations under the rejected non-compete have already been breached, the plaintiff’s right to injunctive relief is rendered moot and the plaintiff must seek a pre-petition claim for monetary damages. This analysis is supported by several courts that provide that rejecting a non-compete under section 365 extinguishes all of the debtor’s future obligations, including its obligation not to compete. See In re Register, 95 B.R. 73, 74–75 (Bankr. M.D. Tenn. 1989); In re Allain, 59 B.R. 107, 109 (Bankr. W.D. La. 1986); In re Norquist, 43 B.R. 224, 231 (Bankr. E.D. Wash. 1984); In re Rovine Corp., 6 B.R. 661, 666–67 (Bankr. W.D. Tenn. 1980). While the analysis in many of these cases is sparse, the holdings are consistent with the statutory effect of rejection under section 365.
Future Obligations under a Non-Compete as a Dischargeable Debts under 11 U.S.C. Section 101(12)
If a non-compete is not an executory contract subject to rejection, the next question is whether the debtor’s obligations are “debts” that are subject to discharge within the meaning of the Bankruptcy Code. Two circuit courts have addressed the issue.
First, in Udell, the debtor violated a non-compete in favor of his former employer, Carpetland, USA. See In re Udell, 18 F.3d 403, 405 (7th Cir. 1993). Carpetland sued the debtor in state court and obtained a preliminary injunction enjoining the debtor from competing. After the debtor filed a petition for relief under Chapter 13 of the Bankruptcy Code, Carpetland sought to lift the automatic stay and enforce its preliminary injunction against the debtor in the state court.
The Seventh Circuit in Udell held that the debtor’s ability to discharge his obligations under the non-compete turned on whether the debtor’s obligations qualified as a “debt” within the meaning of section 101(12). The Udell court began by determining that section 101(12) defines “debt” as a “liability on a claim.” Section 101(5) defines a “claim” as follows:
(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or
(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
11 U.S.C. § 101(5) (emphasis added).
The Udell court focused its analysis on whether the language of 11 U.S.C. section 101(5)(B) requires there to be any connection between the equitable remedy and the legal remedy (beyond the fact that both remedies arise from the same breach of performance) in order to qualify as a “claim.”
To better understand section 101(5)(B), the Udell court looked at its legislative history, which states:
Section 101(4)(B) [now § 101(5)(B)] . . . is intended to cause the liquidation or estimation of contingent rights of payment for which there may be an alternative equitable remedy with the result that the equitable remedy will be susceptible to being discharged in bankruptcy. For example, in some States, a judgment for specific performance may be satisfied by an alternative right to payment, in the event performance is refused; in that event, the creditor entitled to specific performance would have a “claim” for purposes of a proceeding under title II.
On the other hand, rights to an equitable remedy for a breach of performance with respect to which such breach does not give rise to a right to payment are not “claims” and would therefore not be susceptible to discharge in bankruptcy.
Udell, 18 F.3d at 407 (quoting 124 Cong. Rec. 32,393 (1978) (remarks of Rep. Edwards)
(emphasis added by the court)).
Based on this language, the Udell court took the analysis in a new, and sometimes criticized, direction by holding that “[t]here must first be a breach that gives rise to an equitable remedy . . . [and] that remedy may give rise to an ‘alternative’ or other corollary right to payment.” Id. (emphasis added). In short, the Udell court held that a debtor’s non-compete obligations qualify as a dischargeable debt only where the equitable remedy itself, and not the breach, gives rise to a claim for monetary damages. Applying this interpretation of section 101(5)(B) and its legislative history to the facts of the case, the Udell court found that Carpetland’s right to an injunction did not give rise to monetary damages.
Subsequently, the Sixth Circuit held that the debtor could not discharge its obligations under a non-compete because state law did not provide the plaintiff with a monetary remedy for future breach of performance. See Kennedy v. Medicap Pharmacies, Inc., 267 F.3d 493, 497–98 (6th Cir. 2001). Despite favorably citing Udell, the Kennedy court did not rely on Udell’s awkward interpretation of section 101(5)(B) and the relevant legislative history. Instead Kennedy cited Udell for the proposition that “the right to equitable relief constitutes a claim only if it is an alternative to a right to payment or if compliance with the equitable order will itself require the payment of money.” Kennedy, 267 F.3d at 497. The Kennedy court found that injunctive relief was a plaintiff’s only remedy against future breach because, under Iowa state law, a plaintiff was not entitled to monetary damages for a future breach of a non-compete. On that basis, the Kennedy court held that the debtor’s future breach of performance did not give rise to a “right to payment” within the meaning of section 101(5).
The Kennedy court made a critical timing error in its analysis. Under the plain language of section 101(5), a party holds a claim if breach of performance gives rise to a right to payment. See 11 U.S.C. § 101(5). Accordingly, the question should not be whether the plaintiff would have a claim for monetary damages for breach of future performance at the time of the bankruptcy. Rather, the question is whether the plaintiff would have a claim for monetary damages at the time of the breach.
Not all courts have agreed with the Udell and Kennedy holdings. One bankruptcy court is particularly critical of the analysis employed by the Udell court. See Maids Int’l v. Ward, 194 B.R. 703, 712–13 (Bankr. D. Mass. 1996). In Maids, the court sought to determine whether a franchisor’s injunctive rights under a non-compete constituted a dischargeable claim. The Maids court interpreted the plain language of section 101(5) to mean that any equitable remedy is a “claim” subject to discharge in all instances where the “breach giving rise to the equitable remedy also give[s] rise to a ‘right’ to payment.” Maids, 194 B.R. at 710. The Maids court harshly criticized Udell’s holding that section 101(5) requires that the equitable remedy itself give rise to a claim for monetary damages. The Maids court pointed out, among other criticisms, that the “test makes no sense because equitable remedies are typically designed to provide nonmonetary relief”; thus, the Udell court’s requirement that the right to payment arise from the equitable remedy itself creates a “virtually unpassable test.” Maids, 194 B.R. at 714.
While recognizing that injunctive relief is often the most appropriate remedy to make a plaintiff whole in the face of threatened future competition, the Maids court nevertheless found that it is possible to calculate monetary damages in most instances. Id. at 711–12. Maids reasoned that “[t]he perceived difficulty in proving lost profits is less present today because of the receptive attitude of modern courts toward proof of sophisticated financial data through expert testimony.” Id. at 712. Accordingly, the Maids court found that, despite some inherent difficulty, in most cases it is possible to reduce a claim for breach of a non-compete to a monetary amount. As a result, the debtor’s breach of the non-compete gave rise to a “right to payment” so as to qualify as a claim under section 101(12).
Furthermore, although not critical to its holding, the Maids court went out of its way to explain that it does not make a difference whether a non-compete qualifies as an executory contract because the analysis will necessarily revert to whether the claim for breach is dischargeable under section 101(5). The Maids court reasoned that, where the non-compete is a rejected executory contract, the question is whether the plaintiff’s injunctive rights concerning the breach constitute a claim. If the non-compete is not an executory contract, the question is the same—whether the plaintiff’s injunctive rights are a claim. Maids, 194 B.R. at 708 n.6. See also In re Annabel, 263 B.R. at 26. This reasoning fails to account for the fact that rejection under section 365 creates the legal fiction that all of a debtor’s future obligations have been breached prior to the petition date. Upon rejection, the plaintiff’s damages are limited to those that are available to it after the debtor’s obligations have already been breached, at which point any right to injunctive relief is rendered moot. In this regard, Maids got it wrong. Where a non-compete is embodied in a rejected executory contract, the plaintiff is limited to a pre-petition claim for monetary damages. Injunctive relief is simply unavailable after rejection. It is only where a non-compete is not subject to rejection under section 365 that courts must analyze whether a plaintiff’s right to relief for future breach is a dischargeable claim under section 101(5).
Conclusion
Determining whether a non-compete is enforceable in bankruptcy requires an analysis that cannot be found in any single case; rather, it requires a hybrid approach. At the end of the day, the status of a non-compete as an executory contract is relevant because rejection under section 365 creates the legal fiction that all of a debtor’s future obligations were breached prior to the petition date—leaving the plaintiff with a pre-petition claim for damages. If the non-compete is not an executory contract and not subject to rejection under section 365, then courts must analyze whether breach of the non-compete gives rise to a right to payment. If future breach of the non-compete will give rise to a right to payment in addition to, or in lieu of, equitable relief, the debtor’s obligations under the non-compete are “debts” within the meaning of section 101(12) that may be subject to discharge.
Practice Pointers
While case law on the issue of enforcing a non-compete in bankruptcy varies, several guideposts have started to develop. To start, where the non-compete is part of an executory contract, the debtor should argue that the plaintiff’s claim for injunctive relief is moot because the debtor’s entire obligation of performance is deemed to have been breached before the petition date. The debtor should argue that, because injunctive relief is moot, the plaintiff is left with a claim for monetary damages that is dischargeable in bankruptcy. Conversely, the plaintiff should rely on Udell and other courts that have held that future performance under a non-compete is not affected by rejection under section 365 and shift the argument to whether the debtor’s future breach gives rise to a dischargeable debt.
Second, in cases in which the non-compete is not an executory contract or the court has determined that rejection under section 365 does not affect the plaintiff’s right to injunctive relief, the primary focus should be on whether the debtor’s future breach of a non-compete will give rise to a right to payment. Contrary to Udell, neither the language of section 101(12) nor the legislative comments require a different result. 11 U.S.C. §101(12); 124 Cong. Rec. 32,393 (1978). Accordingly, courts and litigants should focus on whether the language of the non-compete provides for equitable or legal relief, as well as whether monetary damages could adequately compensate the plaintiff for the debtor’s breach. The plaintiff should focus the argument on any contractual language providing for a right to injunctive relief and argue that there is no legal or monetary remedy available to compensate it for its damages. On the other hand, the debtor should highlight contract language that refers to monetary damages stemming from the debtor’s breach and argue that it is possible to monetize the plaintiff’s damages.
Next, if a court determines that a non-compete is not a claim under 11 U.S.C. section 101(12), Chapter 11 and Chapter 13 debtors should argue that the plaintiff should nevertheless be prohibited from enforcing the non-compete because the debtor and its creditors will suffer extreme hardship if the debtor is unable to generate sufficient income to fund a plan to repay creditors. Conversely, the plaintiff should argue that forcing it to wait three to five years for the debtor’s plan to be completed will effectively deny the plaintiff its legal rights because the term of the non-compete will expire before the plan is fully performed.
