Focused on Franchise Law - February 2013

by Lewitt Hackman
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FRANCHISOR 101:  ARE COVENANTS NOT-TO-COMPETE DISCHARGEABLE IN BANKRUPTCY?  

 

Is a franchisee's obligation to comply with a covenant not-to-compete in a franchise agreement dischargeable by the franchisee as a "claim" in a bankruptcy proceeding? According to a U.S. Bankruptcy Court in Texas applying Michigan law in Allegra Network, LLC v. Ruth, the answer is "yes".

 

The Ruths operated an Insty-Prints commercial printing franchise in Texarkana, Texas under a franchise agreement with Insty-Prints that was governed by Michigan law. The franchise agreement contained a post-term covenant that forbid the Ruths from continuing in the commercial printing business for one year after the expiration or termination of the franchise agreement, a standard covenant not-to-compete found in most franchise agreements. Insty-Prints ultimately terminated the franchise agreement and sued the Ruths in federal district court to collect unpaid royalties and to enforce the covenant not-to-compete. The Ruths then filed for bankruptcy, and the Bankruptcy Court was asked, among other things, to decide if the covenant not-to-compete was dischargeable by the Ruths in their Chapter 13 reorganization.

 

The Court observed that equitable remedies, such as specific performance, are not typically dischargeable under the Bankruptcy Code unless governing state law provides that such a judgment may be satisfied by the payment of monetary damages. The Ruths argued that a judgment to enforce an otherwise valid covenant not-to-compete could be satisfied by payment of monetary damages to the franchisor under Michigan law. Predictably, the franchisor argued that monetary damages would be difficult to calculate and that enforcement of the covenant not-to-compete was necessary to maintain stability in its franchised system; however, the franchisor was unable to convince the Court that an award of monetary damages would be insufficient under these circumstances. The Court then cited several recent Michigan state appellate court decisions that held that "monetary damages are clearly available as an alternative remedy under Michigan law [as] compensation for violation of a valid non-compete agreement" and held that the Ruths were able to discharge the covenant not-to-compete as a "claim" in their bankruptcy proceeding, conceivably allowing the Ruths to continue to compete with their former franchisor.

 

Bankruptcy Courts are known to ignore pro-franchisor provisions in franchise agreements, when, as an example, they provide for the automatic termination of a franchise agreement when a franchisee files for bankruptcy. But the decision in Allegra Network, LLC v. Ruth might have been different had the franchise agreement in question clearly explained why an award of monetary damages would be an insufficient remedy and had the franchisor not sought monetary damages from the courts for the breach of the covenant not-to-compete. Click here to see the entire opinion.

 

FRANCHISEE 101:  ALOHA-DISTRIBUTORSHIPS ARE NOT FRANCHISES

 

A "distributorship" is an independent business that operates under its own trade name, purchases and resells a manufacturer's or supplier's products and operates according to its own procedures, with minimal interference from the manufacturer of the products it sells. Distributors often claim their distributorship agreements are, in fact, franchise agreements that cannot be terminated without "good cause," notwithstanding language in the distributorship agreement to the contrary. In Prim Limited Liability Company, et al., v. Pace-O-Matic, Inc., a U.S. District Court in Hawaii recently reminded franchisors, franchisees, manufacturers and distributors that the mere grant of the right to distribute a manufacturer's products to a distributor does not render the relationship a "franchise."

 

Pace and Prim entered into an agreement in 2008 that granted Prim the exclusive right to purchase and distribute electronic games manufactured by Pace and codes that allow players to play a certain number of games. In 2010, Pace terminated their agreement after alleging Prim had committed unspecified defaults. Prim then filed suit claiming that their agreement was a franchise agreement under Hawaii's Franchise Investment Law (the "HFIL") that could not be terminated without "good cause."

 

Under the HFIL, a franchise relationship does not exist unless the trademark holder grants a license to use its trade name, service mark, trademark or logotype and unless the licensed business will be substantially associated with those marks. The Court held that Prim's claim that it was entitled to use Pace's name, trademarks and proprietary software was contrary to the language of the Agreement. According to the Court, the Agreement did not authorize Prim to use Pace's marks, but only permitted Prim to "purchase games and [codes] from Pace and to exercise its best efforts to develop markets for the games and to distribute the games." The Court observed that "the very essence of a franchise relationship is that the franchisee represents the franchise to the public; a franchise is not created [solely] when one company purchases and distributes another company's products." Click here to see the entire opinion.

 

MARK MELTON HAS Become of COUNSEL to The Firm

We are pleased to announce that Mark Melton became of counsel to our firm in October 2012. Mark recently sold Coverall Mountain & Pacific, a master franchise company that he built from the ground up to a business operating in six states with more than 560 franchisees and 2,600 clients, and brings more than 20 years of practical experience in franchising, business transactions, mergers and acquisitions, securities and general corporate matters to Kurtz Law Group. Mark lives in Santa Barbara and will be working at both our Woodland Hills and Santa Barbara offices. You can reach Mark at mmelton@kurtzfranchiselaw.com.

 

BARRY KURTZ FEATURED ONLINE

 

Barry's article, "The Accidental Franchisor", was recently featured in the online publication Brandaide/Brand Building Insights, which features insights from noted experts in branding, marketing and law. Brandaide is published by Cheryl Hodgson, Esq. (cheryl@hodgsonlegal.com), a widely respected Santa Monica, CA entertainment, media, trademark and copyright attorney. Visit

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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