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.