Bankruptcy Filing May Not Prevent Enforcement of Non-Compete Against Franchisee

A U.S. district court recently held that a bankruptcy court abused its discretion in denying a franchisor's motion for relief from the U.S. Bankruptcy Code's automatic stay when the franchisee's bankruptcy petition was filed after the franchisor had previously filed litigation against the franchisee to enforce a covenant not to compete. See In re Stone Resources, Inc., 458 B.R. 823 (E.D. Pa. 2011). The district court's ruling is significant because it found that the relief that the franchisor sought ' the enforcement of the covenant not to compete ' could not be considered a “claim” that could be reduced to a claim for money damages in bankruptcy and thus was immune from the effects of the automatic stay.

This issue ' whether a non-competition covenant violation by a bankrupt franchisee can be remedied by a “claim” for money damages, or whether it can be addressed only through an equitable remedy such as an injunction ' has arisen frequently in bankruptcy cases and is important for a number of reasons. First, the characterization of a franchisor's cause of action will often determine the forum in which it is heard. Second, timing can be affected by the characterization of the claim. A claim for money damages addressed as part of the bankruptcy claims process may take a year or more to resolve, while an action for an equitable remedy usually can proceed immediately in the outside forum. Third, the franchisor's recovery on a claim for money damages resolved in the bankruptcy claims process typically may be heavily discounted to “cents on the dollar,” depending on case specifics. An equitable remedy, on the other hand, typically will be fully enforceable outside the bankruptcy process.

Procedural History

Although the characterization of a particular claim will depend on the specific facts and applicable state law of each individual case, the Stone Resources opinion gives some insight into the type of analysis a court will conduct in determining whether a cause of action seeks a purely equitable remedy or can be satisfied by money damages. In Stone Resources, the franchisor, MarbleLife Inc., filed suit in the U.S. District Court for the Eastern District of Pennsylvania against Stone Resources Inc., one of its franchisees, in May 2010. The underlying dispute related to the expiration of a franchise agreement that contained a covenant not to compete and confidentiality provisions, among other things. See Id. at 825-26. Stone Resources had previously filed an arbitration complaint against MarbleLife related to claims over MarbleLife's ownership interest in some patents.

Although the district court granted MarbleLife's request for a preliminary injunction requiring Stone Resources to cease and desist in the operation of the franchise pending resolution of the arbitration proceeding, Stone Resources continued to operate “in direct contravention of the court's directives.” Id. at 827.

On Feb. 16, 2011, without having complied with the district court's preliminary injunction order, Stone Resources filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The bankruptcy court subsequently denied MarbleLife's attempt to dismiss Stone Resources' bankruptcy case and also denied MarbleLife relief from the automatic stay provision to enforce the district court's prior preliminary injunction. See Id. at 828. On MarbleLife's appeal of that ruling, the district court affirmed the bankruptcy court's decision not to dismiss Stone Resources' bankruptcy case, but reversed the bankruptcy court's denial of relief from the automatic stay to enforce the preliminary injunction.

The District Court's Decision

On appeal to the district court, the central issue on the automatic stay relief was whether the request to enforce the preliminary injunction ruling was a “claim,” given that the automatic stay, according to the district court, is designed “to prevent the enforcement of all claims against a Chapter 11 debtor.” See Id. at 832. “What exactly constitutes a 'claim' under the code has been the subject of much discussion.” Id.

After discussing a U.S. Supreme Court decision that analyzed the definition of a claim for bankruptcy purposes, the district court stated that circuit courts have also “held an equitable remedy will 'give rise to a right of payment' and therefore be deemed a 'claim,' when the payment of monetary damages is an alternative to the equitable remedy.” Id. at 833 (citing cases). Nevertheless, the district court explained the key to resolving the issue relates to the remedy available to the non-debtor:

[S]ome causes of action are not claims subject to discharge. At issue here is whether a preliminary injunction ordering a debtor to inter alia cease and desist in the operation of a business in accordance with the terms of a covenant not to compete is a claim within the meaning of the code. The Court finds that it is not. Where the only remedy available for a cause of action is an equitable remedy ' that claim is not dischargeable in bankruptcy. Id. (ellipsis in original; citation omitted; emphasis added).

The district court then analyzed whether MarbleLife's right to an injunction gives right to an alternative or other corollary right to payment of liquidated damages, or
“[s]tated differently, the analysis turns on whether monetary payment is a 'viable alternative' to an equitable remedy for a cause of action.” Id. (citation omitted).

The district court found that Stone Resources' compliance with the prior preliminary injunction order “does not require the expenditure of money.” Id. The relief sought “makes clear that monetary relief is not a viable alternative.” Id. The district court explained that the preliminary injunction barred Stone Resources from continued violation of the covenant not to compete and that “[m]onetary damages are not a viable alternative as [MarbleLife] is continuously harmed by [Stone Resources'] breach of the non compete provision.” Id. “In no sense can the preliminary injunction issued by this Court be deemed a 'claim' within the meaning of the code as compliance with this Court's Preliminary Injunction Orders does not require the expenditure of money, although it limits the ability to earn money.” Id.

The district court also noted that while portions of the injunction directed Stone Resources to turn over some property to MarbleLife, the substance of the property directed to be turned over was that the items were used in operating the franchisee, and “[t]he very operation of this company is forbidden by” the prior injunction determinations. See Id. at 834.

Finally, the district court rejected Stone Resources' argument that its failure to perform its obligations under the preliminary injunction “would justify an award of money damages, and are thus dischargeable,” explaining that:

The ability of a debtor to choose between performance and damages in some cases is not the same as a debtor's liability for money damages for failing to satisfy an equitable obligation. ' While section 101(5)(B) encourages creditors to select money damages from among alternative remedies, it does not require creditors entitled to an equitable remedy to select a suboptimal remedy of money damages. Id. at 835 (quotation and citation omitted).

Conclusion

As described above, this decision may provide an important precedent for franchisors seeking to enforce covenants not to compete or other equitable remedies against franchisees that have filed for protection under the U.S. Bankruptcy Code. Franchisors should be careful in choosing the remedy that they seek against franchisees that may be nearing bankruptcy, recognizing that claims for money damages may become subject to the automatic stay in the bankruptcy case, while equitable remedies may not be subject to the automatic stay and thus may proceed against the franchisee notwithstanding any bankruptcy filing.

Joseph M. Witalec and J. Todd Kennard are counsel and partner, respectively, at Jones Day, in the Columbus, OH, office. They can be reached at 614-469-3939, [email protected] or jtkennard@jones day.com. The views set forth herein are the personal views of the authors and do not necessarily reflect those of Jones Day or its clients.

A U.S. district court recently held that a bankruptcy court abused its discretion in denying a franchisor's motion for relief from the U.S. Bankruptcy Code's automatic stay when the franchisee's bankruptcy petition was filed after the franchisor had previously filed litigation against the franchisee to enforce a covenant not to compete. See In re Stone Resources, Inc., 458 B.R. 823 (E.D. Pa. 2011). The district court's ruling is significant because it found that the relief that the franchisor sought ' the enforcement of the covenant not to compete ' could not be considered a “claim” that could be reduced to a claim for money damages in bankruptcy and thus was immune from the effects of the automatic stay.

This issue ' whether a non-competition covenant violation by a bankrupt franchisee can be remedied by a “claim” for money damages, or whether it can be addressed only through an equitable remedy such as an injunction ' has arisen frequently in bankruptcy cases and is important for a number of reasons. First, the characterization of a franchisor's cause of action will often determine the forum in which it is heard. Second, timing can be affected by the characterization of the claim. A claim for money damages addressed as part of the bankruptcy claims process may take a year or more to resolve, while an action for an equitable remedy usually can proceed immediately in the outside forum. Third, the franchisor's recovery on a claim for money damages resolved in the bankruptcy claims process typically may be heavily discounted to “cents on the dollar,” depending on case specifics. An equitable remedy, on the other hand, typically will be fully enforceable outside the bankruptcy process.

Procedural History

Although the characterization of a particular claim will depend on the specific facts and applicable state law of each individual case, the Stone Resources opinion gives some insight into the type of analysis a court will conduct in determining whether a cause of action seeks a purely equitable remedy or can be satisfied by money damages. In Stone Resources, the franchisor, MarbleLife Inc., filed suit in the U.S. District Court for the Eastern District of Pennsylvania against Stone Resources Inc., one of its franchisees, in May 2010. The underlying dispute related to the expiration of a franchise agreement that contained a covenant not to compete and confidentiality provisions, among other things. See Id. at 825-26. Stone Resources had previously filed an arbitration complaint against MarbleLife related to claims over MarbleLife's ownership interest in some patents.

Although the district court granted MarbleLife's request for a preliminary injunction requiring Stone Resources to cease and desist in the operation of the franchise pending resolution of the arbitration proceeding, Stone Resources continued to operate “in direct contravention of the court's directives.” Id. at 827.

On Feb. 16, 2011, without having complied with the district court's preliminary injunction order, Stone Resources filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The bankruptcy court subsequently denied MarbleLife's attempt to dismiss Stone Resources' bankruptcy case and also denied MarbleLife relief from the automatic stay provision to enforce the district court's prior preliminary injunction. See Id. at 828. On MarbleLife's appeal of that ruling, the district court affirmed the bankruptcy court's decision not to dismiss Stone Resources' bankruptcy case, but reversed the bankruptcy court's denial of relief from the automatic stay to enforce the preliminary injunction.

The District Court's Decision

On appeal to the district court, the central issue on the automatic stay relief was whether the request to enforce the preliminary injunction ruling was a “claim,” given that the automatic stay, according to the district court, is designed “to prevent the enforcement of all claims against a Chapter 11 debtor.” See Id. at 832. “What exactly constitutes a 'claim' under the code has been the subject of much discussion.” Id.

After discussing a U.S. Supreme Court decision that analyzed the definition of a claim for bankruptcy purposes, the district court stated that circuit courts have also “held an equitable remedy will 'give rise to a right of payment' and therefore be deemed a 'claim,' when the payment of monetary damages is an alternative to the equitable remedy.” Id. at 833 (citing cases). Nevertheless, the district court explained the key to resolving the issue relates to the remedy available to the non-debtor:

[S]ome causes of action are not claims subject to discharge. At issue here is whether a preliminary injunction ordering a debtor to inter alia cease and desist in the operation of a business in accordance with the terms of a covenant not to compete is a claim within the meaning of the code. The Court finds that it is not. Where the only remedy available for a cause of action is an equitable remedy ' that claim is not dischargeable in bankruptcy. Id. (ellipsis in original; citation omitted; emphasis added).

The district court then analyzed whether MarbleLife's right to an injunction gives right to an alternative or other corollary right to payment of liquidated damages, or
“[s]tated differently, the analysis turns on whether monetary payment is a 'viable alternative' to an equitable remedy for a cause of action.” Id. (citation omitted).

The district court found that Stone Resources' compliance with the prior preliminary injunction order “does not require the expenditure of money.” Id. The relief sought “makes clear that monetary relief is not a viable alternative.” Id. The district court explained that the preliminary injunction barred Stone Resources from continued violation of the covenant not to compete and that “[m]onetary damages are not a viable alternative as [MarbleLife] is continuously harmed by [Stone Resources'] breach of the non compete provision.” Id. “In no sense can the preliminary injunction issued by this Court be deemed a 'claim' within the meaning of the code as compliance with this Court's Preliminary Injunction Orders does not require the expenditure of money, although it limits the ability to earn money.” Id.

The district court also noted that while portions of the injunction directed Stone Resources to turn over some property to MarbleLife, the substance of the property directed to be turned over was that the items were used in operating the franchisee, and “[t]he very operation of this company is forbidden by” the prior injunction determinations. See Id. at 834.

Finally, the district court rejected Stone Resources' argument that its failure to perform its obligations under the preliminary injunction “would justify an award of money damages, and are thus dischargeable,” explaining that:

The ability of a debtor to choose between performance and damages in some cases is not the same as a debtor's liability for money damages for failing to satisfy an equitable obligation. ' While section 101(5)(B) encourages creditors to select money damages from among alternative remedies, it does not require creditors entitled to an equitable remedy to select a suboptimal remedy of money damages. Id. at 835 (quotation and citation omitted).

Conclusion

As described above, this decision may provide an important precedent for franchisors seeking to enforce covenants not to compete or other equitable remedies against franchisees that have filed for protection under the U.S. Bankruptcy Code. Franchisors should be careful in choosing the remedy that they seek against franchisees that may be nearing bankruptcy, recognizing that claims for money damages may become subject to the automatic stay in the bankruptcy case, while equitable remedies may not be subject to the automatic stay and thus may proceed against the franchisee notwithstanding any bankruptcy filing.

Joseph M. Witalec and J. Todd Kennard are counsel and partner, respectively, at Jones Day, in the Columbus, OH, office. They can be reached at 614-469-3939, [email protected] or jtkennard@jones day.com. The views set forth herein are the personal views of the authors and do not necessarily reflect those of Jones Day or its clients.