A Michigan bankruptcy court held that a debtor-franchisee seeking to reject a franchise agreement for an auto repair center could not reject either a stand-alone confidentiality agreement with the franchisor or the non-compete and confidentiality provisions included within the franchise agreement. The court determined that these provisions were neither executory nor subject to rejection under the Bankruptcy Code. As a result, the debtor-franchisee could be prohibited from operating a competing business from its former franchised location and from using the franchisor’s intellectual property.
The franchisee sought bankruptcy court approval to reject its franchise agreement. Prior to the bankruptcy court’s ruling, the franchisee began taking steps to end its relationship with its franchisor and operate an independent business, by copying customer lists, repainting the interior of its facility, ceasing reports of sales to the franchisor, and posting a notice for its customers advising of its name change to an independent “car care” center.
The court noted a general rule that a debtor in bankruptcy may assume or reject executory contracts. For a contract to be “executory” and subject to rejection, performance by both parties must remain due to some extent. The franchise agreement was a rejectable executory contract because performance by both franchisor and franchisee remained outstanding. However, neither the non-compete and confidentiality clauses, nor the separate confidentiality agreement, could be considered executory because they lacked material continuing obligations. The franchisor had already performed by providing all trademarks, intellectual property and other proprietary confidential information to the debtor-franchisee.
The court next looked to the nature of the franchisor-creditor’s damages that would arise from the debtor’s breach of the agreements as a result of rejection of the franchise agreement, even if the provisions in question had been rejectable executory agreements. Such rejections afford the creditor a claim against the debtor’s bankruptcy estate to compensate it for the debtor’s non-performance. In this case, the franchise agreement contained a liquidated damages clause that calculated the franchisor’s recoverable damages from the debtor’s breach. Accordingly, the court determined the debtor-franchisee’s rejection could be reduced to a monetary claim in the debtor’s estate.
The non-compete and confidentiality clauses in the franchise agreement, and the separate confidentiality agreement, however, could not be reduced to a monetary claim because they provided for the franchisor-creditor’s right to seek equitable relief, i.e., a court order enjoining the debtor-franchisee from breaching those restrictions. Both equitable and monetary relief were available to the franchisor under those provisions, but the bankruptcy court found the protections of the franchisor’s intellectual property to be entirely distinct from protections surrounding ongoing royalty payments that the liquidated damages clause was designed to ensure. Thus, equitable protections could not be reduced to a claim in the debtor’s estate. This finding allowed the franchisee to reject the franchise agreement and the monetary obligations, but not the non-compete and confidentiality obligations.
Franchisees considering bankruptcy cannot eliminate every obligation of a franchise agreement. Provisions protecting intellectual property, whether or not they are contained within agreements sought to be rejected, will not necessarily be discharged. Debtor-franchisees should be mindful of potentially non-dischargeable obligations and their long-term impact on post-bankruptcy operations.
In re Empower Cent. Mich., No. 23-31281-jda (Bankr. E.D. Mich. Apr. 26, 2024)
