Rejection of Franchise 'Bundled' Sub-Agreements: Michigan Decision Highlights Key Contract Drafting, Bankruptcy Principles

One of the most important tools in the Bankruptcy Code is the debtor’s power to reject executory contracts, agreements for which performance remains due to some extent from both sides.  The debtor can essentially breach the contract and cease performing; damages for breach are treated as pre-petition “claims” that can be discharged or otherwise treated through the bankruptcy without burdening the debtor’s post-bankruptcy operations.  Thus, debtors generally will shed loss-making, burdensome contracts before emerging as more profitable reorganized entities.

Courts have long grappled with the meaning and effect of rejection of franchise and related intellectual property agreements because there are many ways to think about them.  Is a franchise agreement just a franchisee’s obligation to pay royalties while putting the franchisor’s mascot on a sign outside?  Or has the franchisee purchased valuable trade secrets, client lists and other information in a one-time transaction?  Is the franchisor simply promising not to sue for infringement of its marks while it receives royalties?  The answers to these questions will depend upon how contracts are written, and they can drastically impact the outcomes of bankruptcy cases in which the franchisee seeks to reject its agreements.

Courts have sometimes approached these thorny questions by looking at the types of claims that may arise under the IP agreements a debtor seeks to reject.  In sum, courts and the Bankruptcy Code say that monetary obligations are “claims” that are deemed to arise post-petition and may be discharged.  But purely equitable (i.e., injunctive) relief is not a “claim” under the Bankruptcy Code that can be discharged or otherwise evaded.  This makes sense to distinguish the viewpoints expressed above: while it is possible that rejection of a franchise agreement would entitle the franchisor to a prepetition monetary claim for royalty payments, it would be unfair to allow the debtor/franchisee to continue using (and potentially damaging) the franchisor’s trademarks indefinitely without providing compensation to the franchisor. Put a bit differently, once the debtor/franchisee rejects its obligation to pay royalties, the franchisor might similarly be freed of its promise not to sue for infringement.

The Bankruptcy Court for the Eastern District of Michigan recently confronted these issues in a Chapter 11 case filed by a former franchisee of Auto Lab Franchising. See In re Empower Central Michigan, Inc. (Case No. 23-31281) (April 26, 2024).  The Bankruptcy Court held that the debtor could not escape confidentiality and non-compete obligations agreed as part of an integrated franchising transaction, even if the franchise agreement itself was deemed executory and rejected in the bankruptcy proceedings.

The franchise transaction in Empower involved an auto care franchise agreement containing a non-compete clause, as well as a separate confidentiality agreement, connected by a purported integration clause.  The franchisee/debtor sought to reject both the franchise agreement and confidentiality agreement entirely.  Without waiting for court approval, the debtor severed its relationship with the franchisor, changed the name of its business, and copied the customer lists “while continuing to utilize [franchisor’s] trademarks and other confidential and proprietary intellectual property.”[1]  Predictably, the franchisor objected to this use of its property.

The Bankruptcy Court thus asked (1) were the agreements executory, and (2) if so, what obligations bound the debtor following rejection?

Examining the terms of the contracts, the Bankruptcy Court found that the franchise agreement was executory.[2]  But the confidentiality agreement was not executory: the franchisor had provided confidential information that constituted full performance on the latter agreement.  The court found that a purported integration clause did not combine the contracts such that they could be rejected  wholesale.

But the Bankruptcy Court observed that the distinction between executory and non-executory was “not particularly important here because…the equitable remedies contained in the Franchise Agreement and the Confidentiality Agreement cannot be reduced to a monetary claim and remain enforceable” by the franchisor.[3] 

As the Bankruptcy Court further observed, a breach of contract giving rise to money damages creates a dischargeable claim in a debtor’s bankruptcy. A breach giving rise to equitable relief is also a dischargeable claim if the right to equitable relief is an alternative to payment of money damages and if the equitable order itself would not require payment of damages.[4]  So, where a franchise agreement includes a liquidated damages formula, the franchisor has a bankruptcy claim for monetary recovery thereunder. 

But the court also determined that the equitable remedies contained in the non-compete provision of the franchise agreement and confidentiality agreement could not be reduced to a monetary claim. Those equitable remedies were not alternatives to payment of money damages. Thus, the court held that the equitable remedies remained enforceable after rejection. The debtor would simply not be allowed to use the franchisor's trademarks, confidential information or intellectual property, regardless of whether the franchise agreement had been rejected.

It is important for franchisors and franchisees and their counsel to understand how courts characterize these contracts, whether they may be rejected in bankruptcy, and what types of claims will arise as a result.  The outcome in this case might have been different had the non-compete provision and confidentiality agreement stipulated solely to liquidated damages, or more fully integrated the various sub-agreements and damages clauses. 

The stakes are far from academic: the terms of the contracts and the parties’ actions in bankruptcy may be the difference between a franchisor’s continuing control over its marks, and the franchisee’s ability to reorganize and conduct business free of its past obligations. 

[1] Decision at 3.

[2] Id. at 9 (citing In re Times Square JV LLC, 648 B.R. 277, 284 (Bankr. S.D.N.Y. 2023).  Franchise agreements are generally considered executory, because of the franchisor’s ongoing duty to protect its marks and provide technical assistance, and franchisee’s duty to pay royalties,  and operate the franchise in conformance with franchisor’s system and brand standards. However, as Empower illustrates, that does not mean that all bundled sub-agreements are executory or that all obligations contained therein are monetary or dischargeable.

[3] Id. at 10.

[4] Id. at 11 (citing 2 Collier on Bankruptcy ¶ 101.05[5]).