§ 102.10 — When Purpose of Plan Is to Deal with an Unfavorable Contract or Lease

Revised: June 11, 2004

[1]

The courts have been reluctant to confirm Chapter 13 plans that are designed only to avoid the burdens of an unfavorable executory contract.

[2]

Several courts have, on bad-faith grounds, refused to confirm Chapter 13 plans targeted to reject an unfavorable contract and to defeat state court litigation seeking to force the debtor’s performance.1 When rejection produced no benefit for creditors and the debtor was not experiencing financial distress from any other source, one court declined to approve rejection of an executory contract.2

[3]

Rejection of an executory contract was allowed under aggressive circumstances in In re Bruce.3 There the debtor was permitted to reject an employee stock investment program required by the debtor’s employer. The employer unsuccessfully objected on the ground that the sole purpose of the Chapter 13 case was to reject the investment plan.

[4]

Bruce suggests some potential for mischief for Chapter 13 debtors with collective bargaining agreements or union contracts.4 Such agreements are typically a bundle of contracts, including wage and hour agreements, health insurance agreements and employee benefits programs such as the stock investment plan in Bruce. If the debtor can use § 1322(b)(7) to cherry pick the beneficial contracts within a larger collective bargaining agreement, then Chapter 13 becomes a useful vehicle for unburdening a consumer debtor of portions of an employment package. The outcome in Bruce is consistent with the rehabilitative intent of Chapter 13: the debtor rejected the purely investment portions of a contractual relationship with an employer and used the liberated income to pay creditors under a plan. It is not likely that Chapter 13 will become a wholesale threat to the viability of collective bargaining agreements.

[5]

There are several reported Chapter 13 decisions in which the rejected contract was a noncompete agreement. When the debtor comes into Chapter 13 after termination of an employment contract that contained a noncompete clause, the issue is whether the former employer can enforce the covenant in the bankruptcy case. The former employer will sometimes seek relief from the stay to proceed with injunctive action in state court. Sometimes the issue morphs into whether a prepetition injunction is a claim in the Chapter 13 case.

[6]

The Chapter 13 cases addressing noncompete agreements reflect the general bankruptcy case law on this subject: the decisions are in conflict about where and to what extent a noncompete is enforceable against a Chapter 13 debtor. The U.S. Court of Appeals for the Seventh Circuit held that a covenant not to compete and preliminary injunction issued by a state court before the Chapter 13 case are not claims; however, the court remanded for further consideration the question whether the bankruptcy court should grant relief from the stay to permit the former employer to enforce of the injunction.5 When the employment contract terminated prepetition and no executory contract remained to be assumed or rejected, another court granted the former employer relief from the stay on the theory that state courts are the more appropriate forum in which to determine whether the covenant not to compete was enforceable, whether the debtor breached the covenant and whether an injunction should issue.6 In contrast, another court held that the beneficiary of a prepetition covenant not to compete is not entitled to stay relief to enforce a prepetition state court injunction when the debtor rejected the underlying executory contract in the Chapter 13 plan.7 This court found that the covenant not to compete survived rejection of the underlying contract8 and the beneficiary of that covenant had a claim in the Chapter 13 case; however, enforcement of the covenant depended upon questions of bankruptcy law that were appropriately determined in the Chapter 13 case.


 

1  See Shell Oil Co. v. Waldron, 785 F.2d 936 (11th Cir. 1986) (Court reverses confirmation of Chapter 13 plan filed by experienced bankruptcy attorney when admitted sole purpose of plan was to reject an option agreement for the sale of land. Debtors were not financially distressed and “had no real need for the bankruptcy process.”); Chinichian v. Campolongo, 784 F.2d 1440 (9th Cir. 1986) (Court denies confirmation on “bad-faith” grounds when purpose of Chapter 13 was to reject executory contract and defeat state court specific performance litigation.); In re Newsome, 92 B.R. 941 (Bankr. M.D. Fla. 1988) (Court denies confirmation on good-faith grounds and dismisses for cause for bad-faith filing when “this plan . . . is nothing more than an attempt to get out of a contractual obligation voluntarily and willingly undertaken and . . . scale down the purchase price . . . to less than one-fourth of the original price agreed upon. . . . [T]his is nothing more than a two party dispute which is already being litigated in a nonbankruptcy forum.”); In re Meehan, 46 B.R. 96 (Bankr. E.D.N.Y. 1985), aff’d sub nom. Bregman v. Meehan, 59 B.R. 380 (E.D.N.Y. 1986) (Court grants relief from the stay upon finding that the debtor “undoubtedly” filed Chapter 13 to reject a contract for sale of the debtor’s home after unsuccessful state court litigation resulted in an order of specific performance.).

 

2  See Setzer v. Hot Prods., Inc., 47 B.R. 340 (Bankr. E.D.N.Y. 1985) (overcoming debtor’s argument that rejection of executory contracts is a legitimate purpose for filing a Chapter 13 case by finding that the debtor has no unsecured debt and would be unable to demonstrate benefit to unsecured creditors to be entitled to reject contracts).

 

3  80 B.R. 927 (Bankr. C.D. Ill. 1987).

 

4  See also § 172.1 [ Debtor Can Assume, Assign or Reject Executory Contracts ] § 102.1  Debtor Can Assume, Assign or Reject Executory Contracts.

 

5  In re Udell, 149 B.R. 898 (Bankr. N.D. Ind. 1992) (Debtor’s former employer is entitled to relief from the stay to enforce preliminary injunction with respect to a noncompete provision in its employment contract with the debtor. Applying Indiana law, the obligation that the injunction is designed to enforce does not constitute a debt or a claim in a bankruptcy case, notwithstanding the debtor’s argument that the debtor can reject the employment agreement and its noncompete provisions.), aff’d in part, 18 F.3d 403 (7th Cir. 1994) (Bankruptcy court correctly determined that covenant not to compete and preliminary injunction issued by state court before the filing of the Chapter 13 case were not “claims” in the Chapter 13 case. Bankruptcy court’s decision to grant relief from the stay to the party in whose favor the noncompete ran was remanded to district court for further consideration.).

 

6  In re Hughes, 166 B.R. 103 (Bankr. S.D. Ohio 1994).

 

7  In re Kilpatrick, 160 B.R. 560 (Bankr. E.D. Mich. 1993).

 

8  Accord Kwik-Kopy Corp. v. Klein (In re Klein), 218 B.R. 787 (Bankr. W.D. Pa. 1998) (Rejection of franchise agreement for a copy center did not terminate noncompete provisions; however, noncompete was unreasonable under state law and was reformed to proper time, space and term restrictions. Royalty claims of franchiser arose from the postpetition rejection of the contract and are postpetition claims entitled to administrative expense status in Chapter 13 case.).