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The outer limits of dischargeability - when is a claim a claim in bankruptcy?

The scope of what may be considered a "claim" in bankruptcy has vital importance to the operation of the Bankruptcy Code. In many respects, the claim is the atom around which much of the Bankruptcy Code is structured. For example, an entity does not qualify as a "creditor" in bankruptcy unless it holds a claim. (2) Further, the discharge provisions of the Bankruptcy Code apply only to a "debt"--defined as a "liability on a claim" in Bankruptcy Code [section]101(5). Accordingly, obligations that do not fall within the bankruptcy definition of a claim are not subject to discharge and survive bankruptcy. Thus, while the relief available to a debtor in bankruptcy is extensive, it is not without limits. This article explores this limitation in the context of two types of such obligations that fall beyond the outer limits of dischargeability in bankruptcy--environmental obligations and contractual obligations not to compete.

The Code Definition

In [section]101(5), the Bankruptcy Code defines a claim as follows:

(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or

(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.

This definition is easily applied to the simple case of a money obligation owed by the debtor to a creditor. Under part (A) of the definition, the creditor to whom the money is owed has a right to payment under nonbankruptcy law and thus holds a claim. The application of the definition is not quite as clear, however, when the debtor has breached a duty that would entitle the person to whom the duty is owed to an equitable remedy under nonbankruptcy law. A breach of performance that cannot be adequately redressed by the payment of money, and thereby lacks an adequate remedy at law, warrants an equitable remedy. If the equitable remedy gives rise to a claim under subsection B of the definition of a claim, then the obligation may be discharged in bankruptcy. However, if the equitable remedy does not qualify as a claim under [section]101(5)(B), then it is not a debt for purposes of bankruptcy, and the obligation survives bankruptcy unaffected by the debtor's discharge. (3) In such cases, the party to whom the obligation is owed may enforce the obligation under applicable nonbankruptcy law.

There are two principal examples of obligations of a debtor that may fall outside the definition of a claim and, therefore, are not affected by the debtor's discharge. The first is a debtor's obligations under state or federal environmental regulations. The second is a debtor's obligations under a noncompete clause in an employment contract. These two obligations illustrate the outer limits of dischargeability in bankruptcy and are the focus of this article.

Legislative History

A brief examination of legislative history will be helpful to understanding the scope of a claim in bankruptcy. Under the Bankruptcy Act of 1898, creditors were not allowed to participate in a bankruptcy for purposes of distribution unless their claims were "allowed." If a claim was not allowed, then it was not discharged. A claim was only allowed if it was "provable." As a result, the debtor would effectively be denied a "fresh start" in cases where a creditor held a significant nonprovable claim that would be unaffected by the debtor's discharge.

When enacting the Bankruptcy Code of 1978, Congress removed the concept of provability from the definition of a claim in favor of the broader definition of the term found in [section]101(5). (4) The legislative history indicates that Congress intended that "all legal obligations of the debtor, no matter how remote or contingent," would be included in the bankruptcy. (5) Consistent with this intent, the Supreme Court has unequivocally adopted a broad interpretation of the [section]101(5) definition, declining to limit the definition as long as the creditor has a right to payment under nonbankruptcy law. (6)

The breadth of the definition, however, is not limitless. This is particularly true with regard to subsection B. To have a claim under [section]101(5)(B) there must be an "equitable remedy" that arises from a "breach of performance" that gives rise to a "right to payment." The existence or absence of an equitable remedy is relatively straightforward; it depends on relevant nonbankruptcy law. Equally settled is the proposition that a breach of performance can stem from both contractual and statutory obligations. (7) The controversy in this area surrounds the right to payment element of the subsection B definition of a claim.

By its terms, [section]101(5)(B) excludes a right to an equitable remedy for breach of performance where there is no concomitant right to payment. Such a right is not a claim in bankruptcy and, as such, is not subject to discharge in bankruptcy. (8) However, the legislative history indicates that equitable remedies that can be adequately satisfied in the alternative by a right to payment were meant to be included as claims. (9) If the right to payment is an "alternative" to the right to an equitable remedy, the necessary relationship clearly exists--"the two remedies would be substitutes for one another." (10) In such cases, the creditor holds a claim that can be discharged in bankruptcy. Whether an equitable remedy gives rise to a right to payment is typically determined under the applicable state or federal law. (11)

Environmental Obligations

The treatment of an environmental obligation in bankruptcy is determined by whether the obligation qualifies as a claim under [section]101(5) and when such claim arose. (12) Typically, environmental obligations can be sorted into three categories, each receiving different treatment under the Bankruptcy Code. (13) The first is a debtor's obligation to pay money to the government as reimbursement for clean up work done prior to the debtor filing under either Ch. 7 or 11. The obligation to pay money in this instance clearly constitutes a right to payment and, therefore, is a claim under [section]101(5)(A). (14) As such, this type of claim is subject to discharge in bankruptcy.

The second type of environmental obligation is an injunction that prohibits future pollution, issued against a debtor before filing bankruptcy, where the debtor intends to continue business operations. This type of obligation does not give rise to a claim under [section]101(5)(B) because the injunction is an equitable remedy for breach of environmental regulations that does not give rise to a right to payment. In this situation, there is no alternative right to payment of money as a substitute for an anticipated violation of a statute or injunction, hence the government does not have the alternative right to payment prepollution. (15) Because the injunction in this case is not a claim, it is not affected by the debtor's discharge.

The third and most debated category of environmental obligation is a debtor's unsatisfied obligation to perform a clean up. This category can be further broken down into two subcategories: those issued pursuant to a statute that gives the government an alternative right to payment, and those that do not expressly do so. (16) One line of cases holds that if the applicable nonbankruptcy law (i.e., an environmental law such as CERCLA) allows the government to pursue an equitable remedy or alternatively seek money damages, then the environmental obligation qualifies as a claim under [section]101(5)(B). (17) Another line of cases holds that no right to payment and, therefore, no claim exists if the government pursues specific performance instead of money damages. (18)

Even in cases where the applicable environmental law does not expressly provide for an alternative right to payment, the Supreme Court has held that the obligation constitutes a claim if the statute contains an enforcement mechanism for equitable remedies and the government uses that mechanism. (19) Other courts have further held that if the government seeks to enforce a clean up order, and compliance with the clean up order would require the debtor to spend money, the injunction thereby becomes a monetary obligation that gives rise to a right to payment and, therefore, qualifies as a claim. (20)

Noncompete Agreements

The second area that tests the limits of whether injunctive remedies constitute claims in bankruptcy is the area of noncompete agreements. A classic noncompete agreement found in an employment contract prohibits an employee from engaging in a specified manner of conduct, within a specified geographical area, and for a specified period of time after termination of employment. The covenants usually provide for injunctive relief and liquidated damages in the event of a breach. Because damages are difficult to estimate and prove, the employer's objective in executing a noncompete agreement is to prohibit competition prospectively--through injunctive relief if necessary.

A common initial reaction by bankruptcy attorneys is to conclude that a noncompete agreement is governed by [section]365 and that the analysis begins and ends with the decision of whether to assume or reject the agreement as an executory contract. (21) However, the analysis should not begin with the question of whether the noncompete agreement falls within the definition of an executory contract on the date of filing the bankruptcy petition. As a fundamental matter, the analysis must begin by resolving the question of whether the breach of such an agreement gives rise to a claim under [section]101(5)(B). (22)

Courts are considerably divided on the question of whether the right to enforce a noncompete agreement through injunctive relief amounts to a claim within the meaning of [section]101(5)(B). One line of cases holds that the injunctive enforcement of noncompete agreements gives rise to a right to payment, and, therefore, is a claim in bankruptcy. (23) The other line holds that it does not. (24) Courts on each side of the argument diverge in the reasoning they adopt to ultimately reach the same conclusion. However, all courts look to applicable state law to determine whether the equitable remedies awarded in a judgment would constitute claims. (25)

The analysis of what constitutes a claim in the context of noncompete agreements must necessarily diverge from the analysis in the seemingly similar context of environmental obligations. In the case of environmental obligations, governmental agencies have an obvious incentive to intervene and to undertake a clean up where a debtor files for bankruptcy. In these situations, the government must act to protect the public where the debtor cannot do so despite the mandates of a clean-up order. However, in the case of noncompete agreements, no other parties are likely to intervene because only the private parties to the contract are affected by its breach.

The more significant difference between these two examples is the nature of the wrong that an injunction would attempt to redress. In the case of past pollution, it is relatively simple to take a snapshot of the damage caused because the damage is physical in nature. On the 200th day of pollution, the debtor has caused a specific level of damage to the property and surrounding environment, which will cost a determinable amount in dollars to repair. Clean up or the cost of clean up, a specific dollar amount, is the only means by which to remedy the wrong committed up to that date, while an injunction against future pollution is necessary to prevent further harm from being committed.

In the context of the breach or threatened breach of a noncompete agreement, however, the intangible nature of the damages makes it harder to take a snapshot of the damage on a specific date. There are many ways in which a debtor can violate a noncompete agreement, and the violative acts of the debtor can have consequences that may not be felt immediately because of the intangible nature of business concepts such as goodwill and client relationships. For example, if a debtor calls his or her employer's clients and informs them that he or she will be moving to a new company or starting his or her own, the detrimental effects of such a breach may not be felt by the employer until much later, when the client actually leaves the employer. If the debtor also makes derogatory remarks about the employer in this conversation, the detrimental effects to the employer may affect the employer's goodwill, but again the timeframe is difficult to pinpoint. It is difficult to draw the line between damages that have already occurred and those that may or may not occur in the future. Because of this, damages are typically inadequate to redress this wrong.

Thus, the intangible nature of damages stemming from noncompete agreements radically complicates the analysis. For the reasons outlined above, the more appropriate conclusion is to find no right to payment exists, and, therefore, no dischargeable claim arises in this context. Among those courts holding that the enforcement of noncompete agreements does not give rise to a claim, some reason that because no expenditure of money is required to comply with an affirmative duty under an injunction, no right to payment exists and, therefore, no claim arises. (26) In the much-cited Seventh Circuit opinion In re Udell, 18 F. 3d 403 (7th Cir. 1994), the court reviewed an employment contract that provided for both injunctive relief and monetary damages and held that there was no alternative right to payment because the injunctive and monetary remedies were meant to be cumulative, not alternatives. (27) Other courts have determined that no claim arises where injunctions are issued in state court based on findings that damages are an inadequate remedy and, thus, no right to payment could arise. (28) In the same vein, other courts have concluded that no right to payment giving rise to a claim can exist because injunctive rights only exist where a remedy at law is inadequate or the threatened harm is irreparable. (29)

In Florida, covenants not to compete are governed by F.S. [section]542.335. Section 542.335(j) states that "[t]he violation of an enforceable restrictive covenant creates a presumption of irreparable injury to the person seeking enforcement of a restrictive covenant." (30) Thus, under Florida law, if an employer can show the existence of one or more legitimate business interests justifying the restrictive covenant and making the covenant enforceable, then irreparable injury is presumed. (31) It is necessary to determine whether damages are ascertainable in order to determine whether a particular injury is irreparable. (32) Where damages are not ascertainable, the harm is irreparable, and an injunction is the only suitable remedy. (33) It follows that in these instances no alternative right to payment exists, and, therefore, no claim arises.

Among the courts that hold that the right to enforce a noncompete agreement through injunctive relief gives rise to a claim under [section]101(5)(B), those favoring strict interpretation hold that because only monetary damages fall within the statutory definition of a claim, an injunction can give rise to a claim only when it has been reduced to an obligation to pay money. (34) Other courts reason that when, under applicable state law, the enforcer of the covenant may choose either injunctive relief or money damages, the existence of this alternative is sufficient to constitute an alternative right to payment and thus a claim, regardless of which option is chosen. (35) These cases do not contradict the above analysis under Florida law. In states like Florida that presume irreparable harm where an enforceable noncompete covenant is violated, monetary damages are not a viable option for future violations, and, therefore, the ongoing breach cannot give rise to an alternative right to payment as to such future violations. Thus, there can be no claim in bankruptcy for future violations which can only be prevented by injunctive relief.

The case law becomes increasingly murky when noncompete agreements involve the transfer of rights in intellectual property by assignment or licensure. This is, at least in part, due to the unique nature of intellectual property, which can be classified as a bundle of contractual commitments as well as property rights. (36) For example, when a debtor licensee fails to perform on a commitment contained in a noncompete agreement, such failure may also constitute an infringement on the licensor's intellectual property. So unstable is the law in this area that one commentator has suggested that the question of whether a licensor can enforce a noncompete clause after the rejection of the agreement in bankruptcy depends on the venue of the bankruptcy case. (37)

Conclusion

While the relief available to a debtor in bankruptcy is extensive, it is not without limits. The exceptions from discharge applicable to debts arising from improper conduct by the debtor, such as fraud, are well known. (38) Similarly, certain debts are excepted from the discharge because of the status of the creditor. (39) Less commonly known is that there are other types of obligations that are also not dischargeable, not because of any improper conduct or the status of the creditor, but because they simply do not fall within the definition of a claim as defined in [section]101(5). Because only obligations that fall within that definition are subject to discharge, such obligations survive bankruptcy. Two significant examples of these types of obligations are certain environmental obligations and contractual obligations not to compete. These types of obligations fall beyond the outer limits of dischargeability in bankruptcy.

(1) This article is an adaptation and update of an article previously written by Judge Williamson and published by The Florida Bar Journal in October 1986. Michael G. Williamson, Claims in Bankruptcy--The Outer Limits of Dischargeability, 60 Fla. B.J., 43 (Oct. 1986).

(2) 11 U.S.C. [section]101(10) (2008).

(3) See id., [section]101(12) (defining "debt" as a "liability on a claim"); Id. Section 727(b) (providing that a discharge in a Ch. 7 case discharges the debtor from all "debts" that arose before the date of the order for relief). Id. Section 1141(d)(1)(A) (providing that a discharge in a Ch. 11 case discharges the debtor from all "debts" that arose before the date of confirmation). Id. Section 1328(a) (providing that a discharge in a Ch. 13 case discharges the debtor from all "debts" that are provided for in the plan).

(4) 124 Cong. Rec. 32,393 (1978) (statement of Rep. Edwards); 124 Cong. Rec. 33,992 (1978) (statement of Sen. DeConcini).

(5) H.R. Rep. No. 95-595, at 309 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6266; S. Rep. No. 95-989, at 21-22 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5807-08.

(6) See, e.g., F.C.C. v. NextWave Personal Comunications, Inc., 537 U.S. 293, 302 (2003) (reaffirming "the broadest available definition" of a claim); Cohen v. de la Cruz, 523 U.S. 213, 218 (1998); see also 2 Collier on Bankruptcy [paragraph]101.05[1] (15th ed. rev. 2008).

(7) See F.C.C., 537 U.S. at 303; Ohio v. Kovacs, 469 U.S. 274, 279 (1985).

(8) Bonnie Kay Donahue & Bryan D. Graham, Definition of a Claim, 9 J. Bankr. L. & Prac. 275, 294 (2000); see also 124 Cong. Rec. 32,393 (1978) (statement of Rep. Edwards).

(9) 124 Cong. Rec. 32,393 (1978) (statement of Rep. Edwards).

(10) In re Udell, 18 F.3d 403, 408 (7th Cir. 1994).

(11) Id. at 407; Donahue & Graham, Definition of a Claim, 9 J. Bankr. L. & Prac. 294-95.

(12) Courts disagree as to the application of both of these elements, but only the former is the focus of this article.

(13) Kathryn R. Heidt, Environmental Obligations in Bankruptcy [section]3:11 (2008).

(14) See Kovacs, 469 U.S. at 282-83; United States v. LTV Corp. (In re Chateaugay Corp.), 944 F.2d 997, 1008-09 (2d Cir. 1991); Heidt, Environmental Obligations in Bankruptcy, [section]3:12, citing, In re Jimmo, 204 B.R. 655, 660 (Bankr. D. Conn. 1997).

(15) Kovacs, 469 U.S. at 285 (specifically noting the court was not holding that an injunction against further or future pollution is dischargable); Heidt, Environmental Obligations in Bankruptcy, [section]3:13.

(16) Heidt, Environmental Obligations in Bankruptcy, [section]3:14.

(17) See, e.g., In re Goodwin, 163 B.R. 825, 829-34 (Bankr. D. Idaho 1993); Heidt, Environmental Obligations in Bankruptcy, [section]3:15.

(18) Torwico Electronics, Inc. v. N.J. Dep't of Envt'l Prot. (In re Torwico Electronics, Inc.), 8 F.3d 146, 148-51 (3d Cir. 1993); LTV Corp., 944 F.2d at 1008-09.

(19) Kovacs, 469 U.S. at 282-83; Environmental Obligations in Bankruptcy, [section]3:15.

(20) Vega v. Rexene Corp., No. 94-50733, 1995 WL 413074, *4 (5th Cir. 1995) (unpublished decision); United States v. Whizco, Inc., 841 F.2d 147, 150-51 (6th Cir. 1988); United States v. Apex Oil Co., Inc., 438 F. Supp. 2d 948, 951-54 (S.D. Ill. 2006); Heidt, Environmental Obligations in Bankruptcy, [section]3:16.

(21) See In re Hughes, 166 B.R. 103, 104-05 (Bankr. S.D. Ohio 1994) (rejecting the debtor's argument that a noncompete agreement is merely an executory contract); Oseen v. Walker (In re Oseen), 133 B.R. 527, 529-30 (Bankr. D. Idaho 1991) (noting the extensive preparation of counsel on issues of executory contracts).

(22) See In re Hughes, 166 B.R. at 104-05.

(23) E.g., id. at 106.

(24) E.g., Oseen, 133 B.R. at 531; see also Kennedy v. Medicap Pharmacies, Inc., 267 F.3d 493, 496 (6th Cir. 2001) (listing the decisions on both sides).

(25) In re Udell, 18 F.3d at 407.

(26) E.g., Kennedy, 267 F.3d at 498; In re Hughes, 166 B.R. at 106 (citing, May v. Charles Booher & Assoc., Inc. (In re May), 141 B.R. 940, 943 (Bankr. S.D. Ohio 1992)).

(27) In re Udell, 18 F.3d at 409.

(28) See, e.g., Oseen, 133 B.R. at 530-31; In re Cox, 53 B.R. 829, 832-33 (Bankr. M.D. Fla. 1985); Howard Steinberg, 2 Bankruptcy Litigation [section]10:4 (2008).

(29) In re Printronics, Inc., 189 B.R. 995, 1001 (Bankr. N.D. Fla. 1995); Oseen, 133 B.R. at 531; William L. Norton, Jr., 2 Norton Bankruptcy Law and Practice [section]46:9 (3d ed. 2008).

(30) Fla. Stat. [section]542.335(j) (2007).

(31) Id.

(32) In re Printronics, 189 B.R. at 1001 (citing, Liza Danielle, Inc. v. Jamko, Inc., 408 So. 2d 735, 738 (Fla. 3d D.C.A. 1982)).

(33) Id.

(34) See Silk Plants, Etc. Franchise Systems, Inc., v. Register, 100 B.R. 360, 362-63 (M.D. Tenn. 1989); In re Annabel, 263 B.R. 19, 27-28 (Bankr. N.D.N.Y. 2001); In re Hirschhorn, 156 B.R. 379, 390-91 (Bankr. E.D.N.Y. 1993); In re Don & Lin Trucking Co., Inc., 110 B.R. 562, 568 (Bankr. N.D. Ala. 1990); Norton, 2 Norton Bankruptcy Law and Practice [section]46:9 (3d ed. 2008).

(35) E.g., In re Ward, 194 B.R. 703, 715 (Bankr. D. Mass. 1996).

(36) Thomas M. Ward, Intell ectual Property in Commerce [section]4:6 (2007).

(37) Id. at [section]4:13.

(38) See 11 U.S.C. [section]523(a)(2) (excepting debts arising from false financial statements and fraud from discharge).

(39) See, e.g., 11 U.S.C. [section]523(a)(5) (excepting domestic support obligations from discharge).

Judge Michael G. Williamson was appointed a bankruptcy judge in 2000 and sits in the Tampa division of the Middle District of Florida. Prior to that, he spent most of his career at the Orlando law firm of Maguire, Voorhis & Wells (now Holland & Knight) specializing in business reorganizations and liquidations. He is a past chair of the Business Law Section of The Florida Bar and has been a fellow of the American College of Bankruptcy since 1993.

Stephanie Crane Lieb is an associate with Trenam Kemker in Tampa, practicing in that firm's business reorganization and bankruptcy area. Prior to that she served in the U.S. Bankruptcy Court, Tampa division, as judicial law clerk to Judge Catherine Peek McEwen from 2006-2008, and acting judicial law clerk to Judge Michael G. Williamson in 2008.

This column is submitted on behalf of the Business Law Section, Russell M. Blain, chair, and Melanie E. Damian and Peter F. Valori, editors.
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Date:Jan 1, 2009
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