Cybertron Int'l, Inc. v. Capps (In re Capps)

IN RE: MICHAEL RAY CAPPS, Debtor.

IN RE: CYBERTRON INTERNATIONAL, INC., Plaintiff, v. MICHAEL RAY CAPPS, Defendant.

Case No. 16-10141

Adv. No. 17-5090

UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF KANSAS

July 26, 2018

DESIGNATED FOR ONLINE PUBLICATION

Chapter 7

MEMORANDUM OPINION

Can the beneficiary of a covenant not to compete (CNC) enforce it against a chapter 7 debtor after discharge? Assuming the covenant is enforceable under state law, whether it amounts to a claim in bankruptcy and whether it is an executory contract governed by 11 U.S.C. § 365 is a matter of bankruptcy law. When Michael Capps sold his interest in Information Technologies of Kansas, Inc. to Cybertron International in September of 2015, Cybertron hired him. In two separate agreements Capps executed - a Restrictive Covenants Agreement and an Employment Agreement, he promised not to compete with Cybertron for five years, not to disclose any of Cybertron's proprietary information, and not to solicit its customers. After Capps filed bankruptcy in February of 2016, Cybertron dismissed him. In a state court action commenced April 10, 2017, Cybertron claimed that Capps violated all three promises after he was terminated and obtained a temporary injunction restricting Capps' work in the information technology industry in Cybertron's market area. Capps argues that his CNC and other obligations were discharged in his bankruptcy case and that Cybertron's lawsuit violates § 524's discharge injunction. He also says that, in any event, the obligations are contained in executory contracts that have been rejected, negating their effect.

But breaches of CNCs that occur post-petition are not claims that are discharged. Nor are CNCs executory contracts. If the CNCs are enforceable under Kansas law, and if Capps breached any of them, Cybertron's rights to injunctive relief and liquidated damages against Capps are not discharged and its actions toenforce the Agreements do not violate the discharge injunction. Cybertron is entitled to a declaratory judgment to that effect.¹

Facts²

Integrated Technologies of Kansas, Inc. (ITK) and Cybertron International, Inc. (Cybertron) were competitors. Michael R. Capps was president and controlling shareholder of ITK. In September of 2015, ITK agreed to sell its customer accounts to Cybertron. Capps was to become a Vice President of Cybertron and to receive minority shares in Cybertron. As part of the transaction, Capps signed an Employment Agreement and a Restrictive Covenants Agreement (together, the Agreements), in which he agreed not to compete with Cybertron, not to disclose Cybertron's proprietary information (including whatever information it bought from ITK), and not to solicit Cybertron's customers for a period of five years within Cybertron's market area.³ Capps filed a Chapter 7 bankruptcy on February 4, 2016 and received his bankruptcy discharge on May 16, 2016. Cybertron fired him on June 2, 2016. The following April, Cybertron sued Capps in Kansas state court to enforce the Agreements and sought an injunction against his continuing violation ofthe restrictive covenants they contain. All of Capps's alleged violations of the restrictive covenants occurred after he filed bankruptcy. The Restrictive Covenant Agreement provides that if Capps violated the covenants, Cybertron would be entitled to an injunction and liquidated damages of $50,000 per violation.⁴ The state court granted a temporary injunction on May 31, 2017.⁵ It remains in effect with the unfortunate but predictable effect that Capps cannot work in his chosen field of information technology in Cybertron's market area.

Cybertron filed this action for a declaratory judgment that Capps's obligations under the Agreements were not discharged and that its enforcement efforts did not violate the discharge injunction.⁶ The parties agreed to submit this matter to me on stipulated facts and briefs. Cybertron's complaint should be granted.

Analysis

The bankruptcy court has jurisdiction of this declaratory judgment action.

Though Fed. R. Civ. P. 57 does not apply in bankruptcy court, Fed. R. Bankr. P. 7001(9) makes actions for declaratory judgments adversary proceedings. A declaratory judgment is a remedy for an underlying cause of action, not a substantive claim for relief.⁷ The Declaratory Judgment Act of 1934, 28 U.S.C. §2201, provides that declaratory judgments may only be issued by "courts of the United States," courts whose judges serve for life or during their good behavior. Though bankruptcy judges do not enjoy that privilege, the case law recognizes bankruptcy courts' authority to grant declaratory judgments.⁸ The Declaratory Judgment Act does not, however, confer subject matter jurisdiction on bankruptcy courts; the plaintiff must establish an actual controversy and an independent basis for federal subject matter jurisdiction.⁹

28 U.S.C. § 1334(a) grants the district courts original and exclusive jurisdiction of all cases under Title 11 and non-exclusive jurisdiction of civil proceedings arising under Title 11, or arising in or related to cases in Title 11. The district courts are authorized to refer all such matters to the bankruptcy judges sitting in their districts by 28 U.S.C. § 157(a). The District of Kansas has made a general referral of those matters to the bankruptcy judges here by standing order and local rule.¹⁰ This adversary proceeding seeks a declaration that Cybertron's enforcement of the restrictive covenants against Capps does not violate § 524'sdischarge injunction. Having issued Capps's discharge, this Court has authority to interpret and enforce it.¹¹ I also have core jurisdiction over proceedings to determine whether Capps's obligations under the Agreements terminated upon entry of his bankruptcy discharge.¹² The Court therefore has an independent basis for exercising subject matter jurisdiction and Fed. R. Bankr. P. 7001(9) authorizes this adversary proceeding for declaratory relief.

Restrictive covenants are enforceable under Kansas law.

The Kansas appellate courts have long approved entering into and enforcing covenants against competition and similar restrictions as part of Kansans' freedom of contract so long as the covenants meet four tests.¹³ The restraint must (1) protect a legitimate business interest of the employer; (2) not impose an undue burden on the employee; (3) not injure the public welfare; and (4) be reasonable both as to its duration and its geographical limitations. In this case, Cybertron asserts that Capps's alleged actions in soliciting its customers, using its confidential information, and competing against it within the five-year term of his contract and within Cybertron's market area all violate the Agreements. In the Agreements, Capps consented to the entry of an injunction against these actions. In addition, theRestrictive Covenant Agreement provides for the payment of liquidated damages of $50,000 per occurrence as a cumulative remedy. Kansas law allows parties to stipulate to a set amount of damages for breach of an agreement if the provision is for liquidated damages and isn't a penalty.¹⁴ Anyone challenging a liquidated damages provision has the burden of proving that it is unenforceable. To determine that, courts look at the whole contract, the positions of the parties, and the circumstances.

A liquidated damages provision will be enforced if (1) the amount stipulated is reasonable in view of the value of the subject matter of the contract and of the probable or presumptive loss if a party breaches the contract, and (2) the nature of the transaction is such that actual damages resulting from the breach would not be easily or readily determinable.¹⁵

The provision will be judged penal if it bears no relation to the actual injury caused by the breach.

For this action's purposes, I assume without deciding that the Agreements' restrictive covenants and damages provisions are enforceable at Kansas law.¹⁶ My role is limited to determining whether Capps's obligations under the Agreements are "claims" as defined in the Bankruptcy Code and, if so, whether the debts that comprise those claims have been discharged. I also consider whether the covenantsare executory contracts that the trustee rejected by inaction and rendered them unenforceable against Capps after discharge.

Capps' restrictive covenant obligations are not "claims" in his bankruptcy and were not discharged.

Capps's obligations under the Agreements are not claims because they do not give rise to a right to payment. Even if they did, his alleged violations occurred after the bankruptcy petition date.

A "claim" is defined in the Bankruptcy Code as a—

(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.¹⁷

In determining whether an obligation forms the basis for a claim under this definition, courts consider whether complying with the obligation involves the expenditure of money.¹⁸ In Kennedy v. Medicap Pharmacies, Inc., the Sixth Circuit Court of Appeals noted that, while the breach of a covenant not to compete gives rise to an "equitable remedy," it is not a claim because it cannot be remediated by mere money. The equitable remedy is available only because the enforcing party has no adequate remedy at law, meaning there arises no right to payment on the enforcer's part. The Sixth Circuit noted that some bankruptcy courts have reachedthe contrary conclusion, holding that because the enforcing party could choose either damages or injunctive relief, the obligation is an equitable right that "gives rise to a right to payment."¹⁹ In concluding that...