EllDan Corp. v. Steele (In re EllDan Corp.), 2023

The debtor, EllDan Corp., and Kevin Steele, the plaintiffs, contended that the covenants not  to compete contained in franchise agreements between the debtor and the franchise, Fantastic Sams Franchise Corp., were unenforceable, and, thus, the plaintiffs should be allowed to operate competing hair salons within the geographic area covenant. The Bankruptcy Court found that, “[n]otwithstanding the debtor’s rejection of the franchise  agreements under 11 U.S.C.S. § 365, the franchisor remained contractually entitled to  injunctive relief for the breach.” The debtor was enjoined from operating businesses in its  current locations and at any other location within the area designated in the covenants for  the duration of the non compete period. 

Fantastic Sams Franchise Corp.’s pleadings at the outset of the adversary proceeding  sought injunctive relief on five counts. The parties have resolved all but one issue. “The  parties remain in disagreement, however, about the legal effect of certain covenants not to  compete in their prepetition agreements.” The Bankruptcy Court held an evidentiary hearing, and both parties consented to summary judgment. 

Summary of undisputed facts

Fantastic Sams Franchise Corp. is a franchisor of the  “Fantastic Sams” brands of hair salons. The debtor purchased seven salons from a former  franchisee. The debtor and Fantastic Sams Franchise Corp. entered into seven franchise  agreements in December 2018. In 2021, the debtor expressed concerns about its solvency  to Fantastic Sams Franchise Corp. In February 2022, Fantastic Sams Franchise Corp. agreed to a 26-week abatement of royalties. By August 2022, the debtor had stopped all payments to Fantastic Sams Franchise Corp. On Sept. 2, 2022, Fantastic Sams Franchise Corp. sent a notice of default. The debtor did not cure the default and filed this bankruptcy  proceeding on Nov. 10, 2022. 

The Bankruptcy Court entered an order granting rejection of the Fantastic Sams Franchise  Corp. franchise agreements on Jan. 11, 2023. “Thereafter, Debtor continued to operate  under the name ‘Sota-Styles’ at four of the Original Locations. Debtor later closed another  the Burnsville Original Location and opened a new ‘Sota-Styles’ salon at 7690 160th St. W.,  Lakeville, MN 55044 (Lakeville).” 

Discussion.

“Both parties affirmatively stated summary judgment was appropriate at this  juncture. Accordingly, with the consent of the parties, the Court now reviews this matter for  summary judgment under Rule 56(f)(3).” 

The post-termination covenants not to compete were enforceable. The rights of the  parties are set forth in the franchise agreements. All of the agreements include covenants not to compete, requiring in part a two-year period following the expiration or termination of  the franchise agreement whereby the franchisee may not participate in any capacity in any  hair care business within a five-mile radius of the salon, including the salon location itself.  Additionally, they may not participate within 2.5 miles of an Fantastic Sams Franchise Corp. salon. “Moreover, the parties expressly stipulated that ‘the periods and geographical  restriction within which [Fantastic Sams Franchise Corp.] has reserved its rights regarding  the continued operation by [Debtor and Mr. Steele] are essential to this Agreement and are  fair and reasonable restrictions.’” 

Covenants not to compete are generally enforceable under Minnesota law if they were “for  a just and honest purpose, for the protection of a legitimate interest of the party in whose favor it is imposed, reasonable as between the parties, and not injurious to the public.” (Adcom Express, Inc. v EPK, Inc.)  

Under Minnesota law, a franchisor had a just and honest purpose and a legitimate interest  in protecting itself from competition from a former franchise operating in the same market. On termination of a franchisee relationship, the franchisor likewise had a legitimate interest  in retaining its business interests and goodwill in that area. 

The duration and geographic range in the covenants not to compete were reasonable under  Minnesota law, and enforcement of the covenants not to compete did not harm the public  interest. Had Steele (who was also a signer of the covenants not to compete) been an  employee and not an owner, they would have been under greater scrutiny, since covenants  not to compete were disfavored “to the extent they limit the right of a person to work and  earn a livelihood.” (Bennett)  

The debtor breached the noncompete covenants by operating in the current  locations. The covenants not to compete covered the debtor’s business activities until Jan. 11, 2025. There was no dispute that the debtor was operating salons within the restricted  area. Those operations constituted a breach of the covenants not to compete. 

Fantastic Sams Franchise Corp. was entitled to injunctive relief. The debtor argued that  rejection of the agreements eliminated them in their entirety or in the alternative “it limited  FSFC’s available remedy to filing a proof of claim for rejection damages in its main  bankruptcy case.” The Bankruptcy Court had considered and rejected this argument. The  agreements were not rescinded by the rejection. The rejection left Fantastic Sams Franchise  Corp. to determine what its remedies would be under nonbankruptcy law for the breaches.  “[T]o the extent FSFC seeks the equitable remedy of injunctive relief for Debtor’s breach of  the Non-Compete Covenant, Debtor’s rejection of the FSFC Franchise Agreements did not  modify FSFC’s legal entitlement to such relief.” 

Under the agreements, the debtor and Steele agreed that Fantastic Sams Franchise Corp. would be entitled to injunctive relief upon breaches of the covenants not to compete. An  addendum to the agreements also emphasized that Fantastic Sams Franchise Corp. would  be entitled to injunctive relief. Despite the rejection, Fantastic Sams Franchise Corp. remained entitled to injunctive relief. 

Ordered

“Debtor (as well as its shareholders, members, partners, and managers) and  Kevin Steele in his immediate family (including spouses, domestic partners, parents or and  persons children), must immediately cease to operate hair care businesses” within the  restricted area. All were further enjoined from “owning or operating a hair care business in  any location prohibited by Sections 12.d.9 or 12.d.10 of the FSFC Franchise Agreements  until January 11, 2025.”