What to do when your franchisee files for bankruptcy

With the economic downturn caused by COVID-19, many expected a tidal wave of business bankruptcy filings. After an initial spike in retail bankruptcy cases at the start of the pandemic, the onslaught of bankruptcy has yet to materialize. Whether due to PPP loans, other available credit, amending and forbearing agreements, or government moratoriums on foreclosure and eviction proceedings, many businesses have been able to temporarily avoid debt without having to need to file for bankruptcy protection at BankruptcyHQ. As moratoriums end and debts become due, franchisors would be keen to prepare for an increase in franchisee bankruptcy filings.

Bankruptcy cases are filed for two main purposes. Most franchisees want to use the bankruptcy process to reorganize their financial affairs and stay in business under Chapter 11 of the Bankruptcy Code. Other franchisees file for bankruptcy protection to liquidate assets through an orderly process in which assets are pooled to make distributions to creditors. In either scenario, without preparation and active participation in a bankruptcy case, a franchisor risks seeing its franchise contract transferred to an unqualified operator or retained by the debtor-franchisee on unacceptable terms.

The franchise agreement becomes the property of the bankruptcy estate

Upon filing for bankruptcy, a franchise agreement becomes the property of the bankruptcy debtor/franchisee’s assets. This means that the franchisee’s rights in the franchise agreement are protected by automatic stay, an injunction imposed by Section 362(a) of the Bankruptcy Code. Unless relief is obtained from the bankruptcy court, the automatic stay prevents any action to terminate or otherwise affect the franchisee’s rights in the franchise agreement, without the permission of the bankruptcy court. Even though a franchise agreement may include provisions that purport to default and terminate a franchisee’s interests based on a bankruptcy filing, such “ipso facto” clauses are not valid in bankruptcy cases. Once the franchise agreement becomes part of the bankruptcy, subject to the remedy of monetary and other defects, the debtor/franchisee will have the option of assuming or rejecting the franchise agreement, notwithstanding these clauses ipso facto. However, a franchisor can take certain measures to prevent its franchise agreement from being assumed and/or assigned in the event of the bankruptcy of its franchisee.

Pre-bankruptcy termination

To prevent a franchise agreement from being tied to bankruptcy proceedings, the best option for a franchisor is to unambiguously terminate the agreement before filing for bankruptcy. The importance of unambiguous termination language has been clearly established by several bankruptcy courts. The importance of this issue crystallized in In RMH Franchise Holdings, Inc. (RMH), 590 BR 655, 661 (Bankr. Del. 2018), which involved one of Applebee’s largest restaurant franchisees. RMH defaulted under its franchise agreement and owed Applebee approximately $12 million at the time of the bankruptcy filing. If Applebee’s contracts had been terminated prior to the bankruptcy, they would not have formed part of RMH’s bankruptcy estate and could not have been taken over and/or assigned by RMH.

Prior to the bankruptcy filing, Applebee’s advised RMH that the agreements would terminate on the 91st day if its flaws remained uncorrected. The healing period was extended several times, and Applebee even agreed to refrain from pursuing his rights until a certain date. On this date, RMH filed for bankruptcy. The bankruptcy court considered whether the franchise agreements had been terminated prior to the bankruptcy, and therefore not the ownership of the bankruptcy assets. The Court ruled that through the cure extension letters, Applebee’s had not clearly and unambiguously terminated the franchise agreements, as required by state law. This case reveals the critical importance of providing valid and unambiguous termination notices before a bankruptcy is filed. Otherwise, the franchise agreement will be subject to assumption and assignment in the event of the bankruptcy of a franchisee.

In particular, even where notices of termination are clear, their effectiveness may be subject to other state court rights that suspend termination. For example, in Krystal Cadillac Oldsmobile GMC Truck,142 F.3d. 631, 636 (3d. Cir. 1998), the Third Circuit Court of Appeals held that a termination of a franchise agreement was not effective on the date the bankruptcy filing was filed, because the notice of termination remained subject to an undecided appeal pending before the State Vehicle Board. Because state law provided that the termination was not effective for the duration of the appeal, the franchise agreement was considered part of the bankruptcy filing.

The franchisor may object to the assignment of franchise contracts

If a franchise agreement is not terminated before bankruptcy, the franchisee’s right to assume and assign the agreement is very broad. Nevertheless, franchisors can block these assignments in certain circumstances. Specifically, Section 365(c)(1) of the Bankruptcy Code requires courts to determine whether a contract is one where under applicable law a franchisor cannot be compelled to accept the execution of an assignee.

For example, it is well established that contracts for personal services fall within the scope of the 365(c)(1) limitation on assignment to third parties. In re Taylor, 913 F.2d. 102, 106 (3rd Cir. 1990). New Jersey courts have held that some franchise agreements require the franchisee’s personal services as owner-operator, and in such circumstances the courts uphold the franchisor’s expectation to consider the named owner-operator as the only party acceptable performer. In a bankruptcy case, the court will seek to apply the applicable state law to determine if the franchise agreement is truly a personal service contract. Noted in the taylor case, such a determination will depend on the nature of the contract, the circumstances of the case and the intention of the parties to the contract. Some of the circumstances considered are the extent of the franchisee’s involvement in the franchise, the extent to which the nature of the franchise permitted personal service from the franchisee, the multi-franchise nature of the operation, the number of employees in the operation of the concession, and other factors.

Another opportunity for a franchisor to object to the assignment of its franchise agreements under Section 365(c)(1) of the Bankruptcy Code is in the context of trademark licensing. Under federal trademark law, trademark licenses are not transferable without the express permission of the licensor. Miller vs. Glen Miller Prods., Inc., 454 F.3d. 975, 988. 992-993 (9^and Cir. 2006). Accordingly, since applicable law prohibits assignments of trademark licenses outside of bankruptcy, such agreements may not be assigned in bankruptcy proceedings. Indeed, some courts have extended the application of this rule to prevent the appropriation of the trademark license by the debtor himself. In In D Trump Entertainment Resorts, Inc., the Delaware bankruptcy court determined that because the trademark agreement was non-assignable under non-bankruptcy law, according to a “hypothetical test”, the debtor could not even assume the trademark license, even when the debtor had no intention of assigning the license to a third party. 526 BR 116, 118 (Bankr. D. Del. 2015).

Whether it involves personal services contracts, brand licenses or other contracts deemed non-assignable outside of bankruptcy, franchisors must be vigilant in monitoring franchisees who may seek to assign such contracts despite restrictions of section 365 (c) (1) of the Bankruptcy Code. .

Adequate performance assurance

Even where a franchise agreement was not terminated prior to bankruptcy and is not subject to the anti-assignment provisions of section 365(c)(1), a franchisor may still object to the taking over. charge and/or assignment of its franchise agreement, when the franchisee/debtor has not provided “adequate assurance” of future performance. The obligor must be able to establish that it or the proposed assignee can promptly remedy outstanding defaults and perform prospectively in accordance with the specific terms and conditions of the franchise agreement. An assignee must be able to meet the financial terms and operational standards set out in the agreement. Again, a franchisor must be vigilant in monitoring the bankruptcy case and ensure that procedures are established to allow the review of the proposed assignee to be carried out in accordance with the specific terms of the franchise agreement.