Bankruptcy Code Amendments Alter Franchise Case Strategies

Thus, unlike most other creditors in a bankruptcy case, a franchisor is not only concerned with maximizing the return on its claim, also with protecting the goodwill and reputation associated with its trademark and other intellectual property. Goodwill is the primary asset of most franchisors, and a poorly run franchise location will tarnish the reputation and value of the greater franchise system.

The franchisor-franchisee relationship is further complicated in bankruptcy because most franchisors maintain some control over the franchisee's business premises. This control ranges from lessor-lessee relationships where the franchisor owns the real estate that it leases to the franchisee, to sublease arrangements where the franchisor has a right of first refusal. Where a franchise is tied to real estate or a Web site, the franchisor typically imposes contractual limitations on the disposition of these actual or virtual storefronts. Thus, in contrast to the typical account creditor, franchisors usually come to franchisee bankruptcies already wrapped in a tangled web of contracts governing intellectual property, real estate and even purchasing.

The dynamics of a franchisee bankruptcy are also greatly influenced by the fact that the franchisors typically come armed with a variety of covenants in their franchise-related agreements, including: 1) cross default provisions between multiple franchise agreements; 2) area development agreements; 3) leases owned or controlled by a common franchisee; 4) rights of first refusal on sale or disposition; and 5) collateral lease assignments, sometimes referred to as conditional options to re-enter. A conditional option to re-enter grants a franchisor the right, but not the obligation, to maintain goodwill by 'stepping-in' to the franchisee's shoes in the event of a franchisee's default.

Cure of Non-Economic Defaults of Leases and Executory Contracts

While the BAPCPA clarifies the right of a debtor to cure non-monetary defaults in leases in the event of assumption so long as the landlord is compensated for pecuniary loss, it is silent with regard to a debtor's right to cure non-monetary defaults in franchise agreements. See 11 U.S.C. 365(b)(1)(A). It is therefore suggested that non-monetary defaults in other executory contracts, like franchise agreements, cannot be cured merely by compensating for pecuniary loss. Accordingly, defaults of franchise agreements as a result of misbranding, underreporting, violations of law, and injury to the brand by the franchisee may no longer be overlooked by bankruptcy courts. Pre-BAPCPA cases interpreted the Code as allowing any default to be monetized and thereby cured by payment. The failure of Congress to amend other sections of the Code to explicitly grant debtors the right to cure non-economic defaults to other executory contracts strongly suggests that such defaults remain incurable and can prevent assumption of the executory contract.

These assumption problems associated with non-monetary defaults will also impact franchisors seeking to reorganize. Consider the bankruptcy of The Ground Round, Inc., where franchisees alleged that the franchisor collected advertising funds from its franchisees and failed to use the funds as contractually obligated. The franchisees took the position that the $3 million in advertising payments, for which the franchisor could not account, generated claims above the $8 million offered at auction for the franchise rights. The franchisees monetized their claims against the franchisor for 'failure to advertise,' and asserted $40 million in lost opportunity claims in order to block the auction sale. The monetizing of the franchisees' claims was recognized by the Turnaround Management Association as the Business Transaction of the Year 2004. Ultimately, the franchisees bought the company with $4 million cash and surrendered their claims. Ironically, the franchisees recovered much of their costs by asserting claims against the Errors and Omissions insurance policy of the franchisor.

Under the BAPCPA, however, the franchisees would have acquired the franchisor for less money and would not have been required to monetize their claims. The franchisor would have been pressed to meet a strict deadline to sell the leases, for which it ultimately received $13 million. The franchisees would have argued that the failure to advertise was a non-monetary default that could not be cured, and, therefore, the franchise rights could not be sold. Aggressive use of the BAPCPA may have turned the balance of power in the case to the point where the franchisor would have little leverage and might have considered not filing bankruptcy. Going forward, franchisors will have this leverage in its franchisees' bankruptcies.

While the determination of whether non-monetary defaults of franchise agreements will be considered 'non-curable' defaults awaits developing case law, but the BAPCPA certainly suggests assumption may be difficult.

Shortened Time for Assumption and Rejection of Leases

Prior to the BAPCPA, a debtor-tenant could extend the deadline or reject its non-residential real estate leases out indefinitely upon a showing of 'cause' over the objection of a landlord. Traditionally, courts granted such extensions for almost any reason and a debtor could extend this deadline until the confirmation of a plan.

The BAPCPA imposes a firm deadline of 120 days after filing a petition to assume or reject non-residential real property leases. See 11 U.S.C. 365(d)(4)(A). This deadline may be extended once by the court for an additional 90 days over the objection of the landlord. 11 U.S.C. 365(d)(4)(B). Thereafter, landlord consent is required for additional extensions. 11 U.S.C. 365(d)(4)(B)(ii). This amendment effectively limits the time for assumption or rejection of a non-residential real property lease to 210 days.

There is no similar temporal limitation to assume or reject a franchise agreement. A debtor may wait to assume or reject franchise agreements and other executory contracts until confirmation. See 11 U.S.C. 365(d)(2). As a practical matter, because the franchisor controls the franchisees' premises as discussed above, the accelerated time for assumption or rejection of the lease most often will link back to a debtor's decision to assume or reject its franchise agreement(s). A franchise agreement is virtually worthless without an underlying real estate lease. Conversely, a real estate lease may be devalued without an accompanying franchise agreement. Additionally, because of the typical interrelationship between the franchise agreement, lease and other licensing agreements, a rejection or breach of one may constitute a breach of another. Thus, assuming the franchisor effectively tied the franchise agreement to the premises, the franchisee debtors will be required to assume or reject the franchise agreement as well as the leases within 210 days.

As if making such decisions within 210 days were not enough, the BAPCPA also triggers a chain of dominos. In order for a debtor-franchisee to assume any executory contract, including a lease and/or a franchise agreement, the debtor must provide the counterparty (the franchisor-landlord) with adequate assurance of future performance. See 11 U.S.C. 365(b)(1)(C). The Code provides no definition of 'adequate assurance' and determination of what constitutes adequate assurance is determined on a case-by-case basis. See, e.g., In re Carlisle Homes, Inc.' 103 B.R. 524, 538 (Bankr. D.N.J. 1988) (the term 'adequate assurance' is adopted from the UCC and should be given a practical and pragmatic meaning based upon the conditions of each case) (citing In re Bon Ton Restaurant & Pastry Shop, Inc.' 53 B.R. 789 (Bankr. N.D. Ill. 1985)). Often, a debtor's 'mere promise' to perform without any factual basis to demonstrate its ability to do so will be challenged by a landlord-franchisor. Therefore, the question arises as to how many franchisee debtors are actually prepared to prove adequate assurance so early in a case. In the past this battle usually was deferred until confirmation. In short, by compressing the lease assumption deadline, Congress may have made it all but impossible for a franchisee to reorganize.

Designation Rights and a Franchisor's Right of First Refusal

The shortened lease assumption period of the BAPCPA also limits a debtor's ability to sell 'designation rights.' A designation right is the right of the transferee to decide whether the debtor should assume or reject an executory contract or unexpired lease. Such rights enable a buyer to reject a lease and insulate itself from any landlord claims by leaving such claims to be paid by the bankruptcy estate. The firm 210-day deadline reduces the time for negotiation of designation rights and their potential value. Companies intending to sell designation rights must act early in a case for those rights to have any real value and the negotiation over the sale of leases will take place sooner in a case. The impact of the compressed time schedule will be magnified in franchise cases where the franchisor has a right of first refusal over a debtor's premises.

A franchisor's right of first refusal will assume greater significance with respect to the sale of designation rights. Rights of first refusal are presumably enforceable. Case in point: In re Mr. Grocer, which held that any right of first refusal granted to a landlord is unenforceable because it violates the Code provision against placing restrictions upon assignments in bankruptcy proceedings. In re Mr. Grocer, 77 B.R. 349, 353 (Bankr. D.N.H. 1987) (citing 11 U.S.C. 365(f)(1)) has been distinguished by subsequent case law. In In Re E-Z Serve Convenience Stores, the court concluded that the statutory language of ' 365(f)(1) does not render any right of first refusal unenforceable and found that, the landlord's right of first refusal was not within the scope of ' 365(f) and did not have a chilling effect on the sale procedure. In Re E-Z Serve Convenience Stores, 289 B.R. 45, 51-52 (Bankr. M.D.N.C., 2003). The landlord presented evidence of economic detriment that he would incur should his bargained-for right of first refusal be denied. See Id. The court also held that the landlord's right for adequate assurance of future performance required that consideration due under the lease agreement, including the right of first refusal, be enforced. Id. at 51-52. Other courts have held that a right of first refusal is not an ipso facto provision, and as such, the right was enforceable. See In re The IT Group, Inc., Co., 302 B.R. 483, 488 (D. Del. 2003) (right of first refusal was enforceable and did not constitute an ipso facto provision); In re Capital Acquisitions & Mgmt. Corp., 341 B.R. 632 (Bankr. N.D.Ill, 2006) (The right of first refusal was not an ipso facto clause in this instance, and thus it was enforceable). Without time to negotiate between the franchisee, the franchisor, and other interested third parties, the value for otherwise marketable leases may be depressed as a result of the shortened lease assumption period.

How the Amendments Can Alter the Outcome of Cases

Planning is now more critical then ever before for a franchisee planning to file for bankruptcy. The deadlines for assumption and rejection of a lease require the franchisee to have a business solution and goal before filing. No longer can the franchisee file the bankruptcy and wait and see how the franchisor responds. The franchisee must know whether it will sell its business or reorganize almost immediately if it intends to obtain a good price for its business. With only 210 days to determine whether to assume or reject a lease, and roughly the same time to cure any defaults and provide adequate assurance of future performance, the franchisee with a lease must have a solution in place on a relatively abbreviated timeframe. If the only alternative is a sale, the motion seeking authority establishes sale procedures and sell should be filed as early as possible in order to allow adequate time to seek buyers. Franchisees can no longer 'park' the case in Chapter 11 and wait until the dust clears, because they will not have sufficient time to cure any defaults under the lease.

Similarly, franchisees cannot fund the Chapter 11 case by withholding pre-petition and post-petition payments to the landlord for working capital during the Chapter 11 proceeding. Before the BAPCPA, although the debtor was required to pay the landlord during the assumption or rejection period, courts usually allowed the debtor to defer the payments for 60 days, when assumption or rejection was required. The BAPCPA emphasizes that tenants are expected pay all post-petition rent and any failure to pay rent may result in the inability to assume and sell the lease to a third party.

Franchisees still can invoke a strategy to take an 'involuntary loan' from their franchisor in order to fund its Chapter 11 case. Unlike landlords, the BAPCPA does not impose a deadline to assume or reject with respect to franchise agreements. Bankruptcy strategy still rewards aggressive franchisors that enforce its agreements and request the court to impose deadlines for assumption and rejection. Absent a claim that the franchisee is committing trademark infringement or causing irreparable harm to the franchisor by not paying fees, a bankruptcy court has little incentive to restrict the franchisee's use of money that would otherwise be used to pay the franchisor. The bankruptcy court recognizes that if the franchise is to survive, the franchisor must be paid eventually. Unless a franchisor argues that it should be paid immediately, the court will assume that the franchisor has the same risk of losing its money that any creditor faces in a bankruptcy case. A court must be made aware of the irreparable harm caused as a result of the franchisor not receiving its fees.

Craig Tractenberg is a Philadelphia office partner with Nixon Peabody LLP. He leads the office's efforts in franchise law and distressed mergers and acquisitions. Richard C. Pedone is a Boston office partner with the firm, and focuses his efforts on bankruptcy and commercial litigation in state and federal courts.

The substantial amendments made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) to the Bankruptcy Code have had a significant impact on the dynamics of franchisee bankruptcies. The BAPCPA was generally intended to accelerate Chapter 11 'reorganizations' and provide relief to certain constituencies in the bankruptcy process (eg, landlords). This article focuses on the nuances of the BAPCPA's impact in franchisee bankruptcy cases.

'Simple' Franchise Relationships Often Contain Complex Legal Structures

The franchisor-franchisee relationship is not one of simple debtor-creditor. Generally, franchisees pay their franchisor an initial franchise fee and ongoing royalties. These royalties may be based on a percentage of sales, or charged when the franchisee buys products by or through the franchisor. In return, the franchisor authorizes the franchisee to operate the franchised business under the trademark of the franchisor, and authorizes/mandates the use of the franchisor's licensed business methods or systems. Additionally, franchisors often provide training, assistance and/or confidential marketing plans to the franchisee.

Thus, unlike most other creditors in a bankruptcy case, a franchisor is not only concerned with maximizing the return on its claim, also with protecting the goodwill and reputation associated with its trademark and other intellectual property. Goodwill is the primary asset of most franchisors, and a poorly run franchise location will tarnish the reputation and value of the greater franchise system.

The franchisor-franchisee relationship is further complicated in bankruptcy because most franchisors maintain some control over the franchisee's business premises. This control ranges from lessor-lessee relationships where the franchisor owns the real estate that it leases to the franchisee, to sublease arrangements where the franchisor has a right of first refusal. Where a franchise is tied to real estate or a Web site, the franchisor typically imposes contractual limitations on the disposition of these actual or virtual storefronts. Thus, in contrast to the typical account creditor, franchisors usually come to franchisee bankruptcies already wrapped in a tangled web of contracts governing intellectual property, real estate and even purchasing.

The dynamics of a franchisee bankruptcy are also greatly influenced by the fact that the franchisors typically come armed with a variety of covenants in their franchise-related agreements, including: 1) cross default provisions between multiple franchise agreements; 2) area development agreements; 3) leases owned or controlled by a common franchisee; 4) rights of first refusal on sale or disposition; and 5) collateral lease assignments, sometimes referred to as conditional options to re-enter. A conditional option to re-enter grants a franchisor the right, but not the obligation, to maintain goodwill by 'stepping-in' to the franchisee's shoes in the event of a franchisee's default.

Cure of Non-Economic Defaults of Leases and Executory Contracts

While the BAPCPA clarifies the right of a debtor to cure non-monetary defaults in leases in the event of assumption so long as the landlord is compensated for pecuniary loss, it is silent with regard to a debtor's right to cure non-monetary defaults in franchise agreements. See 11 U.S.C. 365(b)(1)(A). It is therefore suggested that non-monetary defaults in other executory contracts, like franchise agreements, cannot be cured merely by compensating for pecuniary loss. Accordingly, defaults of franchise agreements as a result of misbranding, underreporting, violations of law, and injury to the brand by the franchisee may no longer be overlooked by bankruptcy courts. Pre-BAPCPA cases interpreted the Code as allowing any default to be monetized and thereby cured by payment. The failure of Congress to amend other sections of the Code to explicitly grant debtors the right to cure non-economic defaults to other executory contracts strongly suggests that such defaults remain incurable and can prevent assumption of the executory contract.

These assumption problems associated with non-monetary defaults will also impact franchisors seeking to reorganize. Consider the bankruptcy of The Ground Round, Inc., where franchisees alleged that the franchisor collected advertising funds from its franchisees and failed to use the funds as contractually obligated. The franchisees took the position that the $3 million in advertising payments, for which the franchisor could not account, generated claims above the $8 million offered at auction for the franchise rights. The franchisees monetized their claims against the franchisor for 'failure to advertise,' and asserted $40 million in lost opportunity claims in order to block the auction sale. The monetizing of the franchisees' claims was recognized by the Turnaround Management Association as the Business Transaction of the Year 2004. Ultimately, the franchisees bought the company with $4 million cash and surrendered their claims. Ironically, the franchisees recovered much of their costs by asserting claims against the Errors and Omissions insurance policy of the franchisor.

Under the BAPCPA, however, the franchisees would have acquired the franchisor for less money and would not have been required to monetize their claims. The franchisor would have been pressed to meet a strict deadline to sell the leases, for which it ultimately received $13 million. The franchisees would have argued that the failure to advertise was a non-monetary default that could not be cured, and, therefore, the franchise rights could not be sold. Aggressive use of the BAPCPA may have turned the balance of power in the case to the point where the franchisor would have little leverage and might have considered not filing bankruptcy. Going forward, franchisors will have this leverage in its franchisees' bankruptcies.

While the determination of whether non-monetary defaults of franchise agreements will be considered 'non-curable' defaults awaits developing case law, but the BAPCPA certainly suggests assumption may be difficult.

Shortened Time for Assumption and Rejection of Leases

Prior to the BAPCPA, a debtor-tenant could extend the deadline or reject its non-residential real estate leases out indefinitely upon a showing of 'cause' over the objection of a landlord. Traditionally, courts granted such extensions for almost any reason and a debtor could extend this deadline until the confirmation of a plan.

The BAPCPA imposes a firm deadline of 120 days after filing a petition to assume or reject non-residential real property leases. See 11 U.S.C. 365(d)(4)(A). This deadline may be extended once by the court for an additional 90 days over the objection of the landlord. 11 U.S.C. 365(d)(4)(B). Thereafter, landlord consent is required for additional extensions. 11 U.S.C. 365(d)(4)(B)(ii). This amendment effectively limits the time for assumption or rejection of a non-residential real property lease to 210 days.

There is no similar temporal limitation to assume or reject a franchise agreement. A debtor may wait to assume or reject franchise agreements and other executory contracts until confirmation. See 11 U.S.C. 365(d)(2). As a practical matter, because the franchisor controls the franchisees' premises as discussed above, the accelerated time for assumption or rejection of the lease most often will link back to a debtor's decision to assume or reject its franchise agreement(s). A franchise agreement is virtually worthless without an underlying real estate lease. Conversely, a real estate lease may be devalued without an accompanying franchise agreement. Additionally, because of the typical interrelationship between the franchise agreement, lease and other licensing agreements, a rejection or breach of one may constitute a breach of another. Thus, assuming the franchisor effectively tied the franchise agreement to the premises, the franchisee debtors will be required to assume or reject the franchise agreement as well as the leases within 210 days.

As if making such decisions within 210 days were not enough, the BAPCPA also triggers a chain of dominos. In order for a debtor-franchisee to assume any executory contract, including a lease and/or a franchise agreement, the debtor must provide the counterparty (the franchisor-landlord) with adequate assurance of future performance. See 11 U.S.C. 365(b)(1)(C). The Code provides no definition of 'adequate assurance' and determination of what constitutes adequate assurance is determined on a case-by-case basis. See, e.g., In re Carlisle Homes, Inc.' 103 B.R. 524, 538 (Bankr. D.N.J. 1988) (the term 'adequate assurance' is adopted from the UCC and should be given a practical and pragmatic meaning based upon the conditions of each case) (citing In re Bon Ton Restaurant & Pastry Shop, Inc.' 53 B.R. 789 (Bankr. N.D. Ill. 1985)). Often, a debtor's 'mere promise' to perform without any factual basis to demonstrate its ability to do so will be challenged by a landlord-franchisor. Therefore, the question arises as to how many franchisee debtors are actually prepared to prove adequate assurance so early in a case. In the past this battle usually was deferred until confirmation. In short, by compressing the lease assumption deadline, Congress may have made it all but impossible for a franchisee to reorganize.

Designation Rights and a Franchisor's Right of First Refusal

The shortened lease assumption period of the BAPCPA also limits a debtor's ability to sell 'designation rights.' A designation right is the right of the transferee to decide whether the debtor should assume or reject an executory contract or unexpired lease. Such rights enable a buyer to reject a lease and insulate itself from any landlord claims by leaving such claims to be paid by the bankruptcy estate. The firm 210-day deadline reduces the time for negotiation of designation rights and their potential value. Companies intending to sell designation rights must act early in a case for those rights to have any real value and the negotiation over the sale of leases will take place sooner in a case. The impact of the compressed time schedule will be magnified in franchise cases where the franchisor has a right of first refusal over a debtor's premises.

A franchisor's right of first refusal will assume greater significance with respect to the sale of designation rights. Rights of first refusal are presumably enforceable. Case in point: In re Mr. Grocer, which held that any right of first refusal granted to a landlord is unenforceable because it violates the Code provision against placing restrictions upon assignments in bankruptcy proceedings. In re Mr. Grocer, 77 B.R. 349, 353 (Bankr. D.N.H. 1987) (citing 11 U.S.C. 365(f)(1)) has been distinguished by subsequent case law. In In Re E-Z Serve Convenience Stores, the court concluded that the statutory language of ' 365(f)(1) does not render any right of first refusal unenforceable and found that, the landlord's right of first refusal was not within the scope of ' 365(f) and did not have a chilling effect on the sale procedure. In Re E-Z Serve Convenience Stores, 289 B.R. 45, 51-52 (Bankr. M.D.N.C., 2003). The landlord presented evidence of economic detriment that he would incur should his bargained-for right of first refusal be denied. See Id. The court also held that the landlord's right for adequate assurance of future performance required that consideration due under the lease agreement, including the right of first refusal, be enforced. Id. at 51-52. Other courts have held that a right of first refusal is not an ipso facto provision, and as such, the right was enforceable. See In re The IT Group, Inc., Co., 302 B.R. 483, 488 (D. Del. 2003) (right of first refusal was enforceable and did not constitute an ipso facto provision); In re Capital Acquisitions & Mgmt. Corp., 341 B.R. 632 (Bankr. N.D.Ill, 2006) (The right of first refusal was not an ipso facto clause in this instance, and thus it was enforceable). Without time to negotiate between the franchisee, the franchisor, and other interested third parties, the value for otherwise marketable leases may be depressed as a result of the shortened lease assumption period.

How the Amendments Can Alter the Outcome of Cases

Planning is now more critical then ever before for a franchisee planning to file for bankruptcy. The deadlines for assumption and rejection of a lease require the franchisee to have a business solution and goal before filing. No longer can the franchisee file the bankruptcy and wait and see how the franchisor responds. The franchisee must know whether it will sell its business or reorganize almost immediately if it intends to obtain a good price for its business. With only 210 days to determine whether to assume or reject a lease, and roughly the same time to cure any defaults and provide adequate assurance of future performance, the franchisee with a lease must have a solution in place on a relatively abbreviated timeframe. If the only alternative is a sale, the motion seeking authority establishes sale procedures and sell should be filed as early as possible in order to allow adequate time to seek buyers. Franchisees can no longer 'park' the case in Chapter 11 and wait until the dust clears, because they will not have sufficient time to cure any defaults under the lease.

Similarly, franchisees cannot fund the Chapter 11 case by withholding pre-petition and post-petition payments to the landlord for working capital during the Chapter 11 proceeding. Before the BAPCPA, although the debtor was required to pay the landlord during the assumption or rejection period, courts usually allowed the debtor to defer the payments for 60 days, when assumption or rejection was required. The BAPCPA emphasizes that tenants are expected pay all post-petition rent and any failure to pay rent may result in the inability to assume and sell the lease to a third party.

Franchisees still can invoke a strategy to take an 'involuntary loan' from their franchisor in order to fund its Chapter 11 case. Unlike landlords, the BAPCPA does not impose a deadline to assume or reject with respect to franchise agreements. Bankruptcy strategy still rewards aggressive franchisors that enforce its agreements and request the court to impose deadlines for assumption and rejection. Absent a claim that the franchisee is committing trademark infringement or causing irreparable harm to the franchisor by not paying fees, a bankruptcy court has little incentive to restrict the franchisee's use of money that would otherwise be used to pay the franchisor. The bankruptcy court recognizes that if the franchise is to survive, the franchisor must be paid eventually. Unless a franchisor argues that it should be paid immediately, the court will assume that the franchisor has the same risk of losing its money that any creditor faces in a bankruptcy case. A court must be made aware of the irreparable harm caused as a result of the franchisor not receiving its fees.

Craig Tractenberg is a Philadelphia office partner with Nixon Peabody LLP. He leads the office's efforts in franchise law and distressed mergers and acquisitions. Richard C. Pedone is a Boston office partner with the firm, and focuses his efforts on bankruptcy and commercial litigation in state and federal courts.