Preventing Conflicts Between Secured Creditors and Franchisors

The lender that perfects its security interest in the franchisee's collateral has a lending base that provides confidence for the credit that is being extended. The collateral may include the franchisee's franchise agreement, inventory, contracts, intangibles, receivables, furniture, computers, customer lists, and virtually anything of value. However, most of this collateral has little value unless the business is operating or is sold as a going concern. The lender dreads the day when it might be required to realize on the collateral because the business may not be operating, and the lender will need to fight with the franchisor about how the lender should be paid in these circumstances. For example, the lender may want the franchised business sold to anyone for any amount so that the lender can obtain some proceeds for the good will of the business. The franchisor may want the business to be closed rather than to be operated by a marginal transferee.

Impact of UCC '9-408(A)

The UCC was amended to provide a balance between the needs of the franchisor and the secured lender. In effect, UCC '9-408 subordinates the interests of the lender to the franchisor. In accordance with '9-408(a) of the UCC, the rights of a secured creditor in a franchise agreement as collateral are subject to the limitations that it: a) is not enforceable against the franchisor; b) does not impose a duty or obligation on the franchisor; c) does not require the franchisor to recognize the security interest, pay, or render performance to the lender, or to accept payment or performance from the lender; d) does not entitle the lender to use or assign the franchisee's rights under the franchise agreement; and e) does not entitle the lender to use, assign, possess, or have access to any trade secrets or confidential information of the franchisor. This provision applies even if the franchise agreement contains prohibitions against using the franchise agreement as collateral.

The balance struck by the UCC appropriately allows the lender to use the franchise agreement for its collateral base, but gives the lender no rights to sell or assign the franchise agreement for value. The lender can only collect money from the franchisee/debtor as revenues are generated or when the franchised business is sold. The lender cannot operate the franchise or force a sale to a particular buyer, because these rights are limited by the franchise agreement. The maximum force that the lender could use in order to collect its money would be to force a bankruptcy sale or similar state law disposition of the franchised business. This may be the only alternative for the lender to collect its money, and the franchisor may not appreciate having its franchised location on the auction block.

The franchisor under its franchise agreement is entitled to collect all of its money upon sale of the franchise agreement, and based on '9-408, has priority over the lender for all operational aspects of the franchise, including sale and transfer. If the franchised business cannot be sold as a going concern, however, the amount due under the franchise agreement cannot be collected, and the secured lender would collect all of the proceeds, with the franchisor recovering none. Based on this doomsday scenario, some counsel advocate that a franchisor take a security interest in its franchisees as a way to maintain maximum leverage in insolvency disputes. The franchise agreement could be drafted to contain security agreement language, and the franchisor could require the franchisee to sign a UCC-1 at the inception of the relationship and file the UCC-1 to perfect its security interest.

It is prudent for the franchise agreement to contain language granting a security interest in favor of the franchisor, but recording a UCC-1 may conflict with the priority that a lender may demand to finance the franchisee. The franchisor's security interest will interfere with other financing if the franchisor will not subordinate its lien. If no lender is required for the franchise purchase, then filing the UCC-1 to perfect the franchisor's interest assures that the franchisor will obtain the maximum recovery in a liquidation. If a lender is needed, then the franchisor will be required to subordinate its perfected security interest to that of the lender. Even in this subordination arrangement, the lender and the franchisor will remain in conflict because the lender still will want the business to be sold as a going concern to maximize proceeds.

The best solutions to reduce conflict and to maximize recovery may be either an “inter-creditor agreement” or a “remarketing agreement” between the lender and the franchisor. In an inter-creditor agreement, the lender and the franchisor may agree in advance of insolvency to exchange information regarding defaults and cures, engage in collaborative decision-making when defaults occur, and confer on how to handle bankruptcy or reorganization issues, such as voting and plan formulation. For example, the franchisor might negotiate to obtain copies of the lender's default notices at the time they were sent, in exchange for the franchisor standing still in a lender default condition; this could avoid cascading defaults and conflicts between the parties that could lead to the abrupt closure of the franchised business. The inter-creditor agreement is simply a plan on how to proceed if the franchisee defaults to either the lender or the franchisor in order to avoid short-sighted action that frustrates the other parties' rights.

The “remarketing agreement” actually can be a separate agreement or can be included in an inter-creditor agreement. A remarketing agreement allows the franchised business to be sold as a going concern in order to maximize the sale price while the default continues. It may require the lender to force the franchisee to relinquish operation to the franchisor during a marketing period to allow the franchisor to improve operations and sell the business. In exchange, the lender may agree to forbear in foreclosure and to allow the franchisor to collect all of its fees during the marketing period, plus a premium for operating the business, without interference from the lender.

Franchisors and lenders with regular finance programs, particularly with multi-unit lending, should develop an inter-creditor agreement as a vehicle for proposing terms to maximize recoveries and cooperation. An inter-creditor agreement eliminates the need for the franchisor to obtain and perfect a security interest in the franchisee because the parties have agreed about how the rights and remedies of the secured party are subordinated to the franchisor's contractual rights. It provides a game plan that the parties must follow when lender and franchisor would otherwise be acting for their own self interests.

Conclusion

In summary, a franchisor has rights and remedies that a secured creditor is not granted under the UCC, but the franchisor, by becoming a competing secured creditor, does not necessarily advance its rights and remedies in a default situation. The inter-creditor agreement and remarketing agreement are alternatives to maximize recoveries and reduce conflicts by cooperation, rather than by litigation.

Craig R. Tractenberg is a partner in the New York City office of Nixon Peabody LLP. He can be contacted at 212-940-3722 or [email protected].

Lenders, franchisees, and franchisors all have a concern in preventing conflicts between their respective interests. The Uniform Commercial Code (“UCC”) was amended to strike a balance among the parties. However, the recent credit crisis has demonstrated that the UCC is only the starting point for the analysis. Some counsel advocate that franchisors should attempt to perfect their interests as secured creditors. The realities of franchising require closer study of whether this is advisable and whether it is better to negotiate superior arrangements.

The UCC grants secured creditors certain “rights, obligations and remedies” against third parties, such as the borrower, other lenders, tax creditors, and the franchisor. In UCC parlance, the “secured creditor” (typically a lender) takes a “security interest” (a lien) in “collateral” (typically assets of the franchisee), and that interest has priority over the conflicting claims of third parties (other creditors and the franchisor). The secured interest is “authenticated” by a “security agreement,” which is the contract between the secured creditor and the debtor. The security agreement describes the collateral that secures the debt, and the rights and remedies of the secured creditor. Theoretically, the security agreement no longer needs to be in writing as long as it is authenticated by click license or even an audio recording (if it is authenticated). Merely having a security interest in collateral is insufficient for the secured creditor to gain much advantage over other conflicting interests.

A secured creditor gains its primary advantages by filing a UCC-1 financing statement. This filing gives notice to the world of the secured creditor's interest and describes the collateral subject to the security interest. The location for filing the UCC-1 is contained in the UCC, and it usually must be filed in the state of incorporation of the debtor, which is not necessarily the state where the debtor operates. A secured creditor seeking to “perfect” its security interest must search the records to assure itself that its filing is first or will have priority over earlier security interests. Security interests that are perfected first have priority over all later liens, but for a few exceptions. One exception is for “purchase-money security interests,” which grant a priority to the lender that loaned the money to purchase a particular item of collateral upon notice to the earlier perfected secured creditor.

The lender that perfects its security interest in the franchisee's collateral has a lending base that provides confidence for the credit that is being extended. The collateral may include the franchisee's franchise agreement, inventory, contracts, intangibles, receivables, furniture, computers, customer lists, and virtually anything of value. However, most of this collateral has little value unless the business is operating or is sold as a going concern. The lender dreads the day when it might be required to realize on the collateral because the business may not be operating, and the lender will need to fight with the franchisor about how the lender should be paid in these circumstances. For example, the lender may want the franchised business sold to anyone for any amount so that the lender can obtain some proceeds for the good will of the business. The franchisor may want the business to be closed rather than to be operated by a marginal transferee.

Impact of UCC '9-408(A)

The UCC was amended to provide a balance between the needs of the franchisor and the secured lender. In effect, UCC '9-408 subordinates the interests of the lender to the franchisor. In accordance with '9-408(a) of the UCC, the rights of a secured creditor in a franchise agreement as collateral are subject to the limitations that it: a) is not enforceable against the franchisor; b) does not impose a duty or obligation on the franchisor; c) does not require the franchisor to recognize the security interest, pay, or render performance to the lender, or to accept payment or performance from the lender; d) does not entitle the lender to use or assign the franchisee's rights under the franchise agreement; and e) does not entitle the lender to use, assign, possess, or have access to any trade secrets or confidential information of the franchisor. This provision applies even if the franchise agreement contains prohibitions against using the franchise agreement as collateral.

The balance struck by the UCC appropriately allows the lender to use the franchise agreement for its collateral base, but gives the lender no rights to sell or assign the franchise agreement for value. The lender can only collect money from the franchisee/debtor as revenues are generated or when the franchised business is sold. The lender cannot operate the franchise or force a sale to a particular buyer, because these rights are limited by the franchise agreement. The maximum force that the lender could use in order to collect its money would be to force a bankruptcy sale or similar state law disposition of the franchised business. This may be the only alternative for the lender to collect its money, and the franchisor may not appreciate having its franchised location on the auction block.

The franchisor under its franchise agreement is entitled to collect all of its money upon sale of the franchise agreement, and based on '9-408, has priority over the lender for all operational aspects of the franchise, including sale and transfer. If the franchised business cannot be sold as a going concern, however, the amount due under the franchise agreement cannot be collected, and the secured lender would collect all of the proceeds, with the franchisor recovering none. Based on this doomsday scenario, some counsel advocate that a franchisor take a security interest in its franchisees as a way to maintain maximum leverage in insolvency disputes. The franchise agreement could be drafted to contain security agreement language, and the franchisor could require the franchisee to sign a UCC-1 at the inception of the relationship and file the UCC-1 to perfect its security interest.

It is prudent for the franchise agreement to contain language granting a security interest in favor of the franchisor, but recording a UCC-1 may conflict with the priority that a lender may demand to finance the franchisee. The franchisor's security interest will interfere with other financing if the franchisor will not subordinate its lien. If no lender is required for the franchise purchase, then filing the UCC-1 to perfect the franchisor's interest assures that the franchisor will obtain the maximum recovery in a liquidation. If a lender is needed, then the franchisor will be required to subordinate its perfected security interest to that of the lender. Even in this subordination arrangement, the lender and the franchisor will remain in conflict because the lender still will want the business to be sold as a going concern to maximize proceeds.

The best solutions to reduce conflict and to maximize recovery may be either an “inter-creditor agreement” or a “remarketing agreement” between the lender and the franchisor. In an inter-creditor agreement, the lender and the franchisor may agree in advance of insolvency to exchange information regarding defaults and cures, engage in collaborative decision-making when defaults occur, and confer on how to handle bankruptcy or reorganization issues, such as voting and plan formulation. For example, the franchisor might negotiate to obtain copies of the lender's default notices at the time they were sent, in exchange for the franchisor standing still in a lender default condition; this could avoid cascading defaults and conflicts between the parties that could lead to the abrupt closure of the franchised business. The inter-creditor agreement is simply a plan on how to proceed if the franchisee defaults to either the lender or the franchisor in order to avoid short-sighted action that frustrates the other parties' rights.

The “remarketing agreement” actually can be a separate agreement or can be included in an inter-creditor agreement. A remarketing agreement allows the franchised business to be sold as a going concern in order to maximize the sale price while the default continues. It may require the lender to force the franchisee to relinquish operation to the franchisor during a marketing period to allow the franchisor to improve operations and sell the business. In exchange, the lender may agree to forbear in foreclosure and to allow the franchisor to collect all of its fees during the marketing period, plus a premium for operating the business, without interference from the lender.

Franchisors and lenders with regular finance programs, particularly with multi-unit lending, should develop an inter-creditor agreement as a vehicle for proposing terms to maximize recoveries and cooperation. An inter-creditor agreement eliminates the need for the franchisor to obtain and perfect a security interest in the franchisee because the parties have agreed about how the rights and remedies of the secured party are subordinated to the franchisor's contractual rights. It provides a game plan that the parties must follow when lender and franchisor would otherwise be acting for their own self interests.

Conclusion

In summary, a franchisor has rights and remedies that a secured creditor is not granted under the UCC, but the franchisor, by becoming a competing secured creditor, does not necessarily advance its rights and remedies in a default situation. The inter-creditor agreement and remarketing agreement are alternatives to maximize recoveries and reduce conflicts by cooperation, rather than by litigation.

Craig R. Tractenberg is a partner in the New York City office of Nixon Peabody LLP. He can be contacted at 212-940-3722 or [email protected].