Franchisee Bankruptcies and Receiverships: What You Don't Know Might Surprise You

Debtor-Franchisee's Options

In bankruptcy terms, a franchise agreement is known as an “executory contract.” A debtor franchisee may assume, i.e., keep, an executory contract, assign an executory contract to a third party, or reject, i.e., terminate it. Assumption and assignment require that the franchisee can cure any defaults existing at the time of the assumption or assignment ' including any amounts owed pre- and post-bankruptcy filing. If that is the case, the franchisee can assign the executory contract to a third party over the objection of the creditor party to the agreement. In other words, under the general rule, a franchisee could file for bankruptcy protection, pay the amounts owed under the franchise agreement, and assign its interests in the franchise agreement to a third party whom the franchisor has never met.

The debtor franchisee must provide the franchisor with evidence, or “adequate assurance,” of the assignee's ability to perform the franchisee's obligations under the franchise agreement. Adequate assurance, however, is not defined in the Bankruptcy Code, and can take many forms, including evidence of the assignee's financial standing, credit worthiness or a personal guaranty.

However, the general rule that a debtor franchisee may freely assign executory contracts is not without exceptions. One exception to the general rule that often comes into play in the franchisor-franchisee relationship is that, under ' 365(c)(1)(A) of the Bankruptcy Code, a debtor franchisee may not assign certain executory contracts in contradiction of federal or state law that requires the other contract party's consent to the assignment. There is some disagreement between courts as to whether this exemption applies to all executory contracts, or only to personal services contracts. This is an important distinction for franchisors, and how a franchise agreement is characterized may determine if the franchisor has a say in who the assignee of the agreement is, or is not.

If the bankruptcy case is pending in a jurisdiction that applies the exception to all executory contracts, or if the franchisor can overcome the initial hurdle of having its franchise agreement characterized as a personal services contract, it remains to find a state or federal law that would limit the franchisee's right to assign. There are several laws and opinions upon which a franchisor may rely.

For example, in In re Pioneer Ford Sales, Inc., 729 F.2d 27 (1st Cir. 1984), the court relied on a Rhode Island statute that prohibited the assignment of an automobile dealership without the reasonable consent of the manufacturer to prevent a trustee from assigning an automobile dealership.

While franchise-specific laws limiting the right to assign are only available to certain industries, the Lanham Act, 15 U.S.C. ' 1051 et seq., regulates trademarks and limits assignment of non-exclusive trademark licenses without the trademark owner's consent. Given that franchise agreements, by definition, include a trademark license, franchisors may object to the assignment of a franchise agreement to a third party based on the Lanham Act protection granted to them as trademark owners.

In some circuits, ' 365(c)(1)(A) of the Bankruptcy Code is taken a step further than described above. Several circuits have adopted the view that it is not just the debtor franchisee's right to assign the contract that is limited by ' 365(c)(1)(A), but even its ability to assume such a contract. The argument is that since a hypothetical assignment would require the franchisor's consent, so would the assumption. For example, in In re Kazi Foods of Michigan, Inc., 473 B.R. 887 (E.D.Mich 2011), KFC was able to block the debtor's motion to assume on this ground. However, not all courts agree. In In re Jacobsen, 465 B.R. 102 (N.D.Miss 2011), the court found the hypothetical test “somewhat nonsensical,” and while it appears to agree that the franchisor could have blocked a potential assignment by the debtor based on its rights under the Lanham Act, it could not block the debtor's assumption of the franchise agreement.

Another bankruptcy possibility is that the debtor or bankruptcy trustee will “reject” the franchise agreement. Under the Bankruptcy Code, a rejected franchise agreement is treated as if the debtor had breached the agreement just prior to filing its bankruptcy petition. This means that the franchisor is left with a general unsecured claim against the debtor franchisee's bankruptcy estate in an amount of the damages that it can prove it suffered as a result of the franchisee's non-performance of the franchise agreement. A general unsecured claim, under these circumstances, is often worth very little.

Foreclosures and Receiverships

Since bankruptcy is a federal proceeding, aside from circuit differences such as the ones discussed above, the proceeding is the same throughout the United States. Foreclosure laws, however, are state law alternatives to bankruptcy, and while the general process is the same, local variations need to be considered. The following is a general overview of state foreclosure laws.

The franchisor's treatment in a foreclosure action initiated by the franchisee's lender is not much different from what happens in a bankruptcy. Once the court appoints a receiver to manage the franchisee's operations, whether the franchisor can terminate the franchise agreement becomes a question of state law. In the absence of a state law preventing termination of the agreement, the receiver may seek an order of the court enjoining any termination during the pendency of the receivership or for a certain period of time to permit the receiver to realize maximum value from the franchisee's operations for the benefit of its creditors ' including the lender that initiated the action in the first instance.

While the franchisor's right to terminate a franchise agreement may be restricted in a similar fashion in bankruptcy and foreclosure, there are other significant differences between the two types of proceedings. The most significant difference might be the management of the franchisee's business during the proceeding. In bankruptcy, at least in so-called Chapter 11 cases, the debtor usually remains in possession of its assets and continues to manage the day-to-day operations of its business, albeit with court supervision.

In that regard, a foreclosure proceeding is more onerous on the franchisor because the court-appointed receiver manages all of the assets subject to the proceeding. The franchisor faces many issues that need to be quickly addressed to avoid the interruption of the foreclosed franchisee's operations. For example, depending on the level of sophistication of the operations, the receiver or the court-appointed management company might not have the necessary expertise and skills to properly operate the franchised business. Confidentiality is another important issue: Most likely the management company will need access to the franchise system operations manual, and other proprietary documents and information. Since foreclosure proceedings can drag out for as long as bankruptcy proceedings, it is usually advisable for the franchisor and receiver to consider some type of operating agreement as well.

Practical Considerations

Of course, there are many different reasons why a franchisee files for bankruptcy or ends up in foreclosure. In many cases, the franchisor might not want to terminate the franchise agreement, but rather hope that the franchisee can work its way through its financial issues. And for the duration of the proceedings an insolvent franchisee that can pay its bills on a going-forward basis might be better than no franchisee at all. Even if the franchisee is not the right person to operate the franchised business long-term, a patient franchisor might be able to replace the insolvent franchisee with a more reliable, and financially able, party. Therefore, a franchisor should weigh all of its options before engaging in costly and uncertain attempts to terminate a franchise agreement that has been wrapped in the additional protections of a federal bankruptcy case, or a state court receivership.

Patrick M. Jones and Beata Krakus are officers in the Chicago office of Greensfelder, Hemker & Gale, P.C. (www.greensfelder.com). Jones is a member of the firm's Creditors' Rights & Bankruptcy and Litigation Practice Groups. Krakus is a member of the firm's Franchising & Distribution and Corporate Practice Groups. Jones can be reached at [email protected] or 312-345-5018. Krakus can be reached at [email protected] or 312-345-5004.

Franchisors do not want to be associated with insolvent or bankrupt franchisees; it's not good for the brand. Therefore, franchisors carefully craft provisions in franchise agreements designed to allow termination in the event of a franchisee's bankruptcy or the appointment of a receiver as a result of a foreclosure action, typically initiated by the franchisee's lender. The bottom line, however, is that those artfully drafted provisions are frequently unenforceable and are, effectively, not worth the expensive contracts in which they are printed.

Timing

As is the case with so much of life, timing is crucial. When a franchise agreement is terminated has a significant (sometimes a definitive) effect on whether the termination will be upheld in court. If a franchise agreement has not been effectively terminated prior to a franchisee's bankruptcy filing, the agreement becomes part of the bankruptcy estate, and the franchisor cannot unilaterally terminate the agreement. This is true even if the franchisee was in default of every essential provision of the agreement, including payment terms, and even if the franchise agreement clearly states that it may be terminated upon the franchisee's insolvency or upon filing for bankruptcy protection. Once the franchisee has received the protection of the U.S. Bankruptcy Code, 11 U.S.C. ' 101 et seq., any actions affecting the franchisee's interests in property ' including a franchise agreement ' are “stayed” and cannot proceed without an order of the bankruptcy court. Also, bankruptcy courts are unlikely to give such an order due to the value that the franchise agreement has to the franchisee.

Debtor-Franchisee's Options

In bankruptcy terms, a franchise agreement is known as an “executory contract.” A debtor franchisee may assume, i.e., keep, an executory contract, assign an executory contract to a third party, or reject, i.e., terminate it. Assumption and assignment require that the franchisee can cure any defaults existing at the time of the assumption or assignment ' including any amounts owed pre- and post-bankruptcy filing. If that is the case, the franchisee can assign the executory contract to a third party over the objection of the creditor party to the agreement. In other words, under the general rule, a franchisee could file for bankruptcy protection, pay the amounts owed under the franchise agreement, and assign its interests in the franchise agreement to a third party whom the franchisor has never met.

The debtor franchisee must provide the franchisor with evidence, or “adequate assurance,” of the assignee's ability to perform the franchisee's obligations under the franchise agreement. Adequate assurance, however, is not defined in the Bankruptcy Code, and can take many forms, including evidence of the assignee's financial standing, credit worthiness or a personal guaranty.

However, the general rule that a debtor franchisee may freely assign executory contracts is not without exceptions. One exception to the general rule that often comes into play in the franchisor-franchisee relationship is that, under ' 365(c)(1)(A) of the Bankruptcy Code, a debtor franchisee may not assign certain executory contracts in contradiction of federal or state law that requires the other contract party's consent to the assignment. There is some disagreement between courts as to whether this exemption applies to all executory contracts, or only to personal services contracts. This is an important distinction for franchisors, and how a franchise agreement is characterized may determine if the franchisor has a say in who the assignee of the agreement is, or is not.

If the bankruptcy case is pending in a jurisdiction that applies the exception to all executory contracts, or if the franchisor can overcome the initial hurdle of having its franchise agreement characterized as a personal services contract, it remains to find a state or federal law that would limit the franchisee's right to assign. There are several laws and opinions upon which a franchisor may rely.

For example, in In re Pioneer Ford Sales, Inc., 729 F.2d 27 (1st Cir. 1984), the court relied on a Rhode Island statute that prohibited the assignment of an automobile dealership without the reasonable consent of the manufacturer to prevent a trustee from assigning an automobile dealership.

While franchise-specific laws limiting the right to assign are only available to certain industries, the Lanham Act, 15 U.S.C. ' 1051 et seq., regulates trademarks and limits assignment of non-exclusive trademark licenses without the trademark owner's consent. Given that franchise agreements, by definition, include a trademark license, franchisors may object to the assignment of a franchise agreement to a third party based on the Lanham Act protection granted to them as trademark owners.

In some circuits, ' 365(c)(1)(A) of the Bankruptcy Code is taken a step further than described above. Several circuits have adopted the view that it is not just the debtor franchisee's right to assign the contract that is limited by ' 365(c)(1)(A), but even its ability to assume such a contract. The argument is that since a hypothetical assignment would require the franchisor's consent, so would the assumption. For example, in In re Kazi Foods of Michigan, Inc., 473 B.R. 887 (E.D.Mich 2011), KFC was able to block the debtor's motion to assume on this ground. However, not all courts agree. In In re Jacobsen, 465 B.R. 102 (N.D.Miss 2011), the court found the hypothetical test “somewhat nonsensical,” and while it appears to agree that the franchisor could have blocked a potential assignment by the debtor based on its rights under the Lanham Act, it could not block the debtor's assumption of the franchise agreement.

Another bankruptcy possibility is that the debtor or bankruptcy trustee will “reject” the franchise agreement. Under the Bankruptcy Code, a rejected franchise agreement is treated as if the debtor had breached the agreement just prior to filing its bankruptcy petition. This means that the franchisor is left with a general unsecured claim against the debtor franchisee's bankruptcy estate in an amount of the damages that it can prove it suffered as a result of the franchisee's non-performance of the franchise agreement. A general unsecured claim, under these circumstances, is often worth very little.

Foreclosures and Receiverships

Since bankruptcy is a federal proceeding, aside from circuit differences such as the ones discussed above, the proceeding is the same throughout the United States. Foreclosure laws, however, are state law alternatives to bankruptcy, and while the general process is the same, local variations need to be considered. The following is a general overview of state foreclosure laws.

The franchisor's treatment in a foreclosure action initiated by the franchisee's lender is not much different from what happens in a bankruptcy. Once the court appoints a receiver to manage the franchisee's operations, whether the franchisor can terminate the franchise agreement becomes a question of state law. In the absence of a state law preventing termination of the agreement, the receiver may seek an order of the court enjoining any termination during the pendency of the receivership or for a certain period of time to permit the receiver to realize maximum value from the franchisee's operations for the benefit of its creditors ' including the lender that initiated the action in the first instance.

While the franchisor's right to terminate a franchise agreement may be restricted in a similar fashion in bankruptcy and foreclosure, there are other significant differences between the two types of proceedings. The most significant difference might be the management of the franchisee's business during the proceeding. In bankruptcy, at least in so-called Chapter 11 cases, the debtor usually remains in possession of its assets and continues to manage the day-to-day operations of its business, albeit with court supervision.

In that regard, a foreclosure proceeding is more onerous on the franchisor because the court-appointed receiver manages all of the assets subject to the proceeding. The franchisor faces many issues that need to be quickly addressed to avoid the interruption of the foreclosed franchisee's operations. For example, depending on the level of sophistication of the operations, the receiver or the court-appointed management company might not have the necessary expertise and skills to properly operate the franchised business. Confidentiality is another important issue: Most likely the management company will need access to the franchise system operations manual, and other proprietary documents and information. Since foreclosure proceedings can drag out for as long as bankruptcy proceedings, it is usually advisable for the franchisor and receiver to consider some type of operating agreement as well.

Practical Considerations

Of course, there are many different reasons why a franchisee files for bankruptcy or ends up in foreclosure. In many cases, the franchisor might not want to terminate the franchise agreement, but rather hope that the franchisee can work its way through its financial issues. And for the duration of the proceedings an insolvent franchisee that can pay its bills on a going-forward basis might be better than no franchisee at all. Even if the franchisee is not the right person to operate the franchised business long-term, a patient franchisor might be able to replace the insolvent franchisee with a more reliable, and financially able, party. Therefore, a franchisor should weigh all of its options before engaging in costly and uncertain attempts to terminate a franchise agreement that has been wrapped in the additional protections of a federal bankruptcy case, or a state court receivership.

Patrick M. Jones and Beata Krakus are officers in the Chicago office of Greensfelder, Hemker & Gale, P.C. (www.greensfelder.com). Jones is a member of the firm's Creditors' Rights & Bankruptcy and Litigation Practice Groups. Krakus is a member of the firm's Franchising & Distribution and Corporate Practice Groups. Jones can be reached at [email protected] or 312-345-5018. Krakus can be reached at [email protected] or 312-345-5004.