Subchapter V Could Be Ideal Choice for Franchisees

By Craig R. Tractenberg

When franchisees choose to financially reorganize under the Bankruptcy Code, they may be the right size to choose to reorganize under Subchapter V of Chapter 11. Subchapter V proceedings are simpler, more streamlined and less expensive than a traditional Chapter 11 and is ideal to allow the self-employed to revitalize their small business. Where the franchisor and the franchisee cannot reconcile, Subchapter V may provide the franchisee with breathing room and leverage to be revitalized. In an unpublished decision, a court noted that the debtor and the franchisor may at the commencement of the case may be at each other’s throats, but during the case may negotiate a different outcome. See, In re Pinnacle Foods of California, Case No. 24-11015 (Bankr. E.D. Cal. Aug. 15, 2024).
In In re Pinnacle (and its companion cases involving its affiliates), the bankruptcy court had the opportunity to decide the franchisor’s motion titled “Motion to Remove the Debtor from Possession and Expand the Powers of the Subchapter V Trustee or, in the Alternative, to Revoke the Debtor’s Subchapter V Designation and Appoint a Chapter 11 Trustee.” The purpose of the motion was to eliminate the debtors’ right to reorganize because of the conduct of the debtor and because reorganization was futile under applicable law. The parties had a litigation history, which poisoned the opportunity for a consensual plan of reorganization without new ownership and management.
The debtor Pinnacle and its two affiliates operate six quick service restaurants in California and filed a Subchapter V bankruptcy in order to restructure its debt. The debtors acquired the restaurants in 2017 and suffered financial hardship exacerbated by the pandemic. The debtors plan to reorganize, shed some debt, renegotiate lease and other arrangements, and perhaps spin off a location or two. The franchisor has opposed attempts to reorganize and wants to force a sale of the locations to a more desirable franchisee. In order to do so, the franchisor filed a motion to eliminate the Subchapter V election or in the alternative, appoint a trustee to operate and liquidate the locations.
Under Subchapter V, only the debtor may file a plan of reorganization, and the court may not appoint a trustee or an examiner. But Section 1185 of the Bankruptcy Code does permit a court to remove the debtor from possession on a showing of cause and allow the Subchapter V trustee is e to operate the debtor’s business. Unlike a regular Chapter 11 trustee, however, this action does not permit any party other than the debtor to propose a plan of reorganization.
Another advantage of Subchapter V is that it relaxes plan confirmation. The phrase “fair and equitable” is redefined such that a plan may be confirmed so long as it commits the debtor’s projected disposable income over the applicable plan period (three or five years) to repay creditors. The absolute priority rule does not apply to Subchapter V plans, which means that the owners can retain their ownership in many cases even if other creditors are not fully paid.
In Pinnacle, the franchisor asserted several reasons for seeking to remove the debtor and appoint a trustee. The debtors were alleged to have been using a management arrangement that violated the franchise agreement. The debtors also were alleged to not be able to consummate a plan of reorganization where they would retain ownership and operation because they were not qualified to assume the franchise agreements. The debtors also had another hurdle, The law in the U.S. Court of Appeals for the Ninth Circuit applies the so-called “hypothetical creditor test,” which prohibits a debtor from assuming an executory contract like a franchise agreement if applicable law prohibits assignment of the contract without the consent of the franchisor. Nevertheless, the court did not grant the franchisor’s motion to remove the debtor, revoke Subchapter V election or appoint a trustee.
The Pinnacle court considered removal of the debtor in possession to be an extraordinary remedy as it is in any bankruptcy case. Under the Bankruptcy Code, the reasons for appointing a trustee include fraud, dishonesty, incompetence or gross mismanagement. See, 11 U.S.C. Section 1185(a). Citing an unpublished opinion, In re Neosho Concrete Products, 20-30314, (Bankr. W.D. Mo., May 6, 2021), the Pinnacle court used five factors to consider when the court is asked to remove the debtor in possession in a Subchapter V case: the materiality of any misconduct; evenhandedness or lack thereof in dealing with insiders and affiliated entities in relation to other creditors; existence of prepetition avoidable preferences or fraudulent conveyances; whether any conflict of interest is interfering with the debtor in possession’s ability to fulfill its fiduciary duties; and self-dealing or squandering of assets.
The Pinnacle court did not find the franchisor had established a factual predicate in order to conclude that the debtor had committed such misconduct as to support the relief sought. Although the debtor had hurdles to plan confirmation, the remedy for such challenges was probably stay relief rather than removal of the debtor in possession. Further, the court commented that the ability of a court to revoke the Subchapter V election of the debtor was not well.