How bankruptcy affects franchise agreements
15 SEPTEMBER 2014 6:17 AM
The bankruptcy filing of either the franchisor or franchisee can increase the uncertainty of how and when provisions of a franchise agreement will be enforced.
Few assets in the hospitality industry are more valuable and important than the franchise agreement. The franchise agreement sets forth the complicated and intricate relationship between the franchisor and franchisee. The agreement also includes a license allowing the franchisee to use the franchisor's trademark and other intellectual property. In the event of an assignment or a termination of the franchise, the franchise agreement will set forth the ground rules for de-branding the franchisee locations, returning property to the franchisor and preserving the confidentiality of trade secrets. In addition, franchise agreements typically include non-competition provisions requiring the former franchisee to refrain from competing against the franchisor for a period of time after the termination of the relationship.
Generally speaking, the rights and responsibilities in a franchise agreement will be determined under applicable state contract law. Thus, there is a certain degree of predictability in how courts will address disputes that arise between the franchisor and the franchisee in relation to the franchise agreement. The bankruptcy filing of either the franchisor or the franchisee can, however, greatly increase the uncertainty of how and when provisions of a franchise agreement will be enforced.
Franchise agreements and bankruptcy
When a party files bankruptcy (known as the "debtor"), the bankruptcy estate consists of the debtor's rights in all property, wherever located and by whomever held. This includes the debtor's contractual rights. Therefore, the franchise agreement also will be considered an asset of the debtor's estate, whether the debtor is a franchisor or a franchisee.
The franchise agreement will be considered an executory contract in the bankruptcy case. An executory contract is a contract with materially unperformed obligations by both parties as of the date the bankruptcy case was filed. Because the franchise agreement is an executory contract, the debtor will have the choice either to assume or reject the agreement. Assumption and rejection both have significant implications to the non-debtor party to the franchise agreement.
Assumption of the franchise agreement is the least disruptive choice, from the perspective of the non-debtor party to the franchise agreement. A debtor who assumes an executory contract must cure all defaults, meaning that all past due amounts must be paid current. The debtor also is required to provide the non-debtor party with adequate assurance of future performance. These are assurances that the debtor will be able to perform under the agreement. What constitutes adequate assurance depends on the particular circumstances of the case and can range from a simple promise to perform to a cash deposit or a letter of credit backstopping the debtor's assurances. Following assumption, the agreement continues to be a binding contract between the two parties. It is common for debtors to assume agreements as part of a plan of reorganization whereby the reorganized debtor continues its relationship with the non-debtor party. Whether the debtor is a franchisor or franchisee, assumption is typically the preferred choice for the non-debtor party.
In some cases, the debtor will choose to accompany assumption of the franchise agreement with an attempted assignment. The general rule under bankruptcy law is that anti-assignment provisions in an executory contract will not be enforced. In other words, in the typical case, even if the contract says that assignment is prohibited, and even if that prohibition is perfectly enforceable under state contract law, bankruptcy law will write that provision out of the contract and the assignment will be permitted. An exception to the general bankruptcy law rule arises when the assignment is prohibited by "applicable law," rather than simply prohibited by the terms of the agreement. Most bankruptcy courts agree that such applicable law includes trademark law prohibiting assignment of a trademark license without the consent of the licensor.
Assignment issues typically do not arise in the case of a debtor franchisor. In that situation, when the franchisor seeks to assume and assign the franchise agreement, the franchisee's rights are limited to enforcing its cure rights and demanding adequate assurance of future performance from the proposed assignee. This protects the franchisee from an assignment to a party that is unable to perform under the agreement. But, as a licensee of the trademark under the franchise agreement, the franchisee cannot rely on trademark law to prohibit the assignment.
The circumstances change in the situation of a debtor franchisee seeking to assume and assign a franchise agreement. In that situation, a franchisor has the normal cure and adequate assurance of future performance rights. As the licensor of the trademark, the franchisor can also cite to trademark law to argue that the assignment cannot go forward without the franchisor's consent. Most bankruptcy courts agree that trademark law is considered "applicable law" for this purpose. This means that, in most cases, a franchisor will be able to file an objection and prohibit the assignment of the franchise agreement. There are cases, however, where franchisors who aren't paying close attention to the bankruptcy case fail to file a timely objection to a proposed assignment. In that situation, the franchisor risks the entry of an enforceable order approving the assignment.
Instead of assuming a franchise agreement, a debtor may choose to reject it. Rejection is treated as a contractual breach of the agreement. The breach of contract damage claim held by the non-debtor party is deemed a general unsecured claim in the bankruptcy case. It is not uncommon for such unsecured claims to be paid out at pennies on the dollar. If the debtor is the franchisee, rejection will have a fairly limited effect on the franchisor. The franchisor will work with the franchisee to ensure an orderly wind down of the franchisee's business and the franchisor will then file a claim in the franchisee's bankruptcy case for the damages associated with the rejection. Rejection of a franchise agreement by a debtor franchisee also gives rise to issues related to the non-competition provision. Some bankruptcy courts will interpret the entire agreement as rejected, including all obligations in the agreement, meaning that the former franchisee will be free to compete against the franchisor following rejection and the franchisor is limited to filing a claim for related damages in the franchisee's bankruptcy case. Other bankruptcy courts have allowed the continued enforcement of non-compete agreements even after rejection.
If the debtor is the franchisor, rejection of the franchise agreement can have a devastating effect on the franchisee. Rejection will deprive the franchisee of the continued use of the trademark, which essentially will put the franchisee out of business. Some franchisees have tried to argue that a certain provision of bankruptcy law (11 U.S.C. §365(n)) allows the franchisee to continue using the trademark even after the franchise agreement is rejected. Unfortunately from the franchisee's perspective, most bankruptcy courts have rejected those arguments.
Jason Binford is a director in the Dallas-based law firm of Kane Russell Coleman & Logan PC where he practices in the firm’s Insolvency, Bankruptcy & Creditor Rights section. His experience includes representation of debtors and creditors in large to mid-size Chapter 11 and Chapter 7 cases. He has significant familiarity and expertise in issues unique to vendor creditors, as well as 363 sales, intellectual property, landlord/tenant and franchise issues.
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