Franchisees’ enormous financial contribution to the U.S. economy is unquestioned. Despite this general success, however, a number of distressed franchisees will declare bankruptcy each year. Franchisees seek bankruptcy relief in pursuit of various reorganization, sale, or liquidation objectives.
Franchisees that wish to restructure their financial affairs through bankruptcy will file a Chapter 11 case. (Certain individual franchisees may also reorganize under Chapter 13.) These franchisees may seek to retain ownership of their business, albeit with a reorganized debt structure, and maintain their franchise relationship. Obtaining franchisor support for “assumption” of the franchise agreement is a critical element of a successful reorganization of a franchisee. Franchisees can also attempt to terminate their franchise agreement in Chapter 11, quantify the “rejection damages” of the franchisor, and continue to operate their business. Alternatively, franchisees can sell some or all of their property in Chapter 11 and potentially assign their franchise agreement to a third party. In this circumstance, the franchisor’s consent to the assignment is usually required.
Franchisees desiring to cease operations will normally file a Chapter 7 bankruptcy. In this scenario, an independent trustee is appointed to liquidate the franchisee’s assets. In rare cases, a Chapter 7 trustee may seek to assign the franchise agreement to a buyer. Chapter 7 is particularly appropriate for franchisees who wish to walk away from their business and leave the liquidation effort to a bankruptcy trustee.
When faced with a bankrupt franchisee, franchisors generally pursue some combination of the following goals.
Franchisors often seek to preserve the franchised business in their system by:
Franchisors sometimes attempt to use a franchisee bankruptcy proceeding to:
When the franchisor-franchisee relationship (or the franchisee itself) is beyond repair, franchisors can proactively protect their trademarks, intellectual property, and brand reputation by requesting bankruptcy court orders that compel bad acting or infringing unit owners to de-brand and dissociate themselves from the franchisor. For instance, when the franchisor has effectively terminated a franchise agreement before the franchisee files a bankruptcy petition, a bankruptcy court can provide injunctive relief if the debtor continues to use trademarks of the franchisor post-petition without the franchisor’s permission. See Ledo Pizza Sys., Inc. v. Singh, No. CIV. WDQ-13-2365, 2013 WL 5604339, at *2 (D. Md. Oct. 10, 2013). Similarly, if a franchisor decides to end a franchise relationship after a franchisee has sought bankruptcy protection, the franchisor can seek relief from the “automatic stay” authorizing it to terminate the franchise agreement and to compel the franchisee to satisfy its post-termination non-monetary obligations under the franchise agreement. See In re Tudor Motor Lodge Associates, Limited Part., 102 B.R. 936, 951 (Bankr. D.N.J. 1989) (“The fact that the automatic stay suspends termination of [a] License Agreement does not prevent termination indefinitely.”).
Franchisors collect amounts due from bankrupt franchisees in various ways, including (i) dividends from bankruptcy proceedings after filing and allowance of a proof of claim, (ii) royalties and related fees from Chapter 11 debtors/ franchisees during the pendency of the bankruptcy case but prior to assumption or rejection of the franchise agreement, (iii) “cure” payments from debtors or third parties in connection with the assumption or assumption and assignment of the subject franchise agreements, and (iv) post-bankruptcy royalties and related fees from reorganized debtors, secured lenders, and/or “new” franchisees.
In various circumstances, franchisors commonly request (i) bankruptcy court-sanctioned releases from franchisees and guarantors; (ii) statements of an absence of affirmative claims against a franchisor, or defenses/set-off as to amounts due, from a franchisee and guarantors; and/or (iii) bankruptcy court orders disallowing or settling affirmative claims against the franchisor. These requests may be sought as part of a franchisee plan of reorganization, in an order authorizing the assumption or rejection of the franchise agreement, in a final cash collateral order, or in an order resolving a contested matter involving the franchisor and franchisee or trustee.
All bankruptcy cases are filed in federal court. 28 U.S.C. § 151. A franchisee can file a bankruptcy case in any of the following locations: (i) where the debtor is domiciled, (ii) where the debtor’s residence is located, (iii) where the debtor’s principal place of business is located, (iv) where the debtor’s principal assets in the United States are located for the greater of one hundred eighty (180) days before filing the petition, or (v) in the same district as a pending bankruptcy case concerning the debtor’s affiliate, general partner, or partnership. 28 U.S.C. § 1408. Thus, a franchisee that is a business entity can commence a bankruptcy proceeding in one of several jurisdictions.
The most common types of bankruptcies for franchisees are cases under Chapter 7 (Liquidation), 11 U.S.C. §§ 701 et seq., and Chapter 11 (Reorganization) of the Bankruptcy Code, 11 U.S.C. §§ 1101 et seq. Individual franchisees with regular income who satisfy certain debt limitations may also attempt to reorganize under Chapter 13. See 11 U.S.C. §§ 1301 et seq. This article addresses only Chapter 7 and 11 matters.
When a franchisee files Chapter 7, it must cease all business activities, though, in limited circumstances, the trustee may continue operations if necessary to maximize the value for the benefit of creditors. 11 U.S.C. § 704. An independent trustee is appointed in all Chapter 7 cases. 11 U.S.C. §§ 701, 702, 704. The trustee acts as a fiduciary for all creditors and is responsible for liquidating (or abandoning) certain property of the debtor and distributing the proceeds to creditors pursuant to statutory priorities. The trustee may also pursue claims held by the estate, including fraudulent conveyance and preferential transfer actions. 11 U.S.C. §§ 547 and 548.
Entities do not receive a discharge of debts in Chapter 7. 11 U.S.C. § 727. With certain exceptions, individuals are relieved of their obligation to pay pre-petition debts as a result of a Chapter 7 bankruptcy. 11 U.S.C. §§ 523 and 727.
Chapter 11 affords debtors the opportunity to reorganize, which may involve (i) the assumption or rejection of contracts such as franchise agreements, and/or (ii) the sale of property, including potential assignment of franchise agreements. 11 U.S.C. §§ 363 and 365. Debtors can also oversee their own liquidation in Chapter 11. CHS, Inc. v. Plaquemines Holdings, L.L.C., 735 F.3d 231, 238 (5th Cir. 2013).
Unlike Chapter 7, a trustee is not automatically appointed in Chapter 11 cases. 11 U.S.C. § 1104. In Chapter 11, the debtor typically remains in control of its property, and management may continue operating the debtor’s business and managing its affairs in the ordinary course. 11 U.S.C. § 1107. The franchisee must obtain the bankruptcy court’s permission for acts outside of the ordinary course of business of the debtor, including the assumption or rejection of franchise agreements or sale of the property. 11 U.S.C. §§ 363 and 365. The debtor-in-possession has an exclusive 120-day post-petition period during which it may propose a plan of reorganization or liquidation. 11 U.S.C. § 1121(b).
In August 2019, Congress enacted the Small Business Reorganization Act, which streamlined Chapter 11 bankruptcy for small business debtors with debts less than $2,725,625. 11 U.S.C. § 1182(1)(A). These debtors have 90 days after filing bankruptcy to file a plan. 11 U.S.C. § 1189(b). If the bankruptcy court determines that the plan satisfies 11 U.S.C. § 1129(a), it must confirm the plan. 11 U.S.C. § 1191(a). A trustee is appointed in all small business cases but does not take control of property or operate the business. Instead, the debtor remains in possession of the estate’s assets. 11 U.S.C. § 1184.
A bankruptcy filing under Chapter 7 or 11 creates an “estate,” which includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541(a) (1). Property of the estate is broad in scope and includes a franchisee’s interest in any franchise agreement in effect as of the petition date.
If a franchisor has validly terminated a franchise agreement pre-petition, the agreement is not part of the estate. Days Inn v. Gainesville P-H Props., Inc. (In re Gainesville P-H Props., Inc.), 77 B.R. 285, 295 (Bankr. M.D. Fla. 1987). Alternatively, when a franchisor has not effectively terminated the franchise agreement pre-petition, (i) it becomes property of the estate and is subject to the protection of the automatic stay (discussed below); (ii) the debtor may continue to use the franchise system, even if it is default of the franchise agreement; and (iii) the bankruptcy court may authorize the franchisee to assume or assume and assign the franchise agreement—even if the franchisor does not consent.
Once a franchisee files a petition under Chapter 7 or 11, the “automatic stay” prevents a franchisor from various enforcement actions against a debtor/franchisee or property of the bankruptcy estate. 11 U.S.C. § 362(a). For instance, a franchisor may not terminate an “active” franchise agreement with the automatic stay in place. In order to pursue remedies against a debtor/franchisee or its property, a franchisor must seek relief from the automatic stay “for cause.” 11 U.S.C. § 362(d).
Cash collateral is defined as cash and liquid property that is subject to a creditor’s security interest. 11 U.S.C. § 363(a). A Chapter 11 debtor may not use “cash collateral” unless each entity that has a security interest in the cash collateral consents or the bankruptcy court authorizes its use. 11 U.S.C. § 363(c)(2). A secured creditor is entitled to adequate protection of its interest in exchange for the debtor’s use of the collateral. 11 U.S.C. § 363(e). Examples of adequate protection are (i) periodic cash payments, (ii) additional or replacement liens, or (iii) other relief resulting in the equivalent of its interest in such property. 11 U.S.C. § 361. A franchisor that maintains a security interest in the property of a franchisee can seek various forms of adequate protection (such as payment of postpetition franchise fees and compliance with system standards) for a debtor’s use of its cash collateral.
An allowed claim in a bankruptcy case is a claim, proof of which is filed with the court, and to which no objection has been sustained by the court. 11 U.S.C. § 502(a). In Chapter 7 cases, the bankruptcy clerk sends a notice of the claims deadline after the trustee determines whether there are any assets available to liquidate and use to pay creditors. In Chapter 11 cases, the court will set a claims deadline. It is crucial to file a proof of claim before the bar date, as a creditor risks being denied the ability to participate in a bankruptcy distribution. Thus, franchisors should remain cognizant of bar date deadlines.
Subject to bankruptcy court approval, debtors or trustees may assume, assume and assign, or reject franchise agreements that have not been effectively terminated prior to bankruptcy. 11 U.S.C. § 365. A franchisor can, of course, object to the proposed disposition of its franchise agreement.
In a Chapter 7 case, an executory contract such as a franchise agreement is deemed rejected if the trustee does not assume and assign the contract within 60 days after the petition date. 11 U.S.C. § 365(d)(1). In a Chapter 11 proceeding, a debtor may assume or reject a franchise agreement any time prior to or upon the court’s confirmation of the plan. 11 U.S.C. § 365(d)(2).
Until the debtor has assumed or rejected the franchise agreement, a Chapter 11 debtor must continue to perform under the contract, including paying post-petition fees. In re MS Freight Distribution, Inc., 172 B.R. 976, 978–79 (Bankr. W.D. Wash. 1994). If a debtor rejects a franchise agreement, it is treated as if the franchisee breached the contract immediately prior to the bankruptcy filing, entitling the franchisor to reject damages for breach of contract. 11 U.S.C. § 365(g).
In order to obtain bankruptcy court approval, a Chapter 11 franchisee must: (i) cure all outstanding franchise agreement defaults on or promptly after assumption, (ii) provide adequate assurance of its future performance under the franchise agreement, and (iii) compensate the franchisor for actual pecuniary loss resulting from any default. 11 U.S.C. § 365(b)(1). Franchisees face significant challenges when seeking to assume and assign a franchise agreement to a third party over the franchisor’s objection.
At some point, franchisee bankruptcies occur within even the most successful franchise systems. While these cases may present complicated legal issues, they can provide astute franchisors with opportunities to retain franchisees and/or units in their franchise system or effect separation. Similarly, franchisees can effectively use bankruptcy to restructure, sell, or liquidate their franchised businesses.
Regardless of the goal, counsel must have a firm grasp of applicable law to successfully navigate a franchisee bankruptcy proceeding. This article is intended to serve as a primer on franchisee bankruptcy issues. An in-depth analysis of this topic may be found in Jason B. Binford & Daniel M. Eliades, The Bankruptcy Handbook for Franchisors and Franchisees, American Bar Association – Forum on Franchising (2018).
Reprinted with permission from The Franchise Lawyer, Volume 25, Number 2, Spring 2022, at 9–12. ©2022 by the American Bar Association. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
