Today, the reality is there are a lot of financially troubled franchisees for lawyers to deal with. However, the world of bankruptcy law can be foreign to the general franchise practitioner.
Jason Binford, partner in Gardere’s financial restructuring and reorganization practice group, recently sat down with Inside Counsel to discuss how the bankruptcy process impacts a franchise relationship, and the necessary steps that parties can take to better position themselves in the event of a bankruptcy filing.
The world of bankruptcy law can be so foreign, even to franchise attorneys accustomed to practicing in federal court. Bankruptcy is a code-based practice and it requires much familiarity with a set of laws that is unique to the practice. It also has its own set of procedural rules that track the federal rules of civil procedure, but with many different and important exceptions.
Franchise practitioners may come across bankruptcy issues from time to time, but they usually do not have a day-to-day need to be conversant in the Bankruptcy Code, Bankruptcy Rules, and bankruptcy jargon. Therefore, when a franchise practitioner does get heavily involved in a bankruptcy case, it can all seem like a foreign language. According to Binford, things often move much faster in a bankruptcy case than in typical federal commercial litigation because the bankrupt party does not have the time or money to deal with protracted litigation.
“The effect on the relationship between the franchisor and the franchisee depends first on the type of bankruptcy filing,” he explained. “If the case is a Chapter 7 liquidation, then the relationship typically ends very quickly as the bankrupt party hands its assets over to a Chapter 7 trustee who administered the liquidation. A Chapter 11 reorganization is altogether different. Franchisee bankruptcy filings are much more common than franchisor bankruptcy filings.”
In the case of a franchisee filing, the debtor will continue to operate during the bankruptcy case in the ordinary course of business. In These cases, the franchise relationship will be the debtor’s most valuable asset. For this reason, franchisees in bankruptcy usually bend over backwards to accommodate the franchisor. This will include maintaining royalty payments and most other obligations under the franchise agreement.That is not to say, however, that there is never discord between a franchisor and franchisee during a Chapter 11 case. In fact, there are a number of situations where the parties may end up at odds.
“In fact, there are several situations where the parties may end up at odds. Assuming, however, that the franchisee wishes to continue operating within the system, the franchisee ultimately is required to assume the franchise agreement,” Binford said, “This requires the franchisee to pay all past-due amounts. A franchisee assuming a franchise agreement must also provide the franchisor with assurances that it will be able to continue performing under the agreement.”
There are steps parties can take to better position themselves in the event of a bankruptcy filing. According to Binford, in the context of a franchisee bankruptcy filing, the franchisor can take several different steps to protect itself. From the franchisor’s perspective, one of the most concerning aspects of a franchisee Chapter 11 case is that an argument could be made allowing the franchisee to assign the franchise agreement over the franchisor’s objection. While there are many arguments a franchisor can make during the bankruptcy case to try and stop such an assignment, the franchisor can also take pre-filing steps. However, it is not as simple as putting a provision in the agreement that assignments are impermissible.
“Such blanket prohibitions are not enforceable in bankruptcy,” he said. “Rather, the franchisor can draft the agreement that makes it easier for the franchisor to argue that it is a ‘personal service contract.’ Provisions prohibiting assignment are enforceable in bankruptcy if it is determined that it is a personal service contract.”
In addition, a franchisor could terminate the franchise agreement prior to a franchisee filing bankruptcy. Even if the franchisee later files bankruptcy, the filing will not resurrect the franchise agreement and the agreement would not be subject to assumption by the debtor. But, in that situation a franchisor must be very careful to ensure that the agreement truly was terminated prior to the bankruptcy filing, per Binford. If for any reason the termination is not considered final and effective, then the franchise agreement will become part of the bankruptcy filing. On the other hand, a franchisee can better position itself for a bankruptcy filing by identifying its dire financial situation sooner rather than later. A Chapter 11 case can be expensive.
So, how can franchises prevent bankruptcy? Per Binford, first, by understanding that a bankruptcy filing can be expensive and unpredictable. For that reason, both the franchisor and the franchisee should make every reasonable effort to work out the financial issues outside of bankruptcy. Non-bankruptcy workouts are quite common, including mediation.
“Bankruptcy filings can also be prevented (or at least made less common) by growing a system at a slow and deliberative pace. A very large number of Chapter 11 bankruptcy filings are a result of a system expanding too fast and/or expanding into areas beyond core competencies,” he explained. “A franchisor may be excited about the bottom-line benefits associated with expansion, but it should weigh that against the cost of one or more of its franchisees later being forced to seek bankruptcy protection.”