So, what happens when a franchisee files for bankruptcy protection?
Drive by any strip mall right now and you are likely to see an empty parking lot. Strip malls are hot beds of franchise establishments struggling to adapt to social distancing and take out or delivery only—if they are open at all. When a franchisee files for bankruptcy protection all of the debtor’s business assets become part of a "bankruptcy estate,”—including the franchise agreement under Section 541 of the Bankruptcy Code.
The Automatic Stay
The franchisee/debtor’s rights under the franchise agreement are protected by the automatic stay under Section 362 of the Bankruptcy Code. Essentially, a franchisor is prohibited from initiating or continuing any act to terminate a debtor’s franchise agreement or take any other action that could diminish the debtor’s rights without first obtaining relief from the automatic stay from the bankruptcy court. The automatic stay, however, is no guarantee the debtor can keep the franchise.
Ipso Facto Clauses
The Bankruptcy Code invalidates ipso facto clauses in contracts purporting to terminate a debtor’s interest in property, such as a franchise agreement, solely because of a bankruptcy filing. However, filing for bankruptcy protection does not expand the franchisee’s rights in the franchise agreement.
Section 365 of the Bankruptcy Code gives a debtor the ability to assume, assume and assign or reject executory contracts and unexpired leases subject to bankruptcy court approval. Bankruptcy courts treat active franchise agreements as a form of executory contract, i.e. a contract where both parties still have obligations to perform and failure to perform them constitutes a breach of contract
In a chapter 7, the bankruptcy Trustee will liquidate the franchisee/debtor's business, disposes of the debtor’s assets to bring funds into the estate, and pay off creditors in order of priority. Generally, the Trustee will attempt to find a buyer to purchase/assume the franchise agreement. However, in many Chapter 7 franchise cases, the franchisee's business is often essentially worthless and the Trustee will either expressly reject the agreement or allow the franchise agreement to eventually be deemed rejected by operation of the Code.
In a chapter 11 “reorganization," the debtor may reject or assume executory contracts (other than unexpired leases of nonresidential real property, i.e., commercial leases) at any time before confirmation of the plan of reorganization. A party in interest may request that the bankruptcy court fix a shorter time period, within which the debtor must reject or assume the contract. Whether the franchisor wants to continue the contract is not a factor; however, a franchisor must assume the complete franchise agreement as is.
If the franchise agreement is not in default, the debtor is entitled to court approval of the assumption, as long as: (a) the contract appears to be in the best interest of the estate; (b) the debtor is able to perform; and (c) the assumption is supported by reasonable business judgment.
In order to assume the franchise agreement that is in default, however, the debtor must: (1) cure the default or provide adequate assurance that the debtor will promptly cure such defaults; (2) compensate or provide adequate assurance that it will promptly compensate a party to the contract or lease (other than the debtor ) for any actual pecuniary loss to such party resulting from such default; and (3) provide adequate assurance of future performance under such contract or lease. The amount of the cure cost and whether the default is curable are often topics of debate, but it is generally required that the cure be a full cure.
Debtors’ and creditors’ rights, obligations, and potential liabilities under the Bankruptcy Code can be hard to navigate. If you need assistance understanding how to safely proceed in Bankruptcy Court or out of court workouts, contact the experienced litigation attorneys at Goosmann Law in our Sioux City, Sioux Falls, and Omaha offices.