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Chapter 11's Impact on the Franchise Relationship

Chapter 11's Impact on the Franchise Relationship

Colorado Bar Association, Business Law Newsletter, April, 1997

©1997 Kevin P. Hein
Moye, Giles, O'Keefe, Vermeire & Gorrell LLP

As corporate America continues to downsize, more workers and families find themselves with the time and financial resources to pursue the American Dream of owning their own businesses. This phenomenon, along with the ever increasing demand for convenience in urban and suburban America, has helped fuel the double-digit growth in the franchise industry. But what goes up most often comes down. Despite boasting success rates that well exceed the success rates of non-franchised start up businesses, even the best franchisors experience some failure in their franchise networks. Moreover, while small business can flourish in a robust economy, as the business cycle peaks and begins to head south, some of these small businesses will feel the fall-out of a slower economy or overexpansion by franchisors hungry to grow market share "while the growin's good." The inevitable result is that an increasing number of franchisees will seek protection in the Bankruptcy Court. Consequently, it is wise for lawyers representing both franchisees and franchisors to have some understanding of the ways in which bankruptcy can impact the franchise relationship.

This article will focus on the bankruptcy process when the franchisee seeks to reorganize its business under Chapter 11 of the Bankruptcy Code, 11 U.S.C. § 101 et. seq. (the "Code"). The article will address the circumstances under which a franchise agreement can or cannot be assumed in bankruptcy, enforcement of a franchise agreement pending formal assumption or rejection, and the franchisee's right to assume, assign, or reject the agreement. The article will also briefly discuss the franchisor's right to enforce a non-competition clause in the event that the franchise agreement is rejected as part of the franchisee's reorganization plan.

Creation of the Estate and the Automatic Stay

Once a bankruptcy case has been filed, an estate is created which encompasses all tangible and intangible rights and property owned by the debtor-franchisee. Section 541 of the Code defines what types of property become property of a bankruptcy estate. The definition is broad and clearly encompasses the rights created by a franchise agreement. In re Varisco, 16 B.R. 634, 637 (Bankr.M.D.Fla. 1981). Immediately upon filing Chapter 11, the automatic stay set forth in § 362 of the Code enjoins all creditors, including the franchisor, from interfering with the day-to-day business operations of the debtor. Any right created in the estate by a franchise agreement is subject to, and protected by, the automatic stay. In re Tudor Motor Lodge Assoc., Ltd. Partnership, 102 B.R. 936, 948 (Bankr.D.N.J. 1989).

Terminated Franchise Agreements Are Not Assumable in Bankruptcy

Franchise agreements have consistently been held to be property of a bankruptcy estate by virtue of their nature as executory contracts. In re Audra-John Corp., 140 B.R. 752, 755 n.6 (Bankr. D.Minn. 1992); In re Quiones Ruiz, 98 B.R. 636, 638 (Bankr. D. P.R. 1988). However, executory contracts only constitute property of the estate to the extent that they have not been previously terminated. "Although the language of § 541 is broad, Congress clearly did not intend to 'expand the debtor's rights against others more than they exist at the commencement of the case.'" In re Tudor Motor Lodge Assoc., Ltd. Partnership, 102 B.R. at 948. Consequently, a debtor's contractual rights in a franchise agreement are considered property of the estate unless the agreement has been effectively terminated prior to the Chapter 11 filing. In re Varisco, 16 B.R. at 637. Therefore, the threshold inquiry a bankruptcy court will make is whether the franchise agreement is in effect at the time the debtor files Chapter 11.

If a franchise agreement has been terminated prior to bankruptcy, there is nothing to be assumed by a debtor once the case has been filed. Moody v. Amoco Oil Company, 734 F.2d 1200, 1212 (7th Cir.), cert. denied, 469 U.S. 982 (1984). "However, the termination must be complete and not subject to reversal, either under the terms of the contract or under state law." Id. Courts evaluating whether a franchise agreement has been effectively terminated prior to bankruptcy have focussed on whether the debtor was granted an opportunity to cure the alleged default. See In re Tudor Motor Lodge Assoc., Ltd. Partnership, 102 B.R. at 950 (citing the court's analysis in In re Varisco, 16 B.R. at 637-38). "Where a franchisee is granted time to cure defaults and the franchisee files its bankruptcy petition prior to the time the cure period expires, the franchise agreement is not terminated and is part of the estate." In re ERA Central Regional Services, Inc., 39 B.R. 738, 740 (Bankr.C.D.Ill. 1984). Consequently, when a franchisee files bankruptcy, a crucial inquiry must be whether any conduct by the franchisee has triggered an effective and irreversible termination of the franchise agreement prior to the debtor-franchisee's entry into Chapter 11.

Franchise agreements generally define what types of franchisee conduct triggers the franchisor's right to terminate the agreement. For example, the consistent failure to operate the business according to franchisor standards, Chia-Hsin Huang v. Holiday Inns, 594 F. Supp. 352, 356 (C.D. Cal. 1984), or the transfer of ownership of a franchisee without the receipt of the franchisor's permission as required in the franchise agreement, General Motors Corporation v. MAC Company, 247 F. Supp. 723, 727 (D.Colo. 1965), constitute grounds upon which a franchisor may terminate the franchise agreement. Provided the franchisor complies with state law regarding notice and reasonable opportunity to cure, the franchisor is within its rights to terminate the franchise agreement automatically upon the expiration of the cure period. Once a termination notice has been sent by the franchisor indicating that the agreement will terminate on a date certain, the franchise agreement only constitutes property of the estate until the designated termination date, and the filing of a bankruptcy petition cannot intervene to prevent the automatic termination of the contract. Moody v. Amoco Oil Co., 734 F.2d at 1213.

Enforcing the Agreement Against the Franchisor Pending Formal Assumption or Rejection

In the event that the franchise agreement has not been terminated, the Code allows a debtor-franchisee to determine whether it desires to assume or reject the agreement. § 365(a). In a Chapter 11 proceeding, the debtor may assume or reject a franchise agreement any time before the confirmation of a plan. § 365(d)(2). The franchise agreement must be assumed or rejected in its entirety. In re David Orgell, Inc., 117 B.R. 574, 575 (Bankr.C.D.Cal. 1990).

In general, a franchisee which is in default of its franchise agreement will have no interest in immediately assuming the contract because, pending the assumption or rejection of the agreement, the franchisor is bound by the contract terms, In re El Paso Refinery, L.P., 196 B.R. 58, 71 (Bankr.W.D.Tex. 1996), and the agreement remains enforceable exclusively against the franchisor. In re Gunter Hotel Associates, 96 B.R. 696, 700 (Bankr.W.D.Tex. 1988). Moreover, a franchisor is required to continue to perform on the franchise agreement until the moment of assumption or rejection, even if the franchisor is aware that the franchisee ultimately intends to reject the contract. See In re Alfar Dairy, Inc., 458 F.2d 1258, 1261 (5th Cir.) (In case under Bankruptcy Act, court held that non-debtor party could not stop performing on contract even when it knew that debtor intends to reject contract), cert. denied, 409 U.S. 1048 (1972). Therefore, delaying assumption of the agreement enables the debtor to continue using the trademark and goodwill of the franchise system without curing any prepetition breaches of the contract.

Courts in Colorado have long endorsed the requirement that the non-debtor must continue to perform on the contract. Even prior to the enactment of the current version of the Code, the Tenth Circuit had opined "[t]hat this inherent equitable power permits a bankruptcy court, in proper circumstances, to restrain cancellation of a contract in order to preserve the continuation of the debtor's business." In re Trigg, 630 F.2d 1370, 1373 (10th Cir. 1980). More recently, the bankruptcy court in this district explained that "[t]he debtor is given the option of assuming or rejecting. In order to make that option effective, the contract must remain in effect and the other party must be bound to perform under the terms of the contract." In re Feyline Presents, Inc., 81 B.R. 623, 627 (Bankr.D.Colo. 1988).

The Code also grants the court the power to issue any order necessary to effectuate the court's authority or enforce provisions of the Code. § 105. This power may be used by the court "to enjoin cancellation of a contract in order to preserve the continuation of the debtor's business." In re Amber Lingerie, Inc., 30 B.R. 736, 737 (Bankr.S.D.N.Y. 1983). Consequently, § 105 is another mechanism that enables a bankruptcy court to enforce a franchise agreement until such time as the agreement is formally assumed or rejected. In re Continental Energy Assoc., Ltd., 178 B.R. 405, 408 (Bankr.M.D.Pa. 1995).

A franchisor may seek an order of the court to shorten the time period allowed for the debtor's assumption of the franchise agreement by filing a motion with the bankruptcy court requiring the debtor-franchisee to assume or reject the contract "within a specified period of time." § 365(d)(2). The "specified period of time" in § 365(d)(2) is a "reasonable period of time" that must be determined based upon the facts and circumstances present in the case. In re Lionel Corp., 23 B.R. 224, 225 (Bankr.S.D.N.Y. 1982). The court will generally consider a number of factors in making its determination, "including 'the nature of the interests at stake, the balance of the hurt to the [parties], the good to be achieved, [and] the safeguards'" available to the parties. Id. (citing In re Midtown Skating Corp., 3 B.R. 194, 198 (Bankr.S.D.N.Y. 1980)). If the court enters such an order, and the debtor-franchisee desires to remain a part of the franchise system, it must assume the contract, cure any existing breaches, and provide adequate assurance that it will be able to perform its obligations under the agreement in the future. § 365(b)(1)(A). This approach is advantageous because it may enable the franchisor to avoid having to seek relief from the automatic stay and the filing of an adversary proceeding to terminate the agreement.

Assuming a Franchise Agreement

Section 365 allows a debtor to assume all executory contracts, including franchise agreements. If the franchise agreement is not in default at the time of filing, the debtor- franchisee is generally entitled to assume the agreement if (1) the agreement appears to be in the best interest of the estate, (2) assuming the contract constitutes a good business decision, and (3) the debtor is able to perform on its obligations under the contract. See In re C.M. Systems, Inc., 64 B.R. 363, 364 (Bankr.M.D.Fla. 1986). Clauses requiring automatic termination of a franchise agreement "ipso facto" upon the filing of bankruptcy or based solely on a debtor's insolvency or financial condition are rendered non-enforceable by § 365(b)(2) and § 365(e)(1).

A contract that is in default at the time of filing can be assumed by the debtor provided the default is cured, or adequate assurance is provided that the default will be promptly cured, and the debtor provides adequate assurance that it will continue to perform under the contract. § 365(b)(1)(A). Courts have generally held that "promptness" is to be determined on a case-by-case basis. See In re Lafayette Radio Electronics Corp., 9 B.R. 993, 998 (Bankr. E.D.N.Y. 1981) ("prompt" cure meant immediate cure); In re ERA Central Regional Services, Inc., 39 B.R. at 742 (franchisee had 45 days to cure defaults); General Motors Acceptance Corp. v. Lawrence, 11 B.R. 44, 45 (Bankr. N.D.Ga. 1981) (prompt cure cannot exceed one year); In re Coors of North Mississippi, 27 B.R. 918, 922 (in case where court found franchisor-distributor to have "dirty hands," court allowed franchisee-assignee three years to cure defaults). Section 365(b)(2)(D) specifies that a nonmonetary breach need not be cured prior to assumption. In re Claremont Acquisition Corp., Inc., 186 B.R. 977, 990 (C.D.Cal. 1995).

Assigning a Franchise Agreement

As part of a reorganization plan, the franchisee may elect to assign its franchise agreement to another operator. Section 365 of the Code, subject to certain exceptions discussed below, allows a debtor-franchisee to assign its franchise agreement. To do so, the debtor must assume the contract and then assign it, and the assignee must provide adequate assurance of future performance to the franchisor. § 365(f)(2). In addition, the debtor must cure any monetary defaults or provide adequate assurance of prompt cure of such defaults at the time the contract is assumed. § 365(b)(1)(A). This assurance may come in the form of an assignee agreeing to pay past-due royalties and other payments to the franchisor over a reasonable period of time after assumption of the franchise. See In re Coors of North Mississippi, Inc., 27 B.R. at 922 (court allowed assignees to pay monetary obligations owed by debtor in possession to beer manufacturer over three year period). Section 365(f) enables a debtor to override clauses providing the franchisor with exclusive control over the assignment of the franchise agreement.

In general, courts are reluctant to prohibit assignment of franchise agreements. See In re Sunrise Restaurants, Inc., 135 B.R. 149, 153 (Bankr.M.D.Fla. 1991) (franchisor's objection to debtor's right to assign fast food outlet without merit because debtor possessed no special skill upon which franchisor relied in making and selling hamburgers to the public); In re Tom Stimus Chrysler-Plymouth, Inc., 134 B.R. 676, 679 (Bankr.M.D.Fla. 1991) (franchise agreements are assignable provided assignee can adequately assure future performance under contract); In re Wills Motors, 133 B.R. 297, 300 (Bankr. S.D.N.Y. 1991) (franchisor's consent to assignment unnecessary because proposed assignee had "been shown to be a successful, competent and financially responsible automobile dealer who offer[ed] adequate assurance of performance under the assigned" franchise). However, the more specifically tailored the agreement is to the franchisee's business, the greater the likelihood that a court will conclude that the franchise agreement is not assignable. Conversely, courts are less likely to rule in a franchisor's favor when the franchisor has historically allowed the sale or assignment of franchises or the franchisor uses "boiler plate" form agreements instead of documents tailored specifically to reflect the agreement reached with each individual franchisee.

Carefully drafted franchise agreements can provide the franchisor with some degree of influence in the event that the franchisee seeks to assign the franchise agreement as part of its reorganization plan. Artful drafting can take advantage of the exceptions to the general rule allowing assignment of the agreement over the objection of the franchisor. Specifically, a franchise agreement may not be assigned without the consent of the franchisor when the terms of the contract require the "personal services" of the franchisee or in cases in which certain provisions of state law prohibit assignment without prior approval of the franchisor. § 365(c)(1).

Characterizing a franchise agreement as a personal services contract and reserving the right to require the franchisee to assign the agreement to the franchisor or the franchisor's designee is the most effective way for a franchisor to prevent an unwanted assignment of the agreement in a bankruptcy proceeding. While it is apparent from case law that § 365(f) enables the court to override a franchisor's absolute veto power to block an assignment of the agreement, In re Coors of North Mississippi, Inc., 27 B.R. at 923, a franchisor's reservation of the right to require assignment of the agreement to itself or its designee presents an opportunity for the franchisor to retain some control in the bankruptcy process. Previously, bankruptcy courts had concluded that such "rights of first refusal" were unenforceable by virtue of the provisions of § 365(f)(1). See In re Mr. Grocer, Inc., 77 B.R. 349, 353 (Bankr.D.N.H. 1987) (right of first refusal granted to landlord in lease unenforceable pursuant to § 365(f)(1)). More recently, some courts have called this conclusion into question. In In re Headquarters Dodge, Inc., 1992 WL 437432 (D.N.J. 1992), the district court concluded that an automobile franchisor's right of first refusal was not eliminated by § 365(f)(1) because the franchise agreement constituted a personal services contract under New Jersey law and thus could not be assigned under § 365(c)(1). Id., at * 8. Although the Third Circuit court of appeals reversed the district court and held that the franchise agreement's status as a personal services contract was a question of fact that must be determined pursuant to Michigan law (the choice of law specified in the franchise agreement), it did not reject the district court's analysis of § 365(f)(1)'s application to franchise agreements. In re Headquarters Dodge, Inc., 13 F.3d 674, 683 (3rd. Cir. 1993). The issue of whether a franchise agreement constitutes a personal services contract is resolved by the state law governing the terms of the franchise agreement. In re Claremont Acquisition Corp., Inc., 186 B.R. at 983; In re Headquarters Dodge, Inc., 13 F.3d at 683. While no court in Colorado has ever published an opinion addressing whether a franchise agreement constitutes a personal spf ervices contract, courts in other states have generally ruled that franchise agreements are not personal services contracts. For example, in California franchise agreements are not considered personal service contracts because they focus on the "marketing place" of the franchisee's business as opposed to the personal service of the franchisee, Kreisher v. Mobil Oil Corporation, 243 Cal. Rptr. 662, 667 (Cal. App.), cert. denied, 489 U.S. 899 (1988) (oil company franchise not a personal services contract), and because the services performed pursuant to the franchise agreement are "routine and fungible." H. Salt of Southern California, Inc. v. Yu, 1993 WL 306153 (9th Cir. 1993), 2 F.3d 1157 (table) (discussing fast food franchisor relationship to franchisee). Courts from other jurisdictions agree that franchise contracts which rely primarily on economic relationships between franchisor and franchisee are not personal service contracts. See In re Sunrise Restaurants, Inc., 135 B.R. at 153 (Burger King franchise constituted merely "a strict business transaction to furnish economic gains to both contracting parties."); In re Tom Stimus Chrysler-Plymouth, Inc., 134 B.R. at 679 (car dealership not personal services contract). Finally, language in a franchise agreement which contemplates the transfer or sale of the franchise tends to limit a franchisor's argument that the franchise agreement constitutes a non-assignable personal services contract. As one court explained, "[t]he idea that [a franchisee's] personal services were the essence of the relationship is further refuted by the very presence of the assignment provisions: if [the franchisee's] services were so unique and vital [the franchisor] would have no reason to either contemplate or to make provision for any possible substitution." Kreisher v. Mobil Oil Corporation, 198 Cal. Rptr. at 667-68.

A second mechanism for retaining some control over assignment of the franchise agreement during the bankruptcy process is for the franchisor to specify in the agreement that the contract is to be interpreted in accordance with the laws of a state which mandates that a franchisee must secure franchisor approval prior to assigning a franchise agreement. Three circuit courts of appeal have held that the prohibition on assignment contained in § 365(c)(1) is dependent upon the law of the state governing the agreement, and is therefore not limited to personal services contracts. See In re Pioneer Ford Sales, Inc., 729 F.2d 27, 29 (1st Cir. 1984) (automobile franchise not assignable); In re West Electronics, Inc., 852 F.2d 79, 83 (3rd Cir. 1988) (debtor not allowed to assume contract to supply missile launcher without express consent of federal government); Pension Benefit Guaranty Corp. v. Braniff Airways, (In re Braniff Airways, Inc.), 700 F.2d 935, 942 (5th Cir. 1983) (airport landing slots not assignable). The Pioneer Ford case is the leading case supporting the rights of franchisors opposed to assignment. In that case, the First Circuit Court of Appeals held that the prohibition against assignment applied not only to personal services contracts but also in cases in which the contract at issue is the type that "contract law ordinarily makes nonassignable, i.e. contracts that cannot be assigned [even] when the contract itself is silent about assignment." In re Pioneer Ford Sales, Inc., 729 F.2d at 28. In Pioneer Ford, the applicable statute expressly directed that automotive dealers could not assign their franchises without the franchisor's consent, but the consent could not be "unreasonably withheld." Id. The appellate court held that the franchisor's consent had not been unreasonably withheld because the assignee had failed to meet the working capital requirements of the franchisor. Id. at 31.

Rejecting a Franchise Agreement and the Effect of Rejection on Covenants Not to Compete

Finally, a franchisee in bankruptcy has the right to eliminate some of the burdens or restrictions imposed on its continued operations by rejecting the franchise agreement. Rejection of an executory contract constitutes a "breach" of the contract "immediately before the date of the filing of the petition." § 365(g). In such cases, the franchisor is left with a prepetition claim for damages resulting from the breach. The claim is accorded the same treatment in the franchisee's reorganization plan as all other prepetition claims. Of course, rejection of the franchise agreement also means that the debtor-franchisee is no longer part of the franchise system.

Because rejection only constitutes a breach of the contract and is not the same as termination of the contract, certain rights may survive the rejection of a franchise agreement. In re Printronics, Inc., 189 B.R. 995, 1000 (Bankr. N.D.Fla. 1995). Of particular concern to most franchisors is whether a covenant not to compete survives the rejection. If it does not, a rejected covenant merely constitutes an additional element of the damage claim resulting from the breach of the franchise agreement.

A franchisor seeking to enforce a covenant not to compete after rejection must rely on one of two theories. The first theory holds that restrictive covenants will be enforced against the debtor where the franchise agreement contains both executory and non-executory provisions and the executory elements are severable from the post-termination obligations. See In re Don & Lin Trucking, 110 B.R. 562, 568 (Bankr.N.D.Ala. 1990). An example is a franchise agreement in which the covenant not to compete is clearly supported by separate consideration. Another example is when a franchise agreement is near expiration and the only obligation remaining is the covenant not to compete. Under those circumstances, equity may preclude the debtor who has benefited from the franchise relationship from rejecting the covenant. In re Noco, Inc., 76 B.R. 839, 843 (Bankr.N.D.Fla. 1987). In contrast, rejection of the franchise agreement also constitutes rejection of the covenant not to compete in cases in which the court finds that post-termination covenants are "an integral, non-divisible part of the executory franchise agreement," In re JRT, Inc., 121 B.R. 314, 323 (Bankr.W.D.Mich. 1990), or it is clear "that the parties did not intend for the pertinent covenant to be a separate contract from the franchise agreement." In re Silk Plants, 100 B.R. 360, 362 (M.D.Tenn. 1989).

If the bankruptcy court determines that the covenant not to compete has been rejected along with the rest of the franchise agreement, the franchisor must rely on the second theory as the basis for enforcement of the covenant. This theory holds that a cause of action which does not give rise to monetary damages, but only allows for injunctive relief under state law, does not constitute a "claim" under the Code and therefore allows a franchisor to pursue its equitable right to enforce the covenant. When a franchise agreement is "breached" as part of a bankruptcy proceeding, a franchisor's rights pursuant to the breach are determined by the laws of the state governing the franchise agreement. In re Ward, 194 B.R. 703, 708 (Bankr.D.Mass. 1996). To secure enforcement under this theory, the franchisor must be able to satisfy the requirements necessary to secure an injunction under state law. In re Audra-John Corp., 140 B.R. at 758. Once the court is satisfied that an injunction is warranted, the theory further requires that the franchisee's breach of the covenant does not give rise to an alternative right to payment under the law governing the franchise agreement. In re Printronics, Inc., 189 B.R. at 1001. Finally, it is worth noting that, while most courts will recognize a choice of law provision in a franchise agreement, some courts refuse to enforce restrictive covenants which conflict with the public policy of the state which is adjudicating the bankruptcy. Id. In those instances, the court generally examines the effect of the covenant under the law of the state designated by the franchise agreement, and then considers whether enforcement would be contrary to the public policy of its own state. Id. at 1001-02. Consequently, the franchisor may find that its claim regarding a covenant not to compete is ultimately reduced to a damage claim, or not allowed by the court at all.

Conclusion

Bankruptcy is intended to give the debtor a fresh start, and the theory is no different for a financially unsuccessful franchisee. A franchisor with valid grounds for termination can avoid the bankruptcy process by ensuring that termination of the franchise agreement is final and irreversible prior to a franchisee's entry into the bankruptcy system. Failing that, a franchisor must be prepared to continue the franchise relationship throughout the reorganization process while the franchisee determines which path best serves the interests of its creditors and its financial future. Although the process may be long and tedious, the best result is a financially resurrected franchisee that is economically viable and committed to remaining a productive part of the franchise system. In the end, as long as franchisors continue to aggressively expand their franchise networks, periodic forays into bankruptcy court will be just another cost of doing business.