Prebankruptcy Considerations of the Franchisee and Franchisor

• Pages: 1-40

1

According to Franchise Direct,1 in 2015 there were approximately

761,991 U.S. franchise establishments providing direct employment to

8,816,000 people and generating over $889 billion in monetary output.

Although these statistics indicate a robust franchise environment over-

all, some businesses have not been successful in the franchise model.

Even in successful franchise operations, individual franchisees may

experience nancial difculties that lead them to consider bankruptcy

or other forms of nancial relief.

A franchisor or franchisee bankruptcy affects all the key players in

the business. A franchisee is usually the party to a franchise agree-

ment, one or more nonresidential commercial leases, and vendor con-

tracts. In addition, a franchisee may have both secured and unsecured

debt. By the time a franchisee is considering bankruptcy options, it

may be in default of its loans or its contracts.

When a franchisee is in distress, key questions are: Could the fran-

chisor have taken steps to minimize its risk? Is bankruptcy the best

option for the franchisee? Or should the franchisee avoid the federal

bankruptcy laws and seek an out-of-court restructuring of its debts,

unwind under state dissolution laws, or simply shut its doors? If bank-

ruptcy is the better option, should the franchisee le a Chapter 11 reor-

ganization, a Chapter 11 liquidation, or a Chapter 7 liquidation?

This chapter will discuss: (1) steps franchisors can take to best

protect themselves and the franchise system in the event of a franchi-

see’s nancial distress; (2) alternatives to bankruptcy for a distressed

franchisee; and (3) prebankruptcy considerations if a franchisee bank-

ruptcy ling is imminent.

1. Franchise Direct Statistics, http://www.franchisedirect.com/information/

usfranchiseindustrystatistics/?r=5003 August 22, 2017 (last visited Feb. 7, 2018).

PrebankruPtcy considerations of the

franchisee and franchisor

By David M. Neff and Frances A. Smith

1

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2 Chapter 1

I. DRAFTING FRANCHISE AGREEMENTS TO

MINIMIZE RISKS FOR FRANCHISORS

The franchise relationship is one of interdependence between the franchisee

and the franchisor and has signicant advantages for both parties.2 Both fran-

chisees and franchisors are interested in the nancial success of the venture.3

But should the venture become distressed, some prebankruptcy strategies can

assist the franchisor in protecting its rights in dealing with a nancially troubled

franchisee, an insolvent franchisee, or a bankruptcy ling. Although contractual

provisions preventing a franchisee from ling bankruptcy are not likely to be

enforced, other provisions, such as personal guarantees and noncompete agree-

ments may be effective tools. These tools may be included in the franchise agree-

ment or in ancillary agreements.4

In drafting or revising a franchise agreement, the franchisor should consider

adding provisions to protect the franchisor and the franchise system in the

event of a franchisee default. The default, remedy, and other provisions can be

drafted to allow protection in the event of a franchisee insolvency or bankruptcy.

Although a franchise agreement clause preventing a franchisee from ling bank-

ruptcy is invalid, and an ipso facto clause is generally unenforceable, franchise

agreements may contain other provisions that are enforceable in bankruptcy

and that will help protect the franchisor and the franchise system in the event of

a franchisee default. Provisions that franchisors should evaluate and consider

adding to franchise agreements or ancillary agreements include: personal guar-

antees, termination provisions upon closing of business, restrictive covenants

such as noncompetition, nonsolicitation, and nondisclosure clauses, security

interests in franchisee’s assets, collateral assignment of leases, business inter-

ruption insurance requirements, and limits on use of condential information,

trade secrets, and intellectual property.

A. AGREEMENTS NOT TO FILE BANKRUPTCY ARE INVALID

It is against public policy to prohibit an entity from ling for bankruptcy relief.5 As

a result, no creditor consent is needed to le for bankruptcy, although approval

to le bankruptcy must be obtained in accordance with the entity’s governing

documents and applicable law. Most often, unanimous consent of directors or

2. Kevin J. Smith, Bankruptcy and the Franchise Agreement: When All, or Only Some, of the Part-

ners of a Franchisee Files Bankruptcy, 28

Cap. U. L. Rev.

775 (2000).

3. Id. (citing Westeld Ctr. Serv., Inc. v. Cities Serv. Oil Co., 432 A.2d 48, 52–53 (N.J. 1981) (inter-

nal citations omitted)).

4. Matthew B. Gruenberg, John W. Mills & Suj M. Pandya, Protecting the System: Ways That Franchisors

Can Plan for Franchisee Financial Distress and Navigate Franchisee Receivership and Bankruptcies, 33

FRanChise L.J.

377 (Winter 2014).

5. In re Huang, 275 F.3d 1173, 1177 (9th Cir. 2002); In re Citadel Props., Inc., 86 B.R. 275, 276

(Bankr. M.D. Fla. 1988).

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prebankruptCy Considerations of the franChisee and franChisor 3

LLC members is required to authorize a bankruptcy ling. In some instances,

creditors have tried to prevent a bankruptcy ling by obtaining a position as a

director on a company’s board and then not approving the bankruptcy ling.

Such position, referred to as a “blocking” position or “golden share,” has largely

been unsuccessful in preventing a bankruptcy ling, as courts have found that

all directors must exercise their duciary duties of loyalty and due care to the

entity, and not act in what is in their best interest as creditor of the entity.6

Parties cannot contract to prohibit the ling of a bankruptcy case. “Prohibi-

tions against the ling of a bankruptcy case are unenforceable.”7 Such agree-

ments are void as against public policy.8 The constitutional and statutory right

to le a bankruptcy case cannot be waived even if such waiver is “bargained for

and knowing.”9 Thus, any provision in a franchise agreement that would pro-

hibit a franchisee from ling bankruptcy is unenforceable.

B. IPSO FACTO CLAUSES ARE GENERALLY UNENFORCEABLE

An ipso facto clause is a provision in an executory contract or unexpired lease

that declares a breach of contract based solely on a party’s nancial condition

or bankruptcy ling.10 Ipso facto clauses are generally unenforceable in bank-

ruptcy. The Bankruptcy Code specically invalidates such clauses. Section

365(e)(1), specically provides:

Notwithstanding a provision in an executory contract or unexpired lease,

or in applicable law, an executory contract or unexpired lease of the debtor

may not be terminated or modied, and any right or obligation under such

contract or lease may not be terminated or modied at any time after the

commencement of the case solely because of a provision in such contract

or lease that is conditioned on—

A. the insolvency or nancial condition of the debtor at any time before the

closing of the case;

B. the commencement of a case under this title; or

C. the appointment of or taking possession by a trustee in a case under this

title or a custodian before such commencement.

6. See In re Intervention Energy Holdings, LLC, 553 B.R. 258, 265–66 (Bankr. D. Del. 2016); In re

Lake Mich. Beach Pottawattamie Resort LLC, 547 B.R. 899, 913 (Bankr. N.D. Ill. 2016).

7. In re Shady Grove Tech Center Associates Ltd. Partnership, 216 B.R. 386, 390, opinion supple-

mented on remand from district court, 227 B.R. 422 (Bankr. D. Md. 1998); Michael St. Patrick Baxter,

Bankruptcy Proofing: Bankruptcy Provisions in Restructuring Agreements, 8

J. BankR. L & pRaC

. 483,

494 (July/August 1999).

8. Baxter, Bankruptcy Proofing (citing In re Peli, 31 B.R. 952, 956 (Bankr. E.D.N.Y. 1983) (“Agreements

waiving the right to le a petition in bankruptcy violate public policy and will not be given effect.”)).

9. In re Madison, 184 B.R. 686, 690 (Bankr. E.D. Pa. 1995) (“Even bargained-for and knowing waiv-

ers of the right to seek protection in bankruptcy must be deemed void.”).

10. In re Peaches Records and Tapes, Inc., 51 B.R. 583, 587 at n. 6 (9th Cir. BAP 1985).

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