When a franchisee declares bankruptcy, the court issues an automatic stay that prevents creditors' seizure of the business's assets. A contract still in effect at the time of the bankruptcy is considered an executory contract, and the franchisee is given the option to maintain (assume) and assign the contract or reject it. An effective contractive between the franchisor and franchisee is deemed an executory contract for bankruptcy purposes.
Procedures differ when it is the franchisor that declares bankruptcy. In this case, a franchisee has to take steps to protect its business operations.
Franchisee Bankruptcy
In a franchisee bankruptcy, the Bankruptcy Code authorizes the debtor or trustee to assume and assign any executory contracts that were not effectively terminated before filing, including the franchise contract. This is true even when the debtor has defaulted under the terms of the franchise agreement. In some cases, the franchisor does not have any input regarding the assignee.
The Bankruptcy Code provides a few protections for franchisors whose contracts were not terminated before filing:
- Before a debtor franchisee can assume and assign a franchise agreement, the debtor (or trustee) must cure all defaults under the agreement. The amount of the cure is calculated by adding the total monetary breach damages (including reasonable attorneys’ fees if addressed in the franchise agreement). The cure also applies to non-monetary defaults if it is within the debtor's ability to cure these defaults. If the debtor cannot cure a non-monetary default, the court will deem the agreement non-executory, and no assumption will be allowed.
- The assumption applies to the entire contract, including those protections given to the franchisor. Additionally, the debtor or trustee must provide the franchisor "adequate assurance" that any performance under the agreement will be executed according to the terms. "Adequate assurance" is determined on a case-by-case basis.
- The Bankruptcy Code provides that where a specific state or federal law excuses a non-consenting contract party from accepting the performance from, or rendering performance, a bankruptcy trustee may not assign an executory contract. In this case, a non-consenting franchisor does not have to accept a transfer of the franchise.
Under the Code, the debtor or trustee can alternatively "reject" a franchise agreement. If the agreement is rejected, it is treated as though the debtor breached the agreement prior to filing for bankruptcy.
Franchisor Bankruptcy
Franchisees retain certain rights when a franchisor declares bankruptcy:
Franchise Name
If a franchisor declares bankruptcy, the franchisor loses all rights to the franchise name. Franchisees are subsequently allowed to continue operations using current franchise name. The franchisees also have the right to continue operations under another name, if they so desire. In some cases, the franchisor and franchisee may have already agreed that upon bankruptcy by the franchisor, the agreement terminates, but the franchisee retains a temporary license to continue use of the name.
Royalty Payments
When a franchisor declares bankruptcy, any payment terms included in the agreement become void and the franchisee is no longer obligated to make royalty payments.
Post-Filing
When franchisees are notified of a bankruptcy filing, the franchisee should notify customers that operations will continue under the transition. They should also meet with business contacts and vendors as soon as possible to maintain supplies during the transition.
Find an attorney
When a franchise declares bankruptcy, all parties must determine their responsibilities, if they have not provided contingencies in the original agreement. The Bankruptcy Code provides certain rights of assumption, assignment or rejection. State laws might also provide specific rights regarding assignments. Consult with a bankruptcy attorney experienced with franchises to determine how both state and federal laws apply to your case.
