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By M. Blen Gee, Jr. (AFA Affiliate Member), and
Jean Winborne Boyles, Esqs.

The cardinal principle for creditors of a bankrupt company is, “if you snooze, you lose!”  In no situation is this more true than when a franchisor has just filed for bankruptcy protection.  Critical rulings are frequently made by the bankruptcy court in the first few days.  The franchisor who has just filed bankruptcy has been working for months with its attorneys to plan for a Chapter 11 or for an expedited liquidation in a Chapter 7 proceeding.  Sometimes the bankrupt debtor has already formed a “prepackaged plan.”  This means that the bankrupt debtor and its major secured creditors have agreed in advance on how to handle significant aspects of the bankruptcy.  There may even be a potential buyer for the franchisor’s business lined up.  If there is a prepackaged plan then other creditors, including franchisees, are playing “catch up” from the beginning.  The decision whether to assume or reject certain franchise agreements, a critical decision to franchisees, is dealt with early in the bankruptcy proceeding. 

In bankruptcy things can happen at a fast pace, frequently with short notice and sometimes with no notice at all.  It is critical for franchisees to get involved and make plans immediately.  Sometimes, there is enough advanced warning in the wind prior to the bankruptcy filing that franchisees can get together and devise a strategy.  After the bankruptcy filing, similarly situated franchisees should quickly try to form a group to share costs for legal representation.  If a group is large enough, it can have significant clout in the bankruptcy.  Such a group is sometimes approved by the court as an official “Franchisee Committee” and then the bankrupt estate will pay its costs.

Franchisees should be particularly aggressive if they believe the franchisor is in default.  The debtor/franchisor must cure past monetary defaults.  If the franchisor is not performing contractual responsibilities, such as nationwide and local advertising, motions can be filed with the Bankruptcy Court to require full performance.  These issues are typically handled on a case-by-case basis and vigorous action by franchisees may yield substantial benefits.  Active franchisees will have greater leverage in every aspect of the bankruptcy proceeding.

A franchisor’s agreements with its franchisees are among its most important assets.  In bankruptcy parlance, a franchise agreement is an “executory contract.”  That is to say, it is a contract, like a lease, that continues for some time into the future.  Under the bankruptcy laws, the bankrupt company can either continue to honor (assume) its “executory contracts,” assign them to someone else (i.e. sell the contracts for money or some other thing of value), or reject the contracts.  This, of course, is a huge issue for franchisees since the franchisee may suddenly find that he is paying royalties to a totally different company that knows very little about him or his business.  Franchisees can object to a buyer who does not have the ability to carry out the franchisor's responsibilities. The Bankruptcy Code does provide some protection to franchisees whose franchise agreements have been assumed.  The franchisees may have significant negotiating leverage, especially if the franchisor has failed to live up to some obligation under the franchise agreement.  The franchisor or the buyer will have to “cure” any default under the franchise agreement and provide compensation for any actual pecuniary loss as a condition of the assumption of the franchisee’s agreement.

If the franchisor “rejects” a franchise agreement, this may lead to an interesting consequence.  The typical franchise agreement has a post-termination non-competition provision that prevents the franchisee from simply de-branding and continuing his business after the franchise agreement expires or is terminated for cause.  In bankruptcy, however, if the franchise agreement is “rejected,” the franchise agreement in most situations ceases to exist.  That most likely means the non-competition provision also ceases to exist; the franchisee is free to de-brand and continue to operate its business from the same location in the same manner.  (Note, however, that the franchisor will continue to be able to assert any trademark, copyright, and patent rights it owns and protect its trade secrets.)

Other issues that may pose problems and some opportunities for franchisees, along with other creditors, include:  

1.         Setoffs – one obligation cancels another;

2.         Preferential transfers – payments of past due debt made by the bankrupt franchisor within 90 days prior to filing bankruptcy (for “insiders” one year).  Preferential payments must be repaid to the bankruptcy estate, much to the surprise of the creditor that thought he “lucked out” to get paid before the debtor filed bankruptcy;

3.           Disallowance of claims,  in whole or in part;

4.           Certain claims may require that you file an adversary proceeding (a lawsuit within the bankruptcy) to protect your rights.

The bankruptcy of a franchisor poses tremendous problems for its franchisees, as well as some opportunities.  However, it is absolutely essential that franchisees assert their rights vigorously and promptly.  Franchisees will have more impact, as well as economies of scale, if they are united as a group.

And remember, if you snooze, you lose.

M. Blen Gee is an Affiliate Member of the American Franchisee Association (AFA).  He and Jean Winborne Boyles are attorneys practicing law with the Raleigh, North Carolina law firm of Johnson, Hearn, Vinegar, Gee and Mercer, PLLC.  Contact Blen at 919-743-2200 or bgee@jhvglaw.


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AFA Enews - August 13, 2004 - Volume 2 Number 4

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