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Five Common Questions When a Client’s Franchisee Files for Bankruptcy

Tue, 06/26/2018 - 11:28 -- admin25

by Cheryl Mullin, Laura Canada Lewis, and Jim Rea

Lawyers who represent franchisors often hear a similar set of questions when a franchisee files bankruptcy.  The authors have collected five of the most common questions they field from franchisors after a franchisee files bankruptcy in addition to the general application of the automatic stay of 11 U.S.C. § 362.

  1. Question: “Will I get paid for the goods we just delivered?”

Answer:  Maybe.  Section 503(b)(9) of the Bankruptcy Code authorizes a party who sold goods to the debtor in the ordinary course of business to make a claim for the value of goods received by the Debtor in the 20 days prior to bankruptcy.  For the Debtor to confirm a Chapter 11 plan of reorganization, your client’s administrative claim must be paid in full.  But, advise your client to remain patient.  It may be several months before they receive any money.  Additionally, subject to state law and other limitations stated in Section 546(c)(1) of the Bankruptcy Code, goods sold to the debtor in the 45 days prior to bankruptcy may be subject to reclamation. 

  1. Question: “The Debtor owes me money! Is it true I may have to give some of that back?” 

Answer:  Yes.  Subject to available defenses, your client may have to pay back some of the money it received from the Debtor.  Sections 547 and 550 of the Bankruptcy Code allow the Debtor or Trustee to recover payments made within 90 days of the bankruptcy filing to the extent the payments provided the franchisor with an advantage vis-à-vis other creditors.

  1. Question: “Does the franchise agreement survive the bankruptcy?” 

Answer:  Franchise agreements in effect when the bankruptcy is filed are typically treated as executory contracts.  In general, a debtor has the right to assume or reject the franchise agreement and, unless precluded by other law, assign it to another party (such as when the Debtor sells its business).  For the Debtor to assume an executory contract, the Bankruptcy Code requires the Debtor to: (a) cure or provide adequate assurance defaults will be cured; (b) compensate or provide adequate assurance of compensation for the franchisor’s pecuniary loss; and (c) provide adequate assurance of future performance of the contract.  The Bankruptcy Code also sets certain deadlines to assume the franchise agreement.  If the agreement is not expressly assumed within those deadlines, the agreement is deemed rejected, and the franchisor has a general unsecured claim for damages. 

  1. Question: “The franchise agreement was not terminated before the bankruptcy.  Can it be terminated now?”

Answer:  Yes, with the Bankruptcy Court’s approval.  The franchisee-debtor’s rights under the franchise agreement are protected by the automatic stay of 11 U.S.C. § 362.  To terminate the agreement your client will have to seek and obtain court approval.  Generally speaking, this will require the franchisor to prove that the debtor is in default, not performing their obligations and has little or no hope of curing its defaults. 

  1. Question: “Is the Non-Compete Agreement discharged?” 

Answer:  This is a complex question.  Authorities are split on whether the non-compete covenants are discharged.  Applicable state law and the terms of the contract further complicate the issue.  The covenants in most franchise agreements provide for injunctive relief and liquidated damages.  Currently, the most common analysis starts by considering whether the non-compete gives rise to a “claim.” Under Section 101(5) of the Bankruptcy Code, a “claim” includes a “right to payment” or “right to an equitable remedy for breach of performance if such breach gives rise to payment . . .”  11 U.S.C. § 101(5)(A) & (B).  Under this approach, if the only adequate remedy for violation of the non-compete is injunctive relief as opposed to a “claim,” then the enforcement of injunctive relief is not a “claim” against the debtor’s bankruptcy estate that is subject to discharge.  As a result, the debtor is still bound by the covenant not to compete after a discharge is entered in the bankruptcy.  The recent case In re La Femina, 2017 WL 4404254 (Bankr. E.D.N.Y. Sept. 2017) (addressing enforcement of the non-compete provision under the Camp Bow Wow franchise agreement) provides a good survey of the complex issues related to non-competes in bankruptcy and the disarray in opinions.

Franchisee bankruptcies present complex issues and many competing interests. The authors recommend you refer your client to bankruptcy counsel to review their specific situation. 

Cheryl L. Mullin, J.D., LL.M and Laura Canada Lewis, J.D. are Shareholders at Mullin Law, P.C. They can be reached at cheryl.mullin@mullinlawpc.com and laura.lewis@mullinlawpc.com, respectively. Jim Rea, J.D., is an attorney at McGuire, Craddock & Strother, P.C. He can be reached at jrea@mcslaw.com.

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