Bankruptcy is sometimes the most appealing alternative for a franchisee, but it's also not the worst-case scenario, and it isn't unpleasant for a franchisor. Looking at the brand's future holistically, business reorganization through Chapter 11 bankruptcy can assist a franchisee in shedding certain debts, freeing up funds to spend on their properties, or otherwise reinvesting in the company. If you want to keep running your business as a franchise, then a Chapter 11 bankruptcy could allow you to do so.

Understanding Chapter 11 Bankruptcy and Franchise

Chapter 11 bankruptcy is widely regarded as one of the most difficult and complex types. That's usually the case owing to the complexity of bankruptcy law and the complex nature of the obligations involved. However, it could be an ideal option for companies or wealthy individuals facing risks from problematic debts. Filing for Chapter 11 bankruptcy is a serious issue that requires professional legal counsel to be handled effectively.

An entrepreneur can use Chapter 11 bankruptcy to discharge several financial obligations and debts. For a franchisee, the process is more challenging. They should first demonstrate in court that declaring bankruptcy constitutes sound judgment. The best interests of the creditors, debtors, and the bankruptcy estate should be taken into account, even if continuation of the agreement is preferred.

Franchise bankruptcy usually constitutes the reorganization of obligations. However, a franchisee should ask the court for authorization to "assume" the franchise or keep running the business. The United States Bankruptcy Court views a franchise agreement as an executory contract in which failure to execute is regarded as a breach of the contract.

The Basic Fundamentals of Franchise Operations

There are 3 main types of franchises, as well as various ways of structuring a franchise model:

Franchise Models for Businesses

The franchisor grants the franchisee permission to utilize a specific business system while also offering assistance in running the firm, such as a marketing program. The franchisee should strictly comply with the rules and operating procedures.

Product Franchises

A franchisee sells products made by the franchisor using a franchisor's brand name or trademark license. Typically, the franchisee will either pay to stock their shelves with the trademarked products or settle an upfront franchise fee in exchange for permission to distribute the goods.

Distributorship

A franchise is authorized to sell and market a parent company's goods. An example is the Ford or Toyota car dealership.

Various franchise structures can be used. Single-unit franchises are based in a single place and have some protection from competitors in their location. Area development franchises allow the franchisees to manage multiple franchise businesses in a given area. A franchisor receives royalty payments under a pure franchise model, whereas in a mixed system, they receive revenues from product sales, franchisor-owned locations, and franchisee fees.

A franchise agreement could be a series of related contracts or a single unitary agreement. Under the fundamental franchise agreement, a franchisee is granted usage rights to copyright, patents, service marks, and trademarks. It could also involve the licensing of the brand name. A future development contract gives the franchisee's right to set up a business in a certain location.

How a Chapter 11 Bankruptcy Affects a Franchise

The following are ways in which filing for bankruptcy can affect a franchise:

Denial of the Franchise Contract

Any franchisor's bankruptcy ultimately concerns whether the contract will be maintained and remain in effect. The franchisee should be ready for the likelihood that their contract would be thrown out if they file for bankruptcy. It often takes more work to understand what it entails when a franchise contract is rejected. A franchisee can have a claim for unsecured damages. However, since they are unsecured borrowers, retrieving their losses is not their top priority.

The Franchise Contract Could Be Put on Hold

Uncertainty and delays could result from declaring bankruptcy. When Chapter 11 bankruptcy is filed, an automatic stay takes effect. This leaves the debtor with three options: liquidation, Chapter 7 conversion, or debt restructuring. Restructuring could take several shapes.

A debtor has enough time in a Chapter 11 bankruptcy case to decide on how to manage debts. It can take time for them to determine whether to accept, assign, or reject the franchise contract. This could leave the franchisees confused and anxious about what would unfold in the future. A franchisee has various options through motions to the courts to reduce the consequences of uncertainty and delays.

Extending the Franchise Contract

There's also the probability that a franchise contract will remain in its current form. The franchisor should correct any issues with the agreement's performance before a business can resume normally. If the franchise contract is upheld, the franchisor should reimburse the franchisee for any losses brought on by non-performance. They should also be able to guarantee future performance adequately. Even still, the franchisee will feel uneasy about the future because of the bankruptcy, which should make him or her question what lies ahead.

Damaged Reputation Within the Community

A franchisee could find it more difficult to operate their business just because the franchisor filed for bankruptcy. Declaring bankruptcy often results in negative publicity for the business. Customers may conclude that all stores have ceased operations. They could also lack confidence that their bookings or purchases will be honored.

The franchisee could find it difficult to maintain operations due to the sudden negative publicity and damaged reputation. At the same time, they might not be able to handle advertising or leverage the brand name to spread the word. Damaged community goodwill could be an unanticipated barrier for a franchisee following a Chapter 11 bankruptcy.

Loss of Training, Marketing, and Other Support Services for Businesses

A franchise agreement is designed so the franchisor handles many business functions. The franchisor manages advertising campaigns, employee training, and even bookkeeping in exchange for a fee. The franchisor could have provided supply chain support, market research, online support, and operational guidance in the past. The franchisee can suddenly find themselves on their own.

Franchisee Could Still Be Required To Perform

Declaring Chapter 11 bankruptcy does not automatically result in the termination of a franchise contract. In reality, a franchisee would be compelled to continue meeting their responsibilities. It might appear that the company is running more or less normally.

A franchisee should not draw assumptions regarding the impact of a Chapter 11 bankruptcy on their debts under the contract. Their responsibilities may remain unchanged. Additionally, if bankruptcy is filed, it could be necessary to renegotiate the conditions of a franchise contract. It's crucial to be aware of all your options and consider your alternatives.

Third-Party Acquisition of the Agreement

The business could be able to sell or transfer its franchise contract to another buyer. The party buying the franchise should continue to comply with the original conditions if this is what the franchisor wants. In the end, the agreement is upheld without any flaws that might have resulted from the earlier financial troubles. The buyer will have to provide adequate assurances about future performance.

Issues Regarding Franchise Bankruptcy Reorganization

When filing bankruptcy and financial reorganization are considered, the franchise contract and future development deals are called into question. These agreements could be separate or unitary obligations.

Real estate leases, frequently utilized in a mixed franchise structure, could also be affected. Corporate stores could be sold, or the franchisor would enter into a new leasing agreement with another franchisee to keep the store open.

Reorganization could also have an impact on a procurement contract. In this contract, the franchisor negotiates a deal with the supplier on the franchisee's behalf. By doing this, economies of scale are achieved, from which a franchisee can profit, or the economies could take the form of vendor rebates given to the franchisor. A franchisee should be informed of the arrangement when this is the case.

The following are some other factors to consider when dealing with franchise bankruptcies:

Estate property

Franchise agreements that are legally terminated before filing for bankruptcy are not regarded as estate property since they are no longer in effect. This includes contracts that have been duly terminated under federal or state legislation or that have been brought to an end as per their own conditions.

Defaults

Franchisees are capable of defaulting without incurring financial obligations. If the franchise owner temporarily closes the business despite the contract's requirement that it be operated continuously, the franchisor could request payment for the nonpayment or terminate the agreement. When an agreement is assumed or when the business resumes its operations, the default immediately needs to be addressed.

Franchise Agreement Termination

Let's say a termination notice is issued before a franchisor declares bankruptcy, but it doesn't go into effect right away. If this occurs, the judge will reason that there's no longer anything the debtor can do to rectify the situation; hence, that termination would be considered to have taken effect. However, when the franchise is able to fix it before being terminated, the franchise contract will be regarded as estate property.

This is because the court has determined that there is still "something left to do" before the termination is finalized. The cure period could be stipulated in an agreement, defined by state statutes, or begin no later than 60 days after filing a bankruptcy petition. Chapter 11 ends if a Plan of Reorganization/POR has been approved.

Process

After the case has been submitted on the petitioning date, a "first-day" hearing will take place anywhere between two and four days afterward. A hearing about financing and cash collateral takes place between 22 to 30 days. The franchisee gets six months to submit a disclosure statement and a plan. After that, the bankruptcy exit process could take between 12 and 18 months.

The bankruptcy of a franchisee under Chapter 11 could involve several different people. Among them are landlords, creditors, franchisors, suppliers, and pre-petition creditors, both secured and unsecured. There could also be involvement from DIP lenders, taxing agencies, employees (who possess wage claims), U.S. Trustees, or government agents, among others.

Common Warning Signs

In most cases, there are warning signs that occur before declaring bankruptcy. The following are among the most typical warning signs of bankruptcy that might not be seen until it is too late to prevent it:

  • Failure to pay essential suppliers who source goods and services for the franchisor.
  • Delay in paying the franchisor or affiliates.
  • External auditors are hired by the business to offer financial reports (revolving door).
  • Efforts to hasten the business sale's closing terms.
  • Cash flow issues are no longer an issue.
  • Debts owed to the landlord.
  • Countless court cases were brought either against or by the franchisee.
  • Many attempts at financial restructuring (in addition to multiple requests for the franchisor to assist in this issue).
  • Important vendors regularly changing, or growing disloyalty to the franchise vendors.
  • Communication issues with their franchisor.
  • Insufficient or excessive inventory.
  • Unrealistic expectations for development and growth.

What Should I Do When a Franchisee Declares Bankruptcy?

It's crucial to carefully analyze the bankruptcy procedures when a franchisee declares bankruptcy. It could be useful to bring a petition to identify relevant rights and duties to make short-term requirements more transparent. In addition, franchisees could face a range of possible outcomes. Franchisees who file the necessary motions and engage in focused negotiations could have some say in how their concerns are resolved.

The franchisee is responsible for determining which business operations, such as training, financial accounting, or marketing, were previously handled by the franchisor. Alternatively, they might join forces with fellow franchisees to combine resources for such tasks. Be ready for the franchise agreement's potential sale or rejection and react accordingly to whatever happens.

How Can I Keep Running My Franchise?

If a franchisee has unmanageable debt and is trying to salvage their enterprise, they would look into alternatives other than bankruptcy. You can try the following:

  • Loan adjustments and restructuring.
  • Voluntary asset sale conducted outside of court.

Other Forms of Business Litigation

You must demonstrate to the court that you possess good business judgment and acted in the debtors', lenders', and bankruptcy estate's best interests if you want to proceed with bankruptcy under Chapter 11. The franchisor's viewpoint is not taken into consideration. Non-monetary delinquencies can make it difficult for you to carry on with business as usual.

The court could insist that you resolve non-financial defaults with your franchisor before allowing you to keep operating as a business franchisee.

Can a Franchisor Cancel Or Alter a Franchise Contract After Chapter 11 Starts?

A bankrupt franchisee is given various safeguards under the Bankruptcy Code to maintain its privileges within the franchise contract.

The "automatic stay" under Section 362 is the primary and most important form of protection. This is because it forbids the franchisor from starting or progressing with any action or advancing to end the franchise contract, or considering taking any other steps that might impact the debtor-franchisee's privileges without acquiring the bankruptcy court's approval.

Put another way, when the franchisor fails to cancel the franchise contract before filing for bankruptcy, it will not be allowed to do so once bankruptcy has been filed without the automatic stay being lifted.

Can A Franchisee Of A Debtor Remedy A Non-Monetary Default?

Perhaps, but fixing a non-financial default is more difficult. Although a debtor-franchisee might be capable of resolving some non-financial defaults—like a previous failure to carry out necessary repairs or any other quality control measures—other non-financial defaults might not be fixable.

For example, there is no possible way for the franchisee to subsequently cure a default when the debtor-franchisee violated the franchise contract by ceasing operations for a period that is forbidden by their agreement.

The damages have been inflicted from the franchisor's perspective. If the franchisor wants to prevent the bankruptcy from adopting its contract, it will have a compelling claim that the borrower is not permitted to assume the agreement due to the cure requirements under section 365(b)(i).

Consequently, it is crucial for operators and owners considering chapter 11 bankruptcy to avoid committing any acts that might later prove irrevocable. And when the defaults do happen, which they frequently do, it's going to be crucial to know whether the defaults are curable since, in the event of non-curable defaults, it'll be extremely challenging to acquire a franchise contract over the franchisor's objections.

Does A Debtor Franchisee Have To Guarantee That It Will Perform Going Forward?

Yes. It is also presumed that the debtor must provide a "sufficient guarantee of performance in the future" under the agreement in Bankruptcy Code § 365(b)(i).

The debtor-franchisee must demonstrate that it will have the resources, either monetary or something else, to comply with the conditions of the franchise contract once the bankruptcy is over.

Typically, solid evidence is needed to demonstrate "adequate assurance," such as proof of past performance, reliable and in-depth cash flow estimates, and new financing. Generalized and unsubstantiated claims of performance capacity won't suffice.

Find a Franchise Bankruptcy Attorney in Los Angeles

If your franchise is or has been showing warning signs of potential bankruptcy or has a significant debt burden, the Los Angeles Bankruptcy Attorney can help you. Our law firm's Chapter 11 bankruptcy experts can assist with procedures and asset protection. We can assist you in devising a plan to reorganize your debts and pay them back so your franchise can avoid bankruptcy. Call us at 424-285-5525 today to schedule your consultation.