Can a Bankrupt Franchisee Assign Its Franchise Without the Franchisor's Consent?

When a franchisee files for bankruptcy, a franchisor naturally has concerns over how the process will affect the parties' relationship. Of particular concern is the possibility that the franchisor will be forced into a relationship with an unacceptable successor as a result of a bankruptcy judge's decision to authorize assumption and assignment of the franchise agreement over the franchisor's objection.

The decision to assume and assign a contract belongs in the first instance to the bankruptcy trustee or the debtor in possession in a chapter 11 case. Of course, that decision is subject to bankruptcy court approval after notice and an opportunity for a hearing. Parties in interest, including the franchisor, can object to both the assumption and assignment of a contract. A contract that is assumed and assigned is taken without modification and then transferred to a third party who will render and receive performance. Only executory contracts, typically defined as contracts as to which material performance remains due by all parties, can be assumed and assigned. See Cinicola v. Scharffenberger, 248 F.3d 110, 119 and 123 (3d Cir. 2001). It is well settled that a franchise agreement that has not terminated or expired is an executory contract, see, e.g., In re Tornado Pizza, LLC, 431 B.R. 503, 510-11 (Bankr. D. Kan. 2010), and is subject to assumption and assignment unless there is an exception or the debtor does not satisfy the standards for assumption and assignment set forth in the Bankruptcy Code.

The general rule in bankruptcy cases is that a trustee or debtor in possession can assume and assign an executory contract, even if there is a provision in the contract that prohibits or restricts assignment. The Bankruptcy Code expressly makes such anti-assignment provisions unenforceable. 11 U.S.C. § 365(a) and (f)(1). In order to assume an executory contract, the trustee or debtor in possession must meet statutory requirements to: (1) cure defaults or provide adequate assurance or prompt cure; (2) compensate the non-debtor party for actual damages resulting from default or provide adequate assurance of prompt compensation; and (3) provide adequate assurance of future performance under the contract. 11 U.S.C. § 365(b)(1). In order to assign an executory contract, the trustee or debtor in possession must: (A) assume the contract in accordance with the Bankruptcy Code; and (B) provide adequate assurance of future performance under the contract by the proposed assignee. 11 U.S.C. § 365(f)(2).

What constitutes adequate assurance is a factual question, determined on a case-by-case basis by applying commercial rather than legal standards. Courts consider several factors in making the determination, including the financial ability of the assignee to perform under the contract, the reputation of the assignee, the past dealings among the parties, the existence of guarantees, and the economic climate. See In re Resource Technology Corp., 624 F.3d 376, 383 (7th Cir. 2010). Adequate assurance is not required for every term of the franchise agreement, but only for terms that are “material and economically significant.” The required assurance may “fall considerably short of an absolute guarantee of performance” because it need only be shown by a preponderance of the evidence that more likely than not the assignee will perform the obligations of the contract. In re Resource Technology Corp., 624 F.3d at 383.

As a practical matter, rebutting the debtor's evidence of “adequate assurance” can be something of a crapshoot for the franchisor. Certainly, if the proposed assignee is financially unsound, the case for assignment should be relatively easy to defeat. But bankruptcy courts have approved assignments in cases where both the financial and operational ability of a proposed assignee were dubious. See, e.g., In re Sunrise Restaurants, Inc., 135 B.R. 149, 151-53 (Bankr. M.D. Fla. 1991). It is all too common a scenario for a reorganization case to hinge on the bankruptcy court's approval of a sale. When all constituents (e.g., secured creditors, unsecured creditors' committee, tax authorities, etc.) except the franchisor support assignment, the franchisor faces an uphill battle to mount a successful challenge to a proposed assignee and “kill the deal.” On the other hand, one bankruptcy court granted a franchisor relief from the automatic stay to terminate a franchise agreement for lack of adequate protection (precluding any possibility of later assumption or assignment) where the debtor was not operating in accordance with franchise standards, including quality and signage defaults. In re Tudor Motor Lodge Assoc. L.P., 102 B.R. 936, 954-57 (Bankr. D.N.J. 1989).

The Bankruptcy Code, which was enacted in 1978, contains a handful of exceptions to the general rule permitting assumption and assignment of contracts, one of which is particularly apt in the franchise setting. Section 365(c)(1) prohibits the assumption or assignment of a contract if:

• Applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
• Such party does not consent to such assumption or assignment.

The classic example of a contract that is non-delegable and non-assignable without consent under applicable law is a personal services contract, which depends on the exercise of special knowledge, judgment, taste, skill, or ability. In re Compass Van & Storage Corp., 65 B.R. 1007, 1011 (Bankr. E.D.N.Y. 1986) (citing 6A C.J.S. Assignment § 32 (1975)).

After the enactment of Section 365(c), many early bankruptcy court decisions interpreted the section as applying only to personal services contracts. Franchisors attempting to fit franchise agreements within this narrow exception met with limited success. There are only a handful of cases where franchisors succeeded in persuading a bankruptcy court that their franchise agreements were personal service contracts. See In re Headquarters Dodge, Inc., 13 F.3d at 684 (remanding to bankruptcy court to determine whether a car dealership franchise agreement constituted a personal services contract); In re Jermoo's Inc., 38 BR 197 (Bankr. W.D. Wis. 1984) (noting that franchise agreements were “nearly similar to a personal service contract” in fraudulent transfer action).

Because the plain language of the statute does not limit the exception to personal service contracts, this limitation has been rejected by every circuit court that has considered the issue and has fallen out of favor with most lower courts as well. See In re XMH Corp., 647 F.3d 690, 695 (7th Cir. 2011). Thus, most courts now define the term “applicable law” to include any law (other than general contract law that enforces anti-assignment provisions) that renders performance non-delegable or otherwise prohibits assignment without the consent of the non-debtor party.

While bankruptcy courts grappled with the interpretation of Section 365(c), there were important developments taking place in the evolution of federal trademark law. In particular, courts had defined the scope of a trademark licensor's rights and duties with respect to its marks—and concluded that, like copyrights and patents, a licensee's interest is not assignable without the licensor's consent. Tap Publications, Inc. v. Chinese Yellow Pages, (New York), Inc., 925 F.Supp 212, 218 (S.D.N.Y. 1996). The stage was now set for the vastly different worlds of bankruptcy and trademark law to converge in a way that would prove a windfall to franchisors in many jurisdictions.

For franchisors, the landscape changed fundamentally with the Travelot case in 2002. This was the first bankruptcy decision to construe federal trademark law as “applicable law” under Section 365(c). In re Travelot Co., 286 B.R. 447, 454-55 (Bankr. S.D. Ga. 2002). In 2005, a district court agreed in the N.C.P. Marketing case that trademark law prohibited assignment of a trademark license absent consent of the licensor and, as a consequence under the plain language of Section 365(c), prohibited both assumption and assignment of the license. In re N.C.P. Marketing Group, Inc., 337 B.R. 230, 235-37 (D. Nev. 2005). In the Wellington Vision case, the court took the next logical step and applied the Travelot analysis to a franchise agreement that contained a trademark license. In re Wellington Vision, Inc., 364 B.R. 129, 135 (S.D. Fla. 2007). Since Wellington Vision, in every reported decision in which the franchisor raised trademark law as applicable law and where the court found a valid trademark license, the court has held that assignment of the franchise agreement is prohibited absent the consent of the franchisor. See In re XMH Corp., 647 F.3d 690, 695, 697-98 (7th Cir. 2011)

As a result, the ability of a franchisee to assume and assign a franchise agreement that contains a trademark license over the franchisor's objection may be a thing of the past. However, complacency is still not an option for the franchisor because bankruptcy rights are not self-actualizing. These rights must be affirmatively invoked in a timely manner or will be lost. Accordingly, a franchisor must timely object to a debtor's motion to assume and assign its franchise or that right may be waived. In re Chicago Investments, LLC, 470 B.R. 32, 86-91 (Bankr. D. Mass. 2012).