This article was published in Law360 on August 4, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360.
In A&F Enterprises v. IHOP Franchising LLC, 742 F.3d 764 (Seventh Cir. 2014), Chapter 11 debtors appealed a determination that their building leases were deemed rejected because they were not timely assumed. Both the bankruptcy court and the district court denied the request for a stay of the decision pending appeal. The Seventh Circuit reversed and granted the stay.
The general rule in a Chapter 11 case is that a nonresidential real estate lease must be assumed within 120 days (or 210 days with a court-approved extension), or else it will be deemed rejected. Other executory contracts can generally be assumed or rejected at any time before confirmation of a plan of reorganization.
A group of affiliated debtors (A&F) held 17 separate IHOP franchise agreements, with corresponding building and equipment leases. A&F argued that the building leases were just one part of the larger franchise arrangement so that it could assume the agreements at any time prior to confirmation.
In contrast, the franchisor (IHOP) argued that the building leases were subject to the shorter deadline applicable to real estate leases. Thus, when the leases were not assumed on a timely basis, they were deemed rejected. As a result the related franchise and equipment lease agreements expired under the terms of the agreements. The bankruptcy court sided with IHOP.
A&F appealed this decision. Since it was concerned that the appeal would be moot if IHOP sold the franchises to a third party while the appeal was pending, it also sought a stay pending appeal from first the bankruptcy court and then the district court. Both courts denied the request on the basis that A&F’s position “lacked merit.” In their view, the text of the Bankruptcy Code imposing the deadline for assumption of real estate leases did allow for not any exceptions.
Both parties appeared to assume that if IHOP obtained new franchisees, A&F would not be able to recover the franchises. Although the Seventh Circuit was not necessarily convinced that A&F would be unable to unwind an interim sale of the franchises if it ultimately won on appeal, the court proceeded as though that was the case.
The court noted that the standard for a stay pending appeal was the same as the standard for a preliminary injunction. It was required to consider (1) the likelihood of the moving party’s success on the merits, (2) the irreparable harm to each party, and (3) whether the public interest favored either side. It also noted that there is a “sliding scale” — meaning that the greater the likelihood of success, the less a party has to show that the balance of harms weighs in its favor, and vice versa.
For most of the restaurants, there were three contracts: a franchise agreement, a building sublease from IHOP and an equipment lease — all of which were cross-defaulted. The crux of the dispute was whether the agreements should be viewed as a single integrated contract, or as separate but related contracts.
The parties appeared to agree that the real estate leases could not be assumed without also assuming the franchises (and even if they could, the leases would be worthless since the only permitted use was as an IHOP restaurant). Similarly, A&F could not assume the franchises without also assuming the leases because the franchises automatically expired if A&F lost the rights to the leased buildings. A&F argued that since the leases and franchise agreements had to be assumed or rejected in tandem, the longer time limit should be applicable to all of the agreements.
In reaching a decision, the court began by considering the probability of A&F’s success on the merits. Although IHOP argued that the text of the Bankruptcy Code clearly controlled, the Seventh Circuit concluded that it was not that clear. While the shorter time limit was applicable to leases, it was equally clear that the longer time limit applied to the franchises. Given that the agreements and leases were inseparable, one of the time limits will necessarily control both circumstances. And the Seventh Circuit was inclined to give credence to A&F’s position on the merits:
There are powerful arguments in favor of A&F’s position. Chapter 11 is premised on giving debtors a full opportunity to reorganize, and provisions like §365(d)(4) that limit this opportunity are the exception not the rule. The franchise agreement is clearly the dominant contract and the focus of the parties’ bargaining, so prioritizing the lease lets the tail wag the dog. Furthermore, what little case law there is on this precise issue favors A&F’s position. Two bankruptcy courts have held on nearly identical facts that §365(d)(4) does not apply to a lease that is so tightly connected to a franchise arrangement.
Consequently, the court decided that its decision on the stay turned primarily on the balance of potential harms. The bankruptcy court did not make any factual findings regarding harm because it thought the legal question wasn’t even close. But that did not stop the Seventh Circuit from considering the issue.
Putting aside the question of whether any interim sale of the franchises could be undone if A&F prevailed on appeal, IHOP argued that the loss of the franchises would not be irreparable since A&F could be compensated by money.
The court’s first response was that valuation would be very difficult. “[A] primary assumption behind Chapter 11 is that reorganization preserves value better than liquidation, and leaving A&F with nothing but a damages remedy is the equivalent of converting the reorganization into a liquidation.” The court felt that A&F would be worth more if there was a reorganization rather than a liquidation, but found that valuation would require consideration of various hypothetical alternatives and would be an “impossible task.”
Further, damages were insufficient to protect A&F’s “interest in continuing to operate his business of choice.” A&F wanted to operate a business, not live on the income from a damages award. If the stay was not issued and IHOP was allowed to sell the franchises, this would put an end to A&F’s ability to reorganize. (The court rejected as premature IHOP’s response that A&F would be unlikely to achieve a successful reorganization in any event.)
On the other side of the harm equation, IHOP argued that the goodwill associated with its trademark would be damaged if A&F continued to operate the franchises. It pointed to “customer complaints, sales inspections, and bad press at one location, and a temporary shutdown at two other locations due to a licensing issue.” The court brushed this aside noting that IHOP did not contend that these were material breaches that would have warranted termination of the franchise agreements. And the court did not even address the public interest factor.
Because (1) A&F demonstrated “a” likelihood of success on the merits and (2) the harm to A&F was greater than to IHOP since it might be precluded from reorganizing, the court granted a stay pending appeal.
In essence, based on the relatively weak conclusion that A&F’s position “has substantial merit” in combination with the adverse effects of interfering with its attempts to pursue a reorganization, the court granted the stay. This seems like an unusually low threshold for granting a stay.