Impacts of Chapter 11 Bankruptcy on Hotel Franchisees

ArentFox Schiff

Arent Fox

Why Achieving Consensus is the Best Path to Preserving the Flag

Hotel owners, operators, and franchisors battling the impact of COVID-19 may need to consider whether chapter 11 of the Bankruptcy Code can deliver a solution for managing these unprecedented circumstances and provide a viable path forward. The analysis requires an understanding of how hotel flags are treated in chapter 11 because preserving the flag is a key driver of value. The chapter 11 process affords numerous tools and protections to franchisees who seek relief under the Bankruptcy Code and to franchisors who may be forced to navigate its intricacies. It offers breathing-room and an organized process for right-sizing a franchisee’s balance sheet and addressing burdensome debt and other claims. In that way, chapter 11 can benefit both the operator and its franchise.

But in order to achieve a positive outcome, it is critical that a franchisee considering chapter 11 take every reasonable measure to ensure its franchisor is on board with its restructuring efforts and to avoid irreversible defaults. The hard work of collaboration and consensus is best done before any bankruptcy filing because, for all of its protections and tools, chapter 11 is not a cure-all; there are many acts that bankruptcy simply cannot reverse or undo. Chapter 11 cannot resurrect a terminated franchise agreement, nor does it enable a franchisee to cure a non-monetary default that is incapable of being corrected. Similarly, achieving consensus benefits franchisors who otherwise run the risk of an expensive, protracted process resulting in the loss of an operator.

This article gives an overview of the chapter 11 process as it applies to franchise agreements, highlighting the various protections, tools, risks, and potential pitfalls for franchisees and franchisors alike, and addresses certain key questions along the way that will be of critical importance for any operator considering chapter 11 relief.

Effect of the Bankruptcy Filing on the Franchise Agreement

Was the franchise agreement terminated prior to chapter 11?

The answer will dictate whether the franchisee’s rights under the agreement are considered an asset of its bankruptcy estate. Immediately upon filing the bankruptcy petition, the debtor-franchisee’s bankruptcy “estate” comes into being, which includes all of its legal and equitable interests in property as of the petition date. This includes a franchise agreement that has not been validly terminated prior to commencement of the case.

Whether a franchise agreement has or has not been terminated prior to commencement of the bankruptcy typically depends on whether there is anything “left to be done” other than the mere passage of time. If there is a pulse, the contract will be alive and in existence. Mere delivery of a termination notice, on its own, may be insufficient.

As long as contingencies remain (such as the opportunity to cure defaults), bankruptcy courts will typically find the franchise agreement to comprise an estate asset. Seee.g.In re RMH Franchise Holdings, Inc., 590 B.R. 655 (Bankr. D. Del. 2018). If the termination notice provides that termination will be effective on some future date without ties to any contingencies, then the agreement has likely been terminated even if the bankruptcy petition precedes the stated termination date. The key factor is whether anything other than the “mere passage of time” remains. Seee.g.Days Inn v. Gainesville P-H Props., Inc. (In re Gainesville P-H Props., Inc.), 77 B.R. 285 (Bankr. M.D. Fla. 1987); In re Diversified Washes of Vandalia, Inc., 147 B.R. 23 (Bankr. S.D. Ohio 1992).

Can a franchisor terminate or modify a franchise agreement after commencement of chapter 11?

The Bankruptcy Code provides a debtor franchisee with certain protections to preserve its rights under the franchise agreement. The first and threshold protection is that of the “automatic stay” of section 362 that prohibits the franchisor from initiating or continuing any act or proceeding to terminate the franchise agreement or take any other act that may affect the debtor-franchisee’s rights without first obtaining bankruptcy court approval. Simply put, if the franchisor did not successfully terminate the franchise agreement pre-petition, it would not be able to do so after the bankruptcy filing without court permission to lift the automatic stay.

Section 365 of the Bankruptcy Code – Assumption and Assignment

The Bankruptcy Code provides a second critical protection for a franchisee debtor seeking to preserve the flag: the right to assume the franchise agreement as part of a reorganization or assume and then assign the franchise agreement to a potential purchaser or other third party in a going concern sale. Section 365 of the Bankruptcy Code prescribes the terms and conditions of such rights, including affording a debtor adequate time to make such a decision. If the franchisee can utilize section 365, it can capitalize on its most valuable asset.

Though section 365 contains important rights for a debtor, it also prescribes powerful protections for a contract counterparty, such as a franchisor. For that reason, the tension between franchisee and franchisor in a chapter 11 bankruptcy primarily surrounds the debtor’s assumption or assignment of the franchise agreement.

Requirements for a Debtor Franchisee Assume a Franchise Agreement

How can a debtor franchisee assume its franchise agreement?

To assume an executory contract, section 365(b)(1) of the Bankruptcy Code requires the debtor to cure any outstanding defaults under the contract, compensate the counterparty for any actual pecuniary loss resulting from such defaults, and provide “adequate assurance of future performance” under the contract.

To cure the default, the threshold question is whether the existing defaults are monetary or non-monetary. A debtor’s ability to cure a monetary default is straightforward. For example, if a debtor franchisee is delinquent on royalty payments, it must promptly pay outstanding royalties or demonstrate it will be able to do so in a timely manner to cure the default before assuming the agreement.

Can a debtor franchisee cure a non-monetary default?

Maybe; however, curing a non-monetary default is less straightforward. While a debtor-franchisee may be able to cure certain types of non-monetary defaults, such as a prior failure to make required renovations or other quality assurance measures, other non-monetary defaults may not be curable. For instance, if a debtor-franchisee breached the franchise agreement by “going dark” for a period of time prohibited by the franchise agreement, there is no conceivable path for the franchisee to later cure that default. From the franchisor’s perspective, the damage has been done and a franchisor wishing to bar the debtor from assuming its agreement will have a strong argument that the debtor is prohibited from assuming the agreement given section 365(b)(1)’s cure requirements.

It is therefore critical for owners and operators weighing chapter 11 to avoid actions that could prove irreversible in a chapter 11 case. And when defaults do occur, as they often do, it will be important to understand whether or not the default is curable because it will be exceedingly difficult to assume a franchise agreement over the franchisor’s objection when a non-curable default has occurred.

Does a debtor franchisee need to provide assurance it will perform in the future?

Yes. To be assumed, section 365(b)(1) of the Bankruptcy Code also requires the debtor to show “adequate assurance of future performance” under the franchise agreement. The debtor-franchisee (or its assignee in a sale, as discussed further below) must show it will possess the wherewithal, financial or otherwise, to perform under the terms of the franchise agreement after the conclusion of the bankruptcy. A sufficient showing of “adequate assurance” will typically require concrete evidence, such as evidence of historical performance, new financing, and credible and detailed cash flow projections. General and unsupported assertions of an ability to perform will not be enough. See In re Memphis-Friday’s Assoc., 88 B.R. 830 (Bankr. W.D. Tenn. 1988) (franchisee’s “generalities,” such as statements that there would be “more than sufficient funds to cure defaults,” were insufficient adequate assurance).

Requirements for a Debtor to Assign a Franchise Agreement to a Purchaser or Third Party

When a debtor-franchisee seeks to sell its business as a going-concern, the assignment of a franchise agreement to the purchaser is governed by section 365(f)(2) of the Bankruptcy Code, which provides that a debtor may assign an executory contract if (a) the debtor has satisfied the conditions for assumption discussed above and (b) like with simple assumption, the proposed assignee demonstrates “adequate assurance of future performance.” The assignment analysis under section 365(f) is therefore in many ways virtually identical to the assumption analysis under section 365(b) and the same considerations apply: defaults must be cured and the purchaser-assignee must demonstrate adequate assurance of future performance in the same manner as the debtor under section 365(b).

What happens if the franchise agreement prohibits assignment?

One of section 365’s critical protections for debtors is 365(f)(1)’s over-ride of contractual anti-assignment clauses. That provision permits a debtor to assign an executory contract “notwithstanding a provision in an executory contract . . . that prohibits, restricts, or conditions the assignment of such contract[.]” Thus, the standard contractual protection requiring the franchisor’s consent to any assignment by the franchisee is unenforceable in bankruptcy.

What if applicable law prohibits assignment?

Fortunately for franchisors, section 365(f)(1)’s invalidation of anti-assignment provisions has a counter-balance in section 365(c), which recognizes any applicable law restricting assignment of a contract without the non-debtor counterparty’s consent. Section 365(c) provides:

  • The [debtor] may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—

(A) 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

  • (B) such party does not consent to such assumption or assignment[.]

The most relevant “applicable law” for hospitality franchise agreements is trademark law as the key feature of any hospitality franchise agreement is a license to utilize the franchisor’s trademarks or operate under the flag. Bankruptcy and non-bankruptcy courts alike routinely recognize what has been called “the universal rule” that trademark licenses are not assignable absent the licensor’s consent. In re XMH Corp., 647 F.3d 690, 695 (7th Cir. 2011). In so holding, courts acknowledge a trademark’s purpose, which “is to identify a good or service to the consumer, and identity implies consistency and a correlative duty to make sure that the good or service really is of consistent quality, i.e., really is the same good or service.” Id. at 695. For that reason, the identity of the licensee is of crucial importance to the licensor.

Numerous bankruptcy courts have applied this principle of trademark law in holding trademark licenses, including those contained in franchise agreements, may not be assigned under section 365 without the licensor’s consent. Seee.g.In re Trump Entm’t Resorts, Inc., 526 B.R. 116, 123–24 (Bankr. D. Del. 2015); In re Wellington Vision, Inc., 364 B.R. 129, 134 (S.D. Fla. 2007); In re N.C.P. Mktg. Grp., Inc., 337 B.R. 230, 236–37 (D. Nev. 2005), aff'd, 279 F. App’x 561 (9th Cir. 2008).

Section 365(c)(1): Assumption When Assignment Prohibited

Finally, an important potential hurdle under section 365(c)(1) for debtor-franchisees to bear in mind arises from its arguably ambiguous first clause – “[the debtor] may not assume or assign any executory contract” if applicable law allows the counterparty to withhold consent to assignment. The inclusion of the word “assume” in this provision, which otherwise deals only with assignment, has been a source of disagreement among courts.

Reading this provision literally, as many courts do, prevents a debtor from assuming a contract if applicable law would prevent assignment without the counterparty’s consent, even when the debtor has no intention of actually assigning the contract to a third-party. This interpretation is known as the “hypothetical test” because it asks whether the debtor would hypothetically be permitted to assign the contract over the counterparty’s consent. If the answer under applicable law is “no,” the debtor may not assume it either.[1]

An alternative view – and one many argue is more consistent with common sense and bankruptcy policy favoring restructuring – is known as the “actual test.” Under this test, the bankruptcy court asks whether the debtor actually intends to assign the contract. If the intent is only to assume the contract, but not assign it, the debtor will not be barred from assuming the contract.[2]

Franchisees preparing to enter chapter 11 should be aware of the prevailing interpretation of section 365(c)(1) in the court where it intends to file. If multiple venues are available, it may be in the franchisee’s best interest to select a court that is known to apply the “actual test” as the alternative “hypothetical test” will bar its assumption of a franchise agreement containing a trademark license even when there is no intent to assign the agreement through a sale.

Open Communication and Building Consensus Will Minimize the Uncertainty and Maximize Value

There are benefits to filing chapter 11 and obtaining breathing room to restructure burdensome debt and deal with unfavorable litigation claims. However, as this overview suggests, a non-consensual chapter 11 presents the franchisee and its franchisor with risks, unpredictable outcomes, and, not least, substantial cost, including the costs of litigation before a bankruptcy court.

Negotiation and consensus-building prior to chapter 11 can avoid those uncertainties. The parties cannot lose sight of their mutual interest in maximizing the value of the flag and the estate. Franchisees must communicate with their franchisors about their challenges and discuss the chapter 11 strategy before and during the case. The parties may be able to agree on the status of the franchise agreement, its assumability and assignability and the go-forward obligations necessary to ensure performance. When franchisor and franchisee enter bankruptcy hand-in-hand, the chapter 11 process will be a useful tool for preserving the flag and enabling a healthy go-forward hotel operation.

[1] The “hypothetical test” has been adopted by the Courts of Appeal for the Third Circuit (Delaware, New Jersey, Pennsylvania), Fourth Circuit (Virginia, Maryland, West Virginia, North Carolina, South Carolina), Ninth Circuit (California, Washington, Oregon, Nevada, Arizona, Idaho, Montana, Alaska, Hawaii), and Eleventh Circuit (Florida, Georgia, Alabama). 

[2] The “actual test” has been adopted by the Court of Appeal for the First Circuit (Massachusetts, Maine, New Hampshire, Puerto Rico, Rhode Island) and is utilized by many bankruptcy courts in circuits where the court of appeal has not decided the issue. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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