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Key to a franchisee bankruptcy: preserving the franchise agreement

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As with virtually every other business, franchised businesses are feeling the pinch of the current financial downturn. Whether it is the nearby family-style restaurant or the corner convenience store, reduced revenues spell economic difficulty not only for the local business owner operating the franchised business, but for the large national franchisor whose network of hundreds of franchisees are all feeling the financial pinch.

Franchisees are not only stretching to cover franchise fees, but also to make franchisor-mandated national and regional marketing contributions. Add to this the inability of franchisees in the existing tight credit market to obtain financing for necessary capital improvements to meet franchisor-imposed site maintenance, refinancing mortgages coming due on locations and the required build-out of additional locations under area development agreements. It is no wonder that many franchisees are seeking protection from the bankruptcy courts.

Preserving the franchise agreement

Typically, the most important issue facing the troubled franchisee is preserving its franchise agreement. A troubled franchisee is usually many months in arrears to the franchisor and the franchisor is threatening to terminate the franchise agreement. Once the franchise agreement is terminated, the franchisor can no longer use the franchise name, signage or trademarked products. Even the color scheme used for the exterior or interior of the store may have to be changed so as not to infringe upon the franchisor's trademarks. All good will engendered by the franchisor's marketing and name and product recognition will have been lost.

A chapter 11 filing is often the strategy that a franchisee will utilize to forestall a termination of the franchise agreement. The filing of a chapter 11 petition will immediately and automatically halt the franchisor's termination of the franchise agreement. However, a franchisee will have virtually no ability to reinstate the franchise agreement absent obtaining franchisor consent or identifying a procedural misstep in the termination process. While in some instances it may seem counterintuitive for a franchisor to terminate the franchise and thus reduce its own potential revenue, there may be good reasons to do so, such as having a replacement franchisee in the wings with stronger financial or operating abilities, exertion of maximum pressure on the franchisee to force payment by the franchisee dipping into personal assets, or just plan fatigue of dealing with an undercapitalized or poor operator.

Assumption of franchise agreement

Getting a chapter 11 case filed before the franchisor is able to terminate the franchise agreement is merely the initial step in preserving the franchise agreement. A franchise agreement is considered an executory contract under bankruptcy law -- a contract under which each party continues to have material ongoing duties to the other. A chapter 11 debtor will almost always wish to assume the franchise agreement. In order to do so, however, the debtor will need to cure any curable defaults under the agreement within a reasonable period of time, typically 12 to 24 months. Defaults that will be required to be cured include bringing payments due under the franchise agreement current, making the capital expenditures to meet image, equipment and training requirements of the franchisor and opening up new locations required under franchise and development agreements. In addition to curing defaults, the franchisee will be required to convince the court that it will meet the requirements of the franchise agreement in the future.

Sale of franchisee's locations

Despite the protections offered by chapter 11, sometimes reorganization will be unlikely. This may be due to any number of reasons, but most likely the debtor's inability to come to agreeable terms with its creditors, a lack of capital and operating revenues available to continue the business, or a franchisor intent on terminating the franchise relationship. In these instances, a sale of the franchisee's business will be the most likely means for a debtor to maximize the return to its creditors.

The franchise agreement plays a key role in the sale process. For example, selling fast-food restaurants without a franchise agreement with a national chain will yield a substantially smaller sale price than the sale of the same restaurants with an intact franchise relationship. However, just as the franchise agreement has to be assumed and cured for a franchisee to reorganize in chapter 11, a sale will also benefit from the assumption and cure of the franchise agreement. Here, just as in a reorganization, defaults will need to be cured, but it is the buyer, not the debtor, that will be required to establish it will meet the requirements of the franchise agreement in the future. Obtaining the franchisor's consent to the potential buyer is critical to a smooth sale process.

Although there are myriad critical issues that any franchisee will face in restructuring its business to address today's economic times, ensuring the continuing effectiveness of its franchise agreement is foremost, whether the goal is reorganization or sale. If you are a franchisee with any financial difficulty on the horizon, now is the time to consult an attorney familiar with the intricacies of franchise agreements in the context of chapter 11 to ensure you are best positioned for a successful result.

Davis is a member in the San Diego office of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC, practicing in the Bankruptcy, Restructuring and Commercial Law Section. He has practiced in the area of bankruptcy, commercial law and debtor/creditor law for over 25 years.

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