The COVID pandemic has forced a large number of restaurants into bankruptcy ¹. Of course, the restaurant industry heavily relies on a system of franchising to conduct operations. Franchisors sell the rights to operate using their brand and trademarks. Franchisees are independent business owners who conduct their operations under the terms of the agreement.

Because of COVID-19 shutdowns and customers changing their economic behavior, franchisors are turning to bankruptcy to adjust their finances. Both Chapter 7 and Chapter 11 filings may be possible for franchisors in distress. When a company files for Chapter 11 bankruptcy, the franchisee needs to know how that affects them. Here are the impacts of Chapter 11 bankruptcy on franchisees explained by our Las Vegas bankruptcy attorneys:

Rejection of the Franchise Agreement

At the heart of any franchisor bankruptcy is the question of whether the agreement is going to stay in place and continue in force. The franchisee must be prepared for the possibility that the agreement will be rejected in bankruptcy. It can be confusing what it means when a franchise agreement is rejected. A franchisee may have an unsecured claim for damages. However, as an unsecured debtor, they have a low priority to recoup their losses.

Extension of the Franchise Agreement

There is also the possibility that the franchise agreement continues in its original form. To continue as normal, the franchisor must cure any defects in their performance of the contract. Affirming the franchise agreement requires the franchisor to compensate the franchisee for any loss resulting from non-performance. They must be able to provide adequate assurance of future performance. Even so, the very fact that the bankruptcy occurred can be unsettling for the franchisee, who must wonder what the future holds.

The Franchise Agreement May Be Left in Limbo

Problems that bankruptcy can cause are delays and uncertainty. Filing a Chapter 11 bankruptcy triggers an automatic stay. The debtor may liquidate, convert to a Chapter 7 or restructure their debts. Restructuring can take a lot of different forms.

In a Chapter 11 proceeding, a debtor gets adequate time to make decisions on how to handle debts. They may take time to decide whether to affirm, reject or assign the franchise agreement. That can leave the franchisee lost and waiting for what’s going to happen in the future. There are some things that the franchisee can do through motioning the court to minimize the impact of the delays and uncertainty.

The Franchisee May Still Have To Perform

A Chapter 11 filing doesn’t automatically terminate a franchise agreement. In fact, a franchisee may be required to continue to meet their obligations. It may look like the business is continuing to operate in more or less a usual manner.

A franchisee shouldn’t make assumptions about the effect that a Chapter 11 filing has on their obligations under the agreement. It’s possible that their duties are not going to change. In addition, it may be possible to renegotiate the terms of a franchising agreement because of a bankruptcy filing. It’s essential to understand all the options and explore the various possibilities.

Loss of Access to Marketing, Training and Other Business Support

The nature of a franchising agreement is that the franchisor takes care of several aspects of business operations. In exchange for paying the fee, the franchisor handles marketing campaigns, training and even some accounting. Supply chain support, internet support, market research and operational guidance may all be things that the franchisor used to provide. All of a sudden, the franchisee may be on their own.

It may be necessary to file a motion with the bankruptcy court to request that the franchisee be able to conduct their own activities. However, the franchisee may not be in the bargaining position to get the same rates and services that the franchisor could obtain. In addition, these activities can take time away from other business activities. The result may be strained operations.

Damaged Goodwill in the Community

Just the event of a franchisor filing for bankruptcy can make it harder for the franchisee to continue in business. A bankruptcy often generates bad press for the brand. Customers may assume that all of the locations are out of business. They may not trust that their reservations or purchases are going to be honored.

The sudden bad press and damaged goodwill can make it harder for the franchisee to continue their operations. At the same time, their hands may be tied to address advertising or use the business brand to get the word out. Damaged goodwill in the community can be an unexpected challenge for a franchisee after a Chapter 11 bankruptcy.

Sale of the Agreement to a Third Party

It may be possible for the company to sell its franchise agreement to a purchaser. If that’s what the franchisor decides, the party that purchases the agreement must continue to perform under the original terms. Ultimately, the net result is that the contract lives on—free of any defects that existed because of the initial financial difficulties. The purchaser must give adequate assurances of future performance.

What To Do if a Franchisee Files for Bankruptcy?

If a franchisee files for bankruptcy, it’s important to pay careful attention to the bankruptcy proceedings. It may be advantageous to file a motion to determine certain rights and obligations in order to have clarity about requirements in the short term. In addition, there are various outcomes possible for a franchisee. A franchisee may have some influence on how their interests resolve through filing appropriate motions and targeted negotiations.

The franchisee should identify what operations need to be performed that the franchisor used to provide, like marketing, training or financial accounting. They may work with other franchisees to pool resources for these operations. Be prepared for the possible rejection or sale of the franchise agreement, and be ready to respond appropriately to whatever occurs.

Attorneys for Franchisee Chapter 11 Bankruptcy

Are you a franchisee with questions about a Chapter 11 bankruptcy filing? Do you need help protecting your interests? Our attorneys represent parties in Chapter 11 bankruptcy and can help you. Contact us today for your free consultation.

Sources:

¹ Sozzi, Brian. (26 January 2021). These restaurants have filed for bankruptcy and many more are at risk. Retrieved 4 May 2021 from https://finance.yahoo.com/news/these-restaurants-have-filed-for-bankruptcy-and-many-more-are-at-risk-110046021.html