Bankruptcy and the Franchise Agreement
by Jason B. Binford
The principal issue in any bankruptcy case involving franchise issues will be the effect of the filing on the franchise agreement. As with most contracts, the party filing bankruptcy—the debtor—has two options. The debtor may assume the franchise agreement, obligating the debtor to pay all past due amounts and to continue performing for the agreement’s remaining term. Alternatively, the debtor may reject the franchise agreement, allowing the debtor to walk away from its obligations under the agreement and generally leaving the non-debtor party with only an unsecured claim in the bankruptcy case, often payable at pennies on the dollar.
The nature of a franchise agreement adds an extra layer of complication to the assumption/rejection framework. By definition, a franchise agreement involves a trademark license. The effect of rejecting a contract that includes a trademark license will depend on whether the debtor is the licensee (i.e., the franchisee) or the licensor (i.e., the franchisor). A franchisee’s rejection of a trademark license follows the normal contract rules: the franchisee loses all rights under the agreement—including the right to use the trademark—and the franchisor files a claim in the bankruptcy case for damages resulting from the rejection.
If the franchisor is the debtor, rejection of the trademark license may not follow this well-worn path. The Bankruptcy Code provides protection to licensees of “intellectual property” when the licensor files bankruptcy and attempts to reject the license. The policy reasoning is that—since the licensee’s business very often centers on the license—permitting a rejection under the normal framework would immediately drive the franchisee out of business.
Bankruptcy Code section 365(n) provides that, upon rejection of such a license, a licensee is presented with a choice. The licensee may follow the normal rules by treating the license as terminated and filing a claim. Alternatively, the licensee may elect to continue using the license, subject to certain restrictions, for the remainder of the term, notwithstanding that the licensor rejected the license. Unfortunately for franchisees, case law has not made clear whether Section 365(n) applies to trademark licenses. Specifically, Section 365(n) relies upon the definition of “intellectual property,” set forth in Section 101(35A), which excludes trademarks. Therefore, while patent and copyright licensees clearly have the right to make the Section 365(n) election, the rights of trademark licensees are less clear. Franchisees wishing to make the Section 365(n) election typically will walk the bankruptcy court through the potentially devastating effect of rejection on the franchisee’s business and the policy that Section 365(n) was enacted to protect against such harsh effects.
The fact that a franchise agreement involves a trademark license may also complicate a franchisee’s attempt to assume and assign the franchise agreement in the bankruptcy case. The general bankruptcy rule is that provisions in a contract prohibiting assignment will not be enforced. The policy reasoning is that assigning a valuable contract may be a significant source of recovery to the debtor’s creditors, and the non-debtor party to the contract should not be given the unilateral right to preclude such recovery. The exception to this general rule provides that contractual anti-assignment provisions will be enforced if “applicable law” excuses the non-debtor party to the contract from accepting performance from anyone other than the debtor. The classic example of such applicable law is state contract law governing personal service contracts.
However, in addition to personal service contract law, many courts have included federal trademark law within this exception to the general rule. Because trademark law generally precludes assignment of the license without licensor consent, this interpretation would preclude debtor franchisees from assuming and assigning the franchise agreement over the franchisor’s objection. There is a basis for a franchisee to make the argument that trademark law should not be included within the exception regarding the enforcement of anti-assignment provisions. Franchisees should be aware, however, that such an argument would be made against the majority viewpoint by courts that trademark licenses cannot be assigned in bankruptcy.
A court’s finding that a trademark license is not assignable in bankruptcy could also, depending on the jurisdiction, lead a court to conclude that the license cannot even be assumed by the debtor licensee, whether or not the licensee seeks to assign the license. The inability to assume a franchise agreement typically would preclude any possibility of reorganization. How the applicable jurisdiction interprets this issue therefore is very significant for franchisees contemplating a bankruptcy filing.
Jason B. Binford is an associate at Kane Russell Coleman & Logan PC. He can be reached at firstname.lastname@example.org.