Impacts of Chapter 11 Bankruptcy on Hotel Franchisees


Hotel managers, owners, and operators may want to examine whether chapter 11 of Chapter 11 of Bankruptcy Code might be able to provide a solution. This chapter can help them manage these unique circumstances and give them a path forward. It is important to understand how chapter 11 treats hotel flags as a key driver of property value. There are many tools and protections available to franchisees that seek bankruptcy relief and to franchisors that may have to navigate the complexities of chapter 11. It gives franchisees breathing room and allows them to address debts burdens and other claims. This chapter 11 can be a benefit to both the franchisee as well as the operator.

A positive outcome can only be achieved if the franchisor and franchisee are on the same page in restructuring efforts. Collaboration and consensus are the best ways to achieve a positive outcome before any bankruptcy filing. Chapter 11, despite its many tools and protections, is not a panacea. There are many acts bankruptcy cannot reverse or undo. Chapter 11 cannot revive a terminated franchise agreement. Nor can it allow a franchisee fix a nonmonetary default that cannot otherwise be rectified. Franchising companies who are not able to reach consensus can also benefit. Otherwise, they run the risk that a costly, lengthy process could lead to the loss of an operator.

This article provides a brief overview of chapter 11 in relation to franchise agreements. It highlights all the protections, tools, risks and potential hazards for franchisees as well as the key questions that can be asked by franchisors, check out here.

The Franchise Agreement and the Bankruptcy Filing

Was there a termination of the franchise agreement prior to chapter 11

It will be determined if the franchisee’s rights under an agreement are considered assets in its bankruptcy estate. The debtor franchisor’s bankruptcy “estate”, which includes all legal, equitable and property rights, is created upon filing of the bankruptcy petition. This includes a franchise agreement that had not been validly terminated prior the commencement of this case.

The question of whether a franchise agreement is terminated or not before bankruptcy proceedings begin will usually depend on whether there is any “left-to-be done”. If the contract has a pulse, it will still exist. It may not suffice to simply deliver a termination notice.

As long as contingencies are not removed (e.g., the chance to cure defaults), bankruptcy judges will likely consider the franchise agreement to be an estate asset. Seee.g.In re RMH Franchise Holdings, Inc., 590 B.R. 655 (Bankr. D. Del. 2018. If the termination notification states that the termination will be effective at some future date with no ties to contingencies, then it is most likely that the agreement has been terminated. The main factor is the extent to which anything else than the “mere progression of time” is still valid. 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).

A franchisor can terminate or modify a Franchise Agreement after the commencement chapter 11.

The Bankruptcy Code gives debtor franchisees certain protections to ensure that they retain their rights under the franchise agreement. The first and most significant protection is the “automatic Stay” in section 362. This prevents the franchisor or any other person from initiating, continuing or threatening to terminate the franchise agreement. Simply put, the franchisor cannot terminate the franchise agreement if it failed to do so pre-petition.

Section 365 Bankruptcy Code-Assumption and Assignment

A second crucial protection for a franchisee debtor who wants to preserve the flag is the Bankruptcy Code. The right to assume or assign the franchise agreement, either as part of an reorganization or as an assignment to a potential purchaser or third party in connection with a going-concern sale. Section 365 in the Bankruptcy Code defines the terms and conditions for such rights. This includes the right to allow a debtor sufficient time to make that decision. Section 365 allows franchisees to take advantage of their most valuable asset.

Section 365 not only provides rights for the debtor but also protects the contract counterpart, like a franchisor. Because of this, tensions between franchisor and franchisee in chapter 11 bankruptcy revolve around the debtor taking over or assigning the franchise agreement.

Requirements for Debtor Franchisees

How does a debtor franchisor take over its franchise agreement.

Section 365(b).(1) of Bankruptcy Code requires debtors to remedy any outstanding defaults and compensate counterparties for any actual financial loss. They also have to provide “adequate assurance about future performance” as required by the contract.

To resolve the default, it is important to determine whether the current defaults are monetary. It is simple to assess a debtor’s ability or inability to resolve a monetary problem. It is not necessary for a franchisee to pay royalties if it is behind on payments.

Is it possible for a debtor franchisee to resolve a nonmonetary default?

Although this is possible, it’s not easy to fix a non-monetary debt. Some non-monetary issues, like a failure to complete renovations or take other quality-assurance measures as required, may be fixed by a debtor franchisor. But other types of nonmonetary defaults might not be. The franchisee may not be able to correct a debtor-franchisee’s breach of the franchise agreement by going dark for a specified period. Franchisors will see the damage done. A franchisor trying to block the debtor’s assumption of its agreement can argue that the debtor is not allowed to assume it due section 365b(1)’s cure requirements.

Operators and owners must be aware of the consequences of any chapter 11 actions. It is crucial that you understand the consequences of defaults, as they are often, so it is possible to accept a franchise agreement without the objection of the franchisor.

Does a debtor franchisee need to offer assurance that it will continue to operate in the future?

Yes. Yes. As discussed below, the debtor or assignee of a franchise must show that it will be able to perform under the terms and conditions of the franchise agreement. A sufficient showing that “adequate security” is possible will require tangible evidence such as financial projections and new financing. Unsupported and general statements of an ability not to perform are not sufficient. In re Memphis-Friday’s Assoc. 88.R. 830 (Bankr. W.D. Tenn. 1988

Requirements of a Debtor for Assigning a Franchise agreement to a Purchaser/Third Party

When a debtorfranchisee wishes to sell its business as an going-concern the assignment of a franchisor agreement to the purchaser will be governed by section (365)(2) of Bankruptcy Code. This section provides that a debtor can assign an executory contrat if (a), the debtor has satisfied all conditions for assumption and (b), the proposed assignee shows adequate assurance of future results in the same way that the debtor under Section 365.

How can I enforce a franchise agreement that prohibits assignment?

One of section 360’s most critical protections is 365f)(1), which overrides contractual clauses against assignment. This provision allows a creditor to assign executory contracts “notwithstanding any other provision in the executory contrat. . . It prohibits, restricts and/or conditions the assignment or modification of such contract[.]. Unenforceablein Bankruptcy is the standard contractual protection which requires the franchisor’s permission to any franchisee assigning such contract.

If applicable law prohibits assign?

For franchisors: Section 365(f(1)’s invalidation for anti-assignment provision has a counterbalance in section (365(c). This recognizes any applicable law restricting assignment a contract without non-debtor side’s consent. Section 365.c provides:

  • The [debtor] is not allowed to assume or assign any executory agreement or unexpired leased of the debtor.

(A.) A party other than a debtor is exempted by applicable law from accepting performance or rendering performance to an other entity than the debtor.

  • (B) This party refuses to assume or assign [.]

The most pertinent “applicable law” for hospitality franchise agreements will be trademark law. This is because the key feature of any hospitality franchisor agreement is a licence to use the franchisor’s trademarks, or operate under the flag. Both bankruptcy and nonbankruptcy courts routinely recognize the so-called “universal rule” that trademark licences are not transferable without the consent from the licensor. Re XMH Corp.. 647F.3d 690. 695 (7th Cir. 2011. The courts recognize that a trademark’s purpose is to identify a good, or service, to the consumer. Identity implies consistency, and a correlative responsibility to make sure that the good, or service, really is the same good,Id. at 655. The identity and status of the licensee are therefore crucial to the licensor.

Numerous bankruptcy courts have applied the trademark law principle to trademark licenses. These trademark licenses can be included in franchise agreements. See,in re Trump Entm’t Resorts, Inc.,526 B.R. 116. 123-24 (Bankr. D. Del. 2015); Re Wellington Vision, Inc., 354 B.R. 129, 134, (S.D. Fla. 2007; In Re N.C.P. Mktg. Grp., Inc., 333 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

Last but not least, a potential problem under section 360(c)(1) for debtors-franchisees is the ambiguous first sentence. “[The debtor] may take or assign every executory contract” if the law allows the counterparty in withholding consent to assignment. Courts differ on the use of the term “assume” within this provision. It otherwise only addresses assignment.

As courts often do, this provision prohibits a debtor taking on a contract if applicable law prevents the counterparty from consenting to the assignment. This interpretation, also called the “hypothetical exam”, asks whether the debtor would hypothetically have the right to assign the contract without the consent from the counterparty. If the answer to the applicable law is “no,” then the debtor may not assume the contract. [1]

An alternative view, and one that many argue is more consistent and in line with bankruptcy policy favoring restructuring is known as “actual test.” This test asks bankruptcy courts whether the debtor really intends assign the contract. If the intent is to simply assume the contract but not to assign it, the debtor cannot be prevented from taking over. [2]

It is important for franchisees who are planning to enter chapter 11 to be familiar with the interpretation of section.365(c.(1) in the court where they intend to file. If there are multiple options, it might be in the franchisee’s best interests to choose one court. The alternative “hypothetical” test will not allow the franchisee to assume a franchise agreement containing an trademark license.

Open Communication and Building Consensus Will Minimize Uncertainty and Maximize Valuation

There are some benefits to filing a chapter 11. This allows you to have breathing room to pay off debts and address unfavorable litigation claims. The franchisor and the franchisee are both exposed to risks and unpredicted outcomes in a nonconsensual chapter 11. This includes litigation before a bankruptcy Court.

These uncertainties can easily be avoided by consensus-building and negotiation prior to chapter 11. It is important that both parties keep in mind their mutual interest to maximize the estate’s potential value. Franchisees must discuss their issues with franchisors, and also discuss chapter 11 strategies before and during a case. They may be able agree on the status and assumability of the franchise agreement and assignability. Chapter 11 is an effective tool for protecting the flag and allowing a healthy and profitable hotel operation.

[1] Courts of Appeal for the Third Circuit, Delaware, New Jersey and Pennsylvania, Fourth Circuit (Virginia Maryland, West Virginia. North Carolina. South Carolina), Ninth Circuit -California. Washington, Oregon, Nevada. Arizona. Idaho. Montana. Alaska. Hawaii. Eleventh Circuit -Florida.

[2] A “actual test” was adopted by the Court of Appeal in the First Circuit (Massachusetts., Maine. New Hampshire. Puerto Rico. Rhode Island). It is also used by many bankruptcy court circuits where the court of appel has not decided on the issue.

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