January 21, 2021
Generally, the only mention of bankruptcy in a franchise agreement for a franchisee in the state of Minnesota relates to what happens when a franchisee declares bankruptcy. This means that a franchise agreement often will not provide franchisees with any protection if their franchisor declares bankruptcy.
Franchise bankruptcies are not always detrimental to franchisees, so it is important to understand what will happen after a franchise fails, and how the two main types of bankruptcy proceedings can impact franchisees in Minnesota in different ways.
What Happens After Franchisors File for Bankruptcy
After a franchisor files for bankruptcy, the bankruptcy court will automatically impose a stay of all actions against the franchisor. A stay prevents franchisees from taking any legal action against the franchisor, including enforcing the franchisor’s obligations under the franchise agreement, unless the franchisee first obtains relief from the stay.
The franchisee, however, is still obligated to perform under the agreement. This means that a franchisee could find themselves in a situation where a franchisor ceases to provide support, manage the system’s marketing program, and supply the products franchisees are obligated to sell. The franchisees in Minnesota who are faced with franchisor bankruptcy must still pay royalties, continue operating, and otherwise adhere to the franchise agreement’s terms.
Types of Franchise Bankruptcies
The next steps for a franchisee in this situation will be dictated by what type of bankruptcy the franchisor filed for. The two most common types of bankruptcy proceedings when dealing with a franchisor’s bankruptcy are Chapter 7 and Chapter 11. As the two types of bankruptcy result in very different results for franchisors, it follows that they have disparate impacts on franchisees as well.
Chapter 7 franchise bankruptcies: result in the liquidation of all the franchisor’s assets in order to pay creditors. Companies file for this type of bankruptcy when they reach the conclusion that continued operation is no longer an option.
In a Chapter 7 bankruptcy, it is unlikely that the franchisor will continue to fulfill any of its obligations under its franchise agreements. This can make it difficult, if not impossible, for a franchisee in Minnesota to stay in business due to franchisor bankruptcy.
Chapter 11 franchise bankruptcies: allow franchisors to reorganize their debts and continue to operate after being discharged from bankruptcy.
Franchisors who file for Chapter 11 bankruptcy will likely continue to fulfill at least some of their obligations, as the franchises are likely one of their greatest money-making assets. However, there is still a possibility that the franchisor may not continue to fulfill any of its obligations under its franchise agreements.
In either case (chapter 7 or 11), franchisees will likely be faced with a loss of at least some of their support, and have to navigate negative publicity surrounding the franchisor’s bankruptcy.
If a franchisee makes it through this initial loss of support and goodwill, it may then be faced with a potential cancelation of the franchise agreement or loss of the right to use the franchisor’s trademarks.
In both Chapter 7 and Chapter 11 bankruptcy cases, the bankruptcy trustee (Chapter 7) or the debtor (Chapter 11) has the option to reject or assume the debtor’s franchise agreements. In a Chapter 7 case, the trustee has sixty days from the petition date to reject or assume the contract, and Chapter 11 debtors have until the reorganization plan is confirmed to decide, unless extensions are obtained. As reorganization plans can take months or even years to be confirmed, franchisees may want to consider asking the bankruptcy court to compel the franchisor to reject or assume the contract.
If Franchise Agreements Are Rejected
- The franchise agreement will technically not be terminated, but any trademark license granted in the agreement is terminated.
- The franchisor will no longer have any duty to perform its obligations under the agreement.
- The franchisor will be deemed to be in default of the agreement, and the franchisee is given a pre-petition unsecured claim for damages resulting from that default.
This means that, while the franchisee has a claim against the franchisor, the franchisee will not be excused from any debts or obligations to the franchisor and will likely not be able to operate using the franchisor’s trademarks. Franchisees should also be aware that they may also be required to comply with any in-term and post-term noncompetition provisions in the franchise agreement, preventing them from rebranding and continuing to operate their business.
Franchisees in this situation may wish to seek relief from the automatic stay in order to file a motion for a judicial declaration terminating the franchise agreement. This way, they will not be hindered by ongoing obligations to the franchisor without the benefit of operating using the franchisor’s trademarks.
If Franchise Agreements Are Assumed
- The franchisor will be obligated to cure any existing defaults and continue performing its obligations.
- The franchisor may also assume the agreement by assigning it to a third party. In that case, the third party will be required to perform the franchisor’s obligations and the franchisee may have the opportunity to negotiate more favorable terms in its agreement with the third party.
In a Chapter 7 bankruptcy, the franchisor’s assets will ultimately be liquidated. This means that there is a possibility that the entire franchise system could be sold to a third-party and the system will continue to operate relatively unchanged. However, if any of the franchisor’s assets are not sold, they are considered abandoned. This could lead to a situation where the bankruptcy trustee decides to abandon the franchise agreements, leaving the franchisees unable to use the franchisor’s trademarks. If the franchisor’s trademark rights are offered for sale, franchisees may want to consider banding together to purchase the trademark rights. Similarly, if the trademark is abandoned by the trustee, franchisees in Minnesota who were affected by the franchisor’s bankruptcy could seek to gain independent rights to the trademarks.
In a Chapter 11 bankruptcy, the franchisor will ultimately undergo reorganization. Franchisees will generally be grouped together based on their claims against the franchisor in this reorganization plan. Therefore, it may be advantageous for franchisees to petition the court to appoint a committee of franchisees as an official creditors’ committee to ensure that their interests are adequately represented during the bankruptcy.
How to Navigate Franchise Bankruptcies for Franchisee Success
Any franchisor bankruptcy is likely going to have a major impact on franchisees in Minnesota. It is crucial for franchisees to stay informed during the proceedings, and franchisees should consider hiring experienced franchise and bankruptcy counsel to help represent and protect their interests. Contact our team of experts today to be informed of your rights and learn your next steps.