Los Angeles Franchise Bankruptcy Attorney

Franchise Bankruptcy and Chapter 11

Chapter 11 bankruptcy is available to businesses, as it is for high net worth individuals. Franchise bankruptcy involves the reorganization of debts, but a franchisee must obtain permission from the court to “assume” their franchise—or continue to do business. The U.S. Bankruptcy Court sees franchise agreements as executory contracts, in which a failure to perform is considered a breach of contract.

A business owner can wipe out many debts and financial obligations with Chapter 11 bankruptcy. The process isn’t so easy for a franchisee. They must first prove in court that a bankruptcy filing represents sound judgement. Even if they want to continue their contract, the best interests of debtors, creditors, and the bankruptcy estate must be considered.

If you wish to continue operating as a franchise, Chapter 11 bankruptcy may give you an opportunity to maintain your business. On the other hand, Chapter 7 liquidates the business while wiping out debts a franchisee owes to a franchisor.

Basics of Franchise Operation

There are three basic types of franchises and several ways to structure a franchise system:

  • Business format franchises: The franchisor licenses the franchisee to use a particular business system, providing assistance to help them run the business, including a marketing plan. The franchisee must strictly adhere to the controls and method of operation.
  • Product franchises: Goods the franchisor produces are sold by the franchisee, under the franchisor’s trademark or brand name license. The franchisee usually pays for the right to distribute products, whether by purchasing trademarked goods or paying an initial franchise fee.
  • Distributorship: A franchise is granted the right to sell a parent company’s product. An example would be an automobile dealership such as Toyota or Ford.

Structuring a franchise can be done in a few ways. A single-unit franchise operates at a single location, with some geographic protection against competition (provided by the franchisor). In an area development franchise, the franchisee can run more than one franchise business within a specific area. In a pure franchise system, a franchisor collects royalty payments, while in a mixed system they obtain part of their revenue from franchisee fees, product sales, and from franchisor-owned stores.

A franchise agreement can consist of a single unitary contract or a series of agreements. The basic franchise agreement allows the franchisee to use trademarks, service marks, copyrights, and patented systems. It can include brand name licensing as well. A future development agreement grants the franchisee the right to further develop a business in a specified area.

Franchise Bankruptcy Reorganization Issues

The franchise agreement and future development agreements often come into question when bankruptcy and financial restructuring are considered. These contracts can be regarded as unitary or separate obligations. Real property leases, often used in a mixed franchise system, may be impacted as well. Corporate stores may be sold off or the franchisor may set up a new sublease with a different franchisee to continue operating the store.

A procurement agreement may also be affected by reorganization. In a procurement contract, the franchisor enters into an agreement with a vendor on behalf of the franchisee. This achieves economies of scale, which the franchisee may benefit from, or these economies may be in the form of rebates delivered from vendors to the franchisor. If this is the case, the franchisee must be made aware of the arrangement.

Other considerations with franchise bankruptcy include:

  • Estate property: If a franchise agreement is properly terminated before petitioning for bankruptcy, it is not considered estate property because it is no longer in existence. This includes agreements properly terminated under state or federal law or that have expired by their own terms.
  • Defaults: – A franchisee can default in ways that don’t involve monetary payments. If the contract states they must run the business continuously, but temporary close it, the franchisor may ask to settle the default, or else they may terminate the contract. The default must be fixed as soon as the contract is assumed (the business reopens).
  • Franchise Agreement Termination: If a notice of termination is provided before the franchisor files for bankruptcy but the termination isn’t effective until a later date, the court will consider there is nothing left for the debtor to cure, so the termination will be deemed effective. However, if the franchise has an opportunity to cure it before termination, the franchise agreement will be considered estate property. This is because the court believes there is “something left to be done” before termination is completed. A cure period can be contractual, determined by state statutory law, or be within 60 days after a bankruptcy filing. In Chapter 11 bankruptcy, it is up until a Plan of Reorganization is confirmed.
  • Process: Once the case is filed on the petition date, a “first day” hearing occurs two to four days later. Between days 22 and 30, a cash collateral and financing hearing takes place. The franchisee has a six-month deadline to file a plan and disclosure statement. It can then take 12 to 18 months to exit from bankruptcy. Several parties may be involved in the Chapter 11 franchisee bankruptcy process. These include creditors, including landlords, suppliers, and franchisors; a Creditors Committee; and pre-petition lenders, including unsecured and secured lenders. A DIP lender, taxing authorities and employees (with wage claims), and a U.S. Trustee, or government representative, may also be involved.

Common Warning Signs

Signs of trouble usually precede a bankruptcy filing. They may not be recognized until it’s too late to avoid bankruptcy, but here are some of the most common warning signs:

  • Delinquencies to key vendors that provide sourcing to the franchisor.
  • Delinquencies to the franchisor/affiliates.
  • The company hires external auditors to provide financial reporting (revolving door).
  • Attempts to expedite closing terms to sell the business.
  • Cash flow problems have been eliminated.
  • Delinquencies to a landlord.
  • Numerous lawsuits by or against the franchisee.
  • Multiple financial restructuring attempts (plus frequent requests for franchisor help in this area).
  • Frequent changes of key vendors/increased disloyalty to franchise vendors.
  • A lack of communication with the franchisor.
  • Too much or too little inventory.
  • Unachievable expectations for expansion and growth.

How OakTree Law Can Help

If your franchise has or is experiencing the warning signs of impending franchise bankruptcy, and/or has a high debt load, OakTree Law can help. Our Chapter 11 bankruptcy professionals can help manage the process and protect your assets. We can help establish a debt reorganization and repayment plan that allows your franchise to survive bankruptcy. Shutting down your business and walking away isn’t always the best solution, but our team can help find the best solution for you, whether it is to sell your business or reorganize your finances but keep operating and making a profit.

To request a free evaluation, contact OakTree Law today by calling 562-219-2979.