Would you know what to do if you learned that one of your franchisees had filed for bankruptcy? Perhaps more importantly, would you know what not to do? While each circumstance and franchise agreement is different, there is a general framework for dealing with a franchisee in bankruptcy. Here we’ll introduce some of the issues you are likely to encounter throughout the bankruptcy process.

The Automatic Stay

One of the most important and valuable benefits for any individual or company filing bankruptcy is the automatic stay. Immediately upon the filing of a bankruptcy petition, the Bankruptcy Code provides the debtor with “breathing space” and promotes fairness among creditors by prohibiting creditors from taking any action, formal or informal, against the debtor or its assets to collect money owed or to enforce contractual obligations. As a result, the automatic stay stops a creditor (including a franchisor) in its tracks, and it cannot take any actions to enforce its rights unless and until allowed by an order from the bankruptcy court.

This means that even if the franchisee is in default under the franchise agreement, whether because of nonpayment of amounts owed or because of noncompliance with obligations under the franchise agreement, a franchisor is prohibited from taking any action to collect those amounts or to terminate the franchise agreement without the prior approval of the bankruptcy court. This includes informal actions like placing phone calls, writing letters and sending emails, as well as formal actions like filing litigation. While the franchisor can communicate with the franchisee regarding ongoing business operations, the franchisor must be careful that its actions are not perceived to be efforts to collect amounts owed or enforce default provisions. The stay does not generally prohibit actions against nondebtor parties, such as a personal guarantor (assuming the guarantor has not filed bankruptcy).

Consequences of Violating the Stay

Violating the stay, particularly when the actions taken are intentional, with full knowledge of the bankruptcy filing, can expose a franchisor to liability. The complexities are many, so when you learn that a franchisee is in bankruptcy,it is wise to contact legal counsel for help in determining your options.

What About the Franchise Agreement?

Not only does the automatic stay provide the debtor franchisee some breathing space, but the debtor will also likely be given time to determine whether to continue with the franchise agreement or not. A franchise agreement is likely to be considered an executory contract, a contract in which both parties still have continuing obligations as of the time of the bankruptcy filing. If the franchise agreement is an executory contract, the franchisor is likely going to be required to continue to perform its obligations after the filing even if the franchisee had defaulted prior to filing. This is true even if the franchise agreement contains a provision that expressly provides that the franchisor is excused from further performance if the franchisee files bankruptcy, because these terms are generally not enforceable in a bankruptcy context. If the franchisee is not complying with its obligations under the agreement after the bankruptcy is filed, the franchisor may be able to seek relief from the bankruptcy court, including the right to terminate the agreement.

During the bankruptcy, the debtor franchisee will have the option of choosing to either assume the franchise agreement, meaning it will continue to operate under the franchise agreement, or to reject it, meaning it no longer will be bound by the agreement nor entitled to its benefits. Before the debtor can assume the agreement, it generally must cure any defaults unless the franchisor agrees otherwise.

As Time Goes By

Unless the franchisee immediately ceases operation, it can often be months, sometimes a year or longer, before the franchisee must make the assumption/rejection decision, during which time it will remain under the protection of the bankruptcy court. While this can be a frustrating process for the franchisor, you are not without rights, and good counsel can provide valuable advice to protect and enforce those rights and obtain the best possible results under less-than-ideal circumstances.