In a case of first impression at the circuit level, the Court of Appeals for the Seventh Circuit addressed a murky legal issue arising from a common commercial context—the entry into interrelated agreements between a franchisee and its franchisor—and held that a real property sublease between the franchisor and franchisee of premises where the franchisee conducts business pursuant to their franchise agreement may not be subject to the earlier assumption/rejection periods of § 365(d)(4), but instead may be subject to the more permissive timeframes of § 365(d)(2).  A&F Enterprises, Inc. v. IHOP Franchising, LLC (In re A&F Enterprises, Inc.), 2014 WL 494856 (7th Cir. 2014).  The Seventh Circuit did not decide the ultimate outcome in the dispute, as its opinion was issued in the context of the debtor’s motion for a stay pending appeal from an adverse ruling by the bankruptcy court.  However, the opinion contains insights which every franchisor should know.

Franchise agreements are executory contracts which a debtor has until the confirmation hearing to decide whether to assume or reject.  11 U.S.C. § 365(d)(2).  Non-residential real property leases, on the other hand, must be assumed or rejected within 120 days after the case is filed, unless the court extends that deadline.  11 U.S.C. § 365(d)(4).  What’s the outcome when a debtor and its franchisor are parties to inter-related agreements: a franchise agreement under which the debtor operates its business and a real property lease under which the debtor leases its business premises from the franchisor?  The matter before the Seventh Circuit had the added complexity that the real property lease before it prohibited a use of the premises for any purpose other than for the operation of an IHOP restaurant, meaning the debtor could not assume the real property lease without also assuming the franchise agreement.

The narrow issue addressed by the court was whether, for purposes of the request for a stay pending appeal of the bankruptcy court’s decision in favor of the franchisor, the debtor was likely to prevail on the merits on appeal;  in other words, that the debtor was likely to prevail on its argument that its obligation to assume or reject the real property lease was governed not by § 365(d)(4) but instead by § 365(d)(2).  In granting the stay, the Seventh Circuit indicated that a real property lease in this type of commercial agreement is subordinate to the dominant franchise agreement, with the result that a debtor’s obligation to decide on assumption or rejection of the real property lease will run concurrently with its decision to assume or reject the franchise agreement.

In analyzing the debtor’s request, the court indicated it did not need to decide whether the franchise agreement and real property lease were a single integrated contract, in which event they would have to be assumed or rejected as a whole.  The court noted that, even if the agreements could legally be assumed or rejected separately, the real property lease would be worthless without the franchise, and the debtor could not realistically assume the franchise agreement without also assuming the real property lease.  The court stated that, where a real property lease and a franchise agreement are inseparable, one of the time limits of §§ 365(d)(2) or (d)(4) will control both: 

“When a franchise agreement and a lease are inseparable, one time limit or the other will control both.  In the same way that applying § 365(d)(2)’s time limit to the entire arrangement creates an ‘exception’ for certain leases, applying § 365(d)(4)’s time limit creates an ‘exception’ for certain franchises.  Granted, the two possibilities are not perfectly symmetrical because one result permits something the code forbids (assuming a lease beyond 120 days) while the other result prevents something the code permits (assuming a franchise agreement beyond 120 days). . . . Either franchisees lose the right to assume franchise agreements at any time before confirmation of a plan, or lessors lose the right to have their leases assumed or rejected within 120 days.  Creating an exception is unavoidable. . . “

In determining which exception to embrace, the Seventh Circuit looked to which of the two agreements dominated the relationship between the parties.  It concluded the franchise agreement was the dominant agreement because it was the focus of the parties’ bargaining.  To allow the real property lease determine the proper time period for assumption or rejection would, in the court’s opinion, “let the tail wag the dog.”