In a case of apparent first impression, U.S. District Court Judge Alan S. Gold recently held in In re Wellington Vision, Inc., No. 06-80446, __ B.R. ___, 2007 WL 762398 (S.D. Fla. Feb. 20, 2007), that a franchisee in chapter 11 cannot assume (i.e., retain) a franchise agreement that grants a nonexclusive trademark license, leaving the franchisor free to terminate the agreement. If followed by other courts, this holding will have a profound impact on future franchisee chapter 11 reorganization cases because it gives franchisors virtual control over the fate of distressed franchised businesses.

Background. A chapter 11 debtor is generally permitted to assume and/or assign executory contracts to third parties, notwithstanding anti-assignment or consent required contractual provisions such as those typically found in franchise agreements, provided the debtor satisfies certain cure and other requirements set forth in Section 365 of the Bankruptcy Code.

There is a narrow exception to this general rule for cases where applicable law (as opposed to a contractual provision) permits a non-debtor party to a contract to refuse to accept performance from or render performance to an entity other than the debtor or the debtor in possession. So-called "personal services contracts" and nonexclusive patent and copyright licenses are examples of contracts that are not assignable in bankruptcy because applicable state or federal law prohibits their assignment.

While courts agree that a debtor may not assign contracts that are covered by the exception, the United States Courts of Appeal are divided over whether the exception also precludes a debtor from assuming a nonassignable contract even if the debtor has no intention of assigning it, but merely wants to retain it subsequent to the bankruptcy. Courts adopting the so-called "hypothetical test" hold that a debtor may not assume such a contract, irrespective of the debtor's intention to assign or not to assign the contract. Courts adopting the so-called "actual test" hold that a debtor may assume (but not assign) a nonassignable contract if the debtor actually has no intention of assigning the contract. At this time, the circuits are about evenly divided on the issue. If the debtor cannot assume or assign the contract, the only other choice is to reject it, the essential effect of which is to cancel the contract altogether.

Nonexclusive Trademark Licenses and Franchise Agreements. In early decisions, courts held that franchise agreements are not personal services contracts and, therefore, debtor franchisees could assume and assign these agreements in bankruptcy proceedings. A few courts barred debtor franchisees from assuming or assigning a franchise agreement, not because operation of the franchise required specialized skill or knowledge, but because provisions of applicable state law restricted assignment of the franchise absent the franchisor's consent. However, none of the early cases addressed the impact of federal trademark law on a debtor's assumption and assignment of a franchise agreement.

The first bankruptcy court decision to address the assignability of a nonexclusive trademark license was In re Travelot Co., 286 B.R. 447 (S.D. Ga. 2002). Although the contract at issue involved the development and implementation of an internet travel website as opposed to a franchise agreement, the bankruptcy court concluded in general terms that under applicable law (the Lanham Act), the grant of a nonexclusive trademark license is not freely assignable to a third party, and the licensor is excused from accepting performance from, or rendering performance to, an entity other than the licensee. In Travelot, the court did not reach the ultimate question of assignability because it determined that the contract in question did not create a license of any kind to use the non-debtor party's marks, but only a right to request a license.

In 2005, the District Court of Nevada decided In re N.C.P. Marketing Group, Inc., 337 B.R. 230 (D. Nev. 2005), in which it, too, concluded that a nonexclusive trademark license is personal and nonassignable under federal trademark law. N.C.P. Marketing involved a license agreement to market and sell products bearing particular trademarks, as opposed to a franchise agreement. Since the Ninth Circuit applies the "hypothetical test," the court affirmed the bankruptcy court's decision granting the motion of the trademark holder to compel rejection of the contract. The case is currently on appeal to the Ninth Circuit Court of Appeals.

The Wellington Decision. The Wellington case was before the district court on a debtor franchisee's appeal of a bankruptcy court order granting Pearle Vision, Inc. relief from the automatic stay to terminate its franchise agreement with the debtor franchisee. The bankruptcy court had ruled that the debtor franchisee could not assign or assume the franchise agreement because (1) federal trademark law (the Lanham Act) barred the debtor franchisee's assignment of the trademark license contained in the franchise agreement to a third party without consent of the non-debtor party, and (2) where assignment was prohibited by applicable law, Fifth Circuit precedent barred both the assumption and assignment of the franchise agreement.

On appeal, the district court first examined the language of the franchise agreement to conclude that Pearle Vision had granted the debtor franchisee a nonexclusive trademark license to use the Pearle Vision marks. The court then rejected the debtor franchisee's argument that Pearle Vision had "opted out" of the Lanham Act's restrictions on assignment by expressly agreeing in the franchise agreement not to unreasonably withhold its consent to a transfer. The court refused to equate this clause to a clause expressly permitting assignment without consent.

Conclusion. The Wellington and N.C.P. Marketing cases have the potential to alter dramatically the playing field in franchisee reorganization cases. If other courts adopt the line of reasoning relied upon in these cases, not only could the courts give franchisors veto power over a debtor franchisee's proposals to assign a franchise agreement to a third party, but in jurisdictions that have adopted the "hypothetical test," the courts could also give the franchisor control over the debtor's ability to assume the franchise agreement and continue operating the franchised business. Control over assumption and assignment of the franchise agreement is tantamount to control over the debtor's ability to restructure or sell the franchised business in almost every franchisee chapter 11 case.

Franchisors should take this opportunity to review their franchise agreements with special attention to the nature of restrictions on assignment and whether or not the franchisor's consent is a prerequisite to transfer. Although the Wellington court ruled in favor of the franchisor on its construction of the "withhold consent" clause, other courts could easily disagree, especially in cases where forfeiture of the franchise agreement is at stake.