What Happens to Franchise Owners When Their Franchisor Goes Out of Business?

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For the past nine years, franchising has experienced annual growth across all sectors, with 733,000 franchise establishments employing 7.6 million employees.  The coronavirus  has rocked our economies in ways no one has imagined, resulting in the closures of a staggering 74% of these franchised businesses, according to a survey conducted by the International Franchise Association.

For some franchisors, the loss in revenue associated with even a few franchisees closing their doors puts severe constraints on liquidity.  Where there is limited access to capital, it is challenging to invest in system-wide marketing and innovation to stay competitive.  Brands with growing debt and declining sales have been unable to provide relief to franchisees in the form of deferred, reduced, or forgiveness of continuing royalties and marketing fees.  Consequently, many franchisees are unable to meet their obligations, having a further domino effect.  Mass terminations and closures can also adversely affect how consumers view the brand, as well as a franchisor’s ability to sell franchises in the future.  These unique issues have resulted in bankruptcy filings by notable brands who have simultaneously announced the closure of most, if not all, company-owned locations as a result of COVID-19.

For example, Logan’s Roadhouse national steakhouse chain laid off 18,000 employees and closed all 261 corporate locations as part of its Chapter 11 reorganization, while GNC Holdings, Inc. announced plans to close 1,200 corporate stores and simultaneously set a bid of $760 million for the sale of its assets.  Since many GNC locations are located within malls and shopping centers, sales immediately declined due to stay-at-home orders and growing consumer fears.  Franchisors, therefore, are finding themselves in very much the same position as their franchisees.

Some franchisors have been forced to liquidate their assets, while others are using insolvency to reduce debt, rid themselves of burdensome contracts (including “problem” franchise agreements), and emerge as a more viable company.  So, when a franchisor can no longer support its franchisees or is unable to continue as a going concern, what happens to its franchisees?  Adequately addressing the interests of all franchisees is a challenging task.  On one end of the spectrum are multi-generational franchise owners who have years of experience, cash reserves, and highly trained staff.  Conversely, there are franchisees who may have just signed franchise agreements or just signed leases when the coronavirus hit.  The ultimate consequences and potential options a franchisee may have will depend on various factors and legal considerations concerning trademark law, franchise and contract law, creditors rights and bankruptcy law.

To better understand what happens to a franchisee when a franchisor fails, it is important to take a look at the two most common types of bankruptcy proceedings and the impact on franchisees, together with the resulting decisions with which they are faced.  For franchisors who decide that continued operation is no longer an option, Chapter 7 of the Bankruptcy Code provides an organized liquidation of all assets.  Conversely, franchisors who decide that business continuity is a possibility can seek reorganization under Chapter 11, with an end-goal to exit the bankruptcy as a viable company going forward. A debtor-franchisor’s assets in Chapter 7 will include, amongst other things, the franchise agreements and intellectual property. Any assets that are not sold are deemed abandoned.  Therefore, if the trademarks are offered for sale, or there is a risk of abandonment, franchisees may be able to pool resources and collectively attempt to acquire the trademark rights to use the marks under a new license or have independent rights to the trademarks via an abandonment.

Under either Chapter 7 or Chapter 11, the debtor or debtor-in possession (respectively), has the option to assume or reject the franchise agreements. In liquidation, the franchise agreements must be assumed or rejected within 60 days from filing bankruptcy, and in reorganization, a debtor-in-possession has until the reorganization plan is confirmed (which can take months or even years).   Assumption requires the franchisor to cure any existing defaults and to continue to perform under the contract.  The franchise agreements can also be assumed and then assigned to a third party, in which case the assignee will be required to perform the original franchisor’s obligations.  Conceptually, this could be beneficial for franchisees who presumably will operate under the control of a more experienced, sophisticated, and financially-able franchisor.  Proactive franchisees could also use the assignment as an opportunity to re-negotiate certain contractual terms with their new franchisor.

On the other hand, rejection will terminate a franchisee’s right to use the franchisor’s trademark, but will not terminate the franchise agreement.  The franchisee will not be excused from its contractual performance, and will continue to be bound by payment obligations and covenants against competition, thereby hindering any desire to continue operations.  On the flip side, the franchisor is relieved from continuing performance under the franchise agreement, and the franchisor’s failure to perform will give rise to a default under the franchise agreement, resulting in a franchisee having a general, unsecured claim for damages.  The concern, obviously, is that there will be insufficient assets to pay the franchisee’s claim, since it has the least priority as a general unsecured creditor.

Given that rejection of a franchise agreement terminates the right to use the franchisor’s trademarks, there will be a period of time in which a franchisee faces an uncertain future regarding the status of its franchise agreement.  To add fuel to the fire, a bankrupt franchisor is likely to cease at least some level of performance of its system-wide services and obligations (and perhaps all services in a Chapter 7 proceeding).  This will require franchisees to conduct their own marketing, locate alternative suppliers, or substitute products and services, which may be legally prohibited by their franchise agreements.  Franchisees who are unable to continue operating on their own will need to seek relief from the automatic stay to have their franchise agreements formally terminated by court order.

Given the uncertainties surrounding the bankruptcy process, a franchisee who begins seeing red flags should first evaluate whether there are any claims under the franchise agreement or applicable law that would give rise to a right to terminate or a claim for damages. With the economic impacts of COVID-19, franchisees and franchisors alike are struggling to stay afloat.  Consequently, even if a franchisee has valid legal claims, it may not be financially capable to deal with the expense of a prolonged litigation, and the franchisor may not be collectable.  Therefore, franchisees need to be proactive in deciding the fate of their businesses, given that they are not always privy to what is going on behind the scenes.

Serious consideration should be given to whether there is an opportunity for a franchisee, or franchisees, to acquire the trademarks (or the franchise system entirely) where a franchisor plans to cease business altogether.  Alternatively, franchisees may be able to negotiate a waiver of non-compete provisions, which would allow continued, independent operations. A franchisee should also consider whether there is an opportunity to minimize losses via a sale and transfer of its business.  Given the looming uncertainties regarding the regulatory effects and impacts of the coronavirus, future sales and costs (and therefore business value) will inevitably be affected.  With that said, it is likely that resales of existing units will still increase as a result of the pandemic, as there is a growing pool of now unemployed people looking to become their own bosses. As franchisees and franchisors exit underperforming units, there are potential resale opportunities within any given system.  It is crucial for a franchisee to seek support from its franchisor where available.  Franchisees should also take advantage of sophisticated, multi-unit owners already within a system who may be willing to acquire additional units and take on the obligations and risks in a post-COVID world.

Regardless of what track a franchisee takes, the current landscape proves that longevity of a franchise system is dependent on its franchisees just as much as franchisees are dependent on their franchisor.  With open communication, combined with leadership, flexibility and appetite for change, the coronavirus can create an unprecedented opportunity for brands to reemerge from adversity to deliver a more purposeful, innovative, and resilient brand.

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