TARNISHED ARCHES:

A SURVEY OF FRANCHISE BANKRUPTCY ISSUES

APRIL 10, 2017

Tarnished Arches: A Survey of Franchise Bankruptcy Issues | April 10, 2017

11:30am REGISTRATION 12:00 – 1:00pm SEMINAR CREDIT 1.0 General CLE PRODUCER Robert Miller

Manier & Herod, PC

PRESENTERS Erika R. Barnes Stites & Harbison, PLLC

Griffin Dunham

Dunham Hildebrand, PLLC

Phillip G. Young, Jr.

Thompson Burton, PLLC

OVERVIEW From treatment of the franchise agreement and the franchisor’s intellectual property to the relationship among the franchisee, franchisor and secured creditor, franchisee bankruptcy cases present distinct issues that are not otherwise present in a bankruptcy case. Through a role-play scenario, the panelists will discuss these issues, the sales of franchises in bankruptcy and the potential issues for individual guarantors of the franchisee. Both circuit level case law and local opinions and practices will be analyzed. The panelists will also discuss the other side of the coin – the effects of a franchisor filing bankruptcy. This topic is especially timely given the recent bankruptcy filings of restaurant franchisors including Logan’s Roadhouse, Old Country Buffet and Ryan’s Grill. Learn:

The typical issues arising in a local franchisee bankruptcy;

The current case law developments both the nationally and locally and

An overview of representation in franchisor bankruptcy cases.

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ERIKA R. BARNES Stites & Harbison, PLLC

Erika Barnes is a member of the firm's Creditors' Rights and Bankruptcy Service Group and the Business Litigation

Service Group. Erika represents creditors and franchisors in bankruptcy cases nationwide. She also has experience

representing creditors' committees and Chapter 11 trustees. Erika handles complex commercial litigation matters

in state and federal courts. She frequently represents lenders and special servicers in commercial foreclosures and

mortgage litigation. Erika is certified as a specialist in Business Bankruptcy by the American Board of Certification.

Erika is a member of the board of directors of the American Board of Certification, an organization that certifies

attorneys as specialists in business bankruptcy, consumer bankruptcy and creditors' rights law. She is Chair of the

Tennessee Bar Association Bankruptcy Section Executive Council and is a graduate of the 2011 Nashville

Emerging Leaders Class. Erika also actively participates in the Lawyers' Association for Women.

GRIFFIN DUNHAM Dunham Hildebrand, PLLC

During Griffin's 13 years as a lawyer, he has represented large and small businesses, business owners and officers,

borrowers, guarantors, private equity investment firms, property management companies, risk management

companies, commercial landlords, healthcare facilities, medical field companies, farmers, electric companies,

construction businesses, and developers.

Griffin handles every aspect of litigation. The first six years of his practice concentrated on trial and appellate work

as a judge advocate in the United States Judge Advocate General (JAG) Corps. Although he enjoys the courtroom,

he recognizes that many disputes should be resolved without the need for court intervention. In those situations,

he strives to develop a workable resolution that makes the most financial sense. The cases he has handled have

included claims of breach of contract, business interference, fraud and misrepresentation, fraudulent transfers,

contract interference, unfair competition, breach of fiduciary duty, conversion, misappropriation, copyright

infringement, harassment, and real estate claims related to contract interpretation, quiet title, partition, and

easements.

As a workout and bankruptcy lawyer, Griffin represents debtors to reorganize their businesses under Chapter 11 of

the Bankruptcy Code. His focus in these cases is concentrated on de-leveraging the business, increasing and

managing cash flow, reducing inefficiencies that are reducing margins, improving the business model, maximizing

the value of the equity interests, and ensuring the company's long-term viability. Griffin also represents creditors in

contested matters or adversary proceedings. Griffin's experience includes all aspects of the bankruptcy process,

to include drafting and confirming plans of reorganization (debtor side), objecting to and defeating plans of

reorganization (creditor side), prosecuting and defending adversary proceedings, claims litigation, claims trading,

stay relief actions, 363 asset sales, preferences and fraudulent transfers, first day motion practice, motions to

appoint a trustee, asset valuation, lien avoidance, disclosure statement approval, negotiating plan treatment, DIP

and exit financing arrangements, and motions to dismiss and convert cases.

PHILLIP G. YOUNG, JR. Thompson Burton, PLLC

Phillip Young is a Partner at Thompson Burton PLLC.

Phillip’s practice specializes in bankruptcy, receivership, creditors’ rights, commercial loan workouts, as well as

complex commercial litigation. Phillip has broad experience representing parties in all manners of insolvency cases.

As part of his creditors’ rights practice, Phillip has represented financial institutions, corporations and governmental

entities in complex workouts, bankruptcies, receiverships, state and federal court litigation, and judgment

enforcement. Phillip has also represented large corporate debtors in chapter 11 bankruptcies, chapter 7

bankruptcies, receiverships, and outside of court debt restructuring. In addition to creditor and debtor work, Phillip

is frequently retained to represent court-appointed bankruptcy trustees and receivers in evaluating, and pursuing,

litigation assets, and has been appointed by the United States District Court for the Middle District of Tennesse to

serve as receiver of assets. The breadth of Phillip’s experience (from creditor to debtor to trustee) enables him to

examine complex legal problems from all angles and craft legal strategies and solutions that are the most effective

and efficient for his clients.

Prior to joining Thompson Burton, Phillip was an associate at Bass, Berry & Sims PLC (2000 – 2008) and a founding

member of Garfinkle, McLemore & Young, PLLC.

Phillip earned his J.D. from Vanderbilt University School of Law (’00), and a B.A. from Harding University (’95).

Phillip has been recognized as a “Rising Star” by Super Lawyers Magazine, and as “A Best Lawyer” by The Best

Lawyers in America. Phillip is also a member of the board of directors for the Mid-South Commercial Law Institute,

where he served for many years as the chairman of the program committee, and is a member of the American

Bankruptcy Institute.

Phillip is very active in the community in Columbia, Tennessee, where he lives with his wife Brandy and their two

sons, Phillip III and Derek. Phillip is currently Vice Chairman of the board of directors of Columbia Academy, a K-

12 private school with campuses in Columbia and Spring Hill. He has combined his passion for Columbia Academy

with his passion for youth football by coaching and serving on the board of directors for the Columbia Academy

Youth Football League (in which both of his sons have played). Phillip previously served on the board of Nashville

Christian School and Main Street Columbia.

In his free time, Phillip enjoys coaching his sons’ athletic teams, restoring his historic home, and attending college

football games. Phillip is a member of the West 7th Street Church of Christ in Columbia, where he frequently leads

Bible studies for college students and young professionals.

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BACKGROUND INFORMATION

In order to have a full appreciation of our fact scenario, it is important that one has

a full understanding of issues that the Debtor and its secured creditor will immediately face

in our hypothetical Chapter 11.

DEBTOR

An attorney advising the Debtor/Franchisee must review a few questions with the

Debtor immediately before agreeing to file a Chapter 11 petition. First, there is an ethical

issue that must be addressed. In cases such as this, where the principal of the business has

guaranteed substantially all of the debt of the business, counsel must determine whether he

or she can represent both the Debtor and the guarantor. Inevitably, the guarantor will wish

to ride the company’s coattails and allow the company (and its creditors) to bear the

guarantor’s legal fees. Section 327 of the Bankruptcy Code stipulates that only attorneys

“that do not hold or represent an interest adverse to the estate, and that are disinterested

persons” may represent a debtor in bankruptcy. 11 U.S.C. § 327(a). It would be a very

rare case where an attorney could represent both the Debtor company and the individual

guarantor, either ethically or pursuant to § 327. An attorney for the Debtor owes a duty of

care to the Debtor and the Debtor only; he owes no direct duty to the officers, shareholders,

or guarantors of the Debtor. See In re Berger McGill, Inc., 242 B.R. 413, 420 (Bankr. S.D.

Ohio 1999). Positions advanced or actions taken by the Debtor in its best interest could

adversely impact an individual guarantor, and vice versa. See In re Roger J. Au & Son,

Inc., 65 B.R. 322, 334-35 (Bankr. N.D. Ohio 1984). Therefore, an attorney generally must

decide whether she wishes to represent the company or the guarantor, and make that very

plain in writing to both parties.

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A second immediate consideration for the potential Debtor and its counsel in our

fact scenario is whether the bankruptcy will adversely affect its franchise agreement.

While anti-bankruptcy clauses (or ipso facto clauses) in such an agreement are not

enforceable, See 11 U.S.C. § 365(e)(1)(B), the Debtor must consider other factors such as

the date of expiration of the franchise agreement (as the court will not force a franchisor to

renew a franchise agreement), the cost of curing any default upon assumption, and/or the

steps required and cost of complying with the franchise agreement post-assumption. With

regard to this last point, it is likely that the franchise agreement will be contingent on the

Debtor remaining current on its lease obligations, current in its tax obligations, and current

on its payroll. The Debtor and its counsel must address these matters proactively in first

day motions.

In addition to factoring in the costs of assuming the franchise agreement, the Debtor

must calculate the cost of providing adequate assurance to the secured lender pursuant to

11 U.S.C. § 361. This is a delicate balance for the Debtor and its counsel, as the franchisor

will likely want the Debtor to spend money to honor its franchise agreement and protect its

brand while the secured lender will likely request that the Debtor make larger payments on

its secured indebtedness. The fact is, in the first months of a bankruptcy, the Debtor may

have the resources to do neither. The Debtor must develop a reliable and conservative

budget for its first six to eight weeks of Chapter 11 and give careful consideration as to

when it must assume the franchise agreement.

Finally, in our fact pattern, prior to filing the Debtor and its counsel should consider

its “worse case scenario;” that is the consequences of an unsuccessful turnaround.

Franchise agreements are closely akin to personal contracts, because a franchisor is placing

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its faith in a specific franchisee to maintain its brand. As such, nearly all franchise

agreements contain prohibitions against assignment. Before filing Chapter 11, the Debtor

and its counsel should consider whether and to whom the franchisee could assign the

franchise agreement as part of a sale of assets, since the franchise agreement is likely its

most significant asset and one that might be required to give all other assets any value.

Generally speaking, an executory contract may be assumed by a debtor and assigned to a

third party if defaults are cured and adequate assurance of future performance by the

proposed assignee is shown. 11 U.S.C. § 365(f)(2). Courts grapple with the adequate

assurance issue, as it is determined on a case-by-case basis. Among the factors typically

considered by bankruptcy courts in approving or denying an assignment is the reputation

of the assignee, the past relationship among the parties, the existence of personal

guarantees, and (most importantly) the financial health of the assignee. See In re Resource

Technology Corp., 624 F.3d 376, 383 (7th Cir. 2010). However, a personal services

contract that requires special knowledge, judgment, taste, skill or ability is generally not

assignable in bankruptcy. In re Compass Van & Storage Corp., 65 B.R. 1007, 1011

(Bankr. E.D.N.Y. 1986). The question a Debtor must ask at the forefront of a case, then,

is whether there will be a market for selling its personal assets and assigning its franchise

agreement consistent with bankruptcy requirements if it must liquidate.

The Debtor must face these issues, plus the host of other issues that must be

discussed and decided in every Chapter 11 case, prior to or at the very beginning of its

bankruptcy case.

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SECURED CREDITOR

The Debtor is not the only party that must carefully make a series of decisions at

the outset of this franchisee Chapter 11. The Debtor’s secured lender must also carefully

consider its initial legal maneuvers.

After confirming that its lien is valid and its security documents are proper, the

secured creditor in our hypothetical Chapter 11 must focus on the Debtor’s motion to utilize

cash collateral, which will inevitably be filed as a first-day motion. In order to

appropriately respond, the secured creditor must know the extent of its security interest,

the value of the assets subject to its lien, and the rate at which those assets are depreciating.

Calculating the value of assets in a franchisee bankruptcy can be very difficult. This is

especially true if the lender has a perfected lien on the franchise agreement itself, as is often

the case in franchisee bankruptcies, because such property can be difficult to value.

The real challenge for the secured creditor is determining exactly how hard it may

press the Debtor without causing it to break. Just as the Debtor must consider the market

and assignability of assets, so too must the secured creditor be aware of such constraints.

While the secured creditor would like the Debtor to pay it the maximum adequate

protection payment allowable by the court, it must also be mindful not to push the Debtor

to the point of conversion. Therein lies the tension: the secured creditor wishes to reduce

its indebtedness as quickly as possible while not jeopardizing the success of the Debtor, as

its assets may have little or no market in a forced liquidation.

In order to navigate these tricky legal situations properly, it is imperative that a

secured creditor determine, as quickly as possible, an accurate value of the Debtor’s assets

and their assignability/marketability. The valuation of the Debtor’s assets will determine

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what, if any, adequate protection the secured creditor is entitled to receive, whether the

secured creditor can or should move for relief from the automatic stay, and whether the

secured creditor is at risk of being crammed down by the Debtor’s plan.

FRANCHISOR

The Franchisor wears many hats in a Chapter 11 case filed by one of its Franchisees.

In most instances, the Franchisor is one of the largest unsecured creditors. The Franchisor

is a party to one or more Franchise Agreements with the Debtor. It is also common for the

Franchisor to be in a landlord relationship with the Franchisee. The Franchisor plays a

significant role in the bankruptcy case, in order to protect its brand and goodwill from

damage as a result of the Franchisee’s actions or inactions.

The Franchisor will closely analyze the Franchisee/Debtor’s prospects of

reorganization. It will analyze not only the Franchisee’s financial data, but also

Franchisee’s history of operations to determine whether to support the Franchisee’s

reorganization efforts. The Franchisor may also evaluate the Debtor’s particular locations

to determine viability.

The Franchisor will also closely monitor Debtor’s post-petition operations. First

and foremost, the Franchisor will check for payment of the post-petition payments for

royalties, advertising contributions and other payments to the Franchisor. Most Franchise

Agreements require not only timely payment of amounts owed to Franchisor, but also

timely payment of rent, taxes, payroll, and other business expenses. The Franchisor may

seek to terminate the Franchise Agreements if Debtor does not timely make its post-petition

payments. The Franchisor will also seek compliance with non-monetary covenants related

to operation of the business.

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The Franchisor has the right to approve or reject any potential assignment of the

Franchise Agreement under both 11 U.S.C. §365 and under the terms of most Franchise

Agreements. Section 365(c)(1) provides that “the trustee may not assume or assign any

executory contract…if (1)(A) applicable law excuses a party…from accepting

performance from an entity other than the debtor… and (B) such party does not consent to

such assumption and assignment.” The Lanham Act serves as the “applicable law” to

prevent assignment of a franchise agreement without consent. In the event the Debtor

seeks to sell one or more franchised locations or the company as a whole, Franchisor

approval of the proposed purchaser will be necessary. Most Franchisors have a complex

approval process that can take weeks or months, so involving the Franchisor in the process

early on is beneficial.

In some instances, the Franchisor may have the right to prevent the Debtor from

assuming the Franchise Agreements, based on 11 U.S.C. §365(c). A circuit split exists on

whether assumption of a Franchise Agreement by a debtor-in-possession constitutes an

assignment. The Sixth Circuit has not weighed in on this issue while bankruptcy cases

within the Sixth Circuit are split. The Middle District of Tennessee bankruptcy court ruled

that an assumption is not an assignment requiring consent in In re Cumberland Corral,

LLC, 2014 Bankr. LEXIS 936 (Bankr. M.D. Tenn. 2014). The Eastern District of Michigan

took the opposing approach, ruling consent was required, in In re Kazi Foods, Inc., 473

B.R. 887 (Bankr. E.D. Mich. 2011).

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In the event of a liquidation, the Franchisor will require the Debtor or Trustee to

immediately cease use of its trademarks and trade dress. This will require “de-imaging”

the franchise location, in order to remove the trademarks. Irreparable harm is presumed

from a defendant’s infringement of a plaintiff’s trademarks. DaimlerChrysler v. The Net

Inc., 388 F.3d 201, 208 (6th Cir. 2004)

EXECUTORY CONTRACTS

Perhaps the most critical factor in our hypothetical Chapter 11 is the existence of

an executory contract, the franchise agreement. A franchise agreement, if not terminated

or expired prior to the petition date, is an executory contract capable of being assumed

pursuant to 11 U.S.C. § 365. See, e.g., In re Tornado Pizza, LLC, 431 B.R. 503, 510-11

(Bankr. D. Kan. 2010). Therefore, in order to determine whether the Debtor can maintain

its franchise agreement throughout a Chapter 11, the Debtor must ask itself the following

questions: (1) Is the agreement truly executory, meaning that ongoing obligations are owed

by both the franchisor and franchisee? (2) Did the franchise agreement expire by its own

terms prior to the petition date? (3) Did the franchisor terminate the agreement, by the

means designated in the agreement itself, prior to the petition date?

Assuming that the agreement is executory and capable of being assumed in the

bankruptcy, the Debtor must look to the requirements of 11 U.S.C. § 365(b) to determine

what factors must be met in order to assume the contract. Pursuant to § 365(b), the Debtor

may assume the franchise agreement by curing all defaults or providing adequate assurance

that it will promptly cure all defaults, compensating the franchisor for any actual damages

resulting from the default, and providing adequate assurance of future performance under

the agreement. In the case of franchise agreements, curing defaults may include significant

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non-monetary defaults that may be extremely difficult, or sometimes impossible, to cure.

See, e.g., In re Claremont Acquisition Corp., Inc., 113 F.3d 1029, 1033 (9th Cir. 1997); In

re Deppe, 110 B.R. 898, 904 (Bankr. D. Minn. 1990).

In Chapter 11 cases, there is no set time period for assuming or rejecting executory

contracts.1 Therefore, the Debtor in our fact pattern may choose to delay a decision about

whether to assume or reject the franchise agreement if it is trying to gain a strategic

advantage as to the franchisor or if it needs additional time to determine whether assuming

the franchise agreement is feasible for the Debtor. Given that it is very difficult to craft a

business plan for a franchisee that does not involve an active franchise agreement, the

Debtor likely depends solely on the franchise agreement for its economic existence.

Therefore, the Debtor must not delay the franchisor too long. Should the franchisor grow

weary of awaiting a determination on the assumption or rejection, it might move the court

to compel assumption or rejection of the contract or, worse yet, might move for stay relief

to terminate the franchise agreement if its assumption and cure seems impossible.

One tactic that the Debtor might attempt, should the franchisor attempt to terminate

the agreement or should the Debtor realize that a reorganization is not feasible, is to sell its

assets and assume and assign the franchise agreement to a third party. Many of the disputes

concerning executory contracts regard the assignment of contracts to a third party buyer.

The Debtor’s rights under an executory contract (except a personal services contract) may

be assigned to a third party, despite a non-assignability clause, if the Debtor assumes the

agreement consistent with the requirements of the Bankruptcy Code and the assignee can

demonstrate adequate assurance of future performance. 11 U.S.C. § 365(f)(2). As

1 As opposed to unexpired leases of nonresidential real property. See 11 11 U.S.C. § 365(d)(4)(A).

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discussed above, whether a third party has demonstrated “adequate assurance of future

performance” is a very factual inquiry, but all that must be shown is that it is more likely

than not that the assignee can and will perform the obligations of the agreement. In re

Resource Technology Corp., 624 F.3d 376, 383 (7th Cir. 2010). As a practical matter, in

order to reduce litigation concerning assumption and assignment of franchise agreements,

the Debtor and the secured creditor often work with the franchisor to identify acceptable,

potential purchasers of the franchise agreement and assets. The tension that exists,

however, is that the Debtor and secured creditor will want to transfer the assets to any party

willing to pay the highest price for the assets; the franchisor will want to “hand pick” a

transferee who might not be the highest bidder but who best fits the franchisor’s goals.