Franchising in the Days of Recession

A study of franchisor protection against franchisee insolvency

Restaurants and have been devastated since the start of the current recession, negatively affecting corporate franchisors and their licensed franchisees. Revenues have declined as customers have tightened their belts and restricted discretionary spending while joblessness has risen. Not surprisingly, bankruptcies in the and hospitality industries have increased - and evidence indicates that they will continue to do so.

What does that mean for franchisors, especially when franchisees begin to teeter on the brink? Without a well-crafted franchise agreement, you might be at the mercy of bankruptcy courts and even be forced to accept financially weak candidates as franchisees. With a better franchise agreement, however, you can increase the chances that you will have control in this challenging economy and be positioned to withstand the impact if a franchisee is forced into bankruptcy.

1) Tips for Drafting a Franchise Agreement

Impose trip wires: If all obligations of the franchisee are up to date, you don't get to unload the franchisee. Clauses that provide for cancellation in the event of bankruptcy or insolvency (called "ipso facto" clauses) don't count in bankruptcy cases.

  • The better franchise agreement: Provide financial benchmarks and requirements for the franchisee to meet. The benchmarks should identify financial distress well in advance of a considered bankruptcy filing. This will increase the odds that you will be able to legitimately cancel the franchise agreement without reference to any bankruptcy filing.

Protect your contract: Your franchise agreement may be at risk! A trustee in bankruptcy, or the debtor in a Chapter 11 case, can choose either to "reject" the contract or "assume" it. If the contract is rejected, the contract ends, and you have nothing but a claim in the bankruptcy court for whatever your damages may be, payable at mere pennies--if that--on the dollar. If the contract is assumed, however, the contract may be assigned to another even if the contract does not allow assignment. Your new franchisee will be pleased to make your acquaintance even if you aren't.

  • The better franchise agreement: Since anyone who assumes the contract must accept the entire contract and make up any arrearages, you must protect yourself before a financial calamity arises. If the contract grants you a right of first refusal, for example, the bankruptcy court is likely to honor it, so you can buy your way out from under a new franchisee if other arguments fail. Also, make sure the franchise agreement contains every benchmark and restriction that is appropriate. Any new franchisee would have to meet, and live by, those standards. The bankruptcy law gives you the right to insist that any new franchisee is financially strong. Take a look at any proposed franchisee, and object if you don't like what you hear.

Avoid preference claims: You may have to pay back to the trustee in bankruptcy any money the franchisee paid you within 90 days (sometimes a year) before a bankruptcy filing. Any payment in that time frame may be called a preferential transfer, or preference. You may have defenses to preference claims brought against you by the bankruptcy trustee when, for example, payments were made to you timely and as agreed. Your risk comes if you suddenly put pressure on a franchisee to pay overdue debts, or by demanding special handling such as certified checks.

  • The better franchise agreement: Get or get paid in advance. To the extent you are paid in advance, or have a security deposit, or are a secured creditor, you will not have to repay that money.

2) Tips for Handling a Franchisee in Bankruptcy

Although these suggestions can protect you in future franchisee agreements, it is important to know what to do if you find yourself in a situation where franchisee insolvency is a serious threat. You are entitled to do everything you legally can to get paid before a bankruptcy is filed. Even if a bankruptcy is filed and you have to return the funds as preferential payments, you are no worse off than if you had received nothing.

Although you must take appropriate steps to protect yourself, you must also be considerate not to interfere in situations where you don't belong. Don't pressure the franchisee once he/she has filed the bankruptcy proceeding. You are forbidden from trying to collect from a debtor without advance permission of the bankruptcy court. You do not need formal service of legal papers by a sheriff from the court to put you on notice of the bankruptcy filing. That said, you aren't restricted from pursuing guarantors and co-debtors who have not filed bankruptcy.

Although the filing of bankruptcy may tie your hands, you cannot allow the case to play out by itself. The law will not protect you automatically. You must be assertive, make objections, and be involved in the case to ensure that you get what you are owed. If you try to hide that you knew about the bankruptcy or deny that you were served formal papers, you could be held in contempt and anything you do, or say, will be invalid.

If the situation of franchisee bankruptcy persists, there are several steps that you must consider to make sure that the financial impact is minimized. First you must review your contract immediately to see what options you have. At this point, you must decide if you would like to keep the franchisee, and if not, be sure to promptly cancel the contract. Consider taking a deposit to apply as advanced payment, as deposits are not typically subject to recovery during bankruptcy proceedings. Consider the advantages of keeping the current franchisee and those of accepting a new one, but make sure you are able to negotiate right of refusal and carefully investigate the financial background of any proposed new franchisee. Remember, you have the right to insist on the financial strength of any potential replacement and you cannot be made to accept either the old or new franchisee until what you are owed is paid in full.

Most importantly, if you are struggling with insolvent franchisees, be aggressive. Under the Bankruptcy Code, if you just watch from the sidelines, you will lose your rights. If you do not like what is happening, get involved, object, and demand information or contact an attorney qualified to lead you in the right direction. It is the only chance you have.

About the Authors

Christopher T. Vrountas is a partner at Nelson, Kinder, Mosseau & Saturley, P.C., a law firm with offices in Boston, Manchester, N.H, and Portland, Me. The firm provides employment counseling and litigation services to clients in several industries, including hospitality, and higher He leads the Employment Counseling and Litigation Practice Group and his clients include local, regional, and national chains. He is a member of the New Hampshire Restaurant and Lodging Association and the Massachusetts Restaurant Association. He can be reached at 603-606-5015 and at

Richard L. Levine is Of-Counsel at Nelson, Kinder, Mosseau & Saturley, P.C., in Boston. He has specialized in bankruptcy law for more than 35 years. He was appointed by the Chief Justice of the United States to help write the Federal Rules of Bankruptcy Procedure, and by the Attorney General of the United States to lead the U.S. Trustee Program. He has consistently been listed in Best Lawyers in America, and is a Fellow of the invitation-only American College of Bankruptcy. He can be reached at 617-778-7500 and

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