Franchisee Bankruptcy: 6 Franchise Agreement Clauses That Trigger on Filing

The franchise agreement was drafted by the franchisor's lawyers with the franchisee's bankruptcy in mind, and the Bankruptcy Code was drafted with those lawyers in mind. Several of the clauses that appear to activate on the day a franchisee files are, after the petition, unenforceable in the way they were written. Others work exactly as drafted. The difference lies in section 365 and in a handful of words that most franchisees have never had reason to read.

The six clauses below are the ones a franchisee should locate in the signed agreement, its amendments and any related lease or note, before a petition is filed. Chapter matters throughout. A franchisee that reorganizes under chapter 11 decides what to keep; a franchisee in chapter 7 has a trustee deciding for it, under a statutory duty to collect and liquidate.

1. The Clause That Terminates the Franchise on Bankruptcy Is Largely Disabled

A franchise agreement that lists the franchisee's bankruptcy, insolvency or assignment for creditors as a default permitting immediate termination meets section 365(e)(1), which provides that an executory contract of the debtor "may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on" the debtor's insolvency or financial condition, the commencement of the case, or the appointment of a trustee or custodian. Section 365(b)(2) adds that a debtor assuming the contract need not cure a default of that kind.

The automatic stay reinforces the point. Section 362(a)(3) stays "any act to obtain possession of property of the estate ... or to exercise control over property of the estate," and the franchisee's rights under the agreement are estate property. A termination notice mailed after the petition, without relief from the stay, is the kind of act the section describes.

The protection has three limits, and each is written into the same statute. The words "after the commencement of the case" mean that a termination that became effective before the petition is not undone by subsection (e); the franchisee who receives a notice of termination with a cure period running should understand that the filing date, measured against the notice's effective date, may decide the matter. The word "solely" means a franchisor may still terminate for a genuine operational default (unpaid royalties, failed inspections, abandoned premises) that exists apart from the filing, subject to the stay. And subsection (e)(2) removes the protection entirely where "applicable law excuses a party, other than the debtor," from accepting performance from a trustee or assignee and that party does not consent.

Ten days after a petition, a termination letter citing the bankruptcy clause and nothing else is a letter the franchisee's counsel will want to see.

2. The Transfer Consent Clause Yields to Assumption, With One Exception That Matters

An agreement that forbids assignment without the franchisor's consent meets section 365(f)(1): "notwithstanding a provision in an executory contract ... that prohibits, restricts, or conditions the assignment," the trustee may assign, provided the contract is first assumed and "adequate assurance of future performance by the assignee" is given. Section 365(f)(3) prevents the franchisor from terminating because of the assumption or assignment itself.

But subsection (f)(1) begins "Except as provided in subsections (b) and (c)," and subsection (c)(1) bars assumption or assignment where applicable law excuses the other party from accepting performance from anyone but the debtor and that party does not consent. The statute does not mention franchises or trademark licenses. Whether the trademark license at the center of a franchise falls inside that exception, and whether the exception stops even the franchisee itself from assuming, are questions the governing circuit's case law answers, and franchise counsel will know which way it has gone.

3. The Cross-Default Clause Sets the Price of Keeping the Franchise

A franchisee that wants to keep its franchise assumes the agreement, and section 365(b)(1) makes assumption conditional: the debtor must cure existing defaults or give adequate assurance of a prompt cure, compensate the franchisor for actual pecuniary loss, and provide "adequate assurance of future performance." Cross-default clauses tie the franchise to the premises sublease, the equipment lease and any franchisor note, so a franchisee behind on rent to a franchisor-affiliated landlord may find that the cure bill for the franchise includes every other document in the package, which is a large number arriving at a moment when the cash is committed to payroll, to the merchant cash advance that took the daily receipts, and to the professionals the case itself requires.

If the franchisor or its affiliate is also the landlord, the lease has its own deadline. A nonresidential lease is deemed rejected unless assumed within 120 days of the order for relief, with one 90-day extension for cause and anything further only with the landlord's written consent. The franchise may be worth keeping and the location may not; the two decisions arrive on different calendars.

4. The Franchisor Financing Clause Keeps Its Force

Where the franchisor extended credit (a development loan, deferred fees, a line for equipment), section 365(c)(2) forbids assuming "a contract to make a loan, or extend other debt financing or financial accommodations," and section 365(e)(2)(B) withdraws the ipso facto protection for such a contract. The franchisor's promise to lend more cannot be carried forward through assumption. The franchisee's obligation to repay what was already lent becomes a claim in the case.

5. The Personal Guaranty Sits Outside the Case

Where the owner guaranteed the franchise agreement, the guaranty is a separate contract with a party who has not filed. The Second Circuit's rule, repeated in Queenie, Ltd. v. Nygard International, is that the automatic stay is limited to debtors; extending it to a guarantor requires a motion and an unusual showing. Discharge of the company's debt, where a discharge is available at all, leaves the guarantor liable under section 524(e). A franchisor denied royalties by the stay can sue the guarantor for them.

6. The Post-Termination Covenants Survive in Some Form

Rejection, the alternative to assumption, is defined in section 365(g)(1) as a breach of the contract occurring immediately before the petition was filed, which turns the franchisor's damages into a prepetition claim paid alongside other unsecured creditors. What rejection does to the covenant not to compete, the obligation to de-identify the premises and the franchisor's option to purchase the equipment, the statute does not say in terms. The option deserves separate attention: section 541(c)(1)(B) brings the debtor's property into the estate despite provisions conditioned on the filing that give "an option to effect a forfeiture." The noncompete (which franchisors will describe as protecting the system and which, for a franchisee with one location and no other trade, protects rather more than that) is a matter for state law and the bankruptcy court together.

A franchisee planning to reopen under its own name in the same space should put that plan in front of counsel before rejecting anything.

Before the Petition, the Debts That Drove It

Delancey Street negotiates merchant cash advance and related business debt and is not a law firm; franchise and bankruptcy questions belong to counsel, and the company coordinates with independently licensed attorneys where legal work is needed. For a franchisee whose distress comes mainly from advances rather than from the franchise itself, a free, confidential initial review can show whether a negotiated resolution would leave the franchise agreement untouched and every clause above unopened. A franchisee facing a termination notice, a defaulted lease with a franchisor affiliate, or a franchisor that will not deal needs bankruptcy or franchise counsel first.

The agreement anticipated the filing. So did section 365, and it was written later.