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Understanding Franchisee Bankruptcy and Its Implications for Franchisors

Learn about Chapter 7 and Chapter 11 bankruptcy, its implications on franchise agreements, and strategies for managing franchisee bankruptcy proceedings effectively.

By Victoria CampisiStaff Writer
Updated 8:08AM 02/19/24

Franchise businesses are vital contributors to the economy, but they’re not immune to financial hardships. One significant challenge is franchisee bankruptcy, which can have profound effects on both franchisees and franchisors.

Understanding the nuances of bankruptcy law and how it applies to franchise agreements is essential for navigating these difficult situations. That said, let’s explore the complexities of franchisee bankruptcy and its implications for franchisors, according to information from the American Bar Association.

Types of Franchisee Bankruptcy

Franchisees facing financial distress often consider bankruptcy as a means of restructuring their obligations, selling their business or liquidating assets. Chapter 11 bankruptcy is typically chosen by franchisees seeking to reorganize, allowing them to retain ownership of their business while restructuring their debt. Conversely, Chapter 7 bankruptcy involves the liquidation of assets by an appointed trustee, often leading to the termination of the franchise agreement.

Challenges and Opportunities for Franchisors

A bankrupt franchisee presents a range of challenges and opportunities for franchisors. Franchisors may seek to maintain their system by supporting the reorganization of a franchisee's business through assumption of the agreement or by facilitating the sale of the franchise to a third party. Alternatively, franchisors may use the bankruptcy process to negotiate favorable modifications to existing agreements or to protect their trademarks and intellectual property.

Jurisdiction and Filing Locations

The location where a franchisee can file for bankruptcy is governed by federal law, which provides flexibility in choosing the jurisdiction. Common types of franchisee bankruptcy cases include Chapter 7 liquidation and Chapter 11 reorganization. In Chapter 11, debtors have the opportunity to assume or reject franchise agreements (subject to court approval) while in Chapter 7, franchise agreements are deemed rejected if not assumed within a specified period.

Franchise Agreements in Bankruptcy

Franchise agreements are considered part of the bankruptcy estate, granting the franchisor certain rights and protections under bankruptcy law. The automatic stay, for example, prevents franchisors from taking enforcement actions against a bankrupt franchisee without court approval. Franchisors may also seek adequate protection for their interests, such as payment of post-petition fees or compliance with system standards.

Assumption, Assignment and Rejection

The assumption, assignment, or rejection of franchise agreements is a crucial aspect of franchisee bankruptcy proceedings. Franchisors must navigate the process carefully, ensuring that any assumptions or assignments meet the requirements of bankruptcy law and protect their interests. Rejected franchise agreements entitle franchisors to damages for breach of contract, highlighting the importance of proactive management during bankruptcy proceedings.

Franchisee bankruptcy is a complex legal matter with significant implications for both franchisees and franchisors. By carefully managing the process and leveraging the opportunities presented, franchisors can mitigate risks and safeguard their interests in the face of franchisee bankruptcy.

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