Chapter 11 Bankruptcy and Hotel Franchisee, in COVID times

Chapter 11 Bankruptcy and Hotel Franchisee, in COVID times

It is no surprise that the COVID-19 pandemic has destroyed the hotel industry all over the world. The circumstances have forced even the large hotel chains to layoff their employees and close their properties, thereby, pushing many of them towards bankruptcy, Chapter 11 being the most viable option. Chapter 11 allows the debtor to keep its directors and officers in place and continue to manage the debtor. Further, it allows a business to restructure debtor’s liabilities and continue operating as a going concern upon emergence from bankruptcy.

One of the major players in the hospitality industry is the hotel franchisees. However, there exists a set of unique issues facing the hotel franchisee undergoing Chapter 11 bankruptcy. Chapter 11 provides certain tools and protections to a franchisee and also its franchisor.  To say the least, it allows the franchisee to re-organize its assets and liabilities in order to pay off the debt and other claims. But in case of a hotel franchisee undergoing bankruptcy, it is of utmost importance to make sure that the franchisor is on board to restructure the hotel’s operation.

To start with, it should be checked whether the franchise agreement was terminated prior to the filing of Chapter 11 bankruptcy. Since after filing the bankruptcy petition, the debtor franchisee’s “estate” comes under the scanner, which includes all of its legal and equitable interests in the property. This also includes the franchise agreement which has not been terminated prior to filing of the petition.  The question of whether or not the franchise agreement has been terminated depends upon the fact that the purpose of the agreement still exists and whether there is anything “left to be done” other than the mere passage of time. If the same exists, then the agreement is alive and existing. A similar issue was resolved in Days Inn v. Gainesville P-H Props., Inc. (In re Gainesville P-H Props., Inc.), 77 B.R. 285 (Bankr. M.D. Fla. 1987). The United States Bankruptcy Court, M.D. Florida, Orlando Division, held that “If the termination notice provides that termination will be effective on some future date without ties to any contingencies, then the agreement has likely been terminated even if the bankruptcy petition precedes the stated termination date. The key factor is whether anything other than the “mere passage of time” remains.” Further, under Chapter 11 the franchisor cannot terminate or modify a franchise agreement once the bankruptcy proceeding is initiated. Section 362[1], which reads as an “automatic stay”, provides protection to the debtor franchisee. The provision prohibits the franchisor from initiating or continuing any act or proceeding to terminate the franchise agreement or proceed with any act that may affect the debtor-franchisee’s rights without prior approval of the Bankruptcy court. Therefore, the franchisor cannot terminate the franchise agreement, once the bankruptcy proceeding has been initiated.

Another protection provided to franchisee is provided under Section 365[2] of the Bankruptcy Code. It provides the right to assume the franchise agreement as part of a reorganization or assign the franchise agreement to a potential purchaser or other third party in a going concern sale. The section also provides adequate time for the franchisee to make the decision. Section 365 also lays down requirements to assume the franchise agreement. Section 365 (b) (1) requires the debtor to cure any outstanding defaults under the contract, and accordingly, compensate the third party of any loss resulting from such default, and provide “adequate assurance of future performance” under the contract. Further, Section 365 (f) (2) governs the procedure of assigning the franchise agreement to the purchaser. The provision states that debtor-franchisee may assign an executor contract if (a) the debtor has satisfied the conditions for assumption stated under Section 365 (b) (1), and (b) that the prospective assignee demonstrates “adequate assurance of future performance”. It is also pertinent to note that Section (f) (1) over-rides anti-assignment contractual clauses. If the franchise agreement prohibits assignment of the agreement, the said provision would be unenforceable by way of Section (f) (1). The section states “notwithstanding a provision in an executor contract… that prohibits, restricts, or conditions the assignment of such contract.” However, Section 365 (c) provides for counter balance, which recognizes any applicable law restricting assignment of a contract without the non-debtor counterparty’s consent.

Therefore, as discussed, a consensual Chapter 11 bankruptcy proceeding can be a life-saving resort for both, the debtor-franchisee and the franchisor. However, a non-consensual filing of Chapter 11 bankruptcy may unearth uncertain outcomes and unnecessary risks, due to the differences between the debtor-franchisee and the franchisor. The most prominent situation to such unwanted circumstances would be sessions of negotiations and consensus-building between franchisee and franchisor. Since, the proceedings and its outcome would affect the franchisor and franchisee, it would be an ideal solution to discuss the mutual interest.   

[1] 11 U.S. Code § 362

[2] 11 U.S. Code § 365