Unless you’re not a sports fan or simply don’t follow Major League Baseball (MLB), you probably know that the Los Angeles Dodgers filed a chapter 11 bankruptcy petition on Monday, June 27, 2011. (Delaware Bankruptcy Court, Case Number 11-12010.) According to Forbes magazine, the Dodgers are one of the most valuable baseball franchises in America. Nevertheless, the franchise hit hard times and filed for bankruptcy.

A & F Enterprises, Inc. v. IHOP Franchising LLC (In re A & F Enterprises, Inc.), 2014 WL 494857 (7th Cir. 2014)

Would you know what to do if you learned that one of your franchisees had filed for bankruptcy? Perhaps more importantly, would you know what not to do? While each circumstance and franchise agreement is different, there is a general framework for dealing with a franchisee in bankruptcy. Here we’ll introduce some of the issues you are likely to encounter throughout the bankruptcy process.

The Automatic Stay

When a franchisee files for bankruptcy, a franchisor naturally has concerns over how the process will affect the parties’ relationship. Of particular concern is the possibility that the franchisor will be forced into a relationship with an unacceptable successor as a result of a bankruptcy judge’s decision to authorize assumption and assignment of the franchise agreement over the franchisor’s objection.

“Do not pass Go, do not collect $200” is a phrase we all remember from the childhood game Monopoly.  Like Monopoly, state franchise sales laws have rules and regulations that must be followed.  A franchisor’s failure to follow these basic procedural rules for selling franchises can result in self-destruction. 

A bankruptcy court in Texarkana, Texas held that breaches by two debtor-franchisees of a non-competition covenant in their franchise agreement with a print shop franchisor qualified for discharge through bankruptcy.  As the court noted, in addition to equitable remedies such as injunctive relief, Michigan law (under which the franchise agreement was governed) allowed for the award of monetary damages as compensation for violation of a non-competition agreement.  Because monetary damages were an available remedy, the court reasoned, the breach of the covenant qualified as a dischar

In Carroll v. Farooqi, 2013 U.S. Dist. LEXIS 22329 (N.D. Tex. Feb. 19, 2013), the United States District Court for the Northern District of Texas affirmed a U.S. Bankruptcy Court’s holding that an individual had standing to pursue an action against a franchisor under the Texas Deceptive Trade Practices Act (DTPA). The case involved an unsuccessful sale of a Salad Bowl franchise. The CEO of the fast causal franchise company (who was also its president, chairman, and CFO) contacted a potential buyer of a franchise.

What is the impact of a bankruptcy filing on the ability of a franchisee to continue utilizing the trademarks of the franchisor?  

The Bankruptcy Code in the United States is generally intended to give honest but unfortunate debtors the opportunity for a fresh start. This includes the honest but unfortunate franchisee who attempts to start a franchise but ultimately fails. Generally, if a franchisee files a personal bankruptcy case, the personal liability of the individual who filed bankruptcy is discharged and that individual has the opportunity for a fresh start.

In a case of apparent first impression, U.S. District Court Judge Alan S. Gold recently held in In re Wellington Vision, Inc., No. 06-80446, __ B.R. ___, 2007 WL 762398 (S.D. Fla. Feb. 20, 2007), that a franchisee in chapter 11 cannot assume (i.e., retain) a franchise agreement that grants a nonexclusive trademark license, leaving the franchisor free to terminate the agreement.