How to Prepare for Franchisee Bankruptcies During COVID-19
A 49-unit IHOP franchisee with restaurants in four Southeast states. Kansas-based Pizza Hut franchisee Keystone Pizza Partners. Aly Eatery, a Subway operator in Nevada. These are among the groups that filed for Chapter 11 bankruptcy in recent weeks, with others likely as disruption from the COVID-19 pandemic impacts what otherwise were successful businesses for some and exacerbates preexisting financial struggles for others.
“The unfortunate reality is some operators will not be able to weather the storm,” said James Wahl, an attorney at Lathrop GPM, as he later added the goal for franchisors “would be to be proactive in the process to have maximum control and flexibility over the outcome” if they believe bankruptcy is on the horizon for a franchisee.
That proactivity can take many forms, but, as fellow Lathrop attorney Robert Haupt noted, it should start with looking for warning signs—a pattern of late payments, lack of communication, notices from lenders—and quickly responding. “Do you have a mechanism in your system for reporting up the chain that a franchisee is struggling?” questioned Haupt during a webinar discussion of how franchisors can prepare for franchisee bankruptcies during the coronavirus crisis.
Because the pandemic has negatively affected many operators, a critical step for franchisors, Haupt and Wahl said, is assessing how franchisees will perform as restrictions ease and consumers resume more typical activity. ‘Zors need to ask themselves, said Wahl, “Is this a franchisee that you as a franchisor want to keep in the system?” because, “there is a risk of being too patient.”
The most common types of bankruptcies in franchising, Chapter 7, Chapter 11 and Chapter 13, all provide for varying levels of protection, from straight liquidation (Chapter 7) to business reorganization (Chapter 11), and debt repayment over three to five years (Chapter 13). Chapter 11 and 13, however, both allow the franchisee to continue operations under a franchise agreement.
“Most franchise agreements I've seen allow for some sort of expedited termination provision in the event of the franchisee's insolvency or bankruptcy,” said Will Jameson of law firm Spadea Lignana, in a separate interview. “Once a bankruptcy is filed, however, the automatic stay imposed under bankruptcy law prohibits the franchisor from enforcing termination or collection without bankruptcy court approval. As a practical matter, working with a struggling franchisee is frequently the best way to avoid the franchisee from seeking bankruptcy protection and the resulting loss of certain franchisor controls under the franchise agreement.”
If a franchisor decides to intervene before bankruptcy is filed, some might consider discussing the possibility of a sale to another franchisee or, in the case of a system that’s overbuilt or dealing with too many struggling operators, franchisors may need to consider terminating a contract.
“Maybe it’s a time that you start looking at which of your operators, which of your franchisees, you want to invest in the future. Which of them you’re going to be more flexible to, and which of them you’re going to tighten things up on,” said Haupt.
“Trimming is scary when you’re taking what you think is an otherwise healthy tree, or relatively recently healthy, and then you start chopping on it, but sometimes that has to be done just to survive or to protect that tree.”
Looking holistically at the future of the brand, Haupt pointed out that a franchisee’s bankruptcy isn’t always bad for the franchisor, “because it can help that franchisee shed certain debts, which frees up capital for them to put into their property” or otherwise invest in the brand, which ultimately benefits the franchise system as a whole.