Bankruptcy Court Ruling Highlights Important Circuit Split on Assuming Franchise Agreements

The Legal Framework
At the heart of this issue is Bankruptcy Code Section 365(c)(1), which prohibits the assumption or assignment of an executory contract if:

• applicable non-bankruptcy law excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor; and
• the non-debtor party does not consent to the assumption or assignment.

Courts have developed two competing approaches to interpreting this provision, leading to a significant circuit split that affects bankruptcy strategy nationwide.

The Hypothetical Test
The Ninth Circuit, along with the Third, Fourth, and Eleventh Circuits, follows the “hypothetical test,” as established in Catapult Entertainment, Inc. v. Perlman (In Re Catapult Enter.), 165 F.3d 747 (9th Cir., 1999). Under this more stringent approach, if applicable law would prohibit assignment of the contract to a hypothetical third party, then the debtor cannot even assume the contract, despite that no actual assignment is contemplated.

In Pinnacle Foods, the bankruptcy court applied this test to franchise agreements, examining both the Lanham Act (federal trademark law) and California's Franchise Relations Act (CFRA) as the “applicable non-bankruptcy law.” The court found that because both federal and state law bar assignment by franchisees of their franchise agreements, the debtor/franchisee could not even assume its franchise agreements without the franchisor's consent.

The Actual Test
In contrast, the First and Fifth Circuits follow the “actual test,” whereby the court looks at whether the debtor actually seeks to assign the contract to a third party. Consequently, if the debtor merely seeks to assume and continue performing under the contract—as is often the case in reorganizations—these circuits hold that the non-debtor party’s consent is not required.

Proponents of the actual test argue that it better aligns with the Bankruptcy Code's reorganization objectives and prevents unnecessary liquidations. They contend that the hypothetical test creates an artificial barrier to reorganization when no actual third-party assignment is contemplated.

Key Findings in Pinnacle Foods
The court's analysis in Pinnacle Foods centered on three key elements:

• Lanham Act Application: The court found that the Lanham Act constitutes “applicable law” under 365(c)(1). Trademark rights are personal to the assignee and not freely assignable without the trademark owner's consent.
• CFRA Interpretation: Despite CFRA’s provisions favoring transferability of franchises, the court held that CFRA still allows franchisors to reject transfers to unqualified buyers. This possibility was enough to satisfy the "hypothetical test."
• Consent Requirement: The court emphasized that under both the Lanham Act and CFRA, the franchisor’s consent is crucial because it provides for stronger protection of intellectual property rights for trademark and other intellectual property owners.

Because assumption in the Ninth Circuit requires that the debtor also be able to assign its contractual rights to a hypothetical purchaser/assignee, the Pinnacle court held that the debtor/franchisee could not assume its executory franchise absent the franchisor’s consent, which was not given. The denial of the motion to assume has significant implications for Pinnacle’s reorganization efforts because without the franchisor’s consent, Pinnacle cannot continue to operate. Whether an agreement can be reached, or on what terms, is not known. A hearing of Pinnacle’s plan of reorganization is scheduled for January 2025.

The Hypothetical Test’s Impact on Stakeholders
Franchisors and licensors will likely enjoy increased leverage in bankruptcy proceedings within “hypothetical test” jurisdictions, thus affording them greater control over the debtor/franchisee’s reorganization efforts.

Conversely, debtor/franchisees may face a significant obstacle to reorganization if they cannot assume their franchise agreements without their franchisor’s consent. Debtors may be forced to liquidate (or sell their businesses to someone approved by the franchisor) if they cannot continue operating under their existing franchise agreements. Consequently, franchisees contemplating bankruptcy may need to consider filing in more favorable jurisdictions where possible.

Key Strategic Considerations

• Venue Selection: Venue selection is critical in franchise bankruptcy cases. Given the opposite results produced by the “hypothetical” and “actual” tests, jurisdiction selection can significantly impact outcomes in bankruptcy.
• Pre-Bankruptcy Planning: Franchisees should evaluate their options and consider negotiating with franchisors before filing for bankruptcy. Proper planning could mitigate risks posed by unfavorable jurisdictions and better position the franchisee for successful restructuring outcomes.
• Alternative Restructuring Options: In jurisdictions adhering to the “hypothetical test,” parties may need to explore out-of-court restructuring options to sidestep the restrictive conditions of court-imposed rulings.

Looking Ahead
As this circuit split persists, franchisors and franchisees should remain alert to the implications of jurisdictional variances, especially in regions applying the “hypothetical test.” In the meantime, the variations across circuits will continue to cause uncertainty and disparate outcomes based solely on geography, complicating the bankruptcy landscape for franchisors and franchisees alike. The Supreme Court may someday resolve this discrepancy.