What Is the Impact of Insolvency on Franchise Agreements?

Franchise agreements, which are legal contracts between a franchisor (the brand owner) and a franchisee (the individual or company operating a franchise), can be significantly affected by the insolvency of either party. Under the Insolvency and Bankruptcy Code (IBC), the rights and obligations of the parties in a franchise agreement may change, depending on whether it is the franchisor or franchisee undergoing insolvency. The insolvency process can lead to the termination, restructuring, or renegotiation of franchise agreements.

Impact of Insolvency on Franchise Agreements:

Insolvency of the Franchisor:

Franchisor Insolvency and the Franchisee's Rights:

If the franchisor goes into insolvency or enters Corporate Insolvency Resolution Process (CIRP), the franchise agreement may be terminated or suspended depending on the resolution process.

Franchisees often rely on the franchisor for ongoing support, branding, and operational guidelines. If the franchisor is insolvent, the franchisee may lose access to essential support and the brand, which could negatively impact the franchisee’s business.

The Resolution Professional (RP) or Insolvency Professional (IP) appointed in the CIRP can decide whether to continue or terminate the franchise agreement. If the agreement is terminated, the franchisee may have to cease operations under the brand name.

Franchisees may file a claim as operational creditors if the franchisor owes franchise fees, royalties, or other outstanding payments, subject to the ranking of claims under IBC.

If the franchisor’s business is sold as part of a resolution plan, the new owner may negotiate with franchisees and decide whether to continue the franchise agreements or not.

Insolvency of the Franchisee:

Franchisee Insolvency and the Franchisor's Rights:

If the franchisee becomes insolvent, the franchisor may have the option to terminate the agreement, as the franchisee is no longer able to meet its contractual obligations, such as paying franchise fees, royalties, or maintaining operational standards.

The franchisor can initiate action for breach of the franchise agreement due to the insolvency of the franchisee. However, the franchisor must comply with the legal framework under the IBC, which may involve submitting claims in the insolvency process to recover unpaid amounts.

Resolution professionals may look at the terms of the franchise agreement and decide whether the insolvent franchisee can continue operating or whether the franchise relationship should be terminated.

In the case of liquidation, the franchisee’s assets, including any rights or licenses under the franchise agreement, could be sold to pay off creditors. The franchisor may choose to retain the franchise agreement or choose to terminate it based on the value of the business and the specific clauses in the franchise agreement.

Impact on Franchise Fees and Royalties:

Whether the franchisor or franchisee undergoes insolvency, outstanding fees and royalties may be subject to the insolvency proceedings.

Unpaid royalties may be considered a debt owed by the insolvent party, and the other party (franchisor or franchisee) may file a claim as an operational creditor for the amounts due.

The insolvency resolution plan or liquidation process will determine how these amounts are paid or written off, depending on the classification of creditors and available assets.

Termination and Continuation of Franchise Agreements:

If a franchise agreement includes termination clauses triggered by insolvency, the resolution professional (RP) may decide to terminate the agreement as part of the restructuring or liquidation process.

In the case of CIRP, if the business is sold to a new buyer or investor, they may choose to continue with existing franchise agreements or decide to renegotiate the terms of those agreements. Franchisee rights may be affected by this change, as the new owner may not want to maintain the franchise relationship.

If the franchisee is unable to operate the franchise due to insolvency, the franchisor may look for a new franchisee or assume control of the franchise unit.

Franchise Agreement Clauses in Insolvency:

Insolvency Clauses: Some franchise agreements contain specific clauses that address the impact of insolvency on the agreement. These may include automatic termination clauses if one party becomes insolvent, or clauses that provide for renegotiation of terms if the franchisee or franchisor enters insolvency.

In the absence of such clauses, the Insolvency Professional (IP) may need to examine the agreement’s terms and determine whether continuing the agreement is feasible or beneficial for all parties involved.

Creditors and Franchise Agreements:

If the franchisee or franchisor owes money to creditors, those creditors (including suppliers, lenders, and employees) may be affected by the outcome of the insolvency proceedings. This could lead to the renegotiation of terms in the franchise agreement, depending on the negotiations with creditors and the feasibility of continuing the franchise business.

Example:

Consider a franchisee of a well-known fast-food brand undergoing insolvency. The franchisee is unable to pay ongoing royalties and franchise fees. In this case:

• The franchisor may invoke the termination clause of the franchise agreement, effectively ending the relationship due to the insolvency of the franchisee.
• The resolution professional (RP) appointed in the CIRP of the franchisee may decide to sell the franchise business and its rights to another buyer.
• The franchisor may be entitled to file a claim in the insolvency proceedings to recover unpaid royalties or other dues, subject to the ranking of creditors.

Conclusion:

The impact of insolvency on franchise agreements can be significant, both for the franchisor and franchisee. The Insolvency and Bankruptcy Code (IBC) provides a framework for handling the rights and obligations of both parties during the Corporate Insolvency Resolution Process (CIRP) or liquidation. Whether the insolvency relates to the franchisor or franchisee, it can result in the termination, renegotiation, or sale of franchise rights. The resolution depends on the specifics of the franchise agreement, the insolvency process, and the decisions made by the appointed insolvency professional.