Franchise 101: Your Neighborhood Debtor; and Rules of the Road

December 2018

Franchisor 101: Your Neighborhood Debtor

A bankruptcy court has found that Applebee’s failed to properly terminate its franchise agreements prior to the franchisee petitioning for bankruptcy. Therefore, the franchise agreements remained in effect and were property of the franchisee’s bankruptcy estate.

On September 20, 2017, Applebee’s sent a letter to the franchisee, who operated 160 restaurants, granting 90 days to cure its failure to pay royalties. The letter said the franchise agreements would automatically terminate on the 91st day if the franchisee did not cure the default. Additional letters from Applebee’s extended the cure period to April 27, 2018, but did not mention termination. Before the cure period ended, Applebee’s sent a final letter to the franchisee agreeing generally to delay exercising its contractual rights under the franchise agreements.

Applebee’s claimed the franchise agreements terminated April 27, 2018, the end of the final cure period and were not subject to or protected by the bankruptcy court’s automatic stay. The franchisee claimed Applebee’s failed to provide clear unambiguous notice of intent to terminate the franchise agreements prior to the franchisee filing for bankruptcy.

The court found Applebee’s argument unpersuasive. It said that the multiple letters extending the cure periods was not clear and unambiguous notice of Applebee’s intent to terminate. The September 20, 2017 letter was the only letter to mention termination. The subsequent letters only extended the time the franchisee could cure the default. The court concluded that Applebee’s could have terminated the franchise agreements by providing the franchisee a clear and explicit notice of termination, but Applebee’s failed to do so.

Franchisors intent on terminating a franchise agreement must make sure the notices of default and termination contain all required language to terminate the franchise agreement at the end of any cure period.

In re: RMH Franchise Holdings, Inc., Case No. 18-11092 (Bankr. D. Del. 2018)

Franchisee 101: Rules of the Road

An ex-franchisee of a vehicle transportation and shipping management franchise was enjoined by a federal court, for two years, from operating a competitive business at its former location in Virginia or anywhere the franchisor, Auto Driveaway Franchise System (ADFS) operated, as required under the franchise agreement’s non-compete provision.

The court found a valid contract existed between the franchisor and franchisee. Although the franchise agreement expired in 2014, it remained in force on a month-to-month basis by the parties’ mutual assent.

The court noted that Virginia courts have upheld covenants not to compete in franchise agreements and nothing about this covenant was against Virginia law. In granting injunctive relief, the court found there was a “better than negligible chance” that ADFS would succeed in showing the ex-franchisee breached the covenant not to compete by using ADFS’s confidential information to build its competing service business, and by continuing to display ADFS’s trademarks while providing competing services. The court also found ADFS suffered harm to consumer goodwill and lost customers due to the ex-franchisee’s unauthorized use of its trademark.

The result may have differed in some other states, such as California, which resist enforcing typical non-compete provisions in franchise agreements.

Franchisees in any state need to confer with their franchise counsel to understand the consequences of non-compete language in their franchise agreements and the attitude of courts in the particular state toward enforcing noncompetition restrictions. In many states, courts will uphold and enforce covenants not to complete that are reasonable in duration, geographic scope and scope of restricted activity, especially if the franchisee continues to display the franchisor’s marks or use its confidential information. In some other states, enforcement of covenants not to compete is limited.

Auto Driveaway Franchise Systems, LLC v. Corbett, 1:18-cv-04971 (N.D. Ill. Oct. 26, 2018)

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