The symbiotic relationship between franchisor and franchisee becomes most evident when a large franchisee is stressed.

The second-largest franchisee of Applebee's Neighborhood Grill & Bar restaurants filed bankruptcy on May 8, 2018, in In re RMH Franchise Holdings, Case No. 18-11092 (Bankr. D. Del. 2018). RMH—and its four other affiliated companies that filed bankruptcy—own and operate 160 franchises in 15 states, which represents about 10 percent of the Applebees locations. The companies filed bankruptcy to save their locations, maintain their good will, and to restructure their debt that almost caused them to lose their locations.

When RMH filed, it owed over $12 million to its franchisor for royalties and advertising fees. The scheduled assets were $67 million, secured debts were $67 million, and unsecured debts were $33 million, for a total debt of over $102 million. In 2017, the net operating loss was over $2 million. The franchise agreements and lease were listed as executory contracts and not valued as assets or liabilities.

This large company chose bankruptcy as a last resort with a plan of revitalization in mind. Turning around a ship this large requires planning. Let's take a look at how this crisis was managed.

Concerns of the Franchisor

Each Applebee's location has a franchise agreement that licenses the operation of a restaurant using Applebee's trademark and system, including recipes for food and beverages, operating methods, décor and know-how. In exchange, the franchisee pays a monthly royalty fee and a percentage of its gross sales toward a national advertising fund. If the royalties are not paid, Applebee's must provide notice of the nonpayment default and provide an opportunity to cure.

The reality of a large franchise system is that Applebee's is very concerned with its second-largest franchisee not being able to pay its bills. Not only is it concerned about the $12 million owed to Applebee's for royalties and advertising fees, but also about impact on the national brand. Is the franchisee keeping the stores clean and the staff trained if it has a money pinch? Is what is happening to this franchisee and reflection of public perception of the brand? How can Applebee's collect the $12 million owed without threatening or actually forcing the closure of some or all of the 160 locations? This is an instance where the franchisor and franchisee interests are more aligned than it may appear because of the failure of the franchisee will impact the entire franchise system. Who will buy new franchises and invest in the system if the large franchisee, presumably sophisticated, has this type of challenge?

Nevertheless, Applebee's felt it must take action to collect its debt and enforce its franchise agreement because compliance with the franchise agreement holds the entire system together.

Franchisor Defaults the Franchisee

Applebee's issued written notices of default to the franchisee for each of the units. Each franchise agreement provides that in the event of breach, Applebee's has the right to terminate without advance notice for breach of certain contractual provisions, including the failure to pay royalties and advertising fees. Upon termination, Applebee's has the right to take over the restaurants within 30 days.

In June 2017, the franchisees stopped paying royalties. On Sept. 20, 2017, Applebee's issued a notice of default granting a 90-day cure period, and additionally advised that for the restaurants that did not cure within 90 days, their franchise agreements would automatically terminate without further notice.

The franchisees did not tender cure, and the parties engaged in dispute resolution discussions. The franchisees claimed that they were in this condition because Applebee's had its own brand issues, and engaged an investment bank, Mastodon Ventures, to discuss the issues with Applebee's and to restructure the franchisees out of court. Before the expiration of the cure period, Applebee's sent an extension letter dated Dec. 18, 2017, which expressly extended the deadline to cure for an additional 30 days until Jan. 22, 2018. In January 2018, the franchisees additionally stopped paying advertising fees. Importantly, and unlike the previous letter, this extension letter did not state that termination would be automatic without further notice if a cure failed to occur. Several other extensions occurred but none of the letters contained the automatic termination notice. Notably, all of the letters stated on extension that the time for the cure was not extended and had passed. The last letter stated that the time for cure had past, and that Applebee's was not intending to enforce its rights until May 8, 2018.

On May 7, 2018, despite discussions with and through the investment banker, the franchisees thought they had reached an impasse and Applebee's threatened to terminate certain locations. On May 8, 2018, before Applebee's could take any action, the franchisee filed Chapter 11 for all four related entities. The amount that would have been necessary for a complete cure was $12,161,823. Applebee's thereafter issued a termination notice for several notices of termination for the locations in Texas and Arizona, and filed a declaratory judgment requesting a finding that the franchise agreement was automatically terminated and not part of the bankruptcy estate, or otherwise terminated by the notice of termination.

Franchisor's Termination Was Ineffective

The bankruptcy court decided the termination issue. The bankruptcy court concluded that the failure to state that termination would be automatic in the extension letters was fatal to the termination argument. Applying Kansas law as required by each franchise agreement, termination is equivalent to a forfeiture and requires clear and convincing proof of termination. Here the extension letters were not clear. The letters merely said that remedies and enforcement would not occur until May 8, and confirmed that the time to cure had expired. Absent language that termination was automatic, and based on the prior action of Applebee's allowing operation for the past months without payment, the additional act of termination was required under the circumstances.

One might ask that if the contractual cure period had expired, and the only thing left was enforcement, why the franchise agreement still remain in full force and effect. The answer is that the bankruptcy code allows a franchise agreement which is not terminated or expired during the bankruptcy to be assumed in the bankruptcy. Unless otherwise ordered, the franchise agreement may be cured upon sale or as designated in a plan of reorganization. The cure of the franchise agreements can still occur in the bankruptcy even though the contractual right to cure has expired.

Franchisee's Choice in Going Forward

The franchisee cannot simply sit in bankruptcy, not paying anyone and continue to operate. The court or Applebee's can compel the franchisees to assume or reject the franchise agreements, no later than confirmation of the plan. A plan of reorganization, if approved, allows the franchisee to pick and choose the franchised units it intends to cure and keep, and paying an abbreviated damage claim for those rejected franchise arrangements. The franchisee can also keep some and jettison the others as long as it promptly cures the defaults, which could be instantly or over time. If the plan of reorganization has sufficient votes for confirmation, and treats the creditors as required by the Bankruptcy Code, the franchisee will emerge from bankruptcy with the locations to operate, or to sell.

The plan filed in court has a sponsor, Acon Holdings and Acon Equity, that will inject $10 million for the equity in the debtors. If approved, Applebee's will be repaid and the original equity holders will lose their stock. Other creditors will be impaired and receive partial payments. The worst locations have been jettisoned and the best will have to reinvestment.

This Applebee's franchisee will continue to restructure in order to find efficiencies and remain competitive in the very difficult market of casual dining. All in all, a bankruptcy reorganization just may be the best result possible under the circumstances to revitalize.

Craig R. Tractenberg, a partner at Fox Rothschild, handles complex business disputes involving intellectual property, licenses, business torts and insolvency issues. He focuses on franchise companies' development and expansion. Contact him at [email protected].