Generally, a debtor-in-possession may assume or reject any executory contract. Franchise agreements are integral assets in a franchisee debtor’s bankruptcy case. The agreements often represent the core of the business operations—controlling brand identity, trademarks and licenses, system operations, and other essential resources. The issue of whether, and to what extent, a debtor franchisee may assume a franchise agreement over the franchisors’ objection has created a deepening divide among courts interpreting section 365 of the Bankruptcy Code. There are also considerable concerns about conflicts with federal law governing intellectual property, including the Lanham Act.[1] Circuit court decisions on the issue reflect differing interpretations of section 365(c)(1) of the Bankruptcy Code. This article considers the varying legal approaches to resolving the issue; recent developments in the law; and practical implications for franchisors, franchisees, and counsel.
I. The Legal Frameworks: Hypothetical v. Actual Tests
Active franchise agreements are, by their nature, executory.[2] Such contracts depend on continuing performance and cooperation of both the franchisor and franchisee. Often, the franchisor holds a trademark and other intellectual property that it licenses to the franchisee for use subject to certain payment and compliance conditions.[3] Section 365(c)(1) of the Bankruptcy Code prohibits a trustee (or debtor-in-possession) from assuming or assigning an executory contract where applicable nonbankruptcy law excuses the nondebtor party from accepting performance or rendering performance to a party other than the debtor.[4] The apparent purpose of the statute is to preserve the rights of nondebtor parties to a franchise agreement. In the franchising context, the rights at issue include prohibitions against third-party assignment under the Lanham Act.
In determining whether the prohibition is applicable in a particular case, courts have taken varying approaches to interpreting section 365(c)(1) of the Bankruptcy Code. Those courts employing the “Hypothetical Test” examine nonbankruptcy law and preclude assumption where such law would prohibit a debtor from assigning the agreement, regardless of whether a third-party assignment is proposed or intended to be made. Theses courts, including the Third, Fourth, Ninth, and Eleventh Circuit Courts of Appeal, center their analysis on a plain reading of the statute irrespective of the subjective intent of the debtor-in-possession.[5] Some objectors also maintain that an assumption by a debtor estate necessarily results in an assignment to an entity other than the one that contracted for the prebankruptcy use rights. Courts applying the “Actual Test,” including the First and Fifth Circuit Courts of Appeal, consider the intent of the debtor and whether there is actual risk to the nondebtor party (franchisor) of being compelled to accept performance from a third party.
II. Recent Decisions and Deepening Divide
A. The Hypothetical Test
1. In re MeSearch Media Tech., Ltd.[6]
Applying the Hypothetical Test, a Western District of Pennsylvania bankruptcy court determined a purported exclusive license granted to a debtor as licensee of two software patents could be assumed by the trustee under a bankruptcy plan. The court acknowledged that patent license agreements are generally nonassignable, but it focused on language in the agreement authorizing assignment to “successors in interest.” The court determined the language was sufficient to meet the Third Circuit’s Hypothetical Test, overriding the general prohibition against assignment and allowing assumption by the trustee.
2. In re Pinnacle Foods of California, LLC[7]
In its application of the Hypothetical Test, an Eastern District of California bankruptcy court recognized the often-devastating effects this test has on a Chapter 11 debtor’s ability to reorganize. Indeed, the court referred to the franchisor creditor’s ability to withhold consent as an effective veto power. But compelled by Ninth Circuit precedent and applicable nonbankruptcy law prohibiting assignment without consent—the Lanham Act and California’s Franchise Relation Act[8]—the court denied the debtor’s motion to assume the franchise agreement.
B. The Actual Test
1. In re Welcome Group 2, LLC[9]
Applying the Actual Test, a Southern District of Ohio bankruptcy court determined that a debtor-in-possession would not be prohibited from assuming a franchise agreement, where it had no intention of assigning the franchise agreement to a third party. Considering the facts, the court reasoned that assumption by the debtor presented no risk to the franchisor of having to accept performance from or provide performance to a third party. Under the circumstances, prohibiting assignment was unwarranted.
III. Statutory and Policy Considerations
Proponents of the Actual Test maintain that a strict focus on a plain reading of section 365(c)(1) of the Bankruptcy Code contradicts bankruptcy policy objectives of facilitating successful reorganizations and maximizing the value of estate assets. The argument is that no creditor should be allowed to effectively veto a debtor’s ability to reorganize in bankruptcy.
Advocates of the Hypothetical Test, meanwhile, point to the intellectual property rights bestowed on patent and license holders to limit the transfer of their intellectual property and exert exacting standards for consent.
IV. Practical Implications for Business Lawyers
For the franchisee debtor, there is no question that the ability to retain the franchise agreement is critical.
Key considerations for business lawyers advising on franchise agreement assumption in bankruptcy include:
- Status of the agreement as of the petition date (i.e., default history, termination, etc.)
- Applicable law governing assignment
- Intent of the debtor (i.e. assumption, assignment, or both)
- What intellectual property is involved
- Whether rights and restrictions (such as IP licenses and limitations) are bundled in a single agreement or separate
- Jurisdictional authority on assumption and assignment
- Venue selection
Monique D. Hayes and Miles Taylor are co-chairs of the ABA Business Bankruptcy Committee’s Executory Contracts Subcommittee.
Lanham Act, Pub. L. No. 79-489, Ch. 540, 60 Stat. 427 (1946) (codified as amended in scattered sections of 15 U.S.C.). ↑
An executory contract is “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973). ↑
Evans v. S.S. Kresge Co., 394 F. Supp. 817, 844 (W.D. Pa. 1975). ↑
11 U.S.C. 365(c)(1). ↑
In re Trump Ent. Resorts, Inc., 526 B.R. 116, 125 (Bankr. D. Del. 2015); RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257, 269 (4th Cir. 2004); Perlman v. Catapult Ent., Inc. (In re Catapult Ent., Inc.), 165 F.3d 747, 754 (9th Cir. 1999); United States v. TechDyn Sys. Corp. (In re TechDyn Sys. Corp.), 235 B.R. 857, 861–62 (Bankr. E.D. Va. 1999). ↑
In re Crivella Holdings Ltd. v. MeSearch Media Tech. Ltd. (In re MeSearch Media Tech. Ltd.), 668 B.R. 828 (Bankr. W.D. Pa. 2025). ↑
In re Pinnacle Foods of California LLC, No. 24-11015-B-11, 2024 WL 4481070 (Bankr. E.D. Cal. Oct. 10, 2024). ↑
Cal. Bus. & Prof. Code § 20028. ↑
In re Welcome Group 2, LLC, 660 B.R. 874 (Bankr. S.D. Ohio 2024). ↑
