The impact of a right of first refusal clause in your franchise agreement during bankruptcy
A right of first refusal provision in a franchise agreement typically allows a franchisor to have “first pick” to the right to buy the franchise back if a franchisee is selling or reorganizing its business. Such a provision, however, may or may not be enforceable in bankruptcy, depending on the unique facts and circumstances of the case.
In re Mr. Grocer is the seminal case on the issue, and it has been cited by many other courts across the country. 77 B.R. 349 (D. New Hampshire 1987). In Mr. Grocer, the court found that the right of first refusal included in a lease was not enforceable because it was an unenforceable restriction on assignment pursuant in the bankruptcy to section 365(f)(1) of the Bankruptcy Code. The court also refused to enforce the clause because its presence could potentially have a chilling effect on other bids in the bankruptcy case. Because the debtor was trying to sell its assets to the highest and best bidder, the court reasoned that other parties would not make the effort to put in a bid if it would only be eclipsed by the lessor via the right of first refusal.
Similarly, in another case in the Southern District of New York, the bankruptcy court refused to enforce a right of first refusal provision because it would be “destructive with respect to maximizing value and have a chilling effect on bankruptcy auctions.” In re Adelphia Communications Corp., 359 B.R. 65 (Bankr. S.D.N.Y. 2007). Applying a “facts and circumstances” test, the court ultimately determined that enforcing the contract party’s right of first refusal was not appropriate in this case because of the debtor’s obligation to sell its assets to the highest bidder.
In yet another case – even though the franchisor had not given any notice of its intent to exercise its right of first refusal – a bankruptcy court found that the mere possibility of enforcing the right of first refusal could potentially chill the possibility of the debtors receiving higher offers. Using the facts and circumstances test, the court found that the franchisor would not be harmed if the right of first refusal provision was not enforced. In re Chicago Investments, 470 B.R. 32 (Bankr. D. Mass. 2012).
However, several other cases have supported the enforcement of the right of first refusal provision regardless of the facts and circumstances of the case. In In re IT Group, the Delaware bankruptcy court found that the right of first refusal to purchase an LLC interest in an LLC agreement is not an “ipso facto” clause that is unenforceable. 302 B.R. 483 (D. Del. 2003). Here, the court was not concerned that enforcing the right of first refusal would hamper the debtor’s ability to sell the property, and ultimately found that to not enforce the right of first refusal provision it would be to usurp a property right under state law. Similarly, in In re EZ Serve, 289 B.R. 45 (Bankr. M.D.N.C. 2003), the court noted that it retains some discretion to determine whether or not a right of first refusal clause in a lease restricts or conditions assignment pursuant to the Bankruptcy Code. This court held that the right of first refusal is a material, bargained for part of the contract that the court should not destroy, and that the the right of first refusal provision should therefore be enforced.
Ultimately, while case law on the issue goes both ways, careful consideration of any right of first refusal provision in a lease or franchise agreement in bankruptcy – and possibly early negotiation with the franchisor or lessor regarding their intentions – could help alleviate any concerns regarding the impact of a right of first refusal clause in bankruptcy.