A not just hypothetically difficult path to continue: Franchisees filing bankruptcy in a “hypothetical” jurisdiction may struggle to continue with franchise agreements

The recent decisions in the Pinnacle Foods bankruptcy case pending in the Eastern District of California highlight the difficulties that franchisees may have in filing for bankruptcy and seeking to assume a franchise agreement in jurisdictions where case law is not favorable or state law may conflict with the Bankruptcy Code.[1] A franchisee of six Popeyes Louisiana Kitchen Inc. (Popeyes) locations filed for bankruptcy in 2024 and sought to assume the franchise agreements. As a franchisor, Popeyes strenuously opposed assumption of the franchise agreements by the franchisee, because Popeyes did not consent, and Popeyes is excused from accepting performance from a “hypothetical” third party. Popeyes also claimed that the franchisee was prohibited from assigning the franchise agreements because of the operation of the Lanham act and certain provisions of the California Franchise Relation Act (the CFRA).

The “hypothetical test” in bankruptcy law states if the debtor simply wishes to assume a contract or lease and not assign its contract rights to a third party, the counterparty may withhold its consent and block the assumption if there is a hypothetical third party to whom the debtor might assign the contractual rights. The “actual test” says that the counterparty would only be able to block the assumption of a contract if there was an actual third party to whom the contract would be assigned. In the initial motion to assume presented to the court in the Pinnacle Foods case in the fall, there was no third party to whom the franchisees were proposing that the contracts would be assigned – the Popeyes franchisees simply wanted to emerge out of bankruptcy and keep operating – but California courts are bound by the “hypothetical test.” Because the Popeyes franchisees could theoretically later assign the agreements to a third party with whom Popeyes may be forced to work, Popeyes could successfully block the assumption and assignment of the franchise agreements. Popeyes also argued that the Lanham Act and the CFRA prohibited the assumption and assignment of the franchise agreements, and the bankruptcy court agreed. The court denied the motion to assume the franchise agreements, leaving the Popeyes franchisees without a way to operate their business post bankruptcy.

The Popeyes franchisees filed a motion to reconsider the bankruptcy court’s decision, and the bankruptcy court issued a further opinion in late December 2024. In denying the motion to reconsider the court’s decision denying the motion to assume, the bankruptcy court analyzed additional case law and noted that “where applicable non-bankruptcy law makes an executory contract non-assignable because the identity of a non-debtor party is material, a debtor in possession may not assume the contract absent consent of the non-debtor party.” Pinnacle Foods, citing Perlman v. Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999). In this situation, Popeyes submitted that the identity of the franchisee with whom it would do business is critical (and must meet Popeyes’ standards), and that the applicable law (here, the CFRA and the Lanham Act) was “applicable law” that would excuse Popeyes from accepting whatever “hypothetical” third party the franchisee may eventually assign the franchise agreements to. The court noted that the Popeyes franchisees argued that such decisions may deter bankruptcy filings by franchisees in jurisdictions governed by the “hypothetical” test, but “[t]hat, unfortunately for debtors, is simply a part of the calculus and risk assessment in franchisees proceeding in bankruptcy cases in this circuit.” Id. at 7. Given this scenario, in both cases where a franchisee is interested in simply assuming the franchise agreement – or assuming and assigning the franchise agreement to a third party – an analysis and informed discussion of the applicable law in the relevant jurisdiction is certainly warranted before proceeding with a potential bankruptcy filing.

[1] In re Pinnacle Foods of California LLC, Case No. 24-11015, 2024 WL 4481070 (Bankr. E.D. Cal. Oct. 10, 2024); In re Pinnacle Foods of California, Case No. 24-11015, 2024 WL 5190414 (Bankr. E.D. Cal. Dec. 19, 2024).