Ohio court adds to circuit split when considering assumption of a franchise agreement

In a new July 2024 opinion out of the United States Bankruptcy Court for the Southern District of Ohio, Judge Mina Nami Khorrami sided with the minority on the issue of whether a franchisee could assume a executory contract – like a franchise agreement – that has ongoing defaults if it has no intention of assigning it to a third party. In re Welcome Group 2 LLC, 23-53043 (Bankr. S.D. Ohio July 10, 2024). 

An “executory contract” in bankruptcy is a contract that the parties have not yet finished performing, and companies often use bankruptcy to get rid of or make modifications to contracts that they may wish to change. In the bankruptcy of Hilliard Hotels, a franchisee of Hilton, the court considered the issue of whether Hilliard Hotels could assume the Hilton franchise agreement in its bankruptcy – even though the franchise agreement had not fulfilled certain financial and other obligations in the contract, and Hilliard Hotels did not intend on assigning the agreement to another party through a sale or otherwise. 

Prior to the bankruptcy, Hilton had notified the franchisee that the hotel needed to make a number of improvements to the hotel to conform with the standards outlined in the franchise agreement. The franchisee made significant improvements to the property, but was still in violation of the franchise agreement when it filed for bankruptcy. The franchisee asked the court to consider whether the Lanham Act, an act regulating trademarks, would prohibit the franchisee from assuming the franchise agreement in bankruptcy. Section 365(c) of the Bankruptcy Code provides that the debtor may not assume or assign a contract if “applicable law” prohibits a debtor from doing so. The parties agreed that the Lanham Act prohibits the nonconsensual assignment of the franchise agreement, but the court needed to consider two primary tests – the “hypothetical test” and the “actual test” used by courts in evaluating assignment of a contract without consent. The hypothetical test, used by the majority of appeals courts, considers the hypothetical question of whether the debtor may assign the contract, and do not consider the intent of the debtor. The “actual test” looks to the debtor’s actual intention to assign the agreement in the bankruptcy, noting that assignment is only prohibited where the debtor intends to assign the contract to a party who could refuse performance.

Judge Khorrami followed the “actual test,” noting that the franchisee here had no intention of assigning the franchise agreement to a third party. The franchise agreement was one of the franchisee’s most valuable assets in the estate for the potential reorganization of its business. The court noted that not allowing assignment in this circumstance would “stymie any efforts by the debtor to reorganize” and “is contrary to some of the most fundamental objections of chapter 11 relief.” The court did not note that the actual test was better policy, but that it led to the most practical result in this case, where the franchisee has no intention of assigning the agreement to a third party. Notably, however, the Court did not approve the assumption of the franchise agreement – this decision only determined which test should be used. The franchisee and Hilton still need to work on their disputes – or ask the Court to determine – their disputes about certain deficiencies under the franchise agreement. This decision only adds to to the growing circuit split on the application of the “hypothetical test” or the “actual test” in bankruptcy, and may lead a higher court to consider the issue. For franchisees in the Sixth Circuit who desire to reorganize in bankruptcy, however, this decision provides clarity about which test parties may use to determine if a contract could be assumed.