Below is a Guest blog post authored by our own Michael Viscount:

A concern for franchisees is the impact on license agreements for intellectual property when the licensor files bankruptcy and seeks to shed itself of burdensome obligations under license agreements. The impact on the licensee is different depending on the type of IP licensed. And, to further complicate matters, with regard to impact on trademarks the results can be different depending upon where the licensor files for bankruptcy.

Registered trademark symbol on a red backgroundRejection of Executory Contracts – An Overview

The scenario arises because Section 365 of the U.S. Bankruptcy Code allows the debtor party to reject certain contracts that are burdensome.

License agreements can be rejected, and this includes licenses for trademarks and other intellectual property. Under Section 365, when a license is rejected, the debtor party is excused from all obligations.

In 1985, in a case involving intellectual property licensed by Lubrizol Enterprises, the 4th Circuit Court of Appeals in Virginia allowed the rejection of the license agreement and ruled that the rejection by the licensor terminated the licensee’s right to use the intellectual property.

As can be imagined, this caused a stir in the business community, particularly in sectors like the franchise business.

In reaction, Congress amended Section 365 by adding subsection (n) to give licensees of certain types of intellectual property protection – under 365(n) the licensee of IP can either treat the license as terminated or continue to use the IP for the balance of the term of the contract provided all royalties are paid without the right of set off, and without the ability of the licensee to receiver any support from the licensor.

Impact on Trademark Licenses

When Congress amended Section 365 by adding 365(n), it also defined what it meant by the term intellectual property. The definition found at Bankruptcy Code Section 101(35A) does not include a reference to trademarks. The result is that cases are all over the board on whether trademark licenses have the protection from rejection codified in Section 365(n).

Some bankruptcy courts in the 4th Circuit and elsewhere hold that since the definition of IP does not include trademarks, the 4th Circuit’s analysis in Lubrizol dictates that the rejection of a trademark license terminates the rights of the licensee to use the trademark, i.e., no 365(n) protection. Courts in other jurisdictions hold that to treat trademark licenses differently cannot be supported, and these courts find equitable reasons to allow licensees to continue to use trademarks after license rejection.

The equitable approach was discussed in the 3rd Circuit’s 2010 ruling in Exide Techs. The 3rd Circuit did not decide the issue in Exide. But in a concurring opinion, Judge Ambro wrote that bankruptcy courts can fashion equitable protections for rejected trademark licensees. That judge is a former business bankruptcy lawyer whose opinions on bankruptcy are often cited favorably, and his concurrence in Exide was applied by at least one judge in New Jersey to support the equitable protections approach.

In 2012, the 7th Circuit weighed in in a case involving the bankruptcy of Sunbeam Products, when it held that the rights of the trademark licensee “do not vaporize” by rejection. The 7th Circuit rejected the analysis of the 4th Circuit in Lubrisol setting up a clear circuit split.

In 2016, a case from New Hampshire, involving licenses for all sorts of IP granted by Tempnology, LLC, started in the Bankruptcy Court, went to a 3-judge Appellate Panel and then to the full 1st Circuit. By the time the Tempnology case got to the full circuit court of appeals, two judges had ruled against the trademark licensee (Bankruptcy and BAP dissent) and two others had ruled in favor. The Bankruptcy Appellate Panel majority of two judges relied heavily on the 7th Circuit’s analysis in Sunbeam in finding that trademark licensees have the same protections as licensees of other IP.

In a split decision, the full 1st Circuit held that:

  1. Licensees of trademarks do not have protection under 365(n).
  2. It is not appropriate to craft equitable remedies to protect trademark licensees – rejecting the Judge Ambro approach
  3. The analysis of the 7th Circuit in Sunbeam was rejected
  4. The analysis of the 4th Circuit in Lubrizol was followed.
  5. The rights of the trademark licensee were rejected.

Conclusion

If you are a franchisee or other license holder and your franchisor/licensor files bankruptcy, until the Supreme Court resolves the split between the Circuit Courts, the outcome and impact on future rights to use trademarks may very well depend on the state in which you find yourself litigating the issues.


Michael J. Viscount Jr. is a partner in Fox’s Financial Restructuring & Bankruptcy Department, based in its Atlantic City and Philadelphia offices. He can be reached at 609.572.2227 or mviscount@foxrothschild.com.

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Each year the ABA Forum on Franchising Annual Meeting offers a regulatory roundup on state disclosure and registration issues consisting of a panel of franchise examiners from some of the most difficult registration states. This past year in Palm Desert regulators from California, Maryland and Washington offered their tips, tactics and recommendations for preparing and registering franchise disclosure documents compliant with federal and state law.   Some of the most interesting takeaways to keep in mind while you prepare your FDD include:

  1. Item 3. For any litigation matter that must be disclosed in Item 3 of the FDD make sure you include all pertinent facts even if the franchisor entered into a settlement agreement with the franchisee where the parties promise confidentiality. The franchisor must disclose the settlement terms regardless of any nondisclosure agreement.
  2. Item 5. Do not forget the 14 day rule requires that no money be paid or any agreements be signed until 14 calendar days pass. California regulator, Theresa Leets, panned the surprising number of FDDs that include territory deposit agreements, option agreements or other agreements requiring the payment of a fee that is not disclosed in Item 5 of the FDD and is collected even before an FDD is distributed.   Make it clear in Item 5 when you require any payment and make sure it does not run afoul of the 14 day rule or you will get comments from state regulators.
  3. Item 10. Be mindful of indirect financing to franchisees by affiliates if you are registered in California. Although franchisors are exempt from California’s Finance Lender Law when offering direct financing to franchisees, the same exemption does not apply to affiliates.
  4. Item 13. Be sure to include a description of all intercompany license agreements In Item 13.
  5. Item 21. Conduct due diligence on your accountant. Maryland Deputy Commissioner, Dale Cantone, reminds franchisors that just because someone has a shingle, you cannot assume he or she is licensed to perform audits. During the past year eager newly hired regulators in Maryland took it upon themselves to check the license status of franchisor’s financial statement auditors and found many were unlicensed. This causes huge issues for franchisors. Use a licensed certified public accountant.

Even seasoned practitioners and franchise systems can face pitfalls when registering with states so hopefully these tips should help speed that process along!

Last year at the ABA Forum on Franchising Annual Meeting, the programming included a seminar entitled “Between You and Me: A Toolkit to Counsel in and to Smaller Systems.” The purpose of the session was to provide new in-house lawyers an overview of some of the day-to-day legal conundrums that growing brands face and instructions on how to face such issues.

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One of the most interesting and important issues addressed during the panel discussion was the franchise application process. Growing brands are often eager to welcome any prospect willing to pay the initial franchise fee. However, all franchise systems have a reason to be selective in the application process. Once a brand meets that critical mass of 50-100 units, it can often afford to be more discerning. Below are some tips to ensuring that a franchise system only accepts the best:

  1. Confirm supporting documents for financing. A financing arrangement may be straightforward if the franchisee is obtaining traditional financing from an institutional lender. However, if a franchisee is expecting a capital investment from friends and family, then you should still require documentation. You do not want a situation where a franchisee is a few months into development and the investing sibling or uncle backs out of the deal.
  2. Do not just run a background check and throw it in a file. Make sure you thoroughly review the results. The panelist described some war stories about clients ordering a background check on owners but failing to analyze it. The background check revealed some serious red flags about the prospect. The franchisor then faced issues with the franchisee down the line that could have been avoided had the franchisor just reviewed the results in the first place.
  3. Always conduct a search of the lists maintained US. Treasury’s Office of Foreign Asset Control (OFAC). OFAC maintains a list of all people and entities whose assets are blocked by the US government as a result of sanctions. You can conduct your own search at no cost online and it takes under a minute.
  4. Request supporting documentation such as tax returns and account statements to verify assets. Dig deeper when evaluating a prospective franchisee’s financial wherewithal.
  5. Don’t forget to determine the applicant’s citizen or immigration status.

While there is no surefire way to avoid all problem or underperforming franchisees, developing a comprehensive screening process is one method in decreasing the number.

Succession plans ask what will happen when the principal owner/operator is not available.

Copyright: deklofenak / 123RF Stock Photo

A succession plan may be coordinated with an estate plan, which contemplates dispositive transfers through sale, and other means. The disposition can also occur by wills and trusts, buy-sell agreements, augmented by life insurance and family partnerships. A valuation of the business is often a key element in any exit strategy, and the succession plan, estate plan and valuation should be coordinated. These issues need to be coordinated with any restrictions that may exist under a franchise agreement on sale or disposition. In addition, state law may invalidate or alter some of these restrictions. For these reasons, the succession planning probably should be coordinated with lawyers familiar with both franchise law and estate planning.

Confronting the Key Questions

  • How will the business continue if the operator unexpectedly exists, becomes incapacitated or dies?
  • Should the business be continued or liquidated in the unexpected exit of the operator?
  • Would it be better if the business were sold in a planned sale?
  • In the absence of the operator, who will be on the making these key decisions and should a team be established now?

All of these issues require business and tax planning by a team of professionals.

Make the Decisions.

For the next generation, will ownership be separate from management? If the business is transferred to the children, do they have the experience, skill and motivation to take over? If not, the compensation plan to retain key employees needs to executed now.

Who will be on the succession team and trusted advisers? These specialists should include a franchise attorney, CPA or financial advisor, valuation specialist and a tax savy estate planning attorney, Judgment calls need to be made and the franchisee needs to be well informed.

As Benjamin Franklin said, “Those who fail to plan, you are planning to fail.” Make your succession plan decisions early, and with good counsel to maximize your goals.

The National Restaurant Association recently released a new guide for restaurant operators looking for more information on how to increase their cybersecurity efforts.

In 2015, the National Restaurant Association released its first manual for restaurant owners called “Cybersecurity 101: A Toolkit for Restaurant Operators” [PDF] which outlined best practices on five core areas of cybersecurity planning. This past month, the National Restaurant Association built on this manual with the release of “Cybersecurity 201: The Next Step,” [PDF]  which provides restaurant-specific type guidance. The National Restaurant Association utilized the expertise of technology personnel from top multi-unit restaurant companies. The guide is a must-read for any franchise system in the food service space.

The guide takes the cybersecurity framework prepared by the National Institute of Standards and Technology (NIST) and adapts it for use in the restaurant hospitality industry. Restaurant franchise systems can learn how to apply the NIST standards by reviewing the real world hypotheticals.

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For example, there is “Sam” whose restaurant experiences a data compromise of customer credit cards. After a forensic team descends on his business, Sam quickly realizes how little he understands about who has access to his computer software, which vendors service his POS Systems and how often he upgrades hardware. The result? Sam lost loyal customers and was slapped with a hefty fine from his credit card processors.

In addition to three other nicely detailed case studies, the guide shows how almost 100 different NIST categories can be applied in a restaurant setting, grades cybersecurity action items from most to least urgent and provides a glossary of cybersecurity terms.  Even the most cyber savvy restaurant systems should find the guide full of useful information.

Michelle Webster, a franchise financial legal examiner with the State of Washington Department of Financial Institutions, took a few minutes at the start of the ABA Forum on Franchising’s Annual Meeting seminar on disclosures to discuss the registration of franchise brokers in Washington. The main takeaway? If you sell franchises in Washington, then there is a good chance you need to register.

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Third parties selling franchises on behalf of a franchisor must register as franchise brokers. The Washington Franchise Investment Practice Act prohibits a franchise broker from offering or selling franchises in Washington unless the seller is registered separately with the Washington Securities Division.    Franchisors, subfranchisors and their respective officers, managers, members, directors and employees are excluded from the broker registration requirements.   However, Ms. Webster reminded attendees that employees of an affiliate “no matter now integrated the franchisor and its affiliated companies may be.”  She explained the common example of where a franchise system offers multiple brands operated under separate legal entities, then employees of an affiliate, subsidiary or parent of the franchisor must be registered with the Washington Securities Division as a broker for all of the brands where the seller is not employed.

Remember that if you, as a franchisor, engage franchise brokers in the State of Washington, then make sure they are separately registered or else you will receive a comment letter.  The Revised Washington Code declares it unlawful for any franchisor, subfranchisor, or franchisee to employ a franchise broker unless the franchise broker is registered.  Therefore, it is important to make sure that anyone selling on behalf of your franchise system is registered or exemption.  The initial application fee is $50 and there is a $25 annual renewal fee.  The standard form can be accessed here [PDF] or you can apply online here.

International franchisors inbound into the U.S. face a complex set of business decisions and legal regulations.  Even seemingly simple tasks–like properly executing a franchise registration application–can become a time-consuming and expensive endeavor (especially where the franchisor does not have an authorized signatory in the U.S.).  Knowing how and when to request waivers can save time and money.

Notary public working on a document with stamp and padsFranchise registration applications must be signed by the franchisor’s authorized representative. In addition, some of the signatures must be notarized.  Generally speaking, satisfying this requirement requires having the signature notarized at a U.S. embassy or obtaining an apostille. U.S. embassies will have policies regarding scheduling appointments, what documents to bring, and how to prepare documents to be notarized. In addition, notarial services can be significantly more expensive at the embassy than stateside. Finally, embassy representatives are not used to seeing standard franchise applications and disclosure documents, which can cause confusion and delays.

Alternatively, the franchisor can obtain an apostille, a specialized certificate that verifies that a document is legitimate and authentic. Apostilles are only effective between countries that are parties to the Hague Apostille Convention (which is many). First, the franchisor must translate the documents into the local language so they can be notarized under local law. Then the franchisor must obtain an apostille, which ensures the documents and signature are accepted by the U.S. examiner.

Unfortunately, both options can be costly and time-consuming. Therefore, inbound international franchisors and their counsel should inquire whether the U.S. examiner will grant a waiver if obtaining an apostille or notarization will create a financial hardship and undue delay. Examiners understand there are specific difficulties to international franchising and may waive the notary requirement or permit the signatory to obtain notarization when he or she is next in the U.S.  Franchisors or counsel should contact examiners to determine how to properly make the request.  Some examiners will accept requests made in a cover letter to the application or in a preliminary email exchange.

International franchising inbound to the U.S. can be very complex. Obtaining a waiver of the notarization requirement is one less headache, which allows franchisors and their counsel to focus on the substantive issues.

In December, we wrote that the NLRB had issued a decision overturning Browning-Ferris’ joint employer test and returning to the previous standard for determining joint employment.  That decision in Hy-Brand Industrial Contractors was seen as a return to sanity by employers and pro-business groups.

Unfortunately, the NLRB announced today that it had vacated the Hy-Brand decision due to the fact that one of its members who heard the case had a conflict.  Member William Emmanuel’s law firm had participated in the Browning-Ferris case.  Since Hy-Brand directly addressed the Browning-Ferris standard, the NLRB Inspector said that Emmanuel should not have participated in the Hy-Brand case.

The Browning-Ferriss case set forth a standard for joint employment that noted that businesses could be joint employers simply because they reserved the right to control the actions of the other entity’s employees, even if they never actually exercised that authority.  That, of course, created great consternation in the franchise setting as franchisor agreements may typically have a broad right to address franchisees’ employee issues that may never actually be exercised.  Franchisors, conscious of protecting their brand’s image, usually inserted such clauses to insure that a franchisee’s employees would not denigrate the brand.

It is not clear at this point when Hy-Brand will be reheard or if the issue will come before the Board in another case.  In the meantime, employers are stuck with Browning-Ferriss.  To the extent that employers revised franchise agreements after the Hy-Brand decision was issued, they should have those agreements reviewed by legal counsel.

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Maybe you are an international company with a successful brand that sold a master franchise or area representative right in California without knowing the robust state franchise registration laws. Maybe you are an up-and-coming pizza joint operating in Los Angeles that decide to sell a business associate the right to operate a location under you brand with your recipes in exchange for a fee without considering if it was a “franchise.”

You did not mean to violate the California Franchise Investment Act but it turns out you did. What can you do? Is there any way to “fix” your violation? The answer is yes. Although, California has a very robust and stringent state registration and disclosure process, it also provides a fair remedy for curing these non-compliance issues. The state wants to encourage self-reporting and rewards a franchisor’s attempt to do so by offering a process to bring finality to an illegal sale.

If you or your franchise system client sold a franchise in California without pre-registering with the California Department of Business Oversight, then you will need to prepare a Notice of Violation.   Instructions on preparing a compliant Notice of Violation can be found here. This is a separate application than the general application for registering the franchise offering.   Once approved, you will submit the Notice of Violation to the franchisee.  The Notice of Violation will describe to the franchisee the nature of the violation and the franchisee’s rights under the law.   However, delivery of the Notice of Violation will also start a 90 day statute of limitations clock running shortening the statute of limitation of 4 years from the illegal act or 1 year from when the franchisee discovers the violation.

In most cases, this is a much better option for a franchise system rather than waiting to see if a franchisee becomes disgruntled and reports the system to the California regulators.

Many franchise agreements contain a provision that restricts a franchisee from hiring or soliciting the employees of the franchisor or other franchisees. A class action lawsuit that was recently filed in the Eastern District of Texas could require removal of this type of provision in the future. Though this suit is only at the initial complaint phase, the outcome of this case could help shape the future of franchisee restrictive covenants.

In Ion v. Pizza Hut, LLC, Kristen Ion (“Ion”) filed this complaint on behalf of similarly-situated managers of Pizza Hut restaurants. Ion claims that Pizza Hut, LLC (“Pizza Hut”) has colluded with all of its franchisees to engage in anticompetitive behavior in violation of the Sherman Act. Further, Ion claims that the restrictive provision is a naked restraint on competition and a per se violation of the antitrust laws.

The provision at issue, as seen in many franchise agreements, forbids a franchise owner from hiring or soliciting any employees of the franchisor, its units, or any other franchise. Ion claims that this restraint eliminated a franchisee’s incentive to offer competitive employment packages to management personnel and restricted the mobility of such personnel. Further, Ion argues that this restraint lowered salaries and benefits due to the limited job marketplace available to Pizza Hut personnel. Ion claims that the training she received from Pizza Hut is only transferable to other Pizza Hut units.

While Ion consistently refers to the fact that each Pizza Hut franchise is its own independent business that has the right to set its own wages for staff, in the same sentence, she argues that the franchisor and franchisees were “co-conspirators” in the endeavor to suppress those wages and mobility. Further, Ion cites to the continued practice of Pizza Hut and its franchisees to cut employee wages and hours through various policies and argues that this restriction is in furtherance of this purpose (as outlined in various news articles). Lastly, Ion claims that executive compensation and franchisee profit increased at the expense of its low-paid management personnel.

However, based on the facts in the complaint, it seems that Ion never attempted to find another job outside of the Pizza Hut franchise system to support her proposition. Further, the citations to commentary by scholars and professors on the topic logically leads one to assume that there is not yet a basis in prior case law for the requested remedy.

The outcome of this case could substantially and materially alter the scope of franchisee restrictive covenants. Any outcome in favor of Ion would trigger an immediate need for revisions to a franchise agreement that contains this restriction and it is important to keep watch of this case.