Antitrust Law Daily Wrap Up, FRANCHISING & DISTRIBUTION—7th Cir.: Bankruptcy order deeming franchise agreement expired stayed pending appeal on the merits, (Feb 11, 2014)

By Linda O’Brien, J.D., LL.M.

In the bankruptcy proceeding of a restaurant franchisee, the bankruptcy court order deeming that the franchise agreements and equipment leases had expired and restaurant building leases were rejected was stayed pending resolution of an appeal on the merits, the U.S. Court of Appeals in Chicago has ruled (In re A&F Enterprises, Inc. II, February 7, 2014, per curiam). Thus, the district court’s order denying the debtor franchisee’s motion for a stay was reversed.

Ali Alforookh manages and operates restaurants under franchise agreements with International House of Pancakes (IHOP). He created several companies to hold the IHOP franchises. Alforookh and his companies subsequently filed Chapter 11 bankruptcy petitions and listed their primary assets as 17 separate IHOP agreements and corresponding building and equipment leases. A&F and IHOP had three separate contracts for each restaurant: (1) a franchise agreement; (2) building lease; and (3) equipment lease. Under Bankruptcy Code §365(d), a debtor may assume or reject executory contracts any time before the confirmation of the plan; however, unexpired leases of nonresidential real property must be assumed within 120 days. A&F did not assume the building leases within 120 days and did not seek an extension. IHOP contended that the building leases were therefore rejected and, under the cross-default provisions of the agreements, the franchise agreements and equipment leases had expired.

The bankruptcy court issued orders deeming the building leases rejected and the franchise agreements and equipment leases expired. A&F appealed the decision to the district court and also sought a stay pending appeal. In denying the debtor franchisee’s motion for a stay of the bankruptcy court order, the district court found that A&F’s arguments lacked merit since Bankruptcy Code §365(d) contained no exception for leases tied to franchises. A&F Enterprises appealed.

The appellate court determined that, since the debtor franchisee demonstrated a likelihood of success on the merits of its appeal and the potential harm to the franchisee was greater than that to the franchisor, a stay was warranted. Under the terms of the three contracts for each restaurant, A&F was unable to assume the building leases without assuming the franchise agreements. Since the leases and franchise agreements must be assumed or rejected in tandem, the longer time limit should apply. The court noted that Chapter 11 proceedings are premised on giving debtors a full opportunity to reorganize. The franchise agreement was the dominant contract and should be given priority.

Additionally, in balancing potential harms, A&F would permanently lose its franchises without a stay. The loss of the restaurants would end A&F’s efforts for reorganization. Although A&F would be compensated for the loss of the franchises, the loss would be irreparable since damages may be inadequate due to difficulties in valuation. Damages were also insufficient to protect Alforookh’s interest in continuing to operate his business of choice. Finally, IHOP did not allege any material breaches that would warrant termination of the franchise agreements.

The case is No. 13-3192.

Attorneys: Michael C. Moody (O’Rourke & Moody) for A&F Enterprises, Inc., Abubecker, Inc., AEA Enterprises, Inc. and East Peoria Enterprises, Inc. Robert N. Hochman (Sidley Austin LLP) for IHOP Franchising, LLC and IHOP Properties, Inc.

Companies: A&F Enterprises, Inc. II; IHOP Franchising LLC

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