Developing Ninth Circuit law, Bankruptcy Judge René Lastreto, II, of Fresno, Calif., ruled under the federal Lanham Act and California’s Franchise Relations Act that a franchisee cannot assume a franchise agreement if the franchisor objects.

The corporate debtor owned and operated six fast-food restaurants under a franchise agreement. The debtor intended to confirm a chapter 11 plan and continue operating the restaurants by assuming the franchise agreement under Section 365(a). The debtor did not intend to assign or sell the assets or the franchise agreement. The debtor pledged to cure monetary defaults promptly and to demonstrate adequate assurance of future performance.

The franchisor objected to the debtor’s motion to assume. The October 10 opinion by Judge Lastreto leaves the impression that the franchisor did not want the debtor to continue operating restaurants under its flag. However, the franchisor had identified a third party to whom the debtor could sell the locations with the franchisor’s blessing.

The franchisor contended that Section 365(c)(1), combined with the Lanham Act and the CFRA, allows a franchisor to nix the assumption of a franchise agreement, even if the debtor does not intend to assign or sell the business. The subsection provides that a debtor or trustee

may not assume or assign any executory contract . . . , whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if — (1) (A) applicable law excuses a party, other than the debtor . . . from accepting performance from or rendering performance to an entity other than the debtor . . . , whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (B) such party does not consent to such assumption or assignment. [Emphasis added.]

The Two Tests

Judge Lastreto explained how the circuits are split on the interpretation of Section 365(c)(1). Under the so-called hypothetical test adopted in the Third, Fourth, Ninth and Eleventh Circuits, a debtor may not even assume a contract if the trademark holder objects, because the subsection says that the debtor “may not assume or assign.” [Emphasis added.] The Ninth Circuit authority is Catapult Entertainment, Inc. v. Perlman (In re Catapult Enter.), 165 F.3d 747 (9th Cir. 1999).

Under the so-called actual test, the First and Fifth Circuits interpret the subsection to mean that a debtor may assume an agreement if the trademark holder objects, but may not assign the agreement over objection.

Judge Lastreto admitted that the “hypothetical test often has devastating effects on the ability of Chapter 11 debtors to reorganize, especially when a debtor franchisee depends upon maintenance of the franchise for any kind of reorganization.” However, he said that “the Ninth Circuit has spoken to this issue unambiguously in Catapult, and the court is obligated to apply the hypothetical test to this case.”

Significance of the Word ‘Or’

Catapult barred assumption of a nonexclusive patent license, leaving Judge Lastreto to decide whether the hypothetical test also applies to franchise agreements covered by the Lanham Act and the CFRA.

Judge Lastreto found no controlling Ninth Circuit law to say whether federal trademark law qualifies as “applicable law” under Section 365(c)(1). However, a Nevada district court decision persuaded him to conclude that trademark law is “applicable law.” N.C.P. Mktg. Grp. v. Blanks (In re N.C.P. Mktg. Grp.), 337 B.R. 230, 236 (D. Nev. 2005), aff’d 279 Fed. Appx. 561 (9th Cir. 2008), cert. denied, 556 U.S. 1145 (2009).

Judge Lastreto held that the franchisor’s “rights under the Lanham Act represent ‘applicable law’ that excuses [the franchisor] from accepting performance from or rendering performance to an entity other than [the debtor] under § 365(c)(1).” He reached the same conclusion regarding the CFRA.

Under the CFRA, he said that the “relevant question” was whether there was “a hypothetical third party to whom [the debtor] might be excused from accepting or rendering performance because such a hypothetical third party might not qualify for [the franchisor’s] standards for approval under CFRA.” Consequently, state law was an alternative ground for denying the motion to assume.

Judge Lastreto denied the debtor’s motion to assume the franchise agreement.

Note

We reported a decision handed down in July by Bankruptcy Judge Mina Nami Khorrami of Columbus, Ohio, who took sides with the minority of circuits and predicted that the Sixth Circuit would adopt the “actual test” for Section 365(c)(1). Judge Nami Khorrami held that “the plain language of the statute” does not prohibit a debtor “from assuming an executory contract if it does not intend on assigning it.” In re Welcome Group 2 LLC, 660 B.R. 874 (Bankr. S.D. Ohio July 10, 2024).

No appeal was taken from Judge Nami Khorrami’s decision. In her opinion, she noted that a majority of bankruptcy courts follow the actual test. To read ABI’s report on Welcome Group, click here.

Chances are the debtor in the case before Judge Lastreto will sell the business and moot the assumption question, obviating the possibility of bringing the circuit split to the Supreme Court on a petition for certiorari. Too bad. Circuit splits like this need to be resolved.