Navigating Franchise Bankruptcy Sales and Competitive Auction Strategies

Mon, 6/2/2025

By Alan Gallup | National Franchise Sales; Newport Beach, Calif. | Reprinted with permission from the ABI Journal, Vol. XLIV, No. 6, June 2025

Franchise businesses, particularly in the retail and restaurant sectors, operate under a unique set of dynamics that distinguish their bankruptcy proceedings from those of independently owned establishments. The intersection of franchisor-franchisee relationships, contractual obligations, and brand considerations introduces complexities that influence the trajectory of bankruptcy sales and auctions. Here we explore what sets franchise bankruptcy sales apart from other retail and restaurant cases, using a recent Pizza Hut franchisee bankruptcy to illustrate how key challenges were navigated and resolved.

Distinctions Between Franchise and Independent Chain Bankruptcies

The bankruptcy process for franchisees differs from that of independent businesses in several key aspects:

Franchisors often possess contractual rights that allow them to influence or control the transfer of franchise assets during bankruptcy. These rights can include approval of potential buyers, right of first refusal, and stipulations regarding the assignment of franchise agreements.

These challenges can be overcome with an understanding of the franchisor’s rights and the elements that might impair the value and recovery to the estate. By collaborating with the franchisor to connect with pre-qualified buyers, the process is expedited, leading to quicker approvals and faster sale completion.

In franchise restaurants, the franchise agreement provides that the franchisor is responsible for providing a cadre of vendors for the franchisee. Independent chains are likely to have a number of vendor contracts that need to be addressed in a sale, along with any patents or trademarks.

Independent chains oftentimes present additional challenges with the quality of the records and accounting methodology. Franchise restaurants are generally required to maintain certain standards and often required to utilize certain bookkeeping and accounting methods.

Franchise assets are intricately linked to the franchisor's brand, POS, and operational systems. This connection can complicate the valuation and sale of assets, as the desirability and functionality of the assets are often contingent upon the continuation of the franchise agreement. In some cases, franchisors have provided operational support or temporary management agreements to stabilize locations during the sales process, preserving asset value. These resources are not readily available to independent chains without significant additional costs.

Debtor in Possession vs. Trustee in Franchise Bankruptcy

When a franchisee encounters financial distress, their restructuring or liquidation process can proceed under different legal frameworks, primarily through a debtor in possession (DIP) arrangement in bankruptcy or through a court-appointed trustee. Each approach presents distinct challenges and considerations for franchisors, creditors, and prospective buyers.

Debtor in Possession (DIP) in Franchise Bankruptcy

• Under chapter 11 (or sub-chapter 5) bankruptcy, a debtor in possession retains control over its business operations while restructuring its debts under court supervision.

• The franchisee continues operating with court approval, negotiating with creditors, landlords, and the franchisor to achieve a feasible reorganization plan, which may include selling some or all the assets.

• Many demands are placed upon the DIP as they attempt to navigate the bankruptcy reorganization process while they continue to address the daily challenges of the struggling business.

• It is difficult for a DIP who will likely have personal guarantees exposed, to distinguish between the best interest of the estate and the best interest of the of the principals of estate. It is incumbent upon the professional advisors to the DIP to guide them through these matters.

Trustee in Franchise Bankruptcy

• In situations when the debtor is unable or fails to effectively manage the business in a manner that serves the best interests of the bankruptcy estate, the court may appoint a trustee to assume control of the franchisee’s assets and operations. The trustee’s role is often focused on stabilizing the business and facilitating the orderly sale of assets to maximize estate value.

• As an independent fiduciary, the trustee assumes responsibility for overseeing the franchisee’s assets and operations. In carrying out this role, the trustee may utilize the franchisee or existing management, or, where warranted, retain outside professionals to support key functions such as accounting, human resources, and operational management. Although the engagement of such professionals can significantly increase administrative costs, their contribution often delivers substantial value by preventing the erosion of asset value typically observed in bankruptcy cases.

• A trustee brings added credibility to the process. The market value of the restaurants may be enhanced with a trustee in place versus a DIP, as prospective bidders’ concerns about the soundness of the assets, transparency, and assurance of no successor liability, are assuaged.

Regulatory and Lease Challenges

Franchise operations often involve complex leasing arrangements, which can become contentious in bankruptcy proceedings. Many franchisees operate out of leased locations with terms tied to their franchise agreements.

Many franchisors lease or sublease locations to the franchisee. This creates another area of negotiation with the franchisor if lease modifications are sought. It can create additional friction where the estate seeks to terminate a lease while the franchisor retains an interest in it. Successful bankruptcy cases have incorporated lease assumption and assignment provisions negotiated with landlords, mitigating risks of location closures.

The opportunity to reject certain underperforming leases presents a strong opportunity for the estate to enhance value. Individual locations’ financial performance can be shared with each landlord to facilitate negotiations of reduced rents, extended terms, and other contractual modifications. Landlords facing the prospect of lease rejection with no replacement tenant in sight will often choose to modify leases more favorably for the tenant. A rental reduction of a few thousand dollars per year can result in tens of thousands of additional value to the estate. Similarly, extending the lease term for a successful restaurant with fewer than 10 years of remaining property control can increase the value of that asset by 10 to 20% or more.

Franchise Agreements and Bankruptcy: Navigating a Complex Landscape

Central to any franchise relationship is the franchise agreement — the legally enforceable contract that delineates the rights and responsibilities of both the franchisor and the franchisee. In the context of bankruptcy, these agreements are considered executory contracts, as they involve continuing duties from both parties. The treatment of such contracts in bankruptcy is pivotal and varies across jurisdiction.

In certain jurisdictions, courts require the franchisor’s consent before allowing a debtor-franchisee to assume a franchise agreement—even when there is no plan to assign it to a third party. This highlights the critical role of franchisor approval in any reorganization effort. In other jurisdictions, courts will allow the bankrupt estate to assume the franchise agreements and further assign those agreements to a new franchisee buyer, provided the buyer can demonstrate adequate assurance of future performance.

With a significant portion of the business value associated with goodwill derived from the branded image of a franchise, the assignment of franchise agreements is essential to optimizing recovery for the estate. In some situations, the franchisor will limit prospective buyers to individuals already known or preferred by the franchisor. When franchisors limit eligible buyers to those within their preferred network, it can significantly narrow the pool of prospective purchasers—potentially suppressing sale price and limiting outcomes for creditors.

Addressing the Challenge

To address these restrictions, franchisors and debtors frequently employ pre-negotiation strategies, such as early restructuring discussions and conditional assignment agreements. These agreements afford franchisors control over the sale process and the selection of the buyer, while also establishing a structured pathway that can expedite the sale and maximize recovery for the estate.

Some debtors strategically select bankruptcy venues with more favorable legal precedents, granting greater flexibility in assuming and assigning franchise agreements. In such cases, prospective buyers must still undergo thorough screening to ensure they meet reasonable standards as quality franchisees and can provide adequate assurance of future performance.

Most commonly, the debtor or debtor’s advisors work with the franchisor so that a broad number of prospective buyers can participate in the sale process and thus optimize the recovery. This requires a collaborative effort by both the franchisor and the estate.

In nearly all cases, it is essential for the sale process to recognize the franchisor’s role in the approval process. This involves addressing the prospective buyer’s future obligations under the franchise agreement, including advertising commitments, remodel requirements, management training, franchise fees, transfer fees, and franchise term limitations. These factors directly affect the business's value and, consequently, the estate’s recovery.

Selecting the Sale Process

There are two fundamental approaches to the sale process of franchise restaurants.

The prevailing approach typically involves a sealed bid process, where marketing materials, a confidential information memorandum, and due diligence documents are prepared for pre-screened, qualified bidders. A bid deadline and prescribed bid format are established, with the estate, in consultation with its advisors, negotiating purchase agreements, selecting a stalking horse bidder, and soliciting overbids.

An alternative approach, the live auction, has the potential to generate a higher recovery for the estate, but certain conditions must be met for its success. The effectiveness of a live auction largely depends on the principle of supply and demand. It thrives when a substantial number of prospective buyers are assembled in a single location at the same time. The presence of multiple bidders fosters both confidence and competition, ultimately leading to higher bids.

Another condition for the success of live auctions is ensuring that stakeholders and parties of interest are not only present to observe but are also empowered and prepared to negotiate any last-minute concessions on behalf of the franchisor and/or landlords during the auction.

Case Study: The Pizza Hut Franchisee Bankruptcy and Auction

The bankruptcy of EYM Pizza[1], a significant Pizza Hut franchisee, provides a practical illustration of the complexities inherent in franchise bankruptcy sales. EYM Pizza filed for chapter 11 bankruptcy protection in July 2024, operating approximately 140 Pizza Hut locations at the time.

The franchise agreements for these locations were terminated prior to the bankruptcy filing, placing the estate in a precarious position, as the restaurants could not operate without the franchisor’s approval. Additionally, the franchisor held near absolute discretion in determining which prospective buyers would be approved to acquire the franchise locations. Because the franchise agreements were terminated, there were no franchise agreements to assign.

The individual unit economics revealed that approximately one-third of the restaurants were operating at a loss, another third broke even, and the remaining locations generated a reasonable profit. Rent for these restaurants was generally low, offering limited potential for significant value improvements through rent reductions. The franchisor was approached to consider royalty or advertising concessions to enhance the viability of the loss-making stores, thereby allowing them to remain open, but no concessions were offered at that time. As a result, the debtor closed the underperforming locations, rejected the leases, and shifted focus to the sale of the remaining 77 restaurants.

In preparation for the sale, it was discovered that the franchisor had specific Capital Expenditure (CapEx) requirements for each restaurant, which would be imposed upon acquisition by a new franchisee. Through negotiations with the franchisor, the scope and timeline for these CapEx requirements were adjusted to provide the new buyer with additional time to complete the improvements. As CapEx is generally considered part of the acquisition cost, any reduction or delay in these requirements benefited the estate by enhancing the value of the assets.

The CapEx requirements created a situation where the marginal restaurants held negative value. To mitigate this, the estate explored the option of selling the leases and equipment outside of the brand (de-branding), thereby avoiding the financial impact of the CapEx requirements and new franchise fees. However, no acceptable offers were received for de-branding these locations, as a surplus of closed restaurants was available in the market at that time.

Given the market conditions in the fall of 2024 and the limited interest in the brand and this opportunity at that time, it was determined that a live auction would likely fail to attract enough bidders to achieve a favorable outcome. As a result, a sealed bid sale process with broad marketing efforts was implemented; however, no acceptable stalking horse bid was received.

The debtor subsequently informed the franchisor that the marginal restaurants would be closed unless additional concessions were made that would provide sufficient value to the estate. Although the franchisor initially rejected this request, an agreement was eventually reached after the debtor began closing those restaurants. This agreement allowed the debtor to continue operating the marginal locations, ultimately enabling the estate to generate value through the auction process.

It was determined that the revised franchisor concessions revitalized market interest and that there was then enough interest to conduct a live auction. A decision was made to proceed with a live auction and to present the franchise concessions in the revised offering material. More than a dozen prospective buyer groups participated in the day-long auction.

During the auction, the franchisor, Pizza Hut LLC, acquired 18 locations across Georgia, Illinois, and Wisconsin, more than doubling its company-owned store count, as Pizza Hut continues to operate primarily as a franchised brand. The remaining 59 locations were purchased by various bidders, including PZH Foods Inc., Valor Pizza LLC, KK Mgmt, PH Hospitality Group, and Shantilal Patel.

The bankruptcy proceedings concluded with a court-supervised auction of 77 restaurants, resulting in a total recovery of approximately $12 million.

Conclusion

The bankruptcy sales and auction processes of franchise businesses are markedly more complex than those of independent retail and restaurant entities. The interplay of franchise agreements, franchisor rights, and brand considerations necessitates a nuanced approach to navigating these proceedings. The EYM Pizza bankruptcy case exemplifies these intricacies, offering valuable insights into the multifaceted nature of franchise bankruptcy sales and the critical factors that influence their outcomes. Understanding these nuances enables stakeholders—from franchisors and creditors to potential buyers—to better navigate the challenges and opportunities presented by franchise bankruptcy sales and auctions, ensuring more strategic decision-making and operational stability in distressed asset scenarios.

[1] EYM PIZZA L.P. and EYM PIZZA OF ILLINOIS LLC Bankruptcy (4:24-bk-41669), Texas Eastern Bankruptcy Court.

Reprinted with permission from the American Bankruptcy Institute ABI Journal, Vol. XLIV, No. 6, June 2025