California Bankruptcy Court Holds that Lanham Act and California Franchise Relation Act Prevent Assumption of Franchise Agreements Under “Hypothetical Test”

On October 10, 2024, the United States Bankruptcy Court for the Eastern District of California (the “Bankruptcy Court”) entered a decision in the case of In re Pinnacle Foods of California, LLC[1] addressing the intersection of Title 11 of the United States Code (the “Bankruptcy Code”), the Lanham Act, and the California Franchise Relation Act (the “CFRA”).

Pinnacle Foods of California, LLC (the “Debtor”) owned and operated six Popeyes fast food restaurants in Fresno and Turlock, California under certain Franchise Agreements (the “Franchise Agreements”) with Popeyes Louisiana Kitchen, Inc. (“Popeyes”).  In conjunction with its Chapter 11 plan of reorganization, the Debtor filed a motion to assume the Franchise Agreements (the “Motion to Assume”) pursuant to Bankruptcy Code section 365(a), which allows a Chapter 11 debtor to assume or reject any of its executory contracts[2] or unexpired leases.[3]  Popeyes  objected to the Motion to Assume, asserting that Bankruptcy Code section 365(c)(1) prohibited assumption of the Franchise Agreement under the “hypothetical test,” described below, absent Popeye’s consent—which consent would not be forthcoming.

Bankruptcy Code Section 365(c)(1)

While Bankruptcy Code section 365(a) allows a debtor-in-possession, such as the Debtor, to assume executory contracts with third parties, that section is qualified by section 365(c).[4]  Under section 365(c)(1), a debtor-in-possession may not assume or assign an executory contract if “applicable law” excuses the contract counterparty from accepting performance from, or rendering performance to, a non-debtor third party, and such counterparty “does not consent to such assumption or assignment . . . .”[5]  Though seemingly straightforward, the language of section 365(c) has resulted in two differing theories of application: the (i) “hypothetical test”; and (ii) “actual test.”

Under the “hypothetical test,” even where a debtor merely seeks to assume an executory contract and continue to render performance thereunder (rather than subsequently assign the contract to a third party), “the counterparty may still withhold its consent and block assumption if there is a hypothetical third party to whom the debtor might assign its contract rights but as to whom the counterparty would be excused from performing for under applicable law.”[6]  In contrast, under the “actual test,” the contract counterparty can only withhold consent under section 365(c)(1) where there is “an actual third party to whom the counterparty would be forced to accept performance other than the debtor with whom the counterparty had contract.”[7]

“Applicable Law” in Pinnacle Foods

“Applicable law” is any law that applies to the contract at issue other than bankruptcy law. From the outset, the Bankruptcy Court noted that the Ninth Circuit Court of Appeals falls in the majority in that 25 years ago, in the case of  Catapult Enter., Inc. v. Perlman (In Re Catapult Enter.),[8] it held that the hypothetical test is the correct theory of application as to section 365(c)(1) and the determination of whether a debtor may assume an executory contract.  As the Ninth Circuit unambiguously enunciated the test applicable to federal courts residing in its jurisdiction, the Bankruptcy Court was required to apply the hypothetical test to the instant controversy, much to the Debtor’s detriment.

The Bankruptcy Court first analyzed the Lanham Act,[9] ultimately holding that it properly qualified as “applicable law” for purposes of the Debtor’s attempted assumption of the Franchise Agreements.  Specifically, any transfer of the Franchise Agreements would naturally require the transfer and use of the trademarks associated with such agreement.  Furthermore, the Lanham Act governs federal trademark law.  Thus, it must be considered “applicable law” in the context of assumption of franchise agreements.  The Bankruptcy Court further noted that, under the Lanham Act, a trademark owner has both the right to assign the trademark as well as the duty to control the quality of the goods associated with, and sold under, that particular mark.  As such,

Because the owner of the trademark has an interest in the party to whom the trademark is assigned so that it can maintain the good will, quality, and value of its products and thereby its trademark, trademark rights are personal to the assignee and not freely assignable to a third party.[10]

Put simply, a trademark owner naturally has the ability to deny a potential licensee the use of the subject trademark and associated goodwill.  Therefore, the Lanham act is “applicable law” that excuses Popeyes from accepting performance from, or rendering performance to, a third party such that its consent is required for the Debtor to assume the Franchise Agreements under the hypothetical test.  Absent consent, the Debtor may not assume the Franchise Agreements.

The Debtor skirted the issue presented by application of the Lanham Act, instead arguing that the CFRA[11] preempts the Lanham Act as to trademarks as part of a conveyance of rights under a franchise agreement.  Specifically, as the Debtor pointed out, the CFRA states, “[I]t is unlawful for a franchisor to prevent a franchisee from selling or transferring a franchise, all or substantially all of the assets of the franchise business, or a controlling or noncontrolling interest in the franchise business, to another person.”[12]  Thus, the Debtor argued, it is unlawful for a franchisor to prevent the transfer or assignment of a franchise and its assets, and Bankruptcy Code section 365(c) is not implicated. 

However, the Bankruptcy Court, and Popeyes, noted that CFRA section 20028 further states that such a prohibition on assignment or transfer is unlawful “provided that the person is qualified under the franchisor's then-existing standards for the approval of new or renewing franchisees . . . .”[13] Furthermore,

Notwithstanding [section 20028(a)], a franchisee shall not have the right to sell, transfer, or assign the franchise, all or substantially all of the assets of the franchise business, or a controlling or noncontrolling interest in the franchise business, without the written consent of the franchisor, except that the consent shall not be withheld unless the buyer, transferee, or assignee does not meet the standards for new or renewing franchisees described in subdivision (a) . . . .[14]

The Bankruptcy Court noted that franchisors like Popeyes have rigorous standards that potential franchisees must meet, thus making the latter’s identity a material aspect of a franchise agreement.  As such, the hypothetical test as espoused by the Ninth Circuit in Catapult is controlling: there is a hypothetical third party to whom Popeyes might be excused from accepting or rendering performance because such a hypothetical third party might not qualify for Popeyes standards for approval under CFRA.  Therefore, like the Lanham Act, the CFRA is “applicable law” under Bankruptcy Code section 365(c), and the hypothetical test dictates that the Debtor cannot assume the Franchise Agreements absent Popeye’s consent. 

Takeaways

Bankruptcy Code section 365 is an integral provision of the Bankruptcy Code, the use of which can, at times, be the key to an insolvent entity’s successful reorganization.  Indeed, the Bankruptcy Court explicitly stated in Pinnacle Foods that “there is essentially no business left to reorganize” absent the Debtor’s assumption of the Franchise Agreements.[15]  However, knowledge of a circuit-by-circuit interpretation of certain aspects of section 365, particularly subsection 365(c), will ensure insolvency practitioners are correctly advising clients as to the best and least restrictive pathways to reorganization.

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[1] No. 24-11015-B-11, 2024 WL 4481070 (Bankr. E.D. Cal. Oct. 10, 2024).

[2] While the Bankruptcy Code does not define the term “executory contract,” courts generally define such term in the bankruptcy context to mean “a contract in which ‘the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach.’”  In re Imperial Cred. Indus., Inc., 527 F.3d 959, 974 (9th Cir. 2008) (quoting Fenix Cattle Co. v. Silver (In re Select–A–Seat Corp.), 625 F.2d 290, 292 (9th Cir. 1980).

[3] 11 U.S.C. § 365(a) (“[T]he [Debtor-in-Possession], subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.”

[4] See id. (stating that a debtor-in-possession may assume executory contracts “[e]xcept as provided in subsections (b), (c), and (d) of this section . . . .”).

[5] 11 U.S.C. § 365(c).

[6] 2024 WL 4481070, at *2 (citing In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994)).

[7] Id. (citing Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 789, 493 (1st Cir. 1997)).

[8] 165 F.3d 747 (9th Cir. 1999).

[9] 15 U.S.C. §§ 1501, et seq.

[10] 2024 WL 4481070, at *4 (quoting N.C.P. Mktg. Grp. v. Blanks (In re N.C.P. Mktg. Grp.), 337 B.R. 230, 236 (D. Nev. 2005)).

[11] Cal. Bus. & Prof. Code §§ 20000, et seq.

[12] Id. at § 20028(a).

[13] Id.

[14] Id. at § 20028(b).

[15] 2024 WL 4481070, at *2.