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April 2011

Dunkin’ Donuts Franchisee Finds a Hole

Summary:  Debtor-Franchisee need not assume or reject nonresidential real property lease within time limitation when it is a party to a corresponding Franchise Agreement

Nonresidential real property leases and executory contracts are treated differently for purposes of a debtor's reorganization.  Section 365(d)(4) of the Bankruptcy Code provides a debtor with only 120 days (or up to 210 with leave of Court), from the filing of the petition, to determine whether to assume or reject nonresidential real property leases.  In contrast, Section 365(d)(2) of the Bankruptcy Code provides that executory contracts may be may assumed or rejected by the debtor up until plan confirmation.  The timing distinction is significant for purposes of a reorganization.  However, what if a lease and an executory contract were interrelated in that the two agreements could constitute as a single controlling agreement? 

The Bankruptcy Court for the Eastern District of New York recently faced this exact issue.  The Court was asked to determine whether a franchisee's leases with a franchisor and their corresponding franchise agreements were integrated agreements that should be treated together as a single controlling agreement between parties.  The Court concluded that the agreements were in fact an integrated agreement and that Section 365(d)(2) would control both the leases as well as the franchise agreements.  With this decision, no longer could a franchisor-landlord rely on the timing provisions of Section 364(d) to pressure a franchisee-lessee to assume or reject a lease. 

In In re FPSDA I, LLC, the debtors were parties to franchise agreements permitting them the right to operate several fast food restaurants (including Dunkin' Donuts franchises).  Some of the restaurants were operating out of locations owned by Dunkin' Brands.  Effectively, Dunkin' Brands wore two hats in such instances; not only were they the franchisor for the franchise agreements, but they were also the landlord for those locations.  The lease and franchise agreements contained cross-default provisions.  Prior to the  date mandated by Section 365(d)(4) to assume or reject their leases, the debtors filed a motion seeking either (i) determination that their leases do not have to be assumed or rejected until confirmation of a plan of reorganization pursuant to Section 365(d)(2), or (ii) that the debtors could assume their leases without having to cure all the existing defaults under the related franchise agreements. 

Debtor and Dunkin' Brands agreed that due to the cross-default provisions between the leases and corresponding franchise agreements, the agreements constitute as an integrated agreement.  The Court agreed, stating that the agreements were "economically interrelated and interdependent" whereby one lease could not stand without its corresponding franchise agreement.  Upon reaching the conclusion that the agreements were interrelated, the Court turned to the underlying motion.  The Court held that the Debtors could not assume their Dunkin' Brand leases without having to cure all of their existing defaults under the related franchise agreements.  The Court explained that because each lease and respective franchise agreement constituted one controlling agreement, the debtors could not assume a lease unless they cured not only the defaults under the lease but also any defaults under its respective franchise agreement.  Essentially, the Court reasoned that this form of relief would deprive creditors (Dunkin' Brands) the benefit of their bargained-for transaction and provide debtors with a windfall at the expense its creditors. 

The Court granted debtors' alternative request, that the leases did not have to be assumed or rejected until confirmation of a plan of reorganization pursuant to Section 365(d)(2).  First the Court reasoned that if the time limitation of Section 364(d)(4) were applied to integrated agreements, there would be a loss of value to the debtor's estate.  Such a time limitation could force the debtor to reject the lease because a debtor did not (or could not within the prescribed time limit) make a determination as to whether to assume or reject the entire integrated transaction.  The Court held that Section 365(d)(2) is applicable to integrated agreements because it facilitates the debtors' reorganization while not having to compromise their most valuable assets, the franchise agreements.

Next, the Court noted that there would be a unequal balance of power between the debtor and franchisor-landlord if Section 365(d)(4) were applied.  The franchisor-landlord, who is a creditor, would be bestowed with "superior power to determine the course and outcome of such debtor's bankruptcy cases than intended."  The franchisor-landlord would be able to pressure a debtor to "prematurely" assume or reject the franchise agreement simply because they could refuse to extend the time for the debtor to assume or reject the lease.  Section 365(d)(4) was not applied because the Court would not allow the franchise-landlord to rely on its agreements' cross-default provisions to the detriment of the debtors. 

Lastly, the Court observed that if it were to apply Section 365(d)(4) to integrated agreements, the franchisor-landlord's decision to enforce its time limitation could affect the outcome of the bankruptcy as well as the relationship between the priority of creditors.  If the debtors had to prematurely assume their leases, they would also be required to cure all defaults under the franchise agreements.  This assumption would turn the franchisor-landlord's unsecured claim into a post-petition administrative expense.  Essentially, the franchisor-landlord would be able jump the creditor line and get paid on its unsecured claim.  For the forgoing reasons, the Court applied Section 365(d)(2).

The Court's decision is of great significance as it is a reminder that as hard as parties may try, bargained-for protections and advantages are never guaranteed.  Furthermore, and especially in this economic climate, when preparing contracts it is important to understand how a party's bankruptcy can affect an agreement.  Now, should you wish to discuss the "do's and don'ts" of contract drafting, well, I recommend we discuss this topic over a cup of Dunkin' Donuts coffee and some chocolate glazed donuts.



Bankruptcy, Restructuring & Creditors' Rights

Bankruptcy, Restructuring & Creditors' Rights
Commercial Litigation
Franchise Law