In commercial finance, the all-asset lien is the gold standard for lenders. If the borrower defaults, the lender takes the keys and continues operations. However, when the collateral includes a franchised business, the keys to the business aren’t actually held by the borrower. The franchisor, through the terms of the franchise agreement, has the final say on all aspects relating to its franchisee.
When the primary value of a business comes from another party’s licensed intellectual property, the licensor naturally has a strong interest in protecting its brand. As a result, franchise agreements typically include provisions that make the licensed intellectual property non-assignable without the franchisor’s consent. Further, these agreements frequently contain strict anti-pledge and anti-hypothecation clauses expressly prohibiting the franchisee from encumbering the agreement without consent. This creates a problem for lenders because without further action, a standard UCC filing will often fail to provide the expected level of security.
A Lien in Name Only
Article 9 of the Uniform Commercial Code allows a lender to take a security interest in a franchise agreement; however, it does not prohibit a contract from containing restrictions on enforcement of the lender’s rights. This creates a problem for lenders as franchise agreements often make the collateral inaccessible without the franchisor’s consent. This leaves the lender unable to assume the contract to operate the franchise location or utilize any of the other rights it expected to be entitled to.
Compounding this enforcement risk is the immediate operational risk created by the security interest itself. If the franchisor’s consent was not obtained prior to execution, the franchisee borrower will be in immediate technical default if the franchise agreement contains any anti-pledge or change-of-control provisions, as most do. This would give the franchisor immediate grounds for termination and further devalue the lender’s collateral. The fallback option of liquidating the business’s assets, such as equipment, furniture, or signage, may be blocked entirely if the franchise agreement required the franchisee to grant the franchisor a first-priority security interest or a purchase option on the franchised business. In either scenario, it is clear that without a pre-negotiated agreement with the franchisor, the lender’s rights in the collateral are effectively non-existent.
Franchisor’s Consent to Collateral Assignment
The most effective way for lenders to protect themselves in this situation is to obtain the franchisor’s consent to a collateral assignment agreement. The consent is best done through a three-party agreement between the franchisor, the franchisee borrower, and the lender, in which the franchisor explicitly recognizes the lender’s lien and, more importantly, waives any underlying anti-assignment and anti-pledge provisions. To ensure protection of the lender’s collateral, the lender must also include the following in the consent: first, the agreement must include notice of default provisions that require the franchisor to send the lender a copy of any notice of default issued to the franchisee; second, the lender must secure robust cure rights, granting them an additional period, typically 30 to 60 days, to step in and cure the franchisee’s defaults; and finally, the consent must outline explicit step-in rights, so that the lender, or a designated nominee or court-appointed receiver, can operate the franchise post-default.
The Comfort Letter
Large franchisors will often refuse to sign the lender’s collateral assignment agreement. Instead, the franchisor may offer a standardized comfort letter granting the lender a basic set of rights. While obtaining a comfort letter is better than having nothing at all, lenders must recognize that the primary purpose of this letter is to protect the franchisor’s brand.
Typically, a comfort letter will grant the lender notice of the borrower’s defaults and a brief window to cure them. However, the franchise will generally package those rights with a right of first refusal or a mandatory buy-back provision allowing the franchisor to jump ahead of the lender in the event of a default. Additionally, these buy-back mechanisms often provide the franchisor with a discounted repurchase price rather than the true market value, capping the lender’s potential financial recovery on the business. As such, lenders relying on comfort letters must carefully evaluate if the cap created by the buy-back mechanics will cover the outstanding debt in the event of a default.
The Licensed Intellectual Property
At its core, a franchise is a license to operate a business using someone else’s intellectual property. Under the express terms of almost every franchise agreement, the intellectual property licenses granted to the borrower are strictly personal and non-assignable. The contracts themselves will explicitly state that the right to use the brand’s intellectual property is granted solely to the franchisee. Consequently, even if a lender can successfully take over the franchise agreement following a default, it does not guarantee the lender the right to use the franchisor’s brand.
Accordingly, a general consent to the assignment of the contract is not sufficient. A lender needs to receive explicit consent to use the licensed intellectual property in the collateral assignment agreement, or have the consent incorporated into franchisor’s comfort letter. The franchisor must agree that the right to use the brand’s intellectual property will remain fully intact for use by the lender, its nominee, or a court-appointed receiver for as long as they are managing the operations or transition of the business post-default. Without this, a lender may find themselves holding a properly assigned franchise agreement but with no legal right to operate the business.
Practical Steps for Lender’s Counsel
Given the complexities outlined above, lender’s counsel should take a proactive approach when securing a franchise-backed loan. Once diligence begins, lender’s counsel should review the underlying franchise agreement to identify what, if any, change of control and anti-encumbrance clauses are present. During this review, lender’s counsel should make special note of any clauses that allow the franchisor to terminate the agreement upon the grant or pledge of a security interest. As franchisors historically move slowly, negotiations for the consent to collateral assignment should start early in the deal cycle to be best received by the franchisor. The loan documents should require that the execution of the consent to collateral assignment, or at the very minimum, a comfort letter, be a non-negotiable condition precedent to the loan closing. Additionally, the lender should secure control over the franchisee’s proceeds by executing a deposit account control agreement on the borrower’s operating accounts. This allows the lender to capture and secure the revenue generated by the business even if the lender can’t assume the franchise agreement.
Ultimately, taking a security interest in a franchise business is only as valuable as the lender’s right to act on it. Taking these steps minimizes the chance that the lender is left holding worthless collateral.
