Brand owner bankrupt, how does a franchisee claim performance bond?

By Wang Zhenxiang, Jingtian & Gongcheng

Many brand owners in the goods and services consumption sector opt to quickly expand sales channels through not only directly operating branch stores, but also through franchising. To compel a franchisee to comply with its management, the brand owner often, when executing the agreement, requires the franchisee to pay a performance bond determined by such factors as the location and number of stores, and business income.

However, if the brand owner goes bankrupt, how should the franchisee go about making a claim for its bond?

Nature of the bond

Wang Zhenxiang, Jingtian & Gongcheng
Wang Zhenxiang
Jingtian & Gongcheng

Under a typical franchise agreement, where a franchise store is opened, the brand owner has the right to deduct from the bond in the event of any illegality or breach of contract, consistent with the seriousness and up to the amount charged. The franchisee is also required to make up for the deducted amount to the brand owner within a specified period following receipt of the deduction notice. The security provided by the bond usually expires sometime after the termination of the authorised retail agreement.

In light of the opinions expressed in the Minutes of the 18th Judges’ Conference of 2021 of the Second Circuit Court of the Supreme People’s Court (SPC), such a performance bond carries the following traits: it is controlled by the brand owner; the amount serves as security for the franchisee’s performance of all the brand owner’s operational and management requirements; and if the franchisee violates such requirements, the brand owner has a priority right to receive compensation by making a deduction from the bond.

Accordingly, the bond carries the traits of both security provided in the form of a pledge, and also a penalty for breach of contract.

Legal provisions on deposits in Chinese law chiefly include articles 388.1 and 429 of the Civil Code, dictating that the creation of a security interest requires the conclusion of a security contract. A pledge is created on the pledgee’s delivery of the pledged property.

So, does a franchisee have the right to recover its bond if the brand owner goes bankrupt? The key lies in the nature of the bond in the brand owner’s account, and the issue is contested by two schools of thought.

The first supports the pledge of claim model: once the franchisee deposits the bond into the bond account it ceases to own the money, but acquires a claim against the bank, which means that the pledge of claim must first be registered.

The second supports the special movable asset pledge model: when the franchisee deposits the bond into the brand owner’s account, it does not necessarily lose ownership of the money. With the bond itself serving as the pledge, the rules of movable asset pledge shall apply, which means it is created on the transfer of possession.

Status in bankruptcy procedure

The authors’ research found that, in most cases, the court is cautious and strict with the recovery of bonds and, unless the parties reached a strict agreement on the specification and transfer of possession of the bond, the common opinion is that the payer loses ownership of the bond when transferred under the control of the recipient.

For example, in Ouyang Houjin et al v Shuicheng County Duge River Mine (2022) and Lin Changxiang v Guizhou Guoyuan Mining (2021), the SPC held that the condition precedent to the payer being able to exercise its right of recovery was its ownership over the bond, but it was in the possession of the recipient. Money, as an unspecified, indefinite thing, follows the principle of “possession is ownership”.

Whether the money has been specified cannot be simply determined by the name of the “bond”, but also whether the bond can be substantively distinguished from other monies of the possessor, via the opening of a dedicated account or other means.

In these cases, the parties did not open a dedicated account for the bond, nor did they exercise joint oversight. Although the amount paid was named performance bond, it was not distinguishable from other monies of the recipient, which means it was not specified. Accordingly, the recipient was deemed to own the amount, rather than simply holding it on the payer’s behalf.

The court of second instance of the Lin Changxiang case also held that the payer had a claim over the amount, which it could file as a general claim in the bankruptcy procedure, but did not have ownership.

In Wuyu Construction v Shui On Land (2022), the Zhejiang High Court set out its requirement for making a deposit account specific, namely that the deposit account could not be used for the charging party’s general day-to-day settlements, and thus enabling a third party to distinguish the deposit from the other funds of the charging party.

Paths to protect rights

Asserting the right of recovery. Following the implementation of the Civil Code, the SPC issued and implemented the New Judicial Interpretations on Security, article 70 of which provides that a deposit account should be specifically opened by the debtor and be under the actual control of the creditor, or the funds are to be deposited into the deposit account opened by the creditor, from which point the creditor enjoys a priority right of compensation and does not lose such right as a result of amount fluctuations.

The provision appears to recognise funds in a deposit account as being a special movable asset pledge. On this basis, a franchisee may attempt to claim recovery against the debtor enterprise, but its support would require a comprehensive determination of the performance of the agreement by both parties based on actual clauses under the deposit terms.

Procure the brand owner’s administrator willingness to continue performing the franchise agreement. Typically, the agreement between a franchisee and the brand owner is time-bound, which means that when the brand owner enters bankruptcy, the agreement may not have reached its end. In such an event, the franchisee may actively communicate with the administrator and procure its consent to continue performing the franchise agreement. With the administrator’s consent to continue, the debt may be recognised as a common interest debt pursuant to article 42 of the Enterprise Bankruptcy Law.

File a claim and strive to secure a favourable arrangement in the restructuring plan. Regardless of the outcome, the franchisee should actively reach out to the brand owner’s administrator and the restructuring investors after the bankruptcy procedure commences, to discuss and try to secure a repayment arrangement more favourable than that of the general creditors. There have been cases where the restructuring plan accords preferential treatment to the supply chain and franchisee claims.

Wang Zhenxiang is a partner at Jingtian & Gongcheng


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