What if your franchisor requires a significant system change
Can My Franchisor Really Make Me Do That?
Imagine receiving notice from your franchisor outlining a significant system change (a costly store renovation, a new menu, a new point-of-sale (POS) system). The notice provides that you as the franchisee are not only required to follow the system change, but are also obligated to expend significant capital to implement it. Absent language in your franchise agreement that specifically provides for the exact change, whether you as a franchisee must comply, or whether you have reasonable grounds to push back, may turn on the contractual standard applied to your franchisor’s discretion.
Disagreements over unilateral decisions made by the franchisor, like the examples above, are common in franchise relationships. This article briefly discusses the implications of the varying standards of discretion applied to franchisor decision making during the term of the agreement and outlines general, practical considerations for both prospective and current franchisees.
Discretion in Franchise Agreements
Franchise agreements do not contemplate a single event, such as purchasing a vehicle, but rather, ongoing conduct over a time period that can span as much as 10 to 20 years beyond the date the agreement is executed. Because it is simply not possible to anticipate all future scenarios, the parties are necessarily left with discretion to take certain actions during the term of the agreement. The lion’s share of discretion, however, is frequently left in the hands of the franchisor, while franchisee duties are specifically defined in the franchise agreement, and to the extent not covered in the franchise agreement, in the ever-changing operations manual. This imbalance is especially concerning because a simple exercise of the franchisor’s discretion can threaten the franchisee’s financial stability and, in turn, put a franchisee’s entire investment at risk.
Good Faith & Fair Dealing
While the franchise agreement is the key document that outlines the parties’ rights and responsibilities within the business model, under the common law, in most states, an implied covenant of good faith and fair dealing attaches to every contract, including, in general, franchise agreements. The implied covenant of good faith and fair dealing requires that when a contract grants one party discretion, that party is required to exercise its discretion in a fair and reasonable manner, consistent with the reasonable expectations of the parties.
In a perfect world for franchisees, the franchise agreement would require both parties to adhere to a discretionary standard of good faith and fair dealing. Indeed, whether implied by law or expressly provided as a discretionary standard in the franchise agreement, good faith and fair dealing has empowered franchisees to combat unreasonable exercises of franchisor discretion. See, e.g., Nat’l Franchisee Assoc. v. Burger King Corp., 715 F. Supp. 2d 1232 (S.D. Fla. 2010); Carvel Corp. v. Diversified Mgmt. Grp., Inc., 930 F.2d 228 (2d Cir. 1991).
Modified Discretion: Absolute, Exclusive, Sole or Business Judgment
More commonly, however, franchisors draft agreements that grant the franchisor wide discretionary latitude, reserving the right to exercise its “absolute,” “exclusive” or “sole” discretion, or to exercise its “business judgment.” While seemingly innocuous, the foregoing discretionary standards may actually become quite costly for franchisees. In these scenarios, significant franchisor decisions are more likely to withstand judicial scrutiny. See, e.g., Burger King Corp. v. H&H Rest., LLC, 2001 WL 1850888 (S.D. Fla. Nov. 30, 2001) (finding that Burger King Corporation (BKC) did not unreasonably withhold its consent to a proposed transfer because BKC had the “sole discretion” to determine whether the proposed transfer was acceptable); but see Northwest, Inc. v. Ginsburg, No. 12-462 (U.S. Apr. 2, 2014) (finding that despite a contractually reserved “sole discretion” standard, the implied covenant of good faith and fair dealing under Minnesota law cannot be waived or contracted around).
Furthermore, to the extent a franchisor retains unrestricted discretion to act, the risk that the franchisor might exploit franchisees increases. For instance, an opportunistic franchisor might decide to increase its revenue by extracting additional funds from franchisees. To do so, franchisors may increase the prices of goods sold to franchisees or require unnecessary renovations. Under lax discretionary standards, franchisors have more incentive to target additional revenue at the expense of franchisees because their discretionary decisions receive less scrutiny and are more likely to be upheld.
Practical Considerations for Franchisees
Prior to Signing, Be Mindful of the Standards in the Franchise Agreement That Apply to Your Franchisor’s Ability to Take Unilateral Actions
Franchisees should attempt to negotiate standards that require both parties to deal with each other, and exercise their discretion, reasonably, in good faith, with honesty, in a non-discriminatory manner, and in accord with recognized standards of fair dealing in the industry. In the same fashion, franchisees should beware of discretionary provisions that permit a franchisor to exercise “absolute,” “exclusive” or “sole” discretion, or to exercise its “business judgment.”
The likelihood that a franchisor will negotiate its discretionary standard will likely depend on the relative bargaining power of the parties. Generally, however, franchisors have the upper hand, and seldom concede their discretionary rights. Franchisees should understand that unfavorable discretionary standards provide franchisors with a significant amount of leeway in making important decisions under the franchise agreement, and as a result, the franchisor may not be obligated to treat the franchisee in a reasonable manner, and instead, may act entirely in its own self-interest.
Evaluate Your Rights If You Believe Your Franchisor Has Unreasonably Exercised Its Discretion
Franchisees should evaluate their rights when facing what they believe is an unreasonable exercise of their franchisor’s discretion. The franchise agreement defines the rights and responsibilities of franchisors and franchisees and it is the logical starting point in this analysis. Franchisees generally have no claims against franchisors for conduct that is expressly permitted in the franchise agreement. La Quinta Corp. v. Heartland Properties, LLC, 603 F.3d 327 (6th Cir. 2010); Burger King Corp. v. E-Z Eating, 41 Corp., 572 F.3d 1306 (11th Cir. 2009).However, there are cases in which the implied covenant of good faith and fair dealing has limited the express rights of franchisors under the agreement. See, e.g., JOC, Inc. v. Exxon Mobil Oil Corp., 2010 U.S. Dist. LEXIS 32305, Bus. Franchise Guide (CCH) 14,352 (D.N.J. Apr. 1, 2010) (holding that under New Jersey law, “a party’s performance under a contract may breach [the] implied covenant even though that performance does not violate a pertinent express term”).
If the franchise agreement does not specifically permit the franchisor’s conduct, franchisors frequently attempt justify their conduct with their contractually reserved discretion in particular areas. For example, franchisors reserve the right to make important decisions, such as whether to approve store locations and transfers or to impose marketing and advertising fees, among others, according to their own discretion. Similarly, franchisors commonly reserve the right to modify system standards, which may be provided for in the franchise agreement, or more commonly in the operations manual. Case law has shown that the discretionary standard applied to franchisor decisions and changing system standards has a significant impact on the franchisee’s rights. See, e.g., Johnson v. Arby’s Inc., Bus. Franchise Guide (CCH) ¶ 12,018 (E.D. Tenn. Mar. 15, 2000) (permitting Arby’s to require that new stores comply with its new building design in part because Arby’s reserved its “sole discretion” to implement system standard changes in its operations manual).
Franchise laws are another source of rights for franchisees. Various states, such as Arkansas, Connecticut, Hawaii, New Jersey, among others, have enacted franchise relationship statutes that impose a general standard of good faith or commercial reasonableness in the franchise relationship. However, while some courts have construed these statutes liberally to insulate franchisees, others have done the opposite. Compare Beilowitz v. General Motors Corp., 233 F. Supp. 2d 631 (D.N.J. 2002) (finding that it was clearly a violation of the New Jersey Franchise Practices Act to require a franchisee to operate at a substantial financial loss while the franchisor attempts to implement a new and unproven marketing strategy); with Remus v. Amoco Oil Co., 794 F.2d 1238, 1241 (7th Cir. 1986) (holding that Wisconsin’s franchise relationship statute does not prohibit franchisors from implementing nondiscriminatory system-wide changes without unanimous franchisee consent).
Prospective franchisees should be mindful of the discretionary standards reserved by the franchisor in the franchise agreement. While not always negotiable, a prospective franchisee should seek a mutually applicable discretionary standard that requires the parties to act and exercise their discretion in good faith, honestly, and in a reasonable manner.
With regard to disputes arising out of franchisor decisions during the term of the agreement, franchisees are particularly vulnerable against the franchisor’s expressly reserved rights and the discretionary standard reserved in the franchise agreement. Still, the success or failure of challenges to franchisor decisions is factually specific, and may vary considerably with differing jurisdictions and applicable laws.
We encourage prospective franchisees negotiating franchise agreements and current franchisees that feel their franchisor has acted unreasonably, and against the business model, to contact one of the attorneys at Dady & Gardner.