Battle over the Franchisor Business Judgment Rule and the Path to Peace

Battle over the Franchisor Business Judgment Rule and the Path to Peace

Brian B. Schnell and Ronald K. Gardner, Jr.

Brian Schnell

In successful franchise systems, both the franchisor and the franchisees obsess over the franchisees’ bottom line. Healthy franchise systems also see the franchisor properly balancing its own interests with the interests of the franchisees and the system as a whole. The franchisor’s role in growing, evolving, and protecting the brand and system is key to this balancing act. If the franchisor fulfills its role, the franchise system is better able to compete effectively against competition, including other franchise systems and non-franchise businesses. But when courts are forced to evaluate the decisions the franchisor makes in attempting this balance, the question becomes by what standard should a franchisor’s decisions be judged?

In many instances, the implied covenant of good faith and fair dealing is used as the yardstick, particularly in cases where the dispute involves a franchisor’s discretionary decision. However, in recent years, many franchisors have started incorporating the business judgment rule into their franchise agreements. From the franchisee’s perspective, franchisors are using the business judgment rule as a “substitute” for the implied covenant. From the franchisor’s perspective, the business judgment rule is a standard for resolving whether a franchisor has acted reasonably and in good faith. This article sets out to explore whether the implied covenant, the business judgment rule, or some other standard is appropriate when the issue of franchisor discretion arises. The reader will find that while our analysis and preliminary conclusions, written from the point of view of both experienced franchisor and franchisee counsel, are polar opposites, our final conclusions are remarkably similar. Ronald Gardner

The franchise agreement is the key document that outlines the roles and responsibilities of the franchisor and franchisee. It also shapes how the franchise system responds to changes in the business environment and other competitive threats. No franchise system will be sustainable without effectively responding to customers’ ever-changing demands. In order to effectively implement change and maintain sustainability in the hearts, minds, and pocketbooks of customers, a franchisor must (1) focus on customer-centric initiatives and the bottom line of its franchisees; (2) instill in its franchisees an undying devotion to the brand so they have the same customer-centric focus; (3) empower its franchisees through collaboration on key strategic and customer-centric initiatives; and (4) create a strong franchise agreement that allows it to fulfill its role and responsibility to grow, protect, and evolve the franchise system and brand.

An important check on the misuse of authority in the franchise relationship has typically been the covenant of good faith and fair dealing. More specifically, within this context of system change or any other decision a franchisor makes, when a franchisee disagrees with the franchisor, the franchisee often raises a good faith and fair dealing claim. Good faith and fair dealing generally require that when a contract grants discretion to one party, that party is required to exercise that discretion in a fair and reasonable manner, consistent with the reasonable expectations of the parties.1

In recent years, however, franchisors have sought to replace or frame the good faith and fair dealing discretionary standard with a corporate law doctrine: the business judgment rule.2 By contractually replacing or defining good faith and fair dealing with the business judgment rule, a franchisor may exercise its discretion on the basis of its “reasonable business judgment.” Often, “reasonable business judgment” provisions also explicitly state that the franchisor meets the standard, even if other reasonable or arguably preferable alternatives are available, if the decision or action is intended to promote or benefit the system generally, even if it also promotes the franchisor’s financial or other individual interests.

Here is a typical business judgment rule provision that may be incorporated into a franchise agreement:

Our Reasonable Business Judgment. Whenever we reserve discretion in a particular area or where we agree to exercise our rights reasonably or in good faith, we will satisfy our obligations whenever we exercise reasonable business judgment in making our decision or exercising our rights. Our decisions or actions will be deemed to be the result of reasonable business judgment, even if other reasonable or even arguably preferable alternatives are available, if our decision or action is intended, in whole or significant part, to promote or benefit the franchise system generally, even if the decision or action also promotes our financial or other individual interest. Examples of items that will promote or benefit the franchise system include, without limitation, enhancing the value of the trademarks, improving customer service and satisfaction, improving product quality, improving uniformity, enhancing or encouraging modernization, and improving the competitive position of the franchise system.

The introduction of the “reasonable business judgment” standard of discretion into the franchise arena significantly impacts the franchisor/franchisee relationship. While franchisors have already introduced the “reasonable business judgment” standard into franchise agreements and discussion on the subject began over a decade ago,3 there is a notable dearth of case law discussing this particular standard of discretion in the franchise context.4

In light of the lack of case law on the subject and the seemingly increased use of the business judgment rule in franchise agreements, this article will provide perspective, from the standpoints of both franchisor and franchisee, on the appropriateness of the business judgment rule as a discretionary standard for franchisors as compared to the application of the covenant of good faith and fair dealing.

This article begins with a discussion of the development of the business judgment rule and proceeds to discuss the franchisor and the franchisee’s perspective as to its application in the franchise context. Finally, this article concludes with the authors’ shared conclusions that aim to benefit franchisors and franchisees alike.

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1. RESTATEMENT (SECOND) OF CONTRACTS § 205 (1981).
2. The authors note that within the last few years a significant majority of the franchise agreements drafted by franchisor counsel or reviewed by franchisee counsel include some form of the business judgment rule.
3. See, e.g., Jeffrey C. Selman, Applying the Business Judgment Rule to the Franchise Relationship, 19 FRANCHISE L.J. 111 (2000).
4. The lack of case law is likely attributable, at least in part, to the prevalence and uniform enforcement of private arbitration agreements and settlements. To date, In re Sizzler Restaurants International, Inc., 225 B.R. 466, 474 (Bankr. C.D. Cal. 1998), is the most notable decision discussing the business judgment rule in the franchise context. See infra notes 50–53 and accompanying text for further discussion of the Sizzler decision.

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Brian B. Schnell (brian.schnell@faegrebd.com) is a partner in the Minneapolis office of Faegre Baker Daniels LLP. Ronald K. Gardner, Jr. (rkgardner@dadygardner.com) is the managing partner of Dady & Gardner, P.A. in Minneapolis. The authors would like to express their thanks to Andrew Malzahn, an associate with Dady & Gardner.