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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.

______________________________________________________________________

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.

The Federal Fair Franchise Act of 2015 – Not So Outrageous After All

At least some franchisor advocates have indicated outrage at the idea that federal legislation such as the Fair Franchise Act of 2015 has been introduced (not passed, but simply introduced) to regulate the relationship between franchisees and franchisors. Even a quick look at the history of franchising and the history of federal legislation demonstrates that the idea of the federal government protecting small businessmen, small investors and everyday citizens from abuse by larger entities is not so outrageous after all.

First, the federal government already regulates the sale aspect of franchising to some extent. The Federal Trade Commission Act, and the FTC’s Franchise Rule enacted pursuant to that Act, have regulated the sale of franchises since 1979. The Franchise Rule has been amended a number of times over the past 36 years. The FTC, a federal agency, has long required that franchisees receive a prospectus-like document (now called a Franchise Disclosure Document, formerly called a Franchise Offering Circular) that contains 23 specific items involving pre-sale disclosures.  The sudden great concern of franchisors and their advocates that the federal government might become involved in franchising comes a tad too late – approximately 36 years too late.

It is not surprising that the first efforts at federally regulating franchising called for a prospectus-like document, because it is generally agreed by people who study the history of franchising that the FTC’s regulation of franchising was patterned after the Securities and Exchange Commission’s regulation of securities sales. Such regulation by the SEC goes all of the way back to the Securities and Exchange Act of 1933 enacted during the Great Depression.

Franchise Law Agreement Gavel

Congress decided in 1933 that the federal government was going to do something about fraudulent sales of securities to investors.

This decision to pass federal legislation was made even though the victims to be protected from the securities scams that had occurred in the 1920s and 1930s would have been people of substantial financial means and not middle class workers investing in 401K retirement plans (the first 401K plans did not come into being until the 1980s, prior to that time most citizens had no personal investment in the stock market at all).

In 1979, 46 years after its regulation of securities sales, the federal government made the same decision with respect to the sale of franchises to franchisees; the federal government wanted to do something about fraudulent franchise sales.

Both federal securities laws and federal franchise laws prohibit improper disclosures and prohibit false and misleading statements, and both the SEC and FTC have enacted rules that are written in a manner such that they can be read as forming the basis for a private party’s complaint against a fraudulent seller. One key difference, however, is that the federal courts limited the ability of franchisees to sue in court while permitting a defrauded securities purchaser to sue in court.

In other words, a securities investor who feels defrauded can sue in court under Rule 10b-5 enacted by the SEC, but a franchisee who feels defrauded is NOT allowed to sue under the FTC’s Franchise Rule.

This shift in the federal judiciary’s willingness to imply a “private right of action” in a federal statute (unfortunately for franchisees, the shift began around 1979), has left franchisees with a federal right for which the franchisees cannot generally pursue a remedy in court. A franchisor sued for a violation of the FTC Act or the Franchise Rule can win in court with this argument: “Even if we did violate the FTC Franchise Rule, there is nothing the franchisee can do about it.”

When amending the Franchise Rule in 2008 the FTC’s Office of the General Counsel stated that it had conducted an extremely minimal number of enforcement actions against franchisors since 1979 (the number stated was well under 100). In roughly 30 years, the FTC had enforced its FTC Franchise Rule….well, almost never. A franchisee who is harmed by a violation of his or her federal franchise law rights cannot sue in court, and the franchisee’s complaint to the FTC will almost certainly never result in an enforcement action. (We at Dady & Gardner used to report violations to the FTC in the mid-1990s. No enforcement action was ever brought, and if the franchisor learned of the report to the FTC it would use the FTC’s inaction to argue that “the FTC investigated this and said that we did nothing wrong.” Reporting matters to the FTC was actually counterproductive to our representation of franchisees. Therefore, we stopped the practice after a few years.)

The Fair Franchise Act of 2015 seeks to remedy this ridiculous situation of having a federal law that is almost never enforced.

The Act allows franchisees the same right that securities investors have had for 82 years – the right to sue to enforce a federal anti-fraud statute. How revolutionary is that? Not very. Franchisees should have a right that others who are similarly situated were given when FDR first became President.

Second, even outside of the securities context (securities laws, it should be noted don’t just deal with initial fraud in sales situations, the securities laws also includes restrictions on insider trading, short swing trading, initial public offerings, reporting requirements, record keeping, etc.) the federal government also regulates various aspects of commerce every day. Certainly innkeepers and restaurateurs in the South in 1964 were surprised to learn that they had to open their doors to African Americans. Having been allowed to do business in the same manner since at least the end of Reconstruction, these business owners certainly had to be shocked that the federal government could question the way they did business or treated actual or potential customers. Yet the federal government regulated them, and Congress has also passed laws requiring businessmen to limit their commercial activities in many other ways. For example, we have federal prohibitions on unfair housing practices, discrimination against those with disabilities, and clean air and/or clean water violations. Each of these federal laws regulates commerce and prohibits certain actions that a business person might want to take. The federal government also regulates conduct toward employees, including employee retirement plans, and tax withholding. For franchisors (who are already regulated by the federal government both through the FTC Rule and otherwise) to claim some sort of “overreach” through the enactment of the Fair Franchise Act of 2015 is, at best, disingenuous.

It is clear that franchising in a great many ways is already regulated by the federal government. Then what exactly is the complaint of franchisors about the newly proposed federal legislation that has been introduced? That the Act is somehow grossly unfair to the franchisor?

Let’s review some of the specific provisions in the Act.

Under the Fair Franchise Act of 2015, Franchisors cannot:

1.) Hinder the formation of or participation in franchisee associations
2.) Charge “excessive and unreasonable” renewal fees
3.) Impose a “standard of conduct or performance” on franchisees unless the franchisor can prove that the standard is “reasonable” and “necessary”.
In addition, Franchisors
4.) Must deal “fairly” and “in good faith” and exercise “due care” with franchisees, and
5.) Cannot sell a product or service to a franchisee unless the price is “fair and reasonable” or unless the franchisor has a “reasonable expectation” that the sale will be profitable for the franchisee’s business.

Let’s stop here and try to recap – are franchisors fighting this legislation because the franchisors want the absolute and unquestionable right to A) prohibit franchisees from having an association and talking with one another, B) charge excessive and unreasonable fees, C) act in an unnecessary and unreasonable manner, D) act in bad faith and without due care, E) sell products to franchisees at a markup so high that the franchisor knows the franchisee will not make a profit upon resale?

contract-franchise-law-agreementAre these really the inalienable rights for which franchisors are fighting? If this is the case, then we know that the California Court of Appeals was correct when it described the oppressive nature of the franchise relationship way back in 1996:

The relationship between franchisor and franchisee is a significant issue, and growing more important each year.

As recently explained, “Franchising is rapidly becoming the dominant mode of distributing goods and services in the United States. According to the International Franchise Association, one out of every twelve businesses in the United States is a franchise. In addition, franchise systems now employ over eight million people and account for approximately forty-one percent of retail sales in the United States. Even conservative estimates predict that franchised businesses will be responsible for over fifty percent of retail sales by the year 2000.”

Although franchise agreements are commercial contracts they exhibit many of the attributes of consumer contracts. The relationship between franchisor and franchisee is characterized by a prevailing, although not universal, inequality of economic resources between the contracting parties. Franchisees typically, but not always, are small businessmen or businesswomen or people like the Sealys seeking to make the transition from being wage earners and for whom the franchise is their very first business. Franchisors typically, but not always, are large corporations. The agreements themselves tend to reflect this gross bargaining disparity. Usually they are form contracts the franchisor prepared and offered to franchisees on a take or-leave-it basis. Among other typical terms, these agreements often allow the franchisor to terminate the agreement or refuse to renew for virtually any reason, including the desire to give a franchisor-owned outlet the prime territory the franchisee presently occupies.

Some courts and commentators have stressed the bargaining disparity between franchisors and franchisees is so great fn. 8 that franchise agreements exhibit many of the attributes of an adhesion contract and some of the terms of those contracts may be unconscionable. “Franchising involves the unequal bargaining power of franchisors and franchisees and therefore carries within itself the seeds of abuse. Before the relationship is established, abuse is threatened by the franchisor’s use of contracts of adhesion presented on a take-it-or-leave-it basis.”

Postal Instant Press v. Sealy, 51 Cal.Rptr.2d 365 (Cal. App. 2 Dist. 1996)(citations omitted)

Franchisor advocates have also complained that the proposed Fair Franchise Act of 2015 addresses the parties’ rights with respect to transfers, renewals and terminations. One of the stated complaints here is that the Act regulates contract provisions that “the parties take for granted.” What the proposed Act prohibits is unfair terminations and non-renewals without good cause. It also prohibits denial of transfer rights without a valid reason. Who are the “parties” that routinely take for granted that they will be able to impose upon the other contracting party the absolute right to terminate an entire long-standing business in the community without good cause, or non-renew the long term 10 or 20 year contract without good cause, or prohibit transfers to a qualified party of a multi-million dollar business that constitutes the seller’s sole asset, all without good cause?   Apparently, the set or subset of “parties” who expect this sort of right = only franchisors. Why is that? It is because franchisors have always enjoyed the ability to impose unfair take-it-or-leave-it contracts upon their franchisees. The Fair Franchise Act of 2015 would remove this disparity of bargaining power.

But one might ask “how will franchising ever survive if franchisors are required to actually treat their franchisees in a fair and reasonable manner”?

Certainly no distribution system could ever work in this manner, correct? Incorrect.

Car Dealer Franchise LawAutomobile dealers in all 50 states enjoy significant statutory rights that prohibit the franchisor (generally called the “manufacturer” or “supplier” in the state auto dealer statutes) from taking unfair actions against these dealers. The rights of auto dealers are so substantial that the when GM and Chrysler made the decision to cut the number of dealers in their dealer network in light of the Great Recession, they each felt the need to first file for bankruptcy protection and only then “rejected” these dealer contracts in bankruptcy, hoping that federal bankruptcy law would override state dealer protection acts. What was the reaction of Congress to these dealer terminations (all of which were permitted by the bankruptcy courts and at least tacitly encouraged by the Executive Branch)? Congress almost immediately passed a law by a unanimous vote allowing the auto dealers to file for arbitration and to seek the return of the product line(s) to the dealers if the dealer was successful in the arbitration.

Since 2002, Congress has also provided automobile dealers with one additional right also sought now by franchisees – the right to not be forced to arbitrate legal claims. In 2002, Congress passed the Motor Vehicle Franchise Contract Arbitration Fairness Act which created a narrow exception to the Federal Arbitration Act. The new law allowed auto dealers to invalidate arbitration provisions in motor vehicle franchise agreements. See 15 U.S.C. § 1226(a)(2).

Again, despite the federal government becoming significantly involved in the dealer/ manufacturer relationship, and staying involved since at least 2002, there are still thousands of car and truck dealers in the nation. The world has not ended over the past 13 years because dealers are allowed to sue in their own states for statutory and contract violations.

What should strike one as odd is that a husband and wife who own one franchised Subway shop in Colorado currently have to arbitrate all of their legal disputes in Connecticut in Subway’s back yard, while a hypothetical multimillionaire football quarterback who owns car dealerships in Colorado can sue in Colorado to redress any dealership issues he has. Certainly franchisees should be treated no worse under federal law than are auto dealers.

None of the lawyers at Dady & Gardner were even born at the time the federal government started enacting regulatory systems that limit the overall discretion of business owners to operate. Legislation that would create a fairer franchisor-franchisee relationship is certainly nothing new. While the federal Fair Franchise Act of 2015 will upset certain franchisors who claim some sort of “divine right” to impose unfair and burdensome contract terms upon their franchisees, this is to be expected. No one who has always had an unfair advantage likes to play on a level playing field.

Both Democrats and Republicans claim to be supporter of the small business owners of America.

If that claim is indeed true, then all elected representatives should desire to provide tens of thousands of small businessmen with protection from unfair treatment and unfair contracts. To suggest that these small business owners should be hung out to dry and treated worse than securities investors and automobile dealers is, in reality, the idea that should be so far outside of the political mainstream that it should be rejected immediately and out of hand.

 

Jeff Haff

Change In Franchise Business Model

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.

business-handshake

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

 

  1. 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.

 

  1. 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”).

 

sign documentIf 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).

Summary

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.

Mission Statement

Watch the video by ReelLawyers below about Dady Gardner’s Mission Statement.

Mission Statement from ReelLawyers on Vimeo.

 

Does Dady and Gardner have a mission statement? Here at Dady and Gardner we do have a mission statement and it really has its start in the serenity prayer.

Typically when people come to see us with some crisis they’ve been told by one or two other lawyers that there’s nothing that can be done. We’re slow to say, “There’s nothing that can be done, and we need to be serene about that and accept it.” Instead, we push hard to see if there isn’t something we can do.

And so, our mission at Dady and Gardner is take a look at issues that clients present with us and make a determination if we have some reasonable likely to been able to be successful and then take all the gifts we’ve been given, use them to the max to deliver as efficiently as we can the maximum opportunity our clients have to be successful, to solve the problem they presented to us or achieve the objective they’ve shared with us.

Franchise Renewal: Rights, Obligations, and Notices

When prospective franchisees are investigating a franchise opportunity, they tend to focus on the terms that will have the most immediate impact on them—the amount of the initial franchise fee, the ongoing royalty obligations, the timeline for build-out and opening, etc. Unfortunately, as a result of this near-sightedness, franchisees (except for those who retain experienced franchise counsel to review their prospective agreements) tend to ignore the provisions in their franchise agreements related to renewal until it is too late, i.e., the point in time when their franchise agreements are up for renewal.

Set forth below are a few of the key issues that arise related to renewal in the overwhelming bulk of franchise agreements we see on a daily basis, as well as some tips on how to proactively deal with the issues before signing your next franchise agreement.

Franchise Renewal Rights and Obligations

While the specific language in the renewal section of a franchise agreement differs among the different franchise systems, in nearly every agreement we see, there are a number of similarities.

Additional Renewal Rights—While most (but not all) franchise agreements grant the franchisee the right to renew, how many renewals a franchisee is entitled to receive varies widely between franchise agreements. For example, some franchise agreements only grant the franchisee one renewal term. After that renewal term expires, the franchisor may not (absent some statutory protection to the contrary) have an obligation to offer the franchisee any further renewal rights. Therefore, we always like to ensure that our clients have the right to receive several renewal terms (e.g., four renewal terms), or, if possible, the right to obtain an unlimited number of successive renewal terms of a specific length.

contractSigning the Then-Current Form of Franchise Agreement—Franchisees often believe that the terms they are currently operating under (including the royalty rate and the size of any territorial protection they might receive) are fixed forever. Unfortunately, that is not generally the case, and, in order for franchisees to renew their franchises, franchisors often require they agree to sign the “then-current form of franchise agreement,” which can contain material differences from a franchisee’s prior franchise agreement, including higher royalty, marketing and other fees. To prevent the franchisor from changing the material terms of the franchise agreement upon renewal, we always attempt to negotiate changes to the franchise agreement to ensure that certain provisions will remain the same in all future forms of the franchise agreement, e.g., keep the same royalty rate, marketing, and other fees, the same protected territory, and any other key negotiating points that the franchisee was initially able to obtain.

Remodeling Requirements—After spending a significant amount of money building out a franchised location, the last thing a franchisee wants to hear is that he or she is required to remodel or reequip his or her franchise to meet the franchisor’s “then-current standards for new franchised locations” in order to renew, yet provisions like this are found in nearly every franchise agreement we see. While avoiding remodeling requirements completely may be difficult, to the extent possible, we always like to see reasonable limits placed on such requirements. For example, placing a limitation on the amount of money a franchisee can be required to spend or, absent specific limitations, at least a commitment from the franchisor that the requirements will be “reasonable.”

Written Notice—Franchise agreements generally require the franchisee to provide the franchisor with written notice that the franchisee wants to renew on or before a specific deadline, e.g., the franchisee must give written notice between six months and one year prior to renewal. While providing notice is simple (a relatively short letter to the franchisor saying you want to renew and asking what the next steps are will usually suffice), failing to provide notice can have drastic consequences. Indeed, a franchisor that was looking for a reason not to renew a franchisee could argue that the failure to provide timely written notice means that the franchisor has no obligation to renew. There are certainly defenses to this argument, but the best course of action is to simply ensure that you comply with the notice requirement in the first place.

Notices of Franchise Renewal and Non-Renewal

Assuming that a franchisee has provided the franchisor with the required notice requesting a renewal, the franchisor will usually respond in one of three ways.

goodFirst, the franchisor may send a written response stating that it will renew the franchisee, usually conditioned upon the franchisee meeting the other requirements related to renewal, e.g., the franchisee agreeing to remodel or reequip the franchise and agreeing to sign the then-current form of franchise agreement. As discussed above, given that the terms of the new franchise agreement can differ significantly from the franchisee’s previous franchise agreement, retaining experienced franchisee counsel to review the terms of the new franchise agreement is highly recommended. Indeed, we have had a number of clients ask us to review their renewal agreements, and, in doing so, we discover that the franchisor did not comply with the franchisee’s right to keep certain provisions the same upon renewal, e.g., the franchisor attempted to increase the royalty rate when it had no right to do so. In short, while receiving notice from the franchisor that it is going to renew a franchisee is certainly a good thing, ensuring that a franchisee is being renewed in the appropriate manner (i.e., under an appropriate written agreement and with appropriate conditions to be satisfied) is something that every franchisee needs to keep an eye out for.

badSecond, the franchisor may send a written response back saying that it does not intend to renew the franchisee. If that happens, hopefully the franchisor has explained the reasons for non-renewal in the letter. If this is not the case, asking the franchisor to explain the reasons for non-renewal would be, in most cases, a prudent course of action. Once the reasons for non-renewal are identified, we generally ask our clients whether the factual allegations in the letter are correct. If the franchisor has its facts wrong, clearing up those misunderstandings can often lead to a reversal of the franchisor’s position and a renewal for the franchisee. Another important thing to keep in mind is that the franchisor’s announced reasons for non-renewal may not be the franchisor’s actual reasons for non-renewal. For example, while a franchisor might claim underperforming sales are the reason for non-renewal, there may be other reasons why the franchisor has made the decision not to renew (e.g., the franchisor may not like the franchisee’s manager). Attempting to address the issues (stated and unstated) underlying the non-renewal is usually a good first step in attempting to have the franchisor reverse its decision. In the event that the issues cannot be resolved (or there are no good reasons for non-renewal in the first place), the next step is to see whether the franchisor’s notice of non-renewal complies with the franchisee’s rights under the franchise agreement and any applicable state franchise laws, many of which require the franchisor to give the franchisee significant, advance written notice and an opportunity to cure. Receiving a notice of non-renewal is certainly a stressful situation, but doing nothing about it (or simply hoping things will improve) is almost never in the franchisee’s best interest. Instead, if the franchisee receives a notice of non-renewal, being proactive, with the assistance of counsel, can oftentimes lead to a reversal of the franchisor’s decision and result in the franchisee being renewed.

Third, franchisors may attempt to have the franchisee agree to a “conditional renewal.” Conditional renewals are situations where a franchisor is unwilling to give the franchisee a full renewal term, and, instead, renew the franchisee, but only for a short period of time, during which the franchisee must, in essence, prove to the franchisor that he or she is a good franchisee by meeting certain criteria, e.g., minimum sales levels, improved inspection results, etc. While a conditional renewal is better than not being renewed, it is important for a franchisee to not be set up for failure. Indeed, the conditions placed on conditional renewals oftentimes are so onerous that no franchisee could succeed. Further, conditional renewals often require the franchisee to sign a general release in favor of the franchisor. Therefore, prior to agreeing to a conditional renewal, a franchisee should, at a minimum, determine whether he or she has the right to be unconditionally renewed (i.e., has the franchisee met all of the required conditions for a complete renewal), and, in addition, attempt to negotiate more favorable criteria in order to receive the unconditional renewal.

Pro-Active Steps Related to Renewal of Franchise

Dealing with issues related to renewals can be a difficult and stressful part of being a franchisee. Those issues, however, are made even more difficult and stressful when they are not addressed proactively. For example, rather than waiting to negotiate the terms of the renewal until the initial term of the franchise agreement has expired, we recommend negotiating some of those terms when the franchisee signs his or her first franchise agreement (i.e., rather than agreeing to sign the then-current form of franchise agreement, attempt to negotiate for the right to keep certain terms the same upon renewal). Similarly, rather than waiting until after the franchisee has been non-renewed and has ceased operating to challenge the franchisor’s decision not to renew, we recommend that a franchisee take action immediately after receiving a notice of non-renewal or notice of default and see what, if anything, can be done to change the franchisor’s mind.

In the end, proactively addressing issues related to renewal almost always produces better results for franchisees than doing nothing. If you find yourself with an issue or question about renewal, do not hesitate to call one of the attorneys at Dady & Gardner or to contact us through our website.

If a franchisor refuses to renew, what are the franchisee’s remedies?

Here’s a short excerpt from this video from ReelLawyers:

I’ve been doing this work for franchisees and dealers for a long time and this issue about renewal comes up more and more often. I used to argue (I’ve given up, because I’ve been unsuccessful) that what’s the difference? A termination or a non-renewal, you’re out of business either way so that the protections that relate to terminations should apply to non-renewals.

Unfortunately the case law, the decision by judges over the years said, “No, a non-renewal at the expiration of the term and written agreement is different than a termination during the term of that agreement and so different principles apply.” And so, if you receive a notice that you aren’t going to be renewed, that’s an issue that we have to deal with.

Watch the video for the full answer.

If a franchisor refuses to renew, what are the franchisee’s remedies? from ReelLawyers on Vimeo.

Business Inspections: Preparing for Franchise Store Inspections

clipboard-smallThe purpose of this article is to provide a recommended “step-by-step” protocol for franchisees to follow upon receiving notice that their franchisor intends to inspect their store.

At the outset, it is important for franchisees to understand that, since franchisors and franchisees have certain inherent economic conflicts of interest — e.g., franchisors are interested in increasing top-line revenues since the royalties they receive are based on revenues, whereas franchisees are interested in bottom-line profitability — it is not a good idea for franchisees to rely on franchisors, including the franchisor’s lawyers and field staff, for legal advice.

Secondly, it is important that franchisees understand that while franchisors have a right to enforce standards, those rights are typically subject to a “reasonableness” limitation. Accordingly, the answer we most frequently give to franchisees when they ask whether a franchisor may lawfully impose a particular standard (e.g., replace the flooring in the backroom), is to say, “It depends on the terms of your franchise agreement, and if it would be reasonable to do so”.

The issue of reasonableness, however, is rather subjective, and, in that regard, we do not want to see franchisees “bet the franchise” on uncertain outcomes.

Although a franchisee’s right to contest a deficiency notice from an inspection will depend on the parties’ respective rights under the applicable franchise agreement, we recommend that franchisees take the following steps for every inspection:

Step 1: Prepare for the Store Inspection

The best way to avoid receiving a deficiency notice is for a franchisee to operate its store(s) in compliance with reasonable operating standards pertaining to cleanliness and facility maintenance. If you receive notice of an upcoming inspection, you should do everything within your power to prepare the store for the inspection. And, if the applicable franchise agreement authorizes your franchisor to provide unannounced inspections, you should train your staff to be prepared for such inspections at any time and to make sure to take the following steps and immediately notify the appropriate person within your business to have that person attend the inspection.

Step 2: Monitor and Record the Store Inspection

To the extent possible, it is critical for the franchisee or the store manager to accompany the franchisor field representative during any inspection. In cases where the franchisor actually makes an appointment with the franchisee, it is critical for the franchisee to keep the appointment, since a failure to keep the appointment could have an adverse effect on the ultimate outcome. Moreover, it is extremely important for the franchisee, or the franchisee’s manager on duty at the time, to accompany the inspector during the inspection. The purpose of this is twofold: (1) it will allow the franchisee to identify in detail those issues with which the franchisor is concerned; and (2) it will allow the franchisee to make a photographic record of each and every item inspected so that the franchisee will have his or her own visual record of those items that the franchisor found satisfactory and those items that franchisor found unsatisfactory.

Step 3: Act Immediately

The only instance in which you need not take any immediate action following an inspection is when the report includes no deficiencies; that is the report includes no negative findings. In every other instance, even those in which the inspection provides you with a passing grade but includes one or more negative findings, you will want to take some kind of immediate action.

act-immediatelyWhen a franchisee receives a demand related to his or her alleged failure to comply with some type of standard (be it cleanliness, food safety, facilities or some other standard), the franchisee’s first inquiry should be directed to its local franchisor representative, asking (1) what, specifically, is the concern, and (2) how the franchisor believes the franchisee can most effectively and efficiently (and cheaply) resolve the deficiency. For example, a “parking lot” deficiency could be interpreted to mean that the franchisee has to rip up and replace the entire parking lot, or it could simply mean that the franchisee has to fill in a few cracks. The franchisee should do what can be done right away to determine what a reasonable cure would be. Franchisees should request that the franchisor field representative provide written answers to these two questions. If the franchisor field representative refuses to provide answers in writing, the franchisee should send the franchisor field representative a written recap of his or her notes of what the franchisor field person said (or refused to say).

If a franchisee’s negotiations with respect to the demand leads to a reasonable, efficient and economical solution, with the franchisor providing the franchisee with a realistic timeframe for effecting the solution, that should be the end of the matter, although the franchisee should be sure and get a letter from the franchisor acknowledging the fact that the franchise has satisfactorily cured the deficiency.

If, on the other hand, the communication with the franchisor field representative is unsatisfactory, and, in the opinion of the franchisee, the proposed “fix” is unreasonably expensive and/or unnecessary, or if the stated time limit for the fix is unreasonably short, it may then be appropriate for the franchisee to get an attorney involved to try and negotiate with the franchisor’s in-house legal counsel to get to a solution that is, in fact, reasonable and doable within a reasonable timeframe. Failing that, the franchisee next would want his or her legal counsel to try and negotiate with the franchisor to get a dispute-resolution mechanism in place that does not “bet the franchise” on the outcome.

Another option franchisees might consider even if the franchisor’s proposed “fix” is unreasonably expensive and/or unnecessary, or if the stated time limit for the fix is unreasonably short, and the franchisee is not interested at the time in challenging the franchisor’s “fix” or timetable, is for the franchisee to advise the franchisor in writing that the franchisee has agreed to comply with the franchisor’s demand, but that the franchisee is not waiving his or her right to later argue that the franchisor’s demand was unreasonable and/or unauthorized by the applicable franchise agreement. In the event a franchisee chooses this option, the franchisee may want assistance from his or her legal counsel in wording the notice to the franchisor.

Step 4: Determine Legitimacy of Each Deficiency

As referenced above, a failure of an inspection likely will constitute a default and start the “clock ticking” to the time when the franchisor eventually will attempt to terminate the franchise. Thus it is critical for the franchisee to address each deficiency individually, and to quickly determine whether the deficiency is valid (that is, the franchisor was correct in noting the deficiency). If the noted deficiency is not valid, the franchisee should immediately tell the franchisor in writing that the specific deficiency is not valid, provide an explanation why the deficiency is not valid, and then request a visit from the franchisor field representative as soon as reasonably possible to get written confirmation from the franchisor that the deficiency is not valid. If the franchisor is unwilling to give the franchisee such written confirmation, then the franchisee must decide whether to timely correct the deficiency anyway, or fight the deficiency through legal channels. If the franchisee desires to fight the deficiency through legal channels, the franchisee should give serious consideration to retaining experienced legal counsel.

Step 5: Correct the Legitimate Deficiencies

If the franchisee agrees with the franchisor’s assessment that action is warranted and can correct the alleged deficiency within the time the franchisor has stipulated to avoid a formal default notice and/or threat of termination of the franchise, then it is strongly recommended that the franchisee notify the franchisor in writing that he or she will correct the alleged deficiency within the time allotted. It also is recommended that the franchisee invite the franchisor’s representative to the store prior to the deadline to inspect the correction; that way, if the franchisor representative does not agree that the franchisee’s action has corrected the deficiency, the franchisee will have additional time to effect the necessary additional corrections.

Step 6: Request Additional Time When Needed

If the franchisee has determined that a deficiency needs correction, but the franchisee cannot complete the correction in the allotted time, the franchisee must seek and secure, in writing, an extension from the franchisor prior to the passing of the deadline. The best practice is for the franchisee to advise the franchisor in writing that the franchisee will correct the deficiency by a certain date. The franchisee should request a written response from the franchisor confirming that the franchisee can have the requested additional time. If the franchisor does not grant the additional time, the franchisee must either correct the deficiency in the required time or seek legal assistance to secure additional time.

Step 7: Seek Experienced Legal Counsel

If, after employing each of the aforementioned “Steps” deficiencies remain, and you have not yet procured legal counsel, it is absolutely essential that you employ legal counsel to assist you, hopefully, in negotiating a resolution with your franchisor prior to the passing of the applicable deadline. Failure to respond in a timely fashion to a failed inspection will lead to default, and, ultimately, if alleged deficiencies are not cured, then termination.

Summary

We hope this step-by-step protocol will help each of you have a more meaningful and less stressful experience upon your franchisor’s inspection of your store or stores.

We also hope that this article will convince every franchisee not only to prepare for inspections, but to act immediately upon the receipt of any negative communication from your franchisor. We cannot stress this enough: THE EARLIER A FRANCHISEE ACTS TO RECTIFY (OR, IF APPROPRIATE, TO FORMALLY CHALLENGE) ANY AND ALL DEFICIENCIES NOTED BY ITS FRANCHISOR, THE GREATER CHANCE THE FRANCHISEE WILL HAVE TO CORRECT OR REMOVE THE ALLEGED DEFICIENCIES WITHOUT FACING A DEFAULT AND/OR TERMINATION NOTICE. It bears repeating that a franchisee’s ability to avoid a default notice (and, ultimately, a termination notice) is significantly greater if the franchisee deals with each and every alleged negative item before the deadline identified in the franchisor’s communication.

SEK

Rights of First Refusal: 7 Things to Consider

Assume that you are a large multi-unit franchisee and you have the opportunity to sell your business to either an existing franchisee or to someone who wants to become a multi-unit franchisee in your system. You read your Franchise Agreements (perhaps for the first time) and discover that you may not transfer without the franchisor’s permission and the franchisor has a “rights of first refusal” that prevents you from selling at all unless you allow the franchisor the first shot at buying “on the same terms and conditions.” What do you do? Well, here are seven things you should do and/or consider.

7 Things to Consider for Rights of First Refusal

7 Things To Consider for Rights of First Refusal

1) Think Back In Time and Regret That Your Franchisor Has a Rights of First Refusal at All? Had Dady & Gardner reviewed your Franchise Agreement in the first place, we would have suggested that you try to avoid the right of first refusal (“ROFR”) altogether. ROFRs generally depress the potential sale price by at least the amount of attorneys’ fees that the buyer will need to incur to reach the ROFR stage. For example, if your buyer would have paid $1,000,000 without a ROFR, the buyer now might only offer $950,000 if there is a good chance that the franchisor will exercise the ROFR. The buyer will waste all of its time and money documenting a transaction that will, at the end of the day, benefit the buyer not at all. You will find very few buyers willing to graciously throw away their own time and money so that the franchisor can acquire your businesses.

 

2) Read the “Rights of First Refusal” Paragraph and the Consent to Transfer Paragraph. The language in most Franchise Agreements regarding transfer rights follows the same format, but that is not always the case. One franchisor permits any transfer at all, so long as the transfer is equal to or less than 49% of your interest in the business. Some franchisors permit transfers freely among current owners, or among close relatives. Maybe your transaction doesn’t need to be approved at all? Similarly, with ROFR issues, there are sometimes exceptions that say there is no ROFR on certain exempt transactions (family transfers, transfers on death, minority shareholder transfers). You never know, you may be able to structure the transaction in such a way that the franchisor has no ROFR, or, possibly, no rights at all.

 

3) Get the Clock Ticking. The Rights of First Refusal language generally sets forth how long the franchisor has to exercise its ROFR. The typical period selected is 30, 60 or 90 days. But one very important question is “30 to 90 days from when?” If it runs from the date when the franchisor receives a non-binding Letter of Intent, get that Letter of Intent formally submitted. If it runs from the date the franchisor gets a signed Asset Purchase Agreement, get that Asset Purchase Agreement formally submitted. If it runs from the date that the franchisor gets “all documents and other information necessary to make an informed decision,” make a strong written record with the franchisor establishing that the franchisor has all of the information the franchisor could ever want. Try to get a letter from the franchisor stating that “we will make a decision no later than [insert date].”

 

4) If the Franchisor Is Likely to Exercise the Rights of First Refusal, Try to Make the Buyer Pay 100% Cash. Many newer ROFR paragraphs in franchise agreements state that the franchisor “may substitute cash for non-cash consideration.” Franchisees often get far too clever and decide that the best course of action is to substitute non-cash consideration for cash. So, instead of $1,000,000, the franchisee will receive $500,000 plus the right to 25% of the company’s profits going forward. It has been our experience that a well-prepared franchisor will quickly state “the value of that 25% is either nothing or next to nothing, and it is certainly much less than $500,000.” What the franchisee has now accomplished is to give the franchisor a chance to drive down the sale price. If the business is worth $1,000,000 and the franchisee wants to get out and pocket $1,000,000, then ask for a $1,000,000 cash offer. Why buy a dispute with the franchisor (who almost always has far deeper pockets and can afford a long protracted fight)? If the issue of whether a ROFR has been properly exercised has to go to litigation or arbitration, the parties 95% of the time will compromise. This means that if the franchisor says the ROFR price is $500,000 and you as a franchisee say it is $1,000,000, the settlement figure will be well below $1,000,000. Why not just make it a cash deal and get the full $1,000,000? While the courts have questioned the “good faith” of non-cash consideration (for example, buyer has to wash my car every week) and chosen not to require such consideration if it is provided in bad faith, the general rule of law is the opposite on cash. When the contracting parties say “$40,000,000 in cash,” it does not matter that the amount is absurdly high, to exercise the ROFR, the franchisor must pay the $40,000,000.

 

5) Be Careful That Your Sale Doesn’t Get Rejected. Suppose you have done steps 1-4 and submitted a $3,000,000 cash offer for your units that are worth $1,000,000. Your franchisor is unlikely to take a $2,000,000 hit just to exercise the Rights of First Refusal. But, your franchisor has another weapon in its bag—it may reject the sale altogether. Almost all franchise agreements allow the franchisor to consider the financial status of the buyer and reject the sale if the financial status of the buyer would be insufficient to cover the debt incurred to pay for the franchise(s). Some franchise agreements specifically allow the franchisor to reject a sale for an excessive price. Do not be confused—the ROFR and the right to approve or reject the sale are not the same thing. They are two different “arrows” in the franchisor’s quiver.

 

6) Review Your Statutory and Common Law Rights. While most franchisees do not have statutory protection to void Rights of First Refusal efforts, some statutes involving car dealers or equipment dealers at least require a manufacturer or supplier who exercises a ROFR to pay the buyer’s attorneys’ fees and costs. If you have such rights, your buyer may be willing to present a 100% offer, knowing that it will at least not lose anything if the sale doesn’t go through. In some states, the “common law” (judge-made law) states that if the buyer promised to pay a broker fee, the franchisor exercising a ROFR also has to pay the same broker fee, but to the selling franchisee. This is the case even though the broker never gets paid! You need to know whether this is the law in your state as well.

 

7) Hire Competent Franchise Counsel and Work With the Buyer Early On. The analysis set forth above assumes that the selling franchisee is represented by competent counsel or has a good grasp of the concepts set forth above. We have recently seen franchisees in a major system lose out on trying to sell to existing franchisee friends because the deal used too much non-cash when the buyer actually had cash it could have offered. The seller ended up selling to a franchisor it didn’t care for, and the franchisor actually made the seller take a lower price. The buyer ended up holding the proverbial bag, left with nothing but a $50,000 bill for attorneys’ fees, while the franchisor stepped in and took the business at issue for less than the buyer thought it was worth. The buyers out there also need to realize that, in almost all states, they have virtually no legal rights and must work through the seller’s rights. For example, if the franchisee wants to sell for $1,000,000 in cash and $500,000 in non-cash, and the franchisor declares the non-cash to be worth $250,000, most courts will not question the ability of the seller to accept that $750,000 proposal. The general rule of law is that, once the Rights of First Refusal is exercised, the initial offer disappears. The buyer basically becomes a non-entity in the transaction. It is only the seller, in most states, who can complain about the ROFR and who can complain about a refusal to approve a sale transaction. If the buyer badly wants the franchised opportunity, it needs to work very closely with the seller and convince the seller that fighting the ROFR issue is in the seller’s best interest. After all, all money spends the same, so a seller who can get $1,000,000 from a buyer or $980,000 from the franchisor has a disincentive to fight if the fight will cost $20,000 or more.

Over the past several years, Dady & Gardner has fought several Rights of First Refusal and transfer approval fights on behalf of franchisees. We believe that we should be your preferred attorneys when these issues arise—whether you are the potential buyer or the potential seller.

 

JSH

Course of Performance: Modification of the Franchise Agreement

When Actions Speak Louder Than Written Words — A Look at Franchise Agreement Modifications because of “Course of Performance”

Course of Performance and Franchise Agreement ModificationsSometimes, when the relationship between a franchisor and a franchisee has evolved in a fashion that differs from the obligations of the parties as described in the franchise agreement, the written agreement may be said to have been modified by the parties’ course of performance. This is true even if the agreement states that all modifications must be in writing and signed by the parties.

Despite often used express provisions in franchise agreements stating that the agreement can only be modified in writing, it is generally accepted that, unless a contract is one required by law to be in writing, the contract can be modified orally or through course of performance.   Where an agreement that has been orally modified has been acted upon, most courts hold that the rights of the parties are to be determined by the modified agreement.

For example, in Ralph’s Distributing Company v. AMF, Inc., an Eighth Circuit Court of Appeals case involving a snowmobile distributor, the distributor was successfully able to argue that even though the franchise agreement did not specifically grant the distributor an exclusive territory, the franchise agreement had been subsequently modified to provide for an exclusive territory. Evidence that indicated a modification through course of performance included the fact that the distributor expended substantial funds on racing and other promotional activities with the expectation that neither the manufacturer nor other distributors would sell snowmobiles in its exclusive territory. Additionally, three manufacturer employees testified that once the manufacturer designated a distributor for a territory, the company would not assign other distributors to the same area; in such circumstance, the designated distributor was entitled to proceed in reliance that the manufacturer would not assign other distributors to his sales market.

In another case, Maintainco, Inc. v. Mitsubishi Caterpillar Forklift Am., Inc., a New Jersey court held that the course of dealing between a dealer and distributor had established an exclusive territory, despite the fact that language in the franchise agreement failed to explicitly grant the distributor an exclusive territory. The court held that because Mitsubishi’s universal practice nationwide was to grant exclusive territories, the distributor was entitled to an exclusive territory.

In a 2002 Tenth Circuit case, Haynes Trane Service Agency, Inc. v. American Standard, Inc., the court found that an at will termination provision in the parties’ franchise agreement had been modified to require good cause for termination because the stated policy of the franchisor was to terminate franchisees only when good cause existed. In that case, a franchisor official testified that he had interpreted franchise agreements to require good cause for termination and that he was unaware of any occasion in the past where the company had terminated a franchise agreement without cause.

A strict interpretation of the written franchise agreement often favors the franchisor when disputes arise in a franchise relationship. However, as demonstrated by the above examples, legal protections available to franchisees will often balance the scale—or even tip it in the franchisee’s favor. If, as sometimes occurs, the ongoing relationship between the franchisor and franchisee deviates from the obligations of the parties set forth in the written franchise agreement, and the franchisor then attempts to repudiate its historical pattern of conduct and points to language in the contract, a franchisee who understands the protections available may be able to obtain an edge in the dispute, thus retaining the modified terms.

If you feel that you may have rights to assert due to your franchisor’s modification of the franchise agreement by course of performance, or have any other franchise related law issue, please contact Dady & Gardner.