By Raymond T. McKenzie
The Law Office of Raymond T. McKenzie, Esq.
The practice of franchise law is a niche area when it comes to the representation of franchisors. Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law. It is the Franchise Disclosure Document (“FDD”), which includes the franchise agreement that will eventually be executed by the franchisor and franchisee, that is disseminated by franchisors to prospective franchisees for review prior to the offer of sale of a franchised business in this country. It is the drafting and filing of the FDD in franchise registration states across the country that relies upon the expertise of a franchise attorney.
There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed by the idea of reviewing a franchise agreement and advising a prospective franchisee. You will hear many business owners say they have reviewed a franchise agreement and feel like they have a “pretty good idea” about what is contained there.
However, attorneys have spent a lifetime being taught that the difference between having a “pretty good idea” and being absolutely, legally, sure, can be quite costly. It is therefore up to the attorney to advise the client as to exactly what the franchise agreement states, which will allow the client to make a fully informed decision. With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.
- Term. The term of a franchise agreement varies, as it depends almost entirely on a business judgment made by the franchisor when drafting the FDD and franchise agreement. Some franchisors prefer shorter terms, so that franchisees are asked to execute new franchise agreements every few years. Other franchisors prefer the stability of having their franchisees committed to longer franchise agreements. Franchisees’ preference as to the length of a franchise agreement varies as well, with some franchisees preferring to enter into a short-term agreement in case the business does poorly or the franchisee is simply not sure that the business is one that he wants to be involved in long term. Just as many franchisees, however, especially where a large capital investment is required, prefer the security and predictability of a longer term. This allows the franchisee to focus on growing the business without the underlying concern of franchise agreement renewal and expiration issues. Bearing in mind the client’s stated business objectives and the franchise’s possible pitfalls, it is up to the attorney to advise the client as to what length of term best suits the client’s goals and needs, and to negotiate such term into the franchise agreement.
- Fees. Many franchise agreements require the payment of an initial franchise fee. This fee is an up-front fee due at the time the prospect purchases the franchise. Some franchisors will offer to finance this fee over a period of time, while others require the lump sum payment to be made without making any financing available. In addition to an initial franchise fee, franchisors usually require in the franchise agreement that the franchisee pay ongoing royalty and advertising fees to the franchisor during the term of the agreement. Royalty and advertising fees are usually paid monthly, and can be a percentage of the business’s gross revenue, a flat fee, or a combination of the two.
One of the issues to watch for with regard to ongoing fees is whether the franchisor requires the franchisee to pay a minimum royalty fee either monthly or annually, without regard to the amount of actual revenue the franchisee generates. Think of it as an alternative minimum tax for franchisees. At the end of a month or year, a franchisee may have to write the franchisor a check to cover the minimum franchise fee if the royalty fee paid by the franchisee, based on a percentage of the franchisee’s revenue, fell short of the minimum royalty fee called for in the franchise agreement. This is unquestionably an issue that an attorney must make sure to bring to the attention of a franchisee prior to executing a franchise agreement.
- Renewals/Subsequent Agreements. Pay careful attention to the language regarding renewals and subsequent agreements. The term “renewal” is a misnomer, since technically most franchisors do not allow the franchisee to simply renew the existing agreement as-is. Rather, most franchisors grant existing franchisees the opportunity to enter into a “then-current” franchise agreement, provided the franchisee is in good standing. The “then-current” agreement will naturally contain terms differing, in some respects materially, from the previous agreement offered by the franchisor. This is the franchisor’s way of making sure that it does not get stuck with a stale agreement, whether it be in the fee structure or numerous other areas that the franchisor may wish to change over time. Some items to pay specific attention to when reviewing subsequent agreements include: whether a renewal fee is called for; whether the right to execute subsequent agreements goes on indefinitely, or instead if only a set number of renewals are allowed; whether the agreement calls for execution of the franchisor’s then-current franchise agreement, which may include terms materially different from the existing agreement; whether there is a cap on how much the franchisor can raise fees in subsequent agreements; what is the term of the subsequent agreement; and, what, if any, improvements, changes, renovations, and upgrades are required of the franchisee prior to a subsequent agreement being offered by the franchisor.
- Termination by Franchisor. The standard franchise agreement includes several breaches that, if committed by the franchisee, allow the franchisor the right to terminate the agreement. When reviewing the sections dealing with termination, make sure to identify which defaults allow for a cure period, that is, a time by which the franchisee may correct the default and thus avoid termination, and which breaches permit the franchisor to terminate the franchise agreement without providing the franchisee an opportunity to cure. A franchisee is unable to cure some breaches as a matter of course, such as abandonment of the franchised business, unauthorized transfer of the franchised business, and repeated breaches of the franchise agreement, and thus in these situations automatic termination is appropriate. However, there are many common breaches found in franchise agreements where it is possible for a franchisee to cure, yet the franchise agreement nonetheless allows the franchisor to terminate the agreement at its discretion. It is in the attorney’s best interest therefore to notify the client of the different classes of breaches, and if warranted, negotiate with the franchisor to move some breaches from the automatic termination section to the termination-after-cure section.
Finally, on the subject of termination, an attorney reviewing a franchise agreement should also pay close attention to the length of time granted to cure a breach, and attempt to lengthen the cure period where possible.
- Termination by Franchisee. Some, but not all, franchise agreements allow for the franchisee to terminate the agreement by providing a certain amount of notice to the franchisor. This can arguably be the most important right granted to a franchisee, since a franchisee that has the right to terminate an agreement if the business gets into trouble can simply cut its losses, notify the franchisor of its desire to terminate the agreement, take the franchisor’s signs down, and cease running the business. Many times, this will allow a distressed franchisee to avoid the fees and other obligations owed to the franchisor before disaster strikes. Otherwise, a franchisee that abandons the franchised business prior to the agreement’s natural expiration could be exposed to a claim by the franchisor for breach of contract combined with a claim for “future royalties.”
“Future royalties” is a still-emerging theory of franchise law that holds that a franchisee that unilaterally ceases operation of its franchise prior to expiration can be held liable to the franchisor for the royalties and other fees the franchisee would have paid during the entire term remaining on the franchise agreement. While this legal theory is complex and depends on a thorough review of the facts of each case, it is certainly an issue for attorneys to think about when reviewing a franchise agreement.
What is clear is that a franchise agreement that allows a franchisee to unilaterally walk away from the franchise can negate this cause of action from being raised and in the end potentially save a distressed franchisee from a costly fight. For an excellent discussion of the future royalties issue by the Texas Court of Appeals applying Georgia law, see Progressive Child Care Systems v. Kids ‘R’ Kids International, Inc. and Vinson, 2008 Tex. App. LEXIS 8416; see also Choice Hotels International, Inc. v. Okeechobee Motel Joint Ventures, et al., Civil Action No. AQ-95-2862 (D. Md. 1998); Burger King Corp. v. Barnes, 1 F. Supp. 2d 1367 (S.D. Fla. 1998) Sparks Tune-Up Centers, Inc. v. Addison, Civ. Action No. 89- 1355 (E.D Pa. 1989).
- Post-Termination Non-Competition Covenant. In many states, including Maryland, a court will hold valid and enforceable a non-competition covenant that is “reasonable” in the activity it restricts, as well as in its geographic scope and duration, absent extenuating circumstances. According to Maryland case law, a “reasonable” post-termination covenant not-to-compete will restrict a franchisee from competing for one or two years, within a reasonable geographic scope, in the business that is identical or similar to the franchised system. Naturalawn of America, Inc. v. West Group, LLC et al., 484 F. Supp. 2d 392 (D. Md. 2007); see also Merry Maids, L.P. v. Kamara, 33 F. Supp. 2d 443 (D. Md. 1998).
The opinion of most franchisors is that a franchise system cannot remain viable if a franchisee is allowed to compete against the franchisor after termination of a franchise agreement. Therefore many franchisors view the inclusion of a post-term covenant not-to-compete in a franchise agreement as non-negotiable. An exception to this stance may exist where a prospective franchisee has had prior experience owning the business before approaching the franchisor. In some instances it may be possible to negotiate the non-compete out of the agreement, since the main objectives of the non-compete (i.e. to protect the franchisor’s system for operating the business along with the goodwill built up using the franchisor’s marks) are somewhat diminished when a prospective franchisee has operated a competitive business prior to purchasing the franchise. The argument goes that the inclusion of a non-compete would fail to put the parties in the positions they occupied before entering into the franchise agreement.
A second scenario to look for when reviewing noncompete language is whether the non-compete covenant applies upon natural expiration of the agreement. The court in the Naturalawn of America case cited above indicates that a non-compete will be enforced against a franchisee upon expiration of the agreement simply because, in the court’s opinion, “’expiration’ of an agreement is a more specific type of ‘termination.’” Naturalawn of America, Inc., 484 F. Supp. at 401. The enforcement of a non-compete upon the natural expiration of a franchise agreement could have enormous consequences on an uninformed franchise client who suddenly finds himself prohibited from continuing in business as an independent owner, despite the fact that the owner, while a franchisee, was a model franchisee during the life of the franchise agreement and exited the system in good standing with the franchisor. Negotiating a change, or at minimum advising the client of the post-expiration covenant prior to signing, is therefore essential to providing the necessary information to allow the client to make informed decisions as to whether to purchase the franchise.
- Assignment; Sales of Assets to Third Party; Franchisor right of refusal. Franchisors uniformly reserve the right to approve an assignment of the franchise agreement by a franchisee to a third party, or a sale of the franchisee’s assets to a third party, and to prohibit such transfers and sales that the franchisor does not ultimately approve of. These rights are rarely negotiable, since franchisors take extremely seriously the approval of the persons and companies that will be holding the franchisor’s trade name and marks out to the public. One exception where negotiation is possible, however, is the form of the franchisor’s right of first refusal. Basically, many franchisors retain an option to either purchase the assets of the franchised business, purchase the franchise itself, or both, on the same terms and conditions the franchisee has agreed to with a bona fide buyer. A franchisor’s right of first refusal can be problematic to a franchisee for a number of reasons. First, the franchisee has to have a bona fide offer from a third party, one that is final and agreed to on every point so that it can be taken to a franchisor for a decision. Next, potential purchasers can be hesitant as a result of the period — 60 – 90 days is standard — that the franchisor has to decide on whether to match the offer.
Some purchasers will balk at the possibility of having to wait while the franchisor contemplates, only to find out that the opportunity to purchase the business or the assets was indeed exercised by the franchisor, thereby leaving the third party searching for a new business to purchase once again. Therefore, an attorney will best serve his client’s interests by removing the right of first refusal altogether, and if unsuccessful, at least shortening the time period granted to the franchisor to decide on the offer so as to make the delay tolerable.
- Dispute Resolution. Reviews are mixed in the franchise world as to the best dispute option for franchisors. A franchisor’s choice of litigation, arbitration or mediation is a business decision cultivated through a franchisor’s experience. Supporters of arbitration point to its cost-effectiveness, as well as its speed. Based on recent reports, however, both points can be seriously debated, since an arbitration nowadays is just as likely to cost as much as, and may take just as long as, any lawsuit. Likewise, supporters of litigation will be hard-pressed to show that a judge will provide a more reasoned and legally sound opinion, since associations such as the American Arbitration Association often provide an arbitrator with a background in franchise law to hear franchise cases.
In some instances, franchisors have chosen a mix of several dispute resolution methods that vary depending on the type and dollar amount of the claim. It is true that beauty is in the eye of the beholder with regard to the method by which a dispute is heard. Rather than argue over the method by which disputes will be heard, an attorney’s time may be better spent attempting to negotiate the jurisdiction where disputes will be heard, since it is common for franchisors to use their home state as the place where disputes will be resolved. An attorney reviewing a franchise agreement must take into account the added expense a franchisee will have to undertake in the event a dispute needs to be litigated or arbitrated in a state other than Maryland. One solution is to add language, similar to what is already found in many state franchise laws, that allows a franchisee to sue or arbitrate in his home state, regardless of the state designated in the franchise agreement.
- Recovery of Attorney Fees. The issue of the recovery of attorney fees spent by either party when a dispute arises between a franchisor and franchisee is a topic that must be looked at carefully when reviewing a franchise agreement. Fees paid to attorneys are costly in even the simplest of matters, and such fees can escalate dramatically as the disputes get more complex and the parties involved get more acrimonious towards one another. It is a priority when reviewing the franchise agreement to determine whether the recovery of attorney fees is addressed in the agreement, and if so, who has the right to recover such fees and how.
There are several different methods by which franchisors address the recovery of attorney fees. The most popular method for recovering attorney fees is through the use of a “prevailing party” clause, which enables the winner of a lawsuit or arbitration to collect its attorneys’ fees from the losing party, provided the judge or arbitrator chooses to enforce such language. This type of clause is popular with franchisors who believe it is useful as a deterrent to franchisees who may otherwise attempt to bring questionable actions against the franchisor.
Other franchisors choose the opposite route and simply state that either party to a dispute is responsible to pay its own attorney fees and costs. A third type of clause is the one-sided franchisor attorney fees clause, which states that if the franchisor is forced to bring an action to enforce its rights under the agreement, or is forced to defend itself from an action brought by a franchisee, the franchisor is entitled to recover its fees as long as it prevails in the action. This language gives the franchisor the best of the prevailing party language without having to share the benefit with a franchisee. This one-sided type of clause is frowned upon by some courts due to the lack of mutuality between the parties. However, rather than rely on a court to strike the language down, it is recommended that a franchisee’s attorney look to change this language to make it mutual for both parties at the outset.
- Territory. Some franchise systems grant franchisees “exclusive” territories, meaning that these franchisees are protected from competition from other franchisees, and in many respects from the franchisor as well, inside this designated territory. Though it depends on the industry, many franchisees view a protected territory as a must. The franchisee believes this market protection will allow its business to flourish, and an agreement that does not contain a protected exclusive area will cause the franchised business to fail. There are several opinions on either side of this argument but hardly an exact answer.
As an attorney preparing to advise your franchise client, you must review the franchise agreement in order to understand what the franchisor is offering in the way of territories. While doing so you must keep the following questions in mind: Does the franchisee understand that even with a protected territory, he will still most likely be competing against several, if not dozens, of competitors from other brands inside an exclusive franchise territory? How does the franchisee view the theory of market saturation that the more of a particular brand, product, or service a customer sees, the more popular and acceptable the brand becomes? Given the choice, would the franchise client prefer to be a franchisee of a system that grants enormous exclusive territories to each franchisee, but with small number of total franchisees overall? Or would the client prefer a franchise system that grants smaller or even no territories, but where the number of franchisees, and thus the number of outlets at which the product or service is available, is much greater? In conjunction with the idea of exclusive territories, make sure to pay attention to the language of the franchise agreement discussing the franchisee’s right to advertise and sell products and services in areas located outside the franchisee’s territory that are not owned by other franchisees of the system. Just as important, also pay attention to any language that reserves to the franchisor the right to compete with the franchisee inside the franchisee’s territory, especially when it comes to the sales of products over the internet.
Conclusion: As mentioned above, the above tips address only some of the issues that you should be aware of when reviewing a franchise agreement. A diligent attorney reviewing a franchise agreement will often find several other issues that are material to the prospect’s decision to purchase a franchise. In addition, please note that this paper does not discuss registration or disclosure issues in the state of Maryland or elsewhere.