Legal restrictions on franchise contracts and the relationship between the parties

Franchise relationship laws

Are there specific laws regulating the ongoing relationship between franchisor and franchisee after the franchise contract comes into effect?

In the US, 21 states, the District of Columbia, Puerto Rico, and the US Virgin Islands have ‘relationship’ laws governing the termination or non-renewal of franchise agreements and other aspects of ongoing franchise relationships, but there are no federal franchise relationship laws of general application.

Numerous states have relationship laws providing that a franchisor may not terminate or refuse to renew a franchise agreement without ‘good cause’, which is typically defined as some type of material default, and provide a minimum number of days or a cure period (or both) before a termination or non-renewal can become effective. These cure periods generally range from 30 to 90 days. However, immediate termination is permitted under certain conditions, which vary by state. Such franchise relationship laws typically also regulate transfers, renewals, discriminatory economic terms, product purchase requirements, and other terms typically addressed in franchise agreements.

The application of state franchise relationship laws creates significant potential liability for franchisors operating in the United States. Franchisors have to be careful not to violate them, and they are frequently violated due to lack of understanding or inadvertence. Generally, state administrators in registration states with relationship laws will require, as a condition of registration, that franchisors amend or rewrite certain provisions of their franchise contracts to conform to the minimum protections required under the relationship statutes. They also require that franchisors include in their disclosure documents notice of the existence of such laws and certain ‘state-specific’ disclosures.

Franchisees who are harmed by violations of state franchise relationship laws may recover damages and costs of litigation, including reasonable attorneys’ fees. Franchisees may also be awarded other appropriate remedies, including injunctive and other equitable relief.

Franchisees sometimes bring claims based on ‘encroachment’, where a franchisor locates a franchised or franchisor-owned outlet in close proximity to an existing franchised outlet and the new outlet has a negative financial impact on the existing outlet. Some franchise statutes expressly prohibit encroachment of the franchisee’s trade area, but these claims are usually rather fact-specific and may turn, in whole or in part, on whether or not the franchisee was granted any form of exclusivity.

Operational compliance

What mechanisms are commonly incorporated in agreements to ensure operational compliance and standards?

To ensure that the franchisee and its outlet are complying with the franchise agreement and the franchisor’s operational standards, a franchisor should reserve the right (itself or through its designated agents and representatives) to (1) inspect the franchisee’s outlet; (2) examine and copy the outlet’s business, bookkeeping and accounting records, tax records and returns, and other records and documents; (3) observe, photograph, videotape or otherwise monitor and/or evaluate, whether on-premises or remotely, the outlet’s operation, including both disclosed and undisclosed or ‘mystery shopping’ evaluations; and (4) discuss matters with the outlet’s personnel, customers and prospective customers. For physical inspections of the outlet, a franchisor generally need not provide prior notice of the inspection, which will occur at the franchisor’s expense. However, if the franchisor conducts a follow-up inspection in order to confirm that the franchisee has corrected any deficiencies that were identified in the initial inspection, then the franchisor may charge an inspection fee to compensate the franchisor for its costs and expenses. For examinations and audits of the outlet’s books, records and other documents, a franchisor often agrees to limit such activity during business hours and gives the franchisee minimum notice (typically one to three days). The franchisee typically must reimburse the franchisor for the costs of the examination or audit, including legal fees and independent accountants’ fees, plus travel and living expenses incurred by the franchisor’s employees and representatives, under certain circumstances: if the examination or audit is necessary due to the franchisee’s failure to provide books, records or other information as required, or if the franchisor’s examination or audit reveals an understatement of royalties, advertising contributions or other payments exceeding a certain percentage (typically 2 per cent to 5 per cent) of the amount actually reported to the franchisor.

Amendment of operational terms

May the franchisor unilaterally change operational terms and standards during the franchise relationship?

Franchise agreements commonly reserve to the franchisor the right to alter the operations manual, giving the franchisor the ability to change system standards. The franchisor may not unilaterally change the terms of the franchise agreement during the term, but if it has reserved the right to update and modify the operations manual, the franchisor may make changes to operational terms and standards in order to do so such things as change practices and procedures, add new products or services, implement new or updated technology and introduce new programs. However, changes that materially alter the franchisee’s rights and expectations under the franchise agreement will likely be found impermissible.

Other laws affecting franchise relations

Do other laws affect the franchise relationship?

There are no federal franchise relationship laws of general application. Certain industries (for example, the petroleum industry, with the Petroleum Marketing Practices Act) have successfully obtained legislation addressing specific needs within the particular industry. Business opportunity laws may also apply, and exceptions or exclusions available under them require franchisors’ attention. In addition, several common law theories affect the franchise relationship; in the absence of franchise relationship laws, franchisees who suffer wrongful acts by franchisors can bring actions based on theories such as breach of contract, fraud, misrepresentation and antitrust violations. Finally, courts consistently hold that the implied covenant of good faith and fair dealing that exists in any commercial contract also exists in franchise agreements. However, the scope of, and the manner of application of, the implied covenant of good faith and fair dealing has been the subject of much litigation and debate.

In addition, it should be noted that the franchisor-franchisee relationship can be implicated in disputes involving third parties. Examples include claims by parties who assert injuries suffered by virtue of acts of commission or omission by franchisees or their employees (raising issues of potential vicarious liability of franchisors); claims by proposed transferees who assert injury because the franchisor disapproved a proposed transfer (which may also include an assertion of tortious interference); and suppliers who claim injury because the franchisor refused to approve them, or withdrew approval.

Policy affecting franchise relations

Do other government or trade association policies affect the franchise relationship?

The United States does not have any trade association codes of conduct that are legally binding on franchisors in their relationships with franchisees, or each other. The International Franchise Association (IFA), of which many - if not most - major US franchisors are members, has a code of conduct that is available on its website, franchise.org. Many franchisees are also members of the IFA. The IFA’s Code of Conduct does not have the force of law, but it could influence a court’s decision-making process if the court chooses to view it as evidence of custom and usage. There are also private franchisee associations that have promulgated codes of conduct. They also do not have the force of law.

Termination by franchisor

In what circumstances may a franchisor terminate a franchise relationship? What are the specific legal restrictions on a franchisor’s ability to terminate a franchise relationship?

The circumstances under which a franchisor may terminate are generally governed by the terms of the franchise agreement, common law, and state franchise relationship laws. Fifteen state franchise relationship laws require the franchisor to have good cause or not to act in bad faith as a basis for terminating a franchise agreement. Good cause generally means a franchisee has failed to substantially comply with the requirements imposed by the franchisor and can include damages to a franchisor’s reputation, the sale of competing products, a failure to maintain standards, a failure to meet sales goals, a failure to report (or under-reporting of) sales, failure to pay royalties, and the franchisor’s complete withdrawal from the franchisee’s geographical market. The bad faith standard for termination applies if the franchisee acts in contravention of reasonable commercial standards of fair dealing. Assuming that either the franchisor has good cause for termination or the franchisee has acted in bad faith, the franchisor must also comply with procedural requirements that often include giving the franchisee the required advance written notice of termination, including in the notice the reasons for termination and how much time, if any, the franchisee has to cure the default, and continuing to comply with the franchisor’s obligations during the notice period.

Termination by franchisee

In what circumstances may a franchisee terminate a franchise relationship?

The circumstances under which a franchisee may terminate the relationship are generally specified in the franchise agreement. Franchisors are free to choose whether they wish for their franchise agreements to expressly allow the franchisee to terminate the franchise agreement if the franchisor fails to cure a material default. Also, some state disclosure laws allow a party to the franchise agreement to rescind the agreement if the other party fails to comply with disclosure requirements. In addition, even if the franchisee’s right to terminate is not addressed in the franchise agreement itself, common law may provide the franchisee such a right.

Renewal

How are renewals of franchise agreements usually effected? Do formal or substantive requirements apply?

Franchise agreements commonly include a right to renew the agreement for one or more successor terms, if certain renewal conditions set forth in the agreement are satisfied. The renewal conditions may include: the franchisee’s compliance with terms of the existing franchise agreement; payment of a renewal fee; execution of a general release; updates to the franchised location; and execution of the then-current form of franchise agreement. If the renewal franchise agreement contains terms that are materially different than the existing franchise agreement, disclosure to the franchisee is generally required.

Refusal to renew

May a franchisor refuse to renew the franchise agreement with a franchisee? If yes, in what circumstances may a franchisor refuse to renew?

Most franchise agreements provide conditions with which the franchisee must comply in order for the franchisor to renew the franchise agreement. Furthermore, the franchise relationship laws of certain states require good cause for non-renewal by the franchisor. Some states have notice requirements regarding non-renewal of the franchise agreement (for example, requiring the franchisor to give the franchisee notice of the franchisor’s intention not to renew at least 180 days prior to the expiration of the franchise agreement).

Transfer restrictions

May a franchisor restrict a franchisee’s ability to transfer its franchise or restrict transfers of ownership interests in a franchisee entity?

Most franchise agreements contain provisions requiring the franchisor’s prior written approval of a proposed transfer, which approval is subject to the satisfaction of several enumerated conditions. In addition, some state laws give a franchisee certain protections where it wishes to transfer. For instance, Iowa law requires that a franchisor’s transfer refusal not be arbitrary compared to the franchisor’s actions in substantially similar circumstances. Some states require that the franchisor have a material reason relating to the character, financial ability or business experience of the proposed transferee to reject a proposed transfer. To prevent a potential unwanted transfer, a franchisor can contractually reserve for itself the right of first refusal to purchase the franchise if the franchisee desires to sell it. Several states also require a franchisee to notify the franchisor of its intention to transfer or sell the franchise.

Fees

Are there laws or regulations affecting the nature, amount or payment of fees?

In the US, no state or federal laws dictate the amounts that can be charged for an initial or ongoing fee. State laws vary as to what constitutes a franchise fee, but it is generally defined as any payment the franchisee is required to provide to the franchisor or its affiliates for the right to do business under the franchise agreement or as a condition to, or practical necessity for, obtaining or commencing operation of the franchise.

A payment for a reasonable quantity of goods for resale at a bona fide wholesale price generally does not fall within the definition of a franchise fee. A number of state franchise laws provide that a payment of less than US$500 does not constitute a franchise fee. The FTC Rule exempts franchises where the total payments to the franchisor at any time prior to the franchisee’s seventh month of operations are less than US$540.

Usury

Are there restrictions on the amount of interest that can be charged on overdue payments?

Most states have usury laws limiting the amount of interest that can be charged on overdue payments. Many franchise agreements include a usury ‘savings clause’, which limits the amount of interest charged to the highest commercial contract interest rate allowed by law.

Foreign exchange controls

Are there laws or regulations restricting a franchisee’s ability to make payments to a foreign franchisor in the franchisor’s domestic currency?

The United States has no restrictions on the currency used by the franchisee to make payments to a foreign franchisor. The currency for payment is typically what is agreed on by the parties to the contract.

Confidentiality covenant enforceability

Are confidentiality covenants in franchise agreements enforceable?

Many courts have found that a franchisor’s confidential and proprietary information, trade secrets, trade dress and intellectual property may be justifiably protected by the use of reasonable confidentiality covenants.

Good-faith obligation

Is there a general legal obligation on parties to deal with each other in good faith during the term of the franchise agreement? If so, how does it affect franchise relationships?

Courts in most states have consistently held that an implied covenant of good faith and fair dealing exists in commercial contracts, including franchise agreements. How this principle is applied varies from state to state. The covenant generally provides that the parties to a contract must exercise their discretion as to the performance of their contractual obligations in a manner that is not inconsistent with the other party’s reasonable business expectations and does not deprive the other party of the benefit of the contract. Courts generally do not apply the covenant to override an express provision in the franchise agreement. Franchisees have used the implied covenant to argue that a franchisor has abused its discretion in interpreting the franchise agreement or in introducing new practices or programmes.

Franchisees as consumers

Does any law treat franchisees as consumers for the purposes of consumer protection or other legislation?

Whether a franchisee is treated as a ‘consumer’ with respect to the franchisor’s dealings with the franchisee for purposes of consumer protection or other legislation varies among the states. Courts in some states have found that a franchisee may be treated as a ‘consumer’ for purposes of consumer protection or other legislation, whereas other courts in other states have found that a franchisee may not be treated as a ‘consumer’ for purposes of consumer protection or other legislation.

Language of the agreement

Must disclosure documents and franchise agreements be in the language of your country?

There is no specific requirement under the FTC Rule or state registration laws that disclosure documents, franchise agreements and related documents used in the United States should be in English, although it is generally assumed that they will be.

Restrictions on franchisees

Describe the types of restrictions placed on the franchisees in franchise contracts.

United States franchise laws do not dictate the duration of franchise relationships, nor do they require or prohibit exclusive territories. However, in certain states, consequences may arise if the franchisor grants a franchise agreement with too short a duration. For example, Connecticut law imposes negative consequences if the franchise term is less than three years. Covenants that restrict a franchisee from competing with its own franchised unit or other units in the franchise system are common provisions in franchise agreements.

Some states’ laws, such as California’s, will not enforce or will provide only limited enforcement of such restrictive covenants. In most states, if such covenants are reasonable and consistent with the public interest (as determined by various factors including geographical scope, time limitations and the scope of activity to be restrained), they are usually enforceable. However, in some states, a court that concludes that a covenant is too restrictive to be enforced may ‘blue-pencil’ the provision (eg, reduce the geographical or temporal scope) and then enforce it as judicially revised. In other states, however, the excessive scope of a restrictive covenant may cause a court to strike the covenant in its entirety.

Franchisors typically include in franchise agreements limitations as to the sources from whom franchisees may purchase products, equipment or supplies. Generally, absent antitrust or state law concerns, if clearly disclosed in the franchise agreement, such contractual limitations are enforceable and may require the franchisee to make such purchases from the franchisor or an affiliate of the franchisor, or require that the purchases conform to criteria set forth by the franchisor in its manuals or otherwise. The franchisor must also provide certain information related to the restrictions regarding required sources in the franchise disclosure document.

The issue of franchisors controlling the prices at which franchisees may charge their customers has evolved over time owing to changes in the US antitrust laws. For many years, these vertical price restraints were deemed illegal per se under the antitrust laws. However, as a result of some decisions by the US Supreme Court over the past few years, the federal antitrust laws now tend to treat these restraints under the more lenient rule of reason standard, which involves a consideration of the pro- and anticompetitive effects of the restraints. Certain state antitrust laws still treat these restraints as illegal per se.

Franchise agreements often contain prohibitions on a franchisee’s right to solicit or hire an employee of another franchisee or of the franchisor. Those prohibitions have recently come under scrutiny because of their alleged competitive effects. The US Department of Justice has taken the position that such prohibitions in franchise agreements should be assessed under the more lenient ‘rule of reason’ approach rather than deeming them per se illegal. At least one state attorney general’s office contends that they should be treated as per se illegal.

Franchisors must decide whether they prefer to arbitrate or litigate disputes with franchisees. If arbitration is chosen, a franchisor may wish to exclude certain matters from arbitration so that those matters may go to court immediately. State franchise authorities have sometimes attempted to restrict arbitration clauses in franchise agreements to some degree as a precondition to registration. However, there is case law stating that the Federal Arbitration Act pre-empts any restrictions on arbitration that states purport to impose. Franchise agreements typically contain choice-of-law and forum selection provisions, citing the state where the franchisor’s principal place of business is located as the state whose law governs and in which any litigation must be held in case of a dispute arising under the franchise agreement. Several state registration laws prohibit the selection of governing law or venue other than that of the franchisee’s state.

Franchisors may not impose restrictions on the customers a franchisee may serve if such restrictions violate civil rights statutes or the antitrust laws. Otherwise, franchisors are generally free to impose customer restrictions, so long as they are disclosed in the franchise disclosure document.

Competition law

Describe the aspects of competition law in your country that are relevant to the typical franchisor. How are they enforced?

Antitrust laws, such as the Sherman Act and the Robinson-Patman Act, apply to franchise relationships. These laws primarily deal with contracts or conspiracies that restrain trade or discriminate with respect to pricing. Two major types of arrangements can restrain trade in violation of the antitrust laws - horizontal and vertical arrangements. Horizontal restraints involve arrangements that restrain trade among competitors at the same level of market structure. Vertical restraints involve agreements among actors at different levels of a market structure. Allegations of horizontal conspiracies are tested under a more stringent ‘per se’ approach, while allegations of vertical conspiracies are tested under the rule of reason.

Most franchise arrangements fall into the ‘vertical’ category. A franchisor that has both franchised units and units it operates faces a higher risk of a vertical arrangement being treated as a horizontal arrangement. The provisions of these antitrust laws are enforced by federal and state governments and by private litigants, who may also bring antitrust claims. Moreover, there are state antitrust laws that may apply to franchise relationships. These state antitrust laws are generally consistent with federal antitrust laws, although some divergence has emerged regarding the validity of pricing restrictions. Franchisors should be aware of applicable state antitrust laws to ensure that they are in compliance.

Courts and dispute resolution

Describe the court system. What types of dispute resolution procedures are available relevant to franchising?

In the United States, civil litigation (in both federal and state court beginning at the trial level and, in some cases, ending at the appellate level), arbitration and mediation are generally available for dispute resolution. While the federal courts operate under the Federal Rules of Civil Procedure and state courts have similar rules, many procedural rules of court will vary by jurisdiction. Arbitration is only available if the parties agree to use it. Franchise agreements often include arbitration clauses. The Federal Arbitration Act generally provides for enforcement of contractual arbitration provisions in all states and supersedes state laws governing arbitration. The United States is a party to the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards and will respect and enforce the parties’ choice of arbitration by non-US arbitration panels, which may include the parties’ agreement to conduct the arbitration outside the United States. In addition, some franchise agreements include mediation clauses.

As a practical matter, the rules of many state court systems and many federal trial courts will require the litigants to engage in some form of court-imposed initial mediation or alternative dispute resolution process before a case can proceed to trial.

Arbitration – advantages for franchisors

Describe the principal advantages and disadvantages of arbitration for foreign franchisors considering doing business in your jurisdiction.

There are advantages and disadvantages to selecting arbitration in the United States as the method of resolving disputes. In terms of the advantages, perhaps the greatest advantage of arbitration is that it avoids a jury trial and, absent an agreement to allow a class action, generally requires that the proceeding be conducted on an individual basis with a single franchisee. Arbitration is a more informal proceeding than litigation, where the parties have a say in selecting the person who will be the arbitrator and can, to some extent, control the scope of discovery by the terms of the franchise agreement. Arbitration is generally considered to be faster and less expensive than litigation, though that is not always the case. While one other benefit of arbitration for US-based franchisors is that it generally allows the franchisor to choose its home state as the location of the arbitration, that consideration is most likely not as relevant for a foreign franchisor unless it has some connection to a particular state in the United States where it would want the arbitration to be held.

The major disadvantage is probably the inability to obtain a reversal of an incorrect ruling by the arbitrator. One of the benefits of arbitration is its finality, but this can also be a disadvantage - in opting for finality, one is also sacrificing the ability to appeal an adverse ruling by an arbitrator. Another disadvantage of arbitration is that the rules governing discovery and how the proceeding will be conducted are not as well defined as in litigation in the courts. For example, the rules of evidence applicable in courts do not need to be followed by arbitrators (absent a requirement in the franchise agreement) and hearsay evidence may well be admitted into the proceeding. Similarly, not all arbitrators will rule on pre-hearing motions raising legal defences, but will allow the hearing to go forward before ruling on these types of issues. Arbitrators also tend to favour equities, and their ruling may reflect this, even if the law were to require a different result. There are court decisions calling arbitrations a ‘court of equity’, and thus one may be sacrificing some predictability in the result by choosing arbitration over litigation. In addition, arbitration can become expensive because, unlike in litigation, the parties are paying for the arbitrator’s time, and, if an arbitration group is administering the proceeding (such as the American Arbitration Association or JAMS), there are administrative costs involved.

National treatment

In what respects, if at all, are foreign franchisors treated differently from domestic franchisors?

Foreign franchisors are not generally treated differently from domestic franchisors. Foreign franchisors must comply with the disclosure requirements under the FTC Rule, as well as any registration or disclosure or relationship laws (or both) promulgated by the states whose laws apply to any particular transaction or relationship (or both). A practical difficulty arises for foreign franchisors because the franchisor’s financial statements must be included in the disclosure document and those statements must be prepared according to United States generally accepted accounting principles, or be prepared in a way that is permitted by the United States Securities and Exchange Commission. For this reason, many foreign companies form a US company to offer franchises in the United States and have US-style audited financial statements prepared for it and included in the disclosure document. However, foreign parent companies’ financial statements must also be included in the disclosure document if the parent commits to perform post-sale obligations for the franchisor or if the parent guarantees the obligations of the franchisor under its franchise agreements.