Franchise contracts and the franchisor/franchisee relationship

Franchise relationship laws

What laws regulate the ongoing relationship between franchisor and franchisee after the franchise contract comes into effect?

Twenty-five states and territories have enacted franchise relationship laws, and many of them govern the manner and procedure by which a franchisor may terminate, decline to renew or consent to a transfer of a franchise. For example, most franchise relationship laws require that a franchisor must have good cause to terminate a franchise and impose certain time periods during which a franchisee may cure defaults. Some of these laws are more limited, such as voiding venue selection clauses that force a franchisee to appear in court outside its home state or prohibiting the imposition of changes among similarly situated franchisees.

Operational compliance

What mechanisms are commonly incorporated in agreements to ensure operational consistency and adherence to brand standards?

Franchisors generally reserve inspection and audit rights to monitor compliance with brand standards. Such inspections and audits may include formal or informal site visits by a representative of the franchisor, mystery shopper programmes or review of a franchisee’s business records through remote access to a computer or point-of-sale system.

Amendment of operational terms

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

The franchisor is not permitted to unilaterally alter the terms of the franchise agreement. However, franchisors commonly reserve the right to alter the operations manual to modify the brand standards to reflect trends in the marketplace or new marketing techniques, technologies, and products and services.

Policy affecting franchise relations

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

The International Franchise Association has a code of ethics, but it has no force of law. Other associations that are formed may establish policies, but these policies would not have 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 terms of the franchise agreement establish the grounds on which a franchisor may terminate the franchise agreement. Common defaults include:

  • insolvency or bankruptcy;
  • abandonment of the franchised business;
  • failure to pay amounts due;
  • violations of health and safety laws; and
  • failure to comply with system standards.

 

Franchise agreements commonly distinguish between curable and incurable defaults. If applicable, state relationship laws may override the terms of a franchise agreement.

Termination by franchisee

In what circumstances may a franchisee terminate a franchise relationship?

Typically, franchise agreements expressly address when a franchisee may terminate a franchise agreement. In addition, common law may provide the franchisee with a right to terminate the franchise agreement upon a franchisor’s material breach. Recission of the franchise agreement is permitted under some state laws if a franchisor failed to comply with disclosure requirements.

Renewal

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

The terms of the franchise agreement generally establish the renewal requirements. Common renewal conditions include:

  • prior notice of the franchisee’s intent to renew;
  • the payment of a renewal fee;
  • execution of a general release of claims;
  • good standing;
  • a remodel of the premises; and
  • the execution of the franchisor’s then-current form of franchise agreement.

 

Disclosure is generally required on renewal if the franchisee would be required to sign a materially different form of franchise agreement than the agreement under which it had been operating.

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?

If a franchisee has not complied with the conditions for renewal that are established in the franchise agreement, the franchisor may generally refuse to renew the franchise agreement. If applicable, state relationship laws may impose certain restrictions on a franchisor’s refusal to renew.

Transfer restrictions

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

Yes. Franchisors typically reserve the right to approve or disapprove a sale of the franchised business and any change in ownership of the franchisee entity. The terms of the franchise agreement dictate the processes applicable to a transfer. Common transfer conditions include:

  • prior notice of the intent to transfer;
  • the payment of a transfer fee;
  • a remodel of the premises; and
  • execution of a general release of claims.

 

The transferee must also meet the franchisor’s standards for new franchisees, execute the franchisor’s then-current form of franchise agreement and complete any required training. Franchisors also commonly reserve a right of first refusal to acquire the franchised business if a franchisee desires to transfer.

Certain state-specific franchise relationship laws may also affect transfers.

Fees

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

No. Franchisors typically designate standard fees, which are disclosed in the franchise disclosure document (FDD), though franchisees are free to negotiate these fees.

Usury

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

Laws that limit the interest rate that may be charged (usury laws) have been enacted in all states.

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?

No. Generally, the United States does not impose currency or exchange controls on the transfer of money by a US-based entity (eg, a US franchisee) to a foreign entity, unless the foreign entity’s home country is subject to sanctions. However, intellectual property-based payments to a foreign franchisor, such as royalty payments, may be subject to a 30 per cent withholding tax. If the United States and the foreign country are parties to an income tax treaty, the foreign franchisor may be entitled to a reduction or exemption.

Confidentiality covenant enforceability

Are confidentiality covenants in franchise agreements enforceable?

Typically, yes. Reasonable confidentiality agreements are often enforced to protect the franchisor’s intellectual property, trade secrets and other confidential information.

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 have held that an implied covenant of good faith and fair dealing generally applies to contracts, including franchise agreements. As applied by many courts, this covenant requires parties to deal with each other honestly and fairly, and a party cannot act to deny the other party the benefit of the bargain. However, the covenant of good faith and fair dealing cannot contradict the express terms of a contract. Therefore, franchise agreements are explicit in their description of each party’s rights and responsibilities to reduce potential uncertainty, and to minimise potential claims alleging a breach of this covenant.

Franchisees as consumers

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

Treatment of franchisees as consumers varies by state. For instance, every state has an unfair and deceptive acts or practices statute, but the protections offered by those laws are state-specific.

Language of the agreement

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

It is assumed that FDDs and agreements will be provided in English. FDDs and agreements filed in the registration states must be in English.

Restrictions on franchisees

What types of restrictions are commonly placed on the franchisees in franchise contracts?

For the protection of the franchisor’s brand, franchise agreements typically require the franchisee to closely follow the franchisor’s business system. Accordingly, franchise agreements often require franchisees to sell all (and only) the goods or services that the franchisor designates, in accordance with the franchisor’s standards and specifications. Usually, the franchisor may prescribe certain approved or designated suppliers, or a process by which a franchisor may vet alternate suppliers. Similarly, franchise agreements often contain tight restrictions on the franchisee’s use of the franchisor’s trademarks. The franchisor’s business system is typically described in greater detail in an operations manual that is expressly referenced throughout the franchise agreement.

It is also typical in the United States for franchise agreements to designate an exclusive territory in which the franchisee must operate, though the size of the territory and level of exclusivity granted varies widely. Restrictions pertaining to confidentiality are also routinely included in franchise agreements, as well as both in-term and post-term covenants against competition (though the enforceability of such covenants varies by state). Franchise agreements also contain lengthy provisions that pertain to dispute resolution, which may include requirements for mediation and arbitration, as well as the franchisor’s choice of law and forum selection, which are also subject to state law.

Most franchise agreements contain restrictions relating to the transfer of the franchised business. Franchisors often require that the franchisee first obtain the franchisor’s prior approval before transferring the franchise, though these requirements are also subject to state law.

Courts and dispute resolution

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

The US federal court system, or the judicial branch, is one of three constitutionally prescribed branches of the US government. Due to federalism, US states have also established their own courts. The United States has a common law court system, which involves a formal adjudication process that creates law by establishing precedents.

Alternative dispute resolution methods are also commonly used to resolve franchise disputes. US law strongly favours the enforcement of arbitration agreements and many franchisors include broad arbitration clauses in their franchise agreements covering disputes arising from or relating to the franchise relationship (though some state laws purport to limit these arbitration agreements). Accordingly, a significant percentage of franchise disputes are arbitrated.

In addition, some franchisors and franchisees agree to pre-suit mediation as an alternative means of dispute resolution. Franchise agreements may even require that the parties first engage in mediation before initiating litigation or arbitration, and those provisions are generally enforceable.

Arbitration – advantages for franchisors

What are the principal advantages and disadvantages of arbitration for foreign franchisors considering doing business in your jurisdiction? Are any other alternative dispute resolution (ADR) procedures particularly favoured or disfavoured in your jurisdiction?

Arbitration has traditionally been viewed as offering several advantages over litigation, including:

  • greater efficiency and lower costs due to more limited discovery and streamlined pre-hearing procedures;
  • the ability to select an arbitrator with specialised experience;
  • the ability to have the venue for the arbitration in the franchisor’s home state (or country) and not in the franchisee’s home state (if the Federal Arbitration Act applies);
  • the opportunity to keep the proceedings confidential; and
  • the general lack of a preclusive effect of an adverse arbitration award.

 

However, in practice, arbitration can be as costly and time-consuming as litigation. In addition, arbitration results in a binding decision and there are limited rights to appeal or challenge arbitration awards.

National treatment

In what respects, if at all, are foreign franchisors treated differently (legally, or as a practical matter) from domestic franchisors?

US franchise laws apply equally to US and foreign franchisors. One aspect of the US franchise disclosure laws that may affect foreign franchisors relates to financial statements. In its FDD, a franchisor must include its audited financial statements for the three most recent fiscal years (with certain adjustments for start-ups), prepared in accordance with US Generally Accepted Accounting Principles (US GAAP). Therefore, a foreign entity seeking to become a US franchisor must prepare its financial statements under US GAAP or include detailed conversions from international standards to US GAAP.