Common features and contractual requirements
What are the common elements of franchise agreements in your jurisdiction? Do any requirements or restrictions on contractual provisions apply?
The franchise agreement details the respective rights and obligations of the franchisor and the franchisee. It establishes the general terms of the franchise relationship, including:
- the length of the initial term and any renewal terms;
- identification of the franchised location;
- any territorial rights or territorial protections granted to the franchisee;
- conditions applicable to renewal and transfer;
- the parties’ respective rights to terminate the agreement;
- covenants against competition during the term of and following the expiration of the franchise agreement; and
- other applicable post-termination obligations.
The franchise agreement should describe the franchisee’s obligations applicable to the development and operation of the business and all fees payable by the franchisee. Other significant operational requirements that are often described in franchise agreements include:
- initial and ongoing training and support;
- site selection;
- technology and computer systems;
- accounting and reporting; and
More specific details regarding the franchisor’s required standards and specifications are often included in the franchisor’s operations manual. The franchise agreement will also address dispute resolution (eg, the use of mediation, arbitration or litigation), governing law and other dispute resolution processes and costs. Many franchise agreements include a personal guaranty that must be signed by one or more owners of the franchisee entity.
The parties are generally free to establish the terms of the agreement. However, certain state franchise laws may prohibit franchisors from requiring a franchisee to waive application of the state’s franchise law, the right to a jury trial or certain types of damages, or from requiring consent to litigation in a forum outside the franchisee’s home state. Certain state laws may also affect or limit the enforceability of non-competition covenants and releases of claims. Many franchisors address these issues as necessary in state-specific addenda to the franchise agreement.
Are parties to a franchise agreement subject to an implied or explicit duty of good faith?
Courts have held that an implied duty of good faith applies to all contracts, including franchise agreements. The implied covenant of good faith and fair dealing, as applied by many courts, means that the parties must deal with each other honestly and fairly, and a party cannot act to deny the other party the benefit of the bargain reflected in the contract. However, the covenant of good faith and fair dealing cannot contradict the express terms of a contract or create rights and duties that are not provided in the contract. Many franchise agreements are explicit in their description of each party’s rights and responsibilities to reduce potential uncertainty regarding terms and conditions, and to minimise potential claims alleging a breach of this implied covenant.
Are franchise agreements subject to any formal or documentary requirements, including registration?
Franchise agreements generally must be in writing to be enforceable. There are no notarisation, seal or registration requirements. The form of franchise agreement that the franchisor intends to offer to, and execute with, a franchisee must be included in the franchise disclosure document (FDD).
What due diligence should both parties undertake before entering into a franchising agreement?
The FDD is, or should be, a critical but not exclusive part in the prospective franchisee’s evaluation of a franchise. Prospective franchisees should review the FDD, franchise agreement and related documents detailing the terms of the franchise relationship to understand the costs involved, the control exercised by the franchisor and the support services offered. The FDD includes a list of all operating franchisees and those franchisees which left the system in the most recent fiscal year. Prospective franchisees can and should speak to as many of these franchisees as possible. Prospective franchisees should evaluate competitive franchised brands and even franchises in other industries. Industry-specific trade associations also have information on businesses and operations, and these resources should be used by prospective franchisees. Prospective franchisees should evaluate whether the business model is an appropriate fit with their own business experience and whether there is a market need for the products or services offered by the franchised business in the franchisee’s ideal territory or location. Prospective franchisees should consider engaging financial and legal advisers to help assess the franchise opportunity.
Franchisors should establish criteria to assess each prospective franchisee. Such criteria should include:
- whether the franchisee is a good fit for the system;
- whether the franchisee has the appropriate experience to successfully operate the franchised business;
- whether the prospect meets minimum capital requirements;
- the availability of territory in the franchisee’s ideal market; and
- whether it makes sense for the franchisor to expand into that region.
Are franchisors subject to pre-contractual disclosure requirements? If so, do any exemptions apply? What remedies are available to franchisees in the event of breach of these requirements?
Generally, franchisors must give a prospective franchisee an FDD at least 14 calendar days before the prospect signs a binding agreement or pays any consideration to the franchisor or its affiliate. The FDD includes 23 specific disclosure items, including:
- information regarding the franchisor and its business experience;
- initial and ongoing fees payable by the franchisee;
- an estimate of the initial investment required to begin business operations;
- information regarding support provided by the franchisor before and after the business opens; and
- summaries of the key terms of the form franchise agreement.
The FDD also must include the franchisor’s financial statements, copies of the forms of franchise agreement and other contracts that a franchisee must sign and contact information for all existing franchisees in the system.
On provision of the FDD, a franchisor must obtain from the prospective franchisee a signed and dated FDD ‘receipt’ page, which is the last page of the FDD. Franchisors must maintain a copy of all executed receipts as evidence of proper disclosure.
A number of disclosure exemptions are available under the US Federal Trade Commission (FTC) Rule. Three of the most commonly used exemptions are the minimal franchise fee exemption, the large franchisee exemption and the large investment exemption. An exemption, if satisfied, means that the franchisor does not need to provide an FDD to the prospective franchisee. The minimal franchise fee exemption exempts franchise sales that require a franchisee to pay less than $570 in franchisee fees during its first six months of operation. The large franchisee exemption exempts franchise sales to franchisees with at least $5,715,000 in net worth and five years of prior business experience. The large investment exemption exempts franchise sales when the initial investment is $1,143,100 or more. The monetary thresholds applicable to the above exemptions are periodically updated for inflation by the FTC.
If a franchisor wishes to avail itself of an exemption under the FTC Rule, it must also ensure that it is exempt at the state level. Not all FTC Rule exemptions are available under state laws and there are registration and disclosure exemptions at the state level that are not available under the FTC Rule. Exemption requirements vary from state to state. State exemptions are often limited to exemption from registration and therefore may require compliance with disclosure obligations.
There is no private right of action available to franchisees under the FTC Rule for failure to provide proper disclosure. Therefore, only the FTC may pursue a violation of the FTC Rule. In registration states, if a franchisor fails to provide proper disclosure or appropriately register, the franchisee may bring a claim under the applicable state law. Remedies available under state franchise laws may include rescission of the franchise agreement and damages. In addition, separate from any potential franchisee claims, if a state agency determines that a franchisor failed to comply with applicable state franchise law, the state may issue a cease and desist order, require payment of civil penalties and require the franchisor to include a disclosure related to the state franchise law violation in the FDD.
Choice of law
May the parties freely choose the governing law of the franchise agreement?
The parties are free to choose the governing law of the franchise agreement. However, since franchise agreements are drafted in the first instance by the franchisor, the franchisor often will choose the law of its home state as the governing law. In some situations, a franchisor may elect to have the law of the state in which the franchised business is located govern the agreement. If applicable, state franchise laws commonly prohibit franchisors from requiring franchisees to waive the protections granted under these laws.
What fees are typically charged under a franchise agreement?
Franchisors commonly charge an initial franchise fee at the time of signing the franchise agreement. During the term of the agreement, franchisees are also generally required to pay an ongoing royalty fee, which is typically a percentage of gross sales. Franchisors also commonly require franchisees to contribute to a system marketing or advertising fund on a regular basis, which is typically intended for general promotion of the brand. Technology-related fees are sometimes charged if the franchisor has developed proprietary software or requires franchisees to maintain access to certain technology capabilities. Other common fees include renewal fees and transfer fees, which are payable only on renewal of the franchise rights or on transfer of the business.
Do franchisees have a right of renewal?
Franchisees’ renewal rights are generally determined by the terms of the franchise agreement. Many (but not all) franchise agreements include a right or option to renew the agreement or to sign a new agreement for a renewal or successor period. However, certain state relationship laws prohibit franchisors from refusing to renew the franchise rights without good cause or without provision of advance notice.
On what grounds 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 or require the franchisor to comply with certain procedural requirements in order to refuse renewal.
How are renewals of franchise agreements usually effected? Do any 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;
- payment of a renewal fee;
- execution of a general release of claims against the franchisor and its affiliates;
- compliance with the current franchise agreement;
- remodel of the franchised business location; and
- execution of the franchisor’s then-current form of franchise agreement.
Disclosure is generally required on renewal if the franchisee will be required to sign a materially different form of franchise agreement than the agreement under which it is operating.
On what grounds may a franchisor terminate a franchise agreement? Are any remedies available to franchisees in this regard?
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 to the franchisor or its affiliates;
- violations of health and safety laws;
- failure to comply with system standards; and
- any conduct that impairs the franchisor’s goodwill.
Franchise agreements commonly distinguish between curable and incurable defaults. If a franchisee has committed a curable default, the franchisor must allow the franchisee the opportunity to cure the default in accordance with the terms of the franchise agreement. On the occurrence of an incurable default, franchisors are generally permitted to terminate the franchise agreement immediately on notice. If applicable, state relationship laws may override the terms of a franchise agreement and require a franchisor to have ‘good cause’ for termination or provide for specific cure periods that must be afforded to the franchisee before termination.
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