Between January and February 2017 the Small Business Administration (SBA) rolled out new regulations aimed at reducing administrative costs and the time spent approving franchise companies, while also decreasing the SBA's risk in relation to SBA-guaranteed loans to franchises.(1)
Under the new rules, the SBA no longer partners with FranData to determine whether a brand is a franchise. Instead, lenders are required to determine whether a brand is a franchise under the Federal Trade Commission's (FTC) amended Franchise Rule.
Further, franchisors are required to use a new standard SBA addendum incorporated into their franchise agreements. For now, the only exception is that some franchisors may elect to use an existing and approved addendum (SBA negotiated addendum), if the SBA approved it before the new regulations and the franchisor submits the SBA certification form.(2) However, the SBA negotiated addendum must be an addendum that was developed by the SBA and the franchisor using a 2015 or 2016 version of the franchise agreement. All other franchisors must use the standard SBA addendum.
The terms of the new standard SBA addendum, which currently is not negotiable, include the following covenants:
- Change of ownership – this clause limits the franchisor's right of first refusal when a franchisee seeks to transfer a partial ownership interest. Franchisors also cannot unreasonably withhold their consent to any transfer. Once a transfer is approved by the franchisor, the selling franchisee will not be liable for the franchise obligations of the buyer. The addendum does not define a legal standard for 'unreasonable'.
- Forced sale of assets – upon the termination or expiration of the franchise agreement, this clause requires an appraisal of assets if the franchisor and franchisee cannot agree on the value of assets before the franchisor can exercise an option to purchase the business's personal assets. However, the addendum does not specify who is responsible for paying the cost of the appraisal.
- Real estate – under this clause, if a franchisee owns the real estate of the franchise location, the franchisee does not have to sell the real estate upon default or termination, but the franchisee may be required to lease the real estate for the remainder of the franchise term at fair market value, excluding renewal terms. In addition, a franchisor cannot record any land use restrictions against the location's real estate, including environmental, branding or other use restrictions. This can be problematic for franchisors that require landlords to agree to allow the franchisor to take action if a location is not properly de-identified following termination.
- Employment – this clause states that the franchise cannot directly control the franchisee's employees, including hiring, firing or scheduling them. For temporary personnel franchises, this clause classifies the temporary employees as employed by the franchisee, not the franchisor. Opponents of this provision argue that it is useless and could instead imply a presumption that franchisors do get involved in employment matters. Moreover, the addendum does not define the term 'temporary employees'.
As for lenders, the new SBA regulations will likely lead to greater risks. As noted, the new rules require lenders to define whether a brand is a franchise under the FTC Franchise Rule. In the event of a default, the SBA could argue that a lender misclassified a brand as a franchise according to the FTC Franchise Rule. Therefore, the SBA may attempt to escape liability for guaranteeing the loan based on this misclassification.
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