Franchise Defaults: THE BIG PICTURE

Finance

While a franchisor may have the legal right to default a franchisee, there are many issues that a franchisor should consider prior to determining whether to send out a default letter.

By Nina Greene

Deciding to default a franchise is a serious step, therefore, it’s important that the franchisor remember that this process may ultimately lead to the termination of the parties’ relationship. Thus, the determination of whether to declare the franchisee in default under the franchise agreement must be given serious consideration. 

In addition to reviewing the franchise agreement between the franchisor and the franchisee, a determination must be made as to whether state franchise relationship, business opportunity, termination or other relevant statutes or case law apply. Further, declaring a default may implicate special business considerations, including the impact on the system’s other franchisees, the impact on customers, and the impact on the franchisor itself. All of these issues should be considered prior to sending a default letter to a franchisee.

Grounds for Default Under the Franchise Agreement 

Whether the franchisor is going to issue a default is a serious decision that should only be made after considering several legal issues. This is so because the declaration of a default may be the first step to ending the relationship between the franchisor and the franchisee. The franchisor must consider the grounds for default under the franchise agreement, as well as applicable state law in determining whether to default the franchisee. The franchisee will seek to have state statutes, if applicable, or other common law defenses protect it from actions by the franchisor.

The first question that counsel should consider with the franchisor is whether the breach is a material breach under the franchise agreement. Generally, a material breach of the franchise agreement will occur when the franchisee commits a monetary breach, e.g. failure to pay royalties, under the agreement. If the franchisee does not cure the monetary breach within the applicable cure period, the franchise agreement will terminate.

In this circumstance, the franchisee typically will not have strong grounds to contest the default and termination. However, the franchisee may raise defenses to attempt to excuse its non-performance of its financial obligations even though these defenses are not usually well received by courts. For example, the franchisee may claim that the franchisor amended the franchise agreement by habitually accepting late payments from the franchisee or that the amount owed to the franchisor is so small that it could not possibly constitute a material breach of the franchise agreement. These defenses may make a seemingly simple and straightforward process, i.e. the declaration of a default and termination of the franchise agreement based on the franchisee’s clear breach by failing to timely make payment, a very complicated process. Thus, the franchisor should thoroughly research and review its accounting processes and documents prior to issuing the default notice.

A more difficult question with regard to materiality arises when the franchisor believes that a franchisee has committed an operational default under the franchise agreement. Prior to asserting an operational default under the franchise agreement, the franchisor must carefully review the standards set forth in the franchise agreement (and any other relevant documents, such as the Operations Manual), and discuss with the appropriate business and or field people the specific activities that are the basis for the default. The franchisor should then consider whether these standards have been applied to the system in an appropriate manner. Further, the franchisor must consider what evidence, e.g. reports or photographs from field people, it has to support its position that the franchisee is not in compliance with system standards. Proper application of system standards and evidence of a franchisee’s failure to comply with system standards are important, because the franchisee may attempt to defend against the operational default by claiming that it has complied with the franchisor’s standards of operation or that the franchisor has applied the system standards to this franchisee in a different manner than other franchisees in the system. Even though these claims may have little, if any, merit, the franchisor must be able to effectively rebut them.

Materiality is also an issue when the franchisor seeks to declare a default under a repeated-breaches-provision in the franchise agreement. In the event that the franchisor determines that it would like to exercise its right to issue a default under the repeated-breaches-provision, the franchisor should carefully examine the number of breaches that have previously occurred and the nature of these breaches. Likewise, the franchisor should consider the length of time over which the repeated-breaches occurred and, if necessary, whether the franchisor gave the franchisee prior notice that the franchisor would issue a default under the repeated-breaches-provision if the breaches continued. Again, while typically without merit, the franchisee may argue in response to termination as a result of a repeated-breaches default that the repeated breaches were minor or that similarly situated franchisees have not been treated the same way with regard to repeated breaches.

Other Legal Concerns 

Assuming that after considering the foregoing the franchisor determines to move forward with declaring the franchisee in default, counsel for the franchisor must then consider whether state franchise relationship, business opportunity, termination or other statutes or case law governs the relationship between the franchisor and franchisee and their rights with respect to each other. These may also impact the procedure the franchisor employs to declare a default. For example, an applicable state statute may provide the franchisee with a longer cure period than the franchise agreement. If so, counsel for the franchisor must ensure that the franchisor provides the franchisee with the longer cure period to ensure compliance with the applicable statute.

Counsel for the franchisor should also consider the likelihood of a franchisee raising a defense or asserting a counterclaim based upon the franchisee’s belief that the franchisor waived its right to enforce the portion of the franchise agreement that is the basis for the franchisor declaring the default. Despite that they are generally without merit and the franchise agreement likely contains a legally enforceable nonwaiver provision, the franchisee may raise this type of defense or claim when the franchisee believes that the franchisor’s past conduct suggests that the franchisor is not going to enforce a provision of the franchise agreement or declare a default in the event the franchisee breaches that provision. Although it may not be legally obligated to do so, if the franchisor is concerned about an issue regarding its past conduct with regard to enforcement of a provision in the franchise agreement, the franchisor may consider other methods of resolving this situation before issuing a default notice to the franchisee. For example, the franchisor could issue a communication to the system stating that that it will declare a default under the particular provision of the franchise agreement for breaches of that provision going forward.

Similarly, counsel for the franchisor should consider whether issuing the default will likely result in the franchisee claiming that the franchisor is acting unfairly by selectively enforcing the provision of the franchise agreement or that the franchisor is engaging in discrimination against the franchisee even if the claims will not be meritorious. These kinds of claims should be of particular concern in states that have franchise relationship, business opportunity and termination laws that prohibit the franchisor from disparately enforcing the terms of its franchise agreements. 

Business Considerations 

While the franchisor may have the legal right to default a franchisee, the franchisor may, however, have various business reasons for refraining from issuing a default notice and ultimately terminating the franchisee. The franchisor may be able to obtain its goals even without issuing a default notice and terminating the franchise agreement, which may potentially lead to costly and lengthy litigation. For example, if both the franchisor and the franchisee recognize that their relationship should end, the parties may decide to work together to find an exit strategy for the franchisee. Where a franchisee is behind in royalty payments, another alternative to issuing a default notice and potentially terminating the franchisee is to allow the franchisee to sign a forbearance agreement and promissory note requiring monthly payments of the amounts past due while remaining current on royalty payments. However, despite the franchisor’s business goals, alternatives to default and termination may not be practical for certain non-monetary breaches of the franchise agreement. For example, a franchisor may have no alternative to issuing a notice of default and terminating a franchisee where the breach involves health and safety concerns to the consumer.

The franchisor should also consider the impact of a default and termination on the former franchisee’s customers and what, if anything, the franchisor is able to do to maintain those customers as customers of the system. Likewise, the franchisor should consider the impact the default and termination would have on other franchisees in that same geographic region, especially if the terminated franchisee is likely to engage in negative publicity regarding the franchisor and the system. Further, the franchisor should consider how to rectify any inconvenience to the terminated franchisee’s customers, as well as whether the franchisor will assist the terminated franchisee’s employees to obtain new employment.

Franchisor Must Determine Whether it Still Desires to Default the Franchisee 

After considering the legal issues regarding the franchisee’s default and the business concerns, the franchisor must then determine whether it chooses to move forward with declaring the franchisee in default under the franchise agreement and issue the notice of default. As evidenced by the foregoing, this decision should be made on a case-by-case basis only after careful review of the relevant agreements, review of the franchise files, review of relevant state franchise and other laws and other issues that may arise, consideration of potential defenses and counterclaims, discussions with business and field people, and consideration of business goals.

Nina Greene is a partner in the Miami office of the law firm of Genovese Joblove & Battista, P.A. She can be reached at ngreene@gjblaw.com  .