The Case for Effective Standards Enforcement

Legal

The best way to avoid litigation is to make exemplary performance a central goal of your system. 

By Robert Zisk
 
You are the CEO of a restaurant franchisor. After a hard day at work, you sit down in front of the local news to catch up on what happened in the outside world. To your dismay, the opening story features a video of two mice eating food off the floor of one of your New York City franchise locations. While you are waiting for your lawyer to call you back, you look to the internet for diversion, only to find that the mouse video has gone viral. Your lawyer assures you that the harm to your goodwill from this publicity is self-evident and irreparable, so you go into court to shut down the franchise. The judge looks down at you and says, “If I shut down every restaurant in Manhattan that had mice in it, there’d be no place left to eat. Motion denied.”
 
This is what often stands in the way of franchisor efforts to enforce system standards: the fear that if the franchisee does not comply, there is little that can be done short of an expensive court battle that the franchisor may not win, no matter how bad the situation. If you can’t win the viral mouse video case, is there any hope for effective standards enforcement? There certainly is, and in fact, you might win that very case in a different jurisdiction, with a different judge, or under different circumstances. And if this episode was just the latest in a long history of standards defaults that have been well-documented and systematically addressed in accordance with company policies and procedures, you might win this case for that reason too.
 
But the best way to avoid this situation is to make exemplary performance a central goal of your system. 
 
Compliance with standards is often viewed as a point of contention between franchisor and franchisee. The franchisor will use a variety of approaches — counseling, inspections (announced and unannounced), rewards, punishments, default notices, legal process — to encourage compliance. 
 
The franchisee will bristle at franchisor efforts to interfere with its operations. Yet it is in the best interests of both parties to work together in this area. Franchisors who have studied it have seen a direct correlation between improved standards compliance and increased sales, which means higher profits for franchisees and higher royalties for franchisors.
 
Achieving success starts with clearly communicating what is expected to the franchisees. The franchise agreement should require compliance with system standards and set forth the consequence of noncompliance, which is a notice to cure or, for particularly serious breaches that harm the goodwill of the brand (e.g., selling unapproved products, committing crimes), immediate termination without a chance to cure. The agreement should incorporate the operations manual by reference, since this is the place where all standards are set forth and fleshed out. Once the manual is incorporated, this gives the franchisor the flexibility to update it as needed. Each time a new standard is issued, an amendment to the manual should be sent to all franchisees with a reminder that they are required to comply with it.
 
One issue that often arises is whether franchisors have a duty to treat all franchisees equally when it comes to addressing standards defaults. The typical franchise agreement has an anti-waiver clause stating that the franchisor does not waive the right to require compliance with a contractual provision just because it has failed to enforce it previously.  However, there are at least two good reasons why franchisors should strive for consistency. First, treating franchisees fairly and equally fosters system harmony. Second, if court action ultimately is required to address a serious standards violation, the franchisor likely will have to show that the violation harms the goodwill of the system and trademarks and that it is causing irreparable harm that warrants injunctive relief. If the record shows that the franchisor has not taken action when faced with prior instances of the same type of default, this will undermine the claim that it considers the default harmful to its brand.
 
If there has been a period of lax enforcement, then it is critical to let franchisees know that things are going to change before stepping up an enforcement program.  Assuming the plan is to enforce standards system-wide, all franchisees should receive a memorandum reaffirming that adherence to standards is critical to brand success, acknowledging that formal enforcement action has not been the approach of choice to date, and putting them on notice that adherence to system standards will now be expected and enforced. If a particular area is of concern, such as monthly submission of profit and loss statements, the franchisees can be given a reasonable period of time to make arrangements to come into compliance, after which defaults will be addressed with notices to cure and, if necessary, termination.
 
Of course, a notice to cure should only be used if the franchisor is willing to enforce it. Many franchisors find themselves in a position of weakness precisely because they are in the habit of sending notices to cure but never taking the next step if there is no cure, or never even following up on the notices at all. This leaves the franchisees confused at best, and sends the message that there will be no consequence for poor performance. When resuscitating a dormant standards program, appropriate use of notices to cure is critical, but there are other approaches that have also proved successful in addressing standards issues. 
 
For example, constant coaching and counseling about standards compliance should be an integral aspect of every system. This should be part of every meeting, particularly when field personnel sit down with the franchise owner to discuss the business and review profit and loss statements. That is the perfect opportunity to discuss the direct tie between store operations and profitability. The franchisee advisory council is another important ally. Franchisee leadership will understand the importance of franchisee compliance with standards and peer pressure sometimes can be more effective than a directive from the franchisor. 
 
If coaching, counseling, and peer pressure do not work, there are more aggressive options. Faced with an egregious situation that poses an immediate threat to the brand and consumers, such as a serious health code violation, the franchisor can require the franchisee to shut down the unit until the problem is addressed. Another option is to use self-help: the franchisor can send its own employees in to clean up the unit and cure the defaults, and (franchise agreement permitting) have the franchisee reimburse it for the costs it incurred.
Litigation is the ultimate weapon when it comes to securing compliance with the franchise agreement. A very effective strategy short of termination is to file a lawsuit and move for a preliminary injunction ordering the franchisee to cure the defaults. The typical franchise agreement provides for the franchisor to recover its attorneys’ fees incurred in enforcing the agreement, so that provides a big incentive for the franchisee to cure the default and settle the case before it gets too costly. But in the end, if all other approaches have failed, you will know you have done all that you can and your efforts to work with the franchisee will strengthen your case for termination. 
 
Robert Zisk is a shareholder at Gray Plant Mooty in Washington, D.C. and has represented franchisors for over 30 years.