Navigating the Impact of NLRB's Latest Joint-Employer Rule on Franchisors
The New Rule
The National Labor Relations Board (NLRB) issued a groundbreaking joint-employer rule on Oct. 26, 2023. This rule, slated to redefine joint-employer relationships, carries substantial implications for franchisors.
The new rule, effective February 26, 2024, changes the definition of a joint employer. Previously, joint employer status was established when an entity had direct and immediate control over employment terms. Under the new rule, joint employer status can also be established when an entity has the mere ability to control employment terms, regardless of whether it uses the ability. This means that the potential to control, whether through intermediaries or a franchise agreement, can establish an entity as a joint employer. Relevant employment terms include wages, work hours, job duties, supervision, employment rules, workplace safety, and health conditions.
If deemed a joint employer under the new rule, franchisors could face increased bargaining obligations, such as collective bargaining with unions, and potential liability for unfair labor practices, even in areas historically managed by franchisees.
What to Do Now
It is imperative that franchisors review current contracts and practices to best adapt to the new rule. Here are a few tips for franchisors to use moving forward:
- Where possible certify and only train managers/owners folks and not employees. Alternatively, if this is not possible, ensure that a manager/owner is present if employees will be trained/certified. In that case, direct and teach the owners/managers the rules to disperse to employees where possible and make clear that the employees do not work for you.
- Require that franchisees have their employees sign an acknowledgement that they work for the franchisee’s entity and not for the franchisor.
- Don’t get involved in employment decisions such as hiring or firing. Similarly, make sure your franchisees are clearly managing all HR matters at their franchised locations.
- Review software such as POS software that you provide to ensure that it does not get involved in labor matters.
- Make sure the franchisees are holding the business out as an independently owned and operated franchised location.
- Require franchisees post something in break rooms saying that they are employees of the franchisee and are not employed by the franchisor entity.
- Make sure franchisees don’t do paychecks that say the franchise name (i.e., “McDonald’s”) – instead have them use their business entity names (i.e., “ABC Co”).
- Review materials in handbooks and operations manuals to ensure compliance.
- Don’t supply employee handbooks to franchisees or, if you feel compelled to do so, ensure they are sample forms that the franchisees must complete and take responsibility for.
We will continue to monitor this new rule and provide updates on our blog as necessary. If you have any questions, please feel free to reach out!
Unraveling Averages and Medians for your Item 19 Financial Performance Representation
Cracking the code of your Franchise Disclosure Document (FDD) may feel a bit like you’ve been thrust into a high-school math test. But fear not! We’re here to turn those numbers from daunting to doable.
When a franchisor has a large number of franchised units, the use of averages may be the best way to show financial information in your Item 19 financial performance representation. This blog is tackling averages and medians for Item 19 – you know, the item about the money stuff.
The Rule of Averages, Medians, and More
If you decide to use averages in your Item 19, you’re required to also provide the median, the number of outlets that met or exceeded the average, and the highest and lowest figures. This rule is in place to ensure full transparency for potential franchisees. By providing these extra numbers, they get a more rounded picture of the financial expectations for your franchise.
Averages: Your Math BFF
In the broadest sense, an average represents a central or typical value in a set of data. It provides a ‘snapshot’ of your data, helping to simplify and understand complex sets of numbers.
Let’s start with averages. Picture your franchises as points on a line. Some are low, others are high, and some are right in the middle. The ‘average’ gives you a way to summarize this entire line with a single point.
So, how do we find an average? Let’s say you have five franchise outlets, with annual revenues of $100K, $200K, $300K, $400K, and $500K respectively. To calculate the average, you’d add up all these individual revenues ($100K + $200K + $300K + $400K + $500K = $1.5M), and then divide this total by the number of franchises (in this case, 5). This results in an average annual revenue of $1.5M / 5 = $300K.This average revenue offers a snapshot, a single number that gives potential franchisees a general idea of the revenues franchisees have historically earned.
Medians: The Middle Kid on the Block
The median is another kind of number that provides a different perspective on your data. It’s the middle point in your data when you line up all the numbers from smallest to largest.
Using the same five franchise outlets, if you list their revenues in ascending order ($100K, $200K, $300K, $400K, $500K), the median value falls right at $300K. It’s the middle value, with two franchise outlets earning less and two earning more.
The median is a great tool to present a ‘typical’ financial scenario, especially when you want to avoid the average being skewed by a single franchise that’s doing exceptionally well or poorly.
Medians of Even Numbered Sets: Double the Fun
The waters get a bit muddier when we’re dealing with an even number of data points. With no exact middle number, calculating the median requires an extra step.
Imagine you have an additional franchise outlet, bringing the total to six, with revenues of $100K, $200K, $300K, $350K, $400K, and $500K. The two middle values are now $300K and $350K. In this situation, you’d take the average of these two numbers to get the median. Add them up ($300K + $350K = $650K) and divide by 2, resulting in a median revenue of $650K / 2 = $325K.
Conclusion: Wrapping Up the Math Adventure
To put it simply, averages and medians are practical tools that can help you understand the financial situation of your franchise outlets. By using these tools, you can transform large amounts of data into single, understandable figures.
Best Practices for Renewing a Franchisee’s Franchise Agreement
Every franchise agreement has an expiration date. Accordingly, franchisors need to know how to properly handle franchise renewals and accompanying successor agreements. Although a franchisee’s right to renew is usually subject to them meeting certain requirements, there is a legitimate litigation risk from franchisees who are not renewed against their wishes. The good news – your friends here at Drumm Law have crafted the following guide for franchisors to utilize when dealing with renewals and nonrenewal of franchise agreements.
I. Determine if Franchisee Has a Right to Renew Under the Franchise Agreement
The first question you should ask – does the franchise agreement grant the franchisee the right to renew? If so, what are the requirements they must meet in order to renew, and have they complied with them (more on this later)? The next step is to review applicable state law.
II. Review Applicable Law
In some states, a franchisee may have a right to renew or you may be required to offer them an opportunity to renew. Here are some of the jurisdiction with statutes that deal with franchise renewals: AR, CA, CT, DE, HI, IL, IN, IA, MI, MN, MS, MO, NE, NJ, WA, Puerto Rico, and the U.S. Virgin Islands.
Most state renewal statutes do not grant a franchisee an express right to renew. Instead, franchisees will likely take the argument that they have a right to renew because the franchisor did not follow the state’s laws. Here are some common statutory renewal requirements that franchisors should be aware of:
• Common Notice Requirements
• A Franchisor must provide notice to a franchisee of its intent not to renew a franchise agreement.
• Notice periods vary across states.
• Good Cause for Termination Requirements
• Franchisors may be required to show “good” or “just” cause to not renew a franchise agreement.
• Types of “good” or “just” cause vary across states, such as voluntary abandonment, nonpayment by franchisee, and a franchisee’s noncompliance with the franchise agreement. Absent good cause, the franchisor may be forced to offer renewals.
• Payment of Compensation to the Franchisee Requirements
• Franchisors may have obligation to pay compensation to franchisees upon nonrenewal or termination of their franchise agreement.
• Some states even have rules that prohibit a franchisor from not renewing if a franchisee hasn’t had enough time to recoup their investment.
Most renewal statutes require either one of the above requirements or some combination of the three. It is crucial for franchisors to understand the applicable renewal rules of their state, and if not, discuss it with their franchise attorney. The rules generally require franchisors to follow them to a “T” or be prepared to lose the option to not renew.
III. Common Law
While the list of states above appears long, the majority of states actually do not have statutes that regulate franchise renewals. However, case law may still exist in those states and be problematic for franchisors. Certain common law doctrines may be available to franchisees such as the duty of good faith and fair dealing. Overall, franchisees who use these common law doctrines, in the absence of a state renewal statute, usually have a difficult time succeeding in the courtroom (absent certain circumstances such as unfair dealing). Despite this, franchisors should still be prepared for any common law claims franchisees may make.
Generally, franchisors should be prepared to disclose franchisees who sign new contracts as part of any renewal.
IV. Franchise Agreement Renewal Provision Drafting Tips
With the above information in mind, we have compiled the following tips to consider when drafting the renewal provision within a franchise agreement.
• Generally, renewals are considered a new franchise agreement, and franchisors should be prepared to follow standard registration and disclosure requirements as part of any renewal.
• Except for a few specific circumstances, provisions in the franchise agreement cannot override a state renewal statute.
• Ensure that the franchisee’s right to renewal, if any, is conditioned on the franchisee’s acceptance and agreement to the terms of the new, successor agreement. This is particularly important because franchise agreements tend to change over time as the system grows and laws are updated.
• Include a provision in the franchise agreement which grants the franchisor rights on how to handle any hold-over or interim term in the event the franchise agreement expires without either termination or renewal.
V. Additional Tips
• Both franchisees and franchisors should be sure to calendar renewal dates. Often the franchise agreement requires one or both sides to send advance written notice:
•E.g. for franchisees – indicating that the party intends to renew
• E.g. for franchisors – the reasons why a franchisee is not qualified to renew and/or how it can right the ship and become qualified to renew.
• Many states’ franchise laws treat a franchisor’s refusal/failure to renew similar to a termination. This means not following the rules can lead to lawsuits or damage claims.
• Franchisees should be ready to send all notices and follow all rules required under the agreement to renew. This can mean upgrading equipment, signing a new lease, sending written notice, signing a new agreement, paying fees, etc.
VI. Conclusion
The renewal or nonrenewal process is ripe with legal pitfalls for franchisors in noncompliance with applicable law. Franchisees should also understand their rights and not just assume that a franchisor can refuse to renew them. This “legal minefield” can be difficult to travel without an understanding of how and which state laws and contract requirements interplay. If you have any questions, please contact us. We’d be happy to help!
The FDD Receipt Page: Why the Last Page in the FDD Matters a Lot
The receipt page is the last page of the FDD and serves as the prospective franchisee's acknowledgement of having received the document. Once signed, it provides evidence that the franchisor has fulfilled its obligation of providing the FDD in accordance with the law.
The receipt page is a simple note at the end that the franchisee signs to say, "Yep, I got this book and I've read it." It's like the franchisee saying, "Okay, I know what I'm getting into."
Why Does the Receipt Page Matter?
Legal Compliance: The Federal Trade Commission (FTC) mandates that you provide the FDD to prospective franchisees at least 14 days before any agreement is signed or money changes hands (the actual timeline works out to about 16 calendar days because you don’t count the day they receive the FDD or they day they sign). The receipt page serves as your legal proof that you've complied with this rule.
Ensuring Due Diligence: A signed receipt page is an affirmation from the potential franchisee that they've had sufficient time to understand the contents of the FDD. This includes all obligations, costs, and expectations associated with buying and operating the franchise. It underscores that you've provided all necessary information for them to make an informed decision.
Protection for Your Business: The receipt page also protects your interests as a franchisor. It guards against claims that you did not provide full disclosure, thereby reducing potential legal risks.
The receipt page might be the last thing you see in the FDD, but it's a pretty big deal. It helps make sure everyone plays by the rules and that you know what you're getting into with your franchise. So the next time you're flipping through an FDD, remember to pay attention to that last little page. It's your proof that you've done your homework and are ready to get into the world of franchising.
Growing Your Brand: Multi-Unit Franchises
When you're planning to grow your brand, the Area Development model (or Multi-Unit model) is a strategic path for rapid growth.
Why Multi-Unit Franchising?
An area developer (or multi-unit franchise owner) is a single person or group runs several outlets of your brand in a certain area. Multi-unit franchising can help your brand grow fast. It lets you cover larger areas quickly, giving your brand more exposure. Also, it lets you work with people who are dedicated, know your brand well, and have shown they can run your franchise successfully. They benefit from their knowledge of your system and economies of scale, and experienced franchisees can bring significant growth to your system. Would you rather work with 100 franchisees that own 1,000 outlets for 1,000 franchisees for those 1,000 outlets? Pricing and territory are two of the key factor of the Area Development offer.
Pricing for Area Development Franchises
For pricing, you generally have two options:
Discounted Flat Fee: Under a discounted flat fee structure, you charge a one-time fee for the right to open all outlets within a certain area. This fee is usually lower than what it would cost to open each outlet separately. Like a Groupon, a franchisee prepays for multiple units at a discount. If the franchisee opens all of the additional units, they will have saved money on the additional units franchisee fees. If the franchisee fails to open the additional units, the franchisor still benefits because it has received the fee up front (which is higher than the fee for a single unit).
Pros: This model is simple and easy to understand, making it attractive to potential franchisees.
Cons: The upfront cost might be too high for some franchisees.
Formula-Based Fee: Under a formula-based fee structure, you charge a development fee based on the number of outlets the franchise wants to open. For example, the development fee may be $10,000 per franchise. If a franchisee wants to open 10 outlets, they will pay a $100,000 development fee. When they are ready to open an outlet, they will pay the initial franchise fee less the $10,000 development fee.
Pros: This model can encourage franchisees to open more outlets because of the lower upfront fee.
Cons: This method can be more complex and harder for franchisees to understand. Also, if the franchisee opens fewer outlets than planned, you might end up with less in fees than if you went with a discounted flat fee model.
Protected Territories for Development
You may choose to offer a protected territory with your area development franchise offer. You would provide an area developer with a reserved “development area,” which generally includes a development schedule with quotas and timelines for entering into additional franchisee agreements. These quotas and timelines prevent an underperforming franchisee from tying up an area for an extensive period as the franchisor typically has the right to terminate the agreement and reclaim the development area if the franchisee does not meet its development quota. Granting a development area provides a franchisee a reserved area to scale operations. For instance, a development area allows franchisees to open centrally located commissaries or operations centers for multi-unit operations. The reserved area can be an incentive for prospective franchisees who want to target a specific area. If you don’t offer a protected territory, the area developer can open additional units anywhere they want so long as there is not another franchise in that immediate area.
Pros: A protected territory can make your franchise more attractive since it guarantees less competition in the area and allows franchisees time to develop the area. Franchisees may also be willing to invest more in their outlets, knowing they have exclusive rights in that area.
Cons: Offering a protected territory can limit your brand's growth. You may end up turning away other potential franchisees interested in the same territory who are more qualified or more likely to open the additional units while the area developer fails to open any additional outlets.
In the end, figuring out how to price your franchise and whether to offer territory protection are big decisions. These choices can really affect how your brand grows. It's all about finding the right balance - you want to make your franchise attractive to others, but you also want to make sure your brand can grow as much as possible. Remember, there's no one-size-fits-all answer. What works best will depend on your specific situation. And, it's always a good idea to chat with an expert or lawyer who knows about franchising to help guide your decisions.
Little Symbols, Big Difference
If you’ve ever browsed the aisles of a grocery store, chances are you’ve passed by a few dozen registered trademark symbols without even noticing. Look around right now, wherever you are. Is there a can of Coca-Cola sitting on your end table? A bottle of Advil there on your desk? Are you drinking water from a Nalgene water bottle? Any of these items will bear the subtle but familiar ® denoting a registered trademark of the brand. This is the symbol you can (and should) use once your trademark registers with the USPTO, whether it is a word mark or design mark and whether it is for goods or services. It establishes “constructive knowledge” of your registration and helps protect your trademark rights, notifying customers and competitors alike that you hold a federally registered trademark and unauthorized use of this mark constitutes trademark infringement.
If your trademark is not yet registered, you cannot use the ® symbol in association with your mark, but you do have the option (which you should take) of using ™ (or ℠ for service-only marks) to claim common law trademark rights. ™/℠ does not signify the same level of trademark protection, just like common law rights are not equivalent to a federal trademark registration, but this is a way of publicly demonstrating your claim to a mark while it is [hopefully] on its way to registration.
In either case, whether your mark is registered or not, the symbol you use should appear in the upper right-hand corner of the mark (DRUMM LAW®) or, if that will look strange, as may be the case with some design marks, the lower right-hand corner.
Wondering what the little © and ℗ symbols mean and how they factor into all of this? © denotes a registered non-audio copyright, while ℗ is the “phonographic copyright” symbol, or the symbol used especially for audio copyrights such as music and audiobook recordings. So you won’t be using these in conjunction with your trademark unless it is the name of an artistic work for which you also hold a copyright.
It’s important to note that, when it comes to international commerce, many countries have different and specific rules and regulations surrounding the use of these symbols, so if you are considering an international trademark, or just distributing your goods to other countries, it may be wise to consult with a trademark attorney first.
New Franchise Policies that Impact Franchise Questionnaires are in effect as of January 1, 2023
On January 1, 2023, a new policy went into effect that will apply to franchisors that use franchise questionnaires as part of their franchise sales process. The North American Securities Administrators Association (“NASAA”) policy places limitations on the FDD questionnaire. In addition, a California franchise law went into effect on January 1, 2023, related to the FDD questionnaire, and additional changes will affect the franchisee selection, termination, and transfer process. As a result of these changes, franchisors will no longer be able to use the current form of FDD questionnaire in the states that adopt and apply the NASAA Policy (generally speaking, the registration states), and additional rules apply in California. Below, we review the changes under the new NASAA Policy and the changes to California law.
When NASAA issues franchise guidance, state regulatory agencies then decide whether to adopt and apply this guidance when reviewing and registering FDDs. In response, state examiners have indicated that they will universally follow this new guidance.
New NASAA Policy
The new NASAA Policy states that franchisors cannot require prospective franchisees to acknowledge or answer questions that are subjective, unreasonable, or that simply repeat disclosures required to be stated in the FDD. It also requires a new legend to clarify that FDD questionnaires and acknowledgments do not waive franchisee’s claims under any applicable state franchise law. Additionally, if your franchise system uses any type of verbal questionnaire when speaking with a prospective franchisee, the NASAA Policy provides that there must be a script of that questionnaire included as an exhibit to the FDD.
The NASAA Policy identifies multiple prohibited questions, and the practical result is that most of the questions contained in your current FDD questionnaire are no longer permitted. Specific prohibitions include:
1. Any questions relating to whether the franchisee understands the documents or any disclosure or term within the agreement.
2. Limits about statements made during the sales process.
3. Related questions, such as whether all waiting periods were observed, may be approved by examiners that adopt the policy.
Impact of NASAA Policy
Moving forward, the FDD questionnaire would be limited to simple questions that don’t relate to any disclosure obligations, the sales process, or the contents of the FDD. This will render questionnaires, for all intents and purposes, much less helpful to protect you in the sales process.
While the NASAA Policy is effective January 1, 2023, franchisors are not required to modify their FDD questionnaire until they are instructed to do so by a state examiner, so changes will likely not be needed until your next state application is submitted. However, if you are not a 12/31 Fiscal Year End (meaning your FDD is not in the majority that is renewed in April) it’s possible this could occur sooner and create the need to file amendments.
To avoid unnecessary comment letters and permit delays, a strategy needs to be formulated to determine whether to include any form of questionnaire in your FDD and where that FDD should be used. Because NASAA policy is not implemented outside of the registration states, we should work together to consider whether you should maintain a registration state-specific FDD so that you can maintain your current FDD questionnaire in non-registration states. While maintaining multiple FDDs can create administrative issues, we can discuss and determine whether the advantages of using a standard questionnaire in non-registration states outweigh these challenges.
Also, until your new FDD is issued for 2023, we and you will need to formulate a plan for sales pending in registration states. Before providing a franchisee in a registration state with your FDD or requiring an existing prospect to sign a questionnaire you should consult our firm to determine if an amendment is needed under state law.
National Sales Impacts
The questionnaire was designed to protect you in a few critical ways. Many of the questions were designed to have the franchisee confirm that there were not certain types of sales violations. Should a franchisee try to argue that sales violations had occurred, the questionnaire was used as a shield by the franchisor (and us) as a first line of defense. For example, if a franchisee claims that a salesperson made improper financial performance representations there was a specific question designed to be answered where they acknowledged that no such statements were made. Also, it was designed to flag a potential legal issue or violation you might have been unaware of had you not asked these questions before closing a sale, allowing you to address these issues up front. This means it’s more important than ever that your sales process is thoroughly documented and your salespeople are properly trained.
• If you are working with a franchise broker or outside franchise sales team, they should be aware of these changes. Because franchisors are ultimately liable for the conduct of sales brokers, we urge you to ask them what new steps and procedures they are implementing to protect the integrity of the sales process. If you have concerns please contact us.
• If you or your team is handling franchise sales internally, it’s even more important that you understand the rules and regulations for franchise sales. These are complicated – even for the experienced salesperson. We are here to help answer any questions that you might have.
New California Law
California has made changes to the California Franchise Investment Law. The California changes include a similar prohibition against waivers by a franchisee which will apply to FDD questionnaires. The NASAA Policy will also apply in California during any future registrations, but as their prohibitions have been signed into law, language in your current FDD will be treated as unenforceable for any deals signed after January 1, 2023. Note, however, that California’s lead state examiner indicated she will not initiate any enforcement actions or require post-effective amendments so changes to the FDD questionnaires can wait until an upcoming renewal.
Other changes to California law such as new prohibitions against offsetting amounts due to a franchisee against amounts owed to your franchise system, and additional obligations relating to franchise transfers also went into effect on January 1, 2023. Under the new law, franchisors are prohibited from the following:
• Offsetting amounts owed to a franchisee on termination or non-renewal unless the franchisee has agreed to the amount, or has obtained a final adjudication for that amount. For example, if you repurchase salable inventory or physical assets, you cannot discount the purchase price by amounts owed to you by the franchisee without either permission of the franchisee or a final judgment permitting the sale.
• Discriminating against franchisees based on sex, race, color, religion, ancestry, national origin, disability, medical condition, genetic information, marital status, sexual orientation, citizenship, primary language, or immigration status, relating to either the franchisee/prospective franchisee or to the population that makes up the neighborhood or geographic area where the franchise is, or would be located; and
• Making modifications to franchise agreements or requiring a general release in exchange for any assistance related to a state or federal emergency.
The following additional obligations have also been placed on franchisors with respect to transfers occurring after January 1, 2023:
• The franchisor must make any form or document required of a prospective franchisee to submit with a transfer application “reasonably available”, or otherwise provide that form or document by email, courier, or certified mail to a prospective franchisee within fifteen calendar days of receiving a written request;
• The franchisor must make its standards for approval of a transfer application “reasonably available”, or otherwise communicate those standards to a prospective franchisee within fifteen calendar days of receiving a written request;
• A franchisor must notify a prospective transferee of its approval or rejection of a transfer application in writing by email, courier, or certified mail within sixty days of receiving a transfer application; and
• If a franchisor rejects a transfer application, it must notify the prospective transferee in writing and include the reasons for the rejection. The reasonableness of any rejection will be a “question of fact requiring consideration of all relevant circumstances.”
Next Steps
Every year there are new laws and regulations concerning franchises. If you have any questions about these changes for 2023 please contact us. If you’ve read this far, congratulations!
One of my franchisees wants to sell their business. What should I do, and what should I avoid?
Franchisors expect franchisees to remain in their system. The franchise relationship is built through significant effort by both franchisors and franchisees over a long period of time. Franchise relationships often last 30+ years. However, at some point, that relationship has to end in some fashion. The franchised business can close, the system can shut down, the relationship could be terminated, etc. One common ending is when the franchisee exits via transfer.
There are any number of reasons a franchisee may wish to transfer their business. They could have viewed the franchise from the beginning as an asset to build and sell. They could be experiencing a life or career change. They could need to cash out. The relationship between the franchisor and the franchisee could have fractured and a new franchisee needs to be put in. As a result, both franchisors and franchisees need to fully understand their legal rights, options and duties concerning transfers.
First, the parties should look to the franchise agreement. A well drafted franchise agreement should set forth specific steps and conditions for the franchisee to transfer. These can include things like:
- Notice. Who gives notice and when? What must the notice include?
- Buyer’s information. The franchisor should ensure that the transferee meets all of its financial and business qualifications.
- Transfer fee payment. Sometimes the franchisee has to pay a deposit at the time it sends the notice.
- Unless they are already a franchisee in the system, the transferee will probably need to be trained. When would this happen?
- The agreement might require that the business be upgraded. Whose responsibility is this? When does it need to be completed? What is needed to upgrade?
In addition to what is listed in the franchise agreement, there are other important considerations that might not be as obvious:
- Many states have laws governing transfers. Sometimes the franchisor cannot unreasonably block a transfer. Sometimes the franchisor might only be able to block a transfer under very specific conditions. An analysis of what state law says about transfers should be made.
- Everyone should ask what is best for the business. Sometimes a new lease will need to be signed, financing will need to be obtained, etc. The parties should inform one another of what business and legal steps need to be taken.
- The franchisor should ask what is best for the system. Sometimes turnover is needed to remove a franchisee who is viewed as a poison pill from a franchise system. Franchisors will typically face less scrutiny and litigation if that business is sold than if it is terminated. Plus, the franchisee can usually cash out instead of being left fighting over whether the termination was proper. This is often the best “win-win” situation 2 parties who aren’t getting along can reach.
Right of First Refusal
Many franchise agreements give the franchisor the right of first refusal (ROFR) on the franchised business when the franchisee decides to sell. Whether a franchisor should execute the ROFR is an important decision.
Involvement in the Sale
Franchisors should take great care with the role you play in the transaction. Most franchisors act as a bystander to the sale, only requiring that they approve the new franchisee and collecting any fees they are owed. Unless you have a good reason to get involved in the transaction, franchisors should only be involved in approving the deal and having the parties sign any paperwork required. The most obvious reason for doing so is that it minimizes your chances of being sued (or, more accurately, of a court allowing a lawsuit against you to stand) if one of the parties later becomes unhappy with the terms of the sale. If you didn’t help negotiate or draft the terms of the sale, it’d be hard for someone to argue you acted in bad faith, committed fraud, etc. We’ll get into more below, but state laws may also come into play if you are too involved in the sale.
Disclosure of New Franchisee
As a condition of approving the franchise sale, most franchisors choose to have the new franchisee sign a new franchise agreement. But, as a new franchisee, do they need to be disclosed with your FDD? Federal law says they don’t. Well, sort of – under the federal rule, all prospective franchisees must be disclosed. But their compliance guide states that someone buying an existing franchise directly from the franchisee who owns it is not considered a prospective franchisee, so long as they don’t have “any significant contact with the franchisor.” Great! But what is “significant contact”? While exercising the right to approve the sale won’t be considered significant contact, they don’t provide us much else. This is rather unfortunate, because a big part of approving the sale is, typically, evaluating whether the buyer would make a good franchisee.
Additionally, some states have their own disclosure requirements, and out of those states, only a few provide a specific disclosure exemption regarding a franchisee selling its existing business. And, similar to the federal rules, those exemptions will only apply as long as the franchisor is not involved in the sale.
Given the lack of exemptions in registration state laws and clarity provided by the federal rules, the safest practice is to always furnish the prospective buyer with your disclosure documents. If you find yourself in a situation where there is no time for proper disclosures, then you should speak to a franchise attorney before moving forward.
Will I Need State Registration?
Sorry, I know that question likely made your stomach do a backflip. The short answer is maybe – if you have a franchisee selling its business in a registration state, you may need active registration in order for that sale to happen. Thankfully, many states have specific exemptions from registration for situations where a franchisee sells its business to a third-party buyer. However, like the federal rules, those exemptions are again contingent on the franchisor not being involved in the sale (many states use headache-inducing phrase, “whether the sale is effected by or through the franchisor”).
While each state provides its own guidance and examples of what is too much franchisor involvement, most end up at approximately the same place. The examples they provide typically outline actions that franchisors are allowed to take without being required to register, as opposed to ones that will require registrations. Some examples of permitted behavior are listed below, but as you can see, they are fraught with exceptions:
- Exercising the right to approve the sale/new franchisee – Washington requires that it is done in a reasonable manner.
- Charging a transfer fee –some states require that the transfer fee must be reasonable, and in Wisconsin it can only be the franchisor’s actual expenses.
- Requiring the new franchisee to sign a new franchise agreement – again, some states require that the new franchise agreement cannot be materially different from the old agreement.
Remember that the examples above are only related to registration. You are certainly allowed to be more involved in the sale if you want – you just might have to be registered in order to do so. Of course, if you are already registered, it won’t be an issue. Of course, there are several other financial and business decisions to be made when you have a franchisee selling its business, but from a legal perspective, these are the big components that could potentially land you in hot water if you don’t take them into account.
Did you know that your fiscal year can affect your franchise sales?
Check out our latest franchise question to find out why: https://drummlaw.com/blog/franchise-question/choosing-a-fiscal-year-end-for-your-franchise-company/
The franchisee breached their agreement. Now what? The default seems plain enough, so why would I need a lawyer’s help?
So, your franchisee has breached the terms of their franchise agreement. What do you do next? While their breach may be cause for termination, you shouldn’t rush into any conclusions. Otherwise, you could be making a misstep.
First, consider whether a lawyer or compliance manager is needed. Not all defaults are equal. Some might require a simple phone call to fix. Others might require a formal default notice and termination. Many fall in between and can be resolved short of termination.
Your franchise lawyer will help you correctly identify what terms of the franchise agreement were breached. This may seem like a simple task, but that isn’t always the case. There are many instances where the franchisee’s behavior, while clearly wrong, doesn’t directly fit with any of the default terms of the agreement. This is where an attorney can help you identify which specific terms of the agreement the franchisee could be considered to have violated.
After determining the nature of the breach, you must provide your franchisee with adequate notice of their default. Your franchise agreement will define how notice must be served, but in general it is best to send notice in multiple forms (email and a hard copy letter) of their notice of default. Serving timely notice is especially important, because the franchisee’s clock for curing the default won’t usually start until they receive adequate notice of that default. Those notices should be sent strictly via the notice provisions under the agreement.
Some breaches require the franchisor to give the franchisee an opportunity to cure the breach. It is imperative you give your franchisee an opportunity to cure if you are required to do so. Your franchise agreement will dictate how long the franchisee has to cure its default, but sometimes it can be in your best interest give them additional time to cure. Similarly, in instances where you have the option to immediately terminate the agreement based on default, it can still be advantageous to allow the franchisee an opportunity to cure. The main benefit for doing so, is that it is a clear indicator that the franchisor is operating in “good faith”, and you are making a legitimate effort to keep the agreement intact. That way, if you are later forced to terminate, the franchisee would have a difficult time proving that you were acting in a way that was unfair to them or deliberately trying to find reason to terminate their agreement.
The last thing you must consider is the location of your franchisee. Many states have additional restrictions on the termination of the franchise agreement, and typically require the franchisor to show good cause in termination. For example, California has “good cause” rules that are defined by state law. So not all breaches necessarily can result in termination. California also has an inventory buyback requirement following termination that needs to be analyzed in order to see whether it applies.
It is important to understand whether a specific default would be considered good cause under specific state law. In some instances, you may be required to offer the franchisee an opportunity to cure where you would otherwise not have to or you may have to give additional time to cure. For example, New Jersey commonly requires 60 days’ written notice and opportunity to cure for many types of breaches.
Violating these laws could end with a franchisor owing damages to a terminated franchisee, despite the franchisee’s default and what appears to be a valid reason to terminate.
In addition, good faith and fair dealing laws should be considered. Would you terminate your “gold star” franchisee for the same reason? Are there other franchisees guilty of the same breaches that you aren’t defaulting or terminating? If so, could this lead to an argument of discriminatory conduct if you were to terminate one franchisee for bad behavior or breaches that have repeatedly occurred across the system without terminating?
All of these factors are important to consider when dealing with a franchisee in default, and a seasoned franchise lawyer can help you navigate the proper route for handling those situations.
As always, if you have any questions, please contact us here.