Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

Continued from Part 1

The practice of franchise law is a niche area when it comes to the representation of franchisors.  Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law.

There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed at the idea of reviewing a franchise agreement and advising a prospective franchisee. With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.

• Termination by Franchisor. The standard franchise agreement includes several breaches that, if committed by the franchisee, allow the franchisor the right to terminate the agreement.   When reviewing the sections dealing with termination, make sure to identify which defaults allow for a cure period, that is, a time by which the franchisee may correct the default and thus avoid termination, and which breaches permit the franchisor to terminate the franchise agreement without providing the franchisee an opportunity to cure.  A franchisee is unable to cure some breaches as a matter of course, such as abandonment of the franchised business, unauthorized transfer of the franchised business, and repeated breaches of the franchise agreement, and thus in these situations automatic termination is appropriate.  However, there are many common breaches found in franchise agreements where it is possible for a franchisee to cure, yet the franchise agreement nonetheless allows the franchisor to terminate the agreement at its discretion.  It is in the attorney’s best interest therefore to notify the client of the different classes of breaches, and if warranted, negotiate with the franchisor to move some breaches from the automatic termination section to the termination-after-cure section.  Finally, on the subject of termination, an attorney reviewing a franchise agreement should also pay close attention to the length of time granted to cure a breach, and attempt to lengthen the cure period where possible.

• Termination by Franchisee. Some, but not all, franchise agreements allow for the franchisee to terminate the agreement by providing a certain amount of notice to the franchisor.  This can arguably be the most important right granted to a franchisee, since a franchisee that has the right to terminate an agreement if the business gets into trouble can simply cut its losses, notify the franchisor of its desire to terminate the agreement, take the franchisor’s signs down, and cease running the business.  Many times, this will allow a distressed franchisee to avoid the fees and other obligations owed to the franchisor before disaster strikes.  Otherwise, a franchisee that abandons the franchised business prior to the agreement’s natural expiration could be exposed to a claim by the franchisor for breach of contract combined with a claim for “future royalties.”   “Future royalties” is a still-emerging theory of franchise law that holds that a franchisee that unilaterally ceases operation of its franchise prior to expiration can be held liable to the franchisor for the royalties and other fees the franchisee would have paid during the entire term remaining on the franchise agreement.  While this legal theory is complex and depends on a thorough review of the facts of each case, it is certainly an issue for attorneys to think about when reviewing a franchise agreement.  What is clear is that a franchise agreement that allows a franchisee to unilaterally walk away from the franchise can negate this cause of action from being raised and in the end potentially save a distressed franchisee from a costly fight.  For an excellent discussion of the future royalties issue by the Texas Court of Appeals applying Georgia law, see Progressive Child Care Systems v. Kids ‘R’ Kids International, Inc. and Vinson, 2008 Tex. App. LEXIS 8416; see also Choice Hotels International, Inc. v. Okeechobee Motel Joint Ventures, et al., Civil Action No. AQ-95-2862 (D. Md. 1998); Burger King Corp. v. Barnes, 1 F. Supp. 2d 1367 (S.D. Fla. 1998) Sparks Tune-Up Centers, Inc. v. Addison, Civ. Action No. 89-1355 (E.D Pa. 1989).

• Post-Termination Non-Competition Covenant. In many states, including Maryland, a court will hold valid and enforceable a non-competition covenant that is “reasonable” in the activity it restricts, as well as in its geographic scope and duration, absent extenuating circumstances.  According to Maryland caselaw, a “reasonable” post-termination covenant not-to-compete  will restrict a franchisee from competing for one or two years, within 25 or 50 miles in geographic scope, in the business that is identical or similar to the franchised system.  Naturalawn of America, Inc. v. West Group, LLC et al., 484 F. Supp. 2d 392, 399-400 (D. Md. 2007); see also Merry Maids, L.P. v.Kamara, 33 F. Supp. 2d 443, 445 (D. Md. 1998). The opinion of most franchisors is that a franchise system cannot remain viable if a franchisee is allowed to compete against the franchisor after termination of a franchise agreement.  Therefore many franchisors view the inclusion of a post-term covenant not-to-compete in a franchise agreement as non-negotiable. An exception to this stance may exist where a prospective franchisee has had prior experience owning the business before approaching the franchisor.  In some instances it may be possible to negotiate the non-compete out of the agreement, since the main objectives of the non-compete, ie.  to protect the franchisor’s system for operating the business along with the goodwill built up using the franchisor’s marks, are somewhat diminished when a prospect operated a competitive business prior to purchasing the franchise.  The argument goes that the inclusion of a non-compete would fail to put the parties in the positions they occupied before entering into the franchise agreement, in the same way as when a franchise is sold to a franchisee with no prior experience running the business.  .   A second scenario to look for when reviewing non-compete language is whether the non-compete covenant applies upon natural expiration of the agreement.  The court in the Naturalawn of America case cited above indicates that a non-compete will be enforced against a franchisee upon expiration of the agreement simply because, in the court’s opinion, “expiration of an agreement is a more specific type of termination.”  Naturalawn of America, Inc., 484 F. Supp. at 401.  The enforcement of a non-compete upon the natural expiration of a franchise agreement could have enormous consequences on an uninformed franchise client who suddenly finds himself prohibited from continuing in business as an independent, despite the fact that the franchisee was a model franchisee during the life of the franchise agreement and exited the system in good standing with the franchisor.   A careful review of the agreement and negotiating a change, or at minimum advising the client of the post-expiration covenant prior to signing, is therefore essential to providing the necessary information to allow the client to make an informed decisions as to whether to purchase the franchise.  .

• Assignment; Sales of Assets to Third Party; Franchisor right of refusal. Franchisors uniformly reserve the right to approve an assignment of the franchise agreement by a franchisee to a third party, or a sale of the franchisee’s assets to a third party, and to prohibit such transfers and sales that the franchisor does not ultimately approve of.  These rights are rarely negotiable, since franchisors take extremely seriously the approval of the persons and companies that will be holding the franchisor’s trade name and marks out to the public.  One exception where negotiation is possible, however, is the form of the franchisor’s right of first refusal.  Basically, many franchisors retain an option to either purchase the assets of the franchised business, purchase the franchise itself, or both, on the same terms and conditions the franchisee has agreed to with a bona fide buyer.  A franchisor’s right of first refusal can be problematic to a franchisee for a number of reasons.  First, the franchisee has to have a bona fide offer from a third party, one that is final and agreed to on every point so that it can be taken to a franchisor for a decision.  Next, potential purchasers can be hesitant as a result of the period — 60 – 90 days is standard — that the franchisor has to decide on whether to match the offer.  Some purchasers will balk at the possibility of having to wait while the franchisor contemplates, only to find out that the opportunity to purchase the business or the assets was indeed exercised by the franchisor, thereby leaving the third party searching for a new business to purchase once again.  Therefore, an attorney will best serve his client’s interests by removing the right of first refusal altogether, and if unsuccessful, at least shortening the time period granted to the franchisor to decide on the offer so as to make the delay tolerable.

Check back for more tips in Part 3 of this series.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com