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Termination of the Franchise Agreement: Just One of Many Options

Most, if not all, franchise agreements preserve the franchisor’s right to terminate the franchise agreement upon the occurrence of one or more contractually prescribed events, including the franchisee’s failure to comply with its obligations under the franchise agreement, a determination that the franchisee is bankrupt or insolvent, the appointment of a receiver as custodian of the franchised business, or a decision on the part of the franchisee to cease operation of the franchised business. The preservation of such a right is, to the extent it allows the franchisor to remove an unproductive franchisee from the system, integral to the well-being of the system, as a whole. Depending on the particular circumstances, however, termination of the franchise agreement may not be the most appropriate means of dealing with a non-compliant franchisee.

Termination is a resource-intensive process for both the franchisor and franchisee. For the franchisor, termination of the franchise agreement often triggers a diversion of time and resources away from the system toward a single franchisee which is either unwilling or unable to operate its franchised business in a satisfactory manner. While the financial burden of termination may be mitigated by an indemnification clause stating that any and all costs associated with termination are recoverable by the franchisor as against the franchisee, the temporary unavailability of resources, both financial and otherwise, may have permanently injurious effects on the system as a whole. This is particularly so in small systems, where the same group of individuals is responsible for all business-related decisions, ranging from the attraction of new franchisees to the enforcement of post-termination covenants. For the franchisee, the practical effect of termination is the loss of a substantial financial investment, as well as one’s livelihood. Accordingly, franchisors are encouraged to consider alternatives to termination and to structure their franchise agreements in a manner which permits the effective implementation of same.

Buyout

A buyout is an attractive alternative to termination because it permits the franchisor to obtain complete control over the franchised business of a non-compliant franchisee in a relatively efficient manner. A buyout provision typically states that the franchisor retains the right to purchase the franchised business for valuable consideration upon the occurrence of a prescribed event. Depending on the language of the franchise agreement, this right may extend beyond the goodwill associated with the franchised business to the franchisee’s premises, the franchisee’s inventory and/or supplies, and items bearing the franchisor’s trade-marks. A properly drafted buyout clause may entitle the franchisor to acquire the franchisee’s business at a favourable price while gaining control over a desirable location and reacquiring items associated with the franchise system so as to avoid their resale to third parties.

In order to facilitate a “tidy” transfer of the franchised business, the language of the franchise agreement should accurately reflect the precise rights and obligations which the franchisor wishes, and has the financial means, to assume. An established franchisor, for example, may wish to reserve the right to purchase the franchisee’s entire business, consisting of the leased premises, as well as equipment and inventory. A less mature franchisor, on the other hand, may wish to restrict its buyout right to certain specified assets. Regardless of the particular assets concerned, franchisors are encouraged to review their franchise agreements to ensure that the buyout provision makes specific reference to those aspects of the franchised business in which the franchisor wishes to maintain a residual interest, as well as a means of valuing same. In addition, the buyout provision should provide a mechanism by which the franchisor may exercise its right to purchase the franchised business, such as an option or right of first refusal, and should set out a time frame within which the franchisor must do so.

Forced Sale

Where a franchisor lacks the financial means necessary to purchase the business of a non-compliant franchisee, the franchisor may wish to compel, or force, the franchisee to sell the franchised business to a third party. A forced sale, like a buyout, results in a transfer of ownership of the franchised business. The processes differ, however, in that a forced sale requires the franchisee to search for a suitable purchaser and, in addition, to assume all legal and financial obligations associated therewith. The franchisor, despite not being directly involved in the franchisee selection process, typically retains the right, pursuant to the franchise agreement, to withhold its approval of a third party purchaser selected by the franchisee. That being said, franchisors should ensure that disapproval, if expressed, is reasonable, so as to avoid a claim for damages pursuant to the fair dealing provisions of applicable franchise legislation.

Contractual Probation Period

The contractual probation period is a less drastic and more flexible alternative to termination than either the buyout or forced sale of a franchised business. The imposition of a probation period, conceptually speaking, is similar to service of a notice of default upon the franchisee. The former mechanism, however, permits the franchisor to fast-track the default resolution process by compelling the franchisee to acknowledge its non-compliance and agree, in writing, to improve its performance or otherwise relinquish its right to operate the franchised business. Probation, like the buyout and forced sale, must be provided for directly in the franchise agreement.

Management of the Franchised Business

Where the event of default relates to mismanagement of the franchised business, an attractive alternative to termination is the imposition of management services, typically for a fee. This may include the performance of accounting and/or reporting services, the replacement of substandard supplies, equipment or machinery, and the payment of any outstanding debts and/or administrative expenses. The franchisor may, having regard to the nature, duration and degree of the particular breach(es) concerned, impose management services on either a permanent or temporary basis. Where temporary, the franchisor may require as a precondition to self-management that the franchisee enrol in, and satisfactorily complete, additional training or that it hire a General Manager to oversee operation of the franchised business.

Workout

Where a franchisee’s non-compliance with the franchise agreement is strictly monetary, meaning that the default takes the form of unpaid royalty fees, advertising contributions, lease payments, and/or supplier payments, the franchisor may wish to consider a workout as an alternative to termination. A workout is a means of providing assistance to the franchisee in order that it may overcome the financial difficulties which are precluding its compliance with the franchise agreement. A workout may take the form of royalty and advertising contribution relief, lease payment renegotiation, or credit extension by suppliers of the franchised business, and can continue in place for as long as the franchisor desires. The terms of the workout, in order to be effective, should be reduced to writing and should set out the precise nature of the relief being granted, the corresponding length of time, and the expectations of the franchisor with respect to franchisee compliance. While a workout can be somewhat costly for the franchisor, in that it requires forgiveness, or at least a relaxation of, certain debts, it represents an attractive alternative to termination where the franchisee is valuable to the system and is, aside from its monetary breaches, fully compliant with the franchise agreement. Further, the franchisor remains at liberty to require that the franchisee execute a repayment agreement as a component of the workout.

Withdrawal of Services

Franchisors are contractually obliged to provide the franchisee with various forms of support and assistance throughout the term of the franchise agreement, including but not limited to, the provision of training, the formulation and implementation of advertising and promotional programs, the establishment and maintenance of administrative, bookkeeping and accounting procedures, and the organization of annual meetings and/or conferences. While a complete withdrawal of services in response to the franchisee’s deficiencies would likely be viewed by an adjudicator as the practical equivalent of constructive termination, the discontinuance of one or more services in proportion to the particular deficiency at hand may provide the franchisee with the “push” necessary to effect positive change. The franchisor’s ability to withhold one or more services is governed solely by the language of the franchise agreement. It is only where the franchisor specifically reserves the right to withhold services that such an action will be deemed legitimate and in accordance with the statutory duty of fair dealing. Accordingly, the franchise agreement should set out, in detail, the precise events capable of triggering the withdrawal of services and corresponding curative periods, as well as the particular services which may be withdrawn upon a breach of the franchise agreement.

Conclusion

Termination is a costly and time-consuming means of ending the franchise relationship. Franchisors are thus encouraged to consider the foregoing alternatives and to ensure that their franchise agreements contain the provisions necessary to implement same.

For more information, please contact Melissa Won or any other member of the McKenzie Lake Franchise and Intellectual Property Team by email or by calling 519-672-5666.