How to handle franchisee terminations
In the wise words of 14th century poet Geoffrey Chaucer, “All good things must come to an end.” Alas, that holds true for franchising as well. And when good (or bad) things end in franchising, there are plenty of legal consequences, as two of the 2020 Legal Eagles describe.
“At some point, every agreement with a franchisee ends,” said David Gusewelle, a transactional lawyer at Drumm Law. “Either it ends and everyone is happy or everyone is bitter in court.”
He said the typical end comes at the contractual end of term, oftentimes 10 years. Then, like a lease, it goes month-to-month, but “that doesn’t happen very often because people think about these deadlines,” said Gusewelle.
In a happy world, the term ends and there are a few options. Get another term and go for another 10 years, maybe with a development agreement or some remodeling commitments that are beyond the scope of the franchise disclosure document. Or, a franchisee can sell.
“If you’re a franchisee and you sell your business, most of the time the concept will have the new owner sign a new agreement. Oftentimes that will include things like a non-compete agreement, so if you’re operating an in-home health business, we and the buyer don’t want you to sell your business and open up another business and take the clients. So that’s a common thing on the more friendly side of things,” said Gusewelle.
There’s also a termination that would end the franchise agreement before the contractual term. He said while “termination” sounds like it’s not on the positive side of things, it’s typically a mutual agreement.
“There’s also a termination that is typically friendly that is mutual. Just because we have a contract that ends in 10 years doesn’t mean we can’t terminate it. It could be you’re unhappy, I’m unhappy—we’re both unhappy. That’s another option, that’s the preferred option,” said Gusewelle.
But of course, it can get dicey if a termination is not mutual.
“You’ll see in Item 17” of the FDD “that summarizes your termination rights. You really need to get to the franchise agreement to see what rights the franchisor has to termination,” said Gusewelle, and franchisors need to look at that, too. “If someone calls and say we want to terminate a franchisee, I’ll say, ‘Why? Is this a good reason.’
That’s a subjective term. There’s nothing in there saying you can terminate franchisees because they’re crappy.”
While the FDD is almost universally favorable to the franchisor, those termination clauses aren’t exactly an easy out.
“Basically, every clause in the agreement can lead to a termination. But real world, if you just close your business five minutes early one day and I try to terminate your business, a judge will likely not be happy with me,” said Gusewelle. “And you also want to be fair with somebody; every state has good faith and fair dealings. Yes, our agreement may say this but are you acting in good faith. So that’s something you need to look at. It’s easier when you have nonpayment; someone didn’t pay royalties for three months and I sent you a note and I terminated you, that’s black and white.”
He said these decisions can be more art than science because how a franchisor acts has ramifications throughout the system.
“It’s a delicate dance to figure out when it’s appropriate,” said Gusewelle. “Franchisees talk. If I terminate this one franchisee for this conduct, do I need to terminate these other 10, or am I sending a message to the system that this conduct is OK?”
In cases where a forced termination does make sense, he said there are a number of things that happen, namely de-identifying the location, signing a mutual release agreement to break the contract and any non-disclosure agreements. Then, it’s down to the FDD and the franchise agreement to outline the post-contract damages and responsibilities.
Dan Warshawsky, a partner at Warshawsky Seltzer, said regardless of how the franchise term ends, franchisees need to think about it before they sign anything and really go through what those post-contract responsibilities are and if they can even renew the contract if they so choose.
“When people are buying a franchise, they’re focused on the initial term of the first 10 years,” said Warshawsky. “So, the first thing you want to do is check what the contract says; most have a limited number of renewals.”
He points to some other key issues that can significantly alter things in a termination, such as customer liabilities, which typically fall on the franchisee that initially worked with the customer.
“That’s another thing to consider in advance. I’ve seen that become a real problem for spa clients. What happens is No. 1, I have an indemnity and No. 2, I probably have a personal guarantee. So, when you close the doors, it’s not just what I owe for royalties or liquidated damages and supplier liabilities. The supplier doesn’t care if you close, they have a contract,” said Warshawsky.
He said the important thing is to get started on all this early, get the franchisor involved to approve or find a buyer for a smooth transition, and help ensure the contract ends as happy as possible.