Remedies if the franchise affair must end

A franchise relationship should be capable of withstanding the test of time. Indeed, the lack of failure among franchisees, as highlighted by the NatWest/BFA survey, is one of the strongest selling points of franchisors. By Nicola Broadhurst, of Surrey law firm, Stevens & Bolton.

However, it is inevitable that disputes may arise and a breakdown in the relationship occur, but this need not be acrimonious. It is important that the franchise agreement deals with this area adequately and that lines of communication are kept open between the parties.

When problems first arise, swift and appropriate legal advice can often resolve most issues. Nevertheless, there are occasions when the relationship comes to an end. This can occur in the following ways.

  • Where the franchisor breaches the agreement.
  • Where the franchisee breaches the agreement and the breach is either not capable of being remedied, or is not remedied, even if the franchisee is given the opportunity to do so.
  • On expiry of the fixed term of the agreement with no right of renewal.
  • On the sale of the business by the franchisee to a purchaser who is then granted a franchise by the franchisor.
  • Where the franchisor becomes insolvent and a liquidator/receiver is appointed.

This article seeks to give a general overview of the usual provisions found in franchise agreements dealing with the consequences of termination and the general remedies available.

On termination, the parties’ objectives will inevitably conflict. The franchisor will want to safeguard its assets, know-how and reputation. The franchisee will want to maximise the value of its business and minimise the extent of any restraints on its future business activities.

It is important that a franchisee understands from the outset what exit routes are available to it. Most agreements expect a franchisee to commit for a minimum number of years without a right to terminate. Therefore, if a problem arises and a franchisee wants out it is rarely in a position to simply down tools and walk away.

The process of termination can be extremely costly, particularly where the breach is contested, and it is worth exploring alternative ways of settling any disputes.

Dispute resolution

In order to try to reconcile the parties’ interests and maintain the integrity of the franchise network, it is advisable to attempt to resolve such disputes without referring the matter to the courts. In these situations, mediation or arbitration can be used if direct negotiation has been unsuccessful.

Often the franchise agreement will provide for any disputes to be referred to mediation or arbitration, rather than litigation. Even where there is no alternative dispute resolution clause the parties will often agree to mediate or arbitrate, rather than litigate, to avoid costs. This approach is encouraged by the courts.

These alternative routes are also supported by the BFA, which operates its own dispute resolution procedure. This is both a mediation and an arbitration scheme.

The mediation scheme is intended to complement the arbitration scheme and can be used prior to, or at any time during, arbitration or litigation. The advantage of mediation is that it is a more informal process than arbitration and can reduce hostilities and help to preserve relationships.

Mediation is essentially a structured negotiation between the parties in which the mediator (whose time is usually paid for equally by the parties) is an independent third party who facilitates the negotiations on a without-prejudice basis. The parties are not bound to settle their dispute, but should they do so this will be recorded in writing, and then be final and binding. Any such settlement can be enforced, but it is not the mediator’s job to make any finding or award.

Arbitration, unlike mediation, is far more formal in terms of the procedure followed and the manner in which it is conducted. The arbitrator makes an award that is final and binding (although there may be limited rights of appeal) and the award is enforceable. The arbitrator will need to be paid and the costs can be awarded against the parties as determined by the arbitrator.

The advantage over mediation is that the arbitrator will usually have knowledge of the subject area and an award may well be sought by one of the parties.

The advantage of both schemes is that the dispute can be resolved in private at a time and place convenient to the parties.

Consequences of termination

Whatever the circumstances surrounding the termination, a well drafted agreement should set out clearly the consequences of termination. Firstly, it should deal with the mechanics of severing the relationship and the protection of the franchisor’s name and goodwill. Secondly, it should protect the franchisor’s intellectual property and prevent a departing franchisee from using its trade secrets in order to compete unfairly with the franchisor and the other existing franchisees.

Mechanics

The franchisor will want to be sure that there is a clear and obvious break with the franchisee, whilst at the same time ensuring that customer contact and continuity of services are maintained with the existing customers. It is, therefore, vital to obtain all the relevant customer lists of the franchisee’s business and to contact customers directly. This should not be left to the last minute, but should be collected regularly throughout the agreement.

In order to ensure that all association between the franchisor and the departing franchisee is removed, the franchisee should be required, amongst other things, to make the following changes.

  • Cancel any relevant trade mark licence recorded at the Trade Marks Registry.
  • Change the fascia, décor and shop fitting of premises and the livery of any vehicles to remove the visible connection between its business and the franchise.
  • Return all advertising, packaging, marketing and promotional materials.
  • Cease to use all stationery, literature and other materials using the franchisor’s trade marks and service mark, trade names and other reference to the franchise.
  • Return the operations manuals.
  • Cease to use the franchisor’s system.
  • Cease to use the franchisor’s copyright material.
  • Where relevant, cease to use all telephone numbers and land lines.

Settlement

In severing the relationship there may be other considerations to be taken into account, such as property. Where location is important for the business, it is increasingly common for the franchisor to either acquire the premises in question and sub-let them to the franchisee, or have the option to take over any lease or termination. This will obviously have an impact on the termination.

In addition, where a departing franchisee is contractually required to sell to the franchisor, all its equipment and stock of products it is essential that the franchisee obtains a fair price for the goods which would otherwise be of little use to it.

Where possible it is usually beneficial to both parties for a settlement to be reached in an amicable way. This avoids any loss of reputation for the franchisor and therefore for the franchise network as a whole and it enables the franchisee to salvage what it may from the breakdown at a reasonable price.

It is essential that the agreement has been appropriately drafted for the franchise in question in order that both parties may know exactly where they stand on a parting of the ways and avoid any unnecessary acrimony.

Occasionally, the agreement contains a right of buy-back of the franchised business on the part of the franchisor, which sets out the basis upon which a value will be calculated for the business. Usually no value is given for goodwill, and assets are bought at the written down value in the accounts or at cost. A franchisee should be aware that it will not receive very much for its business where a termination is acrimonious. It has a better chance of persuading a franchisor to pay more where the relationship can be maintained at an amicable level.

Restrictions on trade

The agreement will usually contain undertakings on the part of the franchisee, agreeing to restrict the way in which it intends to conduct its business activities on termination. This often comes as a surprise to the franchisee.

These restrictions tend to vary from one agreement to another, but in essence they deal with the same objective, which is to ensure that the franchisee will not use the knowledge it has acquired as a franchisee to compete unfairly with the franchisor, or any of its franchisees, following termination for a stated period and within a certain area.

These restrictions require careful drafting, particularly in terms of the time limit and the radius covered. Although the law recognises the need for such restrictions, they must be reasonable both as to time and the area of operation in order to be enforceable, and the franchisor must be able to show it has a legitimate interest to protect. The franchisor has the right to keep and protect what it rightfully owns, but at the same time the departing franchisee must have some freedom to trade and/or to work in its chosen occupation, particularly if this is its only livelihood. This freedom cannot be fettered unreasonably.

Establishing the correct period of time and radius is a matter requiring careful consideration having regard to the nature of the business and its area of operation, and whether it is the ex-franchisee’s only means of earning a living. These restraint of trade clauses have been the subject of much litigation and thankfully the case law is extremely helpful in this area.

Where a franchisee is in breach of such restrictions, franchisors can and do take out injunctions to protect their position and, therefore, it is important that a franchisee is fully aware of the extent of its obligations when entering into the agreement.

Usually there is an additional restraint on franchisees, both during and after termination of the agreement. This is the obligation to keep all intellectual property of the franchisor, including trade secrets, systems, and know-how, secret and confidential, unless in the public domain. This obligation is not usually subject to any time limit as long as the information concerned is shown to be confidential and not generally accessible.

It is this area, and the enforcement of the restrictive covenants, which most often become the subject of court proceedings. At the first sign of any unauthorised disclosure of information or trading, prompt legal advice should be sought to protect the parties’ interests.

Failure of the franchisor

Where a franchisor becomes insolvent, the agreement will not automatically come to an end unless it contains an express provision to this effect. If the franchisor is a limited company it will usually go into administration, receivership or liquidation in which case the administrator/receiver/liquidator will take control of the assets, subject to the rights of the franchisees.

These assets will include all the intellectual property owned by the franchisor in the franchise, together with the franchise agreements (i.e the trade marks, logos, trade name, brand names, copyright in all the literature, trade secrets and the method of conducting the business), any other know-how transferred to the franchisee (unless it is already in the public domain), and usually the goodwill associated with it.

The primary objective of a receiver or liquidator is to protect the assets. As, in most cases, the franchisor will be receiving an income from its franchisees, it is very much in the interests of a receiver or liquidator to ensure that the franchisees continue to operate their businesses as usual. Therefore, franchisees should be allowed to continue trading despite the failure of their franchisor.

The receiver/liquidator also has to realise the best possible value for the assets. This will obviously be enhanced where the franchised network continues to trade.

The network might be bought from the receiver/ liquidator by someone in the same or similar line of business as the failed franchisor although this is not always ideal. Another franchisor may feel there is too much duplication between its network and that on offer. In addition, the franchisees may not wish to deal with another franchisor.

It is obviously important that a prospective purchaser establishes from the outset whether it could work with the franchisees of the failed franchisor and a canvass of the franchisees is usually the first thing a prospective purchaser should carry out. The franchisees may well be reluctant to contract with another franchisor, given their past experience.

Alternatively, one or more of the franchisees could join together and buy the assets. This is usually more successful where the franchisees have taken swift legal advice at the first signs of trouble, and are well prepared and organised. Not all franchisees will necessarily wish to be involved, but this does not prevent a handful of franchises taking over the position of the franchisor.

Once the franchisees have decided amongst themselves the best means of acquiring the assets they will need the advice of a skilled negotiator when dealing with the receiver/liquidator as there may be more than one prospective purchaser in the picture.

Where there is no prospective purchaser for the assets and no group of franchisees willing to put themselves forward then all franchisees in the network should be able to purchase from the receiver/ liquidator some of the essential features of the franchise, such as the copyright in the manual, trade mark and so on at a relatively low price which when shared out amongst the network would be negligible.

From that point on, the franchisees could carry on the business without paying any further franchise fees, but would benefit in co-operating with each other to preserve continuity of image and methodology.

Conclusion

As can be seen, it is vital that the right advice and appropriate action is taken by the parties at the critical time to ensure that the best possible outcome for their businesses can be realised. A failure to take such advice can lead to a lost opportunity and increased costs. A parting of the ways need not, after all, be disastrous.

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