As in all business relationships, problems may occur and there may come a time when the franchisor and franchisee arrive at a parting of the ways. This can occur for a variety of reasons ranging from breaches of the agreement by the franchisee to the ultimate catastrophy, the financial failure of the franchisor.
Here are the steps the parties need to take to protect their interests and salvage as much as possible from the break-up.
Author: Nicola Broadhurst, Partner at law firm, Stevens & Bolton
A good franchise relationship with mutual respect should be capable of withstanding the test of time. The comparative lack of failure amongst franchisees, as opposed to other business start-ups, is highlighted by the NatWest/BFA survey as one of the key strengths of a franchise.
Franchise litigation is still relatively rare which is why perhaps those failures that do occur may gain much publicity.
A breakdown does not need to be acrimonious. When problems first arise, good communication with swift and appropriate legal advice can often resolve most issues amicably. It is important that the franchise agreement deals with this area adequately and that lines of communication are kept open between the parties.
Nevertheless, there are occasions when the relationship must end. This could occur in the following situations.
- Where the franchisor fundamentally breaches the franchise agreement.
- Where the franchisor becomes insolvent and a liquidator/receiver is appointed.
- Where the franchisee fundamentally breaches the franchise agreement.
- On expiry of the fixed term of the agreement with no further renewal.
- On the sale of the business by the franchisee to a purchaser, who is then granted the franchise resale by the franchisor.
On termination, the parties’ objectives then conflict. The franchisor will want to safeguard its assets, know-how and reputation. The franchisee will want to maximise the value of his business and minimise the extent of any restraints on his future business activities.
The process of termination can be costly, particularly where it is contested. In such situations, rather than resort to litigation in the first instance, it is always worth exploring alternative ways of settling any disputes.
Dispute resolution
In order to try to reconcile the parties, avoid bad publicity, and maintain the integrity of the franchise network, it is preferable to resolve such disputes without referring the matter to the courts.
Mediation or arbitration can be used if direct negotiation has been unsuccessful and often the franchise agreement will provide for this. Even where it does not the parties will often agree to mediate or arbitrate, rather than litigate, to avoid costs.
The use of mediation as a means of resolving disputes is an approach that is encouraged by the courts and can often be an influential factor in awarding costs should the dispute end up in court. The courts can take a dim view of a party who has refused to participate in an offer of mediation.
The revised European Franchise Federation’s Code of Ethics (which the British Franchise Association (BFA) adopted at its AGM in 2016) now requires franchisors and franchisees to seek to mediate in good faith before resorting to litigation.
The advantage of mediation is that it is a more informal process than arbitration and can reduce hostilities and help to preserve relationships, but the decision is not necessarily binding unless the parties agree.
For many therefore this is just seen as an additional expense without the benefit of a binding resolution, but held at an appropriate stage before positions become entrenched it can be very helpful.
Mediation is 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 if they do it is recorded in writing, and can 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 is 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.
Arbitration is private and confidential – for franchisors this is an advantage as the franchise disputes that end up in the courts often attract a lot of coverage. There are however more limited rights of appeal from an arbitral award than a court judgment.
The advantage of both schemes is that the dispute can be resolved in private at a time and place convenient to the parties.
Franchise agreement
A well-drafted agreement should set out clearly the consequences of termination. It should not only deal with the mechanics of termination, but also protect the franchisor’s intellectual property name and goodwill.
Mechanics: The franchisor will want to be sure that there is a clear and obvious break with the franchisee, whilst ensuring that customer contact and continuity of services are maintained. 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 be collected regularly throughout the agreement.
With the recent changes in data protection law (following the implementation of the General Data Protection Regulation and the recent Data Protection Act 2018) appropriate data sharing provisions are likely to be needed to be included in the franchise agreement.
In addition, certain mandatory data processing clauses may be required where either party is providing services for the other using the personal data provided by that other to ensure compliance. To overlook this area may mean that not only is a franchisor unable to use the customer data in the way it wishes, but that it and the franchisee risk breaching data protection legislation. This is not a risk to be taken lightly given the increased liability for potentially hefty fines.
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.
- 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 phone numbers and landlines.
Where location is important, the franchisor should have considered what it requires in this situation at the outset. Where the franchisor has acquired the premises and sub-let to the franchisee, the lease should be co-terminous with the franchise agreement. Where the franchisee has acquired the premises directly from a landlord, the franchisor will often have an option, as part of the agreement, to acquire the premises on termination.
Protection: The agreement will usually contain undertakings on the part of the franchisee in which he agrees to restrict the way in which he conducts his business activities on termination.
These restrictions do vary from one agreement to another, but they have 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 need to be drafted very carefully, particularly in terms of the time limit and the radius covered. Although the law recognises the need for them they must be reasonable in order to be enforceable.
The franchisor must satisfy the court that the restriction is reasonable, both as to time and area of operation, and that 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 his only livelihood. This freedom cannot be constrained unreasonably.
Establishing the correct period of time and radius is a matter requiring careful consideration. This has to be done by reference to the nature of the business and its area of operation and, for example, whether the business is in a densely populated area, 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.
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 subject to any time limit as long as it is 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 franchisor’s interests. Any delay can prove fatal.
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.
Failure of the franchisor
Usually a franchisee does not have a contractual right to terminate where the franchisor is in breach, but he has a common law right to terminate where the breach is a material breach which goes to the heart of the contract.
Where a franchisor becomes insolvent this would not necessarily justify termination by a franchisee unless there is an express provision to this effect, or the franchisee cannot trade as a result.
Where the franchisor goes into receivership or liquidation the receiver/liquidator will take control of the assets, subject to the rights of the franchisees.
These assets include all the intellectual property owned by the franchisor in the franchise, together with the franchise agreements.
The primary objective of a liquidator/receiver is to protect the assets. As the franchise agreements will usually be producing an income, it is very much in the interests of a liquidator/receiver 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 liquidator/receiver 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 liquidator/receiver by a third party and most franchise agreements provide for this without the need to obtain each franchisee’s prior consent.
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.
Dealing with termination
Not all franchisors behave ethically and not all franchisees are suited to franchising. It is essential, therefore, that where a dispute arises which may result in termination of the relationship or termination occurs that each party seeks legal advice in order to clearly understand what each can expect to achieve.
If a breach has occurred the wronged party will often want compensation and this needs to be quantified and the merits of any claim assessed. A franchisor may wish to recover its lost earnings on early termination and a franchisee may wish to recover his investment.
The costs of litigation can often outweigh the potential award of damages that a party may receive. Therefore, it is a prudent person who is able to take appropriate advice in order to make an informed and dispassionate decision.
About the author
Nicola Broadhurst is an acknowledged legal expert in the franchise sector providing the full range of advice to franchisors and franchisees.
These include the set-up of franchise networks and franchise agreements, the review and adaptation of international franchise agreements for compliance with English law and the British Franchise Association’s Code of Ethics and advising multi-unit franchisees on their franchise investments.
Nicola Broadhurst is an acknowledged legal expert in the franchise sector providing the full range of advice to franchisors and franchisees.Posted: 3rd February, 2023