The Rundown on System Changes

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This article was originally published in The Lawyer’s Daily on June 18, 2020, under the same title.  The assistance of Anthony Pugh, Associate at Law Works PC, in writing this article is acknowledged with thanks. 

As businesses start to reopen more fulsome operations, retail franchise system may need to implement changes to their premises, and sometimes to their systems and even business models.  Changes may range from the simple addition of safety fixtures on the premises, to adding new product lines or delivery methods.  Franchisees, in turn, may be required to make these changes to their operations, often at a significant cost. 

Typical franchise agreements give franchisors the legal right to make system changes, including these provisions: 

1. a right to make significant system changes; 
2. a right to start new systems, which may compete with current franchisees within their territory; 
3. a right to change the operations manual; and 
4. a right to require renovations. 

However, in some situations, the obligation to act in good faith may constrain the scope of permissible system changes, such as if those changes are commercially unreasonable and if they are expected to have a detrimental effect on franchisees.   

Depending on the significance of the change, and to reduce litigation risk, it may be a good strategy to actively consult with franchisees about intended system changes and to get buy-in from as many franchisees as possible.  This consultation should begin before the franchisor formally announces its intention to make changes.   

Franchisors should document why the system change is commercially reasonable. This includes considerations about the reasons for the proposed system change and the expected impact on franchisees.   

Franchisors can also consider imposing changes through modifications to the operation manual.  These changes will be smaller in scope, will likely impose less litigation risk, and may require less or no consultation with franchisees.  Systems modification this way may be implemented through a gradual series of small-scale changes to the operation manual.  This may not be suitable, however, for all necessary responses to the COVID-19 pandemic. 

If the franchisor needs to reorganize store space across the system, the legal mechanism may be the imposition of a renovation requirement under the terms of the franchise agreement.  Franchisors should keep in mind however that, generally, the renovation requirement should be resorted to only occasionally (for example, once every five years for each franchisee) and where it is reasonable to do so.  The renovation requirement is often contested between franchisors and franchisees since it often comes at a significant cost to franchisees.  As with other system changes, franchisors may need to demonstrate that the required scope of renovation is reasonable in the circumstances. 

Situations where some franchisees refuse to adopt system changes are not uncommon.  The consequences may lead to termination of the franchise relationship by the franchisor.  A franchisor may have other remedies as well, short of terminating the franchise.  Some franchise agreements, particularly in service-based industries, may give a franchisor a right to modify a franchisee’s exclusive territory rights.  This may include the right to set up another franchised business within the franchisee’s original territory, or reducing the franchisee’s territorial boundaries.  A franchisee’s default in a material way with its obligations under a franchise agreement may also have implications on its right to renew the franchise agreement down the road. 

As a result of the economic impact of the lockdown, some franchisors may be taken over by other franchisors.  Most franchise agreements allow a franchisor to assign its franchise agreements to another company.  The result of such a takeover may be an obligation on franchisees to comply with new system and operating standards.  Franchisees may also find themselves operating near competitive businesses which are now part of their new franchise system.   

Other consequences of a takeover by another system may include winding down some non-performing locations, whether by consent termination or otherwise where appropriate legal grounds exist.  Similarly, if a franchisor becomes insolvent and ends up going through a formal insolvency restructuring, non-performing locations may have to be shut down or otherwise taken out of the system.   

While most franchisors and franchisees would prefer to avoid taking termination steps, that remedy may be one that either side ultimately chooses to take, particularly where the location performs poorly.  Both parties should keep in mind that termination on traditional default grounds may not be as straightforward as it otherwise used to be.  Given the statutory obligation on both parties to a franchise agreement to enforce rights or obligations under the franchise agreement in good faith, it is possible that a strict enforcement may be deemed to be unreasonable in the circumstances of the pandemic. 

Disputes between a franchisor and its franchisees about system changes may be, by their nature, system-side and may lend themselves to group or class-based disputes.  Group or class claims based on system changes are usually founded on allegations of breach the good faith obligation.  Franchisors should remain cognizant of the harm to the brand and goodwill with the public, as well as the potential risks of the litigation.