Consequences of franchise terminations and settlement options

Contractual obligations under a franchise agreement

In a franchise termination, both parties should conduct a termination legal analysis with their lawyers.  Both sides should engage franchise lawyers to evaluate the enforceability of post-termination contractual obligations in the franchise agreement. The following clauses of the franchise agreement are common areas where a franchisor can make a claim against a franchisee for breach of post-termination obligations.

• Non-competition covenants

Franchise agreements often impose non-competition obligations (sometimes referred to as “restrictive covenants”) to restrict the franchisee and all those related to the franchisee from operating a competing business, directly or indirectly, within some territory or territories for a certain number of years.

• Non-solicitation of employees

A non-solicitation covenant is clause in a franchise agreement that prohibits a former franchisee from soliciting, or actively pursuing, business partners or other employees of other franchisees or the franchisor, during the franchise relationship and for a set period after termination.  Based on recent amendments to the federal Competition Act, non-solicitation clauses that aim at non-solicitation of employees are no longer enforceable (the recent amendments make it a criminal offence to enter into such an agreement).

• Ownership of client lists

In some franchise agreements, non-solicitation covenants may also apply to clients or customers of the franchise business. This is often found in franchise systems in the service or consulting industries, such as accounting, financial, daycare, health club; franchise systems that cater to other businesses, such as graphic design, signage; and business models that have e-commerce components; in all of these, the franchisees have a customer list or can access a customer database.  Not all such clauses are legally enforceable, and a knowledgeable lawyer should analyze them.

• The franchisor’s right to buy assets or take over the lease

Most standard franchise agreements in Canada provide a franchisor with the right, upon termination of the franchise agreement, to purchase the assets of the franchised business on a net book value basis.

Net book value is the appraised value of the assets without accounting for goodwill and net of all equipment depreciation, among other accounting allowances.  It is often a very nominal amount of money.  It enables the franchisor to buy the assets for a small amount and resell the franchised business as a going concern to a new franchisee.

• Intellectual property rights

If the franchisee is allowed to continue operating a de-branded business after termination, there may be allegations that the former franchisee is infringing on the franchisor’s intellectual property rights.   Franchise agreements must be specific in defining the unique identifying features of the franchise system’s brand, such as colour, distinctive physical features, menu names, etc., and what elements must be de-identified and removed post-termination. The parties should try to agree on a schedule and a list of all required changes to the business operation and premises to properly de-identify it from the franchise system.

Settlement considerations

Both sides should evaluate how to approach potential settlement negotiations and the merits of pursuing litigation or arbitration.  The following are some of the factors that parties should consider.

• Is the non-competition clause enforceable?

For a non-competition to be legally enforceable in Canada, the restriction generally must be clear and unambiguous in the type of business operation that it seeks to restrict.  Also, the radius and time restrictions must be reasonable and must not overreach beyond protecting the franchisor’s legitimate interests. It must contain the following three components to be valid:

• a clear definition of what type of business or products are prohibited,
• a geographic territory for the restriction that is reasonable in the circumstances, and
• a time frame for the restriction post-termination that is reasonable in the circumstances.

If the non-competition clause is likely enforceable and there are valid grounds to allege that the franchisee is engaging in a competing business, either directly or indirectly, in violation of the non-competition covenant, the franchisor’s position will be strong.  On the other hand, if the clause fails to meet these legal requirements or if the evidence about the franchisee’s involvement, directly or indirectly, the franchisor’s position on this issue may not be worth pursuing.

• Who controls the lease?

What happens to the premises of the franchised business after the franchise agreement is terminated depends not only on the enforceability of the non-competition covenant but also on who controls the lease: whether the head lease of the location is in the name of the franchisor or franchisee.  If the franchisor or its affiliate is the tenant under the head lease, it may have the ability to change the locks and retake possession of the location.

If the franchisee controls the lease as the tenant under the lease, the franchisee will have a stronger position in holding on to the location.  The franchisor may still have rights to take over the lease either through a term in the franchise agreement or thorough a schedule to the headlease.  The parties’ positions on this issue may vary depending on the strength of those rights and if the landlord has agreed to them in advance.

• How much is owed to creditors?

Both parties should ascertain how much the franchisee owes to creditors as outstanding debts, including the franchisor, landlord, CRA, banks etc.  A franchisor seeking to take over a franchised business should conduct the necessary due diligence investigations to ascertain all amounts owing by the franchisee to its creditors and all liens against the assets of the business.  These often include amounts outstanding on a Small Business Loan (SBL), back taxes and HST owing to the CRA, and, more recently, amounts owing on Canada Emergency Business Account (CEBA) loans.

As to the lease, another potential consideration if neither party wants to continue operating the franchised business.  Terminating the lease will result in liability of the to the landlord for damages for an early termination of the lease.

If the franchisor or its affiliate is on the head lease, that liability will rest with the franchisor or its affiliate, with a right for it to then claim over that liability against the franchisee.  If the franchisee is a tenant or indemnifier under the lease, the franchisee will be directly responsible to the landlord.

• Does the franchisee have a rescission claim?

Both parties are wise to determine if the franchisee may have a statutory rescission right if the franchisor failed to deliver an adequate franchise disclosure document at the time of the sale of the franchisee, and as part of that analysis, if the franchisee is still within the limitation period for exercising a rescission right, which is typically two years from the date of the franchise agreement.

If there appears to be a valid rescission right, it will be in the franchisor’s best interests to try to negotiate a settlement rather than to face a rescission claim.

• Does the franchisee have the means to pursue litigation or arbitration?

The franchisee may possibly not have the financial means to purse complex or protracted litigation or arbitration.  If that is the situation, the franchisee should put its best efforts at negotiating a timely settlement based on the key factors that favour the franchisee’s position.

Conclusion

There are a myriad of factors that parties to a franchise agreement should carefully evaluate when contemplating termination of the franchise relationship, including post-termination non-competition covenants, liabilities to each other for breach of the franchise agreement and potential rescission rights, and liabilities to third party creditors.  In some situation, litigation may be necessary, including for urgent injunction applications to preserve certain rights of the parties.  Before considering litigation, both parties may benefit from a negotiated settlement of the dispute or a negotiated takeover and resale of the business to transition it to a replacement franchisee.

***

Did you know?

• In a recent franchise takeover dispute, the Supreme Court of Newfoundland and Labrador held that a franchisee who took over the assets of a terminated franchisee without the agreement of the terminated franchisee was liable to the terminated franchisee for the value of equipment (based on conversion) and was awarded damages of about $85,000. The court also held in favour of the franchisor on a counterclaim for unpaid royalties and awarded damages of about $61,000 (see 55668 Newfoundland and Labrador Limited v. Sullivan, 2021 NLSC 38). Click here for more

• In a recent Supreme Court of British Columbia decision, the court rejected injunctions against former franchisees who were in breach of non-competition covenants under their franchise agreements because there was no irreparable harm to the franchisor. The court held that, since the franchisees had completely rebranded their restaurants, there was no possibility that the brand, goodwill or reputation of the franchisor had been harmed by the competing businesses (see RFSP Equipment v Singh, 2022 BCSC 538). Click here for more

• In an Ontario Superior Court of Justice decision, the court dismissed arguments by the franchisor that the former franchisee did not adequately de-identify its store layout after a settlement-based termination. The court ordered the franchisor to pay the agreed-upon $100,000 settlement, and $27,200 for legal fees to the franchisee. The court ruled that the franchisor had no right to withhold payment to enforce the branding issue, and that this was not only a breach of the settlement minutes, but also its duty of good faith (see Unicity Holdings Ltd. v. Great British Vape Co., 2021 ONSC 6268). Click here for more