Ending your agreement with a franchisee

Common Reasons Why Franchisors Terminate Franchise Agreements

When dealing with a franchisee who repeatedly falls short of his or her contractual obligations, at some point a franchisor needs to take default and termination steps. When default steps remain outstanding, despite written notices, a franchisor may have to proceed with termination steps. Some common grounds for termination in cases that I normally see in my practice include those where the franchisee has:

• stopped paying royalties and other franchise fees (or even the initial purchase);
• failed to report sales revenues or other information required in the franchise agreement;
• failed to correct operational or compliance issues after the franchisor has given them proper notice;
• lost a critical licence that they need to operate their business (e.g. a liquor licence);
• took actions that damaged the reputation of the brand or the franchise system, or
• became insolvent or abandoned their franchised location.

My article, Obstacles in Terminating Franchisee and Taking Over Location, explores options available to franchisors when franchisees fail to meet one or more of these contractual obligations.

Curable and Non-curable Defaults

A franchisor’s response to a franchisee who is in default of their franchise agreement depends on whether or not the default is curable.

Curable defaults are those that the franchisee can correct if they do so based on the franchisor’s requirements and timelines. The franchisor must give notice to the franchisee when they are in default, communicate what they must do to cure the default, and establish a reasonable timeline to correct it.

Non-curable defaults are those that cannot be remedied. It is up to the franchisor to decide if they wish to proceed to terminate the franchise agreement in those circumstances, and to exercise “self-help” remedies provided for in the franchise agreement.

The provisions of the franchise agreement for default and termination define what acts or omissions are curable and non-curable, and the mechanism that the franchisor is required to follow to give notice to the franchisee and proceed with the termination if required. I discuss that in greater detail in my article,  Terminating a Franchise Agreement – A Primer.

The Termination Process

A franchisor must adhere to the default and termination provisions set out in the franchise agreement. My article, How to Terminate a Defaulting Franchisee, outlines a four-step process for franchisors to follow in these circumstances:

1. Identify the legal obligation that the franchisee is violating.
2. Collect evidence of the violation from a variety of sources (e.g. inspection report, customer complaints, government reports).
3. Assess the severity of the violation, its duration and what would be considered reasonable requests to make of the franchisee to cure the default.
4. Draft and deliver a formal notice of default.

Throughout this process it is important for the franchisor to be transparent, communicate effectively (and in timely manner), and keep solid records (documents, correspondences, actions taken etc.). It is also important for the franchisor to adhere to the legal requirement to act in good faith, which is generally to act in a commercially reasonable manner with no ulterior motives.

For example, in a case involving a bubble tea franchise, the court was concerned that the franchisor was acting in a commercially unreasonable and unfair manner when collecting evidence against the franchisee. The franchisor sent a representative to spend over six hours at the franchisee’s restaurant location on a daily basis, scrutinizing every detail of the operation and “putting the staff under a microscope”, among many other things. There was also evidence that the franchisor “singled out” the franchisee and treated her differently from other franchisees in the franchise system.

Self-help Remedies to Avoid Litigation

When a default cannot be cured, a franchisor can choose to terminate the franchise agreement, utilizing a mechanism in the franchise agreement called a “self-help remedy”. The default and termination terms outline how a franchisor can potentially shut down or take over a problematic franchise location without having to go to court.

A franchisor may also be able to purchase the assets of the franchised business (discussed below) or take over the lease. My article, Obstacles in Terminating Franchisee and Taking Over Location, expands on self-help remedies as other considerations for franchisors in this situation.

Alternative Remedies to Termination

There are alternative remedies when terminating a franchise agreement that a franchisor may want to consider. These include:

• An asset buy back which enables the franchisor to buy the assets of the franchised business at net book value to either operate the business itself or resell the business as a going concern to a new franchisee. It is important that the franchisor account for the values of those assets in the resale of business. This was disputed in the case 55668 Newfoundland and Labrador Limited v. Sullivan, where the Supreme Court of Newfoundland and Labrador held that another franchisee who took over the assets of a terminated franchisee without the latter’s agreement was liable to the terminated franchisee for the value of the equipment.
• Requiring the franchisee to resell the business to a third party (with the franchisor’s consent). The mechanism for this option is typically outlined in the assignment provision in the franchise agreement.
• Temporarily stepping in to operate the franchised business while searching for a new buyer for the franchise location.

Key Factors in Disputes Over Termination

A franchisee can dispute a franchisor’s right to take over operations of their location by commencing legal proceedings either in court or arbitration, depending on the terms of dispute resolution clause in the franchise agreement. In doing so, they may seek damages or injunctive relief, or both.

In my article, Top Five Franchise Termination Considerations, I outlined some factors that may affect a franchisee’s decision whether to pursue a legal claim, including:

• if he or she is indebted to the franchisor for a significant amount of money;
• if the franchise agreement grants the franchisor post-termination rights (i.e. “self-help remedies”);
• if he or she is personally on the hook under the head lease for lease obligations (i.e. the franchisee is the tenant), or
• if the franchisor adhered to all of its contractual obligations.

A case where Shoppers Drug Mart terminated a franchise agreement provides an example where the franchisee’s claims and actions weakened their position. In that case, the pharmacist who was the franchisee had allegedly misappropriated money and misrepresented personal as promotion expenses that he claimed as damages in the dispute. On top of this, the franchisee made allegations of bullying and harassment in the workplace that the court ruled as scandalous and amounted to pleading evidence (which is not permitted), rather than material facts. The court ruled in favour of the franchisor.

Key Factors in Disputes About Post Termination Obligations

The franchise agreement outlines the obligations of franchisees after termination. Some common obligations have to do with the following:

• non-competition covenants,
• ownership of client lists,
• the franchisor’s right to buy assets or take over the lease, and
• intellectual property rights.

In, Consequences of Franchise Terminations and Settlement Options, I outlined the options that a franchisor should evaluate in the event of a dispute over these obligations. It is important to understand the enforceability of these provisions in the franchise agreement. Some key considerations for the franchisor are:

• Does the non-competition clause pass the legal tests for enforceability? I outlined these factors in the article, When are Non-Competition Restrictions Invalid in Franchising. If the clause appears to be enforceable, the franchisor’s position will likely be strong. If it does not meet the legal requirements, it may not be worth pursuing litigation. In enforcing a non-competition covenant, the franchisor must also be able to prove that it will suffer irreparable harm from the allegedly competing terminated franchisee. For example, in the RFSP Equipment v. Singh, the Supreme Court of British Columbia found against the franchisor. It dismissed two applications for interlocutory injunction by the franchisor, Freshslice, was seeking against a group of franchisees in Vancouver because the franchisees had adhered to their contractual obligations to de-brand their businesses.
• Who controls the lease? If it is the franchisor, it can probably lock out the franchisee as a self-help remedy. If the franchisee is the tenant under the lease, it may be more difficult to take over the location, unless the franchisor has a contractual right to assume the lease in the event of a termination of the franchise. I discussed that in my article, Obstacles in Terminating Franchisee and Taking Over Location).
• How much is owed to creditors? A franchisor should conduct due diligence to uncover all amounts the franchisee owes to creditors and any liens against the assets of the franchisee’s business. A franchisor may not want to take on financial responsibility for these obligations if the total liabilities are greater than the financial benefit of taking over the business.
• Does the franchisee have a rescission claim? If the franchise has potential statutory rescission rights, the franchisor may prefer to negotiate a settlement rather than face a potentially devastating rescission claim. (For more on rescission claims, see my article What to Do if Your Franchisee Wants a Rescission).
• Does the franchisee have the means to pursue litigation or arbitration? If it is unlikely that the franchisee has the means to successfully pursue litigation, it may be more likely to prefer to seek a settlement and the franchisor can avoid the significant cost of legal proceedings.

Conclusion

Franchisors should approach terminations with transparency and fairness, ensuring adherence to legal requirements and acting in good faith throughout the process. Leveraging self-help remedies can potentially help avoid lengthy litigation, but careful consideration of post-termination obligations and potential disputes is critical. Understanding the differences of curable and non-curable defaults, as well as the termination process overall is also important. Franchisors are wise to understand the options that may be available to them in their franchise agreements to protect their interest in the event of a termination.

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The information contained in this article is provided for informational purposes only and does not constitute legal advice. Readers should not act on this information without seeking professional legal advice from a lawyer experienced in this area. The content in this article may not reflect the most current legal developments, and the application of law can vary in different provinces and territories. As such, the information in this article is not guaranteed to be complete, correct, or up to date. The author and the publisher of this article disclaim all liability for any actions taken or not taken based on any or all of the contents of this site.

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