How to terminate a defaulting franchisee

Step 1: Identify the legal obligation that the franchisee is violating

The first step is to identify the legal ground that puts the franchisee in default of any legal obligation imposed upon them. Any such default must normally relate to some obligation  under the franchise agreement. The franchisor should work with its legal counsel to assess the provisions in the franchise agreement and establish if the franchisee’s conduct is in violation of one or more obligations or standards imposed under the franchise agreement.

Some examples of common areas of default are non-payment of royalties, failing to use or sell approved products (e.g., buying meat from non-approved vendors), or failing to offer all services/products that comprise the system (including those that are newly launched).

Other frequent areas of default involve failure to comply with operating obligations that are set out in the franchise operating manual (franchise agreements normally impose an obligation to comply with the requirements of an operating manual).

Another form of violation may relate to a regulatory or other legal standard that is critical for the operation of the franchise in its industry. For example, in a restaurant franchise, the restaurant must pass local food safety inspections, or in a daycare franchise, the daycare centre must pass various other government inspections, such as student-teacher ratio, health and safety, etc. These are legal obligations that the franchisee must comply with (franchise agreements normally impose an obligation on the franchisee to comply with all its legal obligations).

If the action or conduct that is at issue cannot be linked to an obligation imposed under the franchise agreement or the operating manual, or a broader legal obligation (assuming they are linked back to obligations under the franchise agreement), then there is no ground of default of which to complain, but perhaps only “best practice” to suggest for improvement and optimization. In these circumstances, it may also be that the franchisor should consider updating its franchise agreement or operating manual. (Note that, if updating the operating manual, franchisees need to receive advance notice of the update or change, among other legal requirements).

Step 2: Collect evidence of the violation

It is important to gather evidence to establish the franchisee’s conduct that infringes on their legal or contractual obligation. It is a best practice for the franchisor to collect evidence from a variety of sources. For example, if a restaurant franchisee is not complying with food safety or cleaning requirements, the franchisor should consider obtaining reports from inspections and photos, customer complaints, government reports, etc.

When collecting evidence, it is important that a franchisor does not act in a way that may be perceived as commercially unreasonable or unfair, and that the franchisor does not single out the franchisee through unusually stringent standards. For example, in a case involving a bubble tea franchise, the franchisor sent a representative to spend over six hours at the franchisee’s 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 was treating that one franchisee differently from other franchisees in the system.

Step 3: Assess type of action to take and the duty of good faith

Depending on the severity of the violation, how long it has been going on, and the relationship between the parties, the franchisor and its legal counsel need to assess the level of urgency and escalation, how to communicate the default and what the franchisee is required to do.

When a violation is established, the franchisor’s lawyer should assess if the default is curable or non-curable. Curable defaults are those that the franchisee has a right under the franchise agreement to ‘repair’ or rectify to avoid termination.

Non-curable defaults are those defaults that the franchise agreement deems irreparable, which are usually drastic events such as losing a licence or abandoning the business. These defaults give the franchisor the right to terminate the franchise agreement with no notice based on the procedure set out in the franchise agreement.

Assuming that the franchisor is dealing with a curable default, and unless the severity of the violation, the urgency for rectifying it, or other circumstances require the formality of notice of default, it is otherwise a good practice to start with demand correspondence that sets out the key details about the infringement and what the franchisee must do to rectify it.

The franchisor should be transparent, raise the violation soon after becoming aware of it, and give the franchisee a reasonable opportunity to cure the violation before moving ahead with formal steps to terminate the franchise agreement. When enforcing a ground of default, a franchisor is legally required to enforce that contractual right in good faith, which generally means in a commercially reasonable manner and with no ulterior motives. Provincial franchise statutes in Canada impose a mutual obligation on franchisors and franchisees to perform and enforce their rights and obligations under the franchise agreement in good faith and through fair dealings.

For example, a franchisor should generally not rush to take measures to terminate one franchisee, while ignoring similar violations made by other franchisees in the system. A franchisor must also not enforce a right of termination based on ulterior motives for other objectives. For example, in the bubble tea case cited earlier, the judge was concerned that the franchisor had an ulterior motive to take over one of the best performing stores in the system for itself.

As a best practice, the franchisor should put in place a record of demand correspondence and the franchisee’s responses (or failure to respond).

It is also prudent for the franchisor to carefully document all relevant factors that it had considered, including the franchisee’s position, and all the steps it is taking that may lead to a termination of the franchise agreement.

Because of the obligation of good faith and fair dealing and the importance of documenting all the relevant factors that the franchisor has taken into consideration, it is prudent for the franchisor to involve legal counsel in the drafting of demand correspondence (and certainly in the drafting of a notice of default which is addressed in the next section). In the event of a dispute, correspondences between the parties can be submitted as exhibits in court and thus it is important to have them vetted by legal counsel.

It is also often a good practice to send several demand letters to demonstrate that the franchisor has taken appropriate and reasonable effort to bring the franchisee into compliance.

Step 4: Drafting the formal notice of default

If the franchisee does not rectify the defaults, it may eventually be time for the franchisor to deliver a formal notice of default, possibly leading to a termination of the franchise agreement.

Other than any specific requirements in the franchise agreement, a good notice of default should include the following components:

1. the legal obligation and relevant contractual provisions that the franchisee is violating (i.e., reference to specific sections in the franchise agreement, operating manual, or governing law);
2. the actions the franchisee must take to cure the default;
3. the deadline for curing the default, and
4. the consequences of not curing the default by the deadline (i.e., the franchisor’s right to terminate the franchise agreement).

If no response is received from the franchisee, a franchisor should make sure to document the method of service of the notice of default and that the franchisee has received it (sometimes, personal service on the franchisee may be required).

Conclusion

It is vital to approach situations of default franchisees, leading to a termination, having regard to the contractual and legal obligations that are imposed on the franchisee and the franchisor. By following these overall steps and adhering to the principles of good faith, transparency, and fairness, franchisors can navigate the termination process with integrity and reduce the risk of an unfavourable ruling in a franchise dispute.

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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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