Obstacles in terminating franchisee and taking over location

Six common reasons why franchisors terminate franchise agreements

In the course of a franchise relationship, it can become obvious that the franchisee is failing to meet contractual obligations, posing a potential threat to the franchise system, or in more extreme situations has in essence “checked out”, i.e., more or less abandoned the business.

These are some of the most common reasons why franchisors terminate franchisees before the term of the franchise agreement expires.

1. Unpaid debt to the franchisor: the franchisee stopped paying royalties, other franchise fees or maybe even defaulted on the initial purchase fee.
2. Failure to report sales revenues: the franchisee is not forthcoming about reporting sales or other information required in the franchise agreement.
3. Failure to correct compliance/operational issues after being given proper notice: for example, the franchisee fails to adhere to system standards or the operating procedures in the operating manual, even after receiving notices of default.
4. Loss of a critical licence needed to operate the franchised location: for example, a liquor licence for a franchised restaurant.
5. Damage to the brand by the franchisee’s actions: if those actions will damage the reputation of the brand or franchise system (e.g., conviction of a crime).
6. Abandonment of the franchised location, or insolvency: the franchisee’s business is no longer a going concern.

Types of defaults – curable and non-curable

The contractual right to terminate a franchise agreement for defaults usually falls under two main categories: curable and non-curable defaults. These provisions define what acts or omissions by the franchisee are curable and which are not and may be grounds for termination.

Curable defaults are defaults that the franchisee can repair (e.g., training staff on an operating procedure), after receiving a notice of default. If franchisees follow the curing requirements set out in the notice of default and the franchise agreement, they can avoid termination and continue to operate within the franchise system.

Non-curable defaults are defaults that the franchisee cannot fix (e.g., losing a licence or abandoning the business). Franchisees who commit a non-curable default under the terms of the franchise agreement, give franchisors the right to terminate the franchise agreement early. The terminations provisions in the franchise agreement outline the termination procedure.

These contractual provisions also normally outline the process that franchisors need to follow to provide franchisees with notices of defaults and the actions either side can take to cure them (if curable). Franchisors will be wise to strictly follow this process to avoid potential legal challenges down the road.

Exercising self-help remedies

In some situations, franchisors can exercise “self-help remedies” under the franchise agreement to take over the operation of the franchised business without having to go to court. This enables franchisors to take over problematic locations or even shut them down. Franchisors will rely on the default and termination provisions in the franchise agreement to do so.

It is likely that in any event, franchisors will have to pursue a claim for damages or injunctive relief in court or arbitration by launching a legal proceeding.

Franchisors’ considerations before proceeding with a termination

Franchisors should consider the nature of their business before moving ahead with a termination. In a mainstream industry, such as restaurants, it can be relatively easy to find a replacement franchisee to resell the business to.

This may not be the case in a more niche or specialised industry, such as health care, where the franchisee may require highly specialized education, certifications, or other credentials to operate a franchised business. It can be more difficult and time consuming to find a qualified replacement for a terminated franchisee in that scenario.

Some alternatives to termination may be:

• requiring the franchisee to resell the business to a third party, with the consent of the franchisor – the resale would have to comply with assignment provisions in the existing franchise agreement and other conditions that the franchisor may require, or
• stepping in to temporarily take over or operate the franchised business while searching for new franchisee to buy the business.

Franchisors’ post-termination rights

• Right to Take Over the Lease

If the franchisor lacks the right to take over the lease, this can complicate what happens post-termination. If the franchisee controls the lease as a tenant under the lease, they have control of the lease and the franchisor cannot easily “lock out” the franchisee, take over the business, or prevent the terminated franchisee from continuing to operate their business without a court order or very strong self-help remedy provisions.

Getting a court order to restrain the franchisee from operating their business may require a judge’s decision to enforce a non-compete or other restrictive covenants in the franchise agreement. (For more on restrictive covenants and test for their enforceability see our article: “Consequences of Franchise Terminations and Settlement Options” ).

In a situation where franchisors lack this right, they may need to obtain the consent of the landlord in advance – preferably at the time the franchise agreement is executed. Franchisors should make sure that the landlord consents in the head lease to the franchisor or its affiliate having the option to take over the lease if the franchisee is in default of the franchise agreement or terminated, or if the franchise agreement expires without renewal.

• Right to Purchase the Assets of the Franchised Business

Another self-help remedy that may be contained in the franchise agreement is the right to purchase the assets of the terminated franchised business. This is done on the basis of net book value and is normally a very nominal number that excludes goodwill from the valuation. Franchisor can then resell the assets of the franchised business.

The net book value of the franchised business is often much lower than the franchisee’s debt obligation, such as rent, royalties etc., leaving the franchisee with a net debt obligation to the franchisor for damages.

Conclusion

Termination of franchise agreements is a significant step for franchisors, requiring careful consideration and adherence to contractual obligations. By understanding the common reasons for termination, the associated terms and remedies, and post-termination rights, franchisors can navigate these situations with less risk and protect the interests of their brand and franchise system. Given the complexity of these issues and the importance of strictly adhering to the procedures set out in the franchise agreement, franchisors are wise to consult the expertise of an experience franchise lawyer when considering terminating a franchisee or exercising a self-help remedy.

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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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