Legal considerations when expanding your franchise system

Common challenges faced by growing franchisors

Even if no longer a pure startup, a relatively young franchisor may be unaware of weaknesses in its franchise system that can put it at risk as it adds new locations. These risks include the following:

• a franchise disclosure document (FDD) that is not fully compliant with provincial franchise disclosure law (our article, A Franchisor’s Comprehensive Guide to Updating an FDD, explores the process of bringing an FDD up to legal compliance);
• the leases of some early locations may be controlled by franchisees, which can impede the franchisor’s ability to retain desirable locations if the relationships with those franchisees do not survive, and
• some key provisions in the franchise agreement may not protect the franchisors’ best interests (e.g., poorly written non-competition provisions).

Our article Preparing A Franchise System for Growth delves into some of these common challenges and provides some guidance about where growing franchisors need to focus to get their house in order.

Streamlining the franchise disclosure process

Small and mid-sized franchisors often rely on an outdated disclosure process that they started using in the early days of the franchise system. Those early disclosure documents often fall behind the reality of the key elements of the franchise system, such as site-selection, location setup, operations and terminations. This can put franchisors at significant risk of non-compliance and rescissions, particularly if adding more locations without updating the documents.

The FDD itself may be legally deficient by missing key documents or location-specific material facts. Our article 5 tips to Identify Disclosure Risks for Growing Franchisors outlines common FDD errors and omissions that growing franchisors should be wary of before continuing to issue any more non-compliant FDDs.

Once the FDD is brought up to current legal standards, the franchisor should:

• identify franchise sales in the past two years that involved non-compliant FDDs, where there is risk that the franchisee could exercise a rescission right;
• strategically assess which franchisees to approach and when, and
• implement a strategy to correct the errors and omissions in the disclosure that had been delivered.

An approach for taking this corrective action is outlined  in our article, Four-Step Plan to Mitigate Rescission Risks, which discusses strategies to work with franchisees who may have received improper disclosure.

Making changes to the franchise system over time

A typical franchise agreement gives the franchisor the right to modify the franchise system throughout the term of the franchise agreement and to modify the operating manual.

Policies, procedures, and operating standards can require updates many times during the term of a franchise agreement. The operating manual provides a mechanism to do this without having to amend the franchise agreement. This allows the franchisor the ability to modify the franchise system to keep up with changes in the market and business operating environment. For example, this can include adding new menu items, changes to cleaning procedures, new signage to reflect a re-branding, or changing the business hours.

Certain changes to the system can develop into a dispute. These tend to be changes that have a negative impact on the franchisee, as follows:

• changes that are not in line with an existing provision in the franchise agreement, or not authorized by the franchise agreement;
• changes that were implemented without adequate consultation with affected franchisees, or
• changes that impact the profitability of franchisees’ businesses.

The legal test typically revolves around some or all of the following factors:

• the urgency of the situation for the franchisor (e.g. COVID-19 made it necessary for many franchisors to quickly pivot and change their business models to remain in business);
• the severity of the impact of the changes on the franchisees (i.e., how damaging are they to the franchisees’ businesses?), and
• the impact of the change on the franchise system (i.e., are the changes system-wide, focused on a small group of franchisees or a single franchisee?).

The legal test and how it relates to the franchisor’s duty to act in good faith and in a commercially reasonable manner are discussed in our article Evolving Good Faith Principles in Franchising.

Some other Law Works resources that provide more details about challenges franchisors may face when making changes to the franchise system or operating manuals over time include: Changes to a Franchise System; The Operating Manual – Understanding Canadian Franchise Law (short video); and What Changes to an Operating Manual are Enforceable?.

Renovating franchise locations

A franchisor may sometimes determine that a certain location requires renovations to keep up with current standards in the franchise system.

Although it is a typical right of the franchisor in franchise agreements to require a franchisee to renovate the premises during the term, depending on the financial cost of renovations, this requirement can become a point of friction.

Some examples of renovations that could become contentious include buying a new point of sale system, physically remodelling the location, or purchasing/replacing equipment, depending on how costly they are for franchisees to implement.

Our video The Renovation Clause In Your Franchise Agreement – Understanding Canadian Franchise Law, explores the circumstances around renovations and what may be considered commercially reasonable.

Renewal of expiring franchise agreements

At some point in its evolution, a franchisor needs to deal with renewals of franchise agreements.  Issues for the franchisor to consider may include whether the franchisee is entitled to renew the franchise agreement, if there are takeover rights in the event of defaults, and where a resale of the location may be sought or proposed. Some of these options are outlined in our article Ending Your Agreement with a Franchisee.

Not all franchise agreements have a renewal option. The parties to the franchise agreement should confirm if their agreement contains a renewal right and what the requirements are to renew the term.

Many franchise agreements impose various conditions that the franchisee must comply with in order to have a right to renew the franchise agreement.

Renewal may also be at the discretion of the franchisor who can refuse or approve the renewal request or impose conditions to its approval subject to the duty of good faith and fair dealing. Some typical renewal conditions our outlined in our article, Can Franchisors Refuse to Renew Franchise Agreements?

The wording of the renewal provision in the franchise agreement sets the parameters for any changes that the franchisor can make to a new franchise agreement with the franchisee. It may give the franchisor the right to introduce material changes to the new franchise agreement (e.g., higher royalties, higher advertising contribution rates or a franchise fee to enter a new agreement), or it might not expressly give the franchisor the right to make any changes at the time of renewal. A careful review of the franchise agreement and renewal rights and obligations may be in order. For more on this, see our article Franchise Renewals: Introducing Material Changes to the Renewal Franchise Agreement. It provides relevant examples of court decisions about renewal terms, such as the decision in Timothy’s Coffees of the World v. Switt, Pointts Advisory Ltd. v. 754974 Ontario Inc., and France v. Kumon.

Conclusion

By addressing legal considerations diligently, franchisors can lay a solid foundation for growth. As franchisors embark on the journey of expansion beyond the startup phase, proactive legal steps can help navigate sustain growth while reducing rescission risk and other legal disputes with franchisees.

—

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.

The Law Works website offers a vast number of resources by way of blog articles, courses and webinars about franchise, commercial and real estate disputes. Subscribe to our newsletters to stay up to date on the latest information from us.

Law Works offers complimentary initial 15-20 min telephone consultations, which you can book online.