Published on September 28, 2017
Posted in: Blog, Daniel Hamson
“Predicting rain doesn’t count. Building arks does.” Warren Buffett famously made this observation to emphasize a basic axiom of investing that it is not enough to simply anticipate forthcoming “storms” in the market; rather, one must also be prepared to weather the miscellany of events that can threaten one’s portfolio. This adage applies equally in the franchising context, and in particular as parties contemplate the renewal of their franchise agreement.
When approached with preparedness, renewal negotiations can offer the opportunity to retain a great franchisee and adapt the terms of the parties’ agreement to reflect evolving priorities and changing industry conditions, or, if the arrangement is no longer fruitful, amicably conclude the business relationship.
Conversely, when a franchisor pursues a renewal in an ad hoc manner, the experience can become stormy, whereby the franchisor is unable to steer negotiations towards a beneficial conclusion, resulting in missed opportunities and, at worst, exposure to potential legal liability.
In practice, the renewal process invokes a confluence of often competing “heads” of consideration which can—and should—be contemplated during system design, when the architecture of the franchise agreement, head lease, and other ancillary documents affecting the tenor of any eventual renewal is being conceived. By drafting at this stage with an eye towards process, and in particular through fashioning terms that fit together in chronological lock-step, all while paying due attention to statutory obligations, a franchisor will be adequately prepared to effectively navigate the sometimes uncertain waters of renewal negotiations.
While it is beyond the scope of this article to thoroughly examine any particular head of consideration, or discuss at length the substantial interconnection between each head, the following will provide a high-level map of the significant issues that should be settled as a franchisor seeks to renew, or not renew, a franchise agreement.
I. TERMS OF THE FRANCHISE AGREEMENT
(a) What is the renewal right? As a preliminary step in designing any franchise system, franchisors should contemplate what mechanism for renewal will apply to the parties’ arrangement—an automatic renewal, unconditional or conditional renewal, or one of the numerous other species of renewal. To that end, think of this right like a ship’s hull: It should be the first component designed, it establishes the parameters within which all other renewal terms must fit and, on a practical level, when poorly constructed, it can threaten to sink a prospective deal. Further, at the point of negotiation, and leaving analogies aside, whichever renewal right one chooses will help determine, among other things, whether and to what extent contract terms are negotiable and which party possesses what bargaining leverage.
(b) Notice of intent versus notice of renewal? From a procedural standpoint, franchise agreements typically contain notice provisions, and in particular stipulate rules pertaining to the substance and timing of a notice of renewal required to be delivered by a franchisee. The utility of such terms lies in the commercial certainty they offer by providing confirmation of a franchisee’s agreement to continue the parties’ arrangement into a subsequent term. When drafting such provisions, franchisors should choose their language carefully. All too often, agreements speak instead of a notice of intent in place of a notice of renewal, despite the former being, for practical purposes, procedurally superfluous.
(c) When is compliance assessed? A boilerplate renewal condition found in most franchise agreements requires that the franchisee be in full compliance with the terms of the parties’ agreements. With that in mind, franchisors should investigate when such compliance is assessed—at the time notice of renewal is provided, at the time of the renewal itself, or at some other point? The answer to this question could affect the availability of a franchisee’s right to renew, if default provisions were drafted with foresight, and may provide the franchisor with a useful bargaining chip during the negotiation process.
(d) Conditions or obligations? Franchise agreements regularly contain a host of conditions for renewal that must be satisfied in order for the franchisee to enjoy the benefit of a subsequent term. Some franchisors, however, choose instead to style the same requirements as obligations of the parties’ renewal agreement. The difference between the two approaches is apparent when assessed through the lenses of certainty of performance and enforcement. That is, with respect to conditions, a franchisee has discretion whether and to what extent to fulfill the requirement, but once the parties execute a renewal agreement, the condition is tacitly deemed satisfied. With the latter approach, execution of the renewal agreement confirms the franchisee’s duty to fulfill the obligation, and provides the franchisor with tools to compel performance to a standard to the franchisor’s satisfaction.
(e) Noncompliance or leverage? As touched on above, consider the strategic value of certain procedural or substantive requirements for renewal left unsatisfied by a franchisee. Take, for example, a notice to renew submitted outside the prescribed window—while technically deficient and potentially constituting grounds to disallow renewal, a noncompliant notice can also offer leverage when negotiating an update to the parties’ agreement.
(f) What are the terms on expiry? Given that not all renewal negotiations end up with an inked deal, when drafting post-expiry terms in the initial franchise agreement, there are a myriad of considerations franchisors should pay heed to, for example, whether they anticipate wanting the right to subsequently purchase the franchisee’s assets and how those assets will be valued, as well as the enforceability of restrictive covenants, among other things.
II. TERMS OF THE HEAD LEASE
In certain systems, franchisors require franchisees to contract directly with landlords, thus absolving franchisors of leasing obligations and the headache of coordinating head lease and franchise renewal deals. For the vast majority of franchisors who, for the purposes of having more robust and direct land control, do not follow this practice, there are a number of integral considerations to keep in mind when negotiating a head lease at the outset of system design and at the point of franchise renewal.
- Will the head lease renewal be conditional upon the franchisor securing a franchisee for a subsequent term? As discussed more fully below under “When to provide disclosure?”, where a head lease renewal is not conditional, due to certain legislative rules regarding the substance and timing of disclosure documents, franchisors may find themselves forced to renew their head lease without the guarantee of a subtenant, risking the possibility of being saddled with vacant premises or an obligation to operate directly if franchise renewal negotiations falter.
- Does the head lease provide for conditions for renewal or obligations upon renewal, and are these requirements similarly styled in the franchise agreement?
- What is the timing and mechanism for setting rent applicable to the new term?
III. STATUTORY OBLIGATIONS
(a) Whether to provide disclosure? Franchisors must pay attention to their statutory obligations in preparing for renewal negotiations. By way of example, Ontario’s provincial franchise legislation requires franchisors to provide a disclosure document to franchisees prior to renewal of the parties’ franchise agreement, subject to a narrow exemption in cases where, among other things, there has been no material change since execution of the franchise agreement or the latest renewal. Where a franchisor fails to meet this exemption yet neglects to provide a disclosure document, the legislation confers on the franchisee an assortment of statutory remedies, including a right of rescission within two years of executing the franchise agreement renewal. The difficulty, of course, is in determining what constitutes a material change.
(b) When to provide disclosure? The question of when to provide disclosure is affected both by procedural and substantive statutory requirements, and is deeply imbricated with the timeline of any simultaneous head lease renewal negotiations. On the point of statutory procedure, franchise laws ubiquitously require a multi-day “seasoning period” between the time disclosure is provided and when the parties may execute an agreement or transfer any funds. From a substantive perspective, provincial franchise legislation obliges franchisors to include in their disclosure documents a copy of the applicable head lease. Together, these two obligations thus mandate that, in practice, a franchisor must have its head lease locked up before it can include it in the disclosure document, which document must in turn be delivered before the franchisee can sign the renewal agreement. A problem arises, however, in situations where the head lease renewal is not conditional upon securing a franchisee—the franchisor must enter into the new head lease without certainty that the franchisee will agree to renew the parties’ arrangement once it has had a chance to consider the disclosure document. While there are solutions to remedy this timing issue, which are beyond the scope of this article, suffice it to say that with sufficient preparation at the time of system design, this dilemma can be safely managed.
(c) What to disclose? Renewals can be, and are often used as, an excellent time to update franchisees to the current form of franchise agreement. A properly drafted franchise agreement contemplates the availability of this option for implementation at renewal. Note that any proposed updated agreement, however, will need to be the subject of disclosure for further consideration by the franchisee.
(d) How does “fair dealing” apply? Another notable statutory obligation that applies to renewal negotiations—the duty of fair dealing (and the related common law concept of good faith, including where no statute applies)—is particularly relevant in instances where the franchise agreement confers upon the franchisor certain discretionary powers exercisable as a condition or obligation associated with renewal (e.g., the power to oblige a franchisee to renovate its premises). Where these powers are vaguely worded, such that the onerousness of the requirement depends upon the franchisor’s discretion (e.g., the extent of the mandated renovation), this statutory duty is engaged. When the exercise of discretion is done in bad faith, or is made in an unfair or unduly burdensome manner, such conduct may offend the statutory duty.
Generally speaking, the statutory duty of fair dealing, which incorporates the common law duty of good faith, requires franchisors to:
- exercise their powers under the franchise agreement in good faith and with due regard to the interests of the franchisee;
- observe standards of honesty, fairness and reasonableness;
- ensure that they do not substantially nullify the bargained objective or benefit contracted for by the franchisee, or causes significant harm to the franchisee, contrary to the original purpose and expectation of the parties; and
- exercise discretion reasonably and with proper motive, and not in an arbitrary or capricious manner.
Knowing whether a franchisor’s conduct has offended the duty of fair dealing, while difficult to assess, is essential to circumscribing commercial risk, as failure to act in accordance with this duty may result in potential legal liability.
Renewals are an inevitable part of every franchisor’s business. It is therefore vital to prepare for the seamless continuation or amicable expiry of a franchise agreement by contemplating the abovementioned heads of consideration at the outset of system design. In doing so, and in seeking further advice about the application of these heads to the facts of their particular circumstance, franchisors will be better prepared to identify and leverage tactical opportunities during negotiations, further equipped to close renewals on favourable terms, and more likely to enjoy smooth sailing over the sometimes uncertain waters of renewal negotiations.