May 23, 2011

Key Issues in Franchise Transfers and Renewals: Part 1 – What Every Franchisor Should Know About Renewal

Renewal provides a key opportunity for franchisors to institute changes to their business systems and move franchisees over to the then-current franchise agreement form and system standards (i.e. trade-dress and equipment). Such changes can be vital to a franchise system’s continued success in the marketplace. It is essential that franchisors be able to adapt their business format to current and anticipated situations and ensure compliance from their franchisees, both practically and legally. Franchisors, however, must be cautious not to introduce sweeping changes that are materially disadvantageous to their franchisees. The renewal process should be seen as a balancing act between modernizing the franchise agreement on the one hand, but on the other hand not modifying it in such fundamental ways as to make it unpalatable to franchisees (even if the franchisor is contractually permitted by the franchise agreement to do so).

If a franchise agreement provides no right or option to renew on ascertainable terms, there will be no renewal enforceable by the courts. But franchisors should be mindful of the recent decision in Salah v. Timothy’s Coffees of the World Inc., [2009] O.J. 4444 (SC); aff’d [2010] O.J. 4336 (CA), which stands for the proposition that renewal clauses will be interpreted in favour of franchisees where there is ambiguity in the drafting. Franchise agreements are contracts of adhesion, and will undoubtedly be interpreted against the party who drafted them. Keeping this in mind, franchisors must be forthright and unambiguous from the outset when communicating with franchisees about the opportunities for renewal or else they risk having their own franchise agreements turned against them.

Renewal clauses often include specific conditions which the franchisee must fulfill in order to exercise its right of renewal. Typically these include the following:

  • Within a specified period (e.g. between six and 12 months prior to expiry of current franchise term) provide franchisor written notice of intention to renew.
  • Pay a renewal fee (typically a stated amount or a percentage of franchisor’s then-current initial franchise fee), and possibly also reimburse franchisor’s legal fees and other costs incurred as a result of the renewal. Franchisors, however, should be mindful not to make the renewal fee and the other renewal conditions cost-prohibitive compared to the cost of acquiring and opening a brand new franchise.
  • Entering into franchisor’s “then current form of franchise agreement”, which typically differs materially in its requirements from those of the original franchise agreement (for example, by providing for a higher royalty and a greater advertising contribution). Although courts have generally been willing to permit franchisors to enforce such clauses, this does not give franchisors an unfettered right to put into the new agreement whatever they want, presenting it on a “take-it-or-leave-it” basis. Such an arrangement would effectively create a novation, and so would not be a renewal at all: if the parties have bargained for a renewal right or option, then regarding it the franchisor will be subject to the common law/statutory duty to act in good faith.
  • Implementing changes to the franchised business to ensure that it satisfies the franchisor’s then-current image, system standards, and specifications.
  • No current material default under the franchise agreement, and substantial compliance with the agreement throughout the expiring term.
  • Deliver a general release of claims against franchisor, affiliates, etc. Such releases, however, are of questionable enforceability: see discussion of 405341 Ontario Limited v. Midas Canada Ltd. above in the “For The Record” section of the Newsletter.

In Ontario, franchisors are required to provide disclosure documents to prospective franchisees prior to the franchisees signing any franchise-related agreement with, or making any franchise-related payment to, the franchisor or its associate. The rationale is that franchisees should be given sufficient information before acquiring the franchise to be able to make a fully-informed investment decision. However, Section 5(7)(f) of the Arthur Wishart Act says that a franchisor need not provide a disclosure document upon renewal or extension of a franchise agreement “where there has been no interruption in the operation of the business operated by the franchisee under the franchise agreement and there has been no material change since the franchise agreement or latest renewal or extension of the franchise agreement was entered into.” In practice, this exemption is virtually useless, because only rarely will there have been no such material change.

Inevitably parties to most franchise agreements will sooner or later be faced with the issue of renewing the franchise. Parties who are mindful of their commercial relationship and the practical realities of running a business are apt to avoid disputes arising from renewal of the franchise agreement. Those that aren’t mindful usually find themselves in an unwanted dispute regarding renewal of their business relationship and the documentation.