ASSIGNMENT, TERMINATION, AND RENEWAL
By Craig Tractenberg
The franchisor establishes and builds brand equity. Its brand equity is measured by its ability to generate revenues. A franchisee that buys into that brand builds a business. The franchisee’s equity in its business is measured by its ability to generate profits. Some of the tensions between the franchisor and franchisee in maximizing equity in their businesses have to do with the limitations of assignment, termination, and renewal.
Contractual limits on franchise rights to transfer, operate, and renew are based on the franchisor’s need to protect brand equity. Although these limitations are generally a matter of contract, judicial decisions and legislative initiatives have sought to establish an objective balancing of franchisor and franchisee contracts.
This chapter will examine the limits of contract, judicial decisions, and legislative initiatives. The limitations imposed by contract on the franchisee do not establish a “zero sum game” in favor of the franchisee. Rather, a balance is often struck when both the franchisor and franchisee benefit from contractual terms that allow valuable franchises to be resold, financed, and expanded. No uniform contractual language has yet been developed that is acceptable to both franchisors and franchisees. Nor have judicial decisions and legislative enactments established uniform expectations applicable to transfers in every situation.
II. ASSIGNMENTS OF FRANCHISE AGREEMENTS
A. WHAT CONSTITUTES A FRANCHISEE ASSIGNMENT OR TRANSFER
Franchisee assignments occur when the franchisee elects to sell or assign any portion of the franchise agreement, ownership interests in the business entity that owns the franchise, the assets of the business, and/or the business itself before the expiration of the term of the franchise agreement. The term transfer is usually defined in the franchise agreement as an assignment above a particular threshold that triggers some franchisee undertakings or franchisor’s consent and approval. Franchise agreements define such transfers in many different ways; however, definitions generally include any series of transactions that result in a change of control or significant change in ownership of the franchise. A 51 percent change in ownership is a typical threshold used in franchise agreements, though sometimes a lower threshold is used due to franchisor concern about small stock transfers that result in a change of control over time.
For the purposes of this chapter, a transfer is distinct from two other situations in which a franchise can pass into new ownership: renewal and succession. A franchisee’s renewal of a franchise agreement refers to the reinstitution of a franchise following the expiration of the term of the franchise agreement. In contrast, succession refers to transfers of franchise ownership by means of gift or inheritance, typically within the immediate family of the original franchisee.
B. CONTRACTUAL PROVISIONS ADDRESSING THE TRANSFER PROCESS
Franchise agreements generally contain provisions that restrict a franchisee’s ability to transfer the franchise without the express written consent of the franchisor. These provisions may also provide the franchisor a right of first refusal to repurchase the franchise to manage or resell the unit. Agreements requiring franchisor consent to any transfer may contain a protection for the franchisee that such consent shall not be unreasonably withheld. The strength of this protection will often depend on the conditions placed on transfer in the franchise agreement, since courts often look to these terms to determine reasonableness. Although the types of conditions vary by agreement, they often include:
- payment of a transfer fee;
- requiring the transferee to enter into the then-current form of franchise agreement;
- requiring the transferee to qualify financially;
- requiring the transferee to complete training satisfactorily;
- requiring full payment of all amounts owed by the franchisee;
- requiring the renovation or modernization of facilities or equipment;
- requiring execution of a release;
- requiring approval of a designated manager, granting the franchisor the right of first refusal;
- prohibiting an excessive purchase price or leveraged financing;
- prohibiting sale to a competitor;
- requiring notification of the transfer.
Such contractual provisions cannot be considered in a vacuum because statutory limitations and protections regarding transfer rights can supersede such provisions. Even when no statutory backdrop exists, transfer provisions will be tested against common law claims relying on the implied covenant of good faith. Both topics are addressed separately below.
1. CONDITIONS PRECEDENT TO TRANSFERS
Reasonable conditions to transfer are typically as enforceable as any other contractual term. For example, in the case of Perez v. McDonald’s Corp.,1 the franchise agreement expressly prohibited McDonald’s from arbitrarily withholding its consent to the sale of the franchise by the franchisee, but did give McDonald’s the right to require that prospective transferees meet the same criteria that applicants for a new franchise were required to meet, including completion of the preliminary applicant training program that McDonald’s offered to individuals at its sole discretion.
When McDonald’s refused to consent to the plaintiff franchisee’s four proposed sales because they had not taken the training program, plaintiff challenged the franchisor’s selective enrollment practice under common law and statutory theories. Plaintiff contended that McDonald’s had acted arbitrarily in violation of the franchise agreement by refusing to enroll the prospective purchasers in the program. The court rejected plaintiff’s arguments and granted summary judgment to McDonald’s relying upon the plain and unambiguous language of McDonald’s franchise agreement and its offering circular. Both documents had expressly stated that satisfactory completion of the training program was a prerequisite to consent to transfer.
The court refused to find an implied covenant of good faith to require McDonald’s to allow “a qualified, ready, willing and able buyer, based on reasonable standards, to enter the McDonald’s applicant training program.” The court ruled that it would not impute such an obligation because “the covenant is not an independent source of duties” and, therefore, could not limit franchisor discretion on a subject that was not part of the parties’ agreement. A discussion of the typical transfer conditions found in franchise agreements is discussed below.
I. PAYMENT OF OUTSTANDING DEBTS TO FRANCHISOR AND AFFILIATES
Payment of all amounts owed at the time of transfer is a reasonable condition to approval of the transfer. The provision is equivalent to demanding a cure of monetary defaults before recognizing the transferee. The provision has an additional benefit when the transferor has inadequate funds to pay all creditors because the franchisor effectively can hold the franchise agreement as security for the transfer, giving the franchisor a priority over trade creditors. This is particularly true in a bankruptcy setting—as a matter of bankruptcy law the prompt cure of all defaults is a condition of transfer.
II. PAYMENT OF OUTSTANDING DEBTS TO TRADE CREDITORS
The franchisor may desire that its strategic suppliers or landlord be paid as a condition of transfer. As a contractual provision, such a provision is enforceable. In an insolvency setting, however, this provision has been challenged as not being essential to the franchise relationship. The bankruptcy courts consider whether this provision can be severed from the other essential elements of the franchise. The outcomes are usually fact sensitive.
III. PAYMENT OF TRANSFER FEE
This condition requires a payment of a fee, either fixed or determined by a formula. The formula may contain factors such as historical performance, the remaining term, or the type of business entity. The fee may also be lower when the transfer is to an existing franchisee, as an experienced franchisee may not require the franchisor to incur any additional training costs.
Despite an express calculation of the transfer fee in the franchise agreement, these transfer fees are often requested by the franchisee to be renegotiated, especially in cases in which the reasons for the fee are articulated and arguments may be raised regarding how this particular transfer does not cost as much as the fee charged. Franchisors are recommended to have a uniform fee that discourages too-frequent trade in franchise ownership but compensates the franchisor for projected costs in the transfer costs.
IV. FULL COMPLIANCE WITH TERMS
Even in the absence of a default notice issued by the franchisor, the franchisee may not be in full compliance with the franchise agreement at the time the transfer is requested, or may not be in compliance with the franchise agreement at the time the transfer is anticipated. This is a different provision than curing mere monetary defaults. These are nonmonetary performances that have a direct impact to the brand.
Typical compliance issues are non-compliance with operating and managerial standards, up-grades, remodels, and remedying operational defaults. These types of defaults only support termination or specific performance before transfer. It may be desirable for the franchisor to require strict compliance before transfer; however, often the transferor cannot discharge these obligations. Complete overhaul of the location as a condition of transfer may impede or prevent the transfer in time to benefit the franchisor. In these circumstances, the franchisor may waive compliance as a condition of transfer if the transferee agrees to undertake the performance. The franchisor should demand an escrow of the sale consideration and/or a guarantee by the transferor of a deadline for completion, even if the cure must occur after transfer. Nevertheless, cure of minor deficiencies, sign upgrades, and painting can be imposed on even distressed franchisees as conditions to transfer.
Imagine the system if the franchisor did not enforce compliance with the then current standards. Older locations would begin to look dated and dilute the brand. Substandard operations would be the result in those locations undergoing multiple transfers. Not only must this condition be contained in the franchise agreement, but it also must be enforced.
V. SUCCESSFUL COMPLETION OF TRAINING
A trained franchisee increases the likelihood of its success; however, what is the solution if insufficient time for training, testing, and integration into the system occurs before the sale? The reality may be that the franchise is operational, perhaps even in a deficient manner, and needs to be transferred as soon as possible. The options are generally limited to extending the time for closing, or to shutter the business until compliance is demonstrated. The franchisor may nevertheless approve the transfer contingent on successful completion of the education at a later time. In the event the transferee does not complete training by the deadline, the franchisor’s approval of the transfer should explain the consequences of failure to complete post-transfer training. This may require a forced sale, employment of a qualified manager at transferee’s expense, or some other mechanism to ensure brand quality at the transferee’s risk.
In Chu v. Dunkin’ Donuts,2 a prospective purchaser of a franchise brought suit against Dunkin’ Donuts after it refused to approve the transfer of a franchise to them. The franchise agreement provided that the franchisees could sell their franchise “to a transferee approved by Dunkin’.”3 In turn, Dunkin’ contracted with the former franchisees that it would not unreasonably withhold such approval and would consider the proposed transferee under the same criteria used by Dunkin’ to qualify any prospective purchaser of a franchise.
After the Chus executed a sale agreement for the franchise, they took a test as part of the normal application process to become a franchisee. When Mrs. Chu failed the test, the Chus sued, alleging that the franchisor had tortiously interfered with their sales contract, that they were third-party beneficiaries of a prior settlement agreement between the franchisor and the former franchisees, and that the franchisors violated the New York Franchise Sales Act.4 The court rejected these claims, including the cause of action for tortious interference because “the only interference alleged is the defendant’s refusal to approve a plaintiff’s purchase application and that contingency is specifically contemplated in the contract of sale. Dunkin’s exercise of its contractual right to approve proposed transferees is not an ‘interference’ of the sort for which relief may be granted.”5
In BASCO, Inc. v. Buth-Na-Bodhaige, Inc. d/b/a The Body Shop & The Body Shop, Inc.,6 the district court granted summary judgment to a franchisor that the plaintiff franchisee alleged had violated the Minnesota Franchise Act by unreasonably withholding consent to a transfer. The plaintiff, a franchisee of The Body Shop chain, sought to transfer one of her franchises to a prospective buyer. When plaintiff submitted the purchase agreement to the franchisor for approval, the franchisor interviewed the buyer and his spouse only to discover that they had inadequate financing and retail experience, did not plan to work in the shop full time, and would not complete the required training. The franchisor allowed the prospective buyers an opportunity to remedy these shortcomings, but when they did not, the franchisor withheld its consent to the transfer.
The franchise agreement required franchisor approval for transfers, and allowed the franchisor to reject the proposed transfer if the transferee failed to meet the franchisor’s then-current standards for new franchisees. The court did not second guess the franchisor’s exercise of its contractual rights, and noted that although Minnesota courts have held that a franchisor has a duty to act reasonably when withholding consent to a transfer, “acting reasonably does not equate with making a correct business decision.”7
VI. MEETS CURRENT STANDARDS FOR APPROVAL
Transfers present the opportunity to improve the franchise system. The minimum expectation is that the proposed transferee be at least as qualified as a new prospect to a new franchise as published in the current disclosure document or in the policy manual.8 It is tempting to lower the standards on transfer because the seller may be highly motivated or failing, and the risk and delay of building a new outlet in a new location is eliminated. Nevertheless, requiring the transferee to meet the minimum requirements of new franchisees creates a bright-line test and reduces subjectivity in the transfer process. This bright-line test reduces the possibility of a claim by the transferor that consent to transfer is unreasonably withheld or delayed. In fact, even in cases in which state statutes limit a franchisor’s discretion in disapproving transfers, the same statutes often expressly allow a franchisor to determine that a franchisee is unacceptable for material reasons relating to character,9 financial ability,10 language proficiency,11 or business experience.12 Objectively, when the transferee’s experience is lacking, franchisors may usually disapprove of the transfer without a significant risk that they will be determined to have acted unreasonably. For instance, in Portaluppi v. Shell Oil Co., a son proposed to transfer his franchise to his father, who possessed no previous experience in the business.13 The father also admitted that the franchise was being acquired for the benefit of the son, whose franchise had been previously revoked because of a drug conviction. In that case, the court held that the franchisor’s refusal to approve the transfer was reasonable within the Virginia Petroleum Products Franchise Act. Also, in Sun Refining and Marketing Co., v. Brooks-Maupin Car Centers, Inc., a franchisor disapproved of a service station franchise transfer because of lack of business experience of the proposed transferee, and the refusal was upheld.14
To minimize lawsuits, the proposed transferee should be required to submit a formal application. The standard for approving the application also should be as objective as possible. Evaluating criterion may include: meeting minimum financial criteria, good credit scores, relevant experience and sound character, and possibly third-party evaluation or testing. A transferee’s failure to submit a formal transfer application to the franchisor is valid grounds for the franchisor to disapprove of the transfer, and courts will uphold franchise agreements that require the proposed transferee to meet the franchisor’s criteria for a new franchisee.15 The interview process should be formalized to include reports of each interview and perhaps a grade or score. With very few exceptions created by statute, only the existing franchisee and not the proposed franchisee has standing to challenge a denial of the transfer.16
When the prospective franchisee does meet the criteria, however, the selling franchisees are successful in challenging the denial decision of the franchisor. In Richter v. Dairy Queen of Southern Arizona, Inc.17, the court rejected the franchisor’s contention that its refusal to approve a transfer was reasonable as a matter of law because the court found that the proposed franchisees were reputable, experienced, and had a good record of meeting obligations. A court’s finding that the rejection was a pretext is always devastating to the franchisor. In Home Repair Inc. v. Paul W. Davis Systems18, a proposed franchise buyer claimed that the franchisor’s refusal to consent to a transfer was motivated by racial animus toward the African-American owner of the buyer. The court did not find any direct link between the alleged racist statements and the denial of transfer; however, it considered the franchisor’s “racial comments and racial overtones … present in the [franchise] territories” at issue, and found that there was a “convincing mosaic creating a triable issue of whether [the franchisor] intentionally discriminated against [the franchisee] because of the skin color of its owner.” The court thus found sufficient circumstantial evidence to defeat the franchisor’s motion for summary judgment on the federal civil rights claim.
VII. APPROVAL BY LANDLORDS WITH FRANCHISOR CONTROL DOCUMENTS
For bricks and mortar concepts, landlord consent may be required. A valuable condition to be contained in a franchise agreement is to require any landlord consent and to require the landlord to continue or re-execute any option that the franchisor has to re-enter or remarket the franchise upon franchisee default to the franchisor or the landlord. Not only does this requirement serve as checklist function to ensure adequate remedies against default, but it also defeats attempts in bankruptcy and default situations from the franchisee arranging a new real estate deal to diminish or defeat franchisor controls.
VIII. TENDER OF RELEASE UPON TRANSFER
Courts typically will uphold requirements that a franchisee execute a release before a proposed transfer, holding that a franchisor’s consent to a franchise transfer is adequate consideration for a franchisee’s signing a release of all claims.19 Although some state statutes prohibit the use of releases at the time of purchase or renewal of the franchise to the extent a release would relieve the franchisor of its obligations under the statutory protections afforded franchisees, courts typically hold that on transfer, the rights of the selling franchisee under the antifraud provisions of the state-specific franchise statute are not being compromised, and uphold the requirement of a release.
For example, in Franchise Management Unlimited Inc. v. America’s Favorite Chicken,20 the court found that a franchisor’s requirement that prospective transferees execute a release before the approval of a transfer was not commercially unreasonable. There, a restaurant franchisee refused to execute a release of claims before a proposed transfer of one of its franchises, and the court held that the release would not encompass any claims under the Michigan law and constituted good cause to withhold consent to the transfer under the Michigan Franchise Investment Law. In another case, a Pennsylvania federal court interpreting the New Jersey Franchise Practices Act (NJFPA) held that, notwithstanding the broad language of the act, the release was permissible as it only applied to claims existing at the time of execution of the release and not to future activities in New Jersey.21
Similarly, in Alberts v. Southland Group, the court held that conditioning a transfer of a franchise upon signing a release did not constitute a breach of contract by the franchisor, nor did it amount to unfair competition under California law.22 The agreements required a mutual termination and release “of this Agreement” as a condition of transfer. However, the franchisees alleged that the proffered release was too broad, and was therefore improper. The court rejected this claim, finding sufficient evidence that the scope of the release was limited to claims arising out of the franchise agreement being terminated and did not include claims relating to the franchisees’ other franchises.23
IX. PRICE IS NOT EXCESSIVE
Some franchise agreements contain a provision that expressly requires that the transfer price not be excessive. This provision has often been criticized as the franchisor’s unwarranted interference with the arm’s-length bargaining of the existing franchisee and its prospective franchisee. In cases in which an analysis of the transaction demonstrates that, based on existing sales volume, the transferee borrowed too much money to break even, the franchisor cannot be criticized for rejecting the purchase based on insufficient capitalization.
In Burger King Co. v. H&H Restaurants LLC,24 a franchisee challenged the franchisor’s refusal to consent to the transfer of twenty-nine restaurants. The franchisor’s rationale was that the price was too high based on the needed repairs and would jeopardize both the seller and the buyer. The court rejected the franchisee’s asserted claims for breach of contract, breach of covenants of good faith and fair dealing, and tortious interference, primarily because the financial resources of the proposed buyer were unable to sustain the operation of the restaurants at the proposed sales price. A similar analysis would apply in the rejection of a proposed purchase that is unreasonably leveraged with debt and the debt could not be serviced at existing sales levels.
The analysis is different, however, in cases in which the transferee has no debt service and is purchasing the franchise for cash, albeit at an unreasonable price. Courts have, in these circumstances, permitted the franchisor to reject the proposed transfer because of excessive price. In Kestenbaum v. Falstaff,25 the court held that the strong interest of the franchisor in the vitality of the new franchise, its image, and relative position in the market supports disapproval of the transfer. In Walner v. Baskin-Robbins Ice Cream Co.,26 the court held that the franchisor’s motive for disapproval was irrelevant as the contract expressly permitted a transfer to be disapproved and that such disapproval did not violate the federal antitrust laws.
X. THAT FRANCHISOR NOT EXERCISE ITS RIGHT OF FIRST REFUSAL
Franchise agreements often contain a clause establishing that the franchisor has a right of first refusal to purchase a franchise under the same terms offered to the proposed buyer. Such clauses typically apply when a franchisee proposes to sell substantially all of its assets or a significant portion of equity in the franchise to a third party. The reason franchisors insert the right of first refusal is to protect them from being forced into a business relationship with a franchisee that is technically qualified, but may not be acceptable to the franchisor for a variety of subjective reasons. In addition, franchisors would sometimes prefer to own locations than merely license the locations, and proposed transfers provide an opportunity to acquire locations.
Franchisors should exercise their right of first refusal judiciously. Existing system franchisees often wait patiently for existing operating units to become available for sale. When the franchisor exercises a right of first refusal, that exercise causes an eligible buyer to become disappointed. For this reason, a right of first refusal should be exercised sparingly, as it defeats the interests of other franchisees in the system to expand their own network.
The right of first refusal can be a powerful tool that enables the franchisor to shape the system. The franchisor may exercise this right to operate the location itself, may assign the right of first refusal to a franchisee of its choice, or may exercise the right of first refusal for the purpose of later selling the location at a higher price. Unless the right is exercised cautiously, however, frequent use may cause unintended consequences to the system. Multi-unit operators may be inhibited from bidding on outlets for fear that their efforts will be frustrated if the franchisor frequently defeats the proposed purchase. Still other franchisees may desire to avoid competition with their franchisor for desirable units when the franchisor chronically uses the right of first refusal just for the purpose of trading in operating units.
Rights of first refusal are generally upheld provided the franchisor is not acting in bad faith and the right of first refusal does not chill proposed sales or sale prices. In Crivelli v. General Motors Corp,27 the third circuit upheld the exercise of a right of first refusal clause on state statutory and tortious interference grounds. There, a franchisee and owner of an Oldsmobile-Cadillac dealership in Pennsylvania proposed to sell the dealership and all of its assets to Crivelli, a previously established and successful General Motors (GM) multi-unit dealer. However, Crivelli planned to relocate the dealership to one of its other dealerships. GM decided to exercise its right of first refusal contained in the franchise agreement, which provided that GM had a right of first refusal with respect to any proposed transfer or change of the dealership. The only reason GM exercised its right was that it did not want the dealership moved. Instead, GM arranged for the sale to be made on the same terms to another buyer who agreed to keep the dealership at its present location.
Crivelli sued GM, alleging that the exercise of the right of first refusal violated the Pennsylvania Board of Vehicles Act, and that GM tortiously interfered with its purchase contract. After trial, a jury awarded compensatory damages of $3.5 million in lost expected profits to Crivelli. On appeal, however, the third circuit dismissed Crivelli’s claim under the statute, which provided that a manufacturer cannot unreasonably withhold its consent to the sale, transfer, or exchange of a vehicle-dealer franchise. After analyzing the legislative history, the court found that an exercise of first refusal did not constitute an unreasonable withholding of consent. Further, the court held that GM could not have interfered with Crivelli’s contract to buy the dealership because GM acted in good faith in exercising its right of first refusal to protect its own legally protected interest. The court relied upon the language of the Restatement (Second) of Torts, which Pennsylvania had expressly adopted, in reaching its holding that a company’s exercise of a right of first refusal in the franchise context cannot give rise to a claim for intentional interference. The court dismissed this claim as well.
In another case, Prudential Real Estate Affiliates v. PPR Realty,28 the ninth circuit upheld a franchisor’s contractual right of first refusal under California law when it sought to purchase the shares of a closely held franchisee. In that case, the managing shareholders of PPR sought to exercise their right of first refusal contained in the shareholder agreement when they were notified that a PPR employee, Kathy McKenna, had offered to purchase 40 percent of PPR’s shares from two other coshareholders. The shareholder agreement required that share transfers be subject to the terms of “any then effective franchise agreement entered into by PPR.” The franchise agreement, in turn, granted Prudential Real Estate Affiliates a right of first refusal to any transfers of more than 25 percent of the equity in the franchised companies and required Prudential Real Estate Affiliates to exercise its right within ten days of receiving notice of a proposed transfer. When the managing shareholders promised to indemnify the two coshareholders who had originally intended to sell their shares to McKenna, they offered the shares to the managing shareholders on the same terms as the offer made by McKenna.
McKenna initiated arbitration against the managing shareholders, alleging that she had the right to purchase the stock under the shareholder agreement. After several decisions by the arbitrator and a confirmation of the decision by the Pennsylvania Court of Common Pleas, the final order found that McKenna should have been offered the shares before the managing shareholders and awarded specific performance requiring PPR to submit to Prudential Real Estate Affiliates a request to approve the transfer of shares to McKenna. The federal court in California then issued a preliminary injunction prohibiting McKenna, the managing shareholders, and PPR from transferring the stock, reasoning that prudential Real Estate Affiliates had a right of first refusal under the franchise agreement regarding the proposed transfer of shares and was therefore likely to succeed on the merits of the case. On appeal from this decision, the ninth circuit stated that California courts consistently have held that corporate bylaws granting rights of first refusal to other shareholders or to the corporation are ordinarily enforceable.
The court found these rights of first refusal reasonable because they prevent unwanted intrusions into the business by outsiders and protect its shareholders against rivals in business or others who might purchase its shares to acquire information that might then be used against the company’s interests. Applying these same principles to franchisor–franchisee situations, the court stated that, “[a] franchisor’s stock in trade is its good name and its business model. These are vulnerable not only to intrusion by outsiders, but also … to insurgency by insiders whose acquisition of a larger stake may alter the management or control of the franchisee.”29 Accordingly, the court found the right of first refusal set forth in the franchise agreement valid, and because Prudential Real Estate Affiliates had made its offer within the ten-day window set forth in the franchise agreement, it was entitled to the shares.30
As these cases demonstrate, a franchisor will not have difficulty enforcing a well-drafted right of first refusal, absent a showing of bad faith.
XI. TRANSFEREE TO SIGN A THEN-CURRENT FRANCHISE AGREEMENT
Assignment provisions in franchise agreements may grant the franchisor the option to require the transferee to sign a then-current agreement that reflects updates to the franchise system, and may contain different business terms. The transferee would then be required to sign the new form of agreement for the unexpired term of the transferred franchise agreement. Absent statutory prohibition,31 a requirement that the then-current franchise agreement be executed will generally be enforced.32 The franchisor may be obligated to provide a Franchise Disclosure Document (FDD) in those instances, especially when the then-current agreement contains material changes to the original franchise agreement. Even if not obligatory, the furnishing of an FDD when a new form of franchise agreement is requested upon renewal is considered good practice.33
XII. NOTIFICATION CONDITIONS
Courts respect the need for a franchisor to know when a transfer will occur and to whom the franchise is to be transferred. A franchisee’s failure to notify its franchisor of a transfer is also a valid reason for a franchisor to withhold consent to a transfer. In Simmons v. General Motors Corp.,34 the franchisee’s failure to notify the franchisor of an attempted transfer of the franchise to a prospective purchaser was held to be a “substantial breach” of the franchise agreement.35
In a case in which a franchisee failed to notify a franchisor that it purported to transfer its franchise, the fourth circuit in Prudential Real Estate Affiliates, Inc. v. Lona & Foster Real Estate, Inc., held that a franchisor may bring a claim for tortious interference against a prospective franchise buyer. There, a Prudential franchisee in the third year of a seven-year lease notified Prudential that its business was faring badly, and in response, Prudential said that it would help with an exit from the business. The franchisee proceeded to sell the franchise to defendant, a potential buyer. However, the franchisee had not notified Prudential of the sale until ten days after it had been completed, despite a clause in the franchise agreement requiring Prudential’s consent to a transfer and giving Prudential a right of first refusal. The fourth circuit reversed a lower court grant of summary judgment to the buyer and held that there were issues of fact as to whether the buyer knowingly induced the seller’s breach of the existing franchise contract.
Notice requirements are not created solely by contract. Several state franchise laws impose notice requirements on franchisees. For example, The Nebraska Franchise Practices Act36 provides that:
It shall be a violation of this act for any franchisee to transfer, assign or sell a franchise or interest therein to another person unless the franchisee shall first notify the franchisor of such intention by written notice setting forth in the notice of intent the prospective transferee’s name, address, statement of financial qualification and business experience during the previous 5 years. The franchisor shall within 60 days after receipt of such notice either approve in writing to the franchisee such sale to the proposed transferee or by written notice advise the franchisee of the unacceptability of the proposed transferee setting forth the material reasons relating to the character, financial ability or business experience of the proposed transferee. If the franchisor does not reply within the specified 60 days, his approval is deemed granted. No such transfer, assignment or sale shall be valid unless the transferee agrees in writing to comply with all the requirements of the franchise then in effect.37
Notice requirements and the accrual date for measuring these periods were at issue in Rassam v. Shell Oil Co.,38 in which Rassam sued Shell for violating the Michigan Motor Fuel Distribution Act, when Shell refused to authorize the proposed sale and bought the franchise itself. Under the act, Shell had sixty days to object to the proposed sale. Plaintiff claimed that the franchisor’s objection was too late, basing its calculation of the date it provided Shell on a signed preliminary agreement, which was still being negotiated. The court granted Shell summary judgment, noting that the sixty-day timeframe went into effect only when Shell received all reasonably requested information, including a formal purchase agreement.
C. CONTRACT SILENT AS TO TRANSFER
Courts typically require a valid business reason for rejecting a proposed transfer in cases in which the franchise agreement is silent and state law does not regulate the conditions for transfer. On occasion, however, courts will rely on the theory of freedom to contract to decide cases involving transfer rejections.
In Cunningham Implement Co., v. Deere and Co., a Minnesota court held that a dealership agreement that provided that it could not be assigned by the dealer without the manufacturer’s prior written consent granted the manufacturer the absolute right to approve or disapprove any transfers of its dealerships, refusing to apply the implied covenant of good faith to regulate the approval process.39 This ruling is grounded in the reasoning that, absent a contractual limitation, a franchisor has an absolute right to choose its franchisees, and when a contract is silent and there is no applicable statute, courts will not impose the implied covenant of good faith to place limitations on the franchisor.40
Franchise agreements may also expressly allow the franchisor to exercise its own discretion regardless of an implied covenant of good faith. In Zuckerman v. McDonald’s Corp., the court held that the McDonald’s franchise agreement unambiguously forbade the franchisee from assigning its interest without prior written consent from McDonald’s, and which McDonald’s agreed not to withhold arbitrarily.41 The agreement also identified criteria that McDonald’s could consider in deciding whether to grant or withhold its consent. The court held that the contract terms unambiguously allowed discretion by McDonald’s, leaving no basis under Illinois law to apply the implied covenant of good faith. The court further found that even if the covenant did apply, the franchisor’s actions were not arbitrary in that case as a matter of law.42
Other courts, however, favor the right of the franchisee profit on the sale of its business. The tenth circuit in Larese v. Creamland Dairies, Inc., reversed the district court, which erroneously held that a franchisor had the right to be unreasonable in withholding its consent under Colorado law.43 The circuit court noted that although it had not previously addressed whether a franchisor had a duty to act reasonably in withholding consent, Colorado courts imposed a reasonableness standard on consent to transfer clauses in other contracts. It also cited cases from other jurisdictions holding that a franchisor had to be reasonable in terminating a franchise. The court finally held that the franchisor’s rights had to be balanced against the right of the franchisees and held that it would not be “an excessive infringement of the franchisor’s right to require that the franchisor act reasonably when the franchisee has decided that it wants out of the relationship.”44
Similarly, the sixth circuit in Davis v. Sears, Roebuck & Co., held that the transferee must meet standards used by the franchisor in selecting new merchants and must agree to be bound by the provisions of the agreement. 45 The court gave Sears “unilateral power” to determine whether these standards had been met, but, at the same time, held that Sears “must exercise its unilateral right in good faith.”46 By analogy, in Prestin v. Mobil Oil Corp., the ninth circuit held that when a lease provided that transfers were subject to the consent of the lessor, California common law imposed a requirement upon the franchisor/lessor not to withhold consent unreasonably.47
Even when the franchise agreement imposes a duty upon the franchisor not to act unreasonably in withholding consent to transfer (or when it states that the proposed franchisee must meet the franchisor’s then-current standards for approval) there remains a question as to what specific grounds may be used by the franchisor in withholding consent. When the franchise agreement does not detail specific conditions to transfer, courts will formulate standards for reasonableness in disapproving transfers.
In Van Ness Auto Plaza, Inc.,48 the court identified “factors closely related to the proposed assignee’s likelihood of successful performance under the franchise agreement” as a general test for reasonableness. Such factors included: (1) the suitability of combining the franchise in question with other franchises at the same location; (2) the location of the proposed dealer; (3) the adequacy of the working capital of the proposed dealer; (4) prior experience with the proposed dealer; (5) prior sales performance of the proposed dealer; (6) whether the proposed dealer has a history of profitable operation; (7) the business acumen of the proposed dealer; and (8) whether the proposed dealer has provided the manufacturer with solid information about its qualifications.49
D. STATE STATUTES AFFECT THE TRANSFER PROCESS
1. NO REGISTRATION REQUIREMENT FOR FRANCHISEE–TO-FRANCHISEE TRANSFERS
Most states with disclosure statutes exempt from registration transfers by a franchisee for their own account.50 To be eligible for the exemption in the states that provide for it, certain conditions must be met. If the conditions for exemption from registration are not met, the sale is treated as an initial sale of a franchise. One common condition is that the transfer must be for the franchisee’s own account. Some states limit the number of sales that may be made under this exemption in an effort to require franchisees that are brokers—parties that buy and sell franchises for other parties—to register and disclose. For example, Hawaii, Michigan, New York, and Washington apply the exemption only for isolated sales. Minnesota limits the exemption to one sale per twelve-month period. If a franchisee that owns more than one location wishes to sell a second franchise within twelve months after the sale of the first, the exemption may not be available in these and possibly other states. The same issue exists in those states that exempt isolated sales.
In addition, for the exemption to apply, many statutes provide that the sale may not be effected by or through the franchisor. However, most statutes permit the franchisor to approve or disapprove of the transferee without implicating registration and disclosure requirements. Illinois, Washington, and Wisconsin permit the imposition of a reasonable transfer fee, and Hawaii provides that a new franchise agreement may be executed in connection with the transaction.
Some states also require the franchisor to provide information to the proposed transferee before transfer. For example, Michigan requires that the franchisee provide access to the books and records of the business to the prospective transferee at least one week before either the execution of an agreement or the receipt of the consideration, whichever occurs first. Also, in New York, the franchisee may provide a copy of the franchisor’s currently registered prospectus to the transferee at least one week before the execution of an agreement or the receipt of consideration, whichever occurs first.
2. DISCLOSURE REQUIREMENTS
I. THE AMENDED FEDERAL TRADE COMMISSION FRANCHISE RULE (THE “AMENDED RULE”)
The Amended Rule51 requires that an FDD be furnished by a franchise seller to a prospective franchisee to discuss the possible establishment of a franchise relationship. A person who purchases a franchise from an existing franchisee is not a prospective franchisee under the Amended Rule absent “significant involvement” with the franchisor. The franchisor’s mere exercise of the right to approve or reject a transferee is not “significant involvement” under the Amended Rule.52 If the franchisor, however, provided financial performance representations in connection with a transfer, then the franchisor has “significant involvement” and must provide the transferee with its FDD.53
If a franchisor refers a prospective transferee to a selling franchisee, this is probably enough to invoke Federal Trade Commission disclosure requirements since the prospect approached the franchisor. A franchisor can be required to make a disclosure to the transferee if the franchisor has approached a transferee or is approached by a transferee “for the purpose of discussing the establishment” of a franchise relationship.54 Since it is common for franchisors to engage in sales discussions with the potential buyer to facilitate the purchase, most franchisors regularly disclose a resale purchaser. This may be impractical for some franchisors if, for example, the franchisor is not currently selling new franchises and does not have a current offering circular to use for disclosure purposes.
II. STATE LAW DISCLOSURES
Nearly all of the registration states provide exemptions from registration and disclosure for transfers between two franchisees on their own account without franchisor involvement. However, the disclosure laws often require a franchisor’s FDD to include certain items in the event of a franchisee transfer.
III. STATE RELATIONSHIP LAWS MAY CONTROL APPLICATION AND APPROVAL OF TRANSFERS
Nine jurisdictions have enacted legislation relating specifically to the transfer of a franchise: Arkansas, California, Hawaii, Indiana, Iowa, Michigan, Minnesota, Nebraska, and New Jersey. These statutes generally limit the franchisor’s discretion to refuse to consent to a transfer.55
- Arkansas: provides that the franchisor must approve of the franchisee transfer or advise the franchisee of non-approval within sixty days of the notice by a franchisee of its intent to transfer. Any non-approval must set forth a material reason relating to the character, financial ability, or business experience of the proposed transferee. The transferee must agree in writing to comply with all the requirements of the franchise.
- California: prohibits a franchisor from denying the surviving spouse, heirs, or estate of a deceased franchisee or of the majority shareholders of the franchisee the opportunity to own the franchise.56 Such surviving person must satisfy the then-current qualifications for the purchase of a franchise or have a reasonable time to sell the franchise to a qualified person. The franchisor still may exercise any contractual rights of first refusal it has.
- Hawaii: provides that a franchise may not refuse to permit a transfer of ownership of a franchise except for good cause.57 Good cause is defined and includes: the failure of a proposed transferee to meet reasonable qualifications, the proposed transferee is a competitor, the proposed franchisee does not agree in writing to comply with obligations proposed by the franchisor and to sign the current form of franchise agreement, and the failure of the franchisee or proposed transferee to pay any sums owing to the franchisor for cured defaults. The franchisor must approve or disapprove a transfer within thirty days, and must state its reason for disapproval.
- Indiana: states that a franchisor may not deny a surviving spouse, heirs, or estate of the deceased franchisee an opportunity to participate in the ownership of the franchise for a reasonable time after the death of the franchisee, providing that such survivor maintains all of the standards and obligations of the franchise.58
- Iowa: provides that a franchisor may not restrict a transfer if the transferee satisfies the reasonable current qualifications of the franchisor for new franchisees.59 Even if the proposed transferee does not meet the reasonable current qualifications, the franchisor may not arbitrarily or capriciously refuse to permit the transfer.
- Michigan: limits a franchisor from refusing to permit a transfer, except for good cause. Good cause includes: failure of the transferee to meet franchisor’s reasonable qualifications or standards, the transferee is competitor, the unwillingness of the transferee to agree in writing to comply with all lawful obligations, and the failure of the franchise or the proposed transferee to pay sums owing or to cure defaults.60
- Minnesota: provides that a franchisor may not withhold consent to a transfer if the transferee meets the present qualifications and standards required of the franchisees of the franchisor.61
- Nebraska: provides that the only limitation on the franchisor is that within sixty days, it must either approve the transferee or advise the franchisee of the unacceptability of the transferee setting forth “material reasons relating to the character, financial ability or business experience of the proposed transferee.”62 The franchise that intends to transfer must notify the franchisor of such intention by a specific notice. The transferee must agree in writing to comply with all of the requirements of the franchise then in effect.
- New Jersey: provides limitations on the franchisee and the franchisor that are identical to those in Nebraska’s statute.63