Terminating A Franchise: Practical Issues For Franchisors (Part I)

The post termination covenants in the franchise agreement are key factors in a franchisor’s overall termination analysis.  It is necessary to carefully review all sections relating to a franchisee’s post termination and expiration obligations.

Control of Premises and Non-Compete Covenants

If a franchisor or its affiliate does not control the head lease as a head tenant, it is important to determine whether a franchisor has a right to take over the lease either through a term in the franchise agreement or through a schedule to the head lease.

Where such a right does not exist, it is better to obtain the consent of the landlord in advance, at the time that the franchise agreement is executed, and to make sure that the landlord consents in the hea

d lease to the franchisor or its affiliates having the option to take over the lease in the event of default, termination or expiration of the franchise agreement.

Absent an ability to control possession of the franchised business, a franchisor will need to consider applying to a court for an order restraining the franchisee from operating the business by seeking to enforce non-compete covenants in the franchise agreement.

This assumes that the franchisee is in breach of a valid and relevant non-compete post-termination covenant by continuing to operate a business that is competing with the franchisor’s system in violation of the non-compete covenant.  The legal test for the enforceability of a non-compete covenant is complicated and beyond the scope of this article.  It depends on many factors, including the wording of the covenant and the nature of the franchisee’s alleged breach.  It helps to have evidence that the franchisee is misappropriating the franchisor’s confidential and proprietary information.

Sale and Appraisal of Franchised Assets

Upon termination, the franchisor will often seek to realize on the value of the franchised assets as a “self help remedy”.  Typically, the franchise documentation gives a franchisor at this stage the right to purchase the assets of the franchised business on the basis of net book value (usually a very nominal value because goodwill is excluded from the valuation), and to then resell it to a third party purchaser.  To effect this process, the franchisor needs to have a properly registered security interest under a general security agreement.

The appraisal will form the basis for any amount that may be payable by the franchisor to the franchisee.  This amount would be subject to outstanding arrears and other debts owing to the franchisor.  And the sale proceeds would be subject to sales taxes, source deductions, secured debts, rent arrears, etc.

Given the relatively low net book appraisal value, the franchisee’s debt obligations would be typically higher than the appraised value of the assets.  As a result, the value of the assets may be offset by the debts.  The franchisor would then resell the assets of the franchised business to a third party purchaser (i.e. a new franchisee).

Nature of the Franchise

If the franchise system is in a mainstream market where a replacement franchisee is readily available, such as the quick service restaurant industry, a franchisor may be more inclined to take advantage of its post termination options by taking over the location (assuming that such rights exist in the franchise agreement) and reselling it to a third party.

However, if the franchise system is in a niche or specialized market where franchisees may be typically drawn from a specialized industry, rather than the general public, the franchisor should be more cautious before taking over the franchised business, even if the franchise agreement contains adequate takeover rights.

There may typically be the following alternate strategies that a franchisor may choose when seeking to replace a franchisee:

1. require the franchisee to resell the business to a third party, with the consent of the franchisor.  The resale by the existing franchisee to a third party must comply with the assignment provisions of the existing franchise agreement, which include payments of fees, transfer fees, and approval and training by the franchisor of the new franchisee;
2. assist the existing franchisee with the operation of the business and with the search for a franchisee purchaser, or
3. terminate the franchise agreement, take over the operations of the franchised business, and later resell the assets to a third party.

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