Getting Out Of A Franchise Agreement: Termination And Damages For Breach

The legal characteristics of a franchise agreement are different from normal commercial contracts in that they are “contracts of adhesion”. They are typically drafted on a franchisor’s standard form contact and are generally signed by the franchisee with little or no modification.

It is important to assess the conduct of all parties to the franchise dispute and give the franchisor or franchisee client full and frank advice about all the factors that will come into play when assessing whether the client is entitled to terminate the franchise agreement, and if so, under what conditions.

Curable defaults refer to defaults of the franchisee which he or she can cure by complying with curing requirements set out in the franchise agreement and, by doing that, avoid being terminated.

Non-curable defaults refer to defaults of the franchisee which he or she cannot cure. Having committed non-curable defaults, the franchisee cannot cure those defaults. The ball then shifts to the franchisor to decide whether to terminate the franchise agreement. The franchise agreement typically provides a mechanism for doing so.

Where a retail location is involved, what happens to the location after the franchise agreement is terminated depends on who controls the lease (whether the head lease of the location is in the name of the franchisor or franchisee), the terms and conditions in the franchise agreement about any continued operation of the location, and non-compete and other restrictive covenants in the franchise agreement.

Restrictive covenants and control of the location

Post-termination covenants in a franchise agreement are important factors in an overall termination analysis. It is necessary to carefully review all sections relating to a franchisee’s post-termination and expiration obligations.

The legal test for the enforceability of a non-compete covenant is complicated and beyond the scope of this article (see other articles in the Law Works Franchise Law Blog).

If the franchisor or its affiliate does not control the head lease as a head tenant, it is important to determine whether the 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, the franchisor may want 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 head 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 regain 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.

Upon termination, the franchisor may seek to realize on the value of the franchised assets as a “self help remedy”. Typically, the franchise agreement would give 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.

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. The sale proceeds would be subject to sales taxes, source deductions, secured debts, rent arrears, etc.

Given the often relatively low net book appraisal value, a 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).

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 will 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.
3. Terminate the franchise agreement, take over the operations of the franchised business, and later resell the assets to a third party.

Other considerations of the franchisor

A franchisor wishing to terminate the franchise agreement early (before the end of the term in the franchise agreement) will typically rely on the default and termination provisions of a franchise agreement. Often, a franchisor will be able to exercise what is commonly referred to as ‘a self-help remedy’, by terminating the franchise agreement, and either shutting down or taking over the location without going to court.

A franchisor would be wise to strictly follow the notice and any other formal requirements set out in the franchise agreement to effect termination. A termination of a franchise agreement by a franchisor in this way is called a self-help remedy, because the franchisor effects this process without advance court approval, essentially on a self-help basis.

A franchisor who wishes to terminate the franchise agreement or take over the franchised business, but does not wish to do so through a self-help remedy, will need to launch a legal proceeding for damages or injunctive relief, or both, to terminate the franchise agreement and, where desired and justified, take over the operation of the franchised business.

Other considerations of the franchisee

A franchisee who wishes to get out of a franchise agreement through the termination remedy is required to show that the franchisor breached key terms of the franchise agreement. The breach of the franchise agreement has to be extensive and material.

The following are additional preliminary key questions (in addition to the restrictive covenants and control of the location considerations set out earlier):

1. How much is owed to the franchisor?What are all outstanding royalties and other franchise payments that the franchisee likely owes to the franchisor under the franchise agreement and any related agreements?
2. Is the franchisee personally liable under the head lease?Often, franchisees are required to personally guarantee the head lease of their location, even if the head lease is between the landlord and a franchisor’s affiliate. If the franchisee is a guarantor or indemnifier under the head lease, he or she has a potentially significant liability at least to the head landlord.
3. Is bank financing secured against the business assets?Franchised businesses in the food or retail industry are typically financed by a Small Business Loan from a Canadian bank. The SBL is secured against the assets of the franchised business. The bank, as a creditor, likely has rights against the business assets that rank in priority to the rights of the landlord and franchisor.

The franchisee’s conduct may be significant: whether the franchisee – not only the franchisor – breached aspects of the franchise agreement, or failed to comply with his or her contractual obligations.

To determine whether a franchisor breached the franchise agreement, it is necessary to extensively analyze all the terms and conditions of the franchise agreement and all other franchise contracts, as well as obtain from the franchisee all relevant facts about the allegations.

It should be noted that, given Supreme Court of Canada pronouncements in recent years, it is arguable that a party is only entitled to damages, rather than to a termination based on fundamental breach.

A franchisee who disputes the franchisor’s termination of the franchise agreement, or the franchisor’s right to take over the operation of the location, will have to commence legal proceedings, whether in court or arbitration (depending on the language of the franchise agreement), to dispute the termination and either seek damages or injunctive relief, or both.