The Franchise Owner's most trusted news source


Log In / Register | Nov 20, 2017

Important Contract Issues for Area Developers, Area Representatives and Subfranchisors

In addition to the typical purchase of a single-unit franchise, there are three other franchise offerings made by many franchisors referred to as area development rights, area representative rights, and subfranchise rights. Recently, the North American Securities Administrators Association ("NASAA"), the group that drafted the 2008 Franchise Disclosure and Registration Guidelines for the franchise filing states (the "NASAA Guidelines"), adopted its Multi-Unit Commentary to the NASAA Guidelines addressing the pre-sale disclosure obligations of franchisors to area developers, area representatives and subfranchisors. The Multi-Unit Commentary becomes effective on March 15, 2015 or within 120 days of the end of a franchisors fiscal year.

The Amended FTC Franchise Rule (the FTC Rule") was amended in 2008 to become consistent with the Guidelines. The FTC and the Guidelines are merely a pre-sale disclosure and registration laws. The FTC Rule does not regulate the contractual terms of the relationship between a franchisor and its area developers, area representatives and/or subfranchisors. The parties are free to structure the contractual relationship in any manner to which they agree. Several states impose certain limitations on the contractual terms that are usually disclosed in a state addendum.

However, like the franchise agreement*, the area development rights agreement, area representative rights agreement and subfranchisor rights agreement were written by the franchisor's attorney and are all extremely one-sided agreements. The purpose of this white paper is not to explain all of the franchisor's obligations under the FTC Rule, the Guidelines and the Multi-Unit Commentary, but rather to explain these three franchise relationships for prospective purchasers, and most importantly, the important contract issues that need to be addressed and amended to make the relationship fairer from the area developer's, area representative's and subfranchisor's perspective before the investment is made.

AREA DEVELOPMENT RIGHTS

If you desire to own and operate more than one franchise unit, you may want to consider becoming an area developer. An area developer is really a multi-unit franchisee who commits, at the beginning of the relationship with the franchisor, to open a number of franchise units within a given area ("Development Area") over a specified period of time ("Development Schedule). This is different from a franchisee that may have first purchased one unit and later purchases another unit, etc., without ever being contractually bound to open further units.

If a franchisor offers area development rights, the guidelines require specific disclosure regarding the area development rights. This disclosure is included in the franchisor's Franchise Disclosure Document ("FDD") for a single-unit franchise. The area development rights agreement is included as an exhibit. Where required disclosure is the same for a franchise agreement and an area development rights agreement (for example, ITEMS 2, 3 and 4) duplicate disclosure is not necessary. However there are certain items of the FDD (including ITEMS 5, 6, 7, 8, 9, 11, 12 and 17) where there is separate disclosure of certain terms of the area development rights agreement.

AREA REPRESENTATIVE RIGHTS

An area representative is best described as a "super" franchise broker and servicing agent for the franchisor. If you will have management responsibility relating to the sale or operation of the franchise units, you must be disclosed in ITEMS 2, 3 and 4 of the franchisor's Franchise Disclosure Document with your last 5-year employment history and your last 10- year litigation and bankruptcy history.

An area representative differs from a subfranchisor in that the area representative uses the franchisor's Franchise Disclosure Document for a single unit franchise and area development rights. The franchise agreement is signed directly between the franchisor and the franchisee. The area representative is not a party to the franchise agreement. Under the area representative rights agreement between the franchisor and the area representative, the franchisor delegates to the area representative the sale obligation and certain of the franchisor's selling, servicing and support obligations to the franchisee. All initial franchise fees, royalties and other payments are usually paid by the franchisee directly to the franchisor. The franchisor then remits a portion of these fees to the area representative as negotiated in the area representative rights agreement.

The sale of area representative rights may or may not be considered to be the sale of a "franchise" under federal and state franchise laws. There appears to be no specific law, regulation or case on point. The majority of franchise lawyers seem to be of the opinion that, if the area representative pays a fee of $500 or more for the area representative rights and/or there is a license or substantial association with the franchisor's principal trademark, then it is a franchise. If so, the Multi-Unit Commentary clarifies that a separate Franchise Disclosure Document must be given by the franchisor to the prospective area representative disclosing the area representative relationship.

SUBFRANCHISOR RIGHTS

A subfranchisor is sometimes called a "master franchisee," particularly in international deals. A subfranchisor steps into the shoes of the franchisor and acts as the franchisor in a given area (for example, a county, state or country). A subfranchisor sells its own subfranchises and directly enters into a subfranchise rights agreement with a franchisee. The franchisor is not a party to the subfranchise rights agreement.

The Multi Unit Commentary confirms that the offer of subfranchise rights must be made separate and apart from the offer of a single unit franchise or area development rights. The franchisor must prepare a separate Franchise Disclosure Document for the offer of subfranchise rights and given to prospective subfranchisors describing the subfranchise relationship. A copy of the subfranchise rights agreement is attached as an exhibit to the FDD for subfranchise rights.

A subfranchisor is subject to the FTC Rule and Guidelines to the same extent as a franchisor. Therefore, a subfranchisor is obligated to have its own Subfranchise Disclosure Document separate from the franchisor but includes certain information about the franchisor, the franchisor's and the subfranchisor's audited financial statements, and state registration, if the subfranchisor will be offering subfranchises in a registration state or a prospective franchisee is resident in a registration state. Normally, the franchisor provides the subfranchisor's attorney with a "master" FDD containing the information regarding the franchisor. The subfranchisor and its attorney include the information required to be disclosed by a subfranchisor.

COMMON ISSUES FOR AREA DEVELOPERS, AREA REPRESENTATIVES AND SUBFRANCHISORS

There will usually be a number of terms contained in the area development rights agreement, area representative rights agreements or subfranchise rights agreements that are identical to, or substantially similar to, those terms contained in the franchise agreement. Hopefully, as part of your review and negotiation of the terms of the franchise agreement, you have already addressed these issues from a fairness perspective and have negotiated an Addendum to Franchise Agreement.

In addition, there are issues and terms common to area developers, area representatives and subfranchisors that must be addressed to make the relationship between the franchisor and the area developer, area representative and subfranchisor more equitable. A corresponding Addendum to Area Development Rights Agreement, Area Representative Rights Agreement or Addendum to Subfranchise Rights Agreement will contain these negotiated provisions

These common unique contract issues include the following:

A. ORGANIZATIONAL STRUCTURE; PURCHASE OF FIRST FRANCHISE

The franchisor normally requires an area developer to purchase his or her first franchise unit at the same time he or she purchases area development rights. The franchisor may require an area representative or a subfranchisor to also purchase a single-unit franchise that will become his or her showcase unit and training facility. You will be given the franchisor's form of FDD for a single-unit franchise and area development rights. You should negotiate purchasing area development rights, area representative rights or subfranchise rights in one business entity and form separate business entities (either subsidiaries or affiliates) for each franchise unit you own and operate. This separates any potential liability of each franchise unit from exposing the other franchise units and the company owning area development rights, area representative rights or subfranchise rights. You should also have the right to have investors in individual franchise units provided you retain a controlling interest in the business entity owning the unit.

B. YOUR PERSONAL GUARANTY

The franchisor will probably ask that you, and your spouse if you are married, sign the Area Development Rights Agreement, Area Representative Rights Agreement or Subfranchise Rights Agreement personally. This means that your personal assets are at risk as to the monetary obligations of the area developer, area representative or subfranchisor to the franchisor. In my opinion, the franchise businesses should stand alone and generate enough income from which to pay the monetary obligations to the franchisor. As discussed above, the area developer, area representative or subfranchisor should be a business entity and not you personally. Note that none of the franchisor's principals personally guarantee the obligations of the franchisor. Try to limit your guaranty to the agreements confidentiality and noncompetition provisions.

C. CROSS-DEFAULT

The typical area development rights agreement, area representative rights agreement and subfranchise rights agreement contains a provision in the default section stating that a default under any other agreement between the area developer, area representative or subfranchisor and the franchisor (for example, a franchise agreement) is also a default under the area development rights agreement, area representative rights agreement or subfranchise rights agreement. Additionally, a default under the area development rights agreement, area representative rights agreement or subfranchise rights agreement constitutes a default under all other agreements. While many events of defaults are automatic defaults under each agreement (for example, bankruptcy) that trigger defaults under each agreement, there may be a default that only applies to a particular unit ("bad location") leaving the other units not in default. This cross-default provision causes you to be in default under every agreement including every franchise agreement. Therefore, you must make sure that the area development rights agreement, area representative rights agreement or subfranchise rights agreement and each franchise agreement stands on its own. Do not accept a cross-default provision. Otherwise, it would have a "domino effect" and jeopardize everything!

D. YOUR OPTION TO RENEW

The term of an area development rights agreement, area representative rights agreement or subfranchise rights agreement can be five years or less. Once any of these agreements expire and is not renewed, the franchisor will be free to open company-owned units, grant franchises and/or appoint another area developer, area representative or subfranchisor within your former exclusive area so long as these units are not within the protected territories of your operating units. You should try to retain continued exclusive rights by negotiating an option to renew the area development rights agreement, area representative rights agreement or subfranchise rights agreement for an additional term subject to you and the franchisor negotiating in good faith a new development schedule based on demographic, economic and other conditions existing at that time. If the parties cannot agree, the issue will be submitted to binding arbitration.

E. YOUR SALE OF RIGHTS

The area development rights agreement, area representative rights agreement and subfranchise rights agreement require the consent of the franchisor to your sale of your area development rights, area representative rights or subfranchise rights to a third party. Usually, you will be selling all of your existing units as well, if any. You need to add that the franchisor's consent will not be unreasonably withheld, delayed or conditioned. The conditions to the franchisor's giving its consent should be reasonable and unambiguous. Your buyer should be able to assume your area development rights agreement, area representative rights agreement or subfranchise rights agreement and any franchise agreements instead of signing the franchisor's then current form of agreements. The transfer fee should be reasonable and not cumulative. Any general release should be mutual. Upon a permitted transfer, you should be released from all future obligations under the agreements.

F. REDUCED ROYALTY FEES

There may be economies realized by the franchisor in providing its services to all of the franchise units you own and operate. In addition, there may be certain functions that you handle that reduce the services provided by the franchisor. If this is the case, you may consider negotiating that the royalty fees of all your franchise units be aggregated and applied against a reduced sliding scale of royalties as gross revenues increase. Two of your best arguments for reduced royalty fee are that this serves as a greater incentive to you to increase sales and also that the franchisor costs to provide its incremental services as gross revenues increase are reduced. While some franchisors already have a sliding scale of royalties, many do not.

G. LIMIT OTHER FEES

Each area development rights agreement, area representative rights agreement, subfranchise rights agreement and franchise agreement probably contains numerous other fees such as renewal fees, transfer fees, securities offering fees, etc. For example, if you decide to sell all your area development rights, area representative rights or subfranchise rights and related franchise agreements, don't allow these fees to multiply just because you are a multi-unit franchisee. Limit these fees to something reasonable in the aggregate.

H. FORCE MAJEURE

If the area development rights agreement, area representative rights agreement, or subfranchise rights agreement does not contain a force majeure provision and specifically applies to the development schedule or performance schedule, you should insist that it be included. A force majeure provision usually provides that a party to a contract is excused from performance where he or she is unable to perform due to an act beyond the control of the party such as terrorism, earthquakes, floods, hurricanes, tornadoes, and other act of God. Who knows when a fire, flood, earthquake, hurricane, riot, bombing, etc. will occur that interferes with your performance?

I. CO-TERMINUS AGREEMENTS

All the agreements you sign will contain or reference a provision stating you cannot own or operate a competitive business while you are a franchisee. What if you do not renew one of your franchise agreements and decide to operate a competitive business. You will breach your other agreements with the franchisor if you do. You should negotiate that the term of all of the franchise agreements to which you or your subsidiary or affiliate are a franchisee expire at the same time. This will give you more bargaining power and prevent you from violating any in-term covenant to compete.

J. OTHER ISSUES

There may be issues important to the area developer, area representative, and subfranchisor other than the issues discussed in this paper. You and your attorney need to review the area development rights agreement, area representative rights agreement or subfranchise rights agreement very carefully to see what impact certain terms have upon your rights. If there are terms that appear unreasonable and unfair, you need to attempt to negotiate these issues to protect your interests.

This is part 1 of a multi-part series. Read Part 2: Area Developer


*Note: The "Important Contract Issues for Franchisees" is a separate white paper that can be sent to you upon request.

Your rating: None Average: 1 (1 vote)

Reply

CAPTCHA
This question is for testing whether you are a human visitor and to prevent automated spam submissions.