What If the Franchisor Refuses to Negotiate?

Not all franchisors are enlightened to the fundamental truth that the long-term vitality of franchising depends on the mutual success of franchisors and all of their franchisees. Rather, most franchisors, particularly those who are large and mature, take the position: "It's my trademark, I can do what I want, when I want!"

Unfortunately, you signed the franchise agreement in which you agreed, 10 years ago, to sign the franchisor's then current form of franchise agreement no matter what it said. Now you know what it says and you and your fellow franchisees don't like it. You tell the franchisor that you don't like it. The franchisor says "sign it or get out of the business." At this point, there are still two other alternatives:

1.  Mediation, and if that is not successful;
2. Have a court find that the franchisor is acting in bad faith in refusing to negotiate the terms of a renewal franchise agreement.

Mediation

Mediation is like negotiation except there is an extra, impartial person in the room, or going from room to room, to facilitate communication between the disputants and resolution of a dispute. Check to see if your franchise agreement provides for the mediation of any dispute. If so, ask for mediation of the terms of the renewal franchise agreement. If the franchise agreement is silent, ask your franchisor to mediate anyway. It is voluntary and nonbinding.

The International Franchise Association ("IFA"), along with the Center for Public Resources ("CPR") Institute for Dispute Resolution has created the National Franchise Mediation Program ("NFMP"). Franchisors who join the program must agree for at least 2 years to attempt to resolve any dispute with any of its franchisees through mediation. Many of the larger franchisors, that are members of the IFA, have volunteered to participate in the NFMP. To find out if your franchisor has joined the NFMP, contact CPR at (212) 949-6490. Even if your franchisor has not joined, ask it to use the NFMP to mediate the terms of the renewal franchise agreement. Unfortunately, the NFMP applies only to mediation between a single franchisee and the franchisor. Mediation cannot be enforced on a group, class or collective basis without the franchisor's consent. If the franchisor does not consent, than NFMP is not available. This policy needs to be changed by the IFA to require collective mediation of similar disputes affecting more than one franchisee.

Litigation

If your franchisor continues to "stonewall" you, you are now backed into a corner. There is one other avenue left--litigation. While there is no decision, of which we are aware, specifically holding that the typical renewal provision is unenforceable, or that a franchisor that refuses to collectively negotiate the terms of a renewal franchise agreement violates the implied covenant of good faith and fair dealing, recent cases in favor of franchisees are heading in that direction. It is only a matter of time.

Numerous courts throughout the country have begun to take judicial notice of the fact that the typical franchise agreement is a "contract of adhesion" and contains many unconscionable terms. Parties having disproportionate bargaining power enter into the franchise agreement and its provisions are not subject to arms'-length negotiation between parties of comparable bargaining power, notwithstanding the party line of the franchisor community that the typical franchise agreement is negotiated by a knowledgeable franchisor and a knowledgeable franchisee. Franchisees are offered by a franchisor on a non-negotiable "take it or leave it" basis. Franchisees sign the franchise agreement that contains provisions, which are patently "commercially unreasonable." The courts have begun to recognize that the most egregious terms, in which franchisees relinquish valuable rights without getting anything in return, may not be enforceable.

Why would a prospective franchisee sign such an onerous agreement? There are a number of reasons besides the "take it or leave it" attitude of franchisors and their lawyers including: (i) the prospective franchisee's lack of sophistication; (ii) failure to retain proper legal and accounting advice; (iii) the fact that another franchise offering contains substantially egregious terms; (iv) the representations made by the franchisor's salespersons that the franchisor treats all of its franchisees as "partners;" (v) high pressure sales tactics; (vi) their faith and trust in the franchisor that the franchisor, notwithstanding the terms of the franchise agreement, would not do something to hurt them; and (vii) the nationwide "franchise fraud" that a person's chances for success are substantially greater being part of any franchise system than being an independent business.

In Kubis & Persyzk Associates, Inc. v. Sun Microsystems Inc., CCH Bus. Fran. Guide ¶ 10,980 (N.J. Sup. Ct. 1996), a forum selection (venue) clause requiring a New Jersey franchisee to litigate a dispute with a California franchisor in California rather than in New Jersey was found by the New Jersey Supreme Court to be presumptively invalid because it fundamentally conflicted with New Jersey's public policy of swift and effective judicial relief. The New Jersey Supreme Court, quoting from its earlier decision in Westfield Center Service, Inc., v. Cities Service Oil Co., 86 N.J. 453 (1981) stated:

Though economic advantages to both parties exist in the franchise relationship, disparity in the bargaining power of the parties has led to some unconscionable provisions in the agreements. Franchisors have drafted contracts permitting them to terminate or to refuse renewal of franchises at will or for a wide variety of reasons including failure to comply with unreasonable conditions. Some franchisors have terminated or refused to renew viable franchises, leaving franchisees with nothing in return for their investment. Others have threatened franchisees with termination to coerce them to stay open at unreasonable hours, purchase supplies only from the franchisor and at excessive rates or unduly expand their facilities.

. . .[W]e hold that forum-selection clauses in franchise agreements are presumptively invalid, and should not be enforced unless the franchisor can satisfy the burden of proving that such a clause was not imposed on the franchisee unfairly on the basis of its superior bargaining position. Evidence that the forum-selection clause was included as part of the standard franchise agreement, without more, is insufficient to overcome the presumption of invalidity. We anticipate that a franchisor could sustain its burden of proof by offering evidence of specific negotiations over the inclusion of the forum-selection clause and that it was included in exchange for specific concessions to the franchisee. Absence such proof, or other similarly persuasive proof demonstrating that the forum-selection clause was not imposed on the franchisee against its will, a trial court should conclude that the presumption against the enforceability of forum-selection clauses in franchise agreements subject to the [New Jersey Franchise Practices] Act has not been overcome. [Emphasis Supplied.]

The impeccable logic of Sun Microsystems should apply with greater force to a renewal provision in a franchise agreement which requires a franchisee to sign the franchisor's then current form of franchise agreement containing material changes unilaterally made by the franchisor without specific negotiation with the franchisees, which changes are adverse to the economic and business interests of the franchisees. This is a far greater right a franchisee is relinquishing in giving the franchisor carte blanche to change the terms of the relationship from merely agreeing to litigate in the franchisor's home state. This type of renewal provision should be unenforceable as a matter of public policy if it was not subject to specific negotiation in exchange for specific concessions to the franchisee.

If the court refuses to recognize this argument, the alternative argument is that the franchisor is acting in bad faith in failing to negotiate with its franchisees concerning the material changes contained in the renewal franchise agreement. One of the franchisees' newest weapons in their growing arsenal is the franchisor's breach of the implied covenant of good faith and fair dealing. Courts in most states have recognized that the implied covenant of good faith and fair dealing applies to all parties to a contract including parties to a franchise agreement. Many states recognize an independent cause of action for breach of this implied covenant of good faith and fair dealing. Scheck v. Burger King stands for the proposition that a franchisee is entitled to expect the franchisor will not act to destroy the right of the franchisee to enjoy the fruits of the franchise agreement. The Scheck court found that, while the franchisee did not have an exclusive territory, it did not automatically mean that the franchisor had the absolute right to place additional units anywhere it wanted. The franchisor's right was subject to the exercise of reasonable discretion, not unfettered discretion. The court denied the franchisor's motion for summary judgment and determined that the issue of whether the franchisor breached the implied covenant of good faith and fair dealing by locating another unit 2 miles from the franchisee's unit causing a 42% loss of the franchisee's sales, was an issue for the jury to decide. After this ruling and before the jury trial, the case was settled with the franchisor paying the franchisee about $4,000,000.

In the instantly famous case of Vylene Enterprises v. Naugles, the U.S. Court of Appeals for the Ninth Circuit (only the U.S. Supreme Court is higher) held that a franchisor that refused to renew a franchise agreement except on terms that the franchisee previously had rejected as commercially unreasonable breached the franchise agreement by failing to negotiate the terms of renewal in good faith. The court also found that the franchisor, by establishing a new franchise within 1.4 miles of the franchisee's unit, which had the effect of cannibalizing the franchisee's sales, breached the implied covenant of good faith and fair dealing, even though the franchise agreement did not grant the franchisee an exclusive territory. Although not entitled to an exclusive territory, the court ruled that the franchisee was entitled to expect that the franchisor would not act to destroy the franchisee's rights to enjoy the fruits of the franchise agreement. The court agreed with the analysis of Scheck. With respect to the renewal of the franchise agreement, the court stated:

. . .[A]lthough the terms of the renewal provision did not give Vylene [the franchisee] a guaranteed right to renew on a determinable basis, the provision obligated Naugles [the franchisor] to negotiate in good faith concerning the terms and conditions of a renewal.

The Vylene case is probably the biggest case in franchising in the 1990s. Much recently has been written about this case and much more is being written. Not only did this case follow Scheck, it went beyond it to hold that, even if certain rights are expressly reserved in the franchise agreement in favor of the franchisor, the franchisor is guilty of bad faith if, in the exercise of these rights, the franchisor destroys the right of the franchisee to enjoy the fruits of the franchise agreement. Vylene will apply not only in encroachment situations but also in all other contractual situations between the franchisor and a franchisee as well including the renewal of existing franchise agreements where the franchisor unilaterally makes material changes to the franchise agreement which materially adversely affects the legitimate business and economic interests of its franchisees.

Under the rationale established by the encroachment cases discussed above, if the renewal provision in the existing franchise agreement is specific as to what the changed terms will be on renewal, then the court should uphold these changed terms. If these changed terms are not specified in the renewal provision of the existing franchise agreement, then any changes made unilaterally by the franchisor must be measured against the implied covenant of good faith and fair dealing to determine their reasonableness. For example, if an existing franchise agreement specifically provides that upon renewal the royalty will be increased from 5% of gross sales to 10% of gross sales, a court should deny a franchisee's claim of breach of the implied covenant of good faith and fair dealing and uphold the 10% royalty on renewal because that is what the contracting parties specifically agreed to. If the existing franchise agreement merely provides that the renewal franchise agreement may contain terms materially different than the existing franchise agreement, including an increase of the royalty, without specifying the exact change in the royalty, any increased royalty contained in the renewal franchise agreement, must be measured against the implied covenant of good faith and fair dealing.

If a renewal franchise agreement increased the royalty fee from 5% of gross sales to 100% of gross sales, no person could reasonably question the ludicrousness of this provision. Yet, if you believe that the franchisor has unfettered, unilateral discretion because of the general language in the existing franchise agreement, you must say that it is permissible. Of course, the proper approach is the exercise of reasonable discretion held in check, preferably through negotiation with the franchisee, or through imposition of the implied covenant of good faith and fair dealing by a court and a jury.

The franchisees' argument should be that, although the franchisor has the contractual right to condition the renewal of the franchises by the franchisee signing a new franchise agreement, any material changes contained in the new franchise agreement which are commercially unreasonable and adverse to the legitimate economic and business interests of the franchisees must be subject to specific negotiation with its franchisees in good faith by both parties to the agreement. It is bad faith and an actionable breach of the covenant of good faith and fair dealing for a franchisor to unilaterally make material adverse changes to the terms of the franchise relationship and impose these changes on its franchisees on a nonnegotiable "take it or leave it" basis, particularly if this is coupled with the threat of termination of the franchise agreement and the automatic and immediate imposition of a restrictive and penal covenant not to compete which puts a significant number of franchisees and thousands of employees out of business. One day soon, a court will so hold.