Franchise Renewals: They've Got You Coming and Going

Renewals have always been a hot topic in the franchise world. Not surprisingly, most, but not all, of the legal history on renewals shows franchisees to be the definitive losers.

Historically, in most instances, franchisees have argued that a right to renew should always be available, regardless whether such a right exists in the franchise agreement, and franchisors have contended that no such right should exist, unless it is explicitly provided for in the franchise agreement.

Absent the applicability of state or federal franchise legislation, the underlying legal principles that govern most franchise renewal disputes include: (1) any contract, including a franchise agreement, will remain in effect until the end of the term identified in that agreement; (2) unless the agreement contains a right to renew, neither of the parties has a right to renew; (3)  if the agreement does contain a right to renew, and the electing party chooses to renew, the agreement will be renewed only on the terms identified in the agreement.

Where no renewal provision is explicitly included in the franchise agreement, and where no state or federal statute can be used to imply such a renewal right, the court will usually never imply such a term. The common law has a clear and definitive penchant for limiting the duration terms of contracts absent the parties’ expressed crystal clear intention to provide for renewals.

A harsh example of this rigid tendency can be seen vividly in a painful case involving H&R Block back in 2002. The case began when Block franchisees sued Block alleging in part that Block had breached their franchise agreements by selling tax preparation services over the internet in the franchisees’ territories. Block counterclaimed seeking a court order permitting it to terminate the franchisees’ agreements at the conclusion of their current five year terms.

In filing the suit it appears that the franchisees had assumed that they possessed perpetual renewal rights, which would therefore have protected them against any retaliatory terminations by Block. The franchisees’ assumption at that time was reasonable. The duration provision in their agreements stated that“The term of this Agreement shall run for a period of five years from the date hereof, with further provisions that it shall be automatically renewed for successive periods of five years each, unless mutually terminated or terminated [for cause under the agreement].”

Although the court noted that the provision was “unusual” in that it provided for automatic five-year renewals unless both parties assented to termination, it proceeded to apply a legal analysis that was even more unusual, seemingly lifted from a court in 18thCentury England. The court stated that although the practical effect of the duration provision in the franchise agreements was the creation of a perpetual contract, that provision would nevertheless need to be voided since the provision had failed to use the necessary magical words to create an enforceable perpetual contract.

According to the court, to be an enforceable perpetual contract, the perpetual nature of the clause would have had to have been unequivocally expressed in the franchise agreement, which, the court stated, it was not. In fact according to the court, almost unexplainably, the language “automatic renewal” itself actually doomed the conclusion that the term could be viewed as perpetual. The court stated: “That a contract would run for five years, terminate, and be in need of renewal-whether automatically or otherwise-belies any contention that it was to run in perpetuity.”  The Court clearly had no intention of enabling one of the parties, in this case the franchisee, “to coerce the other” into a perpetual cycle of five-year obligations.

The common law principles of renewals, discussed above, are not always the final arbiters of renewal disputes. These black-letter common law principles regarding contractual renewals in some cases are supplemented and modified by a rag-tag group of internally inconsistent state and federal franchise laws. Not all states, however, have enacted such legislation. And, for those that have, none of the statutes is congruous with any other, in language, intent, scope or application. Some of the statutes explicitly address renewals and others touch on renewals indirectly.

The most common provision in these state laws that is drawn into play in renewal disputes is the requirement that the franchisor have “good cause” for nonrenewal. In almost all cases the term “good cause” is defined by reference to the degree to which the franchisee has met its obligations during the term of the franchise. Some of the legislation, however, does define “good cause” to include the legitimate business reasons of the franchisor for nonrenewal. This latter concept has now begun to eat away at franchisee protection that had historically been provided to franchisees by the “franchisee-culpability” program.

With regard to the former, “franchisee-culpability” based standards, some statutes set out explicitly the specific operational defects of the franchisee that would permit nonrenewal, and others define these defects in a more general conclusory definition, such that the franchisee must have been in “substantial compliance” with its obligations during the term of the agreement. These statutes attempt to capture the concept that where the franchisee has materially breached the agreement he will not be eligible for renewal protection of that statute. Repeated defaults by the franchisee are usually sufficient to prevent the franchisee from using these favorable renewal rights. This conditioned-availability trigger itself leads to a significant host of troublesome questions such as what the terms “material breach” and “substantial compliance” mean, and whether the franchisor is applying its renewal criteria in a non-discriminatory manner for purposes of the statute.

Not unlike at common law, franchises in perpetuity are not friends of franchise legislation. Very few state franchise acts have ever been viewed to grant such perpetual franchise renewal rights. New Jersey and Wisconsin are examples where such statutory rights arguably exist. Each state, of course, consistent with the overall pervasive lack of uniformity in direction, design and language among all franchise statutes, addresses the renewal concept very differently.

Under the Wisconsin statute, a franchisor is prohibited from refusing to renew a franchise except for “good cause” which is defined as the failure of a franchisee to “comply substantially with the essential and reasonable requirements … which are nondiscriminatory as compared with the requirements imposed on other similarly situated dealers either by their terms or enforcement.” And, in New Jersey, one court has described the renewal right thusly: “Once a franchise relationship begins, all that a franchisee must do is comply substantially with the terms of the agreement, in return for which he receives the benefit of an “infinite” franchise – he cannot be terminated or refused renewal.”

Last, there are antidiscrimination provisions in state franchise legislation that have been used to decide renewal disputes. The bottom-line on these provisions is that so long as the franchisor publicly offers the same renewal terms to every franchisee – regardless how oppressive those terms might be – they will be held to be lawful. In these states, however, savvy franchisor counsel are easily able to side-step these laws by closely controlling the terms of the renewal deals that their franchisor clients cut. Differences without any meaning become king.

Franchisors have always offensively used renewal rights to cleanse their systems of franchisees that they view to be troublesome, inefficient, and under-funded. With very rare exception, franchise laws enable and support this purging behavior. Not surprisingly, there are no laws on the books prohibiting franchisors from selling franchises to franchisees that they view to be troublesome, inefficient, and under-funded at the time they sell their franchises. From a franchisee’s perspective, “they’ve got you coming and going.”

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Jeffrey M. Goldstein is the founding partner of the Goldstein Law Group, PC, a law firm specializing in representing franchisees and dealers in franchise and dealership disputes. www.goldlawgroup.com(202-293-3947) [email protected]

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Comments

The backend

The vast majority of franchisees I have encountered never considered end of term implications.  They were sold on the excitement of the franchise and going into business. Most had no idea of how involved due diligence should be and they tended to get their education when it was too late. 

Given that nonrenewal virtually means what you take out of the franchise when the contract is terminated or expires is what you have already taken out, perhaps there is a better approach to considering the franchise investment.

Perhaps business plans and due diligence should start at the backend of the contract term where it is clearly understood the outgoing value is zero.  

I was wondering if Wisconsin and New Jersey have less litigation and less franchise conflict with regard to renewal interpretations?

There is no franchise investment opportunity available today in

which "renewal" rights figure as a positive value element in the pre investment due diligence process.

The risk today is that the business will not last through the first term. Moreover, the franchisors of today know this, and the lack of durability is one of the several reasons for liquiidated damages clauses.

Some of the very old deals come up for renewal - deals that used to be for real - from another generation. "Renewal" rights are not material to investment decisions in today's franchise offerings. The reasons for this are a long story that you probably don't want to hear me go on about. I have alreaduy addressed these issues in other posts and articles.

Suffice it to say that anyone who is worried that he or his children may not be able to continue the business after 10 years of a first term is seriously out of date, to put it nicely.

Hey Rich

Hey Rich: Good point. I think that with 95% of franchise opportunities your analysis holds; however, there are a few, which in my experience, are the more arguably successful and sophisticated franchises, where the provision has great financial consequences. And, when coupled with a post-term covenenant, the nonrenewal is very costly. So in bigger dollar franchises, like successful hotel and real estate brands, the renewal issue is one that needs to be examined closely both upon execution and when expiration approaches. With regard to the "average" franchise purchase now-a-days, you're correct that the renewal program is not even on the radar screen, as, in some sense, these franchisees have ironically already factored-in the very high average likelihood that their program goes down hill within the first few years. Best, Jeff

I agree as to the higher end hotels. As for the lower rungs,

those Super 8 franchisees who have been whining in here for the past few weeks, they have no economically meaningful expectations of continuation beyond their first term.

You're Right

You're right; the chances of a lower to mid-tier brand hotel making it beyond its first 5 year "out" are negligible especially when there unexplainably are always a throng of "new hoteliers" lined up volunteering to put $500,000 into remodeling another relatively ancient hotel for the "privilege" of becoming the "new" non-performing brand hotel in that area. The churning of these expensive franchises is facilitated by the joke of liquidated damages, which, despite years and years of criticism by hoteliers, remains unabated. So long as vendors, including the very franchise hotel corporations who are guilty of playing out these franchise ponzi schemes, continue to heavily contribute to the salaries and operating budgets of allegedly independent franchise associations (including one that is the very largest of its type in the world), this mulit-million dollar rip off program will continue to operate. So long as everyone's paid off, wrong becomes right.

Theoretically - in business school speak - it should be quite

rational for a large hospitality company to have entries in every segment of the market. So much for theory.

In reality, however, when you get to the bottom rung of the ladder, you attract a different kind of investor - one whose cultural inclinations tend to be inconsistent with the "corporate" mindset of your tyipal hospitality company management mentality.

I think of the low end motels as a type of "Raj", a relationship of people who have no idea about who each other really is. They pass each other in the night and the milieu is a petri dish for dispute.

When I was in a corporate setting I encountered several acquisitions in which the sellers didn't fit in with "us", but "we" tried anyway to include them in the ongoing management of the acquired company because we had no idea how to operate it and the sellers had earn out agreements that contractually included them for reasons of "keeping us honest",

None of them worked, and we ended up divesting all of them. I managed to save some of the relationships at least through the earn out periods to avoid litigation over who owed what to whom, but you cannot fit the square peg into the round hole. I used ot be married to an Episcopalian, and you could no more turn me into an Episcopalian Vestryman than you can turn a bottom rung hospitality franchise investor into someone willing to follow the corporate line of an otherwise high end hotel company.

Liquidated Damages and AAHOA

I think that this is a thoughtful discussion of the issue of liquidated damages.

The suggestion that AAHOA facilitates churning by accepting hoteliers as vendors needs further explanation.

Well then I guess we like being out of date

"Suffice it to say that anyone who is worried that he or his children may not be able to continue the business after 10 years of a first term is seriously out of date, to put it nicely."

We know many fellow Zees in our system who are 2nd generation.  The Zor has a Next Generation program to encourage Zees to pass their businesses down to the next generation, and to get the new candidates trained and qualified.

We don't have anyone in our next generation that we forsee going into the business, but it is very common in our system for the businesses to be passed down.

Likewise

Just think Granville; don’t we make a rare couple?

Comment moved

This comment has been moved here.

Hi Ray

Hi Ray: Good point on the issue of whether the legislation actaully impacts on litigation. It's a good question, but not amenable to a theoretical response. Here's why. First, the language of the statutes is messy and not easily interpreted. In Wisconsin, this has arguably given way to a balancing-test as part of the analysis; what franchisee has the time or money to invist in a balancing analysis, especially one in which the franchisor holds 99% of the evidence on balancing? Fewer than 5% of franchisees, I'd guess. And, there's also some bizarre language in the statute that unexplainably grafts a "discrimination" type of analysis regarding the renewal; always a safe shelter for a franchisor. Second, these state statutes are rarely used and interpreted. Thus, even in cases like the statute in NJ, there are enough analytical gaps to keep 10 judges busy for 4 years during which a trial and appeal would occur. The statutes that are on the books on renewals all ran into the constitutional buzz-saw as soon they were used offensively by franchisees. That is not to say, however, that in the right time and place a franchisee wouldn't be able to "hit" on a wrongful non-renewal claim in either state. .I'd prefer NJ. I'll let you know how my case looks in another month or so. Best, Jeff

A question of good will?

Thanks Jeff.  You mentioned possibly fewer than 5% would be in a position to test their renewal position and for the sake of this point I’ll take that as a national figure; unless someone suggests it differs and the difference matters. And then of course there are those of the 5% that fail on the test due to the inability to access evidence held by the franchisor.

If I have that clear than could it be suggested on that same basis that access to remedy is extremely limited for the majority of franchisees in the US in regard to conflict in general?   I consider Granville’s earlier comment regarding franchise systems with a long history where renewal does not become contentious as indicative of the reality that there are some truly good franchise operations with minimal conflict in the market.  Am I stretching it too far to suggest your ‘fewer than 5%’ might still be a good guess?

Within my knowledge of Australian franchising conflict renewal, as you would expect, would probably be up there in the very top causes along with misrepresentation and yet we rarely see a successful case mounted by franchisees on any cause and never on renewal. 

The last attempt was by Competitive Foods when Yum International just simply began acquiring Jack Cowan’s 30 plus Western Australian franchises at end of term.  Even Jack’s wealth could not produce a successful defence under Australian law and even when Yum decided to open in competition with at least one of his franchises where the end of term was too distant for an impatient Yum.

Jack Cowan was a strong force as a franchisee and a franchisor behind our last federal franchising inquiry where he is hopeful to see the introduction of ‘good faith’ and to cause further alarm, where the Committee was at one stage discussing the value of franchisee good will at end of term when renewal was not on the table.

 Jack had built the brand in Australia.  It was his money and his effort over, from memory, 10 and 15 year contracts.  I don’t see the influence of franchisors on legislators allowing the current position of franchisees at end of term to change. 

It seems that there are a lot of parallels everywhere there is franchising and renewal and nonrenewal are simply just too rewarding for most franchisors where franchisees have little to zero chance of achieving anything but what the contract states and with no regard to who invested all the capital.  Even when the franchisee can fund a case.

At least many systems assist with good old fashioned [fashioned] terminations that take the whole renewal/nonrenewal issue right off the table.