Changing the Rules: Requiring Franchisee Compliance with Future Performance Standards

Sterling Truck Corporation makes medium-duty and heavy-duty trucks and sells them through a nationwide network of independent dealers. Sterling and its dealers are party to a Sales and Service Agreement that contains general performance obligations of the dealer. For example, dealers must “conscientiously and diligently promote sales” and obtain a reasonable share of the market. Sterling reserved in the contract the right to establish “annual operating requirements,” which would be embodied in the Annual Operating Requirements Addenda (AORA). The AORA covered such items as unit sales, stock inventory, trained service technician, special tools, and parts inventory.

After signing the Sales and Service Agreement and an AORA for a prior year, Crossroads Ford refused to sign the current AORA, contending that it violated the Illinois Motor Vehicle Franchise Act. Crossroads sued Sterling in Illinois state court claiming that Sterling's AORA process was coercive under the Illinois Act. The Illinois Act provides that it is a violation for a manufacturer to coerce, or attempt to coerce any motor vehicle dealer, to accept, buy, or order any motor vehicle which the dealer had not voluntarily ordered or requested. The statute also contained the same prohibition for parts, accessories, equipment, machinery, and tools. Crossroads claimed that Sterling's AORA requirements coerced a dealer into ordering trucks, parts, and tools that the dealer did not choose to order. Interestingly, Crossroads did not raise a challenge that Sterling's requirements were factually unreasonable, ie, Crossroads did not argue that the minimum truck sales or parts inventory were inconsistent with market potential. Crossroads' position was nothing short of a frontal attack on a franchisor's right to specify future contractual performance.

Sterling's contract provided that the AORA became part of the contract whether or not the dealer signed the AORA. Thus, the question for the court was whether Sterling's periodic creation of performance requirements could be incorporated into the contract without being an amendment of the contract and without the dealer's signature. This question the court answered strongly in the affirmative.

Analogizing to a requirements contract, the court held that it was appropriate for the parties to grant to the franchisor the right to specify future performance requirements, even if these requirements were not individually agreed to by the franchisee. Conversely, the court suggested that in the absence of contractual provisions permitting the franchisor to establish future performance requirements, an attempt to impose requirements would be unenforceable.

The Illinois court also looked to another provision of the Act, which prohibited “unreasonable” requirements demanded by a motor vehicle manufacturer. The court inferred that the prohibition of unreasonable requirements implicitly recognized that a manufacturer could create reasonable requirements. In so holding, the court recognized that Sterling could not establish unreasonably high expectations for performance for the dealer consistent with the Act's prohibition against terminations without good cause. The court stated: “Depending upon such factors as conditions in the market, the recent performance of plaintiff's dealership and changes in the design of defendant's vehicles, it would seem that what constitutes a 'suitable' inventory could change from year to year and it is therefore impossible to state in advance the specific requirements for future years. If, for example, the demand for defendant's trucks spikes sharply upward, the market might support a larger inventory than in previous years, and a conscientious and diligent dealer might acquire a larger inventory. Fifteen trucks might not be enough if the trucks become hugely popular.”

This case is important because it strongly supports the contractual right of a franchisor to analyze market conditions and set annual performance objectives within the bounds of the contract. Although the franchisor will not have a free hand in doing so if the obligations are unreasonable (as mandated by statute in the Illinois case), reasonable obligations in various aspects of the relationship will be enforceable.

As a practical matter, franchisors should avoid unscientific establishment of performance requirements, such as an additional 5% performance for all franchisees against year-ago performance. Such requirements unfairly penalize diligent franchisees and reward modest improvement against poor prior performance. A properly drafted franchise contract preserves the right to establish standards and creates a defensible process for the establishment of ongoing performance requirements.

Even as a matter of pure contract law (outside the regulated sphere of the franchise world) a supplier would not be free to change all aspects of the performance of the dealer, even if the contract expressly permitted the action. Take, for example, a distribution contract that permits a supplier to determine at any time during the period of the contract not to fill the distributor's orders. Such a contract may well be void because it lacks “mutuality of obligation,” in that the right to purchase by the distributor is illusory. Yet, many, if not most, contracts permit a supplier to change prices, warranties, terms and conditions of sale, distributor performance requirements, and other significant matters, all without running afoul of a lack of mutuality of obligation. In the real world, such contracts will permit the distributor to terminate at will if the conditions of the contract become unsatisfactory.

But suppose there is a fixed-term contract in an unregulated industry or an unregulated state and the franchisor by specific contract provision reserves the right to demand performance by the franchisee, which the franchisor may vary from time to time. At what point does the right to modify performance, even if contractually permitted, amount to a lack of mutuality of obligation? The law to date does not give a ready answer to this question. Perhaps the answer is that the contract is void when the franchisor has made no binding commitment to performance or, conversely, has made no commitment to demand only achievable or reasonable performance from the franchisee.

One suggestion often advanced by franchisees is to say that the obligation of good faith inherent in every contract and required by the terms of the Uniform Commercial Code (UCC) will prevent a franchisor from demanding unreasonable performance. Indeed some courts have imposed a requirement of commercial reasonableness, especially under the UCC. See '1-102(3). However, courts are increasingly reluctant to bar a manufacturer (absent some state law inhibition like that under the Illinois Motor Vehicle Franchise Act) from enforcing one-sided provisions that are unambiguous. For example in Super Valu Stores, Inc. v. D-Mart Food Stores, Inc., 431 N.W.2d 721 (Wis. App. 1988) the court found no breach of the obligation of good faith when a supplier invoked the express contractual right to appoint a second grocery store franchisee in the market of an existing Super Value store, with the effect that the existing store went out of business.

With the Sterling Truck case, the Illinois court set down the rule that a franchisor may establish performance requirements that vary from time to time, even against the backdrop of significant industry regulation. The limitation on such changes is that the requirements must be reasonable. In so holding, the court struck a fair balance in the franchisor-franchisee relationship.

In today's world, franchisors frequently design franchise contracts to govern relations with franchisees for several years. As a result, it is critically important that franchisors be permitted to set reasonable performance requirements, not only for the present, but periodically over the life of the agreement.

There are several methods for creating contractually enforceable performance requirements, but in most cases a franchise contract contains general statements of performance obligations, such as “best efforts,” “adequate sales,” “sufficient inventory,” and “continuous and systematic sales efforts.” Some contracts supplement general performance provisions with a standards manual defining the details of many performance obligations under the franchise contracts. Other contracts simply reserve the right to set annual performance obligations, based on what the franchisor believes to be reasonable expectations of performance, given current market conditions.

Franchisors' attempts to specify annual performance obligations have frequently been criticized by franchisees as a one-sided amendment to a contract and occasionally challenged in court as unenforceable. Franchisors have countered with the argument that so long as the franchise contract permits the franchisor to set annual performance requirements, they are not an amendment to the contract, but rather consistent with the contract and the expectations of the parties. A recent case decided by the Illinois Court of Appeals has answered the issue in favor of franchisors. In Crossroads Ford Truck Sales, Inc. v. Sterling Truck Corporation, 792 N.E.2d 488 (Ill. App. 2003), the court solidly affirmed the franchisor's right to set contractually enforceable future performance requirements.

Sterling Truck Corporation makes medium-duty and heavy-duty trucks and sells them through a nationwide network of independent dealers. Sterling and its dealers are party to a Sales and Service Agreement that contains general performance obligations of the dealer. For example, dealers must “conscientiously and diligently promote sales” and obtain a reasonable share of the market. Sterling reserved in the contract the right to establish “annual operating requirements,” which would be embodied in the Annual Operating Requirements Addenda (AORA). The AORA covered such items as unit sales, stock inventory, trained service technician, special tools, and parts inventory.

After signing the Sales and Service Agreement and an AORA for a prior year, Crossroads Ford refused to sign the current AORA, contending that it violated the Illinois Motor Vehicle Franchise Act. Crossroads sued Sterling in Illinois state court claiming that Sterling's AORA process was coercive under the Illinois Act. The Illinois Act provides that it is a violation for a manufacturer to coerce, or attempt to coerce any motor vehicle dealer, to accept, buy, or order any motor vehicle which the dealer had not voluntarily ordered or requested. The statute also contained the same prohibition for parts, accessories, equipment, machinery, and tools. Crossroads claimed that Sterling's AORA requirements coerced a dealer into ordering trucks, parts, and tools that the dealer did not choose to order. Interestingly, Crossroads did not raise a challenge that Sterling's requirements were factually unreasonable, ie, Crossroads did not argue that the minimum truck sales or parts inventory were inconsistent with market potential. Crossroads' position was nothing short of a frontal attack on a franchisor's right to specify future contractual performance.

Sterling's contract provided that the AORA became part of the contract whether or not the dealer signed the AORA. Thus, the question for the court was whether Sterling's periodic creation of performance requirements could be incorporated into the contract without being an amendment of the contract and without the dealer's signature. This question the court answered strongly in the affirmative.

Analogizing to a requirements contract, the court held that it was appropriate for the parties to grant to the franchisor the right to specify future performance requirements, even if these requirements were not individually agreed to by the franchisee. Conversely, the court suggested that in the absence of contractual provisions permitting the franchisor to establish future performance requirements, an attempt to impose requirements would be unenforceable.

The Illinois court also looked to another provision of the Act, which prohibited “unreasonable” requirements demanded by a motor vehicle manufacturer. The court inferred that the prohibition of unreasonable requirements implicitly recognized that a manufacturer could create reasonable requirements. In so holding, the court recognized that Sterling could not establish unreasonably high expectations for performance for the dealer consistent with the Act's prohibition against terminations without good cause. The court stated: “Depending upon such factors as conditions in the market, the recent performance of plaintiff's dealership and changes in the design of defendant's vehicles, it would seem that what constitutes a 'suitable' inventory could change from year to year and it is therefore impossible to state in advance the specific requirements for future years. If, for example, the demand for defendant's trucks spikes sharply upward, the market might support a larger inventory than in previous years, and a conscientious and diligent dealer might acquire a larger inventory. Fifteen trucks might not be enough if the trucks become hugely popular.”

This case is important because it strongly supports the contractual right of a franchisor to analyze market conditions and set annual performance objectives within the bounds of the contract. Although the franchisor will not have a free hand in doing so if the obligations are unreasonable (as mandated by statute in the Illinois case), reasonable obligations in various aspects of the relationship will be enforceable.

As a practical matter, franchisors should avoid unscientific establishment of performance requirements, such as an additional 5% performance for all franchisees against year-ago performance. Such requirements unfairly penalize diligent franchisees and reward modest improvement against poor prior performance. A properly drafted franchise contract preserves the right to establish standards and creates a defensible process for the establishment of ongoing performance requirements.

Even as a matter of pure contract law (outside the regulated sphere of the franchise world) a supplier would not be free to change all aspects of the performance of the dealer, even if the contract expressly permitted the action. Take, for example, a distribution contract that permits a supplier to determine at any time during the period of the contract not to fill the distributor's orders. Such a contract may well be void because it lacks “mutuality of obligation,” in that the right to purchase by the distributor is illusory. Yet, many, if not most, contracts permit a supplier to change prices, warranties, terms and conditions of sale, distributor performance requirements, and other significant matters, all without running afoul of a lack of mutuality of obligation. In the real world, such contracts will permit the distributor to terminate at will if the conditions of the contract become unsatisfactory.

But suppose there is a fixed-term contract in an unregulated industry or an unregulated state and the franchisor by specific contract provision reserves the right to demand performance by the franchisee, which the franchisor may vary from time to time. At what point does the right to modify performance, even if contractually permitted, amount to a lack of mutuality of obligation? The law to date does not give a ready answer to this question. Perhaps the answer is that the contract is void when the franchisor has made no binding commitment to performance or, conversely, has made no commitment to demand only achievable or reasonable performance from the franchisee.

One suggestion often advanced by franchisees is to say that the obligation of good faith inherent in every contract and required by the terms of the Uniform Commercial Code (UCC) will prevent a franchisor from demanding unreasonable performance. Indeed some courts have imposed a requirement of commercial reasonableness, especially under the UCC. See '1-102(3). However, courts are increasingly reluctant to bar a manufacturer (absent some state law inhibition like that under the Illinois Motor Vehicle Franchise Act) from enforcing one-sided provisions that are unambiguous. For example in Super Valu Stores, Inc. v. D-Mart Food Stores, Inc., 431 N.W.2d 721 (Wis. App. 1988) the court found no breach of the obligation of good faith when a supplier invoked the express contractual right to appoint a second grocery store franchisee in the market of an existing Super Value store, with the effect that the existing store went out of business.

With the Sterling Truck case, the Illinois court set down the rule that a franchisor may establish performance requirements that vary from time to time, even against the backdrop of significant industry regulation. The limitation on such changes is that the requirements must be reasonable. In so holding, the court struck a fair balance in the franchisor-franchisee relationship.