Observations on Negotiating Franchise Agreements in Today's Legal Environment

Franchise law has long characterized franchise agreements as adhesion contracts (see, Ticknor v. Choice Hotels Int'l, 265 F.3d 931 (9th Cir. 2001) (Montana law); Bolter v. Superior Court, 87 Cal. App. 4th 900 (2001) (California law)). While no empirical data exist on the percentage of franchisors that will negotiate the terms of their franchise contract with prospective franchisees, it is fair to conclude that they remain a minority. To start the pre-sale disclosure process, a franchisor must present a prospect with the terms of its bona fide offer for the sale of a franchise. Frequently, these are the only terms the franchisor is prepared to accept.

Franchisors resist prospective franchisee efforts to negotiate better terms for themselves for any number of reasons. Some franchisors have no incentive to negotiate: Enough prospects are ready to buy a franchise on the franchisor's economic terms. Some franchisors offer their franchises on a strict 'take-it-or-leave-it' basis to avoid the administrative burden of managing a network of diverse contracts. Other franchisors eschew negotiating to avoid the possible fallout from charges of favoritism or to simplify the paperwork burdens associated with franchise sales. Some franchisors hide behind the extra disclosure duties that arise from contract negotiations by perpetuating the impression that franchise laws forbid franchisors from negotiating changes to their standard deal, which, of course, is untrue. Franchise laws do not forbid franchisors to negotiate franchise agreements, and franchise regulators do not intend for pre-sale disclosure rules to discourage contract negotiations. Nevertheless, the prevailing public perception is that franchise agreements are non-negotiable (see, for example, http://franchises.about.com/od/franchisinglegalissues/f/Fran_negotiate.htm, as of Dec. 10, 2006).

This is not to say that franchise contracts are never negotiated by franchise parties. In many situations, the franchisee enters the scene with negotiating leverage, whether due to a new franchisor's eagerness to close its first few sales or the prospective franchisee's particular experience, relative size, willingness to open up a new market, scope of investment, or other special circumstances. The more sophisticated the prospect, the less likely the prospect will be put off by the franchisor's initial resistance to negotiating special terms. As a result, some degree of negotiation is not uncommon particularly in franchise systems requiring larger initial investments that tend to attract more sophisticated buyers.

Regulatory Requirements for Negotiated Franchise Sales

A negotiated franchise sale raises certain regulatory compliance issues. First, there is the duty to re-disclose the prospect with the modified franchise agreement containing the negotiated terms and wait at least five more business days following re-disclosure before the prospect may sign any binding agreement, even the one that the prospect has negotiated, or pay any consideration for the franchise, even a good faith, refundable deposit.

The re-disclosure requirement arises under the FTC Rule and therefore applies to franchise sales throughout the United States. The FTC, recognizing that the duty to re-disclose and wait another five business days to close a sale may chill a franchisor's willingness to entertain contract changes, intends to eliminate the re-disclosure duty entirely for franchisee-initiated contract modifications that result in changes that solely benefit the franchisee in the long-awaited revised FTC Rule. As the FTC writes in its Staff Report to the proposed revised FTC Rule (see Staff Report to the Federal Trade Commission of August 2004, 16 CFR Part 436.1 at p 276-77): 'The staff believes that franchise sellers and prospective franchisees should be free to negotiate the terms of the franchise agreement, as in all other transactions, without fear of violating the Rule. The Commission has no interest in preventing the parties from seeking the best deal possible, as long as the prospective franchisee understands in advance of the sale how the terms and conditions differ from the standard ones set forth in the disclosure document, and has the opportunity to review the actual franchise agreement prior to the sale.'

Second, there is the regulatory quan-dary when a negotiated sale involves a registration state (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin): If the negotiated offer materially differs from the terms of the franchisor's registered offer, must the franchisor first register the negotiated terms as a material change to its registration in order to sell a franchise on those terms? Arguably, every negotiated sale creates a new offer that should be subject to review and registration before the franchisor concludes the sale.

Fortunately for franchisors and franchisees operating in registration states, this is not the prevailing view on negotiated sales. Except in California, all that the registrations states currently require a franchisor to do in order to consummate a negotiated sale is to satisfy the five-business-day re-disclosure rule described above. The franchise sales laws in Illinois, Maryland, Rhode Island, Virginia, and Washington ex-pressly recognize that a franchisor's negotiation with one prospect is not, in and of itself, something that is material to the next prospect necessitating a filing duty nor does negotiation with a prospect make the franchisor's registered offer less than bona fide. Indeed, in Virginia, a franchisee who is denied the chance to negotiate the terms of the registered offer may void the franchise agreement within the first 30 days after signing it.

California's Unusual Negotiated Sales Law

Somewhat surprisingly, California, otherwise considered a progressive state, clings to a more formalistic interpretation of negotiated sales, maintaining that a negotiated sale is a new franchise offer requiring its own registration. California regulators first articulated this strict interpretation in the mid-1980s when they added Regu-lation 310.100.2 to the California Franchise Investment Law. Among other things, Regulation 310.100.2 required franchisors to file a 'Notice of Negotiated Sale of Franchise' with the California Department of Corporations within 15 business days after consummating each negotiated sale and to include a copy of all Notices in the offering circular that it delivered to new prospects during the following 12 months, thus creating a public record of the franchisor's negotiating history. These extra burdens were on top of the franchisor's duty to comply with the five-business-day re-disclosure rule in connection with the negotiated sale itself. Regulation 310.100.2 was indifferent to the potential chilling effect that public exposure of the franchisor's negotiating record might have on the franchisor's receptiveness to negotiate its standard deal.

Recently, California's lawmakers took another look at the state's negotiated sales rules. While they could have liberalized California's approach to negotiated sales and brought California in line with every other jurisdiction that has considered the subject, regrettably they did not. Instead, California adopted Corpora-tions Code '31109.1, effective on Jan. 1, 2005, which amends the requirements for negotiated sales. California's failure to acknowledge the chill that its negotiated sales rules have had on a franchisee's ability to secure better contract terms is even more regrettable considering that California now addresses negotiated sales by statute, instead of by regulation, making fu-ture legislative reform more difficult.

Section 31109.1 exempts negotiated sales from the general registration duty when the franchisor complies with the following requirements: 1) the initial offer made to the prospect is the registered offer; 2) the prospect who negotiates receives a summary of all negotiated sales with California franchisees during the prior 12 months in a separate written appendix to the franchisor's offering circular, 3) the franchisor informs the prospect that it may request a copy of the negotiated terms of sales concluded during the prior 12 months, and 4) the negotiated terms, on the whole, confer additional benefit on the prospect. A franchisor that negotiates sales during the year must certify in its California renewal application that it has complied with the new section, which means that franchisors still must publicly disclose if they have negotiated franchise sales in the past year.

Section 31109.1 eliminates the post-sale Notice filing requirement of the former regulation, making it more difficult for prospects outside of California to discover the terms the franchisor may be willing to yield on. However, by requiring franchisors to deliver 'a copy of the negotiated terms,' a franchisor may now have to disclose far more about its negotiating history than before when summary disclosures sufficed. Section 31109.1(b) does not explain what is meant by delivering 'a copy of the negotiated terms' and if the franchisor must share a copy of the actual executed amendment or interlineated franchise agreement that reveals the identity of the franchisee.

California's approach to negotiated sales is a far cry from the FTC's liberal view that franchise sale regulations should not impede parties from negotiating the franchise agreement and seeking the best deal possible. Section 31109.1 worked its way through the California legislature in 2004 around the same time that the FTC issued its Staff Report in August 2004 on the proposed revised FTC Rule. Because of the timing, California lawmakers may have had no chance to be influenced by the Staff Report's more liberal attitude toward negotiation of franchise agreements.

Unfortunately, California's new negotiated sales statute does not benefit all franchisees seeking to buy a franchise in California equally, only those that succeed in their effort to draw the franchisor into negotiating the terms of the registered franchise agreement. A prospective franchisee who believes that the law forbids negotiation or is misinformed by the franchisor to that effect, or who assumes that all franchise offers are take-it-or-leave-it propositions and therefore never initiates the negotiation process, is not entitled to any disclosure about previously negotiated terms. Only the prospect who negotiates changes to the franchise contract is entitled to receive a 12-month summary of prior negotiated sales and to ask for the actual negotiated terms. Therefore, the larger franchisee with negotiating leverage can discover the franchisor's negotiating history and use it advantageously; the textbook 'mom and pop' franchisee is left uninformed.

Franchisors may fairly criticize the new statute, which injects a new level of uncertainty about negotiations by limiting the exemption from registration to those negotiations that, on the whole, confer additional benefits on the franchisee. While the proposed revised FTC Rule can be similarly criticized for eliminating the re-disclosure duty only when contract negotiations result in changes that solely benefit the franchisee, unlike the situation in California, a franchisor complying with the revised FTC Rule will not be asked to expose its negotiating history to future prospects.

Negotiation is a 'give and take' process where it is sometimes unclear if the overall exchange leaves a party better off. For example, a franchisee that succeeds in eliminating a post-term non-compete provision may be required to accept as a fair quid pro quo delivering additional personal guarantees or something else that, standing alone, is not advantageous. Who, but the franchisee willing to make the deal, should say if the negotiated changes, as a whole, confer additional benefits? Parties often seek specific terms for very personal reasons, leaving one person's idea of a better deal very different from another's. If a franchisee accepts the negotiated deal, why should California law permit that franchisee later to challenge the sale on the basis that, in hindsight, the negotiated changes did not, on the whole, amount to something better after all?

By carving out an exemption from registration for certain negotiated sales, the California legislature expects franchisors to register all other negotiated offers before consummating them. It is unclear what additional protections result from requiring franchisors to register a negotiated offer when a franchisee is willing to accept a negotiated deal that, on balance, may be a wash in terms of conferring additional benefits. A franchisee who negotiates in California still receives the benefit of the five-business-day re-disclosure rule, which protects the prospect against sharp sales tactics by giving the franchisee extra time to consider whether to accept or reject the negotiated offer. What more protection does registration of the negotiated offer afford? The Department of Corporations does not review the fairness of franchise offers; rather it requires franchisors to disclose that registration does not signify the Department's approval or endorsement of the franchise offer. So, what is accomplished by requiring a franchisor to register the negotiated changes before consummating the deal? Furthermore, who should have standing to complain if the overall negotiated deal does not confer additional benefits on a franchise buyer? Just the franchisee who goes ahead and enters into the negotiated sale? What about later franchisees who buy a franchise during the next 12 months? Will the duty to give new prospects who negotiate a copy of past-negotiated terms allow them to complain that a prior sale to someone else did not confer additional benefits and should not have been registered? None of these issues are addressed in new '31109.1.

With an infinite list of variations that can be made to any franchise agreement, new '31109.1 does little to encourage free negotiation of franchise contracts or dispel misconceptions that franchise agreements are not negotiable. Regrettably, California had the chance to follow the mainstream approach to negotiated sales and leave negotiation as a private affair between contracting parties, but opted not to do so.

California is the only jurisdiction to burden the negotiation process with extra regulations, so it is fair to ask, why is sunny California giving negotiated franchise sales the deep chill? No data show that franchise sales fraud is more prevalent in California than elsewhere in the United States. With laws like '31109.1, the impression that franchise agreements are adhesion contracts may be borne out not just by an unleveled playing field, but also by legislative obstacles to negotiation.

Rochelle B. Spandorf is a partner in the Los Angeles office of Sonnenschein Nath & Rosenthal LLP, and she can be contacted at 213-892-5036 or [email protected]. Beata Krakus is an associate in the firm's Chicago office and can be contacted at 312-876-8246 or [email protected].

Franchise law has long characterized franchise agreements as adhesion contracts ( see, Ticknor v. Choice Hotels Int'l, 265 F.3d 931 (9th Cir. 2001) (Montana law); Bolter v. Superior Court , 87 Cal. App. 4th 900 (2001) (California law)). While no empirical data exist on the percentage of franchisors that will negotiate the terms of their franchise contract with prospective franchisees, it is fair to conclude that they remain a minority. To start the pre-sale disclosure process, a franchisor must present a prospect with the terms of its bona fide offer for the sale of a franchise. Frequently, these are the only terms the franchisor is prepared to accept.

Franchisors resist prospective franchisee efforts to negotiate better terms for themselves for any number of reasons. Some franchisors have no incentive to negotiate: Enough prospects are ready to buy a franchise on the franchisor's economic terms. Some franchisors offer their franchises on a strict 'take-it-or-leave-it' basis to avoid the administrative burden of managing a network of diverse contracts. Other franchisors eschew negotiating to avoid the possible fallout from charges of favoritism or to simplify the paperwork burdens associated with franchise sales. Some franchisors hide behind the extra disclosure duties that arise from contract negotiations by perpetuating the impression that franchise laws forbid franchisors from negotiating changes to their standard deal, which, of course, is untrue. Franchise laws do not forbid franchisors to negotiate franchise agreements, and franchise regulators do not intend for pre-sale disclosure rules to discourage contract negotiations. Nevertheless, the prevailing public perception is that franchise agreements are non-negotiable (see, for example, http://franchises.about.com/od/franchisinglegalissues/f/Fran_negotiate.htm, as of Dec. 10, 2006).

This is not to say that franchise contracts are never negotiated by franchise parties. In many situations, the franchisee enters the scene with negotiating leverage, whether due to a new franchisor's eagerness to close its first few sales or the prospective franchisee's particular experience, relative size, willingness to open up a new market, scope of investment, or other special circumstances. The more sophisticated the prospect, the less likely the prospect will be put off by the franchisor's initial resistance to negotiating special terms. As a result, some degree of negotiation is not uncommon particularly in franchise systems requiring larger initial investments that tend to attract more sophisticated buyers.

Regulatory Requirements for Negotiated Franchise Sales

A negotiated franchise sale raises certain regulatory compliance issues. First, there is the duty to re-disclose the prospect with the modified franchise agreement containing the negotiated terms and wait at least five more business days following re-disclosure before the prospect may sign any binding agreement, even the one that the prospect has negotiated, or pay any consideration for the franchise, even a good faith, refundable deposit.

The re-disclosure requirement arises under the FTC Rule and therefore applies to franchise sales throughout the United States. The FTC, recognizing that the duty to re-disclose and wait another five business days to close a sale may chill a franchisor's willingness to entertain contract changes, intends to eliminate the re-disclosure duty entirely for franchisee-initiated contract modifications that result in changes that solely benefit the franchisee in the long-awaited revised FTC Rule. As the FTC writes in its Staff Report to the proposed revised FTC Rule (see Staff Report to the Federal Trade Commission of August 2004, 16 CFR Part 436.1 at p 276-77): 'The staff believes that franchise sellers and prospective franchisees should be free to negotiate the terms of the franchise agreement, as in all other transactions, without fear of violating the Rule. The Commission has no interest in preventing the parties from seeking the best deal possible, as long as the prospective franchisee understands in advance of the sale how the terms and conditions differ from the standard ones set forth in the disclosure document, and has the opportunity to review the actual franchise agreement prior to the sale.'

Second, there is the regulatory quan-dary when a negotiated sale involves a registration state (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin): If the negotiated offer materially differs from the terms of the franchisor's registered offer, must the franchisor first register the negotiated terms as a material change to its registration in order to sell a franchise on those terms? Arguably, every negotiated sale creates a new offer that should be subject to review and registration before the franchisor concludes the sale.

Fortunately for franchisors and franchisees operating in registration states, this is not the prevailing view on negotiated sales. Except in California, all that the registrations states currently require a franchisor to do in order to consummate a negotiated sale is to satisfy the five-business-day re-disclosure rule described above. The franchise sales laws in Illinois, Maryland, Rhode Island, Virginia, and Washington ex-pressly recognize that a franchisor's negotiation with one prospect is not, in and of itself, something that is material to the next prospect necessitating a filing duty nor does negotiation with a prospect make the franchisor's registered offer less than bona fide. Indeed, in Virginia, a franchisee who is denied the chance to negotiate the terms of the registered offer may void the franchise agreement within the first 30 days after signing it.

California's Unusual Negotiated Sales Law

Somewhat surprisingly, California, otherwise considered a progressive state, clings to a more formalistic interpretation of negotiated sales, maintaining that a negotiated sale is a new franchise offer requiring its own registration. California regulators first articulated this strict interpretation in the mid-1980s when they added Regu-lation 310.100.2 to the California Franchise Investment Law. Among other things, Regulation 310.100.2 required franchisors to file a 'Notice of Negotiated Sale of Franchise' with the California Department of Corporations within 15 business days after consummating each negotiated sale and to include a copy of all Notices in the offering circular that it delivered to new prospects during the following 12 months, thus creating a public record of the franchisor's negotiating history. These extra burdens were on top of the franchisor's duty to comply with the five-business-day re-disclosure rule in connection with the negotiated sale itself. Regulation 310.100.2 was indifferent to the potential chilling effect that public exposure of the franchisor's negotiating record might have on the franchisor's receptiveness to negotiate its standard deal.

Recently, California's lawmakers took another look at the state's negotiated sales rules. While they could have liberalized California's approach to negotiated sales and brought California in line with every other jurisdiction that has considered the subject, regrettably they did not. Instead, California adopted Corpora-tions Code '31109.1, effective on Jan. 1, 2005, which amends the requirements for negotiated sales. California's failure to acknowledge the chill that its negotiated sales rules have had on a franchisee's ability to secure better contract terms is even more regrettable considering that California now addresses negotiated sales by statute, instead of by regulation, making fu-ture legislative reform more difficult.

Section 31109.1 exempts negotiated sales from the general registration duty when the franchisor complies with the following requirements: 1) the initial offer made to the prospect is the registered offer; 2) the prospect who negotiates receives a summary of all negotiated sales with California franchisees during the prior 12 months in a separate written appendix to the franchisor's offering circular, 3) the franchisor informs the prospect that it may request a copy of the negotiated terms of sales concluded during the prior 12 months, and 4) the negotiated terms, on the whole, confer additional benefit on the prospect. A franchisor that negotiates sales during the year must certify in its California renewal application that it has complied with the new section, which means that franchisors still must publicly disclose if they have negotiated franchise sales in the past year.

Section 31109.1 eliminates the post-sale Notice filing requirement of the former regulation, making it more difficult for prospects outside of California to discover the terms the franchisor may be willing to yield on. However, by requiring franchisors to deliver 'a copy of the negotiated terms,' a franchisor may now have to disclose far more about its negotiating history than before when summary disclosures sufficed. Section 31109.1(b) does not explain what is meant by delivering 'a copy of the negotiated terms' and if the franchisor must share a copy of the actual executed amendment or interlineated franchise agreement that reveals the identity of the franchisee.

California's approach to negotiated sales is a far cry from the FTC's liberal view that franchise sale regulations should not impede parties from negotiating the franchise agreement and seeking the best deal possible. Section 31109.1 worked its way through the California legislature in 2004 around the same time that the FTC issued its Staff Report in August 2004 on the proposed revised FTC Rule. Because of the timing, California lawmakers may have had no chance to be influenced by the Staff Report's more liberal attitude toward negotiation of franchise agreements.

Unfortunately, California's new negotiated sales statute does not benefit all franchisees seeking to buy a franchise in California equally, only those that succeed in their effort to draw the franchisor into negotiating the terms of the registered franchise agreement. A prospective franchisee who believes that the law forbids negotiation or is misinformed by the franchisor to that effect, or who assumes that all franchise offers are take-it-or-leave-it propositions and therefore never initiates the negotiation process, is not entitled to any disclosure about previously negotiated terms. Only the prospect who negotiates changes to the franchise contract is entitled to receive a 12-month summary of prior negotiated sales and to ask for the actual negotiated terms. Therefore, the larger franchisee with negotiating leverage can discover the franchisor's negotiating history and use it advantageously; the textbook 'mom and pop' franchisee is left uninformed.

Franchisors may fairly criticize the new statute, which injects a new level of uncertainty about negotiations by limiting the exemption from registration to those negotiations that, on the whole, confer additional benefits on the franchisee. While the proposed revised FTC Rule can be similarly criticized for eliminating the re-disclosure duty only when contract negotiations result in changes that solely benefit the franchisee, unlike the situation in California, a franchisor complying with the revised FTC Rule will not be asked to expose its negotiating history to future prospects.

Negotiation is a 'give and take' process where it is sometimes unclear if the overall exchange leaves a party better off. For example, a franchisee that succeeds in eliminating a post-term non-compete provision may be required to accept as a fair quid pro quo delivering additional personal guarantees or something else that, standing alone, is not advantageous. Who, but the franchisee willing to make the deal, should say if the negotiated changes, as a whole, confer additional benefits? Parties often seek specific terms for very personal reasons, leaving one person's idea of a better deal very different from another's. If a franchisee accepts the negotiated deal, why should California law permit that franchisee later to challenge the sale on the basis that, in hindsight, the negotiated changes did not, on the whole, amount to something better after all?

By carving out an exemption from registration for certain negotiated sales, the California legislature expects franchisors to register all other negotiated offers before consummating them. It is unclear what additional protections result from requiring franchisors to register a negotiated offer when a franchisee is willing to accept a negotiated deal that, on balance, may be a wash in terms of conferring additional benefits. A franchisee who negotiates in California still receives the benefit of the five-business-day re-disclosure rule, which protects the prospect against sharp sales tactics by giving the franchisee extra time to consider whether to accept or reject the negotiated offer. What more protection does registration of the negotiated offer afford? The Department of Corporations does not review the fairness of franchise offers; rather it requires franchisors to disclose that registration does not signify the Department's approval or endorsement of the franchise offer. So, what is accomplished by requiring a franchisor to register the negotiated changes before consummating the deal? Furthermore, who should have standing to complain if the overall negotiated deal does not confer additional benefits on a franchise buyer? Just the franchisee who goes ahead and enters into the negotiated sale? What about later franchisees who buy a franchise during the next 12 months? Will the duty to give new prospects who negotiate a copy of past-negotiated terms allow them to complain that a prior sale to someone else did not confer additional benefits and should not have been registered? None of these issues are addressed in new '31109.1.

With an infinite list of variations that can be made to any franchise agreement, new '31109.1 does little to encourage free negotiation of franchise contracts or dispel misconceptions that franchise agreements are not negotiable. Regrettably, California had the chance to follow the mainstream approach to negotiated sales and leave negotiation as a private affair between contracting parties, but opted not to do so.

California is the only jurisdiction to burden the negotiation process with extra regulations, so it is fair to ask, why is sunny California giving negotiated franchise sales the deep chill? No data show that franchise sales fraud is more prevalent in California than elsewhere in the United States. With laws like '31109.1, the impression that franchise agreements are adhesion contracts may be borne out not just by an unleveled playing field, but also by legislative obstacles to negotiation.

Rochelle B. Spandorf is a partner in the Los Angeles office of Sonnenschein Nath & Rosenthal LLP, and she can be contacted at 213-892-5036 or [email protected]. Beata Krakus is an associate in the firm's Chicago office and can be contacted at 312-876-8246 or [email protected].