Counseling Franchises During the Recession

What are the franchisor's goals in this environment? Maintain or minimize loss of cash flow ' that might be survival mode for the franchisor, but at what cost to the franchise system? Maintain or minimize loss of market share ' that might preserve the franchise system, but at what cost to the franchisor? Maintain brand standards ' that might preserve the brand long-term, but it incurs costs, too. Can these goals be reconciled or balanced?

Role of Franchise Counsel

In determining how franchisors should adapt to these difficult times, significant pressures are being placed on the shoulders of franchise counsel to navigate through a thicket of legal issues. Here are some scenarios franchise counsel may need to confront.

Inability to Pay. How will the franchisor handle franchisees' failure or inability to pay? To what extent will the franchisor be willing to work with franchisees that are in financial difficulty? To what extent will the franchisor want to terminate at least some franchisees to maintain pressure on others to keep paying?

Financial Concessions. If the franchisor is prepared to make financial concessions on an individual basis, a number of issues will arise. In many instances, the franchisor will want to preserve the confidentiality of concessions due to concern that others will then ask for similar concessions. But how realistic is it to expect that confidentiality agreements will be effective? Can they be structured to enhance effectiveness (loss of benefits if they become known)? Also, bear in mind the disclosures about “gag agreements” under the new FDD guidelines. In connection with financial concessions, will debts be forgiven or deferred, and how will deferrals be handled (e.g., separate promissory notes)? Should the franchisor try to: a) obtain releases to cut off potential claims, and/or b) enhance collectibility of remaining payment obligations through personal guaranties, security interests, etc.? How will selective concessions comport with the franchisor's obligations under the anti-discrimination provisions contained in numerous state franchise laws?

Franchise Terminations. For franchisees chosen to be terminated, franchise counsel will need to very carefully consider to what extent a court may have greater sympathy toward the franchisee's desire to preserve his business and livelihood in these economic times. The franchisor will need to have adequate cause under franchise agreements and state franchise relationships laws, will need to have met all procedural requirements for termination, and will need to have its decision fully supported and documented in order to make a compelling case if the termination is challenged. Does the franchisor have a process in place to give the franchisee at least several opportunities to become current, lest the franchisor be perceived as acting precipitously or harshly? Will any public knowledge of financial accommodations with other franchisees further complicate any challenged terminations?

Breakaway Franchisees. The franchisor also will need to consider breakaways. How does a franchisor discourage franchisees who are having a difficult time getting through the recession from pulling down their signs and going independent to save the ongoing expenses of being associated with the franchise system? What if several franchisees band together in doing so? Does the franchisor select one or more of them for legal challenge, thereby setting an example to discourage others? What if franchisees file for bankruptcy as part of their effort to restructure their financial arrangements, and they legally reject their contractual commitments to their franchisors? Will the bankruptcy court allow the former franchisee to continue in business without regard to any post-term non-compete? Can the franchisor prevent the business from being sold as an independent?

Systemwide Issues. Should the franchisor be prepared to make systemwide financial concessions and adjust its financial model in an effort to preserve the entire franchise system? How can this be done without compromising the future financial health of the franchisor when the economy improves? Will the franchisor only do so when franchisee pressure becomes so great that there is no practical choice? How should the franchisor react to the formation of an independent franchisee association seeking to achieve a rebalance in the economics of the relationship ' engage the association or resist it? What are the legal constraints in dealing with such associations? How can a franchisee representative group effectively represent the entire system when it does not have the power to bind other franchisees to the concessions that the leadership finds acceptable? What if the franchisor finds that it's negotiating against itself, as other franchisees (or groups of franchisees) demand even more concessions?

Stalled Unit Developers. How should franchisors handle franchisees who are unable or unwilling to fulfill further unit development obligations? Do the current circumstances constitute force majeure, thereby excusing performance? Should the franchisor hold franchisees to their development commitments, or does the franchisor waive and defer development obligations (and on what terms)?

Sales Practices. Franchisors also need to consider franchise sales practices in this environment. Should the franchisor offer financial concessions to induce sales? Should the franchisor entertain negotiations on financial terms, such as initial and ongoing fee structures? Can this be structured in a way that these concessions come to an end when the economy turns around? Can the franchisor engage in these individual negotiations in states that have anti-discrimination provisions in their franchise statutes? What are the franchisor's legal obligations to disclose these concessions to other prospective franchisees or existing franchisees? How can the franchisor minimize the risk that franchise sales activities in this difficult environment will lead to further legal liability? Should the franchisor amend its disclosure documents in connection with any deterioration in its financial condition and/or deterioration in Item 19 financial performance representations?

Conversion Opportunities. If financing for new units is difficult to obtain, should the franchisor seek to convert franchisees from competitive chains? What are the limits on soliciting those franchisees without creating risks of tortious interference with their contractual arrangements with your competitors?

Conclusion

These are extremely trying times for all businesses, including franchisors, seeking to survive through this recession. It is imperative that franchisors demonstrate leadership in preserving their franchise systems, but fault lines undoubtedly will emerge. In this environment, much pressure will fall on the shoulders of franchisor's counsel to guide clients to achieve their goals.

Erik Wulff is a partner in the Washington, DC, office of DLA Piper LLP (US), and is the editor-in-chief of this newsletter. He can be contacted at [email protected] or 202-799-4271.

This deep recession is hitting virtually every corner of the economy. Some companies are faring better than others (McDonald's and Wal-Mart, just to name a couple), but there are very few companies that are not adversely affected in a significant way, including franchising companies of every stripe and size. Depending on one's particular industry or segment of industry, the effect may vary considerably. However, every company has to take stock of its business model and decide how it can best weather adverse conditions.

It is axiomatic that franchisors and franchisees need to work together to overcome the impact of the declining economy. Their success is deeply intertwined, and they are mutually dependent. Now more than ever, franchisors need to demonstrate leadership by making every effort to assist their franchisees. This might include redoubling marketing efforts to increase (or at least to maintain) sales levels, finding every way to cut operating costs without compromising brand integrity, providing effective training, and so on.

But history also shows that when faced with challenging times, fault lines will show in franchise systems and tensions will tend to rise. We have to acknowledge that there is an inherent financial tension in the franchise model, attributable to the manner in which franchisors and franchisees make money: Franchisors typically generate earnings from the franchisees' revenues, whereas franchisees seek to maximize their net income, regardless of the magnitude of their revenues.

What are the franchisor's goals in this environment? Maintain or minimize loss of cash flow ' that might be survival mode for the franchisor, but at what cost to the franchise system? Maintain or minimize loss of market share ' that might preserve the franchise system, but at what cost to the franchisor? Maintain brand standards ' that might preserve the brand long-term, but it incurs costs, too. Can these goals be reconciled or balanced?

Role of Franchise Counsel

In determining how franchisors should adapt to these difficult times, significant pressures are being placed on the shoulders of franchise counsel to navigate through a thicket of legal issues. Here are some scenarios franchise counsel may need to confront.

Inability to Pay. How will the franchisor handle franchisees' failure or inability to pay? To what extent will the franchisor be willing to work with franchisees that are in financial difficulty? To what extent will the franchisor want to terminate at least some franchisees to maintain pressure on others to keep paying?

Financial Concessions. If the franchisor is prepared to make financial concessions on an individual basis, a number of issues will arise. In many instances, the franchisor will want to preserve the confidentiality of concessions due to concern that others will then ask for similar concessions. But how realistic is it to expect that confidentiality agreements will be effective? Can they be structured to enhance effectiveness (loss of benefits if they become known)? Also, bear in mind the disclosures about “gag agreements” under the new FDD guidelines. In connection with financial concessions, will debts be forgiven or deferred, and how will deferrals be handled (e.g., separate promissory notes)? Should the franchisor try to: a) obtain releases to cut off potential claims, and/or b) enhance collectibility of remaining payment obligations through personal guaranties, security interests, etc.? How will selective concessions comport with the franchisor's obligations under the anti-discrimination provisions contained in numerous state franchise laws?

Franchise Terminations. For franchisees chosen to be terminated, franchise counsel will need to very carefully consider to what extent a court may have greater sympathy toward the franchisee's desire to preserve his business and livelihood in these economic times. The franchisor will need to have adequate cause under franchise agreements and state franchise relationships laws, will need to have met all procedural requirements for termination, and will need to have its decision fully supported and documented in order to make a compelling case if the termination is challenged. Does the franchisor have a process in place to give the franchisee at least several opportunities to become current, lest the franchisor be perceived as acting precipitously or harshly? Will any public knowledge of financial accommodations with other franchisees further complicate any challenged terminations?

Breakaway Franchisees. The franchisor also will need to consider breakaways. How does a franchisor discourage franchisees who are having a difficult time getting through the recession from pulling down their signs and going independent to save the ongoing expenses of being associated with the franchise system? What if several franchisees band together in doing so? Does the franchisor select one or more of them for legal challenge, thereby setting an example to discourage others? What if franchisees file for bankruptcy as part of their effort to restructure their financial arrangements, and they legally reject their contractual commitments to their franchisors? Will the bankruptcy court allow the former franchisee to continue in business without regard to any post-term non-compete? Can the franchisor prevent the business from being sold as an independent?

Systemwide Issues. Should the franchisor be prepared to make systemwide financial concessions and adjust its financial model in an effort to preserve the entire franchise system? How can this be done without compromising the future financial health of the franchisor when the economy improves? Will the franchisor only do so when franchisee pressure becomes so great that there is no practical choice? How should the franchisor react to the formation of an independent franchisee association seeking to achieve a rebalance in the economics of the relationship ' engage the association or resist it? What are the legal constraints in dealing with such associations? How can a franchisee representative group effectively represent the entire system when it does not have the power to bind other franchisees to the concessions that the leadership finds acceptable? What if the franchisor finds that it's negotiating against itself, as other franchisees (or groups of franchisees) demand even more concessions?

Stalled Unit Developers. How should franchisors handle franchisees who are unable or unwilling to fulfill further unit development obligations? Do the current circumstances constitute force majeure, thereby excusing performance? Should the franchisor hold franchisees to their development commitments, or does the franchisor waive and defer development obligations (and on what terms)?

Sales Practices. Franchisors also need to consider franchise sales practices in this environment. Should the franchisor offer financial concessions to induce sales? Should the franchisor entertain negotiations on financial terms, such as initial and ongoing fee structures? Can this be structured in a way that these concessions come to an end when the economy turns around? Can the franchisor engage in these individual negotiations in states that have anti-discrimination provisions in their franchise statutes? What are the franchisor's legal obligations to disclose these concessions to other prospective franchisees or existing franchisees? How can the franchisor minimize the risk that franchise sales activities in this difficult environment will lead to further legal liability? Should the franchisor amend its disclosure documents in connection with any deterioration in its financial condition and/or deterioration in Item 19 financial performance representations?

Conversion Opportunities. If financing for new units is difficult to obtain, should the franchisor seek to convert franchisees from competitive chains? What are the limits on soliciting those franchisees without creating risks of tortious interference with their contractual arrangements with your competitors?

Conclusion

These are extremely trying times for all businesses, including franchisors, seeking to survive through this recession. It is imperative that franchisors demonstrate leadership in preserving their franchise systems, but fault lines undoubtedly will emerge. In this environment, much pressure will fall on the shoulders of franchisor's counsel to guide clients to achieve their goals.

Erik Wulff is a partner in the Washington, DC, office of DLA Piper LLP (US), and is the editor-in-chief of this newsletter. He can be contacted at [email protected] or 202-799-4271.