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The trouble with success: a franchise litigator's perspective

06/09/2018

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United Kingdom

The franchisor/franchisee relationship is, in many respects, just like any other long term relationship.

From husband and wife, to best friends, even through to (perhaps less long-term these days) a football club and its manager, each party will change over the years and there will be challenges and tensions along the way.

Successful relationships which stand the test of time share the common traits of mutual respect, good communication, a convergence of interests, an appreciation of what drew the parties together in the first place and, perhaps most importantly, a willingness to kiss and make up.

Even the biggest and most successful franchise networks run into difficulties.
Take for example the recent supply chain issues at KFC and reports of franchisee discontent at Domino's Pizza Group (due to increasing supply costs and a push to increase the number of stores within existing franchised territories).

As dispute resolution specialists in the franchise sector, we are familiar with the types of tensions which can bubble away in the franchisor/franchisee relationship and which, if left unattended, can boil over and create an expensive mess (and at times, an existential threat) for a franchisor.

In this article we briefly consider four of the typical issues well established and successful franchisors face, and how to best handle or avoid them.

1. "I don't need you anymore"

Once a franchisee has established its business, and is turning over a solid profit, it is almost human nature for the franchisee to question why it is they are still paying royalties to a franchisor.

Some take that thought a step further.

We have advised franchisor clients on attempts by their franchisees to terminate franchise arrangements with a view to running the same or similar business under their own brand, without the pesky royalties.

The obvious franchisor answer: post-termination restrictive covenants.

Post-termination restrictive covenants are essentially contractual terms which prevent a franchisee doing certain acts after the franchise agreement is terminated.

Like preventing a franchisee running the same business under another brand.

Such clauses will usually focus on, amongst other things, preventing a franchisee from competing with the franchisor, soliciting existing customers or enticing employees away from the franchisor.

However, a franchisor does need to tread carefully when it comes to these types of clauses.

If a restrictive covenant acts as a restraint on trade, on the face of it at least, it is unenforceable. The exception to that rule is if the franchisor can show that the relevant clauses were designed to protect its legitimate business interests and that they go no further than necessary to achieve that purpose.

From a franchisor's perspective, it is imperative that their franchise agreements contain such restrictive covenants, and, perhaps more importantly, that the relevant clauses are pitched correctly so as not to be found unenforceable when needed most.

2. Enforcing franchise agreements overseas

Well established franchisors will always be mindful of possible new markets further afield.

International expansion can bring great rewards, however there are various pitfalls too.

These pitfalls largely fall in to two categories: commercial and legal.

To give a flavour, commercial considerations include the level of local government interference, different local customs and business behaviours, the capacity to extract profits back to the franchisor, practicalities like language barriers and timing and scalability issues.

And then there are the legal considerations.

One obvious, but extremely important example, is the differing local laws. Laws on competition, brand protection, pre-disclosure requirements and guarantees can be enormously different. Local advice is critical. Often the franchisor's standard franchise agreement will have to be tailored.

Enforcement is another problem we commonly come across. Take for example the following scenario.

Due to any one of the pitfalls mentioned above a franchisee abroad starts to fail. Royalties may not be paid. Non-competes ignored.

The franchisor terminates the franchise agreement however the franchisee ignores this and continues to trade (which is more common than you may think in certain countries).

The franchise agreement will likely enable the franchisor to enforce its post-termination restrictive covenants to stop the now terminated franchisee trading. This is done by way of an injunction through a local court. Local courts however, depending on the jurisdiction, have been known to refuse to grant the required Order until a court from the UK has first granted an injunction (on the basis that the franchise agreement is under UK law, for example).

This means the franchisor is faced with the cost of securing an injunction in the UK, then the cost of having that recognised by the local courts and finally having local authorities enforce it (if indeed the local authorities will do so).

The expense, practicalities and time burden in doing so can be hefty, all to stop one miscreant former franchisee.

There are, in some cases, ways around such drawn-out enforcement procedures.

For example, depending on the jurisdiction, the franchisor may be able to freeze the franchisee's assets via an injunction through the local courts for debts owed (rather than the broader injunction to enforce post-termination restrictive covenants). This can get the result the franchisor is after, stopping the rogue franchisee, without the added cost of UK proceedings.

Ultimately however, the best solution to most international expansion issues is painfully simple: get your ducks in a row prior to expanding and entering in to any agreements. Obtain clear advice (both legal and commercial) from seasoned advisors, and undertake thorough due diligence on any potential international franchisee.

3. The threat of a group

Reports indicate that 11 of the larger Domino's franchisees recently created the Domino’s Franchise Association UK and Ireland, in response to the concerns mentioned above.

Whilst this is a long way from becoming a litigious group action, it does act to highlight the commercial leverage a group of franchisees can create (and of course the corresponding threat that poses to a franchisor).

Well established franchisors by their nature tend to have numerous franchisees. Unrest or concerns from within the franchisee network can quickly escalate in to a group of franchisees forming, potentially to work against the franchisor.

Many a franchisor has spent sleepless nights worrying about such groups. And for good reason.

A well organised, committed group of disgruntled franchisees is possibly the greatest threat to a franchisor. That group has the potential to unpick the very fabric which the franchisor's business rests upon.

There are various strategies that can be deployed when faced with an unhappy group of franchisees working against a franchisor.

Ideally, the franchisor will be able to work with the group to iron out problems and avoid the dispute escalating further. They may however, be forced to take a more aggressive approach. For example litigating against individual franchisees to send a message and deter the other franchisees, or perhaps reaching agreement with key franchisees in a bid to break the group up.

The best approach of course, is to avoid the confrontation in the first place.

Perhaps ironically, the best way to do that is for the franchisor and franchisees to open a strong line of communication (potentially even by starting a committee that represents and speaks for the broader franchisee network) before issues arise. This allows the franchisor and franchisees to identify problems and resolve them, before they snowball.

4. Silence at renewal

This happens all too often.

After a successful initial term, both the franchisor and the franchisee forget (or ignore) the underlying contractual arrangement. The parties continue to operate as they have always done and the original franchise agreement is left to one side.

From a legal viewpoint, very generally speaking, it is likely in such a circumstance that the parties will have been deemed to have extended the original franchise agreement by conduct (also referred to as a franchise at will).

Ambiguity and uncertainty are the result.

Let's step the above example through a bit further to explain.

Months, or even years, down the track the franchisee decides to go it alone and operate independently of the franchise. Given the formal renewal process was not followed, the term of the extension and the trigger point for the non-compete provisions (such as a likely restriction on the franchisee not to operate a competing business) will be up in the air.

The franchisee will want to exit as quickly as possible, minimising or avoiding any non-compete obligations. The franchisor on the other hand will want the term to be as long as possible, and to enforce the non-competes.

And there you are; another avoidable franchise dispute.

How these issues are decided will depend on the facts in each case. Even then there is competing case law as to how the law is applied.

Take for example the trigger point for non-compete clauses for a franchise at will.

Previously, the High Court held in Flat Roof Co Ltd v Bowden [2009] EWHC 2894 (Ch) that post-termination restrictive covenants (including non-compete clauses) do not extend beyond their contractual expiry dates, even if the parties continue the franchise informally.

In PSG Franchising Ltd v Lydia Darby Ltd [2012] EWHC 3707 (QB) however, the High Court disagreed. Indeed it was found that Flat Roof did not represent a widely shared understanding of the legal position and that restrictive covenants applied with effect from the point where the parties' relationship had terminated (in that case, 17 months after the written franchise agreement had expired).

Until a higher court sheds some light on this issue, there will be uncertainty when it comes to non-compete clauses for a franchise at will.

The best approach therefore, is to use the renewal process to recalibrate the underlying contractual arrangements to bring them into line with the business relationship, and to document those in an updated franchise agreement.

Taking such steps is more than simply avoiding a future, potentially expensive, dispute. It is an opportunity for the parties to strengthen their relationship and ensure their intentions for the future are aligned.

Our final two cents

These are just some of the typical issues that lead to disputes and our involvement.

Arguably some are good problems to have (if there is such a thing). Certainly better than a failing franchise network and the associated issues that brings.

However, a good portion of the issues raised above can be avoided. Primarily through a well drafted franchise agreement and a genuinely open and frank line of communication with the franchisee network.

It is ultimately a matter of balancing the interests of both the franchisor and the franchisee (which are sometimes aligned, other times divergent). Take the recent Domino's example. The more the franchisor pushes to increase its profits (for example opening more stores), quite often, the more a franchisee's revenues suffer.

Finding a middle ground that means both are happy and profitable, is really what it is all about.

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