In 1980, California adopted the California Franchise Relations Act (CFRA). It established a good cause standard for termination of a franchise, and set out conditions under which a franchisor could refuse to renew a franchise. However, it did not address franchisors’ right to prohibit franchisees from selling their franchises to third parties.
As of January 1, 2016, franchises granted or renewed after that date in California will be subject to an amendment to the CFRA, which establishes a “substantial compliance” standard for termination, and creates unprecedented obligations for franchisors when they terminate or refuse to renew franchises in compliance with the laws. It also requires franchisors to apply written standards if they disapprove transfers of franchises or of ownership interests in franchisees that are business entities.
The Termination Standard
AB 525 modified the definition of “good cause,” which is a condition of a lawful termination. “Good cause” is “limited to the failure of the franchisee to substantially comply with the lawful requirements imposed upon the franchisee by the franchise agreement….” Advocates of the new law argued that a substantial compliance standard was necessary to prevent franchisors from terminating franchises for insignificant breaches. Franchisors argued that there was no evidence that courts were permitting terminations for insignificant breaches, and that the “substantial compliance” standard is only likely to lead to uncertainty, litigation and a diminution in the enforcement of operating standards.
The Repurchase Requirement
For the first time anywhere, when a franchisor terminates a franchisee in compliance with the applicable law in California, if the franchisor “restricts the right of the franchisee to control the principal location of the franchise business,” the franchisor must purchase virtually all of the franchisee’s business assets for the franchisee’s purchase price, minus depreciation. The franchisee must deliver clear title to and possession of the assets to the franchisor. The franchisor may set off, against amounts to be paid to the franchisee, amounts the franchisee owes to the franchisor.
Because of the scarcity of good franchise locations in California, franchisors in the foodservice and retail sectors have often subleased locations to franchisees, executed conditional lease assignment with franchisees and their landlords, giving the franchisor the right to step into the franchisee’s position if the franchisee defaults under the franchise agreement or lease, or used post-termination purchase options giving the franchisor or its designee (often another franchisee) the right to acquire the franchisee’s business assets for their fair market value.
In California, post termination non-compete covenants are generally not enforceable, unless the franchisor purchases the franchisee’s business. Moreover, post termination claims of franchisors for lost future profits have been held unenforceable by a California Court of Appeal when a franchisor terminates a franchise because a franchisee has failed to pay fees owed. So, franchisors that hope to recoup their investment in establishing a franchised unit or control the premises from which their franchisees have operated have frequently used post-termination purchase options to acquire a former franchisee’s assets and keep the location as a part of the franchise network. Under AB 525, if a franchisor does not allow a terminated franchisee to stay in business selling the same products and services that were sold pursuant to a franchise, at the same location, the franchisor must buy the franchisee’s assets in the manner outlined in the law.
However, because the law’s purchase requirements and standards are vague and subject to many interpretations, it is unclear whether a franchisor’s customary terms of a purchase option granted in a franchise agreement will survive a challenge by franchisees in the courts.
If a franchisor terminates or refuses to renew a franchisee in violation of the CFRA, the franchisor must pay the franchisee “the fair market value of the franchised business and franchise assets and any other damages caused by the violation. . . .” The law does not define “franchise assets” or whether they are components of a “franchised business.”
AB 525 also requires franchisors to deliver written standards for approving “new or renewing” franchisees to franchisees that notify a franchisor of their desire to sell or transfer their franchise business or an interest in the company that owns a franchise business. The right to deny approval of a transfer is dependent upon the franchisor’s decision being based upon those standards, and its ability to establish that those standards have been “consistently applied” to similarly situated franchisees of the same brand. Moreover, one section of AB 525 suggests, but does not expressly require, that the transfer standards applied by a franchisor be “reasonable.”
Because no other law has required franchisors to identify all of their standards for approving new or renewing franchisees, or transferees, and because most franchisors may have only sketchy records of reasons for denying approvals in the past, this section of AB 525 is also likely to lead to litigation and, to franchisors that fear litigation, accepting transferees that they believe are unqualified.
AB 525 will require all franchisors doing business to reevaluate their franchise agreements, operations manuals and termination and transfer practices.
Carl Zwisler, IDI franchising country expert for U.S.A.