How to Divorce Your Master Franchisee

How to Divorce Your Master Franchisee

Despite the best of intentions by both parties, and all of the investment they make in successfully expanding a brand in a new market, a significant number of master franchises don’t meet the parties’ goals, and the Master Franchise Relationship (hereafter “MFR”) must be unraveled.  Although international franchising professionals estimate that as many as 80% of international franchise relationships of US-based franchisors with foreign franchisees are MFRs, no definitive statistics are currently available.

Lawyers have always urged their franchisor and franchisee clients to focus on an exit strategy when negotiating a franchise relationship, but many MFAs reflect only a partial understanding of the factors that must be addressed at the end of an MFR.  That is not surprising.  Common law lawyers, in particular, learn about legal issues by studying legal decisions.  To the extent that failed international MFRs end up in dispute resolution proceedings, they are usually addressed in arbitration proceedings, which tend to be confidential, unreported or both.

Each MFRs is different.  Each begins and ends for different reasons and at different points in its development.  Thus, the size, financial capabilities and experience of the master franchisee (hereafter “master”) and franchisor, the proximity of the two to each other, the number of subfranchisees involved, applicable laws, etc. will all affect how the parties can and will end their relationship.  So, rather than address those variables, which often determine the outcome of relationship ending, this article focuses on the common relationships and situations in which the parties find themselves.

Intellectual Property

MFAs establish many rights and duties for masters.  As de facto franchisors in their territories, which are often one or more countries, masters are granted the right to use and sublicense their franchisor’s trademarks, know-how and other intellectual property (“IP”) in a territory.  IP protection is typically the first concern a franchisor should have when an MFA ends.

MFAs usually require Masters to enter into numerous contractual relationships in the territory, most of which require ongoing performance.  At the end of a MFR, what happens to each of the contractual rights and duties?  What happens to payments collected by or past due amounts owed to or by the master?  These are critical issues that are often underappreciated at the outset of an MFR.

MFAs may be subject to termination or nonrenewal notice requirements imposed by contract and by applicable laws.  Termination notices usually are only sent after one or both parties are so frustrated with each other that they no longer have many, or any, aligned interests.  Anticipating what can go wrong during the period between the date a termination notice is sent and its effective date is an essential goal of an MFA.

Protecting the Franchisor’s IP Rights

Because its IP is the principal asset of most franchisors, once a notice of termination is sent, a franchisor’s first concern should be how to protect its IP rights.2 Typically, the franchisor has given the master access to its operations manuals, training programs, marketing and advertising plans, and network financial performance.  The master will have acquired trade secrets relating to operation of the franchising program within the territory, including a plethora or information about each franchisee’s business, supplier contracts, advertising and marketing plans, to name a few.

The franchisor will want the master to discontinue all uses of the IP and to refrain from disclosing or using confidential information.  A master may be willing to walk away from the MFA, but many masters will own company-owned outlets or want to continue in business under a different brand, perhaps with the franchisor’s subfranchisees.  These masters will resist having their investments and capital undermined by the former franchisor.  What is the solution?

Some franchisors may be willing to allow a master who agrees to discontinue using the franchisor’s trademarks to continue to use certain other IP rights after the relationship ends.  That may avoid expensive litigation over who actually owns certain proprietary information and trade secrets.  But franchisors that adopt this approach need to be able to verify that the master and its subfranchisees are actually no longer using the IP they have committed not to use.  Usually, the only way to know if a master is complying with IP restrictions is to retain right to inspect the former master’s business and its records.  Will a master agree to give these rights to its former franchisor?  If the franchisor does not pursue the right to police the ongoing use of its IP in the territory, it may risk exposure to claims that it has lost the right to protect its trade secrets elsewhere.

Franchisors often use post-term noncompete covenants to protect their IP following a termination.  Masters making large investments, including those who convert an existing brand to a franchise, will frequently not agree to post-term noncompete covenants.  Even if they do so in MFA, in some countries, noncompete covenants are unenforceable under applicable laws, especially when a franchisor no longer has operations in a country.

During MFA negotiations, master prospects sometimes demand that franchisors pay them for the value of their businesses when their MFA terminates.  However, many franchisors have neither the assets nor the management depth to acquire a business in a distant country, even if they wanted to.  Ideally, the parties will agree on the parameters for dispute resolution at the outset of their relationship.  Still, each party will usually undertake risks that they would prefer to avoid.

What Happens to Contracts the Master Has Executed?

Consider some of the more common commitments a master makes in the operation of its business, and what would happen if the master could no longer perform them because of a termination.

1. Subfranchised Agreements.  Normally, only the master and a subfranchisee are parties to a subfranchise agreement.  If the master can no longer perform its obligations to subfranchisees, how are subfranchisees’ claims to be addressed?  Do the MFA and subfranchise agreements grant the franchisor the right to terminate, assume or assign subfranchise agreements upon the termination of a MFA?

2. Multiunit franchise agreements and option agreements.  The master may have agreed to grant future franchises in exchange for the payment of area development or option fees.  What happens to the holders’ rights and to the payments they have made for the rights when a MFA terminates and the Master can no longer grant subfranchises?

3. Advertising funds.  The master may have established an advertising fund, collected fees from franchisees, and made commitments to advertising and promotional organizations.  What happens to these agreements and the funds collected by the master and funds owed to the fund or to other contracting parties upon termination of an MFA?

4. Company-owned units.  The master will usually own and operate one or more company-owned (franchised) units in the territory.  What happens to them when the MFA terminates?

Damage Control Following a Termination Notice.

Not only are each of the master’s contractual obligations described above called into question when a termination notice is delivered, even if the MFA has addressed the parties’ rights under those circumstances, uncertainty usually affects everyone associated with the franchise brand in the territory.  Subfranchisees and other contracting parties will demand to know what will happen to them and their investments.  The master will move to protect its investment.  Franchisors must be prepared to promptly address each of the issues when they send a termination notice.

Everyone associated with the brand will be concerned with the publicity surrounding the break.  So, franchisors will want the right to control communications relating to the brand, and masters will want to place their own spin on developments.

Franchisors should have a contractual right to stop the master from entering into any new agreements or making any new commitments on behalf of the brand without the franchisor’s prior approval once it has received a termination notice.

Most of these issues can and should be addressed in the MFA.  But a contract cannot contemplate all of the issues that may arise, and the parties should strive for a good faith resolution that preserves the interests of both parties, to the extent possible.  Unfortunately, human nature being what it is, the parties will often turn to legal counsel to both understand their rights, and for help in achieving what is possible only after many problems could have been avoided.

ABOUT THE AUTHOR

Carl E. Zwisler is an internationally acclaimed franchise lawyer who has written a book and presented dozens of programs throughout the world on all facets of master franchising.  He represents franchisors and master franchisees from the Washington, D.C. office of Gray Plant Mooty.
He may be reached at Carl.zwisler@gpmlaw.com

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