Franchise disputes and exits

Franchises have become increasingly common in an era where brands dominate. Franchisors tend to very tightly regulate and control permitted actions of the franchisee. It’s very likely the franchisee will have invested a significant amount of money to buy into the franchise  with the result that their expectations of support and success are high.

The current covid-19 pandemic are likely to add another dynamic to franchise problems and disputes. Previously strong brands with franchise values may see that value diminished and franchisees might have even less ability to run their business in a way which facilitates recovery as the pandemic eases.

So, what are the reasons for franchise disputes and potential options for disgruntled franchisees?

The starting point –  franchise agreement

If you’ve ever tried to negotiate on a franchise agreement you’ll know that franchisors are very resistant to attempts to changes their standard franchise which are generally drafted strongly in favour of the franchisor.

Most franchise agreements include few obvious ‘get out’ clauses for franchisees and are light on actionable commitments or targets to be complied with by the franchisor. It is extremely rare for a  franchise agreement to include a termination provision allowing the franchisee to end the agreement early.

This means a franchisee seeking to exit a franchise before the end of the term will need to do so on the basis of a common law breach of contract. However, any obligations on the part of the franchisor are usually very carefully drafted to avoid giving the franchisee the right to terminate for fundamental breach.

Certain breaches of a franchise agreement are more likely to give the franchisee the right to terminate than others. For example, where no manual is supplied, no training is given or no support is offered by the franchisor, the franchisee is likely to have a strong argument that the agreement can be terminated.

However, this is not common, as the agreement will usually give the franchisor the right to ‘remedy’ any obligations they have failed to meet rather than allowing the agreement to be terminated.

 Misrepresentations made before franchise agreement

The most frequently used legal ground for claiming a right to rescind (cancel) a franchise agreement is misrepresentation. The law recognises 3 types of misrepresentation – fraudulent, negligent and innocent. The distinction is significant because most franchise agreements include a provision which attempts to exclude liability for misrepresentation, but it is much more difficult to exclude liability for negligent and fraudulent misrepresentations than innocent misrepresentation.  That said, even innocent misrepresentations can sometimes give a franchisee the right to terminate if they relied on a representation which turned out to be untrue.

The most important elements of misrepresentation are that there must be a misrepresentation of an existing fact (rather than an opinion or a guess about the future) and that the misrepresentation caused the franchisee to enter into the Franchise Agreement. In our experience, this most often happens where franchisors have made exaggerated claims about the financial performance of the franchise.

Derogation from Grant

Another argument franchisees might employ in a franchise dispute is that there has been a ‘derogation from the grant’ instigated by the franchisor. If a franchisor has agreed to confer a particular benefit to the franchisee (for example, the exclusive right to trade in a particular area), then they must not do anything which substantially deprives the franchisee of enjoying that benefit, because they would effectively be giving with one hand and taking away with the other. It is very common for franchise disputes to include a claim that the franchisor has derogated from the grant of a franchise.

Trading Schemes Act 1996

This act was intended to police pyramid schemes, but it can affect franchises as well. If a franchise is caught by the act it must conform to certain regulations, with the penalty for non-conformance being the termination of any affected contracts. The act and the regulations are very complex, and specialist advice should be taken if you are seeking to rely upon them, but this can be a useful tool to those seeking to escape a franchise agreement.

A franchise will not be caught by the act if it is a 2 tier system (i.e. just the franchisor and the franchisees, with no intermediate parties) or if all the UK parties are VAT registered. This is why many franchise agreements only come into force once the franchisee is VAT registered, and will immediately terminate if that registration lapses or is revoked.

Negotiated exit from franchise

However aggrieved you may feel as franchisee with your position and financial outlay, you may reach the commercial decision that you don’t want to throw good money after bad. Disputes in the courts are very expensive and inherently risky, and the unfortunate reality is that the franchisor is likely to be a business with considerable resources to devote to litigation.

Notwithstanding the fact that franchise agreements rarely include exit clauses, it’s also true that in many cases a franchisor does not want to retain disgruntled franchisees. This can create reputational and brand damage risks for the franchisor, so there may be an opportunity to negotiate. The negotiating position of a franchisee may be better if that franchisee has little more to lose. For example, if the  franchisee is a limited company created for the purpose of taking up the franchise, there is very little personal risk to the individual who operates the business, and so they are likely to have a better negotiating position.

Expiry of the Franchise

Franchise Agreements typically last for 5 years, with the franchisee having the option of renewing for a further term if they have not committed any material breaches of the agreement. The franchisor is likely to insist upon a new franchise agreement before the new term begins.

Trading in breach of franchise agreement

Where franchisees see little obvious benefit from the franchise, they may be are tempted to trade in ways which breach the strict terms of the agreement. For example , they might use unauthorised marketing activities, or offer services or goods which are not permitted in the franchise agreement, or fail to disclose revenues which may trigger payments to the franchisor. However, franchisees should be very wary of doing any of these things, as they are likely to give the franchisor a right to claim damages from the franchisee. If in doubt, seek advice. 

Post termination restrictions

You may find yourself in a situation where your franchise has been very successful. It provided you with a springboard to build a business, and that business now revolves largely round your own hard work in building up a great reputation with customers and others. You no longer really need the brand backing and your agreement is scheduled to expire. All great. You’re ready to go it alone. Except that almost all franchise agreements include post termination restrictions on running a rival business outside the franchise even if you have committed no breach.

On the face of it, such restrictions, if included in your contract, are legally binding. However, you may have grounds to challenge such restrictions and there may be legal grounds for doing so. We are experienced in these situations so please do get in contact to discuss.

Group action tactics

We have said that franchisors are reluctant to make changes to their standard agreements. They don’t want to keep track of who is entitled to bespoke arrangements, and instead want everyone to be on the same set of terms. This means that if a franchisor is in breach of your franchise agreement, they are quite likely to be in breach of everyone else’s as well.

There is strength and safety in numbers, so a sensible first action in a  dispute situation might be to ask your fellow franchisees if their experiences are the same as yours and if they would be willing to join in any action you take against the franchisor.

Be careful not to be seen as an instigator of trouble; if your claim has no basis, attempting to ‘turn’ franchisees may be a breach of your own agreement which would entitle the franchisor to claim damages.

Covid implications for franchise disputes

Coronavirus and its resulting lockdown have affected all businesses, particularly in the hospitality and catering sectors where franchises are common. Franchisees may be searching even more urgently for a way out of their existing agreements.

We have written elsewhere about force majeure and frustration as possible protections against contractual liabilities during this time.  Whether it applies to the coronavirus depends entirely on how the particular clause is drafted. Most franchise agreements contain a force majeure clause which delays the performance of obligations, and gives parties the right to terminate only if the force majeure event continues for many months.

Frustration is another possibility with a franchise. However, courts are reluctant to find that a contract has been frustrated, and will usually construe the doctrine very narrowly.

As an alternative to a dispute about force majeure or frustration, if the franchise is currently unable to trade due to covid, you may be able to freeze payments which would otherwise be due. Care and caution are needed and we can help. 

How can Gannons help?

Successful franchises benefit both parties, and it is possible that any problems or disputes can be solved with frank and honest discussion between franchisor and franchisee. Where no compromise is possible, legal advice is essential if parties are to avoid contractual traps. Gannons are experienced in all types of contractual dispute, and we are happy to talk you though your situation to find a way to get the best resolution.

Alex Kennedy

After studying at Cambridge University, Alex spent 5 years with an international law firm before joining Gannons. He specialises in high-value and complex commercial disputes and employment law.

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