In the most basic sense, a franchise is a business model wherein a trademark holder licenses the use of its intellectual property, along with its method of business operation, to a licensee for a fee. In that relationship, the owner of the mark is the ‘franchisor,’ while the licensee is a ‘franchisee.’ The relationship between the two is typically memorialized in a contract known as a franchise agreement. Not all trademark licensing agreements establish a franchisor/franchisee relationship, but those that do must comply with both federal and state law, as applicable.
The question focused on here then, is what a franchisor or franchisee should do when either party violates the franchise agreement. In determining the legal rights and obligations of the respective parties, the first place to look is, of course: the franchise agreement. A well-drafted franchise agreement will contain the appropriate dispute resolution procedures, of which both franchisor and franchisee should be aware.
For example, the agreement will lay out how a notice of a default must be given and how much time either party may have to cure that default. Short of involving a formal process, however, the parties should first communicate with one another about the perceived default, why it has occurred, and how the default can be rectified.
In practice, it is often the best option for all involved if the franchisor and franchisee can work together to resolve any disagreements which may arise. Generally, cooperation and communication can be the path of least resistance. More, determining how to deal with the default can be a crucial consideration, because not only will the relationship between the franchisor and franchisee be affected, but also, communication can help avoid undue business disruptions – or worse, damage to the brand.
Moreover, an informal resolution achieved through open, productive communication with the franchisee can keep costs down for everyone involved. For example, a franchisee in default can be counseled how to better follow the franchisor’s system, offered additional training, or additional support to ensure compliance with the system. In the alternative, a franchisor may learn of some of the struggles a particular franchisee is facing or even identify a larger systemic problem that if approached correctly, can benefit not only that franchisee, but the system at large.
Notice of Default
If open communication does not resolve the problem, the parties must follow the procedure outlined in the franchise agreement. Typically, the first step a franchisor will take is to issue a Notice of Default, which will set forth the breaching conduct and the time in which the franchisee may cure the defect.
Often, “formalizing” the process is sufficient to obtain compliance from a franchisee. However, if the franchisee does not cure in the time provided, the franchisor may issue a Notice of Termination. Once the Notice of Termination is issued, the franchise agreement will typically set forth post-termination obligations on the franchisee, such as ceasing operations, returning operations manuals and other, branded materials and removing all signage (“debranding”), non-compete provisions, final accountings, and other measures designed to protect the franchise system. The reality of this is enough to encourage, if not force compliance.
In practice, an attempt to terminate a franchisee before the franchise agreement expires (or failure to renew) may well lead to a dispute. Therefore, it is critical to know the limitations imposed by the franchise agreement on the parties’ respective remedies. Typically, a well-drafted franchise agreement will include choice of law provisions and a forum selection clause which is intended to benefit the franchisor. The franchise agreement may also include a covenant to use a chosen, alternative dispute method to litigation, like mediation or arbitration, and set forth a roadmap the parties mutually agree to follow.
Mediation/arbitration provisions should be carefully crafted to maximize the parties’ understanding of the roadmap. Mediation has become more and more utilized in franchise disputes – for obvious reasons. Mediation is an “informal” meeting of the parties with a third party neutral party that is hired to help the parties work through a dispute to resolution. Mediation can help limit costs, time, and the public embarrassment that litigation may invite. Also, mediation is confidential by its nature, permitting the parties to speak more openly and freely than they might if they are trying to work through a dispute on their own.
Arbitration
Arbitration is also often used in franchise agreements to limit the party’s access to the courts to resolve a dispute. Often, arbitration is touted as a more efficient, streamlined approach to dispute resolution. Arbitration is typically completed more quickly than trial, with motion practice is typically kept at a minimum. In general, the parties can often control their own schedule with far greater precision than may be available in state and federal courts. However, arbitration hearings can be virtually identical to preparation and execution of a litigation matter and thus, it is critical to understand the scope of any arbitration provision and the economic impact if arbitration is required.
The best practice is, of course, to have a well-drafted, thorough franchise agreement, which properly identifies how defaults will be handled – and to have strong operations and oversight to ensure that defaults do not occur. This will help protect the franchisor, but also the system at large considering that each franchisee is dependent on the other franchisees in the system to maintain the brand standards and ensure the best customer experience.
How to Navigate Franchisor/Franchisee Disputes
Know Your Franchise Agreement: thorough understanding of your rights/obligations under the franchise agreement is crucial to both maintaining a positive relationship between franchisor and franchisee, but also so both parties know what they should expect from the other’s performance.
* Keep lines of communication open: When the franchisor and franchisee are able to openly discuss issues, in many cases a problem can be quickly and inexpensively resolved
* When talking doesn’t work, follow the franchise agreement’s notice requirements: Your franchise agreement will dictate how notices are sent and when, and what the parties must do to cure. A formal letter can often resolve a situation where regular communication cannot.
* Follow the dispute resolution plan: Your franchise agreement may require the parties privately mediate disputes before moving forward with litigation/arbitration. You should use this mechanism because it may narrow the scope of dispute and keep costs in check
* When all else fails: Some disputes cannot be resolved amicably or through mediation; be sure to know whether your franchise agreement requires arbitration, whether there is a forum selection clause or choice of law provision, and whether and under what circumstances a party may be obligated to bear the other’s costs.
ABOUT THE AUTHOR
Justin M. Klein is a founding partner of Marks & Klein, LLP, a nationally recognized franchise law firm. Steven T. Keppler is a commercial litigator with the firm whose practice focuses on contractual interpretation and business torts in franchise law. More information can be learned about Marks & Klein, LLP at www.marksklein.com or by emailing info@marksklein.com
