Revisiting Franchise Agreements In Light Of COVID-19

By Michael Gray
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Law360 (April 2, 2020, 4:21 PM EDT) --
Michael Gray
Michael Gray
Even though franchisors are in the middle of dealing with closed locations, modified operating procedures, supply chain disruptions and employment turmoil, it is not too early to review standard franchise agreement provisions in light of what we have learned from the COVID-19 pandemic.

Whether or not franchisors have completed their annual registration renewal process, franchise disclosure document amendments could occur in the near future with potential revisions to Item 8 supply issues, Item 19 financial performance representations, or Item 20 tables relating to location closures. 

If franchisors have not completed this year’s renewal, or amendments are required, the following are some standard franchise agreement provisions that merit review and potential revision for new sales going forward.

1.  Franchise Fees 

With diminished sales and percentage franchise fees, it may be worth considering a minimum monthly royalty not tied to sales. It can stabilize cash flow and incent franchisees to remain open, if that is an option. In addition, if the franchisor does not collect fees by automated clearing house or electronic funds transfer, it should consider adding this as a mandatory payment method to minimize disruption of royalty fee payments.

2.  Franchisee’s Obligations

If the language in the standard franchise agreement does not address the franchisee’s operational obligations in extraordinary circumstances such as a national or local emergency or pandemic, consider whether adding such language makes sense for your system. Make sure that the franchise agreement gives the franchisor the right to make operational changes via the operations manual and that the franchisor is not required to apply the changes uniformly, depending on the circumstances.  

For example, depending on the nature of the franchised business and the local emergency, locations may be authorized to remain open even if other types of businesses are ordered closed. In the current situation, gas stations, convenience stores, health care franchises, cleaning companies and others may be designated as essential by local, state or federal authorities.  

How does the franchisor want the franchisee to respond in these situations? Can franchisees close down even if designated as essential? Silence in the contract creates uncertainty and confusion. Franchisors should also review their “health and safety” provision to make sure that it covers national or local emergencies and requires the franchisee to comply with legitimate governmental directives. 

3.  System Standards

Given the infrequency of such occurrences, it is unlikely that standard franchise agreement language regarding the franchisee’s obligation to comply with system standards includes an exception for national emergencies or a pandemic. In these situations, does the franchisor want to reserve the right to specify acceptable deviations from system standards? What will be the procedure and how will the franchisor communicate the new standards to the system? 

Franchisors should consider adding similar language to supply chain provisions, making it clear that the franchisor has the power to designate alternative suppliers in exigent circumstances, which may include regional variations.

4.  Comply With All Laws  

In some parts of the country, franchisees are subject to multiple pronouncements from local, state and federal authorities regarding operational restrictions. Many franchisees are reaching out to their franchisor for direction on how to proceed. Now is the time to review and edit the “comply with all laws” provision to make clear whether these governmental pronouncements are within the scope of the clause and therefore mandatory, or should be excluded for reasons particular to the nature of the particular system.

If the franchisor wants the right to require franchisees to comply with governmental or agency “recommendations” during a time of crisis, the agreement should give it that power explicitly. Also, consider a notice provision requiring franchisees to notify the franchisor of any local pronouncements. It will help franchisors stay informed at a local level.

5.  Termination  

Not all franchise agreements include a provision allowing the franchisor to terminate the franchise agreement for failing to comply with local, state or federal declarations during a state of emergency or pandemic. If the “obey all laws” clause does not include specific language relating to these situations, there may be no breach of the franchise agreement if a franchisee ignores government declarations. 

The termination provision should make it clear that failing to comply with legitimate government directives during a time of crisis is a default. Depending on the applicable state law, consider whether such a breach is curable or grounds for immediate termination.

6.  Invention Assignments

Creative franchisees find a way to be successful in difficult times. Many develop unique processes, procedures, products and methods to overcome adversity and stay in business. No doubt, countless franchisees are developing ways to keep their businesses operating despite the challenges presented by COVID-19. Some of these methods of operation could become the “new norm” in the future. 

If the franchise agreement does not have a provision whereby the franchisee automatically assigns these new “inventions” to the franchisor, it may be difficult for the franchisor to adopt them and roll them out to the entire franchise system. Adding such a provision could eliminate disputes about who owns the “invention” in the future.

7. Insurance

With all of the recent focus on business interruption insurance issues, consider whether to make a business interruption endorsement a mandatory part of the franchisee’s insurance requirements. Go further by providing franchisees with the specific language for the endorsement to ensure proper coverage and allow the franchisee to present the language to their insurance broker or carrier. As long as the franchisor is revising the insurance requirements in the franchise agreement, it is imperative to make sure that the franchisee’s policies name the franchisor as an additional insured through a separate specific endorsement, not just on the certificate of insurance.

8.  Force Majeure  

Largely ignored by everyone until COVID-19, the force majeure provision must be scrutinized with the help of counsel. Anecdotal evidence indicates that newer franchisors simply used what previous franchisors used in their standard agreements without analyzing the efficacy of the language. Because there is no standard legal definition of the term “force majeure,” it is critical that the language of this provision specify the circumstances under which either party is free from performing under the franchise agreement. 

From the franchisor’s perspective, the scope should be limited to instances where performance is impossible for unforeseen and unavoidable reasons beyond the parties’ control. Whether to draft a more specific provision designating the events or conditions that must occur before performance is excused is a function of the franchise business and what makes sense in that context. 

In this regard, the franchisor should determine the scope of what performance is excused when a force majeure event occurs. Are all obligations relieved, or is the franchisee still required to do things such as make reports, continue advertising, answer the phone, etc.? Also, make sure that the force majeure clause is bilateral and not just applicable to the franchisee’s performance obligations.

Conclusion

Let us sincerely hope that COVID-19 is an isolated event that will not repeat itself anytime soon. However, history tells us otherwise. As long as franchisors are in the middle of the registration season, or will be amending in the coming months, time spent addressing these contract provisions can bring clarity to the franchisor and franchisee’s obligations in times of crisis.   



Michael R. Gray is a partner at Lathrop GPM LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

For a reprint of this article, please contact reprints@law360.com.

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