Excerpted from “It’s Not Over ‘Till It’s Over – Termination, Transfer and Renewal”, presented to the American Franchisee Association Legal Symposium, (1998) (Lake Tahoe, Nevada)
Business owners sell their businesses for many reasons – to profit from the sale of the equity in a successful business, to cut losses in an unsuccessful venture, or for personal reasons. In franchising, a franchisee who desires to sell will usually be required to obtain the franchisor’s consent to the sale, and to sign a release of the franchisor for any alleged misconduct occurring through the point of sale.
The franchisor’s contractual authority to veto a proposed franchise sale is one of several important limitations on the franchisee’s equity in the business – after all, if you can’t sell your business at the highest price that the market will bear, then what do you really own? From the franchisor’s viewpoint, this control is essential to maintain quality control over the franchise system. Not surprisingly, courts routinely uphold the franchisor’s express contractual right to approve proposed transfers, usually, however, subject to the implied covenant of good faith and fair dealing, which requires that the discretionary veto be exercised in good faith under a “commercially reasonable” test. There are reported cases where courts upheld the rejection of proposed franchise sales on the grounds that the sales price was to high, where the franchisor argued that the new franchisee would be overpaying and hence in a poor position as it began operating. If the franchisor can sustain that position under the commercially reasonable good faith standard, the franchisee cannot argue that the franchisor was motivated by a desire to punish the selling franchisee, as subjective motives are generally irrelevant under the implied covenant of good faith and fair dealing. To establish that a franchisor was in bad faith in withholding consent, the franchisee must essentially show that the franchisor was not acting to further its legitimate or reasonable business expectations – and expert testimony will probably be needed.
Proper conditions for the franchisor’s consent to a transfer.
The franchisor may properly condition its consent to a transfer on some or all of the following factors, usually without controversy: -- Payment of sums due and owing. If a franchisee has failed to pay royalties or is otherwise in default, it is reasonable to require those defaults to be cured before a transfer is approved.
-- Curing Other Defaults. Almost every franchisor can usually find some ground for declaring a default under some provision of the operating manual depending on how far the franchisor might go in purporting to apply its standards. Therefore, it is in the franchisee’s interest to negotiate for language providing that the franchisee must be in “substantial compliance” in order to proceed with the proposed transfer.
-- Payment of a reasonable transfer fee. The franchisor may collect a reasonable transfer fee, providing that fee was disclosed in the offering circular and provided for in the franchise agreement. It is possible to conceive of situations where the franchisee might object to a particular fee as so large as to be prohibitive, but to be declared unconscionable, the fee would have to “shock the conscience of the court” in most states.
-- The financial qualifications, and other qualifications, of the transferee. Most courts would recognize the franchisor’s right to qualify the transferee under reasonableness standard. Qualifications include sufficient net worth and operating cash, to preserve the financial viability of the system, other qualifications as if the transferee was seeking to buy a new franchise directly from the franchisor (business experience, if required for new franchisees; personal commitment; willingness to undergo training etc.)
-- The transferee must not have “negative qualifications.”
For example, it is reasonable to disapprove a transfer to a competitor of the franchise system. While this seems obvious, it is an important limitation on the ability to transfer a franchised business as compared to the ability to transfer a non-franchised business – which are typically sold to competitors.
-- The transferee must sign a franchise agreement. The transferee must agree to become a franchisee, subject to all of restrictions on franchisees in the particular system. The battleground here is whether the transferee may simply sign the transferor’s existing franchise agreement, or whether she must sign the “then current” franchise agreement:
Existing vs. “Then Current” Agreement
This debate is an issue to be resolved, if possible, in negotiating the initial franchise agreement: On the assumption that franchise agreements in any particular system will become progressively more restrictive over time (a very pessimistic view of franchising, by the way), the textbook response of most franchisee lawyers would be to negotiate to allow the transferee to accept an assignment of the existing franchise agreement.
There is, however, another side of this issue. If the existing agreement will be expiring in a relatively brief period of time, then transfer of that agreement might be difficult, unless the transferee can be assured of a right to renew. Otherwise, the transferee is unlikely to invest, and the transferor is highly unlikely to receive top dollar.
One possible solution: Negotiate at the time of buying a franchise for the right to transfer an existing franchise agreement, but be ready to negotiate at the time of a proposed transfer to obtain a new franchise agreement for the transferee, with a full term.
Demands that the franchisee sign a release
As a condition to its consent to a sale, whether to another franchisee or back to the company, most franchisors will require the selling franchisee to release the franchisor for all of its alleged acts, representations, omissions, etc. up to and including the moment of the sale.
Make no mistake, courts routinely uphold the franchisor’s right to insist upon being released. The release will usually be included in the sales agreement, or could be presented as a separate document. Either way, it will be part of the sales agreement.
Once a release is knowingly signed, it is usually enforceable, and in any attempt to set aside or evade the release, the franchisee would have a very difficult if not impossible burden of proof. Releases in franchise sales are enforced because the franchisee usually receives valuable consideration (the franchisor’s consent to a sale, and the actual proceeds of sale) as part of the transaction in which the release is signed.
Releases are enforced against every type of claim including
(i) claims that the franchisor breached the franchise agreement, either before the sale, or in connection with the sale – for example, by vetoing an earlier proposed sale at a higher price, where the earlier proposed purchaser was deemed not qualified; (ii) antitrust claim; (iii) claims that the franchisee was defrauded in the franchise relationship; and even against claims that the alleged fraud constituted a violation of the federal Racketeer Influenced and Corrupt Organizations Act (RICO).
The legal test is whether the franchisee knew or reasonably should have known of the alleged claim (for breach of contract, fraud, or whatever) when the franchisee signs the release. Even an argument that the franchisee signed the release under economic duress, or as the culmination of the franchisor’s alleged fraudulent scheme, is probably insufficient to avoid the release once it is signed and the sales transaction is concluded. Courts simply will not entertain the schoolyard tactic of signing a release with your fingers crossed behind your back, enjoying the proceeds of sale and later arguing that the release should not count because you were pressured into signing it.
There may be a [very] rare case where the franchisee truly does not discover that it was the victim of a contract breach or fraud scheme until after the release is signed, but that is certainly the exception to the usual situation. It is not necessary for a prospective plaintiff to know all the details of the alleged misconduct, or to realize the extent of the financial injury, in order to release a claim arising from that misconduct for the redress of that injury. Releases are enforced if the franchisee had sufficient facts to be “on notice” of the possible claim at the time the release is signed. Thus, if a franchisee that believes or suspects that it has a grievance that might give rise to a meritorious lawsuit, the time to explore legal options with a competent trial lawyer who has franchise law experience is before selling the franchise and signing a release.
It may well be that the attractiveness of the sale outweighs the prospective gain from litigation. In either event, the decision whether to sign a release as part of the sale is a critical business decision that you must assume will be binding after the sale.
