Considerations for Franchisors and Manufacturers in a Termination Case

January 23, 2003 Published Work
Reprinted with permission from The Connecticut Law Tribune, January 23, 2003

Every franchisor or manufacturer is likely to have to decide whether to terminate a dealer or distributor. * Termination should be taken seriously, because it can be expensive, invite a counterclaim, and a wrongful termination carries the risk of a substantial damage award.

Still, there are times where a franchisor believes it is necessary to terminate. The following should be considered before any termination.

1. Is There an Applicable Franchise Termination Statute?

About twenty states have enacted statutes that affect a franchisor's right to terminate a franchise agreement. The Connecticut Franchise Act, for example, requires a franchisor to show that its decision to terminate or refusal to renew a franchise agreement is supported by "good cause." Unlike many state statutes, this Act does not limit the definition of "good cause" to the franchisee's breach of the franchise agreement. In certain circumstances, a franchisor may base a termination on legitimate business concerns unrelated to the franchisee's performance (e.g. the franchisor's decision to withdraw from the market). In addition to general franchise acts, there are federal and state laws that restrict the right to terminate in specific industries (e.g. liquor distributors, car dealers).

A franchisor that fails to comply with the procedural and substantive requirements of a state franchise relationship statute may be exposed to a claim for compensatory and punitive damages, as well as attorneys' fees. Accordingly, before deciding to terminate, counsel should always review any applicable, or potentially applicable, statutes including notice or opportunity to cure requirements.

2. What are the Grounds For Termination?

a. The Dealer Fails to Pay Royalties or Other Amounts Owed Under the Franchise Agreement.

There are two reasons why a dealer's failure to pay amounts owed under the franchise agreement presents a strong termination case. First, virtually every court that has considered the issue has held that monetary defaults constitute good cause to terminate the franchise agreement. Second, proving a breach of the franchise agreement for nonpayment is generally relatively easy.

b. The Franchisee is Convicted of a Crime Relating to the Operation of the Franchise.

A dealer who is convicted of a crime in connection with the franchised business can obviously harm the entire system. Every franchisor should include a clause requiring the dealer to comply with all applicable laws in the operation of the franchise. If the agreement contains this type of clause, the termination should survive any challenge.

c. The Dealer Fails to Operate the Franchise in Accordance with the Franchisor's Operations Standards.

It may be more difficult to win a termination case based on a failure to comply with the franchisor's operational standards. First, compliance with standards may be based on subjective determinations. (e.g. how does a food or hotel franchisor define the requisite level of cleanliness?) Although there are undoubtedly objective criteria that factor in the analysis, enforcing standards often involves subjectivity.

Second, the materiality of a deficiency may be difficult to prove. A dealer will attempt to portray any operational violations as trivial, minor offenses that do not warrant termination.

Nevertheless, there are obviously cases where a franchisor must pursue termination for operational defaults. Benign neglect is not a sensible policy for any franchisor to follow, because a failure to enforce system standards will ultimately lead to dilution of the franchisor's trademark and hurt every franchisee in the system. And if the offenses are serious enough (e.g. health or safety violations), the franchisor has a compelling argument that terminating the agreement will protect the public's health and welfare.

3. What are the Franchisees' Defenses?

a. "Selective Enforcement"

Dealers often claim they are being "singled out" for unfair treatment and that a franchisor had improper motives for terminating the contract. Numerous courts have rejected this argument, concluding that the motive for termination is not a defense if there has been a material breach. As one judge put it, that other franchisees or dealers may be treated more leniently "is no more a defense of a breach of contract than laxity in enforcing the speed limit is a defense to a speeding ticket." Original Great Am. Chocolate Chip Cookie Co., 970 F.2d at 279 (7th Cir. 1992).

Although a franchisor is not required to enforce its contracts identically, it still should have a reasonable justification for treating similarly situated dealers differently, since leniency to dealers for a particular kind of contract breach might convince a court that the breach is not material. For example, if two dealers each defaulted on the same performance requirement, but one has taken affirmative steps to improve its performance, the franchisor would have a legitimate business reason for being more lenient with this dealer. If, however, there is no rationale for the disparate treatment, the termination will be much harder to sustain.

Additionally, certain state franchise relationship statutes require that the franchisor treat similarly situated franchisees similarly. Again, this is an area where a thorough per-termination review of the law by the franchisor is essential.

b. The Franchisor Breached First

Although this defense has fared poorly in most jurisdictions, a court will often look at what steps, if any, a franchisor has taken to aid the struggling dealer. Accordingly, the party seeking to sustain a termination will not only want to show that the dealer breached the contract, but that they also were given a reasonable opportunity to succeed.

* "Franchisor" and "dealer" refer to franchisors/manufacturers and franchisees/dealers/distributors, respectively.