By Carmen Caruso
Presented to the American Association of Franchisees and Dealers, Summer 2008
When a franchisor seeks to compel its franchisees to make investments that fundamentally change the business concept that is the subject of existing franchise agreements, the franchisor might be in breach of the implied covenant of good faith and fair dealing, which protects franchisees from arbitrary and capricious conduct by one party that would deprive the other party’s reasonable expectations in entering into their contracts. See Interim Health Care v. Interim Health Care,225 F.3d 876, 884 (7th Cir. 2000); Restatement (Second) Of Contracts, § 205 (1981)).
No doubt, consumer preferences for quick service food, retail, and lodging (among other types of franchises) will evolve over time, such that franchised business concepts must also evolve in order to remain competitive. For these reasons, franchisors typically include “remodeling,” “reinvestment,” or “modernization” clauses in their franchise agreements to address these possibilities. Independent franchisee associations need to monitor the changes that the franchisor might seek to impose, and to review with their attorneys whether or not there is a valid legal objection to be asserted. There will always be questions of fact: e.g., whether the franchisor has done adequate testing before any franchisee is required to invest in “change;” whether the franchisees can reasonably expect a decent return on investment; and whether the franchisor has any improper motives (such as trying to capture revenue on the mandated expenditures for change). Ultimately, the question is whether the mandatory change is within the reasonable expectations of the parties when the franchise agreement(s) were signed, taking into account the degree to which the parties anticipated (in their franchise agreement) that there would be changes in the relevant market over time. The association’s critical task will be to protect the legal rights of those individual franchisees who find the required investments to be unaffordable, or that they just don’t make sense in the local market. Here are just a few of the important factors to be considered by the association and its attorney that we have gleamed from a recent “actual case” experience:
(1) Concept Evolution versus Concept Change: The system’s franchise agreements will probably permit some degree of reasonable concept evolution over time, and an enlightened association should not seek to prevent reasonable, pro-competitive changes that were within the parties’ “reasonable expectations” at the time of contracting, and that make good business sense. (However, even “evolutionary” change may not be reasonable at every single location, and some exceptions might have to be made). On the other hand, there are times when the changes that a franchisor might be seeking to impose will go beyond simple evolution and amount to coerced concept conversion under the threat of franchise termination for non-compliance. Telltale signs of concept change include new trademark(s) and trade name(s); significant (and expensive) structural changes to the physical facility; changes in the products or services being sold, coupled with changes in retail pricing, reflecting a difference in target customers; changes in the delivery of the products or services (e.g. having wait-staff instead of self-serve); and consequent increased operating costs on an ongoing basis. With these types of radical changes, there comes a point where the system will “cross the Rubicon” and (as the franchisor might intend) there will be no turning back to the original concept. In such cases, the franchisor might have trouble demonstrating that these changes were within the parties’ “reasonable expectations” at the time of franchising, and the grounds for a legal challenge may be much stronger.
(2) Protecting Choice versus Opposing Progress: Almost inevitably, the franchisor will find some franchisees who are willing to make the required changes (not necessarily with enthusiasm) and will try to portray the association as standing in the way of progress. Here, the best legal strategy for an association might be to seek preservation of the right of each franchisee to decide for himself or herself, whether or not to invest in the new concept, or to stick with the original franchised concept. Protecting the legal right of each franchisee to make an independent decision (as opposed to trying to impose a uniform decision on every franchisee) has a profound all-American ring that we believe that courts will find appealing. It is very comparable to past lawsuits in which the courts allowed associations to protect the right to vote (as opposed to trying to dictate how anyone should vote). See, e.g., Sandusky County Democratic Party v. Blackwell, 387 F.3d 565, 573-74 (6th Cir. 2004), where political parties and labor unions were granted standing to sue to protect their members’ right to vote in the next election.
(3) The Franchisee’s Bright Line Strategy: Associational standing to sue is difficult, but certainly not impossible, to establish in cases where the association seeks to enjoin the franchisor from imposing mandatory changes that are not contractually permitted. The franchisor will try to capitalize on differences in franchise agreement language occurring from year to year. The Association may be able to overcome this objection by challenging the franchisor to identify any version of its franchise agreement that would permit the type of changes being imposed in the particular case. If the franchisor cannot convincingly demonstrate that at least some of its agreements permit the conduct being complained of, the association should be on firm grounds in asserting standing to sue on behalf of its members.
(4) Watch Out For The Franchisor’s Earthworm Strategy: There is an old saying about taking over the garden, one inch at a time. Franchisors may try to create confusion and keep the franchisees off guard by trying to inch their way to total concept change in a series of incremental steps.
(5) Associational standing is not a numbers game. At the end of the day, the association need only identify one member who would have standing to sue in his or her own name. Warth v. Seldin, 422 U.S. 490, 511 (1975).
There are many more legal issues raised in associational standing cases than space permits to be addressed here. All franchisee association leaders are urged to review these issues with experienced counsel in order to best protect their members.