by MITCH MILLER, J.D., MBA
During the crisis created by COVID-19, many franchisees are considering terminating their franchise agreements, as well as considering other options under their franchise agreements and the law. While franchisees do not have a right to terminate the franchise agreement, franchisors may choose to accept termination of the relationship. Typically, liquidated damages (LDs) are triggered by the premature termination of a franchise agreement. During the pandemic, LDs can still be enforceable but there are a number of strategies franchisees think they can use to compromise or possibly avoid the liquidated damages.
A franchisee’s options are limited and not necessarily easy to accept. Let’s discuss.
If a franchisee believes that termination is in their best interest, they should seek to do so forthrightly and proactively with an eye toward negotiating a compromise of the contractual LDs. Often, a franchisor will be willing to accept a negotiated settlement in such circumstances, even sometimes paid out over time. Of course, the guaranty obligations of any of the franchisees must be considered in strategizing how to best approach a negotiated settlement. This also is true if a reorganization under the bankruptcy laws (Chapter 11) can be used and what that means for the guarantors.
When entering negotiations, distressed franchisees should consider whether termination is their best result or would some other arrangement, including deferral of fees, be desirable until travel resumes normal patterns. You may be able to negotiate a reduction in the royalty or other fees payable until the hotel begins operating at normal levels. These ideas may or may not be acceptable to your franchisor, but some franchisors are willing to listen to the concerns of their franchisees to support them and take a pragmatic approach where possible.
Many businesspeople have a cursory familiarity with force majeure and believe that it can be used to get them out of a contract. Unfortunately, the reality is that it probably will not work to get a franchisee out from under their contractual obligations.
Often, a provision in a contract known as “force majeure” excuses performance when events beyond the reasonable control of the parties makes performance virtually impossible. Usually, the express language of a force majeure provision details the specific types of events that will invoke the application of the provision and excuse performance at least until the circumstances making performance impossible return.
Keep in mind that many franchise agreements for existing hotels do not have force majeure provisions that excuse performance. Obviously, if the provision is not included, then a franchisee cannot make use of the potential benefits.
For those agreements that do include a force majeure provision, historically, a pandemic is not an event expressly set forth as an event that excuses performance. The courts have been grappling with this and to date there is certainly no judicial guidance that would allow one to think that they can rely on using force majeure as an excuse. More likely, the provision includes government restrictions or regulations that make performance impossible. If government mandates are included in the language, then there is a good chance that a franchisee can use the mandate to excuse their performance, at least until the mandate is lifted.
Before we move on, it should be noted that franchise agreements that contemplate new development typically include force majeure provisions, but usually it only applies to the period of development and construction and typically does not allow a franchisee to altogether terminate the agreement. Performance would be excused if it is impossible to proceed due to government restrictions or other expressed applicable events, and only for so long as those conditions, or the delay, exist. An example might be that a franchisee cannot get workers on the job due to mandates. This would clearly trigger an excusable delay. Remember, to get any use, the triggering event beyond one’s control must be expressly set forth in the agreement.
FRUSTRATION OF PURPOSE
Somewhat related to force majeure is a concept in contract law known as “frustration of purpose,” which, if applicable, could excuse a party’s performance. Usually, frustration of purpose results from a “frustrating event,” which is one that unexpectedly occurs during the term of the contract. The frustrating event must be seminal to the essence of the agreement and must affect the parties in a way that is entirely beyond what they could reasonably have contemplated. The event cannot be attributable to one party’s performance and it must make further performance illegal, impossible, or at least radically different from that which was contemplated by the parties at the time the contract was made. The way some franchised businesses are going to have to operate going forward will be very different indeed, but whether this meets the “radically different” high bar remains to be seen, and we don’t yet know what stance the courts will take on this.
If frustration is proved, then the party is relieved from further performance of its contractual obligations. Keep in mind that this is very high bar a franchisee would need to overcome.
Both force majeure and frustration of purpose only concern an obligation being “impossible” to fulfil rather than no longer being practical or financially attractive. If fulfilling contractual obligations just becomes more expensive for one party, that is unlikely to frustrate the franchise agreement.
CHAPTER 11 REORGANIZATION
If applicable cap rates have increased 100 to 200 basis points and net operating income is down 35 percent, your property may only be worth 50 percent of its previous fair market value. While this may be temporary (as all market values always are), you may be a candidate for getting the loan written down to the current fair market value and discharging the franchise obligation and other unsecured debts for a fraction on the dollar. One of the main benefits of this strategy is that as the property resumes its increase in value, the owners will be increasing their equity and not simply working to benefit the lender.
This process is somewhat complex and expensive, but the benefits can be substantial and frequently far outweigh the costs.
Don’t wait to receive a notice of termination to notify your counsel. Putting the franchisor on notice that you are represented by counsel, and by using your counsel to present your situation, before you end up being terminated or sued is likely to result in a far more favorable resolution for the franchisee. Yes, it will have a cost attached, but that cost is likely to be far less than the costs resulting from the alternative path.
Not all franchisors are equal or have the same policies regarding negotiation of agreement provisions. Some franchisors are more aggressive and hungrier for market share. They will be more amenable to negotiating the terms of the agreement. There is no clear path to success in dealing with franchisors, particularly during COVID-19. The stakes are substantial. The technical legal aspects of these agreements are complex requiring the experience and expertise of attorneys who work in this area.
Mitch Miller is the founder of the Miller Law Group, a full-service hospitality law firm representing hotel developers, owners, and management companies throughout the U.S. Mr. Miller is a past member of the Franchise Law Committee of the California State Bar Association. Allied Memberships: CHLA, CLIA, AAHOA, NABHOOD, AHIA, and ICSC. For further information, contact Mitch Miller at mmiller@MillerLG.com or 650-566-2290.