Default and Termination in a Franchise System

By Michael Seid, Managing Director, MSA Worldwide

Part 1 – Analyzing noncompliance

At some point in every franchise system, dealing with non-compliant or difficult franchisees will become an issue. While it is essential that franchisors enforce their brand standards, the approach taken in dealing with franchisee defaults needs to be thoughtfully managed. Default management should always take into account the culture the franchisor is trying to establish and maintain within the franchise system – and often, it does not.

Understanding the root causes of noncompliance

Noncompliance can be isolated to a single franchisee, but often it can also be widespread. While the actions of a single franchisee may seem a routine occurrence that requires no further action than working with legal counsel in dealing with that one event, it is good practice, even with an isolated occurrence, to gain an understanding of the underlying cause of the problem. Understanding the root cause of noncompliance can surface underlying issues the franchise system may need to consider in formulating a change strategy.

Often when MSA is working with our clients in evaluating the direction that they should take in dealing with noncompliant or difficult franchisees, what becomes clear is that the franchisee may be reacting, rightly or wrongly, to franchisor policies or events that have taken place in the system. This does not lessen in any way the requirement that they meet their obligations under the franchise agreement. However, we frequently find that it is the structure of the franchise system, or the methods used in managing franchisee recruitment or franchise relations, that have baked into the DNA of the program the factors contributing to potential conflict issues.

Let’s start with the basic notion that there would not be a noncompliant franchisee if the franchisor had not allowed that person to join the system in the first place. How prospective franchisees are evaluated before they are allowed to join the system; how the recruitment process was conducted; what the prospective franchisee comes away expecting from the system; and what they understood the franchisor was expecting from them are all factors that need to be evaluated. Relationships, especially ones as long as those contemplated in franchising, can only work effectively when both parties understand the expectations of the other at the start.

Franchisors will also often mistakenly view their system primarily through a legal lens, both because of the regulatory nature of franchising, and because of the requirements and process of developing their disclosure documents. However, from a practical viewpoint, very little in franchise law, other than those requirements found in pre-sale disclosure and in a handful of state relationship laws, has much – if anything – to do with how a franchisor structures, recruits, or manages their franchise system. While the Franchise Disclosure Document and franchise agreement may be required to become a franchisor, those documents were never designed to be effective management tools. Each lays out the minimum standards, and details the rights and obligations of the parties, but they are generally the work product of the franchisor’s legal counsel and may not fully represent the views of the business leaders on how best to manage franchise relations on an ongoing basis. Franchise system management is a business exercise and, if there are legal constraints in the agreements that management does not agree with, that needs to be the first step in evaluating some of the root causes of noncompliance. It is essential for franchisors to understand their rights and obligations under their franchise agreements, but it is equally important that they not lock into a belief that those minimal requirements significantly limit their capabilities in using business judgment when working with franchisees to sort through system issues.

But isn’t following best practices enough?

As business leaders, we often look for those “best practices” and formula solutions that have worked for others in solving similar problems. Best practices, more as a concept than as a reality, are certainly useful in providing some guidance. But the reality of best practices, more often than not, is that they fail because franchise programs are not fungible. Even for franchisors in the same industry subset, differences in how each company operates and its level of maturity, among other factors, may be material. Instead of “best practices,” what franchisors should strive to identify are “contextual practices” best suited for their unique system and for the unique set of problems they are facing at that time. To develop these contextual practices, franchisors first need to determine what issues they are facing and the underlying causes for noncompliance or dissatisfaction by franchisees; only then can an effective approach suitable for their franchise system be identified and adopted. Certainly the experiences of others should be evaluated, but rarely do solutions transport from one company to another without significant modification.

While it is a common practice in many franchise systems, I have never been an advocate for automated form default letters or automated processes when problems with franchisees arise. There can be little argument that these methods provide a franchisor with a consistent and simple approach, and that legal counsel may have formulated this approach to protect the rights and interests of the franchisor and to avoid mistakes that may lessen the ability of the franchisor to enforce their rights under the agreements. However, while they may have some legal benefit, the “autopilot” approach is rarely beneficial to the long-term interests of the franchise system. This is especially true in the area of maintaining franchise relations and determining why disruptive events occur in the first place. It is therefore essential, before choosing any path in solving disruptions, to first gain some basic facts about the immediate situation, and also about underlying reasons for the problem which may not be as apparent from looking solely at the immediate situation.

Certainly, discussing the immediate situation with your staff, including your field consultants and outside legal counsel, is a prudent and essential first step. It is important to obtain a clear understanding of what has taken place, what steps have already been taken to deal with the problem, any history of previous issues, what discussions have taken place, and what (if any) offers have been received or suggested. You most certainly need to understand the entire history of the relationship before making any evaluation based on the specifics of the current problem.

While it is always essential for franchisees to meet their obligations, gaining a complete understanding of the situation and determining if there are any possible communications or other problems that may have contributed to the issue will enable you to determine whether default and potentially termination is the right way to go. If it is, having a complete understanding of the causes and reasons for the franchisee’s default will be important in building a case so that default can become an effective termination. The lack of compliance on one issue could be part of a bundle of other issues that the system may be facing, and may be a leading-edge indicator of broader concerns for the system that should be evaluated and addressed. Take a step back from your rights under the agreement and any emotions you may be feeling about the franchisee and that single event. Discuss with your lawyer any risk of delay, and make your evaluation of the issues in a deliberate manner.

Part 2 – Evaluating system issues

Part 2 of this article addresses evaluating whether the culture of your franchise system is part of the issue of franchisee non-compliance or dissatisfaction.

Is there an opportunity for system improvement?

One mistake many franchisors make when addressing compliance issues – even for an isolated event – is not fully understanding why it occurred, and assuming the problem is solely of the franchisee’s making. Often it is, but how you deal with a non-compliant franchisee can create other problems within the system; heading down the default process too quickly or routinely can cause you to miss an opportunity for beneficial change.

Each franchise system has its own culture and ways in which its leadership views system management. Often, the culture that has been created within the franchise system harbors elements that have driven or enabled problems to occur and many times, there is little if any direct link between the event that has occurred and the underlying problems that created the environment for it to happen.

The hard part of evaluating whether the culture of your franchise system is part of the issue of franchisee non-compliance or dissatisfaction is that you are doing a self-analysis of how well you are managing your business. Accurate self-analysis is exceedingly hard; this is one reason why experts recommend that you bring experienced outsiders into the evaluation process so that the fog of personal responsibility and blame can be eliminated.

Sometimes the problem is systemic and is being driven by the structure of the franchise offering itself. Franchise offerings often come together through the creation of the disclosure document and underlying agreements, and have factored in more of the legal requirements and less of the business realities that would have been considered had the system chosen a downstream expansion strategy other than franchising. It is this approach toward a fungible offering that may be beneficial to the legal drafting that frequently creates the underpinnings for relationship issues.

Take the typical system, with its single unit or multi-unit development agreement. As the franchise system has evolved and grown, the franchisor has recruited different classes of franchisees into the mix. What was developed in laying out the terms for one class of franchisee is not appropriate or beneficial in how you should be managing the offering for other classes of franchisees. As a simplistic example, what is needed for a single-unit offering is not the same as for a multi-unit offering; and within multi-unit offerings, what is needed for a strategic franchisee is widely different than what should be in place for an investor franchisee. If concerns arise with compliance to brand or other standards, have you determined that those have been clearly stated and well communicated in your manuals or other communications? Merely having differing initial fees is not sufficient, as the differing needs of each class’s obligations and economics also need to be part of the equation. This singular offering focus can lead to long-term compliance and relationship concerns, and needs to be considered.

In evaluating and possibly recasting your franchise program, you need to evaluate how you recruit, onboard, support, and structure the relationship by classes of franchisee. Franchise disruption is often rooted in many factors:

• The cultural flow of how the system is managed
• The types and level of communications and information provided
• The level and beneficial nature of support you provide to each class of franchisee
• How you include franchisees in the strategic process
• Your views on protecting the equity franchisees have built in their businesses
• The structure of your initial and continual fees
• The other revenue streams for the franchisor
• The outcome of the economics
• How you have dealt with evolution of the brand

Putting compliance and disruption into a filter of possible broader issues can create opportunities for beneficial change. You should never waste an opportunity for improvement, and evaluating the root causes for noncompliance and disruption can have significant benefits for your entire system.

Living in the glass box

One of the early lessons I was taught as a franchisor was that we live in a glass box: how we treat franchisees at their most vulnerable is looked upon and evaluated by the other franchisees in the system. Default, litigation and termination may show strength and may also create fear in some franchisees that keeps them in line. At the same time, maintaining the dignity of the franchisee during the resolution of any problem requires better management skills that can foster a level of cooperation throughout the franchisee community; this creates a culture of compliance and facilitates the ability to manage change so that dealing with the occasional problems becomes much easier long term.

We will all face the need to deal with default or other disruptive acts by franchisees. Especially when the problem is serious or continuous, discussions with the franchisee are essential and should always be the first step. Default letters and emails may be simple, easy, less time-consuming, and possibly more exacting as you have time to think carefully about what you are communicating in the message. But letters and emails are not effective tools for real discussion. Like any dunning notice, emails and letters may also negatively change or elevate the temperature of the situation.

Discussions allow you to better understand what is going on. Sometimes, the mere act of picking up the phone or meeting with the franchisee creates options better suited to solving the problem in a way that benefits the system. Preferable to terminating a franchisee is often giving them the opportunity, with support, to simply exit the system, if they or you know that conflicts will continue. In those situations, creating an environment where the franchisee can leave the system with dignity and as much equity as they can reasonably retain will be far more beneficial to both parties than the termination option. This is also frequently less disruptive and less expensive than litigation and, more importantly, may be viewed as a more constructive approach to problem solving by the other franchisees. Even when you have the absolute right and capability to enforce the terms of the agreement, how you manage through the process will be on display to the rest of the franchise community.

Consistent, sustainable replication is only possible when a franchise system is managed so that compliance is part of its culture. Programs that deal with disruption through punishment or rewards to franchisees for meeting their contractual obligations generally find that those approaches result in mere short-term and unsustainable solutions. More importantly, the punishment-and-reward approach masks the opportunity to look at other, more endemic concerns and to change the system culture for the benefit of all.