A new California law (AB 525, effective January 1, 2016) makes it harder for franchisors to terminate defaulting franchisees, requires franchisors to buyout franchisees in some cases, and adds new burdens for evaluating franchisee transfers. Touted by lawmakers as bringing more balance to the franchise relationship, AB 525 unfortunately introduces new uncertainties into that relationship that will need to be clarified through lawsuits or administrative action, and will ultimately increase costs for both franchisors and franchisees in California.

Termination

Under AB 525, a franchisor terminating a franchisee for “good cause” must show a “failure to substantially comply” with the requirements of the franchise agreement, and provide a franchisee between 60 to 75 days’ notice of default and opportunity to cure.  This concept of substantial compliance (not defined in AB 525) invites more subjectivity into whether good cause for termination exists and will likely lead to more lawsuits between franchisors and franchisees.  Will it lead to fewer “wrongful terminations” by abusive franchisors?  That remains to be seen (if it was ever a significant problem in the first place), but it could lead to fewer or delayed terminations of problematic, non-compliant franchisees that are hurting their entire system, including other franchisees.

Termination – Practical Tips For Franchisors

• Have your lawyer check the alternatives to the “good cause” and 60-day cure period terminations (which are found in Section 20021 of the CFRA) that may allow a franchisor to terminate immediately or with short notice in certain cases.
• Be diligent with providing proper and timely notices of default, especially because repeated defaults might allow faster termination
• In your franchise agreement, consider adding to the general acknowledgement regarding the importance of uniform quality to the goodwill of the trademarks, a statement that any breach of the agreement or manuals could substantially and materially affect the goodwill

Buyback Obligations

Although obligations to repurchase a franchisee’s tangible assets after termination are not new and exist under many other state franchise laws, AB 525 expands them further than any other state. You can read the specific requirements of the law here, but basically after a lawful termination or nonrenewal the franchisor must purchase (at net book value) all of the inventory, supplies, equipment, fixtures and furnishings that are in the franchisee’s possession at the time of the notice of termination or nonrenewal, for which the franchisee can deliver clear title, and that were purchased from the franchisor or its approved suppliers and sources.

No other state franchise law requires a franchisor to purchase so many of a franchisee’s assets, to bear all the risk of overpayment for such assets (by paying net book value rather than fair market value), and to do so when the termination or nonrenewal was justified and lawful. The use of undefined and ambiguous terms also plagues the buyback obligations. What level of involvement by the franchisor makes a vendor an approved supplier or source? What method of depreciation is used to arrive at net book value?

Thankfully AB 525 contains several exceptions to this buyback obligation and one or more may apply in many termination or nonrenewal situations (see Section 20022 of the CFRA). For example, the buyback obligation does not apply if the franchisee cannot deliver clear title or possession of an asset, is allowed to retain control of the premises, or declines a bona fide renewal offer.  Even so, at the very least franchisors can expect an increase in audit costs related to evaluating and reporting the impact of potential buyback obligations.

Buyback Obligations – Practical Tips for Franchisors

• Consider adding specific asset purchase terms to your franchise agreement or a form of asset purchase agreement as an exhibit, that contains agreed-upon definitions for key undefined terms in AB 525, sets a timeline and process for closing the asset purchase, allocates responsibility for removal and transportation costs, and provides other helpful details missing from AB 525
• Consider requiring franchisees to periodically provide detailed information on their assets, liens, and any major purchases so that you can better assess the costs of a termination and assess contingencies for your audited financial statements
• Consider adding to your franchise agreement a right to purchase all of the franchised business’s assets at the lower of net book value or fair market value, subject to state law; this prevents a franchisee from being able to cherry pick and sell off items with a higher fair market value than book value
• Consider using a long termination or nonrenewal notice period where possible so that the list of assets in possession at the time of notice may shrink before the date of termination or nonrenewal
• Consider the potential for termination or nonrenewal of a franchisee before requiring the franchisee to make major renovations or other expenditures
• Consult your accountant and auditor now for the potential impact these purchase obligations may have on your system, financial statements, and audit process and expense

Transfers

Under AB 525 franchisors now have to follow a specific transfer application and approval procedure when considering a franchisee’s request to transfer its franchise or an ownership interest in the franchisee entity. The detailed process is fairly self-explanatory in the statute here, but the most important thing for franchisors to note is that they can only disapprove a proposed transferee if the transferee fails to meet the franchisor’s then-current written standards for evaluating franchisees and notice of disapproval is given by a certain deadline (60 days by default). The written standards must be provided to the franchisee and transferee in a timely fashion, and the franchisor’s use of the standards must be consistent. There is also an ambiguous implication in the law that the franchisor’s decisions must be reasonable.

Transfers – Practical Tips for Franchisors

• Develop sophisticated and detailed franchisee application forms and standards that will allow you to consistently provide good reasons for denying unqualified candidates; train your sales and compliance staff to use them consistently
• Consider providing for a transferee-evaluation period of longer than 60 days in your franchise agreement
• Consider including a right of first refusal in your franchise agreement for transfers of ownership interests and a method for valuation in the case of involuntary transfers (e.g, death)
• Consider adding transfer conditions that might weed out potentially problematic operators (e.g., personal guarantees)
• Consider including in your franchise agreement authorization to discuss an outlet’s operations with a proposed transferee and the franchisee’s waiver of any liability related to your truthful, non-confidential disclosures

Note: This post does not contain all the details about the impacts of AB 525.