“System Standards” reflect a franchisor’s knowledge and experience regarding the operation of the franchise business and entail the practices and procedures a franchisee must abide by in the establishment and operation of a franchise unit. What constitutes a System Standard is typically defined in the franchise agreement,
For instance, a franchise agreement may state that the “System Standards” is the Franchisor’s valuable know-how, information, trade secrets, methods, Manuals, standards, designs, methods of trademark usage, copyrightable works, rental space sources and specifications, software, confidential electronic and other communications, methods of Internet usage, marketing programs, and research and development connected with the operation and promotion of the Franchised Business, as modified by Franchisor at any time.
These standards promote efficiency in the franchisee’s operation of its franchise units, ensure quality and uniformity of goods and services, and help reduce risks to customers, associates, and the general public. When a franchisee does not comply with a System Standard, a franchisor may have good cause to end the franchise agreement. There are, however, several steps that a franchisor should follow between the time a violation is identified and the termination of the franchise agreement. Fortunately, our skilled attorneys could help a franchisor understand how to terminate a franchisee for violating System Standards.
When an issue in a franchisee’s operation occurs, the franchisor’s first step should be to gather the relevant information relating to the problem. This may include obtaining information about the specific circumstances that gave rise to the issue. This information can be obtained by reviewing inspection or incident reports and related email correspondence or by interviewing relevant personnel who have specific knowledge of the situation.
While focusing on the specific circumstances surrounding the violation of System Standards is important, it is also important for a franchisor to collect information concerning the full history of the franchisor-franchisee relationship. Doing so will benefit the franchisor in the long run, as it informs this party of possible counterarguments that the franchisee may raise if it is placed in default or if the franchise agreement is terminated.
The franchisor should then consider whether the franchisee’s conduct is significant enough to amount to a violation of System Standards that warrants the default or termination of the franchise agreement. The franchisor should first look to the franchise agreement, operation manual, or other authority that governs the franchisee’s establishment and operation of the franchise, in order to find such a basis.
In many instances, the violation can be easy to identify because the System Standards is set forth in a provision of the franchise agreement, typically under a termination provision. In other situations, there may not be a franchise agreement provision specifically permitting termination for the violation in question. Still, the franchisor may still be able to begin the process of terminating the franchise agreement if the franchisee’s conduct is such a fundamental violation of the material purposes of the agreement.
For example, conduct that is particularly damaging to the franchise system or its trademarks, or acts like the commission of a crime by the franchisee, a declaration of bankruptcy by the franchisee, or a violation of standards that affect health and safety, even if not expressly included as a System Standard in the franchise agreement is likely to warrant placing the franchisee in default and terminating the franchise agreement. This is so, because the conduct is significant and precludes the franchisee’s continued operation of the franchise.
Once the franchisor has identified the violation of System Standards, it must first give notice to the franchisee of the violation by placing the franchisee in default.
When a franchisor determines that a franchisee is in violation of the System Standards, before proceeding straight to a notice of immediate termination, the franchisor’s next step should be to review the mechanics of the default or termination process in the agreement. The franchisor should determine whether the violation is of the type that specifically provides the franchisee with an opportunity to resolve, or “cure,” the violation. There are few, exceptional circumstances that warrant terminating a franchise agreement without first giving a notice of default and allowing the franchisee to fix the issue. As most contracts already provide for it, the franchisor must first notify to the franchisee that the franchisor is placing the franchisee in default for a violation of System Standards.
The method of transmission and timing of the notice of default should comply not only with the terms of the franchise agreement, but also any applicable state franchise laws; as some state franchise laws regarding notice of default may supersede the terms regarding notice of default in the franchise agreement. Once the franchisor has decided to notify a franchisee that it is in default because of a System Standards violation, it should look to the franchise agreement to determine how the notice should be provided to the franchisee, as well as how much time the franchisee has after receipt of the notice to cure the violation.
For the method of transmission, the franchisor should determine how, and to where, the franchisor should deliver the notice. Many state franchise laws and notice provisions in franchise agreements provide that the notice is not effective until a specified number of days after it is sent. Others provide that notice is not effective until the confirmed receipt of the notice. Both standards further depend on the delivery method of the notice.
For example, sending a notice of default via email, does not trigger the running of the franchisee’s time to cure the violation of System Standards, if the franchise agreement or a state law provides that notice is not effective until three days after it is sent. Additionally, a notice of default may amount to an ineffective provision of notice, and therefore may fail to trigger the amount of time available for the franchisee to fix the problem, if the franchise agreement requires it be sent by certified mail or other method of delivery. Compliance with the method of transmission required of a franchise agreement, and knowledge of when that notice becomes effective ensures that the franchisor’s attempt to place the franchisee in default or to terminate the franchise agreement goes as smoothly as possible.
The timing of the notice is also extremely important. Once a franchisor provides a franchisee a notice of default, it generally must afford the franchisee an opportunity to cure the default. Most franchise agreements require that a specific amount of time elapse after notice is provided before the franchisor can terminate the franchise agreement.
However, in some states, if the number of days a franchisee has to cure an alleged violation of System Standards is greater than the number of days provided for in the franchise agreement, the franchisor must provide the franchisee the greater number of days to cure under the state law. A notice of default should generally contain:
Once a notice of default has been effectively provided, the next step is for the franchisee to cure the violation of System Standards within a certain number of days, as specified by state law or the franchise agreement. During this time, the franchisor should monitor and evaluate the franchisee’s compliance or non-compliance with the required fix. This may require on-site visits to the franchise unit to determine if such violations have been resolved.
While some violations of System Standards can be determined objectively, such as failing to file certain reports, those relating to safety and cleanliness are largely subjective. Therefore, it is important that the franchisor document and obtain photographic evidence of the franchisee’s progress in fixing the violation in question. This may assist the franchisor in proving that the franchisee’s failure to remedy the violation if the franchisee contests the franchisor’s determination at a later date.
If the franchisee does not cure the violation within the time allotted under the franchise agreement or state law, the franchisor has the right to terminate the franchise agreement. In some circumstances, where a franchisee partially fixes a violation, but does not fully cure the violation in accordance with the terms of the notice of the default, the franchisor may need to carefully evaluate the degree of cure, the remaining possibilities of harm to the franchise system, and any other aspects of non-compliance to weigh its options of continuing to work with the franchisee or exercising its right to terminate.
Once the cure period has expired and the franchisor has determined that the franchisee has failed to fix the violation of System Standards, the franchisor should notify the franchisee in a manner similar to the notice of default, that the franchisor is exercising its right to terminate the franchise agreement. It is important that the termination notice comply with the franchise agreement and applicable state laws, as a failure to do so may invalidate the notice and expose the franchisor to claims of wrongful termination.
After a termination letter has been sent and the termination has become effective, additional action is often required when the franchisee does not voluntarily comply with the termination. Prior to initiating formal litigation or dispute resolution procedures, sending a cease and desist letter is an efficient and effective next step, as it may force the franchisee into compliance.
Terminating a franchise also requires complying with all post-term obligations under the franchise agreement, formerly documenting the termination of the franchise agreement, and collecting any remaining payments due to the franchisor. Franchisors should also determine if there are any unique termination-related requirements under applicable state laws, such as the requirement that the franchisor purchase certain items or make certain payments to the franchisee.
A violation of System Standards may permit the franchisor to terminate the franchise agreement with its franchisee. However, there are several steps a franchisor must adhere to when going through this process. It is important that the franchisor gather as much information relating to the violation and the history of the franchisor-franchisee relationship before determining whether to issue a notice of default.
It is equally important that a franchisor document the efforts taken by the franchise to fix the problem within the allotted time. When faced with such a decision, it is best practice for a franchisor to consult with its franchise attorney to ensure that the requirements of the franchise agreement and state law are complied with, and to choose the best course of action to protect the franchisor’s interests. For more information on how to terminate a franchisee for violating System Standards, call our office today.