Navigating the Post-Term Franchisor-Franchisee Relationship

American Bar Association - Forum on Franchising
Publication
April 1, 2022

This article was co-authored by Adrian K. Felix and Andra Terrell.

A franchisor-franchisee relationship that continues beyond the termination or expiration of the franchise agreement can be a risky proposition for both parties. There may be legitimate business reasons for the franchisor and franchisee to continue their relationship without the safety of a renewal or other written agreement in place, but, more often than not, the parties are on (or end up on) different pages about the precise nature of their continuing association. The foregoing divergence in the parties’ motivations is often inconsequential until one side seeks to change the status quo and/or move on from the relationship, resulting in a dispute between them as to what contractual terms governed their post-term relationship. 

In that situation, and particularly where the franchisee wants to operate a competing business, the franchisor will often file suit and move for a temporary restraining order (TRO) or preliminary injunction against the franchisee’s new operations. The franchisor’s success in obtaining a preliminary injunction, though, is not guaranteed and can hinge on a seemingly innocuous action or set of facts. Consider the following scenario: 

The franchisor entered into a franchise agreement with the franchisee on January 15, 2015, for the operation of a daycare center in Main City (the “MC Daycare”). The franchise agreement included an initial term of three years, contained a non-compete provision that prohibited the franchisee from operating a competing daycare center within 50 miles of the MC Daycare for two years after the termination or expiration of the agreement, gave the franchisor the right to enter and take possession of the franchised location upon the franchisor’s termination of the agreement, and provided the franchisor with the option to take assignment of the franchisee’s interest in the MC Daycare lease with the landlord within thirty (30) days from the termination or expiration of the agreement.

The franchise agreement expired by its terms on January 15, 2018, without a written renewal agreement. The franchisee, however, continued to operate the MC Daycare after the franchise agreement expired, use the system, and pay royalties to the franchisor for the next two years, although the franchisee did not abide by other terms of the franchise agreement (e.g., monthly reporting requirements, pricing model, or hours of operation). The Franchisor continued to accept royalty payments, and its employees continued to conduct field visits at the MC Daycare to discuss operations after expiration. On January 15, 2020, the franchisee notified the franchisor that it would close the MC Daycare immediately. The franchisor thereafter discovered that the franchisee had opened and operated a new daycare center under a different name at the same franchised location on January 18, 2020. The franchisor filed suit against the franchisee, moving for a TRO to enforce the franchise agreement’s non-compete provision and shut down the new daycare center, and requesting the court to authorize the franchisor’s assumption of ownership and control of the MC Daycare and underlying lease.

Who prevails?

Implied-in-Fact Contract

Courts look to the original contract and the conduct of the parties to determine whether an implied-in-fact contract exists post-termination or post-expiration. For example, in United States ex rel. Oliver v. Parsons Co., 195 F.3d 457 (9th Cir. 1999), although the defendant alleged that the contract with the plaintiff became invalid upon expiration of the contract, the appellate court upheld the district court’s ruling, which found the actions of the parties after expiration, including performing under the terms of the agreement, demonstrated the contract still existed. Id. at 462. Similarly, in Astral Health & Beauty, Inc. v. Aloette of Mid-Mississippi, Inc., 895 F. Supp. 2d 1280 (N.D. Ga. 2012), the court found that the plaintiff franchisor and the defendant franchisees’ continued dealings following the expiration of their franchise agreements “could create an implied contract under which ‘their rights and obligations are to be measured as provided in the old contract.’” Id. at 1282–83 (citation omitted); see also Webb Candy, Inc. v. Walmart Stores, Inc., No. 09-CV-2056, 2010 WL 2301461, at *9–10 (D. Minn. June 7, 2010) (noting that an implied contract is only created when the parties’ postterm performance flows continuously from their in-term performance under the original contract and is substantially unchanged following the original contract’s expiration); but see Consol. Bearings Co. v. Ehret-Krohn Corp., 913 F.2d 1224, 1230 (7th Cir. 1990) (reasoning that evidence of negotiations of a new contract is contrary to an intent to be bound by terms of the expired agreement).

There is little doubt that the franchisor and franchisee in our MC Daycare scenario would, in most instances, be presumed to have entered into an implied-in-fact contract that encompassed the “same terms” as the expired franchise agreement. The facts in our MC Daycare scenario show that not only did the franchisee continue to operate under the same terms as the expired franchise agreement, but the franchisor did as well by accepting royalty payments and conducting field visits. However, who prevails in the above-hypothetical TRO motion largely depends on the answer to the following core question: What terms of the expired franchise agreement are properly included in the franchisor and franchisee’s implied contract?

Duration

An important aspect of contract enforcement is determining the contract length. The fixed duration of an agreement (i.e., the time of performance) is generally understood to be a material term. Yet, in cases involving post-term relationships, courts have not presumed that the fixed term of an initial agreement was renewed in a subsequent implied contract simply because the parties continued their same dealings after the initial agreement expired. See, e.g., City of Roswell v. Mtn. States Tel. & Tel. Co., 78 F.2d 379, 386 (10th Cir. 1935) (finding that the parties’ continued dealings for years after the expiration of a 25-year fixed term franchise constituted an implied agreement of indefinite duration and which was terminable at will); Wirt v. Ticona Polymers, Inc., No. 04-73753, 2006 WL 2660607, at *9–11 (E.D. Mich. Sept. 14, 2006) (rejecting the supposition that the duration of an implied contract can be derived from the parties’ expired definite term contract, absent a consistent pattern of conduct by the parties); but see Amerispec, LLC v. Omni Enterps., Inc., No. 2:18-cv-02247- TLP-dkv, 2018 WL 2248459, at *5 n.11 (W.D. Tenn. May 16, 2018) (refusing to determine the issue, but noting that the language of the general presumption suggests that the implied contract could have the same fixed term as the original agreement).

Then again, courts have also not adopted any express rule that the parties in a post-term implied contract operate on a month-to-month basis. See Dunkin’ Donuts Inc. v. Donut Ring Corp., No. 05-CV- 1385, 2008 WL 11429347, at *16 (E.D.N.Y. Jan. 31, 2008) (noting the mere fact that the parties continued to operate after the franchise agreement expired did not support the claim that they were operating on a month-to-month basis, terminable at will). Rather, courts have seemingly only found a month-to-month continuation existed when the parties expressly negotiated such arrangement and/or a specific provision of the initial franchise agreement or the franchisor’s policies or terms provided for that arrangement. Id.

Based on these cases, it is unlikely that the franchisor in our MC Daycare scenario could successfully argue that the initial three-year term of the franchise agreement was extended by implication through January 15, 2021, either by renewal or on a month-to-month basis. If, however, the franchisor and franchisee had a history and consistent pattern of renewing the franchise agreement for full three-year terms, a court might conclude that the implied contract had the same duration.

Post-Term Covenant Not to Compete

The non-compete provision in the franchise agreement, like the franchise duration, would generally be considered a material term of that agreement. The parties’ continuation of their dealings postexpiration though would not typically reveal how they intended to treat the restrictive covenant. See Cunningham Lindsey US LLC v. Box, No. 1:18-cv- 04346, 2018 WL 10560768, at *2 (N.D. Ga. Dec. 4, 2018). Thus, courts have heavily scrutinized the parties’ post-term conduct to determine when the non-compete period started and have reached differing outcomes based on seemingly similar facts.

For instance, in Toddle Inn Franchising, LLC v. KPJ Associates LLC, No. 2:18-cv-00293-JDL, 2018 WL 3676826, at *1 (D. Maine Aug. 2, 2018), the court denied the plaintiff franchisor’s motion for a TRO on the grounds that the franchisor had failed to demonstrate that all of the terms of the franchise agreement, including the non-compete provision, remained in effect after the agreement expired. Id. at *3. The court observed that, even though the defendant franchisee continued to pay royalties to the plaintiff, the defendant had not abided by other terms of the agreement. Id. at *2. The court further observed that the franchisor’s earlier notice of default, which declared that the franchised daycare had been operating as an “at-will” operation and would not be eligible for renewal until the franchisee had cured various defaults, conflicted with the plaintiff’s contention in the case that the parties continued their relationship with the understanding that the franchise agreement remained in effect. Id. Last, the court pointed out that there was no evidence that the parties ever communicated about extending or tolling the start of the non-compete period that began at the expiration of the franchise agreement, and it was unreasonable to infer that the defendant impliedly agreed to a two-year extension. Id.

By contrast, the district court in Bambu Franchising, LLC v. Nguyen, No. 5:21-cv-00512-EJD, 2021 WL 1839664, at *1 (N.D. Cal. May 7, 2021), rejected the defendants’ arguments that the noncompete period began when the initial franchise agreement expired and was not renewed. Id. At *7. There, the court explained that the plaintiff established an implied-in-fact contract existed with the same terms as the franchise agreement based on the defendants’ continued operation under the franchise system and an (internal) discussion the defendants had about whether the franchisor would give the prospective new owners of the franchisee the same favorable terms as the current agreement if the new owner entered into a franchise agreement. Id. Hence, the Bambu Franchising court inferred an implicit agreement by the parties to extend the non-compete provision.

Our MC Daycare scenario then could have entirely different outcomes depending on the court hearing the matter. For instance, a Georgia court is likely to hold the non-compete period started on January 15, 2018 (i.e., the expiration date of the franchise agreement), whereas a California court is likely to hold the non-compete period started on January 15, 2020 (i.e., the date the franchisee notified the franchisor it would close the MC Daycare).

Post-Term Contractual Rights

The franchisor’s right to take possession of the MC Daycare upon the franchisee’s termination of the agreement, as well as its right to take assignment of the daycare’s lease within 30 days of the termination or expiration of the agreement, would arguably constitute material terms of the franchise agreement. Like the post-term restrictive covenant discussed above, the parties’ engagement in the same course of dealing would not overtly show whether they intended to continue to be bound by those post-term rights. Hence, it would be difficult for the franchisor or franchisee to establish whether these terms were part of their implied contract.

But, with that being said, would it matter either way under the facts of the hypothetical? Historically, courts have only allowed franchisors to take possession of a franchised location and assume management and control of the business in the context of a holdover franchisee where the franchisor is also the landlord or guarantor, or the lease expressly provides such right. See, e.g., P.P.&K, Inc. v. McCumber, No. 94-2721, 1995 WL 46207, at *2–4 (7th Cir. Feb. 6, 1995) (granting the franchisor a right to possession based on the default and re-entry provision in the parties’ sublease); Pearle Vision, Inc. v. Romm, No. 04-C-4349, 2005 WL 2172393, at *7 (N.D. Ill. Sept. 1, 2005) (finding that the franchisor was entitled to assume the leases and take immediate possession of the franchised locations because the franchisor was either the landlord or guarantor of the leases). Our MC Daycare scenario, however, has a twist.

Here, the franchisee discontinued operation of the MC Daycare upon its own termination of the parties’ post-term relationship, so there was no termination by the franchisor. Additionally, the franchisee’s underlying lease was with a thirdparty, thereby limiting the court’s ability to force an assignment. Under analogous circumstances, courts have been reluctant to enforce a franchisor’s right to assume control of a franchisee’s business, even when the franchisor may have a strong argument regarding its loss of goodwill associated with the franchised location. See, e.g., Toddle Inn Franchising, 2018 WL 3676826, at *1 (ruling against awarding the plaintiff franchisor possession of the defendant’s franchised location due to the potential long-term impact on the defendant’s new business and the likely impact on the defendant’s customers); Bambu Franchising, 2021 WL 1839664, at *1 (declining to completely shut down the defendant franchisee’s operations because of the potential long-term business and financial impact it could have on the defendant).

Based on the Toddle Inn and Bambu cases, it is unlikely that our franchisor would gain ownership of the franchisee’s fixed assets and lease.

Possible Solutions

What is a franchisor to do? First, a franchisor can include in its franchise agreement express nonwaiver language that its continued acceptance of royalty payments, provision of franchise support, and/or performance of its obligations under the franchise agreement does not constitute an implied contract or extension of the franchise agreement. Second, franchisors should continuously monitor franchise agreement expiration dates and cure deadlines, and send the appropriate notices before or shortly after those dates and deadlines. Any expiration or termination notice should cite the non-waiver language in the franchise agreement and/or state that the franchisor’s actions do not constitute an implied contract or extension. Along those lines, where the franchise agreement has expired or been terminated, franchisors should instruct their internal departments on how to handle things such as accepting payments, providing inventory, and conducting store visits. Third, although it may present a burden, franchisors should also develop a process to monitor the franchised location post-expiration or termination to determine whether the franchisee has, in fact, shut down in accordance with the franchise agreement. If not, the franchisor can document the franchisee’s continued operation by, among other things, taking photographs or videos (including location, time, and date), obtaining receipts, and identifying credible and willing witnesses.

The franchisee should also plan ahead. The franchisee should know the expiration date of its franchise agreement and anticipate that it may need to shut down by that date. If the franchisee fails to receive a notice from the franchisor, then the franchisee should consider sending its own notice that clearly states its intention to renew, continue, or shut down, and abide by the same. The franchisee should likewise understand the obligations upon termination or expiration to determine what it can and cannot do, especially if it wants to continue a similar business in the same location or elsewhere. If the franchisor has a right to purchase, the franchisee should be aware of what recompense it is entitled to receive if the franchisor timely invokes that right. And if it wishes to sell the business instead, the franchisee should know whether the franchisor has a right of first refusal or must match the offer. It may sound a little hackneyed, but both franchisor and franchisee should know their contract and plan ahead. It will save both sides grief in the end.

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