Reed Smith Client Alert

Authors: Diane Green-Kelly Peter M. Ellis

The California Small Business Investment Protection Act, Assembly Bill 1141, was recently proposed and makes several changes to California’s current franchise laws, the Franchise Relations Act and the Franchise Investment Law. Among them are provisions which significantly narrow franchisors’ existing rights to terminate or refuse to renew a franchise.

Adds Policy Statement: The proposed amendment adds a liberal policy statement favoring franchisees. The stated policy expressly notes that franchisees lose more than their investment in a franchise if the franchise is terminated or not renewed, resulting in the loss of a personal residence and other property. The significance of the policy statement is that courts must interpret the statute consistent with that stated policy.

"Good Faith" Standard: The proposed bill creates a statutory "good faith" standard of dealing between franchisors and their franchisees. We anticipate franchisees contending that this change creates a “good faith” cause of action separate from any breach of contract claim.

Limitations on Termination and Refusals to Renew: Currently, California law generally requires that a franchisor have "good cause" to terminate a franchise agreement, and defines "good cause" broadly to "include, but not be limited to [emphasis added], the failure of the franchisee to comply with any lawful requirement of the franchise agreement after being given notice thereof and a reasonable opportunity, which in no event need be more than 30 days, to cure the failure."

The proposed bill redefines "good cause" to mean "a substantial and material breach of any lawful requirement of the franchise agreement after being given written notice thereof and 60 days to cure the failure." Noticeably absent from the proposed revision is the concept that "good cause" need "not be limited to" the circumstances set forth in the statute. Thus, the proposed change would remove necessary flexibility for franchisors to address various activities by franchisees that adversely impact the franchise relationship, yet do not necessarily constitute a substantial and material breach of the franchise agreement. The change in the cure period, of course, is also noteworthy.

The proposed bill also would narrow a franchisor’s ability to terminate the franchise agreement without an opportunity to cure, in certain circumstances, by requiring that the franchisee’s conduct be "material" or "substantial." For example, California law, like that of many other states, currently allows a franchisor the right to terminate a franchise agreement, immediately and without opportunity to cure, if "the franchisee is convicted of a felony or any other criminal misconduct which is relevant to the operation of the franchise." The proposed bill would require that the criminal misconduct not only be "relevant" but also "material" to the operation of the franchise. By inserting a materiality requirement, the proposed bill would introduce uncertainty into franchisors’ operations and make it more difficult for franchisors to ensure that their networks are free of criminal activities without inviting litigation from even those franchisees that "get caught with their hand in the cookie jar."

As a further restriction on a franchisor’s ability to terminate a franchise agreement, the bill proposes that, in addition to "good cause," a franchisor can only terminate a franchise agreement "in accordance with the current terms and standards established by the franchisor then equally applicable to all franchisees, except with respect to any classification of, or discrimination between, franchisees that is reasonable, is based upon proper and justifiable distinctions, considering the purpose of this chapter, and is not arbitrary." The law expressly places upon the franchisor the burden of showing that a classification or discrimination is permissible. This provision raises the question of whether new provisions in new franchise agreements would be enforceable on grounds that they are discriminatory where older, existing agreements lack such provisions. This could stifle franchise development. At the very least, it introduces uncertainty and invites litigation.

The proposed bill also virtually eliminates a franchisor’s ability to refuse to renew a franchise by requiring the franchisor to demonstrate that the franchisee has substantially and materially breached the franchise agreement. In the event that the franchisor terminates or refuses to renew a franchise in violation of the new statutory provisions, the franchisee could seek damages or require the franchisor to purchase the franchise at fair market value, where the franchisor currently is required to repurchase only inventory.

Finally, the proposed bill eliminates a post-termination covenant not to compete, even where the franchise agreement merely terminates by its terms and is not renewed. This provision offers very little, if any, benefit to the purported beneficiaries of the bill, i.e., franchisees located in California, who already benefit from California’s policy of not enforcing non-competition covenants. The proposed change, however, could be a significant threat to franchisors whose franchise agreements with franchisees in other states contain California choice of law provisions. Those franchisees might argue that a non-competition covenant included in the franchise agreement should not be enforceable under California law, even though the franchisee’s home state would enforce the covenant.


Client Alert 2013-074