Amendments to the California Franchise Relationship Act (CFRA) become effective January 1, 2016. The new law has the potential to trigger major shifts in the economic incentives for companies to expand through franchising.
AB 525 is probably the most significant and problematic franchise law ever adopted in the United States. The law requires franchisors that comply with the law when they terminate or don’t renew franchises to buy their franchisees’ business assets—often for more than fair market value—even if the franchisor did not sell the assets to the franchisee or benefit in any way from the sale.
The purchase obligation exists even when a termination results from a franchisee having lied, cheated, refused to pay fees, flaunted customer service standards, and broken the law. Although the repurchase duty does not apply if a franchisee can control the principal place of its franchise business after the termination, if it does apply, it will be very difficult to understand the details of the purchase obligation.
Under the new law, a franchisor is also liable for refusing to approve a proposed buyer of a franchised business if the franchisor does not supply the franchisee with written standards that would disqualify the buyer. Moreover, a franchisor must prove that it has consistently applied those same standards to “similarly situated franchisees.” This may sound harmless, but most franchisors have not kept records of their reasons for disapproving prospective or renewing franchisees. So, how can they prove that standards were consistently applied? AB 525 requires disclosure of the standards applied to “new or renewing” franchisees, but fails to explain which set a franchisor may lawfully use. Now, rather than face a lawsuit, franchisors are more likely to approve unqualified franchisees—which makes the post-termination purchase obligation even more of a problem.
Finally, the law prohibits a franchisor from terminating a franchise unless the franchisor has failed to “substantially comply” with a lawful requirement.
If you think that AB 525 is strange, how this law came about is even stranger. Its history reminds us of the aphorism: “If you like sausages, you should never see how they are made.”
Three years ago the Coalition of Franchisee Associations (CFA) prevailed upon several California legislators to introduce a bill to amend the CFRA by imposing a duty of “good faith” in franchise relationships.
Franchisee advocates argued that a statutory duty of good faith was necessary to protect them from abuses, mostly by large franchisors. The CFRA already clearly defined good cause for termination and nonrenewal, which are historically the most often alleged franchisor abuses. Proponents of the legislation did not demonstrate that franchisors were unfairly terminating or not renewing franchises, or that courts were permitting terminations for immaterial breaches. They just wanted more “protection.”
The Service Employees International Union (SEIU) became the most significant proponent of the legislation. Why? SEIU decided that the best way to expand its membership base was to focus on franchised businesses. SEIU supported AB 525 because of its conviction that if franchisees did not fear unfair termination and “oppression” by franchisors, they would have more money and pay their employees higher wages.
In 2013, the IFA Board of Directors adopted a “Statement of Guiding Principles” that would explain to all where IFA stood on key franchise relationship issues. Franchisee members of the Board made it clear that the Guiding Principles must address franchisees’ concerns. Accordingly, the IFA Board adopted a set of Guiding Principles that included “Principle 5,” which states: “While not transferring any equity in the franchisor’s intellectual property to the franchisee, franchisees should have the opportunity to monetize any equity they may have developed in their business prior to the expiration or termination of the franchise agreement.”
The 2013 California good faith legislation carried over to 2014, when a version of it passed the legislature. However, Governor Jerry Brown vetoed it. He noted in his veto message that the legislation was drastic, and urged the franchisors and franchisees to attempt a sensible compromise the next year.
In February 2015, CFA, working still with SEIU, convinced legislative leaders to sponsor a new franchise bill. The 2015 bill dropped the ambiguous “good faith” standard, and changed the CFRA’s “good cause” and notice/cure provisions, set out unprecedented standards for disapproval of a franchisee’s transfer of its business, and included language that was, almost verbatim, IFA’s Guiding Principle 5!
Stoked by how close they had come to victory in 2014, SEIU applied further pressure to legislators, making the CFRA amendments integral to its legislative agenda. Any legislator voting against AB 525 would be subject to SEIU opposition in the next primary election. Because of the SEIU’s clout, the Democratic majority in the California legislature was not looking to make SEIU its enemy. The likelihood of passage was further enhanced by the sponsorship of the California State Assembly’s Majority Floor Leader, Chris Holden.
Recognizing that neither the legislature nor the Governor would stop the bill this time, IFA endeavored to make the language of the bill as palatable as possible. However, this forced IFA to argue that its own Guiding Principle 5 was inappropriate for legislative language. Instead of stating that franchisees should have “the opportunity to monetize the equity in their businesses,” AB 525 morphed into a post-termination obligation requiring franchisors purchase the assets of their franchisees. In other words, franchisors should “monetize the equity” in terminated franchisees’ businesses by buying their assets.
Upon its passage, Majority Floor Leader Holden issued a press release about AB 525 stating, “Following a multi-year stalemate, these amendments add clarity that decreases the potential for litigation and increases franchisor accountability.”
So, franchisors are now grappling with an entirely new form of franchise regulation that makes them evaluate the costs they will incur if they exercise their lawful right to terminate or not renew a franchise. Gray Plant Mooty’s franchise practice group has identified at least 50 issues arising from the language of the amended law and is developing strategies to mitigate its adverse impact on franchisees. Despite Leader Holden’s assurance, the new law is far from clear in all respects but these: AB 525 will cost franchisors and franchisees millions of dollars in legal fees, will result in franchisees’ assets being purchased at inflated prices, and will lead to acceptance of unqualified franchisees and the retention of underperforming franchisees.