A New Year, a New Day: The Amendments to the California Franchise Relations Act Are Now in Effect
For franchisors with franchisees in California, ringing in the New Year means navigating a new regulatory landscape. All franchise agreements renewed or entered into after January 1, 2016, as well as existing indefinite ones that are terminable without cause, are now subject to the amendments to the California Franchise Relations Act (“CFRA”), which the California legislature passed in fall 2015. The amendments to the CFRA make significant changes to the transfer, termination, and nonrenewal of franchises in California, as well as the resulting remedies available to franchisees. While there are some ambiguities that will need to be resolved by the courts, it is clear that franchisors will have a number of new issues to consider when deciding how to deal with franchisees in California.
I. The amended CFRA prohibits a franchisor from withholding its approval of a proposed transfer unless the transferee does not meet its “then-existing standards.”
Many franchise agreements reserve the franchisor’s right to approve a proposed transfer of the franchise agreement, either by providing the franchisor with the sole discretion to do so, or that the franchisor’s approval will not be unreasonably withheld. Before the amendments to the CFRA, California did not regulate a franchisor’s contractual right to approve a proposed transfer of a franchise.
Under the amendments to the CFRA, however, a franchisor may no longer withhold its approval unless the proposed transferee does not meet its “then-existing standards for the approval of new or renewing franchisees.” This requirement does not preclude a franchisor from exercising its contractual right of first refusal, but the franchisor’s offer must be equal to the franchisee’s bona fide offer.
California joins at least eight other states in regulating a franchisor’s contractual right to approve a proposed transfer. And compared to these other states, California’s requirement that a franchisor may not withhold its consent unless the proposed transferee fails to meet its then-existing standards is more onerous than most. In addition, if a franchisor is no longer issuing new franchises, and therefore does not have any then-existing standards the approval of new or renewing franchisee, it is unclear what standard will apply in determining whether the franchisor may withhold its approval, if it may do so at all.
II. The amended CFRA imposes a notice procedure for a proposed transfer of a franchise.
In addition to establishing a standard for a franchisor’s approval of a proposed transfer, the amendments to the CFRA also impose a fairly detailed notice procedure. First, the franchisee must provide written notice to the franchisor identifying the proposed transferee, copies of all agreements related to the proposed transfer, and the proposed transferee’s application for approval, which must include all forms and information required by the franchisor.
If the required forms are not readily available to the franchisee, then the franchisor must provide them within fifteen days of the franchisee’s request. In addition, if the franchisor’s then-existing standards for the approval of new or renewing franchisees are not readily available to the franchisee, then the franchisor must communicate them within fifteen days of the franchisee’s notice of intent to transfer.
After the franchisor receives the required forms and information, it must notify the franchisee of its approval or disapproval of the proposed transfer in writing within sixty days, or the proposed transfer is deemed approved. If the franchisor disapproves the transfer, then the franchisor must provide a statement setting forth the reasons for its disapproval. Franchisors should take care in drafting this statement, which will certainly be an important exhibit in any litigation that results from the franchisor’s disapproval of the proposed transfer.
III. The amended CFRA prohibits a franchisor from terminating or declining to renew a franchise unless the franchisee has failed to “substantially comply.”
California, like most states with franchise relationship laws, prohibits a franchisor from terminating a franchisee without good cause. Before the amendments to the CFRA, good cause existed if the franchisee failed to comply with the franchise agreement. Under the amendments to the CFRA, however, good cause now only exists if the franchisee failed to “substantially comply” with the franchise agreement.
The precise meaning of the substantial compliance standard is unclear and will likely require judicial interpretation. New Jersey has the same standard. It seems possible that the California legislature intended the substantial compliance standard to reflect a requirement that a franchisee materially breach the franchise agreement in order for the franchisor to have good cause to terminate the franchisee. In that case, the new standard might not be so significantly different from the old one, but franchisors should watch for developing case law on the issue and be ready to justify why a terminated franchisee’s non-compliance was substantial.
IV. The amended CFRA doubles a franchisee’s opportunity to cure a default and impose an independent requirement for notice of termination as well.
The amendments to the CFRA also expand a franchisee’s opportunity to cure a default and required notice of termination. Before the amendments to the CFRA, a franchisor was required to provide a franchisee with thirty days’ opportunity to cure. The amendments to the CFRA have doubled that time, requiring a franchisor to provide a franchisee with sixty days instead. The amendments to the CFRA also now require a franchisor to provide sixty days’ notice of termination.
Franchisors should be aware that the time periods for the opportunity to cure and notice of termination may run independently of each other if a franchisor provides notice of a default before a notice of termination. Absent an agreement, however, a franchisee’s opportunity to cure a default may not exceed seventy-five days. Nevertheless, franchisors should pay attention when issuing notices of default and termination to provide the amount of time for the opportunity to cure and notice of termination that they expected when issuing such notices.
V. The amended CFRA continues to provide grounds for immediate termination, except a franchisee has a ten day opportunity to cure noncompliance with any law.
As was the case before the amendments to the CFRA, a franchisor may continue to terminate a franchisee without providing an opportunity to cure or notice of termination in the event that the franchisee: declares bankruptcy, abandons the franchise, agrees to termination, materially misrepresents information related to the franchise sale, engages in repeated noncompliance, engages in certain illegal activity, or operates the franchise in a manner that presents an imminent danger to public health or safety.
Under the amendments to the CFRA, however, a franchisor must provide ten days’ opportunity to cure any noncompliance with federal, state, or local laws, including but not limited to “all health, safety, building, and labor laws or regulations.” Franchisors should note that this new opportunity to cure may create issues when the franchisor needs to make a determination about whether to immediately terminate a franchisee due to an imminent danger to public health or safety.
VI. The amended CFRA allows a wrongfully terminated franchisee to recover the fair market value of the franchise.
The amendments to the CFRA expand the remedies for a wrongfully terminated franchisee to include the franchisee’s recovery of “the fair market value of the franchised business and franchise assets.” In addition, a franchisee’s recovery of the franchise’s fair market value may be offset by any amounts owed by the franchisee. California is not alone in allowing a franchisee to recover the franchise’s fair market value. Moreover, franchisees were allowed to recover compensatory damages even prior to the amendments to the CFRA.
The amendments do not provide a definition of fair market value, and franchises can be a notoriously difficult type of business to value. Does the valuation of a franchise’s goodwill differentiate between that owned by the franchisor and franchisee? How does one assess the fair market value of a franchise that has been terminated or not renewed? In addition, it is unclear whether the recovery of the fair market value of the franchise may be offset by damages arising from the franchisee’s breach of the franchise agreement, specifically a liquidated damages provision.
VII. The amended CFRA allows a lawfully terminated or non-renewed franchisee to recover the fair market value of its inventory.
Last but not least, the amendments to the CFRA require that “upon a lawful termination or nonrenewal of a franchisee, the franchisor shall purchase from the franchisee, at the value of the price paid, minus depreciation, all inventory, supplies, equipment, fixtures, and furnishings purchased or paid for under the terms of the franchise agreement or any ancillary or collateral agreement.” The amendments to the CFRA provide some exceptions.
A franchisor need not re-purchase any “personalized items,” equipment that is “not reasonably required to conduct the operation of the franchise business,” or to which a franchisee cannot provide clear title. The re-purchase obligation also does not apply if the franchisee declines to renew the franchise, retains control over the franchise location, the franchisor completely withdraws from the franchise’s geographic market area, or by agreement. Finally, the re-purchase obligation may be offset by any amounts owed by the franchisee.
The re-purchase obligation under the amendments to the CFRA will be a substantial change for franchisors in California. While an important exception exists when a franchisor allows a franchisee to retain control over the franchise location, this risks the franchisee setting up a competitive business at the franchise location, which is a particularly concerning given that California otherwise prohibits a franchisor from enforcing a covenant not to compete. In addition, it is unclear whether the re-purchase obligation may be offset by damages arising from a franchisee’s breach of the franchise agreement, specifically a liquidated damages provision.
The amendments to the CFRA establish some of the toughest franchise relationship laws in the country. Some of the requirements can be traced to other jurisdictions, while other more novel ones will require judicial interpretation. For the time being, franchisors should review their franchise agreements to identity potential issues going forward and stay apprised of judicial developments to avoid surprises when dealing with franchisees in California. Further, franchisors should revise their franchise agreements or California state addenda to address the amendments to the CFRA in connection with their upcoming annual renewal or earlier FDD amendment in California.