(Ambrosio’s note: My readers ask the most interesting questions. “What happens when a franchisor goes out business?” is a difficult question but one that has to be asked, and answered.
I needed an expert to answer this question intelligently, and the first person that came to mind was Jeff Fabian. I follow Jeff’s guest blog posts on Franchise Help, a franchise portal that is near and dear to my heart for naming Franchise Chatter one of the best franchise blogs of 2011. I sent Jeff an email to introduce myself and to ask for his help. Within 24 hours, he responded with this comprehensive and thoughtful answer to my reader’s question. Thank you so much, Jeff, and I hope we hear more from you here on Franchise Chatter.
I’m trying to get someone from the International Franchise Organization to answer the first part of the question, so stay tuned.)
M.W.: I read your blog daily and enjoy your work! It seems like everyone is selling franchises. Do you have any stats on how many franchises close down and what happens to the owners of that system when their group does close?
Jeff Fabian: It’s not all that common for a franchise to close down given the number of franchise systems that are out there these days, although it does happen on occasion. Rates for smaller systems are somewhat obscure, but big ones make headlines a few times a year for going into bankruptcy (though bankruptcy doesn’t necessarily mean they go out of business).
When Your Franchisor Goes Out of Business
You did it. You did your due diligence, you negotiated the franchise agreement, you worked hard to secure the financing, and you committed to a promising franchise opportunity. You did it because you trusted the experience of the franchisor’s executives, they had a sound yet fluid system that adapted to change, and their brand name had instant recognizability and goodwill.
So, what happens if the franchisor goes out of business? All of a sudden, everything that made the franchise opportunity so secure is suddenly up in the air. Can you keep using the system? The trademark? Your suppliers? Do the post-term non-compete and non-solicitation clauses apply? Do you have any real options at all?
The fact of the matter is that the answers to these questions will depend largely on why the franchisor is shuttering its doors, and how it chooses to handle the process. It may also depend on how different franchisees within the system want to wield the leverage that presents itself. There is no one answer that applies to all situations. This fact can be just as unsettling as the matter itself.
So, while I can’t answer, “What do I do when my franchisor goes out of business?”, I can provide some food for thought on the issues that individual franchisees need to consider carefully if and when the franchisor turns out the lights.
What about the system?
If your franchisor goes out of business, the ability to continue to make use of its system may be the least of your concerns. Although, if you operate a restaurant or other highly-structured business, this can be a substantial issue to overcome. Certain things that are public knowledge (menu items, for example) might be fair game, but recipes, menu layouts and confidential operating procedures can still remain the property of the franchisor. Addressing how and to what extent you will be able to continue operating under the same business format needs to be a top priority. Franchisors who hang their former franchisees out to dry may be exposing themselves to a host of lawsuits, but not all franchisees are willing (and financially capable) to deal with years of prolonged litigation — especially when their business is in a state of flux.
If the franchisor disappears, so do its franchisees’ territorial rights. Antitrust laws prohibit market allocations among horizontal competitors (in this case, the former franchisees), so there is little franchisees can do to protect their former territories from invasion. Whether this is an issue in practical terms will of course depend on the locations of other existing franchised outlets and the nature of the business. If you view exclusive territory rights as critical to your success, your best option might be to seek to join a different franchise system. In doing so, however, the post-term non-compete and other similar provisions in your former franchise agreement will need to be addressed.
What about the trademarks?
If one or more franchisees can band together to buy the franchisor’s trademark, then it may be possible to continue using the mark pursuant to a licensing arrangement. Another option would be to claim that the franchisor has legally abandoned the trademark, thereby making it fair game for adoption by former franchisees. If the franchisor continues to claim ownership of the mark, the situation might be headed for litigation unless you and the franchisor are both willing to negotiate an amicable separation.
If you have no interest in using the mark (or are willing to let it go), then your biggest hurdle may be dealing with the existing franchisees who want to keep it a part of the disbanded system.
Importantly, trademarks receive special treatment in bankruptcy, and the franchisee of a bankrupt franchisor might be able to assert a claim for continued use of the mark.
What about supplier relations and buying power?
If cooperative buying power was a significant benefit of the franchise system, loss of the franchisor may have dire consequences. Suppliers are under no obligation to continue to provide benefits to a system’s former franchisees. You may be able to work with other former franchisees to build a new cooperative, but it may or may not have the same influence as the former franchise system. Also, suppliers recognizing former franchisees in distress may seek to take advantage of the situation with which you are faced.
Can I operate a competing business?
As alluded to above, there are issues relating to proprietary systems information and the post-term non-competition covenants that can come into play if you want to continue to operate your business independently. If the franchisor is a complete failure, it may be fairly easy to get cleared of these types of issues. But, if it has any hopes of retaining or selling off its assets, it may still seek to enforce your post-term obligations. If your goal is to go independent, the safest route is probably going to be to approach the franchisor early in the process, recognizing that it may take some sort of buyout to achieve complete independence in a competing business.
These are some of the primary issues that franchisees will need to take into consideration if their franchisor goes out of business. Ideally, the franchisor will provide plenty of notice and be willing to work with its franchisees, and the franchisees will generally be on the same page as to how they want to handle the transition. However, the worst case scenario can be pretty bad; and, while there may be little to no opportunity to plan ahead, this is something that franchise candidates do need to keep in mind when evaluating franchise opportunities.
Jeff Fabian is the owner of Fabian, LLC, a boutique trademark and franchise law firm that represents independent business owners and both active and prospective franchisors and franchisees. Visit fabianlegal.com for more information, and follow Jeff on Twitter @jsfabian.
This article is provided for informational purposes only, and does not constitute legal advice.