In this article, our franchise expert Peter Dillon explores what factors are driving change in our economy and in franchise systems, and discusses ways in which franchisors can—and should—deal with these changes. For more information on the legal aspects of franchising, visit www.franchiselaw.ca
1. Introduction

The rate at which businesses must successfully navigate change, sometimes at a fundamental level, is increasingly rapid. Technological enhancements, globalization of production and increasingly fickle consumer tastes ensure that the pace of change will increase.

Coping with change presents particular challenges to franchised systems. Where the entire means of distribution is centrally owned, the pace, placement and methodology of dealing with the change can be managed by a small team of senior management. In the franchise setting, the cost and responsibility for a change typically lies with the franchisee. This means that the franchisee must be "sold" on the necessity for implementing the change. In the case of a reluctant franchisee, it may be necessary to "force" the change through a vigorous enforcement of the franchisor's contractual rights.

Drafting contracts with terms ranging from 5 to 20 years that will deal with an unforeseeable but predictably enormous scope of change presents obvious challenges and makes for an equally obvious need for flexible wording and reservation of discretion to the franchisor. Franchisees, of course, eschew discretion since they are left to deal with an uncertain scope of system change, and the concomitant cost of that change. However, failure to meet competitive challenges in a timely way through the necessary system changes may seal the fate of the entire franchise system.

2. What Causes Change?

Some of the factors that may necessitate change in a franchise system include the following:

(a) new marketing channels (example the now ubiquitous drive-through and the Internet);

(b) redesigned product delivery systems (have you checked out the razor or toothbrush selection at your pharmacy lately?);

(c) changing consumer tastes;

(d) shifting demographics;

(e) new technology;

(f) new advertising media;

(g) increased market segmentation;

(h) changes in the competitive landscape as the result of the importation of new systems, or the merger or acquisition of various players; and

(i) legislative changes.

Over time, and with increased rapidity, we have come to expect changes in the product lines of the goods and services providers with whom we deal. Image changes, including name and logo changes are also increasingly frequent. Seemingly endless increases in competition may also necessitate a greater allocation of resources to advertising.

3. Roadblocks to change

The greatest single impediment a franchisor will face to introducing change in its franchise system is the content of its franchise agreement(s). Over time, in response to an increased recognition of the necessity of change for the very survival of most franchise systems, the wording permitting such changes has become much more discretionary and wider in scope. The franchisor who has not updated its franchise agreement recently may find themselves hamstrung in terms of its ability to impose, by virtue of the clear wording of its franchise agreement, such changes. Of course, most systems will have more than one form of agreement in effect. Developing the best strategy for implementing change will therefore require consideration of all forms of franchise agreement currently in use.

Where the relationship between the franchisor and its franchisees has been a rocky one, introducing system change will be all the more challenging. Perhaps the most important tool in the introduction of system change is communication. Some franchisors have not developed the methods, channels or habit of communicating with their franchisees. In the absence of a clear contractual right to force implementation of system change, a franchisor will need to get in front of its franchisees -- particularly the opinion leaders -- to make its case.

One practical impediment to convincing franchisees of the need for change may be the question of who benefits from the change. Benefits of the change may not be equally shared as between the franchisor and franchisee. For instance, a proposal to introduce a satellite based POS system to centralize ordering, inventory control and warehousing may provide substantial benefits to a franchisor, but little benefit to the franchisee, who may be the party bearing most of the cost and inconvenience of the required change.

4. Opportunities for Change Implementation

The typical lifecycle of a unit (or area, or master) franchise will present a number of opportunities to implement major or minor system change that, for one reason or another, have not otherwise been introduced-- including either specific wording that prevents the change from being made, the absence of wording permitting a requirement to make the change, or wording that specifies a specific time at which such a change is to be made. Such strategic opportunities include the following:

(a) at the outset, appropriate wording being implemented in to the franchise agreement to reserve certain specific rights to the franchisor;

(b) upon request of a franchisee for a variation in the terms of his agreement, such as a grant of additional territory;

(c) as a condition of renewal at the end of a term;

(d) as a condition of forbearing to enforce any right of default that has accrued to the franchisor;

(e) upon the failure of the franchisee to achieve any sales or unit opening quotas or criteria;

(f) upon the adoption by the franchisor of a revised trade name or logo (provided that the franchise agreement permits the imposition of such a change);

(g) the implementation of new marketing initiatives (provided that the franchise agreement permits the imposition of such a change);

(h) as a condition of the franchisor's consent to a transfer of the franchise (particularly if the agreement calls for the transferee to execute the franchisor’s then current form of agreement);

(i) at any time at which the franchise agreement calls for a scheduled renovation or refurbishment;

(j) upon the exercise by a franchisee a the first right of refusal, according to the terms of the first right of refusal;

(k) any time at which the franchisor introduces new products or services in accordance with the terms of the franchise agreement;

(l) in accordance with the system change modification rights contained within the franchise agreement; and.

(m) In accordance with the operations manual.

5. Success in Implementing Systemwide Change: KFC v. Scott's Hospitality

In an era where fair dealing and good faith have become common weapons in any franchisee’s list of potential grievances, one might anticipate an argument that the imposition of certain changes by a franchisor would breach the franchisor’s duty to deal fairly and in good faith with the franchisee. One aspect of the KFC case dealt with the ability of the franchisor to require extensive renovations and modifications by a franchisee. While the scope of such changes was contemplated by the franchise agreement, the franchisee protested that the extent of the required modifications was nevertheless unreasonable. The court found that where the franchisor acted in such a way that the change was consistently applied, including corporate locations, that the individual effect on a particular franchisee was not sufficient to override the express contractual requirement. So good drafting and consistent practice saved the day for the franchisor.

6. Failure in Implementing Systemwide Change: Pizza Pizza

One of the aspects of the Pizza Pizza litigation from the 1990s concerned the ability of the franchisor to modify the contribution rate of franchisees to various funding pools used to offset costs incurred by the franchisor in delivering various services. Although the franchise agreement provided some discretion to the franchisor to vary the contribution rate, it provided a ceiling on that contribution rate. Notwithstanding the existence of the contractual ceiling, the franchisor levied charges though bulletins sent to franchisees which charges were in excess of the maximum amount permitted under the contract. The franchisor argued that the additional amounts were needed to offset deficits within those pools. The arbitrator (subsequently upheld on appeal) disallowed the franchisor's attempts to collect amounts beyond the maximum permitted by contract, notwithstanding the existence of such deficits.

7. Franchise Agreement

Preparing a form of franchise agreement that is a really going to work for a franchisor requires a true appreciation for the nature of the franchisor's business, and the market in which it operates. An in-depth discussion of with the franchisor's management concerning the issues and problems they have faced in the past will be indispensable in appreciating the kind of flexibility and provisions they require. Obviously, understanding where the franchisor wants to take their system is also imperative. Even so, experienced counsel will reserve as many rights as they possibly can to the franchisor, in order to account for the unanticipated. One example is the ability of the franchisor to acquire a competitor. At the time the franchise agreement is being prepared, such an acquisition may be the furthest thing from your client's mind. However, a few short years later, it may be the most crucial opportunity and decision facing them. Such an acquisition will usually be for the benefit of the entire system, including existing franchisees of both systems, so the reservation of such rights at the outset should not be problematic.

Another factor to be considered in terms of the franchisor's opportunity to implement change is the term of the franchise agreement. In general, the term of franchise agreements has shortened over the past 20 to 30 years, to the point where five-year agreements are probably the norm (the same can be said of most commercial leases). This permits a maximum opportunity for change implementation by franchisors, while still permitting the franchisee some degree of stability. Notwithstanding the KFC decision discussed above, a franchisor needs to be mindful of the ability out of a franchisee to recover his investment and earn a decent rate of return over the term of the agreement.

Likewise, as the Court of Appeal’s decision in Shelanu makes clear, the ability of a franchisor to operate similar systems under different brand names, and at different price points needs to be properly spelled it in the franchise agreement. Alternative distribution channels (Häagen-Dazs ice cream through supermarkets, and not just franchised stores) or Internet-based sales, must be considered at the outset.

The necessity for and the ability to implement changes "on-the-fly" needs to be clearly expressed and provided for in the franchise agreement. This needs to be addressed at each strategic point referenced in section 4 above. It should also be clearly and concisely expressed through "system modification" wording (see the “Article 16” sample wording in Schedule A below) and through the incorporation by reference of an operations manual, which is widely defined (see the “section 2.3(j)” sample wording in Schedule A below), and the end is expressly stated to be subject to ongoing revision (see the “section 11.4” sample wording in Schedule A below).

8. Manual

It's an almost universal practice of franchisors to develop operations manuals for their franchise systems. These documents often contain voluminous information regarding the preparation and delivery of the various products and services offered by franchisees. As opposed to the somewhat legalistic content of a franchise agreement, which may never be opened or referred to once signed, an operations manual tends to get pretty thumb worn and greasy. It is a constant, daily reference source for franchisees.

Typical standard contents of a business format franchise system’s operations manual will include some or all of the following:

(a) Introduction: some background or history of the franchise system, members of management and their responsibilities and contact information, information concerning any franchisee association or advisory council, a brief overview of the franchisee’s principal obligations under the franchise agreement, and an organizational chart of the franchisor’s internal organization;

(b) General standards: the general standards to be adhered to by the franchisor including, a description of the trademarks, a description of required dress standards and uniforms, minimum standards for equipment and supplies, and building design, service, image or menu standards;

(c) Reporting requirements: including royalty reporting forms and instructions on completion, advertising fee reporting and payment procedures, financial statement requirements, record retention requirements, time for payment of royalties and other amounts due, and penalties for late payment;

(d) Advertising and marketing requirements: including limitations on advertising, submission of advertising, outdoor advertising and signage requirements, cooperative advertising policies, formats of approved advertising, and other marketing policies;

(e) Administrative and operating policies: including pricing policies, handling and depositing of cash, credit cards, required filing systems, fixed asset controls, internal audit procedures, and other administrative forms required by the franchisor, absentee owner requirements, minimum hours of operation, requirements in connection with the transfer of any interest in the franchise, and requirements in connection with the expansion of an existing unit;

(f) Franchisee operations: including customer service standards, cleanliness standards, personnel qualifications and requirements, product or service presentation, preventative or periodic maintenance requirements, and exterior building and grounds maintenance;

(g) Standards enforcement and field inspection information:including the frequency and nature of periodic field inspections, consequences of failure to meet specified standards, and requirements in connection with governmental inspections;

(h) Legal and safety requirements: including accepting and handling service of legal documents, reporting criminal activity, handling of disorderly customers, potential claims handling including customer injury or loss, recommended safety and security procedures, and required insurance coverage;

(i) Employee relations and training:including required management certification programs, required employee training, minimum wage and overtime standards, workers compensation, workplace safety requirements, hazardous product warnings and handling procedures, employee termination procedures, union organizing activities, information, and employment law policies.

The right of the franchisor to revise its operations manual must be clearly set out within the franchise agreement.

Amendments to the operations manual should be dated and distributed to all franchisees in a manner that insures that the updates have been received. These days, intranets are becoming an increasingly popular way to disseminate changes to the operations manual instantaneously and at low cost. 9. Disclosing change

The ability to cope with change requires excellent franchisor-franchisee communication. This starts with the franchisor's disclosure document. The competitive circumstances and other market conditions in which the franchise system operates should be discussed, and the need for flexibility and change, including reinvestment by the franchisee, disclosed. From a pure compliance perspective, the ability of the franchisor to require or impose modifications upon the franchisee, especially where those modifications will result in an expense to the franchisee, needs it to be set out.

Ontario and PEI require that disclosure be made to any franchisee who is renewing or extending his franchise agreement, where there has been a material change since the grant of the franchise being renewed. It's frankly hard to imagine any franchise not experiencing a material change over the term of a 5 or 10 year franchise agreement. Reliance upon this disclosure exemption should therefore be avoided.