Franchising during the Coronavirus recession

Seyfarth Shaw LLP
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Franchise systems around the country are confronting unprecedented challenges and business disruptions from the spread of the coronavirus (COVID-19). Given the widespread government closure orders and social distancing restrictions, any hope of a short-lived interruption and a return to business-as-usual is highly unlikely. The questions many franchisors are confronting include: what does this mean for our franchisees and the network itself? How will our offering documents, operating standards and revenue models need to change? Should we adapt and implement new system standards, how quickly, and for how long? The answers vary by industry, by market, and in some cases by franchised location.

The coronavirus pandemic will cause significant financial challenges especially for franchise systems in the restaurant, hospitality, health and fitness and personal service sectors. So far, and it is changing by the minute, government leaders in Massachusetts, Illinois, Michigan, New Jersey, Philadelphia, Ohio, San Francisco and New York City, for example, have limited gatherings and mandated the closing of restaurants, bars, fitness centers, and entertainment venues. Franchisees in those industries undoubtedly will suffer reduced revenues and those who cannot meet sales quotas, have minimum royalty obligations, or cannot pay their fixed expenses may have no choice but to close or seek bankruptcy protection. Employee misclassification claims like those erupting in California and Massachusetts with the potential for back wages and recovery of losses may also be a strategy for some.

Just some of the COVID-19 issues that franchisors face, include:

  • whether and how to support franchisees who are suffering from reduced sales and are thus struggling to pay minimum royalties or other fees;
  • supply-chain issues that might result in shortages of branded goods or other proprietary ingredients or critical materials, and whether sourcing from non-approved sources is permitted;
  • a myriad of labor and employment related issues both for their own employees and those facing their franchisees;
  • whether to continue to market and sell new franchises during the COVID-19 pandemic;
  • as part of the FDD renewal process, whether to address any of the COVID-19 implications for the short-term and long-term in various categories of renewal conditions, such as site improvements and/or development obligations;
  • modifications (temporary or otherwise) to business systems and operations manuals to revise approved business, revenue and operating models, including, for example, takeout and delivery;
  • whether to impose new or additional health, hygiene, maintenance or sanitation measures upon franchisees and if so the implications for joint employment or vicarious liability concerns;
  • whether to suspend or modify obligations such as mandatory operating hours, minimum inventory levels and inventory ratios, local advertising obligations, on-site events, etc.;
  • the need to provide lease support or delayed rent payments;
  • how sales and marketing efforts will need to be changed if trade shows, etc., are canceled or postponed;
  • if third party cancellations such as sporting events, concerts, and theatre closings will affect operations, sales and profitability/viability of the business model;
  • how international sales and growth programs will be affected by current travel and immigration restrictions;
  • whether franchisor staffing at the headquarters level will need to shift and be reprioritized in the areas of field support and operations; and
  • if franchisees are infected and unable to be involved in the active management of their business due to sickness or death, whether and how to enforce successor / transfer provisions, including temporary transfers or authorizations.

Any changes or modifications likely should be clearly and accurately documented in temporary amendments to franchise agreements to make clear the scope, extent and duration of any accommodations. Accommodations made orally or via e-mail run the risk of unwittingly waiving important franchise agreement provisions and contradicting FDD disclosures. Rather than rush to provide answers to complicated system-wide questions, we recommend that franchisors quickly but deliberately create a holistic plan to address these issues in a way that protects the franchise business model and network.

Undoubtedly franchisees will be looking to franchisors for guidance on a number of issues that the franchisors themselves have never faced. It is essential for franchisors to provide consistent and well thought out communications and seek to make the best decision to protect the brand while keeping in mind all available data inputs. Franchisors must also remember that the best decisions may vary from market to market, and the social and legal landscapes in the franchisor’s local region may vary greatly from what is happening in the franchisees’ markets and from industry to industry.

The number, scope, and complexity of the system-wide COVID-19 issues facing franchisors is unprecedented. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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