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Bulletin

Can Your Right of First Refusal be Easily Circumvented?

Fasken
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Franchising Bulletin

Nearly all franchising agreements contain a right of first refusal stipulated in favour of the franchisor in the event the franchisee would like to sell its franchised business.

Such a right of first refusal plays a significant role in maintaining the integrity of any franchise system. It is therefore an important tool, enabling the franchisor to avoid being compelled to welcome within its network a new franchisee that it finds unsuitable. It can also prevent a competing network from attempting, through attractive offers, to purchase establishments of the franchise network, in order to bring them into its own network.

To ensure enforcement of the right of first refusal granted to the franchisor, some franchising agreements also provide for penalties in the event where this right is breached.

However, pursuant to Article 1623 of the Civil Code of Québec, the amount of a penalty stipulated in a contract can always be reduced (but not increased) by a Court. Furthermore, with the passage of time or owing to changes in the market, it may well turn out that a penalty that was intended to be a deterrent will become so insignificant as to amount to nothing more than a user charge that a purchaser with ill intent will be willing to pay in order to circumvent a right of first refusal.

The past few years, however, have taught us that several right of first refusal clauses only offer the illusion of protection and can easily be bypassed in many manners.

For instance, if the franchisee's business is operated from leased premises, a potential buyer could purchase the building in which the business is operated before making an offer to purchase the business. If the lease is nearly up, the owner of the right of first refusal may find itself facing the following dilemma:

  • not exercising its right of first refusal, or
  • exercising its right, knowing that it will have to quickly move the purchased business while a competing business will very likely settle into its current premises.

I have also witnessed situations where the consideration offered was property (for example, a work of art or a building) which the third-party purchaser owned but that the holder of the right of first refusal obviously did not.

I have also encountered other situations where all or nearly all of the consideration offered was payable by way of a promissory note payable on demand. In such a scenario, if the franchisor exercises its right of first refusal, payment of the amount of the promissory note is demanded forthwith upon completion of the sale. However, if the franchisor does not exercise its right of first refusal, payment of the amount of the promissory note is requested much later and maybe even never!

Finally, it is important to know that, pursuant to Article 1397 of the Civil Code of Québec, a sale made in breach of a right of first refusal is nevertheless valid and can be set up against the owner of such a right (the franchisor), subject only to the latter's right to claim damages (or, if the contract contains a penalty clause, to claim the agreed-upon penalty). Hence, once a sale has been made in breach of its right of first refusal, the franchisor will not be able to seek the cancellation thereof. There are, however, some exceptions to this principle.

Therefore, the drafting of a clause granting a right of first refusal must be entrusted to an expert in these types of agreements if the franchisor truly wishes to provide for strong protection that cannot easily be circumvented.

If the clause is not exhaustive and very well drafted, the franchisor may come to the realization, only too late, that, if the potential purchaser has found a way around the exercise of the franchisor's right of first refusal or a way of rendering it inoperative or too cumbersome to exercise, its right of first refusal does not afford the necessary protection.

Three practical tips

Owning the property or holding the head lease of the premises in which the franchisee carries on business

One of the best ways of ensuring that a competing business will not potentially be able to settle into the premises from which the franchisees' businesses are run is for the franchisor to hold, as owner or head lessee, the right to occupy the premises that it will then rent out or sublease to its franchisee.

It is also one of the best ways of ensuring compliance with a right of first refusal clause.

Where the franchisor does not wish to be the owner or head lessee of the premises, it can also enter into a three-way agreement with the lessor and the franchisee, which agreement provides that the franchisor is entitled to an automatic transfer of the lease in the event of termination of the franchise agreement and to a right to approve any new lessee or sub-lessee.

Securing and publishing a movable hypothec encumbering the assets or your franchisees

Another way of guaranteeing better compliance with your right of first refusal is to secure and publish a movable hypothec encumbering your franchisees' assets.

Once again, if the agreement or the clause providing for such a hypothec is properly drafted, it will represent a major obstacle hindering any person wishing to impinge on, or to circumvent, your right of first refusal.

In addition, it is important that this hypothec clearly stipulates that it is guaranteeing compliance by the franchisee with the franchisor's right of first refusal (as well as compliance with the other non-financial obligations of the franchisee), and not just compliance with the franchisee's financial obligations.

Clearly stipulating in your right of first refusal clause that you are entitled to assign it

Many franchisors are hesitant to stipulate a right of first refusal clause in their agreements on the grounds that they do not wish to be required to acquire businesses in their network or because they do not have the financial means to effect such acquisitions.

In order to safeguard the integrity of their franchise system, it is nevertheless often to their advantage to stipulate such a right of first refusal clause anyway and to specify that they have the right to assign it to any person of their choosing.

Armed with such an assignment right, should a franchisee forward to the franchisor an offer to purchase that triggers the exercise of the latter's right of first refusal, the franchisor will be in a position to embark on a search for a purchaser already within its network, or who wishes to become a franchisee, and thereafter assign the right of first refusal to such person. As a result, the business will ultimately be sold to the person the franchisor has selected rather than to an offeror-purchaser whom it does not know or, worse yet, who wishes to join another network.

As far as rights of first refusal are concerned (as in many other fields), "An ounce of prevention is worth a pound of cure".

Fasken has all the necessary expertise and resources to help you draft agreements that truly protect your rights and to ensure that such agreements are, and remain, genuinely appropriate to your needs.

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