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The role and importance of a first refusal provision in a franchise agreement

Fasken
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Franchising Bulletin

A right of first refusal (sometimes also referred to as a "preferential right") consists of a contractual clause stipulating that, when the franchisee receives an offer that she/he wishes to accept for the sale of its franchised business or an interest therein, she/he must first submit it to the franchisor who, within a period of time provided for in the agreement, may, in preference to the offeror-buyer, decide to acquire such business or interest at the price and on the terms provided for in the offer.

Such a provision is found in most franchise agreements.

Recently, in the context of the negotiation of a major franchise agreement, the lawyer representing the franchisee raised the following interesting question: "Given that the franchise agreement already stipulates the franchisee's obligation to obtain the franchisor's approval prior to selling the franchised business and a process to be followed to obtain such approval, why also add a right of first refusal provision in favour of the franchisor?".

The answer to this question rests first and foremost on the franchisor's role, indeed the duty, to protect its franchise network both in the face of its competition and in the face of any delinquent franchisee, a duty that was clearly stated in the important decision rendered by the Superior Court of Québec (which was confirmed by the Court of Appeal of Québec) in Dunkin' Brands Canada Ltd. v. Bertico Inc.

In order to fulfill this role, the franchisor must, among other things, (i) ensure a healthy continuity of the network, (ii) be able to count on solid and performing franchisees, and (iii) avoid that a franchised business ends up in the hands of persons not chosen or previously accepted by the franchisor.

Certainly, the clauses dealing with the franchisee's obligation to obtain the franchisor's approval prior to selling its franchised business, as well as the process to be followed to obtain such approval, already allow the franchisor to fulfill many of these roles and duties.

However, they do not suffice in all cases!

Here are two examples:

First example:

 

After several months of inadequate management of her/his franchised business, a franchisee decides to sell it at a discount to a person who, although meeting the franchisor's approval criteria, does not have solid experience in the network's sector of activity.

 

In such a case, in the best interests of the franchise network, a franchisor may well prefer to purchase such a franchised business, or have it purchased by another experienced and successful franchisee, in order to improve its management and performance and thereby enhance its performance and value before selling it to a less experienced third party.

 

The provision granting the franchisor a right of first refusal will enable it to achieve such an objective, while the mere clause requiring its approval of the proposed sale will obviously not suffice.

 

Second example:

 

A franchisee wants to sell an interest in her/his business to a friend who has relatively large financial means but who essentially wants to make an investment and does not intend to work actively in it.

 

On the other hand, the franchised business has a key employee who has the interest and skills to eventually take over the management and ownership of the business, but who does not yet have the financial means to acquire the interest that the franchisee wishes to sell now.

 

In such a scenario, through the exercise of its right of first refusal, the franchisor could purchase the interest that the franchisee wishes to transfer to a third party and then transfer it later (or, alternatively, transfer it immediately with assistance in financing the purchase price) to that key employee, thereby enabling a healthy management succession process to be undertaken for that franchised business.

 

Once again, a sale approval clause alone would not allow the franchisor to achieve such an objective.

 

These are only two of the many circumstances that justify the inclusion in a franchise agreement of a provision granting the franchisor a right of first refusal in the event of the proposed sale of the franchised business or an interest therein.

However, such a right of first refusal provision must be in addition to, and not in substitution for, the clause requiring the franchisor's approval in the event of a proposed sale or assignment. These two provisions each play a different but complementary role.

Here are three practical tips in relation with the right of first refusal provision in a franchise agreement:

1. Coordinate the periods and deadlines for exercising the right of first refusal with those for the approval process of a proposed sale or assignment.

Where the franchise agreement contains both a right of first refusal provision and a provision describing a process for approval of a proposed sale or assignment by the franchisee, it is important to coordinate the periods, timeframes and deadlines for exercising these two provisions.

Thus, it is unnecessary to initiate several of the steps of the process of evaluating a proposed buyer if the franchisor exercises its right of first refusal.

However, it is important to allow the franchisor a reasonable and realistic period of time to (i) first, decide whether or not to exercise its right of first refusal and, only if the franchisor chooses not to exercise its right of first refusal, (ii) second, to properly evaluate the proposed purchaser.

2. Have experts draft your right of first refusal provision.

It is important to entrust the drafting of a provision conferring a right of first refusal to an expert in this type of provision in order to ensure that you obtain solid protection that cannot be easily circumvented.

If the clause is not complete and very well drafted, the franchisor may not realize until it is too late, by the time a potential buyer has found a way to circumvent its right of first refusal or to make it impossible or too costly to exercise, that its right of first refusal provision does not really provide the protection it needs for itself and for his network.

3. Add to the right of first refusal provision a dissuasive penalty (or liquidated damages) clause in order to prevent any breach.

Under article 1397 of the Civil Code of Québec, a sale made in breach of a right of first refusal is nevertheless valid and enforceable against the beneficiary of such right (the franchisor). According to this principle, once a sale is made in breach of the franchisor's right of first refusal, the franchisor may not seek its annulment. There are, however, some exceptions to this principle.

 

Therefore, if a sale or assignment is executed in breach of a right of first refusal provided for in a franchise agreement, the franchisor's only recourse will be to terminate the franchise agreement (which may not be in the best interests of the franchise network) or to claim damages (which, in such a case, are often difficult to establish and prove).

 

In order to prevent such a breach, it is therefore appropriate to add to the right of first refusal provision a clause stipulating an appropriate (but not abusive) penalty (or liquidated damages) for contravention of the franchisor's right.

 

This penalty (or these liquidated damages) must be significant enough to act as a real deterrent to the franchisee, or a potential buyer, from entering into a transaction that contravenes the franchisor's right of first refusal.

 

Unfortunately, we have seen a few situations where, due to a low penalty, a franchisee and its purchaser have preferred to pay the penalty rather than respect the franchisor's right of first refusal.

 

You will also find, in our bulletin entitled “Can Your Right of First Refusal be Easily Circumvented?”, a few other practical tools to prevent a breach of a franchisor's right of first refusal.

 

Fasken has all the experience and resources to help you draft agreements that are complete, appropriate and, even better, well adapted to your concept, needs and resources, that well protect your rights while avoiding potential pitfalls.

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