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Bulletin

Disputes Between a Franchisee’s Shareholders: Better to Prevent than to Cure

Fasken
Reading Time 6 minute read

Franchising Bulletin

The management and operation of a franchised business require a great deal of time and energy on the part of the franchisee. A number of franchised businesses also require financial resources that are not always readily available from a single individual.

For these reasons, and even more so in the case of franchisees from younger generations (Generations X and Y, and Millennials), franchisors often find themselves with franchisees made up of several partners or shareholders.

This has several advantages, but also carries a risk: that of a disagreement, or even litigation, between a franchisee's partners or shareholders.

In my professional practice as an advisor, lawyer, and mediator in franchise law, I am consulted more and more often for this type of issue.

Disputes between a franchisee's partners or shareholders can often have serious consequences for the franchisee's performance, as well as on its relationships with its employees and with the franchisor, and can even, in some cases, paralyze the decision-making process within the franchisee's organization. I have even witnessed situations where such disputes ultimately led to the franchisee's collapse.

For example, a recent situation where a minority shareholder of a franchisee (who was the spouse or, more precisely, the ex-spouse of the majority shareholder) had obtained the seizure of the business as part of their divorce proceedings, thus leading to its closing.

In other situations, franchisors have found themselves confronted with a shareholder's sometimes insistent demands to terminate the franchise agreement in order to grant the franchise to a new company made up of only this shareholder (with the obvious aim of excluding one or several other current shareholders).

In several of these cases, the franchisor is not willing to accept one of the franchisee's shareholders becoming the franchisee's sole shareholder (particularly when, until that point, this person was not really active in the management of the franchised business, or in the case where this person does not meet the franchisor's selection criteria) while the franchisee's other shareholder does not have the necessary resources to buy his interests in the franchisee.

Can a franchisor do anything to prevent or avoid such difficulties, or at the very least minimize their impact on the franchisee's operations, its relationship with the franchisee, and the franchise network?

This is a delicate subject, since there is always the risk that, by getting involved in a dispute between a franchisee's shareholders, the franchisor may subsequently be criticized for any intervention and underlying motives (whether perceived or genuine), before a court in the event of litigation.

Here are six useful tips for preventing and managing such risks:

Verify that new partners are compatible and complement each other.

During the qualification process for a new franchisee made up of more than one person, it would be appropriate for the franchisor to gauge the partners' compatibility and complementarity.

This can be a good opportunity for the franchisor to ascertain that each one of the partners fully understands his/her role and responsibilities; that the partners are genuinely all in agreement on the franchisee's business plan; that they fully understand and accept all the risks inherent in the franchise; and that their goals are compatible and realistic.

Stipulate appropriate clauses in your franchise agreement

Increasingly, franchisors are including clauses in their franchise agreements enabling them to take effective action if a problem arises between the franchisee's partners or shareholders.

Several clauses may come in handy to prevent and manage such risks, including, among many others, a compulsory monitoring clause, a designated operator clause, a clause requiring a shareholders' agreement, clauses instituting dispute resolution measures, etc.

It is also possible to include a clause stipulating that a dispute between shareholders will constitute a breach of the franchise agreement if it impairs the operation of the franchised business, negatively affects the reputation of the brand, or prevents the franchisee from complying with one or more of its obligations.

Make sure that the partners have complete and well-drafted agreements between themselves.

Whether or not the franchise agreement includes a clause to this effect, the franchisor can seek assurance from its franchisee that its partners or shareholders have signed a proper shareholders' agreement.

Although it is somewhat risky for a franchisor to interfere with the contents of this agreement, it may nevertheless raise the awareness of the franchisee's partners as to its importance, of the clauses which the agreement should contain, and of the importance of appealing to a competent and experienced professional when drafting such agreements.

An incomplete or inadequate shareholders' agreement may leave the franchisee's shareholders or partners with the false sense that their interests are adequately protected, only to discover the weaknesses of the agreement when there is a problem.

In my experience, an agreement that is ill-defined, incomplete or inadequate for the needs and situation of each business is sometimes worse than not having one at all.

Make sure the franchise agreement takes precedence over the shareholders' agreement.

Even though, as I mentioned earlier, it is risky for a franchisor to interfere with the contents of a franchisee's shareholders' agreement, the franchisor might very well require, with a clause in the franchise contract to such effect, that this shareholders' agreement contains certain obligatory clauses, particularly a clause stipulating that, in any event, the provisions of the franchise agreement take precedence over those of the shareholders' agreement and a clause that states that any transaction of shares or other interests in the franchisee, even between its partners or co-shareholders, may only be made in accordance with the provisions of the franchise agreement.

Obtain personal covenants from each partner

A great way to get a franchisee's associates and shareholders to work together with the franchisor to help them deal quickly and effectively with any dispute between them is to get, at the time of the signing of the franchise agreement, personal covenants from each of them (even those who are not active in the operation of the franchised business) to respect all clauses and conditions of the franchise agreement.

Consult an expert without delay

If, despite your precautions and efforts, a serious dispute arises between the partners or shareholders of a franchisee, a practical and important piece of advice for the franchisor is to quickly call on an expert in the field.

These are indeed very delicate situations in which a franchisor may unintentionally render itself liable if it takes an inappropriate action or, conversely, fails to take an appropriate action in due course.

In this regard, it is also useful to include a clause in your franchise agreement that stipulates the obligation of the franchisee to reimburse the franchisor for any fees or other expenses incurred by the franchisor when the franchisor has to seek the assistance of a legal advisor or other expert in connection with any difficulty involving or affecting the franchisee.

Fasken has all the expertise and resources needed to help you draft agreements that protect your rights, as well as to advise, guide, and assist you in all cases of difficulties or disputes with one or more of your franchisees.