By Richard Brown and Andrew Heckler, SDV

 

There has been a recent surge in lawsuits filed by employees and customers of restaurants, hotels, and other major retailers, alleging violations of the Illinois Biometric Information Privacy Act (“BIPA”). BIPA generally prohibits the collection, use, and disclosure of biometric data without an individual’s prior written consent. As part of the enforcement mechanism of BIPA, the Illinois legislature created a private cause of action permitting individuals to bring lawsuits against entities and recover between $1,000 and $5,000 for each violation of the law. Since 2008, plaintiffs have increasingly taken advantage of this private right of action, asserting claims against companies spanning multiple industries for violations of BIPA.

Several notable franchise systems have been the recent target of suits brought by current and former employees alleging BIPA violations. In July, for example, a McDonald’s franchisee was hit with a class action complaint alleging that its use of a fingerprint scan timecard device violated BIPA and exposed workers to “serious and irreversible privacy risks.[1] Just this past month, KFC, Taco Bell, and Pizza Hut’s parent company, Yum! Brands, Inc., was sued by a group of employees, similarly alleging that the franchisors’ use of biometric time-tracking equipment violated BIPA and exposed the plaintiffs to serious privacy risks.[2]

Commercial policyholders facing suits for alleged BIPA violations have turned to their insurance carriers seeking a defense and indemnity against such actions. These efforts have largely been met with skepticism by insurers and a denial of coverage due to the unique nature of BIPA claims, which include elements of both cyber and privacy-related risks. As the use and regulation of biometric data continues to expand, a similar increase in associated privacy suits and insurance coverage litigation is expected to follow.[3] As a result of these growing exposures, it is critical that policyholders carefully review their insurance programs to confirm that coverage is available for alleged violations of BIPA and similar privacy laws regulating the use of biometric data.

This article will discuss recent case law involving insurance coverage for BIPA claims and the associated implications for corporate policyholders, including relevant policy terms to consider and recommended strategies for policyholders facing BIPA claims.

Though few courts have interpreted insurance policies in the context of BIPA claims, one significant decision came out of the Appellate Court of Illinois earlier this year. In W. Bend Mut. Ins. Co. v. Krishna Schaumburg Tan, Inc., 2020 IL App (1st) 191834, appeal allowed, 154 N.E.3d 804 (Ill. 2020), the Court held that West Bend had a duty to defend a franchisee for a lawsuit by a former client alleging violations of BIPA. In April of 2016, Krishna Schaumburg Tan, Inc., a franchisee of L.A. Tan, was hit with a class action lawsuit alleging that Schaumburg violated BIPA through its use of biometric scanning equipment to confirm membership and monitor access to the business. Id. at 2. Upon receipt of the complaint, Schaumburg tendered the claim to its carrier West Bend, who issued a Business Owners Liability Coverage Policy for the relevant period. Id. at 1. The policy stated that West Bend would defend and pay “those sums that [Krishna] becomes legally obligated to pay as damages because of…’personal injury’…to which this insurance applies.” Id.“Personal injury” was defined to include “oral or written publication of material that violates a person’s right of privacy.” Id.

West Bend denied coverage to Schaumburg, arguing that the allegations did not fall within the definition of “personal injury,” and further, that they fell within the scope of an exclusion for “personal injury” arising out of “any statute, ordinance or regulation…that prohibits or limits the sending, transmitting, communicating, or distributing of material or information.” Id. at 2. West Bend then filed suit seeking a declaration that it had no duty to defend or indemnify Schaumburg against the underlying class action. Id.

The trial court granted Schaumburg’s motion on the issue of West Bend’s duty to defend. Id. West Bend subsequently appealed, at which point the Appellate Court of Illinois affirmed the decision of the trial court, holding first that the complaint alleged a “personal injury” as defined by the West Bend policy. Id. at 4-6. The Appellate Court similarly held that the allegations did not fall within the scope of the Violation of Statutes Exclusion, noting that the BIPA statute does not regulate methods of communication, but rather the “collection, use, safeguarding, handling, storage, retention, and destruction of biometric identifiers and information.” Id. at 7 (emphasis in original). Accordingly, the Appellate Court affirmed the trial court’s decision that West Bend has a duty to defend Schaumburg in the underlying class action suit.

Corporate Policyholder Coverage Implications

The Schaumburg decision is significant to policyholders for several reasons, including being one of the only decisions analyzing the scope of an insurer’s duty to defend in the context of a BIPA suit. Schaumburg is of further significance due to its broad precedential value in that the policy language at issue is standard Insurance Services Office (“ISO”)[4] language commonly found in most general liability policy forms. As such, the principles and holding of Schaumburg can easily be applied to any general liability policy to determine whether coverage is afforded in connection with alleged BIPA violations.

Policyholders Should Look To General Liability Coverage For BIPA Claims

            Most general liability policies provide coverage for claims alleging personal and advertising injury, defined to include “oral or written publication, in any manner, of material that violates a person’s right of privacy.” This is a standard coverage grant for “personal and advertising injury” that is widely utilized and found in most general liability forms, including ISO Commercial General Liability Form CG 00 01 04 13 and Businessowners Coverage Form BP 00 03 01 06.[5] Again, the Schaumburg court held that this standard coverage grant for “personal and advertising injury” provides coverage for BIPA claims alleging disclosure of biometric data to one or more third-parties. Thus, policyholders should consider coverage under general liability forms when facing such claims for alleged BIPA violations.

Exclusion For Distribution of Material in Violation of Statutes Does Not Apply

West Bend further argued that the Violation of Statutes Exclusion, which is a standard provision found in ISO Commercial General Liability Form CG 00 01 04 13 and Businessowners Coverage Form, applied to bar coverage. The exclusion bars coverage for personal and advertising injury arising directly or indirectly out of any action or omission that violates or is alleged to violate:

• The Telephone Consumer Protection Act, including any amendment of or addition to such law; or

• The CAN-SPAM Act of 2003, including any amendment of or addition to such law; or

• Any statute, ordinance, or regulation, other than the TCPA or CAN-SPAM Act of 2003, that prohibits or limits the sending, transmitting, communicating, or distribution of material or information.[6]

The Court in Schaumburg notably rejected this argument, however, holding that the exclusion applies to statutes that govern certain methods of communication, such as emails, faxes, and phone calls. BIPA, on the other hand, “says nothing about methods of communication, but rather, “regulates the collection, use, disclosure, retention, and destruction of biometric data.”[7]

Thus, policyholders seeking coverage under a general liability policy for BIPA claims should note the holding in Schaumburg and challenge any denial of coverage or reservation of rights that is based upon the Violation of Statutes Exclusion.

Additional Exclusions To Consider

            Policyholders should consider a number of exclusions recently raised by Insurers in defense of coverage, including exclusions for employment-related practices and access or disclosure of confidential or personal information.[8] Although no decision has been issued construing these exclusions in the context of a BIPA claim, policyholders are likely to prevail in defeating these defenses to coverage based upon the language of the exclusions and general principles of policy interpretation. The law in nearly every jurisdiction places the burden on an insurer to prove that a claim is within the scope of an exclusion and requires an exclusion to be narrowly construed against the insurer and in favor of coverage.

Conclusion

The Schaumburg decision, and the recent influx of BIPA related suits filed in Illinois courts, are a further reminder of the evolving risks franchise systems face. Though biometric claims are primarily concentrated in Illinois, other states have drafted and passed similar legislation. It is anticipated that further laws will ultimately be enacted at both the state and federal level.

As a result of these growing exposures, it is critical that policyholders carefully review their insurance programs to confirm coverage is available for alleged violations of BIPA and similar privacy laws regulating the use of biometric data.SDV’s Franchise Practice Group is here to assist policyholders review their insurance programs and confirm whether access to coverage is provided for BIPA and similar privacy claims.

 

Richard W. Brown (RBrown@sdvlaw.com) is a Partner in SDV’s Northeast Offices and leads the Franchise Practice Group. Andrew G. Heckler (AHeckler@sdvlaw.com) is an Associate with SDV and a member of the Franchise Practice Group. Saxe Doernberger & Vita’s Franchise Practice Group provides counsel to policyholder franchisors and franchisees on all issues related to insurance coverage and risk management. For more information about International Franchise Association (IFA) supplier member Saxe Doernberger & Vita, click here.

 

[1] Currie et al. v. McEssy Investment Co., case number 2020-CH-04825, in the Circuit Court of Cook County.

[2] Ronnell Payne v. Yum Brands Inc., case number 2020-CH-06811, in the Circuit Court of Cook County, Illinois.

[3] Advancements in technology and the proliferation of biometric data has resulted in states like Texas and Washington passing legislation similar to BIPA. More recently, federal legislation known as the National Biometric Information Privacy Act (“NBPA”) was introduced, which would impose uniform national requirements similar to those of BIPA.

[4] The Insurance Services Office, Inc. (ISO), “an association of approximately 1,400 domestic property and casualty insurers… is the almost exclusive source of support services in this country for [general liability] insurance. ISO develops standard policy forms and files them with each State’s insurance regulators; most CGL insurance written in the United States is written on these forms.” Hartford Fire Ins. Co. v. California, 509 U.S. 764, 772 (1993).

[5] See, e.g., Insurance Services Office (ISO) Commercial General Liability Form CG 00 01 04 13, Section I – Coverage B – Personal and Advertising Injury, § 1. a. 1., and Businessowners Coverage Form BP 00 03 01 06, Section II – Liability, § A. 1. a.

[6] See e.g., ISO Businessowners Coverage Form BP 00 03 01 06, Section II – Liability, § B. 1. s.

[7] Schaumburg, 2020 IL App (1st) 191834, at *7.

[8] Am. Family Mut. Ins. Co. v. McEssy Inv. Co., No. 1:20-cv-05591 (N.D. Ill. Sept. 21, 2020).

By Jennifer Stallings Dewey & Rebecca Papi, Dickinson Wright

It would be difficult to find any person or business that has not been affected by COVID-19. Over the last few months, most states have issued “stay at home,” “shelter-in-place,” and other similar orders. Businesses all over the country have ceased operating. Many others that have remained opened have experienced a substantial decrease in their business volume. Americans have filed for employment in record numbers. Franchise systems are no exception and have faced closures, layoffs and a myriad of other issues. While this ongoing crisis is causing hardship all around, franchise systems will eventually recover. This will undoubtedly present opportunities for existing and prospective franchisees interested in buying or selling franchise units amidst recovery from this difficult period.

These mandated closures (or decreased business) and uncertain economic climate will uniquely, and perhaps disproportionately, affect franchise businesses. Although a number of franchisors have made concessions to their franchisees (i.e. waiving or deferring royalty payments or making concessions relating to defaults), not all franchisors are able or willing to make such accommodations. This means that many franchisees are not only losing revenue, and subject to the normal expenses of a business (rent, utilities, labor costs and the cost of supplies and/or inventory), but they may also still be liable for royalty fees and/or required purchases.

These forced closures may make it impossible or undesirable for some franchise units to return to business as usual. Some businesses will suffer financial hardship such that reopening will be impossible. Other franchise owners may have used this mandatory time off to consider what might be next for them. Regardless of the reason, it may be time for many franchisees to consider selling their businesses.

The good news is that there will probably be continued, and maybe even increased, interest in purchasing a franchise. Over 30 million Americans have filed for unemployment since the beginning of the pandemic. (1) With relief afforded under the CARES Act, this not only includes traditional employees, but also self-employed contractors and business owners. For those in this position looking for a new beginning, it may be a good time to consider investing in a franchise. While there are of course risks with opening a business, franchises offer certain advantages including: 1) a business model (everything from pricing to branding) that has already been established and proven; 2) scale for purchasing supplies and inventory; 3) communal knowledge and experience across the system; and 4) shared operating costs such as marketing. These elements provide a benefit to franchises as they reopen following quarantine and make these businesses attractive to prospective purchasers. Further, according to Franchise Direct, even though the 2008-2010 recession took a toll on the U.S. economy, franchises fared better than most other retail chains and small businesses. (2)

Franchising is a unique and complex business model and the resale of a franchise unit by the franchisee includes a number of considerations. This article will address pertinent legal concerns relating to this type of sale and discuss some of the steps that can be taken now in preparation of a sale.

Franchise Agreement and Other Contractual Obligations

When addressing any question or issue relating to a franchise, the first stop should always be the relevant franchise agreement. A franchise agreement outlines all of the terms of the franchise relationship. Most franchise agreements contain provisions relating to the transfer of the franchise. The franchise agreement may contain provisions relating to any or all of the following:

 

• Franchisor must approve of sale.
• Purchaser will have to be approved by franchisor and a franchisee.
• Franchisee must pay a transfer fee.
• Franchisee must be in compliance with the franchise agreement and other related agreements.
• Purchaser must execute franchisee’s current franchise agreement (or a new franchise agreement), and any subsequent addendums, or ancillary agreements.
• Franchisee must execute a general release of the franchisor from obligations under the franchise agreement and related agreements.
• The purchase agreement between franchisee and purchaser relating to the sale of the franchise must be approved by the franchisor.
• Franchisor requires franchisee or purchaser to update the franchise to the most current facility image, which may include design, construction, signage, and equipment specifications required by the Franchisor.
• Franchisee must pay all costs of franchisor in granting approval.

 

The franchise agreement may also contain provisions relating to a franchisee’s conduct following its termination (which would occur along with a sale). Such provisions may include any or all of the follow:

• Non-compete, exclusivity, or territorial requirements – prohibition against franchisee engaging in business that competes with the franchise system, owning competitor franchises, or locating a new franchise in another franchisee’s exclusive territory.
• Non-solicitation – prohibition against the franchisee recruiting customers, suppliers or employees of the business being sold
• Confidentiality obligations with respect to the franchisor’s trade secrets, financial information, business model, etc
• Requirement that the franchisee cease using the franchisor’s trade name, service marks or trademarks
• Requirement that the franchisee de-identify or disassociate property with the franchise system (in the event the selling franchisee retains such property)

 

If a franchisee owns multiple units or has additional arrangements with the franchisor, such as an area development agreement or territory agreement, there may be additional documentation to consider relating to a sale of one or multiple franchise units. Each such document should be carefully reviewed by an attorney experienced in franchise law to determine what contractual obligations exist between the franchisor and franchisee that will affect the sale.

In addition to the franchisor, there may be other parties affected by the sale. If there is any financing associated with the business, it may be necessary to obtain the lender’s approval to the sale. Likewise, depending on whether real property is owned or leased, approval from a lender, transfer of the property, or assignment of a lease may need to occur. If the business involves special licenses or permits, those may need to be transferred and may require approval of a government agency or other third party. When updating a facility image, there may be local governmental approvals required in connection with design and construction. Lastly, the sale may trigger contractual rights of other parties such as suppliers or customers that may have a right to notice or consent to the sale.

Statutory Law

Generally, franchises are governed by both state and federal law. The federal law, the Federal Trade Commission’s Franchise Rule, focuses on the disclosure requirements for a franchisor selling franchises and does not contain anything specific to subsequent transfers. A number of states contain statutes specific to franchises. A smaller subset of those states have what is known as franchise relationship laws. Certain relationship laws contain provisions relating to the transfer of franchises. If the business is located in one of the ten states (3) with such laws, it is important that the seller be familiar with the obligations or rights provided in this legislation.

These laws differ in content but generally impose one or both of the following: 1) restrictions on the franchisor’s right to approve or disapprove the sale of the franchise and/or 2) notice requirements that provide certain time periods during which the franchisee must provide notice of the proposed sale to the franchisor. These state statutes will overrule the contractual terms contained in the franchise agreement.

Preparing for Sale

The purchaser of a franchise business from a franchisee (as opposed to purchasing a new unit directly from a franchisor) will need to assume the rights and obligations of the existing franchisee under the franchise agreement (or enter into a new franchise agreement). Further, the purchaser will assume all or some of the assets (including contract rights and obligations) of the seller. The purchaser will learn all about the brand and related franchise system from the franchisor; however, the seller will be responsible for providing detailed information about its specific unit(s). This process, common in the sale of all businesses (not just franchises), is typically referred to as due diligence.

During the due diligence process, the purchaser will request a considerable amount of information about the business it is purchasing. Requests for information may include some or all of the following documentation:

• Corporate records (formation documents, bylaws, operating agreements, minute books, list of officers, directors, and/or managers, organization chart)
• Member or shareholder information
• Financial statements for the past 3-5 years (as well as internal budgets, projections and other financial reports)
• Financings/encumbrances (debt agreements, financing arrangements, details of any governmental grants, subsidies, or other financial assistance)
• Lists of assets
• Material contracts and commitments (vendor contracts, distributor contracts, sales representative contracts, joint ventures or partnership agreements, franchise agreements, license agreements, advertising, and consultant agreements, equipment or other personal property leases, installment sales agreements, standard form contracts, etc.)
• Tax returns for the past 3-5 years (including any correspondence from the IRS, audits and reports by the IRS, list of any deficiencies, fines, penalties or assessments, etc.)
• Legal/liability issues (including all law suits, claims, administrative proceedings or other governmental investigations, etc.)
• Intellectual property (including registered and unregistered patents, trademarks, copyrights, tradenames, domain names, software licenses, technology sharing, use and disclosure agreements, etc.)
• Insurance policies
• Environmental matters
• Human resources (including a list of all employees, including positions salaries and bonuses paid, employment agreements, non-solicitations or non-competition agreements, employee benefits, retirement plans, company handbook, etc.)

The list above is not exhaustive. The information a prospective purchaser will need to evaluate depends on the type of business involved and the individual circumstances underlying the transaction. Ideally, every business would maintain accurate and complete records. Realistically, this does not always happen. It is not uncommon for records to be disorganized, out of date or incomplete. The recent closures and/or decline in business due to COVID-19 may be a great time to do an internal audit of records and get things in order. This is especially a good idea if a sale is on the horizon.

Conclusion

The decision to buy or sell a franchise is a difficult one. As outlined in this article, there are a number of considerations to take into account and the initial decision is just the beginning of the process. The current state of affairs in the world with mass quarantines, business closures, and economic uncertainty is alarming to say the least. While no one is certain as to when things will return to business as usual, we do know it will happen eventually. This crisis may give rise to an increase in opportunity for the purchase and sale of franchise businesses. Securing experienced and knowledgeable advisors to assist with this process including attorneys, accountants and financial advisors is invaluable preparation for such opportunities.

 

Jennifer Stallings Dewey is a Member in Dickinson Wright’s Detroit office. Rebecca Papi is an Associate in Dickinson Wright’s Detroit office. For more information on Dickinson Wright, click here.

 

 
(1) https://www.nytimes.com/2020/04/30/business/stock-market-today-coronavirus.html

(2) https://www.franchisedirect.com/information/a-look-at-how-franchises-impact-the-economy

(3) Arkansas, California, Hawaii, Indiana, Iowa, Michigan, Minnesota, Nebraska, New Jersey and Washington. See Ark. Code Ann. § 4-72-205(a); Cal. Bus. & Prof. Code § 20027; Haw. Rev. Stat. Ann. § 482E-6(2)(I); Ind. Code Ann. § 23-2-2.7-2(3); Iowa Code § 523H.5; Mich. Comp. Laws Ann. § 445.1527(g); Minn. R. 2860.4400; Neb. Rev. Stat. § 87-405; N.J. Stat. Ann. § 56:10-6; Wash. Rev. Code Ann. § 19.100.030.

Most franchise systems are facing severe financial impacts as a result of the continued spread of COVID-19 and the numerous government-mandated shutdowns that have been ordered by state and local officials in response. Even if your franchised operations are considered essential and able to remain open during the shut-down, franchisees may have exposures, in addition to a loss of revenue, which may further impact franchisors. Below is a list of possible exposures franchise systems should be thinking about and preparing an action plan to minimize the risk of loss.

 

Is insurance coverage available for the loss of revenue resulting from COVID-19 and related government mandated shutdowns? 

Franchisors should review their current business interruption insurance policies to assess their ability to file claims as a result of virus-related business interruptions. Even if there are potential coverage exclusions that would preclude coverage for COVID-19 related losses, such as a virus exclusion, it is important to discuss with coverage counsel if it is necessary to report the claim to meet any reporting obligations in the event a government authority mandates coverage under the policy regardless of the virus exclusion. In addition to business interruption insurance, franchisors should also review other active insurance policies, such as directors’ and officers’ insurance and general liability insurance, among others, that may be implicated by complications caused by the COVID-19. It is crucial that franchisors understand the extent of their current coverage, any weaknesses in their coverage that should be addressed, and what their options are in the event of business disruptions or other adverse events.

 

How will royalties be affected during COVID-19 government-mandated shutdowns? Will franchisors be able to collect royalties from the proceeds of a business interruption claim? 

A franchisee may or may not be obligated to pay the required royalty minimum if the business is shut down because of a government-ordered shutdown. A careful reading of the FDDs will determine if royalties are owed or if there is a contractual clause that removes the requirement during this time. If a franchisee has a covered business interruption claim, the franchisor may be entitled to royalties, depending on a variety of contractual considerations. There are two key sections that may affect the outcome: 1) the definition of the contractual term which dictates how to calculate the royalty, such as “gross revenues” or “income” and 2) the insurance requirements. Is there a specific requirement for the franchisee to carry business income coverage? If so, is there a requirement that the business income limit include the amount owed to the franchisor for royalties? Additionally, there may be an equitable argument to be made by the franchisor that the franchisee (insured) is not able to profit from the loss. Therefore, if the franchisee receives insurance coverage for the full amount of income lost during this time, and if the franchisee does not pay the contractually required royalty, then it has unfairly profited from the insurance proceeds. The ability for this argument, to be made by the franchisor, may vary from state to state depending on the applicable law.

 

Franchisees may not be able to make rent payments because of the loss of income. What are the landlord’s rights if a tenant is unable pay rent or pays rent late? 

A review should be made of all lease agreements for corporately owned and sub-leased franchised locations to assess the parties’ rights and obligations in light of the COVID-19. Many commercial leases will afford landlords special powers, in light of a public health emergency, and the franchisor should consider whether these landlords may have the ability to take any action that may disrupt the franchisor’s business or the business of its franchisees. The franchisor should also look to the lessees’ rights under the various government actions in response to COVID-19 as some are temporarily relieving lessees of their rental obligations. There  may also be temporary relief of utility payments, that the responsible party should be aware of, in the event those payments cannot be made as required.

 

Supply chains are being affected because of COVID-19. What steps can be taken to mitigate the negative implications of supply chain disruptions? 

A number of businesses are already experiencing supply chain disruptions, especially those that purchase key supplies and goods from vendors based in China, Italy, or South Korea. As COVID-19 spreads and government-mandated shutdowns continue, further and more frequent supply chain disruptions are anticipated and should be expected. It is necessary to remain in constant contact with core suppliers and vendors to assess their current status, whether these suppliers and vendors are expecting any disruptions that may impede their ability to meet the franchisor’s demands, and whether it is possible to address any supply bottlenecks or shortages before they have a substantial impact on the franchisor’s operations. Additionally, you should be requiring your key suppliers and vendors, especially in the food, retail, and hospitality spaces to demonstrate that they have implemented additional health and safety measures, concerning their own operations, to assure the safety of products being provided to franchisees for resale. When possible, alternative suppliers should be sourced and crucial materials and products should be stockpiled to ensure continuity of business. As supplies and goods, particularly food, become more limited and there are additional financial burdens put on the supply chain, there may be an increase in price. It is important to review your contracts to establish if either the franchisor or franchisees is responsible for price variances. As a franchisor, it is important to communicate with and provide the needed assistance to your franchisees as to the policies that will be implemented to minimize the risks associated with supply chain disruptions.

 

Will new legislation effect my business during the COVID-19 pandemic? 

COVID-19 Legislation 

New York, Pennsylvania, New Jersey, Massachusetts, Ohio, Louisiana, and South Carolina, along with the federal government have drafted legislation that would mandate insurers cover business interruption losses resulting from government-mandated shutdowns because of COVID-19. The legislation would effectively negate the property policy trigger requiring a direct physical loss to property and void virus/disease/pandemic/public health exclusions. If the Pandemic Risk Insurance Act of 2020 (“PRIA”) is passed and the Federal Pandemic Risk Reinsurance Fund and Program is established, the coverage would apply retroactively to commercial property and casualty policies already in place. Upon renewal of the insurance policies, the insured would need to affirmatively elect the coverage and pay an increase in premium, similar to Terrorism Insurance.

 

Legislation Impacting Franchised Operations

In addition to pending legislation addressing insurance coverage for losses resulting from COVID-19, proposed legislation pertaining to franchises throughout the country, may continue to be enacted and enforced as planned or maybe suspended due to the outbreak. The enforcement of California AB5 is expected to have an impact to franchisors based in and operating in California. Currently, the law has had an impact on the ability to hire healthcare workers which has caused Governor Newsom to suspend the enactment of the bill. There may be other legislation that effects your business that Governors either most strictly enforce or lift the enforcement because of the effects on managing the outbreak of COVID-19.

 

Franchisors and franchisees enter into a variety of contracts to carry out the day-to-day needs of the business. If a business is unable to meet its contractual obligations, is there a way to be excused without being in breach of contract? 

Many contracts will contain force majeure provisions, which typically excuse one party from performing its obligations under the contract as a result of a specified event. Such events often include war and unrest but can also often contain broad language concerning global health issues or events. Key contracts need to be assessed to determine whether a force majeure provision is present, whether its scope addresses this issue, and whether there is any risk of the other party exercising such provision to excuse its own performance under the contract. Franchisees may be excused from payment of minimum royalty or advertising fees and other financial obligations franchisors generally rely upon, under the express terms of their franchise agreement. Franchisors should be looking to all contracts they have entered into and not just contracts with their franchisees. Furthermore, franchisors will want to review contracts for upcoming events, supplier and vendor agreements, and relevant leases to confirm their scope of rights and obligations and identify any force majeure terms that may be utilized to avoid certain contractual obligations.

 

COVID-19 is causing a crisis for many businesses. How should franchising organizations prepare for an ensuing crisis? 

Now is a good time to test the performance of your organization’s crisis management plan. Franchisors should practice how the system would address and respond to a potential crisis, including health-related emergencies. At a minimum, in light of the current situation, the plan should be reviewed, updated, and circulated across the system to ensure all parties understand what their obligations are under the plan. Although the risk that COVID-19 poses to business is severe, franchisors should avoid taking any premature drastic actions that may adversely impact their business and those of their franchisees. Measured and proactive steps, such as those explored above, can allow the franchisor to minimize potential COVID-19 risks to its business. It is advised for organizations to reach out to their broker or coverage counsel to determine if the applicable insurance policies contain crisis-related coverage extensions which may provide coverage for action needed to be taken in order to prevent the spread of the virus.

 

How will COVID-19 and the government-mandated shutdowns effect renovation work and the construction of new locations?

For any location that is currently undergoing construction, franchisors and franchisees will want to establish if and how construction may continue under the various government orders. Some states and cities have established that only construction that is deemed essential may continue and all other projects must be shut down. Depending on the nature of your business and what projects are considered essential, as defined by the particular government order, the construction of your project may be deemed essential and allowed to continue work. For those projects where work may be continued, there may be certain safety standards that are required by the government order that you will need to include in any updates to site safety measures that are to be taken as COVID-19 continues to be a risk.

We hope that you and your families are staying safe and healthy during these difficult times, and while we recognize that you will need to consider these issues in the context of your particular franchises operations and agreements, we hope that you find the guidance provided herein useful as you navigate these difficult times.

Richard W. Brown is a Partner with SDV and leads the Franchise Practice Group. Anna M. Perry and Andrew G. Heckler are Associates with SDV and members of the Franchise Practice Group. Saxe Doernberger & Vita’s Franchise Practice Group provides counsel to policyholder franchisors and franchisees on all issues related to insurance coverage and risk management generally. To learn more about Saxe Doernberger & Vita, P.C., click here.

By Andrae J. Marrocco, McMillan LLP

Franchise systems are facing unprecedented upheaval in the wake of the COVID-19 pandemic. Franchisors are currently responding to a myriad of challenges confronting their franchise systems. However, as the implications of COVID-19 continue to unfold, franchisors must continue to assess and pivot to successfully navigate through these uncertain times.

This article explores some of the high-level issues, strategies and recommendations arising from the experiences of various franchisors that may assist other franchisors as they continue to respond to the COVID-19 pandemic.

1. Health and Safety is Paramount

The health and safety of all individuals associated with a franchise system is a primary and continuing concern for franchisors. Reconsidering protocols, processes and persons involved at all levels of a franchise system – from the franchisor’s employees and service providers to the ultimate customers serviced by franchisees – and focusing on protecting health and safety are more important than ever.

The following are recommendations for creating, implementing and monitoring enhanced health and safety policies:

• Carefully assess where health and safety protocols require enhancement, and this assessment will likely need to be done more than once as the pandemic continues.
• Review the legal rights and mechanisms available (in franchise agreements and operations manuals) for both implementing and monitoring system changes.
• Communicate with franchisees regarding the rationale and legal framework for proposed changes.
• Consider consultation with franchisees for input and feedback (before and after implementation).
• Record proposed changes with robust legal documentation that addresses all legal concerns associated with the system change and monitoring. The legal terms should allow for flexibility to, among other things, permit further updates, and should adequately cater to the ever-changing legal environment (for example, mandated closures of non-essential services businesses).
• Observe applicable franchise laws, such as the obligation to act in good faith toward franchisees, to minimize the risk of later claims. Some of the items in this bullet list can assist franchisors in satisfying their obligation to act in good faith.
• Create implementation and monitoring protocols that include informing franchisees of proposed measures and the process for adopting them.
• Protect against the potential liability created by implementing system changes, including the risk of franchisors being deemed to be taking an active role in franchisees’ businesses.

1. Remain Current and Informed

Undoubtedly, one of the conundrums faced by franchisors is that franchisees are looking to franchisors for guidance in circumstances where there is no blueprint or manual. It is essential for franchisors to remain informed about developments (across all relevant jurisdictions) including with respect to: (i) changing health and economic conditions as they relate to COVID-19; (ii) regulatory policies and orders from all levels of government, and how such regulations are being interpreted; and (iii) the relief and stimulus packages available. In each case, franchisors should understand how these developments impact and apply to the franchise system (and particularly the franchisees). Franchisees are relying on their franchisors’ wisdom and judgment in these matters.

McMillan has a number of resources to assist franchisors in staying current on all regulatory notices and changes taking place across Canada. These resources can be found on our website here. 

In addition to establishing consistent and multi-faceted methods of communication to keep franchisees informed of the above matters, prudent franchisors are also: (i) synthetizing the relevant information so that it makes sense to their franchisees (in their respective jurisdictions); (ii) monitoring and assessing what other businesses and franchise systems are doing in the circumstances; and (iii) sharing the franchisor’s plans and responses to daily changes and challenges with franchisees. Importantly, the latter type of communication must be undertaken with care to ensure that, among other things, franchisors are acting within their rights and not making promises that they are not able to deliver on (which may result in misrepresentation or good faith claims down the road).

1. Communicate Continually

The determination by many franchisors to communicate more frequently with their franchisees during the challenges caused by the pandemic demonstrates their commitment to their franchisees. In most cases, these frequent communications extend beyond information updates and system changes. They are part of an intentional strategy to ensure that franchisees receive the support they require, whether it be technical and business-related, or more general and personal.

There are several practical and empirical points to glean from franchisors in this regard. First, franchisors are being creative in utilizing as many platforms as possible – social media, video-conferencing tools, online content, intranet portals, etc. – in maintaining communications with their franchisees. Second, franchisors are also using these platforms to give franchisees an opportunity to voice their concerns, provide feedback on proposed and implemented changes (and the results from same), and share their stories and experiences. Moreover, franchisors are sharing best practices gleaned from their franchisees across jurisdictions as well as “success stories” of what some franchisees are doing to overcome business challenges creatively.

The importance of communication cannot be overstated. However, franchisors must take caution to ensure that all communications with their franchisees are reviewed by appropriate senior management, made by authorized representatives and monitored to avoid inconsistencies and ambiguity, which carry with them increased risk of liability. Such precautions depend on both the content and the form of the communication.

1. Crisis and Continuity Planning

Whether it be an outline of damage control measures or a set of creative solutions to address challenges (or likely both), it is critical that a franchisor chart its franchise system’s course through the pandemic with a plan. Understandably, such a plan is typically a “working document” with sufficient flexibility and nimbleness to deal with current uncertainties and ever-changing conditions. Undoubtedly, the underlying assumptions and proposed strategies will require tweaking and fine-tuning throughout 2020.

Many franchisors are undertaking comprehensive “stress tests” of their entire systems and infrastructure, including business formats, policies, procedures, manuals, supply chains and franchisees, etc. This level of analysis facilitates more robust “modelling” and assessment of various eventualities (both during the course of the pandemic and beyond it). Ultimately, all of this provides franchisors with the insight and tools required for contingency planning, understanding and mitigating the impact of COVID-19 on their system, and for adopting many of the suggested strategies reflected in this article.

The planning process should also identify and address legal issues associated with the strategies to be implemented, and the potential liability arising from both good and bad activities/outcomes, as well as any contemplated present and future system changes. Furthermore, franchisors should seek advice on changes to the judicial process (in all regions in which they operate) as many jurisdictions have limited access to their courts and suspended limitation periods under various laws (although there is ambiguity as to whether such suspension applies to rescission claims).

1. Adaptations and Enhancements

Franchisors acknowledge that addressing the threats caused by COVID-19 has in some cases provided the opportunity to innovate, to develop adaptations and enhancements to their systems, many of which will continue beyond the pandemic. There have been numerous innovative “pivots” by franchise systems, some of the common ones being mobile ordering, delivery and take-out for food businesses, and transition to online formats for service brands such as fitness and child activity concepts. Some have stretched the pivot further by introducing new COVID-19 specific services, for example, brands that utilize vehicles are repurposing them to provide grocery shopping/delivery and home sanitization services. Others have converted their infrastructure to produce new products/equipment to specifically support COVID-19 relief measures, for example, sanitization products and medical supplies. Many of these innovations will enhance franchise system offerings following COVID-19. Online formats are a good example. The demand for online fitness solutions existed prior to the pandemic and the format has met with major success during COVID-19. Significant investment in further research and development has begun, and the demand (as well as the offerings) are set to increase post-pandemic.

These turbulent times have also been helpful for testing and improving franchisors’ business interruption and crisis management policies. In addition, there has been a significant increase in the adoption of remote working and virtual activities. New virtual training courses, increased continuing training activities through free webinars, and virtual discussion sessions where franchisees share their feedback and suggestions have all been beneficial.

There are number of legal matters to address with respect to adaptations and enhancements. First, franchisors must communicate clearly (and in writing) the terms and conditions upon which franchisees are free to explore their own adaptations and enhancements to the business format and franchised business operations. Second, franchisors must determine how adaptations and enhancements will be monitored, assessed, and (as applicable) rolled out across the franchise system. Further, where novel online formats are being offered, franchisors must ask how they accord with existing franchise agreements, as well as applicable laws (such as privacy laws) and how these formats will be integrated into the system offerings going forward. Many of the other legal considerations set out in the first paragraph of this article apply to these types of system changes.

1. Franchisees

Franchisors are able to bring significantly more resources and infrastructure to bear in addressing the challenges created by COVID-19. This gives credence to the familiar franchise refrain, “franchisees are in business for themselves, but not by themselves.” Franchisors are providing assistance and support to franchisees in a number of ways, some of which are detailed below.

Assessment and Monitoring

The focus of many franchisors is on assessing the viability of franchisees and their franchised business. Early intervention in identifying and diagnosing the more vulnerable franchisees and franchised businesses, and those requiring more assistance, has been key. Franchisors must continue to make these assessments on an ongoing basis, as the vulnerabilities and the need for assistance may develop as issues stemming from the pandemic become more severe.

Franchisors should review and confirm the rights they have to obtain more regular, quick and informal financial reports and updates from franchisees. Analysing terms/renewal periods may also be important at this time. This will enable franchisors and franchisees to make informed decisions, even if that involves hard decisions around bankruptcies, permanent closures, or franchisor buy-outs (which will require a careful review of the relevant rights and obligations of the franchisor under the franchise arrangement).

Relief and Concessions

Despite the urgency, prudent franchisors have been deliberate about developing systematic and flexible frameworks for franchise relief and concessions, while still moving with a degree of haste. More than other strategies, providing franchisees with any form of assistance by way of relief or concession can create a landmine of legal issues if not done properly. Importantly, the framework within which a franchisor offers such relief or concessions must include, among other things, a time frame/term, regular review periods, conditions, a statement of no-waiver and termination events. Furthermore, franchisors must build flexibility into these frameworks to accommodate changes that will likely be necessary to address new developments over time.

Any kind of relief, concession, or other deal made with franchisees must be documented in detail with robust terms, and not with a “back of the napkin” type approach (including emails). This is particularly so where such deals involve changes to royalty fees, advertising contributions, minimum inventory purchases, development and opening deadlines, marketing activities and brand standards, etc. Clearly, the best practice is to document these deals beforehand, but executing agreements after the fact is better than not at all. In certain cases, franchisors are providing outright financial assistance by way of loans to their franchisees. These types of arrangements must be treated as separate financing transactions with the typical loan and security legal documentation.

Some franchisors have decided not to provide any form of relief or concession with respect to financial obligations, but are assisting franchisees in other ways. Even where franchisors offer other forms of assistance, it is crucial that such assistance be provided through clear written communication with the appropriate provisos and disclaimers. Even the best of intentions and cooperation at the outset of the crisis can end in disagreement and acrimony (particularly if things become increasingly dire as the crisis continues).

Further Assistance

Franchisees are also calling on franchisors to assist with various franchised business-level issues. There are a few elements to the rationale behind these requests. First, in many cases the issues are system-wide (faced by many franchisees) and second, the franchisor has the appropriate resources and infrastructure to more competently deal with them. Franchisors who decide to provide any form of assistance must do so in an organized and systematic manner, exercising caution so as not to increase their risk of liability, including being held vicariously liable for franchised business-level activities (i.e., being held to be taking an active role in the operations of franchised business). There are legal protections that franchisors can adopt to mitigate and manage risks in this regard. The following are select issues and suggested approaches that franchisors have taken during the COVID-19 pandemic.

• Suppliers. Franchisors have been addressing supply chain issues faced by franchisees. In some cases, this has involved identifying alternative arrangements (whether temporary or permanent), including permitting franchisees to source their own supplies. Structuring and documenting supply chain modifications can be both complex and pressing.
• Financing. Particularly where established financing programs are in place, some franchisors have been involved with system-wide negotiations for relief/concessions under loan arrangements between their franchisees and financial institutions. The best practice recommendation here is for the franchisor to keep in mind the clear distinction between its relationship with the financial institution and its franchisees’ financing arrangements with the financial institution.
• Leases. Franchisors are being called upon to assist with lease negotiations, including considering whether government subsidies apply to certain lease arrangements. While this kind of assistance may be critical to a franchisees survival, if not undertaken prudently and documented carefully, it can also create potential liability for the franchisor.
• Contracts. Franchisees are facing contractual issues with various counterparties in a number of contexts, including invoking force majeure clauses. A franchisor is best advised to avoid giving guidance/advice on contracts to which it is not a party, and instead assist franchisees in securing independent legal advice.
• Insurance. Franchisors should avoid providing guidance on insurance policies held by franchisees, including business interruption insurance, as liability issues and conflicts of interest are prevalent in this context (e.g., where policies require holding off on closing businesses and franchisors are mandating closure to comply with government orders).
• Employees. While it is critical that franchisors do not involve themselves in the affairs of franchisees as they relate to their employees, there may be scope for franchisors to include general guidance in operation manuals (subject to legal review) and to identify a list of resources, including professionals, from which franchisees are able to seek advice.
• Customers. Franchisees are under significant pressure to maintain/increase customer engagement in these times. Franchisors may wish to provide high-level guidance on such matters, but must avoid the risk of becoming actively involved in franchised business operations.

1. Franchise Development

Some franchisors have put franchise development entirely on hold, while others are determined to continue. Those who have decided to continue with franchise development have devised workarounds to partially advance development and onboarding, despite the interruption caused by the COVID-19 pandemic. Virtual discovery days and remote training are a few of the tools utilized by franchisors moving forward with development activities. Clearly, other processes such as on-site training, site development and location openings cannot continue, but franchisors are positioning themselves for a strong recovery in anticipation of post-pandemic times.

Irrespective of the approach to franchise development, at some point franchisors will likely face circumstances where they are required to issue a franchise disclosure document to a franchisee or prospective franchisee; whether as a result of a renewal, resale, or a new franchisee looking to get ahead of the curve. In certain cases, franchisors have provided franchise disclosure documents to  prospective franchisees, but no agreements have been signed, nor any money paid. Accordingly, these franchisors are considering whether to re-disclose or issue a statement of material change. Finally, some franchisors have decided to make further disclosure to franchisees in the onboarding phase, even though they may not be legally required to do so.

Preparing a franchise disclosure document (or other form of disclosure) in each of the scenarios depicted above involves careful consideration and analysis of how COVID-19 has affected the franchise system, and how it will continue to affect the franchise system. However, this is much easier said than done. Largely, the issues, strategies, recommendations set out in this article (as applicable to the relevant franchise system) provide meaningful guidance on the kinds of information that may need to be reflected in any further disclosure.

 

Andrae J. Marrocco is Partner and Co-Chair of the Franchise & Distribution Law Group at McMillan LLP. To find out more about McMillan LLP, click here.

Monday April 6, 2020; 3:15pm-4:15pm

Updates on Rent Relief/Deferment

Panelists: Rocco Fiorentino / Ty Brewster / Rob Cambruzzi

Webinar Summary –

This webinar, featuring returning panelists, outlined changes and updates in negotiating between tenants and landlords given Covid-19-related business uncertainty and slowdowns. The panelists detailed the challenges being faced by both tenants, and landlords, and provided a step-by-step for action by tenants, and guidance on how and what to communicate to landlords. The panelists also discussed the opportunities on the other side of the pandemic crisis.

Key Bullets –

• Landlords continue to look to/for long-term leases in place from reliable tenants
• Existing tenants are valuable, and negotiations are possible, if not now, then soon
• Ask yourself what is “reasonable” before beginning negotiations; be prepared to leverage your position
• Make sure you understand your lease, and equip yourself with knowledge before communicating early, in writing, and reasonably with your landlord
• Use this time to prepare to capitalize on opportunities given new market realities after the crisis has passed

Full Bullets –

• Panelists are Franchise Real Estate specialists; represent tenants
• The world has changed – Landlords are now facing the following challenges:
  • Tenants downsizing, seeking rental relief
  • Access to capital / cash constraints
  • Commercial real estate values / limited buyers for assets
  • Downward pressure on Rent / rising vacancy rates
  • Debt service / looming maturity dates
  • Potential negative PR and reputational issues
• More than anything, Landlords need long-term leases in place from reliable tenants
• 75% of landlords have been open to tenant relief of deferment. 25% have been firm about not accepting requests
• Existing tenants are valuable – the cost and risk of replacing tenants is significant
  • Renewal vs. New tenant à value for landlord is in renewals, rather than offering space to new tenants. It is in the interest of the landlord to stay active and in their location
• State mandates – each state has ordinances in place to help businesses
  • NY – evictions suspended for 90 days
  • CA – no evictions through May 31
  • Municipalities with their own ordinances – pay close attention to these
• What should I ask for? à “What’s reasonable” and ask for what you need; it’s more important the way you ask, rather than what you ask for
  • 1) 3 months of deferred rent – ideally this is the time horizon
  • 2) 2 months of deferred rent
  • 3) April deferment
  • 4) Payment holiday for 90 days
  • 5) Short term & Long term options
• Insurance companies they’re working with are denying claims
• Landlord responses:
  • Landlord response: We’re making no concessions at this time. Tenant response: rent is due now
  • Landlord response: Please provide us an enormous list of documents for consideration. Tenant response:  I am unable to provide in the required time
  • Landlord response: Your store is open and operating, why do you need relief? Tenant response: My sales are down by XX% – push landlords to maintain you as a long term tenant given the circumstances
  • Landlord response: There are government programs for you, have you checked on PPP & EIDL? Tenant response: I have applied and the funds are not available for weeks / months
  • Landlord response: Have you checked for business interruption insurance? Tenant response: No insurance carrier is accepting this given the pandemic circumstances
• Communicate early
• Communicate in writing
• Communicate reasonably
  • Your landlord is a long-term partner that you will need to work with in the future
  • Ability to be genuine in what you need and are asking for, and understand the perspective of the landlord
  • Possibility of using security deposit – remember that this is your money, and you’ll be using for a different purpose than for what it was assigned for
• Summary checklist:
  • Find, read, and consult to make sure you understand your lease
  • Explore and fully vet all of your options
  • Design a thoughtful and proactive strategy
  • Keep your financials and projections updated and in order
  • Understand your leverage and how to maximize it
  • Put all requests in writing and don’t act impulsively
  • Don’t close the door – stay away from phrases like “if I can’t get this, I’ll go out of business” – be clear to make sure there is opportunity to stay open and work through the crisis

• Market Overview
  • 25% or more of new locations are on hold
  • New starts down by about 50%
  • Geographic regions affected differently
  • Landlords are not giving great deals yet, but it will change soon – they are busy putting out fires & April will start seeing impact; keep negotiations open
  • Looking to technology for site tours (like Matterport) or video recording to keep site searches alive
  • 90-120 days to secure a site; 3+ months to construct = time is on our side if you’re early in the process negotiating with landlords
  • New inventory & new market reach capabilities (moving from B to an A-grade center)
    • Market shifts mean looking into spaces where you couldn’t look before
  • Conversions – coming soon…
    • Independent locations that weren’t as strong as franchises opens the opportunity for conversions
• What to be thinking about?
  • Zees à ways to protect yourself in new deals:
    • Extend delivery dates
    • Rent commencement dates tied to permits or ability to open
    • Pull forward T.I. or get installments
    • Permit language
    • AIA Agreements tied to TI & permitting for payment schedules
    • Ensure General Condition charges or Mobilization Charges are spelled out properly
  • Zors à 
    • Extend development schedules
    • Continue soft openigs – use space for training or 1:1 sessions/carry out/video studio – be ready to go when things turn around
    • Look to use closed locations equipment to reduce costs for growing franchisees
    • Use 3rd parties if you don’t have inside support
• Capitalize on Opportunities
  • Fix old mistakes
    • Relocate / upgrade
    • Prime spots or areas outside of reach might be available
    • Upfit/brand image improvements
  • Conversions
    • Reduced costs/distressed prices
    • Landlords want to minimize gap on market
    • Reduce time to open 2-3 months minimum
  • Less competition
    • Less growth = sweetheart deals
    • G.C. cost will come down and more labors hitting the market
    • Independents will be less likely to survive

 

Landlords and tenants have a different perception of what PPP is, and neither side fully knows. It will still be 6-8 weeks before you get any loan funds. This shouldn’t hinder your ability to negotiate with the landlord. But no landlord is able to tell a tenant a different perspective on PPP.

Look at lease in terms of language that provides tenant with an out if in fact the landlord does not deliver – there may be opportunity, because it’s difficult to say when the county/municipality will be able to inspect and give you a C.O.

Should you hire someone to negotiate for you? It’s a reasonable choice: you need to get what you need from your landlord. Do what you need to do to achieve that goal. Both tenant and landlord are looking to be as prudent and efficient as possible – so determine if hiring that person will be to your benefit (i.e. do you want an expensive fight?)

Getting out of a lease is not as easy as negotiating through it reasonably

Supply and demand will set the market