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The Hidden Costs Of Acquiring Another Franchise System

Written by: Peter Macrae Dillon

Article Overview: When a franchisor is considering acquiring a competing franchise system, it should be aware that such transactions often involve unexpected costs that need to be factored in to its acquisition planning. peter macrae dillon Siskinds franchise franchisor franchising lawyer attorney Toronto Ontario Canada www.franchiselaw.ca

The Hidden Costs Of Acquiring Another Franchise System

Generally speaking, when a franchisor makes the decision to acquire another franchise system, it is looking for a similar system in the hope that some economies of scale can be realized. The franchisor may also be acquiring some unexpected legal headaches that should be fully flushed out prior to completing the acquisition.

The franchisor may want to add or subtract certain items from the acquired franchisor’s (“Newco’s”) system to either allow for additional distribution of the franchisor’s product or to make the systems more similar. Otherwise, the acquiring franchisor may have plans to convert Newco’s system to the franchisor’s system.

As the acquiring franchisor conducts due diligence on Newco, it should review Newco’s existing franchise agreements to determine whether or not language is included that allows the franchisor to add to, subtract from, or alter the existing system at its discretion. The franchisor should also plot the locations of Newco’s franchisees on a map to determine whether any of them are within the trading area of the franchisor’s franchisees.

Although the franchise agreement may allow for an altering of the product mix with Newco’s franchisees, the acquiring franchisor must take in into account its duty of fair dealing in exercising any discretionary powers under the franchise agreements, a duty that is codified in Ontario and Alberta under franchise legislation in the two provinces. If, for example, the franchisor decided to require Newco’s franchisees to stop selling a product that competes with the franchisor’s system and there is no independent reason for doing so other than the elimination of the competitive product for the benefit of the franchisor’s franchisees, the franchisor may be seen to be not acting in good faith. In Gateway Realty Ltd. v Arton Holdings Ltd. and LeHave Developments Ltd, a Nova Scotia court has held that bad faith is:

when one party, without reasonable justification, acts in relation to the contracts in a manner where the results would be to substantially nullify the bargained objective or benefit contracted for by the other, or to cause significant harm to the other, contrary to the original purpose and expectations of the parties.

In the above scenario, there may also be competition law issues if the result of a product removal is to unduly lessen competition.

If the product being replaced was unique to Newco’s franchise system and the removal of the product, would “substantially nullify the bargained objective” of the franchise agreement, then the franchisor should proceed with caution. The practical consequences of introducing new products or re-branding locations is that it may cost the franchisor a significant amount of money to coerce franchisees into making the required changes if the changes would result in a franchise fundamentally different than what the franchisee had originally bargained for.

The franchisor may decide that it will stop promoting the growth of one system over the other. In the Ontario case of Shelanu Inc. v. Print Three Franchising Corp. the court held that there was nothing in the franchise agreements which required the franchisor to maintain a certain level of franchisees. That being said, if the franchisor stops promoting the Newco brand, it may be open to liability for misrepresentations made in marketing materials or other representations made to franchisees with respect to building a certain number of new stores to help support marketing and brand name awareness.

If the franchisor’s goal is a complete re-branding of Newco’s system, the franchisor should have, in advance of the acquisition, mapped out areas of potential conflict that would result in franchisees of both systems competing too closely or encroaching on one another. The leading Canadian case on encroachment is a 1995 Quebec case, Provigo Distribution Inc. c. Supermarche A.R.G. Inc. In that case, the Court found Provigo, the franchisor, to be acting in bad faith towards its grocery store franchisees when expanding its corporately owned discount grocery stores. The Court stated that, although it was commercially reasonable for a franchisor to undertake changes to develop its system in tandem with contemporary market realities, it had to do so in ways that would not injure or destroy the franchise relationship.

If the franchisor intends to operate two competing systems, then again the issue of encroachment must be reviewed. In the Shelanu Inc. case discussed above, the franchisor opened a smaller, but nearly identical franchise system targeted at a slightly different group than the original franchise system. The Court found that the establishment of a direct competitor was fundamentally at odds with the obligation to deal in good faith and that, without the agreement of the franchisees of the original system, the franchisor could not properly and fairly institute the new concept. The law may not view the purchase of an existing system, where competition pre-existed, in the same light as creating a new one, as in the Shelanu case, but decisions made after the common ownership will be scrutinized by franchisees much more closely as franchisees of both systems will not want the other to receive any unfair advantage.

Although there can be no certainty as to the outcome of negotiations with franchisees of the acquired system, the acquiring franchisor is best advised to make itself fully aware of the potential hidden costs of the acquisition and budgeting an appropriate amount to cover such costs prior to completing the purchase.

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