Business, Professions and Economic Development

SENATE COMMITTEE ON BUSINESS, PROFESSIONS AND ECONOMIC DEVELOPMENT Senator Jerry Hill, Chair 2015 - 2016 Regular

Bill No: AB 525 Hearing Date: June 29, 2015 Author: Holden Version: June 23, 2015 Urgency: No Fiscal: No Consultant: Bill Gage/Mark Mendoza

Subject: Franchise relations: renewal and termination

SUMMARY: Revises the rights and responsibilities of franchisors and franchisees, as currently specified in the California Franchise Relations Act, as to the termination of a franchise agreement, compensation to the franchisee pursuant to a termination or nonrenewal of the franchise agreement, the sale, transfer or assignment of a franchise by the franchisee and remedies provided for violation of the Act, and makes other minor and clarifying changes.

Existing law:

1) Establishes the California Franchise Relations Act (CFRA) which governs the renewal, termination, transfer, and all other conditions and provisions made pursuant to franchise agreements. (BPC § 20000 et seq.)

2) Defines a franchise as a contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:

a) A franchisee is granted the right to offer, sell or distribute goods or services under the plan or system of the franchisor;

b) Operation of the business is substantially associated with franchisor's trademark, advertising or other symbol; and,

c) A franchise fee, as defined, is paid by the franchisee. (Business & Professions Code (BPC) § 20001 (a), (b) and (c))

3) Excludes from the definition of a franchise those governed by the Petroleum Marketing Practices Act, lease departments, licenses, or concessions at or with a general merchandise retail establishment, and a cooperatively operated nonprofit organization. (BPC § 20001 (d))

4) Specifies that a “franchisee” is a person to whom a franchise is granted and a “franchisor” is a person who grants or has granted a franchise. (BPC § 20002, § 2003) AB 525 (Holden) Page 2 of 21

5) Provides that any condition, stipulation, or provision waiving compliance with the CFRA is contrary to public policy and void. (BPC § 20010)

6) Establishes that the provisions under the CFRA apply to any franchise where either the franchisee is domiciled in this state or the franchised business is or has been operated in this state. (BPC § 20015)

7) Prohibits termination of a franchise agreement prior to the end of the term, except for good cause which includes failure to comply with any lawful requirement of the franchise agreement after written notice and a reasonable opportunity (no more than 30 days) to cure the failure. (BPC § 20020)

8) Authorizes the immediate termination of a franchise agreement without notice or an opportunity to cure in cases of bankruptcy, abandonment, mutual agreement, material misrepresentation; failure to comply with any federal or local law applicable to the operation of the franchise; repeated noncompliance after cure; seizure of the premises by a governmental entity or creditor; conviction of a felony or relevant misdemeanor; failure to pay franchisee fees within five days of overdue notice; and imminent danger to public health or safety. (BPC § 20021)

9) Requires a franchisor to notify the franchisee of its intention not to renew a contract at least 180 days prior to the expiration of the franchise under specified circumstances, during which time the franchisee may attempt to find a purchaser acceptable to the franchisor that meets their current requirements regarding new franchises or for renewal franchises. Provides that nothing shall prohibit a franchisor from exercising a right of first refusal to purchase the franchisees business. (BPC § 20025)

10)Provides that no franchisor shall deny the surviving spouse, heirs, or estate of a deceased franchisee or the majority of shareholder of the franchisee the opportunity to participate in the ownership of the franchise under specified conditions. (BPC § 20027)

11)Requires a franchisor that terminates or fails to renew a franchise without complying with the CFRA to offer to repurchase the franchisee's resalable current inventory at the lower of the fair wholesale market value or the price paid by the franchisee. (BPC § 20035)

12)Provides that the franchisor may offset against any repurchase offer made pursuant to Item #11 above, any sums owed the franchisor or its subsidiaries by the franchisee pursuant to the franchise or any ancillary agreement. (BPC § 20036)

13)Provides that nothing under the CFRA shall limit the right of a franchisor and franchisee to agree before or after a dispute has arisen to binding arbitration of claims under the CFRA, as specified. (BPC § 20040) AB 525 (Holden) Page 3 of 21

14)Defines “relevant geographic market area” as this state or a standard metropolitan statistical area within this state which has been established by the United States office of Management and Budget. (BPC § 20999) 15)Establishes a Franchises Act and the Franchise Dealers Fair Practices law – which governs franchise relationships and contracts between a refiner and a distributor, between a refiner and retailer, between a distributor and another distributor, or between a distributor and a retailer for the sale, consignment, or distribution of gasoline, diesel, etc. (BPC § 20999 et seq. and BPC § 21140 et seq.)

16)Establishes the California Franchise Investment Law (CFIL) – which governs financial disclosures and registration requirements with the Department of Business Oversight. (Corporations Code (CORP) § 31000 et seq.)

17)Makes it a violation of the CFIL for any franchisor, directly or indirectly, through any officer, agent or employee, to restrict or inhibit the right of franchisees to join a trade association or to prohibit the right of free association among franchisees for any lawful purposes. (CORP § 31220)

18)Provides that any person who offers or sells a franchise in violation of specified sections of the CFIL, or in violation of any provision that provides an exemption from the requirements of the CFIL, as specified, shall be liable to the franchisee or sub- franchisor, who may sue for damages caused thereby, and if the violation is willful, the franchisee may also sue for rescission, unless, in specified cases, the defendant proves that the plaintiff knew the facts concerning the untruth or omission, or that the defendant exercised reasonable care and did not know, or, if he or she had exercised reasonable care, would not have known, of the untruth or omission. (CORP § 31300)

19)Allows any person who violates the right to free association to be sued in the superior court in the county in which the defendant resides or where a franchise affected by the violation does business, for temporary and permanent injunctive relief and for damages, if any, and the costs of suit, including reasonable attorneys’ fees. Further provides that a plaintiff shall not be required to allege or prove that actual damages have been suffered in order to obtain injunctive relief. (CORP § 31302.5)

20)Prohibits an action from being maintained to enforce any liability for violation of the right of free association unless it is brought within two years after the violation upon which it is based or within one year after the discovery by the plaintiff of the facts constituting such violation, whichever occurs first. (CORP § 31302.5)

21)Except as explicitly provided, prohibits civil liability in favor of any private party against any person by implication from or as a result of the violation of any provision of CFIL or any rule or order thereunder. (CORP § 31306)

This bill: AB 525 (Holden) Page 4 of 21

1) Provides that no franchisor may terminate a franchise prior to the expiration of its term except for good cause, but that good cause shall be limited to the failure of the franchisee to substantially comply with the franchise agreement and that the franchisee must be given notice at least 60 days (rather than the current 30 days or less) in advance of the termination to cure the failure.

2) Specifies that one of the reasons for an immediate notice of termination of the franchise without an opportunity to cure, is if the franchisee fails, for a period of 10 days after notification of noncompliance, to comply with any federal, state, or local law or regulation, including, but not limited to, all health, safety, building, and labor laws or regulations applicable to the operation of the franchise.

3) Requires a franchisor, upon termination or nonrenewal of a franchise, to compensate the franchisee at the value of price paid minus depreciation, of all inventory, supplies, equipment, fixtures, and furnishings purchased or paid for by the franchisee from the franchisor or its approved suppliers and sources under the terms of the franchise agreement or any ancillary or collateral agreement, and, at the time of the notice of termination or nonrenewal, are in possession of the franchisee or currently used in the franchise business.

4) Provides that a franchisor is not required to purchase any personalized items, inventory, supplies, equipment, fixtures, or furnishings not reasonably required to conduct the operation of the franchise business in accordance with the franchise agreement or any ancillary or collateral agreement.

5) Provides that the franchisor is not required to compensate the franchisee as specified, when the franchisee declines a bona fide offer of renewal from the franchisor or if the franchisee is to retain control of the principal place of the franchise business.

6) Provides that franchisor is not required to compensate the franchisee as specified, if termination or nonrenewal of a franchisee is due to publically announced and non- discriminatory decision by the franchisor to completely withdraw from all franchise activity within the “relevant geographic market area” in which the franchise is located. For the purpose of this section “relevant geographic market area” shall have the same meaning as BPC § 20999 (p).

7) Provides that the franchisor does not have to compensate the franchisee for any inventory, supplies, equipment, fixtures, or furnishings that are sold by the franchisee between the date of the notice of termination or renewal, and the cessation of operation of the franchise business, by the franchisee, pursuant to the termination or nonrenewal.

8) Provides that, upon termination of a franchise, a franchisor may offset amounts owed to a franchisee by any amounts owed by such franchisee to the franchisor.

9) Deems it unlawful for a franchisor to prevent a franchisee from selling or transferring all of substantially all of the assets of the franchise business, or a controlling interest AB 525 (Holden) Page 5 of 21

in the franchise business, to another person provided that the person is qualified under the franchisor’s then-existing and reasonable standards, as consistently applied to similarly situated franchisees operating within the franchise brand, for the approval of new or renewed franchisees.

10)Provides that a franchisee does not have the right to sell transfer, or assign the franchise or substantially all of the assets of the franchise business, or a controlling interest in the franchise business, without the written consent of the franchisor, except that the consent shall not be withheld unless the buyer, transferee, or assignor is not qualified under the franchisor’s then-existing and reasonable standards for the approval of new or renewed franchisees.

11)Provides that nothing shall prohibit a franchisor from exercising the right of first refusal to purchase a franchise after receipt of a bona fide offer to purchase the franchise by a proposed purchaser of the franchise; additionally provides that any franchisor exercising the right of first refusal must offer the franchisee payment at least equal to the value offered in the bona fide offer.

12)Specifies that pursuant to the provisions that permit the sale, transfer or assignment of a franchise business by the franchisee, that “franchise business” shall include a legal entity that is a party to a franchise agreement.

13)Requires the franchisee, prior to the sale, assignment, or transfer of all or substantially all of the assets of the franchise business, or a controlling interest in the franchise business, to another person, to notify the franchisor of the franchisee’s intent to sell, transfer, or assign the franchise or substantially all of the assets of the franchise business, or a controlling interest in the franchise business, as specified.

14)Requires the franchisor to notify the franchisee of the approval or disapproval of the sale, assignment, or transfer of the franchise within 60 days, as specified.

15)Provides that a proposed sale, assignment or transfer shall be deemed approved, unless disapproved by the franchisor by providing notice as specified and if the proposed sale, assignment, or transfer is disapproved, the franchisor shall include in the notice of disapproval a statement setting forth the reasons for the disapproval.

16)Provides that in any action in which the franchisor’s disapproval of a sale, assignment or transfer is an issue, the reasonableness of the franchisor’s decision shall be a question of fact requiring consideration of all circumstances and that the finder of fact may be an arbitrator as specified in the franchise agreement and satisfies the requirements of BPC § 20040. Provides however that nothing shall prohibit summary judgment when the reasonableness of transfer approval or disapproval can be decided as a matter of law.

17)Provides that a franchisor is not required to exercise a right of first refusal pursuant to the sale, assignment, or transfer of the franchised business, but that nothing shall prohibit a franchisor from exercising the right of first refusal to purchase a franchise after receipt of a bona fide offer to purchase the franchise by a proposed purchaser AB 525 (Holden) Page 6 of 21

of the franchise, however, any franchisor exercising the right of first refusal must offer the franchisee payment at least equal to the value offered in the bona fide offer.

18)Provides that in the event a franchisor terminates or fails to renew a franchisee in violation of provisions of the CFRA , the franchisee shall be entitled to either of the following remedies:

a) Reinstatement of the franchisee under the same terms as the existing franchise agreement, and the franchisor shall pay all the damages caused to the franchisee from the violation.

b) Upon request of the franchisee, or if the relief provided above (reinstatement) is determined by the finder of fact to be impossible or impracticable, then the franchisor shall pay the franchisee the fair market value of the franchise and franchisee assets and any other damages caused by the violation of the CFRA.

c) A court may grant preliminary and permanent injunctions for a violation or threatened violation of the CFRA.

19)Provides that the franchisor may offset against any remedies made pursuant to Item #18 above, any prior recovery by the franchisee made as to compensation for their inventory, supplies, etc. and any sums owed the franchisor or its subsidiaries by the franchisee pursuant to the franchise or any ancillary agreement.

20)Makes other technical and clarifying changes.

FISCAL EFFECT: None. This bill is not keyed “fiscal” by Legislative Counsel.

COMMENTS:

1. Purpose. This bill is sponsored by the Coalition of Franchisee Associations. According to the Author, the California Franchise Relations Act provides franchisee’s fewer rights than nearly every other form of contract law in California, especially as it pertains to termination, breach and damages. Franchise agreements are frequently one-sided contracts that strongly favor the franchisor over the small business owners who operate franchises. Unlike traditional small businesses, most franchises reflect a profound imbalance of contractual power that favors the franchisor and places franchisees in a financially precarious situation. “AB 525 restores fairness to franchise agreements by applying traditional contract law standards, giving franchisees the right to transfer the business, ensuring franchisees can recover their [investment] when a franchise relationship end[s], all while protecting the franchisor’s rights to terminate the worst actors, including those who break laws, cannot make required payments or operate in direct defiance of the contract terms.” AB 525 (Holden) Page 7 of 21

The Author further states that, “The current franchise relations act has allowed franchisors to use unethical practices against franchisees. These practices are used to terminate a franchise agreement which effectively takes the franchisees business away from them. This is evidenced in multiple lawsuits throughout the country involving franchisors that engage in ‘churning.’ Recent whistleblower lawsuits have exposed franchisors engaging in this churning process whereby franchisors file questionable violation reports against franchisees in order to generate ‘good cause,’ a one-sided contractual standard, to ‘take back’ the business. Once the business is returned to corporate control, the business is sold to a new franchisee for higher franchise fees. Good cause is a legal standard rarely used in contract law. Even if a franchisor is in the wrong, franchisees are severely limited in the equity or damages they can recover- frequently leaving many franchisees penniless.”

2. The Franchise Business. Franchised businesses represent a large and growing segment of the nation’s businesses, making up almost 11 percent of businesses with employees, employing an estimated 9.1 million people, and consistently adding jobs faster than non-franchised businesses in recent years. According to the International Franchise Association (IFA), 21 percent of franchisees nationally are minority owned businesses, while there are 14 percent of minority non-franchised small business ownerships. Also, a higher proportion of Asian Americans and African Americans are in franchised business than non-franchised business, and a similar proportion of Latinos are in franchised and non-franchised business. In California, over 83,000 franchised establishments employ more than 925,700 workers. Fast food restaurants are the biggest employers in the franchise sector. Franchises are a popular and potentially lucrative way for people to open their own business. Just like any other small business owner, franchisees invest a large amount of their own money in the business and continue to pay for upgrades and changes in response to the market. Also like independent business owners, they often work long days and nights handling operations, managing employees and overseeing expenses. According to the Author, “they are the accountants, human resource managers, office managers, and employees of these businesses. Franchise owners invest so much of their time, money and energy into these businesses because the business is their livelihood for today and security in the future.”

The advantage of owning a franchise over an independent business is the name brand recognition and the support of the corporation. Franchise owners rely on the trusted name brand of their products to drive sales. Reliably providing the well- known product or service makes their business successful. It can also lead to ownership of more franchises.

The franchise agreement contract is the central authority for the relationship between the franchisor and franchisee, which can be hundreds of pages long and contains a highly detailed description of the rights, responsibilities and remedies of the parties. The franchisee must sign the contract promising to comply with all of the requirements and the franchisor’s service and marketing directives now and in the future. According to the International Franchise Association, a “franchise is the agreement or license between two legally independent parties which gives a person AB 525 (Holden) Page 8 of 21

or group of people (the franchisee) the right to market a product or service using the trademark or trade name of another business (the franchisor)." It also gives the franchisee the right to market a product or service using the operating methods of the franchisor and the obligation to pay the franchisor fees for those rights. The franchisor has the obligation to provide those rights and support the franchisee according to their agreement. More specifically, franchisees serve to provide the look, name recognition, and brand of the business. The franchisee builds the brand locally and develops good will within the community. The franchisee’s business success helps support the community with taxes and other contributions as well as improves the bottom line for franchisors. 3. Current Law Regulating the Franchisor-Franchisee Relationship. A substantial part of California franchise law is largely embodied in California Franchise Investment Law (CFIL) and California Franchise Relations Act (CFRA), although certain specific industries (i.e., auto dealers and gas stations) have their own unique provisions as well.

Under the Corporations Code, CFIL was enacted in 1970 to regulate franchise investment opportunities in order to protect California investors from potentially fraudulent franchise investments. CFIL generally requires franchisors to disclose to prospective franchisees the information necessary to make an informed decision about franchise offers, and prohibits the sale of franchises that would lead to fraud or the likelihood that a franchisor’s promises would not be fulfilled. CFIL contains explicit provisions for enforcement generally through damages (payment for economic losses) and rescission (cancellation of the contract). It also provides for injunctive relief (to require or prohibit a specific action), and reasonable costs and attorneys' fees in certain circumstances.

CFRA (which excludes petroleum-related franchises, like gas stations) was enacted in 1980 to govern relationships between franchisors and franchisees after they have entered into contract with each other. CFRA is designed to prevent unfair practices in the transfer, renewal, or termination of a franchise. CFRA prohibits termination of a franchise agreement except for good cause and only after notice and an opportunity to fix the problem. It also lays out certain circumstances where immediate termination is permitted, for example: bankruptcy, abandonment, mutual agreement, material misrepresentation, illegal activity, noncompliance with the franchise agreement, failure to pay franchise fees, and imminent danger to the public. CFRA prohibits nonrenewal of a franchise agreement without 180 days prior notice, and with certain additional protections for the franchisee. It also provides for the transfer of ownership to surviving spouses or heirs. CFRA does not contain explicit provisions to compensate a franchisee for the nonrenewal or termination of a franchise, except for the buyback of inventory when a franchise is improperly terminated or nonrenewed, although general contract remedies may still be available.

4. The Imbalance in Bargaining Power between Franchisors and Franchisees. Supporters of this bill argue that there is both a systemic problem (a basic imbalance in bargaining power between the franchisor and the franchisee), and a host of specific abuses of that power which make this bill necessary. AB 525 (Holden) Page 9 of 21

An oft-cited 1996 court decision by the California Court of Appeal (2nd Dist.) describes the franchise dynamic this way:

The relationship between franchisor and franchisee is characterized by a prevailing, although not universal, inequality of economic resources between the contracting parties. Franchisees typically, but not always, are small businessmen or businesswomen or people seeking to make the transition from being wage earners and for whom the franchise is their very first business. Franchisors typically, but not always, are large corporations. The agreements themselves tend to reflect this gross bargaining disparity. Usually they are form contracts the franchisor prepared and offered to franchisees on a take-it-or- leave-it basis. (Emerson, Franchising and the Collective Rights of Franchisees (1990) 43 V and L. Rev. 1503, 1509 & fn. 21.)…Some courts and commentators have stressed the bargaining disparity between franchisors and franchisees is so great that franchise agreements exhibit many of the attributes of an adhesion contract and some of the terms of those contracts may be unconscionable. “Franchising involves the unequal bargaining power of franchisors and franchisees and therefore carries within itself the seeds of abuse. Before the relationship is established, abuse in threatened by the franchisor’s use of contracts of adhesion presented on a take-it-or-leave-it basis. Indeed such contracts are sometimes so one-sided, with all the obligations on the franchisee and none on the franchisor, as not to be legally enforceable. (Postal Instant Press v. Sealy, 43 Cal. App. 4th 1704, 1715-1717 (1996.))

As indicated by the proponents, franchising in California today is still characterized by increasingly one-sided and non-negotiable franchise agreements. What may be worse, according to proponents, is that franchisees cannot easily close down even a money-losing franchise. With zero cash flow, the franchisee cannot pay rents, loans, employees, or other obligations. Indeed, many franchise agreements are written so that failed franchisees are required to continue to pay the franchisor royalties for the balance of the franchise term, even if there is no franchise generating income. Franchisees thus become indentured servants to the franchisor. At least by keeping the business open, there is some money to cover or partially cover these expenses. The franchisee become literally trapped in a downward spiral and cannot close the business. Unfortunately, this happens repeatedly in franchising as pointed out by proponents. When the funds completely run out the only remaining recourse may be bankruptcy.

The Small Business Administration has lending programs for individuals seeking to buy franchises. A published report, however, found dozens of franchise systems with over fifty percent of franchisees with loans failing to pay back their loan obligations and some systems have loan failure rates over ninety percent as noted in the report. Veterans have also been targeted through the use of SBA loans to own and operate a franchise and are experiencing high failure rates as well with particular franchises. VetFran, a program sponsored by the IFA, has worked to make franchise ownership and employment more accessible to veterans since 1991. According to VetFran, veterans own approximately 66,000 franchise AB 525 (Holden) Page 10 of 21

businesses, and since 2011, over 5,600 veterans have become franchise business owners since 2011, and 65 percent of franchisors report an increase in the number of veterans being recruited over just the last 12 months. Proponents point out, however, that there are certain franchises which have had a higher than normal risk of failure for veterans even though they are listed as by VetFran directory as one of its “premium veteran franchisors.” AAMCO Transmissions, for example, has a 23.8 percent SBA loan failure rate, Meineke Car Care Center has a 22.2 percent failure rate, Huntington Learning Center has a 30.8 percent, and Matco Tools has a 33.4 percent failure rate on SBA loans. Veterans have actually accused Matco Tools of aggressively recruiting and falsely representing the business opportunity and have online petitions and urged Matco Tools in other social media to “stop selling fraudulent franchises to our troops.”

As indicated, the CFRA was enacted over thirty years ago as one of the first state statutes to address the franchise relationship and partially limit terminations and nonrenewals. But even then, franchisees were opposed to the bill (AB 295, Chapter 1355, Statutes of 1980) to implement the CFRA and argued that while the original intent of creating the CFRA was to cure the widespread abuses in the termination and nonrenewal of franchises, it instead basically sanctioned many of those abuses in law. They stated, [We] cannot describe how distressed franchisees throughout the State of California are over the fact that this bill is no longer in their best interests but is, in reality a franchisor bill.” Proponents argue that it has been proven over time that the statutory provisions which were intended to protect franchisees are not strong enough and the remedies provided are limited. Other states including Arkansas, Hawaii, Indiana, Iowa, Nebraska, New Jersey, Rhode Island, Washington and Wisconsin have enacted stronger provisions for franchisees to prohibit unfair practice in the franchise relationship and to address franchisors who unfairly terminate, fail to renew, block transfers, or adequately compensate franchisees for their investment in the business.

5. Recent Survey of Franchisees Satisfaction and Relationship with Franchisors. A recent survey was conducted in 2015 by an organization called, “FranchiseGrade.com.” The purpose of the survey was to develop and conduct a survey of franchisees, and various dimensions related to their satisfaction [in the franchise business]. Some of the topics covered in the survey included satisfaction with the franchise business, level of work and business experience, degree of investment due diligence, types of financing and assets pledged, relationship with franchisor, and economic success. The survey sample was drawn from a list of 282,809 unique franchisees nationally, and 39,681 in California and the target population were those that had been in a franchise business for one year or more.

According to the survey, 72% of franchisees are in the 40 to 60 age range, 77% are male, 68% have a community college or four-year degree, a majority of franchisees have been in business over 5 years and 66% have only one franchise business. This survey seems to indicate that many franchisees in California are dissatisfied with their franchises because they have invested a lot into their business, but are not receiving the benefits they expected. Approximately 46% said they were dissatisfied or very dissatisfied as a franchisee and 65% said they would not recommend AB 525 (Holden) Page 11 of 21

franchising to a family member. Meanwhile only 28% said they were satisfied. Many had little experience owning a business initially, but they indicate that they did their research before purchasing: 85% spoke to a franchisee and 72% had an attorney review the franchise agreement before signing it. Although franchisors’ representatives provided revenue and profit projections, only 13% said they also received a clear estimate of how much they would need to spend on major improvements.

The survey also indicates that after deciding to invest their time and energy into a new business, franchisees also invested heavily financially. Approximately 74% took out a loan, 34% of those were SBA loans and 49% pledged their home as an asset to purchase the franchise. After establishing the franchise, the large, mandatory financial investments continued. About 50% have been required to make major capital improvements and only 33% of them believe it improved their business. Another 78% say there have been mandatory changes to the business model that increased their costs, but not increased revenue, and 73% said there has been an increase in mandatory fees. There is a possibility that these required changes to the business model can cause a franchisee to be terminated for noncompliance, and many of them have been warned accordingly. Approximately 82% said they have been warned that a failed inspection can lead to termination or nonrenewal.

Finally, only 22% say they can earn a decent living from their franchise, and 79% pull a salary of less than $50,000 from their business. The survey also asked franchisees about transfers and 48% say that they cannot sell their business for a fair price and only 30% believe they can.

6. Requirements and Remedies Provided in this Measure Attempt to Level the Playing Field Between Franchisee and Franchisor. Supporters argue that this bill provides significant new remedies for franchisees from unfair terminations and nonrenewals of their franchises by the franchisor, adequate compensation to the franchisee upon termination or nonrenewal of their franchise business, and protection of their rights to sell, assign or transfer their franchise business. The following describes existing law and the changes proposed and the responses of the Author, proponents and opponents to these changes:

a) Substantial compliance standard applied to termination and renewal. BPC Section 20020 currently allows premature termination of a franchise agreement for good cause, which includes failure to comply with any lawful requirement of the franchise agreement after written notice and a reasonable opportunity to comply with the agreement within at least 30 days. Section 20025 allows the franchisor to not renew a franchise agreement simply by providing the franchisee with 180 days written notice of its intent not to renew. According to the Author, these standards unfortunately allow some franchisors to unfairly take advantage of franchisees by using the contract to punish franchisees by taking their business away and to avoid their legal obligations to give franchisees another chance. AB 525 (Holden) Page 12 of 21

Accordingly, this bill would allow termination of franchise agreement for good cause only upon the failure of the franchisee to substantially comply with the franchise agreement, and give the franchisee advance notice and an opportunity of at least 60 days to comply. According to the Author, this provision ensures fairness to franchisees by barring the termination of any franchisee that is in substantial compliance with the franchise agreement, instead of allowing termination much more broadly for failure to comply, in the case of terminations, "with any lawful requirement of the franchise agreement."

Proponents of the bill argue that the "substantial compliance" legal standard reduces ambiguity in terms of the franchise agreement because the term is well- defined, historically accepted, and is a central tenet of contract law used by many other states to regulate franchise agreements and contracts, generally. They note that California courts have been interpreting substantial performance of contracts dating back to at least the early 1900s (see, e.g., Thomas Haverty Co. v. Jones, 185 Cal. 285 (1921), holding that substantial performance was achieved when the non-breaching party still "is enjoying the fruits of the . . . work in performance of the contract.") Proponents also note that current California jury instructions provide for a simple two-part test to determine the existence of substantial performance. First, the breaching party must show they “made a good faith effort to comply with the contract,” and second, “[the non-breaching party] received essentially what the contract called for because…failures, if any, were so trivial that they could have been easily fixed or paid for." (California Civil Jury Instructions No. 312. Substantial Compliance.)

Opponents argue that the bill limits good cause to the “failure of the franchisee to substantially comply with the franchise agreement,” and removes the words “any lawful requirement” of the franchise agreement. This language poses a much higher threshold for a franchisor to establish than the “failure of the franchisee to substantially comply with lawful requirements of the agreement.” California would be the only state imposing such a high threshold. The language in this Section allows a franchisee to avoid termination, no matter how serious and longstanding its default and failure to cure, as long as the franchisee complies with its remaining obligations. Each default situation will require an individual balancing of the uncured default against the balance of the required contractual performance in order to assess "substantial compliance."

b) Allow 60-day opportunity to substantially comply with franchise agreement. BPC Section 20020 allows the franchisor to set a period of time to cure noncompliance with the franchise agreement “which in no event need be more than 30 days to cure the failure.” Supporters report that franchisees are often given as little as 5 days to cure noncompliance; an unreasonable amount of time depending on the nature of the cure needed. Therefore, providing 60 days to cure is a reasonable solution common to many other commercial transactions. Initially, opponents argued that the substantial compliance standard and the extended opportunity to cure provisions will make it burdensome and difficult for existing franchisors to conduct business in California, and will render it an unattractive place to open new franchises. AB 525 (Holden) Page 13 of 21

Proponents argue that economic data derived from states that employ the substantial compliance standard and a 60-day notice before termination requirement, or both, do not support this contention. Instead, they report that between 2003 and 2013, the eleven states that have one or both of these provisions had an average franchised unit growth rate of 23.2 percent, as compared to the 18.9 percent growth rate for the other 39 states and the District of Columbia that have neither provision in law. Of those eleven states, five (Arkansas, Nebraska, New Jersey, Rhode Island and Wisconsin) employ both the "substantial compliance" standard and require at least 60 days' notice before termination. The same data show that the franchise growth rate for those five states is essentially identical to the growth rate as compared to the other 45 states and the District of Columbia (19.4 percent vs. 19.8 percent, respectively.) In short, proponents contend that “substantial compliance” standards and extending the time frame to cure noncompliance of the agreement have resulted in greater certainty and investment protection, not less, for franchisees in those states that employ such standards.

Opponents assert that Section 20020 contains no cap on the cure period beyond the minimum 60-day cure period in which a franchisee has the opportunity to fix a violation of the franchise agreement. Each franchisee will be able to argue that the new 60-day minimum cure period, already at least twice as long a cure period as the cure period in the current statute, still is an inadequate cure opportunity. That will result in a case-by-case analysis of the proper cure period for a particular franchisee, in a particular situation, involving a particular default. There will be no guidance for franchisors and franchisees, inviting litigation in each and every situation. “We suggest a cap on the franchisee's cure period [of 75 days].”

c) Clarifies grounds for immediate termination. Existing law, BPC Section 20021, provides for a number of circumstances that justify immediate notice of termination of a franchise agreement without an opportunity to cure. These circumstances are considered so serious that they threaten to damage the brand reputation of the franchise and are thus grounds for immediate termination by the franchisor, for example, when a franchisee abandons the business, is convicted of a felony, goes bankrupt, or the franchise operation poses an imminent danger to public health. One set of circumstances listed in Section 20021 calls for immediate termination when "the franchisee fails, for a period of 10 days after notification of noncompliance, to comply with any federal, state or local law or regulation applicable to the operation of the franchise." Supporters of the bill contend that, like the provision that allows early termination "for any lawful requirement of the franchise agreement," this particular set of circumstances justifying immediate termination should be clarified to avoid an unnecessarily broad interpretation of laws that would allow the franchisor to immediately terminate the franchise agreement. Accordingly, the bill clarifies that violations of federal, state of local law or regulation, including, but not limited to, all "health, safety, building and labor laws or regulations” applicable to the operation of the franchise, are grounds for immediate termination. AB 525 (Holden) Page 14 of 21

d) Removes “monetization of equity” provision for termination or nonrenewal of a franchise and requires instead “compensation” to franchisee for inventory, supplies, equipment, fixtures and furnishings at current depreciated value. Unlike other types of contract law in California, the CFRA only entitles franchisees to recover the cost of any existing inventory remaining upon dissolution of the franchise. Current law that allows the franchisor to essentially take all equity, personal capital, and goodwill a franchisee has developed upon franchise dissolution is particularly unfair to small business franchisees, contends the Author, given that franchisees invest a large amount of their own money in the business and continue to pay for upgrades and changes in response to the market. Even if the franchisor breaches the franchise contract, the franchisee is limited by the original franchisee agreement in what contract damages they can claim.

This measure, prior to recent amendments on June 15, 2015, codified the IFA's own “Statement of Guiding Principles” by providing for a franchisee’s right to “monetize any equity” they have developed in their business prior to the termination or nonrenewal of the franchise agreement, this “equity” included the fair market value of the franchise and franchise assets, all investments in the franchise made by the franchisee, including, but not limited to, purchase of real property, equipment, inventory, advertising, and real estate.

The recent amendments to Section 20022 of the BPC removed this requirement and instead now provides for compensation to the franchisee, upon termination or nonrenewal of a franchise, for the value of price paid, minus depreciation, of all inventory, supplies, equipment, fixtures and furnishings purchased or paid for by the franchisee from the franchisor or its approved supplier, or other sources under the terms of the franchise agreement or any ancillary or collateral agreement, and, at the time of the notice of termination or nonrenewal, are in possession of the franchisee or used in the franchise business. It also specifies under what circumstances a franchisor would not have to compensate the franchisee for the above items, or provide for an offset against amounts owed to the franchisee.

The opponents still raise a concern about including the term, “termination” under this Section since it would allow for a franchisee to receive compensation from the franchisor when its franchise agreement is terminated for cause [immediate termination without an opportunity to cure]; a previous version of AB 525 at least excluded from coverage any termination under Section 20021. Opponents ask, “Why should a franchisee whose franchise is legitimately terminated under the new and heightened good cause standard be entitled to any compensation?” A bad-actor or wholly incompetent franchisee can unfairly harm a franchise system by daring the franchisor to terminate the franchise, knowing that the franchisor ultimately must compensate the franchisee even if the termination decision is lawful. AB 525 (Holden) Page 15 of 21

Opponents are also concerned that one of the reasons for not compensating the franchisee would be if the franchisee retains control of the principal place of the franchise business. Opponents argue that there should be no compensation to the franchisee “if the franchisor does not prevent the franchisee from retaining control of the franchise business.” It should be the franchisor preventing the franchisee from continuing the use of the franchise business, not the franchisee who decides to retain control of the business.

Opponents believe as well that the compensation would not be needed if the franchisor and franchisee mutually agree not to renew or where purchases are required by applicable law. As explained by the opponents, this is to clarify that the parties can mutually agree not to renew and Section 20022 (g) will not be applicable. Similarly, a franchisor should not be required to pay the franchisee for items the franchisee must purchase because of the requirements of applicable law and not because the franchisor requires such purchases.

Opponents lastly indicate that compensation would not be needed if the franchisor provides notice of nonrenewal of the franchise agreement not less than one year prior to the expiration date of the agreement during which time the franchisee has the opportunity to transfer or assign the franchise or the assets of the business.

e) Attempts to streamline process and timeline for sale, assignment or transfer of franchise business by franchisee. BPC Section 20025 required a franchisor to notify the franchisee of its intention not to renew a contract at least 180 days prior to the expiration of the franchise under specified circumstances, during which time the franchisee may attempt to find a purchaser acceptable to the franchisor that meets their current requirements regarding new franchises or for renewal franchises, and provided that nothing shall prohibit a franchisor from exercising a right of first refusal to purchase the franchisees business.

BPC Section 20027 limits the transfer of franchises to family members of a deceased franchisee as long as those family members meet criteria for owning a franchise as determined by the franchisor. Similarly, Section 20027also provides the deceased franchisee’s family the opportunity to sell or transfer the franchise to a third party that meets the franchisor’s criteria for owning a franchise, as specified.

According to the Author, this bill seeks to establish a streamlined process and timeline for the sale or transfer of a franchise and under what conditions the sale, assignment or transfer could occur. Section 20025 is repealed and two new Sections were added to the CFRA. The Section 20028 specifies that it is unlawful for a franchisor to prevent a franchisee from selling or transferring all or substantially all of the assets of the franchise business, or a controlling interest in the franchise business, to another person provided that the person is qualified under the franchisor’s then-existing and reasonable standards, as consistently applied to similarly situated franchisees operating within the franchise brand, for AB 525 (Holden) Page 16 of 21

the approval of new or renewing franchisees, but also provides that the franchisee shall not have the right to sell, transfer, or assign the franchise or substantially all of the assets of the franchise business, or a controlling interest in the franchise business, without the written consent of the franchisor, except that the consent shall not be withheld unless the buyer, transferee, or assignor does not meet the standards for new or renewing franchisees as specified. The measure also details the requirements of the notice and other necessary information and documentation that shall be provided to the franchisor and provides that the franchisor may still exercise their right of first refusal to purchase the franchise.

Opponents argue that the new requirements of Section 20028 appear to allow unfettered transfers by franchisees of non-controlling interests in either the franchise business or the legal entity that is a party to a franchise agreement. Applying transfer qualifications only to a person who obtains all or a controlling interest of a franchise eliminates the qualification requirements of people who may acquire lesser ownership interests in a franchise. All purchasers or acquirers of an interest must be qualified in order to protect the brand and the integrity of the franchise. For example, someone could purchase a 10% ownership and may be selected to operate the franchise. Or someone acquiring a non-controlling interest could already own or operate a competing business, buy his way into the franchise business to which he otherwise would not have had access, and now have access to proprietary information generally unavailable to competitors. The franchisor should have the right to review and approve all potential owners of the franchise business or legal entity. In addition, retaining the word “reasonable” as a modifier of "standards" under Section 20028, rather than relying solely on "then applicable" or "then-existing" standards, for the approval of new franchisees, allows every franchisee to challenge any standard a franchisor articulates, even if the franchisor consistently applies the standard to similarly-situated franchisees.

f) For violation of CFRA, provides for reinstatement, award of damages or fair market value of franchise to the franchisee. Current BPC Section 20035 provides that in the event a franchisor terminates or fails to renew a franchise other than in accordance with the CFRA, the franchisor shall offer to repurchase from the franchisee the franchisee’s resalable current inventory meeting the franchisor’s present standards that is required by the franchise agreement or commercial practice and held for use or sale in the franchised business at the lower of the fair wholesale market value or the price paid by the franchisee. The language in this Section has now been eliminated and recast and now specifies that in the event that a franchisor terminates or fails to renew a franchise in violation of the CFRA, the franchisee shall be entitled to either of two remedies: (1) “reinstatement” of the franchisee under the same terms as the existing franchise agreement and for the franchisor to pay all damages caused thereby; or (2) upon the request of the franchisee, or if the relief provided for pursuant to reinstatement above is determined by the finder of fact to be impossible or impracticable, then the franchisor shall pay the franchisee the fair market value of the franchise and franchise assets and any other damages caused by the AB 525 (Holden) Page 17 of 21

violation of the CFRA. It also provides that a court may to grant preliminary and permanent injunctions for violation of threatened violation of the CFRA.

Opponents argue against the “reinstatement” remedy and contend that it still makes no sense when the franchisee may seek injunctive relief to stop an allegedly inappropriate termination or non-renewal and also be entitled to recover damages. In the event of a violation, the franchisor must pay the franchisee the fair market value of the franchise and franchise assets and any other damages caused by the violation. This is an adequate remedy.

g) Measure Have Prospective or Retroactive Effect. Although laws which are generally passed by the Legislature have prospective effect unless explicitly indicated otherwise in the measure, Opponents are concerned that since there is no language specifying that SB 525 will have only prospective application that this would unfairly and unconstitutionally impair all existing franchise agreements that were entered into by franchisors and franchisees under a specific set of legal rules and expectations. “Litigation attacking the constitutionality of AB 525 on this basis alone would be a given.”

7. Prior Legislation. SB 610 (Jackson) of 2014 would have revised various provisions of the California Franchise Relations Act with respect to termination or transfer of a franchise, as well as the right of association among franchisees. (Status: This bill was vetoed by the Governor. In his veto message he indicated the following:

“This bill alters the relationship between franchisors and franchisees by, among other things, changing the standard required to terminate a franchise agreement from "good cause" to a "substantial and material breach." While the "good cause" standard is common and well understood, the standard provided in this bill is new and untested.

The bill's changes would significantly impact California's vast franchise industry that relies on the certainty of well-settled laws. I am open to reforming the California Franchise Relations Act to give more protections to franchisees if there are indeed unacceptable or predatory practices by franchisors. I need, however, a better explanation of the scope of the problem so I am certain that the solution crafted will fix those problems and not create new ones.

Additionally, the parties supporting and opposing this bill have diametrically different views. Given the polarized positions, it is in the best interest of all that a concerted effort be made to reach a more collaborative solution.”)

AB 1141 (Dahle) of 2013 would have enacted the “Small Business Investment Protection Act of 2013” to incorporate some of the good faith and rights association provisions of SB 610 as well as changes to the right to terminate a franchise agreement. (Status: This bill was held in the Assembly Judiciary Committee).

AB 2305 (Huffman) of 2012 would have enacted “The Level Playing Field for Small Business Act of 2012” to revise the rights and responsibilities of franchisors and AB 525 (Holden) Page 18 of 21

franchisees as well as the rules that govern the franchise relationship in California. (Status: This bill was held in the Assembly Business, Professions and Consumer Protection Committee).

SB 814 (Oller) of 2001 would have authorized a franchisee to pursue damages, including attorney’s fees, from a franchisor that violates the CFRA by terminating or failing to renew a franchise. It also provided a franchisee could seek injunctive relief if the franchisor did not provide adequate notice of termination of a franchise to seek injunctive relief. (Status: This bill was held in the Senate Judiciary Committee.)

8. Arguments in Support. The Coalition of Franchisee Associations (CFA) is the sponsor of this measure and explains that across the country, millions of small business owners embrace the entrepreneurial spirit and support their local communities by opening their own franchise. These businesses are their livelihood, supporting their family and the families of their employees. However, contracts with franchisors, the franchise agreement, allow franchisors to take away that livelihood for any reason, with all the equity the franchisee invested into it and without recourse for the franchisee. Franchisees have had their business terminated without any proof of any substantial violation of a contract or with manufactured evidence. They have also been denied the ability to sell, assign or transfer their business to a legitimate purchaser. After the business is taken, the franchisee cannot even recover the hundreds of thousands of dollars they have invested. This is all done through unethical intimidation tactics that remain legal because franchisors write contracts that allow them to do what they want and hide behind vague state laws. According to CFA, this bill will clarify state law to specify that a franchisor can terminate a franchise, but only when there are serious and substantial violations of contract. It will also allow these small business owners to sell their business to legitimate buyers or family members, prevent franchisors from terminating a franchise without any opportunity to cure, and allow franchisees to renew their contracts pending compliance so as to continue their financial and personal investment in the franchise.

The Service Employees International Union supports the bill and writes, “These provisions are significant steps toward rebalancing the relationship between franchisors and franchisees. Prohibiting unfair terminations and non-renewals ensures that franchisees who play by the rules have the opportunity to thrive, while still providing franchisors with authority to terminate or not renew franchisees who don’t meet franchise standards. Protecting franchisees’ rights to transfer their business means that franchisees can pass their franchise on to their children or sell it can reap the reward of their labor and investment. Many franchisees operate in an unpredictable environment of ever changing rules and financial requirements as dictated by the franchisor. A more balanced system would stabilize franchisees and enable them to invest in their business as well as pay living wages to a chronically underpaid low-wage workforce.”

The California Labor Federation also supports this measure and believes it will clarify exiting law and provide modest and important protections to franchisees. The provisions in the bill are significant steps toward rebalancing the relationship AB 525 (Holden) Page 19 of 21

between franchisors and franchisees. Prohibiting unfair terminations ensures that franchisees that play by the rules have the opportunity to thrive, while still providing franchisors with authority to terminate franchisees who do not meet franchise standards. Protecting franchisees’ rights to transfer their business means that franchisees can pass on the fruits of their labor. Allowing franchisees to receive compensation for their investments in the franchise will enable them to recoup some what they put into the business upon termination of the franchise. “The current system is one where the franchisor has all the power and the franchisee has little security or say. This structure is not only unfair for small business owners, but it also promotes a low-wage, high turnover environment for the almost one million fast food workers. Franchisees need the protections in this bill, especially those seeking to do the right thing for their workers.”

Other proponents of this measure including the Small Business California and the Small Business Majority and many of the franchisees from across the nation and state make similar arguments and the need for this measure. They indicate that the legislation is crucial to helping California’s small franchises grow and thrive. While franchisee-franchisor relationship is often mutually beneficial, there have been instances of franchisors taking advantage of individual franchise owners, using their contract as a shield. Certain franchisors include unfair provisions in their contracts to limit franchisee rights while others have broadly interpreted state law to terminate the franchise agreements without cause and avoid their legal obligations to give franchisees another chance or return the franchisees basic investment. This has led to business owners who have invested their money into a franchise to be left with no possibility to regain the equity invested and no legal recourse to gain their investment back.

9. Arguments in Opposition. The International Franchise Association (IFA) has an “Oppose Unless Amended” position on this measure. The issues and most of the suggested changes they propose are reflected in this analysis. The IFA has argued initially that, “AB 525 is unnecessary. California already regulates franchise disclosure above and beyond the requirements established by the Federal Trade Commission’s Franchise Rule to provide consumers with protections about the investments they feely enter into under the CFIL. Additionally, California regulates certain terms of the relationship between franchisor and franchisee under the Franchise Relations Act. If adopted, AB 525 would make it extremely difficult for existing franchise systems to conduct business in California, rendering the state an unattractive place to open a new franchise business.” IFA has, however, been working with the Author’s office to try and address many of their concerns with this bill. It appears as if the Author’s office has tried to address many of these concerns and have met with the IFA and the opponents and provided this Committee with at least two significant sets of amendments; one set of amendments on June 15, 2015 and another on June 23, 2015.

As of June 25, 2015, this Committee received an “Oppose Unless Amended” letter from the Civil Justice Association of California (CJAC) and they state that this bill “would create uncertainty and encourage litigation in the franchise relationship by (1) changing the standard under which a franchisee agreement may be from good AB 525 (Holden) Page 20 of 21

cause when failing to comply with lawful requirements of the contract, (2) introducing new, litigious standards on nonrenewals/nontransfers of the franchise relationship, and (3) impacting existing, complex long-term contracts making these changes retroactive.” CJAC goes on to raise many of the same concerns which have been expressed by IFA.

10.Policy Issue: Is it intended that petroleum companies and their convenience stores (mini-marts) would be covered under, or exempt from the current requirements of the CFRA? Petroleum related franchises are regulated by both state law, BPC § 20999 et seq., and federal law, the Petroleum Marketing Practices Act. Both statutes outline “good cause” requirements for the termination and nonrenewal of a franchise. However, it is unclear whether state or federal “good cause” guidelines would apply to their convenience stores or “mini-marts” located at the same premises as a franchise governed by the Petroleum Marketing Practices Act. The Author may wish to clarify in the future whether or not it is intended that these franchises would be covered under this measure.

11.Recommended Amendments:

a) Because of concerns raised that there is no cap on the cure period beyond the minimum of 60-day cure period in which a franchisee has the opportunity to fix a violation of the franchise agreement, recommend the following amendment:

On page 3, line 10, insert after “failure.”: In no event will the right to cure the failure exceed 75 days unless there is a separate agreement between the franchisor and franchisee to extend the time.

b) Because of concerns raised that under Section 20028 the franchisor would not have the right to review and approve a person who may acquire a lesser ownership interest in the franchise and possibly threaten the brand and integrity of the franchise, recommend the following amendment:

On page 5, line 40, insert after “controlling”: or non-controlling interest

c) Clarify that the implementation of this measure will be prospective rather than retroactive.

NOTE: Double-referral to the Senate Committee on Judiciary.

SUPPORT AND OPPOSITION: AB 525 (Holden) Page 21 of 21

Support:

Coalition of Franchisee Associations (Sponsor) California Association for Micro Enterprise Opportunity California Beer and Beverage Distributors California Fair Franchise Association California Labor Federation EA Independent Franchisee Association East Valley Business Legislative Advocacy Committee Service Employees International Union Independent Organization of Little Caesars Franchisees North American Association of Subway Franchisees Plumbing Heating Cooling Contractors Association of California Small Business California Small Business Majority 10 Individual Business Owners and Representatives and Franchisees

Opposition:

Civil Justice Association of California (Oppose Unless Amended) International Franchise Association (Oppose Unless Amended)

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