IMPLEMENTING SYSTEM UPGRADES AND ENHANCEMENTS: BUSINESS AND LEGAL CONSIDERATIONS David J. Kaufmann Kaufmann Gildin Robbins & Oppenheim LLP New York, New York Robert Zarco Zarco, Einhorn, Salkowski & Brito, P.A. Miami, Florida By: Kenneth A. Cutshaw* Chief Legal Officer Cajun Global LLC (Franchisor of Church’s Chicken) Atlanta, Georgia International Franchise Association 44th Annual Legal Symposium May 15-17, 2011 *Mr. Cutshaw is a contributing author of certain segments of this paper. TABLE OF CONTENTS I. INTRODUCTION ......................................................................................................................1 II. CASE LAW ADDRESSING MATURE FRANCHISOR SYSTEM/CONCEPT MODIFICATION .......................................................................................................................2 A. Systemic Changes .............................................................................................................2 B. Price Point Advertising/Resale Price Maintenance ........................................................8 C. System Modification Attendant to Franchisor Acquisition...........................................12 1. Analyzing the Motives Underlying Proposed Acquisition Activity..........................13 2. The Third Player at the Table ......................................................................................15 3. The Franchise Agreements at Issue...........................................................................16 4. Judicial Decisions Addressing Franchise Network Acquisitions ...........................17 D. Impact of Franchise Relationship Law on Ability to Modify System ..........................23 E. E-Commerce .....................................................................................................................25 F. Prior Course of Dealing ...................................................................................................27 III. SUGGESTED FRANCHISE AGREEMENT PROVISIONS ...................................................31 A. Network Modification.......................................................................................................31 B. Co-Branding .....................................................................................................................31 C. Uniformity Of Retail Prices Within Network (Retail Price Maintenance Keyed To Price Point Advertising) ..................................................................................................32 D. Franchisor’s Right To Acquire Other Businesses, Be Acquired, Go Public, Go Private Or Merge ..............................................................................................................32 E. Network Reidentification (New Or Additional Marks) ...................................................33 F. Franchisor’s Reserved Rights Within Franchisee’s Territory......................................33 G. Franchised Unit Remodeling ..........................................................................................35 i I. INTRODUCTION A constant source of tension between mature franchisors and their franchisees is the periodic need to modify the network’s concept and system to keep up with (or ahead of) the competition; to incorporate new technologies; to respond to changed consumer demographics, ethnicities, preferences and trends; to introduce new products or services and delete from the system older products and services; to modify existing trademarks/service marks, or abandon them altogether in favor of new trademarks/service marks; to modify the exterior and interior design of the network’s units and the equipment utilized thereat; to establish new advertising platforms and campaigns; to require integration of new technologies; to compel franchisees to undergo additional training regarding the foregoing; and, otherwise to keep the mature franchise network’s image, products and/or services fresh, competitive and responsive. Sometimes, modifying a mature franchisor’s concept and system requires franchisees to make only slight changes. Other times, substantial unit renovations, franchisee retraining and new product/service offerings are involved. Yet other times, a complete system overhaul is involved, requiring franchisees to retrofit their units completely to the new concept, operate under new trademarks/service marks and deal with entirely new product/service lines in lieu of existing product/service lines (whether attendant to a “conversion” acquisition of the chain -- as when United Parcel Service [“UPS”] acquired the Mail Boxes Etc. network -- or merely to recast the franchise network’s competitive positioning). Modifying the mature franchisor’s system almost always involves a degree of expense to be absorbed by the franchisee. As reflected by the range of activity set forth above, sometimes this franchisee expense is minimal, and sometimes it is most substantial. Frequently, the mature franchisor’s attempt to overhaul its system encounters resistance from franchisees, which can range from slight to massive depending upon the degree of franchisee investment required; franchisee uncertainty about what the economic impact will be of the contemplated changes; the sometimes disparate burdens the overhaul will trigger among franchised units; the number of years remaining before franchise expiration; and, truth be told, franchisee inertia (“I’ve been doing this for so long, I don’t want to change my ways now”). It is useful to remember that a number of McDonald’s franchisees were absolutely aghast when, following many years of tests, McDonald’s informed them three decades ago that the McDonald’s system would now include breakfast. Over the previous decades, McDonald’s restaurants were keyed only to lunch and dinner. The notion of opening their units before dawn, having to add an extra shift, having to learn how to prepare and offer a multiplicity of new menu items and investing the money required to achieve the foregoing (including unit renovations) prompted great fear and, 1 sometimes, hostility on the part of some McDonald’s franchisees. In hindsight, of course, such concerns seem unworthy, since McDonald’s launch into the breakfast arena proved so popular and profitable to all concerned. But at the time, the concerns were very real. McDonald’s franchisees were not alone in having to confront significant system and concept changes. Pizza Hut franchisees had to get into delivery when Domino’s success thereat started threatening Pizza Hut’s market share. Several commonly controlled franchise networks – such as Dunkin’ Donuts and Baskin Robbins - - had to learn how to co-brand each other’s products to increase both chains’ menu offerings and daypart opportunities. Virtually every guest lodging network over the past decade had to implement a “guest loyalty” program and properly allocate its costs and benefits. And McDonald’s franchisees once again recently confronted a significant system overhaul - - the implementation of the new “McCafe” coffee concept. The ability of a mature franchisor to effect such system/concept changes largely derives from the reserved contractual right to do so. Franchise agreement language addressing this subject is critical - - and we furnish suggested language below. But even when franchise agreement language specifically reserving to the franchisor the right to initiate systemwide changes is extant, franchisee lawsuits complaining of the franchisor’s exercise of said right have been forthcoming, as analyzed immediately below. To minimize the risk of such lawsuits, a franchisor is well- advised to be sensitive to the franchisee community’s receptiveness to the change. Even if the contract imbues the franchisor with the authority to require a change, consideration should be given to “selling” the change to franchisees, so that the franchisee perceives the requirement not as a mandate, but rather as a logical business investment. Thus, as a practical matter, the way in which the mature franchisor rolls out system-wide change among franchisees can be just as critical to a successful transition as the enabling contractual language. While the franchise agreement provides the contractual authority for change on the one hand, the well-prepared franchisor will also take proactive measures to present to franchisees a compelling business case for the change. Such efforts on the front end serve to minimize dissent and friction with the franchisees. II. CASE LAW ADDRESSING MATURE FRANCHISOR SYSTEM/CONCEPT MODIFICATION A. Systemic Changes It did not take long for a franchisee to sue its franchisor complaining of imposed system modifications. 2 The franchisor in question - - Burger King - - was not so “mature” at the time, namely 1966. It was then that a franchisee, in Trail Burger King, Inc. v. Burger King of Miami, Inc.,1 complained of Burger King changing certain standards and specifications - - including an increase in the quantity of meat to be used in making hamburgers. The franchisee refused to comply with Burger King’s new standards. According to the Court, the franchisee deliberately sold hamburgers containing less meat than Burger King’s new specifications required; refused to provide adequate condiments on tables; refused to provide background music; refused to paint his building; and, utilized unauthorized drink dispensers. The franchisee filed suit over Burger King’s threatened termination of its franchise. Following a motion for a judgment on the pleadings, the Court found that there was