Considerations Before Modifying An Existing Franchise Agreement Under California Law
By Kevin A. Adams on January 07, 2015
California has unique laws governing material modifications to existing franchise agreements. Generally, California Corporation Code § 31125 prohibits a franchisor from soliciting its franchisee to materially modify the existing franchise agreement without the franchisor first delivering to the franchisee an application for registration of the material modification – identifying the proposed modification – either 5 business days before execution of the binding modification, or containing a statement advising the franchisee that it can rescind the agreement to the modification by written notice to the franchisor within 5 business days after the date of execution.
This procedure tasks the franchisor with preparing the application for registration of a material modification and then registering the application with the Department of Business Oversight (“DBO”) before presenting the proposed material changes to the franchisee. In practice, however, most modifications to existing franchise agreements are exempt from this arduous registration and disclosure process.
The registration and disclosure obligation identified above only extends to those changes to the franchise agreement that are considered “material modifications.” By contrast, changes to the franchise agreement that are not material are not required to be registered with the DBO or pre-disclosed to the franchisee. However, deciding what is and what is not material can be a bit tricky.
The terms “material” and “materiality” are not defined in the California Franchise Investment Law (“CFIL”), case law interpreting the CFIL, or the DBO’s regulations. The lack of a finite definition should require franchisors and their legal counsel to exercise extreme caution and liberally disclose all questionable modifications rather than find out from a court later that the change was material.
The Federal Trade Commission (“FTC”) has expressed a view that “materiality” is to be measured from the perspective of the franchisee rather than the franchisor and generally includes information or circumstances having a substantial likelihood of influencing or having a significant financial impact on a reasonable franchisee in the decision to buy the franchise.
Also, modifications to a franchise system in accordance with the franchisor discretionary power under the franchise agreement have not been found to constitute material modifications. See R.N.R. Oils v. BP W. Coast Prods. LLC, 2011 Cal. App. Unpub. LEXIS 108, 31-33 (Cal. App. 2d Dist. Jan. 6, 2011) (the change to the system was not a modification, but instead, “an exercise of a right expressly reserved in that agreement”); In re ConocoPhillips Co. Serv. Station Rent Contract Litig., 2011 U.S. Dist. LEXIS 40471, *5-6 (N.D. Cal. Apr. 13, 2011) (changes to lease term was not a material modification to the agreement because agreement provided that it “may be amended or modified by [franchisor] at any time or from time to time”).
Additionally, one district court sitting in California court refused to dismiss a franchisee’s claim for violation of the CFIL on the basis that the parties’ agreement to terminate the franchise agreement constituted a material modification of the franchise agreement without prior registration or notice. Romio's Franchise Group, Inc. v. Romio's of California, Inc., Business Franchise Guide (CCH) P 13,740 (C.D. Cal. Sept. 25, 2007) (“In the light most favorable to the [franchisee], this ‘cancellation’ can be seen as substituting the bailor/bailee relationship for the initial franchise agreement, which could still constitute a material modification.”)
Material Change Exemptions
Corporation Code § 31125 also expressly exempts certain material modifications from the registration and disclosure requirements.
For instance, any modification that “is offered on a voluntary basis and does not substantially and adversely impact the franchisee’s rights, benefits, privileges, duties, obligations, or responsibilities under the franchise agreement” is exempt from the registration and disclosure rule. (Corp. Code § 31125(d).) Arguably, the language of this exemption suggests that the modification is immaterial and, therefore, not subject to the registration and disclosure requirements regardless.
Additionally, Corporation Code § 31125(c) exempts material modifications to an existing agreement if all of the following are satisfied:
- First, the franchisee receives (1) the complete written modification at least five business days prior to the execution of the binding modification, or (2) a statement advising the franchisee that it can rescind the agreement to the modification by written notice to the franchisor within five business days after the date of execution;
- Second, 12 months or more have elapsed since the original franchise agreement was entered into;
- Third, the proposed modification does not waive any right of the franchisee under the California Franchise Relations Act – although the modification may include a general release of all known and unknown claims; and
- Fourth, the proposed modification is either offered (1) in connection with the resolution of a bona fide dispute between the franchisor and the franchisee and is not applied on a system wide basis (e.g., the modification is not offered on a system wide basis if it is offered on a voluntary basis to fewer than 25 percent of the franchisor’s California franchises within any 12-month period), or (2) “on a voluntary basis to fewer than 25 percent of the franchisor's California franchises within any 12-month period, provided each franchisee is given a right to rescind the modification agreement if the modification is not made in compliance with [California Corporation Code § 31125(c)(1)].” The franchisor cannot make modifications in consecutive years for the purpose of evading this 25 percent requirement. (Corp. Code § 31125(f).)
Large Franchisor Exemption
Franchisors that satisfy explicit net worth and experience benchmarks are exempt from certain registration and disclosure requirements, including those associated with material modifications to existing franchise agreements. (See Corp. Code § 31101.)
To qualify for this exemption, the franchisor must satisfy the four criteria set forth in Corporations Code §31101.
First, the franchisor must meet one of the following net worth requirements:
- 1. The franchisor has a net worth of not less than $5,000,000 as demonstrated by its prior year-end audited financial statement;
- 2. The franchisor has a net worth of not less than $1,000,000 and its parent company has a net worth of $5,000,000 as demonstrated by their prior year-end audited financial statements; or
- 3. The franchisor has a net worth of not less than $1,000,000 as demonstrated by its prior year-end unaudited financial statement, the parent company has a net worth of $5,000,000 as demonstrated by its prior year-end audited financial statements, and the parent company unconditionally guarantees the obligations of the franchisor under the franchise agreement should the franchisor become unable to perform its duties under the contract.
A parent company is defined as a corporation owning at least 80 percent of the franchisor. (Corp. Code § 31101(a).)
Second, the franchisor intending to qualify for the large franchisor exemption must, for the entire five-year period immediately preceding the offer and sale, show that it (or its parent company) has either:
- 1. Been conducting business that is the subject of the franchise; or
- 2. Had at least 25 franchisees conducting business which is the subject of the franchise.
Third, the franchisor must disclose, in writing, to the franchisee the specific sections of the franchise agreement that are to be modified “and such additional information as may be required by rule or order of the commissioner.” (Corp. Code § 31101(c)(2).)
Fourth, before offering the material modification to the franchisee, the franchisor must file with the DBO a notice of exemption and pay the appropriate fee. (Corp. Code § 31101(d); 10 CCR 310.101; see Dollar Systems, Inc. v. Avcar Leasing Systems, Inc., 890 F.2d 165, 168 (9th Cir. Cal. 1989) (large franchisor otherwise exempt under Corporation Code § 31101 violated CFIL by not filing a notice of exemption before offering franchise for sale).)
Any material modification agreed to by a franchisee under the conditions set forth in Corporation Code § 31101 is not binding if the franchisee, within 14 days after the receipt of the disclosure identifying the material modification, notifies the franchisor in writing that the agreement to the modification is rescinded. (Corp. Code § 31101(c)(2).)
As a practical matter, the large franchisor may prefer the procedures set forth in Corporation Code § 31125 (i.e., to prepare and file the application for registration of a material modification before presenting the franchisee with the proposed material changes) over the large franchisor exemption in Corporation Code § 31101 because both sections impose some form of notice and filing requirements, and under Corporation Code § 31125, the franchisee is not presented with a 14-day right to rescind the modified agreement.
Sophisticated Franchisee Exemption
Franchisees that meet specific experience criteria are considered “sophisticated,” thereby exempting the franchisor from having to comply with the filing and disclosure requirements set forth in Corporation Code § 31125.
For the sophisticated franchisee exemption to apply, the franchisee must satisfy one of the following three conditions:
- One or more of the owners of the franchisee company – owning at least a 50% of the franchisee – have had at least 24 months’ experience, within the prior 7 years, “being responsible for the financial and operational aspects of a business offering products or services substantially similar to those offered by the franchised business, and are not controlled by the franchisor;
- One or more of the owners of the franchisee company – owning at least a 50% of the franchisee – have been, within 60 days prior to the transaction, an officer, director, managing agent, or an owner of at least a 25% interest in the franchisor for at least 24 months, and are not controlled by the franchisor; or
- The modification consists of an additional franchise to an existing franchisee or to an entity, officer, director, managing agent, or owner of at least 25% interest in the franchisee company, provided that, the purchasing franchisee or qualifying person has been engaged for 24 months or more in a business offering products or services substantially similar to those to be offered by the franchise being sold, or otherwise transferred.
To take advantage of the sophisticated franchisee exemption, the franchisor must file with the DBO a notice of exemption and pay the prescribed fee no later than 15 calendar days after the transaction. (Corp. Code § 31106(b); 10 CCR 310.101.)
Large Franchisee Exemption
In addition to the sophisticated franchisee exemption, franchisors are exempt from having to comply with the filing and disclosure requirements of Corporation Code § 31125 when the franchisee qualifies as a “large franchisee” under Corporations Code § 31109.
To qualify as a large franchisee, each and every member of the franchisee must be one of the following:
- A partner, executive officer, director, or holder of a similar management position with the franchisor;
- An entity (e.g., corporation, business trust, LLP, or partnership) having a net worth exceeding $5,000,000 according to its most recent financial statements;
- A natural person whose net worth (or joint net worth with that person’s spouse) exceeds $1,000,000 at the time of the transaction, excluding the value of the franchisee’s personal residence, any and all retirement or pension plan accounts or benefits, home furnishings, and automobiles;
- A natural person whose gross income exceeds $300,000 per year in each of the two most recent years, or whose joint gross income with that person’s spouse exceeds $500,000 per year in each of those years, and who reasonably expects to reach the same income level in the current year; or
- An entity in which all of the equity owners satisfy criteria 1 through 4, above.
Also, the franchisee must have knowledge and experience in financial and business matters, either alone or with independent professional advisers, such that the franchisor reasonably believes, based on reasonable inquiry before the sale, that each and every purchaser has the capacity to evaluate the merits and risks of, and protect their own interests in, the franchise investment.
Additionally, the franchisee must enter into the modification for the purpose of conducting the business as a franchise and not with a view to, or for a sale in connection with, any resale or distribution of the franchise or any interest in the franchise.
Finally, the franchisor must file with the DBO a notice of exemption and pay the prescribed fee prior to offering the franchisee the material modification. (See 10 CCR 310.101.)
In satisfying the above criteria, Corporations Code § 31109 precludes the franchisor and its officers, directors, employees, and agents from forming, organizing, engaging in, or assisting any person to avoid the registration requirements of the CFIL. Also, any cash payment required by the franchisor in connection with the material modification is not permitted to exceed 10 % of the franchisee’s net worth.
New Product & Service Exemption
Proposed modifications to franchise agreements that do nothing more than add new products or service lines to the existing franchised businesses may be exempt from the filing and disclosure requirements of Corporation Code § 31125. This exemption is known as the “fractional franchise” exemption.
To satisfy the fractional franchise exemption, six separate criteria must be met.
- First, the individual franchisee (or, if a company, the franchisee’s officer, director, or managing agent) must have been engaged in a business offering products or services substantially similar or related to those to be offered by the franchised business for at least 24 months prior to the date of the transaction.
- Second, the new product or service is substantially similar or related to the product or service being offered by the franchisee’s existing business.
- Third, the added franchise business offering must be operated from the same business location as the franchisee’s existing business.
- Fourth, the parties anticipated, in good faith, at the time the modification was agreed to, that the sales resulting from the new product or service would not represent more than 20% of the total sales of the franchisee on an annual basis.
- Fifth, the franchisee is not controlled by the franchisor.
- Sixth, the franchisor must file with the DBO a notice of exemption and pay the prescribed fee prior to offering the franchisee the material modification. (See 10 CCR 310.101.)
Remember, if the added product or service is not considered material from the franchisee’s perspective, the franchisor is not obligated to file and disclose the modification under Corporation Code § 31125 – rendering the new product and service exemption becomes moot.
Modifications To Out-Of-State Franchise Agreements
The CFIL’s rules on material modifications only extend to those individual franchisees residing in California – irrespective of where their franchised business is operated – and to those franchised businesses physically present in California – irrespective of where the individual owner is domiciled.
Franchisors seeking to materially modify the existing franchise agreements of franchisees located and/or doing business outside the State of California do not need to worry about the notice and filing requirements of Corporation Code § 31125 so long as “all locations from which sales, leases or other transactions between the franchised business and its customers are made, or goods or services are distributed, are physically located outside [California].” (Corp. Code § 31105.)
California stands alone among the states in having imposed upon franchisors a registration and disclosure requirement in connection with the material modification of an existing franchise agreement. Legal counsel should be retained to assist the franchisor in safely navigating these laws and to help ensure full compliance with the CFIL.
Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an experienced franchise lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.