Franchisees, licensees and other businesspeople who have more than one agreement with their franchisors, or who have more than one location, should pay attention to the “cross default clause.”
The legalese is often worded like this:
Where there is more than one agreement in existence between the parties (or their respective affiliates), you agree that we have the right to treat a material breach or default of any one agreement as a material breach or default of all or any of the other agreements and any such material breach or default of any one agreement shall be treated, in respect of any of the other agreements as a material breach or default of each such agreement.
In English, it means “if you commit a default under one agreement with your franchisor, that franchisor has the right to declare a default of all your other agreements.”
A clause like this can kick you when you’re down in a number of ways.
The first is a scenario where your franchisor is also your landlord under sublease for your location. If you commit a material default under your franchise agreement – by failing to pay royalties, for example – the franchisor also has the right to treat it as a default under your sublease. If that material default isn’t cured, the franchisor then has the right to terminate all agreements with you – especially the sublease – even if your rent is up to date and you aren’t in breach of your sublease.
The second scenario occurs when you are a successful franchisee of a number of locations, meaning you have franchise agreements, subleases and other contracts with your franchisor for each location.
If you’re an existing franchisee seeking a second or subsequent location, always enter it – and any accompanying franchise agreement – with a new corporation.
This keeps each franchise location in watertight compartments. Each one will be independently owned by different corporations, even though the shares of all those corporations may be owned by you and your partners.
It's more expensive from a legal and accounting perspective, but it’s arguably easier to sell off one location if it’s owned by one company that owns nothing else. And if a subsequent location is an unmitigated disaster, your creditors won't be able to follow the assets of your profitable locations (unless of course, you've agreed to pledge those assets as security).
The problem with the cross default clause in this scenario is that if you default under your franchise agreement for a poor location, and that default leads to a termination of your franchise, your franchisor can declare a default under your other franchise agreements even if you are in full compliance and those locations are thriving. You could lose all of your locations simply because one has failed, and a Machiavellian franchisor might very well take all the successful locations back for virtually nothing and re-franchise them, or operate them corporately despite the years you spent building the businesses.
In terms of having all of your locations and agreements within separate corporations, the clause normally applies to the franchisee and its affiliates.
The solution is that when you're negotiating subsequent franchise agreements for an existing franchisee, make sure you obtain in the franchisor’s agreement that a default under the subsequent agreement will not amount to a default for any other location.
Why would a franchisor agree to this? Good franchisors understand that franchising is simply a business model. "We don't want franchisees,” the president of a well-known Canadian franchisor said to me some years ago. "We want operators. Franchising is simply the way we do it.”
It may be easy to find franchisees, but it's difficult to find talented and motivated multiple-unit operators. If a successful franchise takes a risk with a subsequent location and that location fails, it shouldn't automatically lead to the termination of successful locations.
It's up to the franchisee and the franchisee's lawyer to spot this issue when negotiating franchises for subsequent locations.
Tony Wilson is a franchising, licensing and intellectual property lawyer at Boughton Law Corp.in Vancouver, he is an adjunct professor at Simon Fraser University (SFU), and he is the author of two books: Manage Your Online Reputation, and Buying a Franchise in Canada. His opinions do not reflect those of the Law Society of British Columbia, SFU or any other organization.