How to draft a good franchise agreement

Written by Super User on .

Your franchisor has the audacity to act as though your agreement means something other than what you thought it meant when you signed it, and, heaven forbid, your choices are to capitulate, renegotiate, or head to the courthouse to try the case of the confusing contract. The remainder of this Article addresses questions that arise in the litigation of confusing or ambiguous franchise agreements.
 
A contract is ambiguous if is reasonably susceptible to two or more different interpretations.
 
A contract does not become “ambiguous” merely because the franchisor and franchisee differ as to what it means — the differing positions must each be reasonable. The task of contract interpretation is generally defined as determining the “intent of the parties” as revealed by their written language. Of course, this task is much more difficult when the parties had different, even adversarial, intentions — a situation that invites the courts to impose their view of what a “reasonable” person would have intended in light of the words that were chosen.
 
Examples of ambiguity abound, and include cases of “ambiguous words or phrases” and “ambiguity by silence”:
1. An agreement provides that Franchisor shall not open any competing stores within a defined franchise territory. Is Franchisor barred from soliciting Internet sales in the territory? Mail order sales? What do the words “shall not open a store” really mean? Does precedent regarding older technology provide a clue toward interpreting what the parties “agreed to” regarding the Internet?
2. An agreement provides that Franchisee is licensed to conduct business at a specific location or within a specific territory? The word “exclusive” is not mentioned. How is the question of exclusivity decided? Is it automatically not exclusive? Even if it is not exclusive, can the franchisee argue that any degree of territorial protection is expressly or impliedly created the Agreement?
3. An agreement provides that Franchisor agrees to “furnish national account leads” to Franchisee. What does it mean to “furnish” a business “lead?” How is a “national account” defined, absent a definitional clause elsewhere in the agreement? Is the “duty” to “furnish national account leads” impacted by the question of whether the franchisee has a defined territory in which it might attempt to service a national account?
4. An agreement provides that Franchisor may designate the sources of supply. From this language alone, is Franchisor able to derive a profit in the form of supplier rebates? If the rebate is permitted, because among other things it was disclosed in the Offering Circular, is there any limit on the amount of the rebate, or the price that the franchisee may be charged?
5. An agreement contains an “integration clause” that provides that the written agreement is the complete agreement and that there are “no other oral or written agreements between the parties.” Does this language preclude Franchisee from arguing that he was fraudulently induced to sign the agreement by Franchisor’s pre-contractual representations? Does your answer change if the Agreement provided that there are “no other oral or written agreements or understandings between the parties?” Exactly what is an “understanding” when included in an integration clause?
 
How could reasonable persons disagree on the meaning of a written agreement? One party or the other might have preferred to leave the agreement ambiguous for it feared an adverse result if the issue was clarified in the process of negotiations. In other words, “no one would sign the agreement if they knew what I really meant.” Or, the drafter might have failed to anticipate the real life situations that might arise in the life of the franchise, leading to questions about what the contract meant. An agreement may become ambiguous over time, when business conditions change, witness the confusion created by the Internet as applied to pre-Internet agreements.
 
How do courts or arbitrators address cases of confusing contracts? The first task is to determine whether the agreement is, in fact, ambiguous. The stated test is whether the agreement (or the disputed portion of the agreement) is reasonably susceptible to two or more different interpretations. Judges, not juries, decide whether an agreement is ambiguous — but there is no perfectly clear standard for applying the test of whether an agreement is reasonably susceptible to two or more interpretations. On this point, there is a distinction between intrinsic ambiguity (which is established on an agreement’s four corners) and extrinsic ambiguity, whereby the agreement is ambiguous by reference to an extrinsic fact, such that the contract would make no sense if it were interpreted literally. The parties may seek to introduce such evidence for the purpose of establishing ambiguity, as opposed to the usual purpose of introducing evidence to resolve ambiguity. The danger is that judges may place themselves in the position of ultimate fact-finder and resolve ambiguity in favor of one party or the other, in the guise of declaring that an agreement is not ambiguous.
 
How might a franchisee convince a judge that an agreement is ambiguous, where the franchisor probably drafted the agreement? Initially, this argument is presented in stages — first, we usually argue that the agreement clearly and unambiguously favors the franchisee, and, as a faliback, argue that the agreement is ambiguous. Not surprisingly, the judges usually cut right to the faliback argument, as cases that reach litigation rarely involve contract language that clearly and unambiguously favor the franchisee.
 
The analysis usually begins with the language of the agreement to determine the intent of the parties — a so-called intrinsic analysis, limited to the four corners of the contract. The task here is not to establish that the agreement could only be interpreted in a way that benefits the franchisee, but rather, that the language used, taking the agreement as a whole, could be reasonably read in the franchisee’s favor. Here are some recurring principles:

  • Words in an agreement are usually given their plain and ordinaiy meaning, but if the parties meant something different, they can usually introduce evidence of that different meaning, which the court may accept or reject.
  • Rules of grammar and punctuation may be considered, but courts are often reluctant to ascribe grammatical expertise to lawyers who draft contracts!
  • An agreement must be considered as a whole. Interpretations that result in conflict between provisions are disfavored, whereas interpretations that lead to harmony between all the provisions of the contract are favored. 
  • An agreement should be construed to produce afair result, or a legal result, whenever possible. However, at least as to “fairness”, the practical value of this rule is sharply limited. Courts will not reject a franchisor’s position merely because it may appear unfair, particularly if the court concludes that a franchisee might have “bargained for” an unfair result in one area in exchange for other benefits. For example, courts may conclude that a franchisee bargained to allow the franchisor to open new stores in close proximity to the franchised location, in exchange for the right to do business under the franchisee’s name and mark. 
  • An agreement should be construed against the drafting party if there is any ambiguity, or in determining whether the words are ambiguous in the first place. However, this “rule” has been given limited effect in franchise cases, where courts often indulge the presumption that the agreement reflected the intent of both parties, two sophisticated business entities, that negotiated and “bargained for” the final language.

What evidence will the court permit jf it determines that the agreement is ambiguous? If the agreement is ambiguous, the parties may be permitted to introduce evidence of the parties’ negotiations leading up to the final agreement, as well as preliminary drafts of the contract — and hence your contract-negotiating attorney could become a witness at trial. This “parol evidence” may become admissible despite the presence of an integration clause in the agreement, where the agreement is ambiguous. However, courts generally do not indulge a party’s self-serving, after-the-fact testimony as to what he or she claims that he thought the agreement meant.
 
The court will also consider the parties’ course of dealing, which is evidence of their conduct leading up to the execution of the agreement. Franchisees may seek to introduce evidence of the franchisor’s course of dealing with other franchisees. Closely related is evidence of the parties’ course of performance, their conduct after the agreement is executed. Industry custom and usage, how other actors in the industry treat the subject, is also considered, and may be proven by expert testimony. In addition, as a corollary to the rule that agreements should be construed whenever possible to make the agreement legal, statutes (and regulations etc.) in existence at the time a contract is executed may be a source of implied contractual terms.
 
The Franchisor’s Policy
 
An intriguing issue in franchise cases is the role, if any, of “policy” established by the franchisor in determining the parties’ intent. Some franchise agreements make specific reference to policies, for example, in imposing compliance with polices as part of the franchisee’s duties. Using the franchisor’s policy as a source of duties upon the franchisor or as a limitation on the franchisor’s rights has been difficult.The assumption appears to be that policy is not part of the contract unless it is clearly incorporated by reference — nor can policy be added to the contract by the “implied covenant of good faith and fair dealing” as discussed below. Nonetheless, where the franchise agreement is ambiguous, arguably the franchisor’s policy is important “course of dealing” and “course of performance” evidence of the parties intent. This principle has been recognized in a select few cases.
 
The Implied Covenant of Good Faith and Fair Dealing
 
The role of the implied covenant of good faith and fair dealing cannot be ignored in any discussion of ambiguous or confusing franchise agreements. In almost every jurisdiction, the implied covenant of good faith and fair dealing is implied as a matter of law in every contract absent express disavowal. The implied covenant may not replace express terms in the contract, but it may supplement the express terms. Where a party to a contract retains discretion as to performance of contract terms, the covenant requires that party “not exercise his discretion arbitrarily, capriciously, or in any manner inconsistent with his co-party’s reasonable business expectations.” It has been stated that the duty of good faith will apply when there is a “gap” in the specific contract language, and that “good faith is … the duty to avoid taking advantage of gaps in a contract in order to exploit vulnerabilities that arise during performance.”
 
Determining the application of the duty of good faith arguably requires proof of the parties’ intentions and expectations under the franchise agreement, but only where the are “gaps’ in the contract language. Here, policy evidence may play a key role in arguments based on the duty of good faith. If the franchisee enters into an agreement with knowledge of the franchisor’s policy, should not that policy supply evidence of the parties’ reasonable expectations? Should the franchisor then be permitted to take actions against a particular franchisee that contradict its stated policy? Arguably, these questions should be decided in the franchisee’s favor at least in the absence of express contract language that clearly and unambiguously gave the franchisor the right to take the disputed actions that the franchisee finds inimical to its best interests.