Source: http://www.mulcahyllp.com/firmnews/practicenews/considerationsbeforemodifyinganexistingfranchiseagreementundercalifornialaw.html
Timestamp: 2019-04-20 16:15:18+00:00

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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”).
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.
To qualify for this exemption, the franchisor must satisfy the four criteria set forth in Corporations Code §31101.
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.
2. Had at least 25 franchisees conducting business which is the subject of the franchise.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.

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