KEY FRANCHISE ISSUES FOR 2016
This article focuses on two issues that are affecting many franchisees in 2016, as a result of certain market conditions.
Cyber Risk – Is it Real and How Should The Franchisee Protect Itself?
In December 2015, Hyatt Hotels reported that malware attacked its computers affecting at least 250 properties Hyatt manages. Officials said that they found malware which possibly exposed the credit card information of previous guests. The malicious software was designed to collect the names, card numbers expiration dates, and internal verification codes on credit and debit cards. It also noted that franchisees’ properties were not impacted. But, of course, they could have been. What would happen?
If previous guests of one or more franchisees were damaged as a result, the franchisees could be sued by those guests for the resulting losses. If Hyatt was also named as a co-defendant, under the franchise agreement, Hyatt would have the right to tender its defense to the affected franchisees pursuant to the indemnification provisions of the franchise agreement. Talk about adding insult to injury.
If, for example, information of 1,000 guests that had stayed at a franchisee’s hotel had been compromised and each guest suffered damages of approximately $1,000, that equates to exposure for the franchisee of $1,000,000. Hardly a small sum.
Hyatt’s indemnification provision is typical for franchise agreements in the industry. Although we have tried to negotiate more equitable terms on this issue, we have found the franchisors to be unwilling to waive indemnification, should this type of hacking of the franchisor’s system occur.
Franchisees are well advised to protect themselves by obtaining cyber risk insurance coverage. It is readily available and affordable, especially in light of the potential exposure. Every franchisee who does not already have this coverage should immediately contact their insurance broker to obtain a quote for such coverage.
Development Risk in Franchise Agreements –
How Can a Franchisee Minimize The Risk?
The current economic climate has seen developers more active than any time in recent memory. Often times, a developer will seek to engage with a franchisor prior to obtaining all of the necessary government approvals for the project, or before even securing title to the land for the proposed hotel.
Most franchise agreements contain liquidated damage provisions, some of which distinguish between pre-opening defaults and post-opening defaults. Keep in mind that although the pre-opening liquidated damages may be less than post-opening, they can still be substantial. This creates significant risk for the developer who may not as yet have all the entitlements, or may not have title to the property. Especially in the situation of hoped for government approvals, the developer should seek to lessen the liquidate damages risk as much as possible. The various franchise companies differ in how flexible they are when working with a developer on this issue.
Assuming that the developer will know within six months to one year, whether the entitlements will be approved, the developer should negotiate with the franchisor on this issue. The pre-opening liquidated damages anticipate that the hotel will not open for approximately three years. The franchisor takes the position that it is tying up the market for that period of time and if the hotel does not open, the franchisor has excluded itself from soliciting other franchisees to its detriment. This is reasonable.
However, if the developer finds out that the government approvals have been denied within three to twelve months after the agreement is executed, then the franchisee can so inform the franchisor and terminate at that point. In this scenario, the franchisor will have been out of the market for three to twelve months and it follows that the franchisor should be willing to consider a lesser liquidated damages settlement amount.
Of course, the franchisor will be influenced by a number of factors including: how much it wants a presence in the market, does it already have a presence with another flag in the family, the franchisor’s preexisting relationship with the franchisee, the franchisor’s desire to establish a new relationship with the franchisee, and others.
The franchisee should always be conservative when it comes to agreeing to a development/construction timeline in projecting an opening date. Build in time for delays of all types. Remember that Murphy is alive and well and is likely to visit you in some way. Negotiate extensions without additional fees. There is a limit but typically a franchisor will give some leeway, when asked. Avoid being in default by not having enough time.
It is my experience that different franchise companies enforce pre-opening liquidated damage provisions more or less strictly than others. Even when there are liquidated damages that are technically owing, some of the franchise companies don’t enforce them provided that the developer has made a good faith effort to obtain the necessary approvals. Hopefully your hotel gets the needed approvals but if not, then hopefully your franchisor is one of these more reasonable companies.
Do your best to mitigate these risks. Goodness knows the development process is risky enough, but will more likely reward the prudent developer.