Fairness and Good Faith and McDonald's Remodeling Requirements

By Robert Zarco, Esq.

Consortium Members, Inc. Equity Forum, A Publication for McDonald's Franchisees, Convention 2000

It is the year 2000 and McDonald's franchisees have much to be proud of: According to Entrepreneur Magazine's 21st Annual Franchise 500® list, McDonald's is once again the nation's premier franchise opportunity.  During the past year, McDonald's system has become more field-focused, and plans to build 90 percent of its new restaurants overseas, meaning a potential decrease in interbrand competition domestically.  The burgers and fires are hotter, taste better, and thanks to some new technology, interesting new products are coming on line.  Not only that, McDonald's has been touting the new restaurants as energy-efficient, potentially making McDonald's the "greenest" franchise around.  What could possibly be better?

This rosy picture notwithstanding, there will always be difficulties in every franchise system, and particularly within any system undergoing substantial changes.  The McDonald's-designed "Made for You" is a costly proposition, even if the company does not require any additional remodeling, or relocation of the restaurant site.  Change may be good for some, but the key is how change is implemented - and whether the company approaches its planned modifications from a position of good faith.

McDonald's has stated publicly that its owner/operators are "free" to choose whether to participate in its "Made for You" program: however, other McDonald's announcements suggest otherwise.  The company had promised industry analysts that by the end of 1999, the system would be implemented in virtually every restaurant in the U.S.  Because, the ultimate goal of a franchise system is to achieve uniformity and consistency of its products, whether the restaurant is in Boise or Beijing, it is unlikely that any of McDonald's franchisee will operate for any substantial period of time without the "Made for You" makeover.

Understandably, there is a significant risk in undertaking costly renovation projects when, for example, an owner might be faced with deteriorating sales resulting from a hyper-competitive fast-food market or even from interbrand competition.  Owner/operators have already expressed concerns that the new ordering system will not fare well during peak hours in high volume restaurants because customers will take much longer to order their food.

In projecting that owner/operators will profit from the new system to the tune of approximately $15,000 per restaurant during the first year, McDonald's assumes that an overwhelming consumer response will generate increases sales and thus, cash flow - eventually to pay for the cost of the remodeling.  The company also estimates that the stores will save in food costs.  Originally, the average cost was estimated to be less than $25,000, but there are reports that older restaurants have required up to $100,000 to implement the system.  McDonald's plan also calls for a revised financing structure under which franchisees will eventually own the restaurant building.  McDonald's will receive decreased rental income, but expects to save $150 to $200 million in capital expenditures.

Aside from the centerpiece "Made for You" program, McDonald's often conditions a franchisee's option to renew or expand on his or her agreement on other, more extensive renovations.  In the past, the company has targeted certain owner/operators for termination when they did not readily cooperate with McDonald's remodeling or relocation program.  What legal rights do owners/operator have in this situation?

Over the past several years, Zarco Einhorn Salkowski & Brito, P.A. has successfully represented numerous McDonald's owner/operators in varied legal disputes throughout the world as well as franchisees from over 150 different franchise systems.  The firm is exceedingly familiar with the company's methods of doing business with its franchisees and how trial and appellate courts ultimately decide these disputes.

Do Franchisors Have an Obligation to Act in Good Faith?

The requirements of performing a contract in good faith is well-entrenched in American commercial law, and in franchise law.  In fact, this obligation dates back to Roman law, and comes to America by way of English common law.  Franchisors, like McDonald's, do not dispute that the obligation exists, of course, but usually tend to minimize its effects on their ability to control certain events within the franchise system.

Good faith becomes all-important to franchisees in situations where the franchise agreement gives the franchisor discretion to take a particular action, such as making changes to the franchise system, building new restaurants, etc. Even without rules restricting its, the franchisor must still exercise its discretion without depriving its contractual partners of an opportunity to remain profitable, i.e., "to enjoy the fruits of the contract."  Franchisees rely upon this mutual obligation as a way to maintain fairness in an ongoing contractual relationship.    Attorneys argue as to how this standard applies to individual disputes.  From the very beginning, Zarco Einhorn & Salkowski has, and continues to break new ground in this area of franchise law.

Can Franchisors Change the System After the Parties Have Signed a Franchise Agreement?

To keep a mature franchise system competitive, "fresh" and responsive to consumers' changing needs, a franchisor has the right to update its franchise concept from time to time.  These modifications normally involve the franchisee absorbing some of the expenses of the transition, and the makeover may range in cost from minimal to quite substantial.  Some owner/operators will bear a disproportionate burden, such as those whose restaurants are older and require extensive overhauls and those with fewer years remaining in their franchise agreements.

A franchisor's right to propose changes originates from the parties' franchise agreement, whose language gives the franchisor discretion to modify the system.  McDonald's has reserved this type of discretion, and for this reason, was able to add breakfast to its product offerings years ago.  Most courts have decided in the franchisor's favor - not only McDonald's but many other franchise systems - when confronted with systemic resistance to the proposed modifications.

One of the few instances in which franchisees successfully challenged their franchisor's modifications involved a franchisor-oil company's systemwide restructuring, which eventually destroyed the dealers' ability to compete successfully in their market.  A significant factor in that case was that the franchisor had not conducted any prior studies of the effect of the proposed change on the dealers, despite evidence that the franchisor had recognized, but ignored the risk.  In acting with complete indifference to its dealers' needs, the franchisor exceeded even the discretion its franchise agreement provided it.

This is not often the case with McDonald's - although it occasionally misses the mark with regard to its guesses as to consumer preferences - it is usually not for lack of market research or genuine efforts to improve the products.  For example, the "Made for You" program is focused on stystemwide improvements of food quality and taste - proven to be one of the most important factors in American consumers in choosing a restaurant.  McDonald's goals of improving food taste and service, if effective, will certainly not hurt sales.  Rather than sabotaging the system's success, however, it is in dealing with individual operators that McDonald's sometimes acts opportunistically.

Does the Obligation of Good Faith Protect Franchisees from Termination for Refusing to Remodel?

The McDonald's franchise agreement provides specific conditions under which an owner/operator's franchise may be terminated.  McDonald's does not explicitly have the right to terminate your contract because you do not want to remodel or relocate your store.  Nevertheless, your position on these issues may subject you to more intense scrutiny in other areas.

One of the most frequently contested bases of threatened termination stems from unsatisfactory QSC scores.  McDonald's has the authority under the agreement to conduct QSC inspections; nevertheless, it assigns grades under a highly subjective process, and is certainly subject to franchisor abuse.  Where this type of discretion is present, McDonald's is bound to act in good faith.

If the scores are legitimate - i.e., constituting public health and safety violations - then McDonalds's will not run afoul of its good faith obligations in terminating the franchise, even if the corporate actors have some other, improper motives.  If, on the other hand, QSC scores suddenly plummet following an owner/operator's resistance to corporate pressure to remodel or relocate a store, McDonald's may be acting in bad faith.  A successful defense to termination may depend upon proof that McDonald's had graded the stores unfairly and without following its own evaluation procedures.

If you find that following some pressure about remodeling or relocating your store, the QSC inspectors are visiting you with increased frequency and are applying more stringent standards than before, this is the time to seek legal advice from an experienced franchise attorney.  Your franchise attorney should be able to advise you as to your rights under the franchise agreement.

How Does the Obligation of Good Faith Relate to a Franchise's Right to Renew?

The McDonald's franchise agreement expressly disavows any contractual right to renew on the part of the owner/operator. Nor does it provide for any explicit renewal obligations on the part of McDonald's.  Accordingly, McDonald's is free to impose any criteria - such as requiring that owner/operator remodel or relocate - that will further its own business interests.  McDonald's need not consider the franchisee's business interests at all.

Further, the courts have decided consistently that the terms of McDonald's "rewrite" policies were internal procedures, meaning that they are not enforceable, as are other terms of the franchise agreement.  Certain states have franchise laws governing the renewal process which may even incorporate some "good faith" standards; however, the McDonald's franchise agreements contain a "choice of law clause" which requires that courts interpret it under Illinois law, which does not have such a statute.  As a result, reviewing courts have decided that McDonald's need not meet any particular "good faith" terms in deciding whether to renew a franchise.

Occasionally, McDonald's may advise an owner that the renewal of this or her franchise depends upon the undertaking of substantial leasehold or capital improvements.  Obviously, these are both very costly propositions - particularly as an owner/operator nears the end of the license term.  Typically, franchisors know that franchisees have already made a substantial investment in their restaurants and would rather invest additional sums into a property rather than lose their entire, original investment.  The investment will only increase under McDonald's "New Economic Package," as a result of which operators will own their buildings, rather than rent them from McDonald's.  Clearly, this leverage has the potential for, and often results in, serious abuses.  An operator may reinvest substantial amounts in a remodeling effort in the hope of a rewrite approval, but, ultimately, McDonald's retains the sole discretion as to whether it will renew the agreement.  If you find that you are in this or a similar situation, it is best to consult with legal counsel sooner, rather than later, after McDonald's has officially denied your rewrite application.

McDonald's has the same, and maybe even greater freedom in deciding whether to grant an operator the opportunity to expand.  Typically, an owner/operator's expressed willingness to remodel or relocate according to the company's wishes impacts upon its highly-subjective "positive, contributive attitude" evaluation, which is an integral component of obtaining expansion approval.

What about Transfer or Assignment of the License?

The alternative to renewal is to sell your business, and transfer your license, to a qualified buyer.  By virtue of the franchise agreement, McDonald's retains the right to approve potential buyers.  On occasion, the company has used its leverage to force owner/operators to sell their restaurants to McDonald's or other McDonald's-approved buyers, at prices far below fair market value, rather than lose their entire investment.  Under the New Economic Package, owner/operators will own their building, but McDonald's will still own the land upon which the building sits.  Therefore, McDonald's retains, and perhaps increases, its leverage with regard to approving buyers.  When a new operator purchases the restaurant, McDonald's reaps the benefits of the goodwill which the former owner had worked so hard to create.  The agreement lists criteria, including a "catch-all" provision which makes McDonald's authority virtually unlimited with respect to approval of a buyer.

The agreement provides only that McDonald's will not "arbitrarily withhold" its consent to a qualified buyer.  Whether McDonald's has "arbitrarily withheld" its consent must be determined on a case-by-case basis.  As with rewrites, courts have decided that, under the precise contractual language, McDonald's is not legally held to a good faith standard in evaluating a potential assignee.  Even if McDonald's does approve the assignment, the company may still condition its approval on the buyer's compliance with current remodeling objectives.  Thus, the franchise owner may have to accept a lower purchase price so that the buyer can complete the McDonald's-required renovations.  If you find yourself in this situation, seek legal advice.

McDonald's is a highly experienced and extremely sophisticated franchisor.  In the large majority of cases, you as an owner/operator will benefit from your association with this very powerful ally.  Nevertheless, if you are faced with having to make decisions about extensive remodeling (or relocating) which you feel is unwarranted under the circumstances, or are facing abusive and aggressive QSC evaluations which you believe are too frequent or ill-motivated, you should seek legal advice from an experienced franchise attorney before making any decisions - and certainly, before putting anything in writing.  It is often difficult to know how to handle these situations when they arise; do not gamble with the substantial investment which you have made in your franchise license.  Your attorney will advise you as to your best course of action to protect your investment and the goodwill that you have created in your business.

Robert Zarco is an internationally recognized franchise legal expert who has successfully represented many McDonald's owner/operators throughout the United States and internationally.  Robert has also represented franchisees from well over 150 related matters and author of many articles pertaining to issues facing franchises.  Robert is a recognized media source who appears frequently in news articles and television interviews as a franchise expert.  You may contact Robert Zarco, Esq. at the law firm of Zarco Einhorn Salkowski & Brito, P.A. at either addresses listed below; by telephone in Miami at (305) 374-5418 or in Los Angeles at 9213) 627-2449; by facsimile at (305) 374-3428; or by email at zarco@zarcolaw.com. 

Zarco Einhorn Salkowski & Brito, P.A.

Miami Office	Los Angeles Office
100 S. E. Second Street	550 South Hope Street
Suite 2700	Suite 2070
NationsBank Tower	Los Angeles, CA 90071
Miami, FL. 33131	(213) 627-2449
(305) 374-5418