SDV Insights

COVID-19 Related Exposures Facing Franchise Systems


This article was published by the International Franchise Association (IFA) on April, 29, 2020. Click here to visit their website. 

Most franchise systems are facing severe financial impacts as a result of the continued spread of COVID-19 and the numerous government-mandated shutdowns that have been ordered by state and local officials in response. Even if your franchised operations are considered essential and able to remain open during the shut-down, franchisees may have exposures, in addition to a loss of revenue, which may further impact franchisors. Below is a list of possible exposures franchise systems should be thinking about and preparing an action plan to minimize the risk of loss.

Is insurance coverage available for the loss of revenue resulting from COVID-19 and related government mandated shutdowns?

Franchisors should review their current business interruption insurance policies to assess their ability to file claims as a result of virus-related business interruptions. Even if there are potential coverage exclusions that would preclude coverage for COVID-19 related losses, such as a virus exclusion, it is important to discuss with coverage counsel if it is necessary to report the claim to meet any reporting obligations in the event a government authority mandates coverage under the policy regardless of the virus exclusion. In addition to business interruption insurance, franchisors should also review other active insurance policies, such as directors’ and officers’ insurance and general liability insurance, among others, that may be implicated by complications caused by the COVID-19. It is crucial that franchisors understand the extent of their current coverage, any weaknesses in their coverage that should be addressed, and what their options are in the event of business disruptions or other adverse events.

How will royalties be affected during COVID-19 government-mandated shutdowns? Will franchisors be able to collect royalties from the proceeds of a business interruption claim?

A franchisee may or may not be obligated to pay the required royalty minimum if the business is shut down because of a government-ordered shutdown. A careful reading of the FDDs will determine if royalties are owed or if there is a contractual clause that removes the requirement during this time. If a franchisee has a covered business interruption claim, the franchisor may be entitled to royalties, depending on a variety of contractual considerations. There are two key sections that may affect the outcome: 1) the definition of the contractual term which dictates how to calculate the royalty, such as “gross revenues” or “income” and 2) the insurance requirements. Is there a specific requirement for the franchisee to carry business income coverage? If so, is there a requirement that the business income limit include the amount owed to the franchisor for royalties? Additionally, there may be an equitable argument to be made by the franchisor that the franchisee (insured) is not able to profit from the loss. Therefore, if the franchisee receives insurance coverage for the full amount of income lost during this time, and if the franchisee does not pay the contractually required royalty, then it has unfairly profited from the insurance proceeds. The ability for this argument, to be made by the franchisor, may vary from state to state depending on the applicable law.

Franchisees may not be able to make rent payments because of the loss of income. What are the landlord’s rights if a tenant is unable pay rent or pays rent late?

A review should be made of all lease agreements for corporately owned and sub-leased franchised locations to assess the parties’ rights and obligations in light of the COVID-19. Many commercial leases will afford landlords special powers, in light of a public health emergency, and the franchisor should consider whether these landlords may have the ability to take any action that may disrupt the franchisor’s business or the business of its franchisees. The franchisor should also look to the lessees’ rights under the various government actions in response to COVID-19 as some are temporarily relieving lessees of their rental obligations. There may also be temporary relief of utility payments, that the responsible party should be aware of, in the event those payments cannot be made as required.

Supply chains are being affected because of COVID-19. What steps can be taken to mitigate the negative implications of supply chain disruptions?

A number of businesses are already experiencing supply chain disruptions, especially those that purchase key supplies and goods from vendors based in China, Italy, or South Korea. As COVID-19 spreads and government-mandated shutdowns continue, further and more frequent supply chain disruptions are anticipated and should be expected. It is necessary to remain in constant contact with core suppliers and vendors to assess their current status, whether these suppliers and vendors are expecting any disruptions that may impede their ability to meet the franchisor’s demands, and whether it is possible to address any supply bottlenecks or shortages before they have a substantial impact on the franchisor’s operations. Additionally, you should be requiring your key suppliers and vendors, especially in the food, retail, and hospitality spaces to demonstrate that they have implemented additional health and safety measures, concerning their own operations, to assure the safety of products being provided to franchisees for resale. When possible, alternative suppliers should be sourced and crucial materials and products should be stockpiled to ensure continuity of business. As supplies and goods, particularly food, become more limited and there are additional financial burdens put on the supply chain, there may be an increase in price. It is important to review your contracts to establish if either the franchisor or franchisees is responsible for price variances. As a franchisor, it is important to communicate with and provide the needed assistance to your franchisees as to the policies that will be implemented to minimize the risks associated with supply chain disruptions.

Will new legislation effect my business during the COVID-19 pandemic?

COVID-19 Legislation

New York, Pennsylvania, New Jersey, Massachusetts, Ohio, Louisiana, and South Carolina, along with the federal government have drafted legislation that would mandate insurers cover business interruption losses resulting from government-mandated shutdowns because of COVID-19. The legislation would effectively negate the property policy trigger requiring a direct physical loss to property and void virus/disease/pandemic/public health exclusions. If the Pandemic Risk Insurance Act of 2020 (“PRIA”) is passed and the Federal Pandemic Risk Reinsurance Fund and Program is established, the coverage would apply retroactively to commercial property and casualty policies already in place. Upon renewal of the insurance policies, the insured would need to affirmatively elect the coverage and pay an increase in premium, similar to Terrorism Insurance.

Legislation Impacting Franchised Operations

In addition to pending legislation addressing insurance coverage for losses resulting from COVID-19, proposed legislation pertaining to franchises throughout the country, may continue to be enacted and enforced as planned or maybe suspended due to the outbreak. The enforcement of California AB5 is expected to have an impact to franchisors based in and operating in California. Currently, the law has had an impact on the ability to hire healthcare workers which has caused Governor Newsom to suspend the enactment of the bill. There may be other legislation that effects your business that Governors either most strictly enforce or lift the enforcement because of the effects on managing the outbreak of COVID-19.

Franchisors and franchisees enter into a variety of contracts to carry out the day-to-day needs of the business. If a business is unable to meet its contractual obligations, is there a way to be excused without being in breach of contract?

Many contracts will contain force majeure provisions, which typically excuse one party from performing its obligations under the contract as a result of a specified event. Such events often include war and unrest but can also often contain broad language concerning global health issues or events. Key contracts need to be assessed to determine whether a force majeure provision is present, whether its scope addresses this issue, and whether there is any risk of the other party exercising such provision to excuse its own performance under the contract. Franchisees may be excused from payment of minimum royalty or advertising fees and other financial obligations franchisors generally rely upon, under the express terms of their franchise agreement. Franchisors should be looking to all contracts they have entered into and not just contracts with their franchisees. Furthermore, franchisors will want to review contracts for upcoming events, supplier and vendor agreements, and relevant leases to confirm their scope of rights and obligations and identify any force majeure terms that may be utilized to avoid certain contractual obligations.

COVID-19 is causing a crisis for many businesses. How should franchising organizations prepare for an ensuing crisis?

Now is a good time to test the performance of your organization’s crisis management plan. Franchisors should practice how the system would address and respond to a potential crisis, including health-related emergencies. At a minimum, in light of the current situation, the plan should be reviewed, updated, and circulated across the system to ensure all parties understand what their obligations are under the plan. Although the risk that COVID-19 poses to business is severe, franchisors should avoid taking any premature drastic actions that may adversely impact their business and those of their franchisees. Measured and proactive steps, such as those explored above, can allow the franchisor to minimize potential COVID-19 risks to its business. It is advised for organizations to reach out to their broker or coverage counsel to determine if the applicable insurance policies contain crisis-related coverage extensions which may provide coverage for action needed to be taken in order to prevent the spread of the virus.

How will COVID-19 and the government-mandated shutdowns effect renovation work and the construction of new locations?

For any location that is currently undergoing construction, franchisors and franchisees will want to establish if and how construction may continue under the various government orders. Some states and cities have established that only construction that is deemed essential may continue and all other projects must be shut down. Depending on the nature of your business and what projects are considered essential, as defined by the particular government order, the construction of your project may be deemed essential and allowed to continue work. For those projects where work may be continued, there may be certain safety standards that are required by the government order that you will need to include in any updates to site safety measures that are to be taken as COVID-19 continues to be a risk.

We hope that you and your families are staying safe and healthy during these difficult times, and while we recognize that you will need to consider these issues in the context of your particular franchises operations and agreements, we hope that you find the guidance provided herein useful as you navigate these difficult times.

To read this article on IFA's website, click here
 






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