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September 2, 2015

Best Practices: SBA’s Franchise “Magic Words”

by Starfield & Smith

The SBA is in the process of reevaluating its rules on franchises and affiliation. The task at hand is daunting. The new rules need to be clear and comprehensive, yet remain malleable enough to address a wide array of industries and their ever-evolving business models.

The current rules reflect the need for that balance. The rules contain certain very specific requirements and provide guidance on the nuances of particular industries. But the main thrust of the current rules is conceptual in nature, which opens them to varied interpretation. Lenders should proceed cautiously in any regulatory space that is subject to varied interpretation. But sometimes it’s the clear and concrete rules that can trip up a lender.

For example, the SBA affiliation rule is very specific regarding the sale or transfer of the franchised business (or its assets) by the franchisee. Such transfers typically are subject to the prior, written consent of the franchisor. The current rule requires that such consent “shall not be unreasonably withheld or delayed.” Although it may seem quite simple to require these “magic words” in the franchise agreement, the issue can get murkier in practice.

This type of transfer provision in a franchise agreement very frequently is followed by a list of conditions that must be met before the franchisor will consent to a transfer. Those conditions ordinarily appeal to logic and common sense: requiring the current franchisee to be in compliance with the franchise agreement, requiring the current franchisee to also be current on its payment obligations to the franchisor, requiring the proposed transferee meet all of franchisor’s criteria for a new franchisees, and requiring the proposed transferee to enter into a new franchise agreement with franchisor.

In other words, the conditions placed on a transfer typically are non-controversial and facially reasonable. Lenders, however, should resist the urge to replace SBA’s required “magic words” with their own judgment on the reasonableness of the stated conditions to the transfer. Lenders should not succumb to push-back from a franchisor who refuses to amend its agreement to state that it will proceed reasonably when the stated conditions of its approval are non-controversial and reasonable on their face. No matter how reasonable the franchisor’s conditions to transfer may appear, the franchise agreement must specifically state that the consent to transfer “shall not be unreasonably withheld or delayed.” Unless the franchise agreement contains those “magic words,” the agreement will ultimately be deemed ineligible.

The SBA’s revised rules on franchise affiliation may change this requirement. For now, it remains the law of the land. Unless and until the rule changes, lenders may need to take an unreasonably strong position (in the face of very reasonable opposition) to ensure the phrase “shall not be unreasonably withheld or delayed” is included in a borrower’s franchise agreement.

For more information, please contact Greg at 215-390-1023 or at gkupniewski@starfieldsmith.com.