Does a Franchisor’s Right of First Refusal Have to Encompass the Entirety of the Franchisee’s Business?

Franchisors often include a right of first refusal in franchise agreements to allow them the opportunity to buy a franchise that is being sold. How must that right be exercised and how much of the franchisee’s business must the franchisor buy? In Tavarua Restaurants, Inc. v. McDonald’s USA, LLC, Case No. 19cv21-MMA (LL), 2019 WL 3858826 (S.D. Cal. Aug. 16, 2019), the court answered that question.

Can a Franchisee Force the Franchisor to Match the Terms of the Purchase and Sale Agreement?

The owners of Tavarua Restaurants sought to sell eight McDonald’s franchises in the San Diego area along with an office and a storage facility to John Cook. The Purchase and Sale Agreement (“PSA”) set forth that Cook would purchase the corporate stock to own the eight franchisees for $17.5 million and further that he would purchase Tavarua’s office and storage facility for 6% under the appraised value.

McDonald’s exercised its contractual right to purchase the eight franchises and related restaurant assets for a purchase price of $17.5 million. However, McDonald’s refused to purchase any additional assets of the corporations unrelated to the restaurant franchises, such as the office and storage facility. Because of this, Tavarua rejected McDonald’s purchase attempt and a lawsuit ensued.

The parties both sought declaratory relief as to the exercise of the right of first refusal and McDonald’s filed a motion for judgment on the pleadings on that claim. As the material facts were not in dispute, the court decided the issue as a matter of law.

The key language in the franchise agreements was “McDonald’s shall have the first option to purchase the Restaurant by giving written notice to Franchisee of its intention to purchase on the same terms as the offer within ten (10) days following McDonald’s receipt of such notice.” McDonald’s argued that the language unambiguously gave it a right to purchase the restaurant franchises and that this right was not contingent upon the purchase of unrelated assets. Tavarua did not dispute that this language was unambiguous. Instead, Tavarua argued that the language “on the same terms as the offer” meant that McDonald’s had to agree to the terms of the PSA, which included the purchase of the office and storage facility.

Using the Right of First Refusal to Buy Some but Not All of the Franchisee’s Assets

Citing Illinois law, the court stated “that for the exercise of an option to be valid, the acceptance must be in the precise terms of the offer contained in the option.” McDonald’s had notified Tavarua that “Pursuant to Section 15(c) of Mr. Seder’s Franchise Agreements for the Restaurants, McDonald’s hereby exercises its First Option to Purchase the franchises for and assets of, the Restaurants on the same terms as set forth in the PSA.” And therein was the crux of the matter. Did McDonald’s have to agree to the entire offer, the PSA, or just the terms in the PSA that related to the restaurants?

The court held that McDonald’s notice “constituted a timely, effective exercise of the option and gave rise to a binding contract of purchase.” Responding to Tavarua’s arguments, the court reasoned that the terms and conditions of the PSA regarding the office and storage facility were outside of the scope of the franchise agreements. The right of first refusal option is only related to the restaurant franchises.

Although the scope of the PSA went beyond the restaurant franchises that did not mean that McDonald’s had to agree to terms that did not regard the restaurant franchises. The court concluded that the inclusion of the additional covenants and agreements unrelated to the purchase of the restaurant franchises had no legal effect on McDonald’s valid exercise of the option. Thus, the court granted judgment in McDonald’s favor.

When Dealing with a Right of First Refusal, the Purchase and Sale Agreement Should be Carefully Drafted

An argument could be made for both sides’ perspective on the case. For example, if the PSA had involved the sale of 8 McDonald’s franchises and 3 Taco Bell franchises, it would not be expected that McDonald’s exercising the right of first refusal meant it had to buy the Taco Bell franchises. Accepting Tavarua’s argument would have led to the conclusion McDonald’s had to accept the entire PSA and thus buy the Taco Bell franchises.

On the other hand, was there an argument that the office and storage facility were assets related to the restaurant? If they were necessary for running the restaurants, and perhaps they were not in this case, there would be an argument that McDonald’s had to buy those assets. Would it have mattered if the purchase price set forth in the PSA also encompassed the office and storage facility instead of the valuation of those assets being distinct?

The takeaway is that when properly drafted, a franchisor can exercise a right of first refusal without having to agree to all the terms in a related PSA. Instead, the franchisor can focus on the terms of the PSA that regard the franchises specifically. From the franchisee perspective, it is important to carefully draft the PSA to define which assets relate to the franchise. Both the franchisor and franchisee must look to both the terms in the franchise agreement and in the PSA to identify the extent of the right of first refusal.

* Originally published in shorter form in the California Lawyers Association, Business Law Section, Franchise Law Committee, Case Report, September 2019

Work With an Experienced Franchise Lawyer

How you draft a purchase and sale agreement may determine whether and to what extent a franchisor may buy the franchisee’s assets. This is where it’s important to have an attorney who knows their way around a franchise agreement. If you need an experienced California franchise lawyer to analyze or litigate the issue of franchise rights of first refusal, contact Luther Lanard, PC, to schedule a consultation.