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When Can a Franchisee Be Terminated for Not Complying with Image Standards?

by on Breach of Contract

When is an image standard in a franchise system appropriate and enforceable and when is it arbitrary and unenforceable? Franchisors have a strong interest in maintaining consistent image standards across their franchisees. How far can that interest go and how can it be properly administered? On the other hand, franchisees naturally do not want arbitrary standards enforced upon against them. And when push comes to shove, is the “failure” to follow the “image standards” even a breach of the franchise agreement. A recent case, S.A. Mission Corp. v. BP West Coast Products, LLC, 2019 WL 99042 (N.D. Cal. Jan. 3, 2019) involved application of the Petroleum Marketing Practices Act (“PMPA”) and raised these and other related issues.

When Does an Inspection Violation Become a Material Breach of the Franchise Agreement?

S.A. Mission Corp., a gas station franchisee, moved to preliminarily enjoin B.P. West Cost Products (“BP”) from terminating its Contract Dealer Gasoline Agreement (“the gas agreement”) and an am/pm Mini Market Agreement (“the am/pm agreement”). BP had moved to terminate S.A. Mission based on its alleged failure to comply with BP’s image standards. In particular, S.A. Mission had failed 6 inspections under BP’s Consumer and Operations Retail Excellence (“CORE”) program. The CORE program required franchisees to score at least 70 percent to stay compliant and if they did not, the franchisee would receive a notice of default. But was a failed inspection under the CORE program a breach of the franchise agreement?

BP needed to show a breach to justify its termination. Under the PMPA, a franchisee is entitled to a preliminary injunction if the balance of hardship tips in its favor and there is a reasonable chance that the franchisor will be unable to prove that the termination was permissible under the PMPA. One of the statutory grounds for termination under the PMPA is where there is a “failure by the franchisee to comply with any provision of the franchise, which provision is both reasonable and of material significance to the franchise relationship”.

The gas agreement provided that “[t]he Premises must be clean, well maintained, and graffiti free, with structures, driveways and pavement in good repair. [BP] will perform periodic inspection for which repeated failure or poor performance is grounds for termination or nonrenewal of this Agreement.” The am/pm agreement provided that the “Operator agrees that it shall operate the Store and maintain the Premises in accordance with the standards, methods, procedures, requirements, instructions, food specifications and equipment specifications set forth in the am/pm Store Systems/Operations Manual … and any and all subsequent amendments and supplements thereto….” What neither of these provisions explicitly required was that the franchisee pass the CORE program inspections.

Do Franchisees Need to Comply with Obscure Operations Manual Requirements?

Instead, compliance with the CORE program was set forth in the systems manual. However, even there, the systems manual only set forth that there would be inspections and that the required passing score was 70%. S.A. Mission argued that how the CORE inspection program was administrated was arbitrary. Further, that a jury may not agree with BP that the CORE inspection failures translate to violations of the image standards in the agreements. The court agreed finding that there was a reasonable chance that BP would be unable to prove that termination was permissible.

In coming to its conclusion, the court reviewed the CORE inspection program. The court found the following serious questions going to the validity of the CORE inspections:

  • The CORE program is not mentioned in the franchise agreements. 

  • The CORE program exhibits examples of “dubious authority”. For example, it deducted 
points for failing to produce a “source log” when that was not required under the systems

  • The CORE program imposed point deductions without supporting evidence. For 
example, the systems manual required that the “fruit merchandizer must be available and stocked”. However, S.A. Mission had been deducted points for not having bananas despite having apples and oranges available for purchase and thus arguably complying with the standard. 

  • The CORE program instituted an “all or nothing” scoring mechanism wherein if a franchisee missed out on one element of a five element compound question, it would receive no points despite complying with the other four elements. 

  • The CORE program changed its questioning and how it allocated points on almost a quarterly basis. 

  • The CORE program had automatic deductions for not passing parts of the inspection, such as fifty points for not receiving 80 percent on food safety. However, those 50 points represented a larger share of some inspections and less of others depending on the changing total point scale. 

  • S.A. Mission had satisfied various conditions in the CORE inspection but received no points for it. BP tried to explain this by arguing that some questions don’t lead to additional points, only subtractions for not complying. 

Lastly, the court stated it could not fully understand the “convoluted” summary provided to franchisees of how the CORE program worked and was scored.

How Franchisors Should Structure Inspection Programs

The lessons from the court’s review are many. A franchisor should review these image inspection programs, preferably through counsel, to make sure they are in accordance with the franchise agreement and systems manual. Inspections should require compliance with standards that are known and communicated to the franchisee. Those standards must be understandable to the franchisee or anyone reading it. Standards should be uniformly enforced and consistent rather than a moving target. The scoring system for the inspections should be straightforward and even-handed.

The court stated that although it found a question as to whether termination was proper here, that a franchisor could enforce image standards. In that regard, the court stated:

When a franchise agreement imposes a general requirement to maintain image standards, the franchisor may presumably adopt specific but reasonable image standards, communicate them to its franchisees, and terminate those who fall short, at least after notice and opportunity to cure. In turn, to police the standards, the franchisor may presumably devise an objective list of inspection questions and compose a scoring scheme so long as the list and scheme are fair and reasonable in light of the objectives of the franchise. The administration of the inspection and scoring must also be uniform across all stations, meaning that if the standards are read into one agreement, they must be read into all like it. Leniency as to one would mean leniency as to all. But it will still be up to a jury to say whether or not a flunking grade in the instant action translates to a violation of the image standards required by the contract.

The court also considered another interesting issue regarding whether the cross-default provisions could be enforced. It was unclear whether S.A. Mission had failed the inspection as to the gas agreement or the am/pm agreement because the CORE inspection was ambiguous on this point. The court held that there was a “serious question” as to whether termination of one agreement for failing to follow “image standards” would give rise to termination of the other agreement. This issue could equally apply to situations where a franchisee own multiple units and one unit has difficulties.

Ultimately, because there was a serious question as to whether BP had properly terminated S.A. Mission, the termination caused S.A. Mission immediate hardship, and the public interest favored injunctive relief, the court enjoined BP from terminating S.A. Mission’s gas and am/pm agreements.

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

Work With an Experienced Franchise Breach of Contract Lawyer

A breach of contract can threaten the stability and future of your franchise business. If you need an experienced California franchise breach of contract lawyer to analyze or litigate your contract issues, contact Luther Lanard, PC, to schedule a consultation.