May 10th, 2013
In Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky issued another decision demonstrating the danger of franchisors relying on disclaimers in their contracts and the Franchise Disclosure Document (“FDD”) to defeat claims that it provided false financial performance information in selling a franchise. The court denied summary judgment for the franchisor of A&W Restaurants, Inc. (“A&W”) and will allow the franchisee’s claims of fraud and violation of franchise sales laws to be decided at trial. The case is particularly noteworthy because the franchise purchased was the claimant’s fourth from the same franchisor.
A&W’s FDD had what is known a “negative disclosure” in Item 19 concerning the provision of information about the sales or profits at existing franchises, specifically saying “[w]e do not make any representations about a franchisee’s future financial performance or past financial performance of company-owned or franchised outlets.” The Minnesota-based franchisee alleged that, in connection with considering purchase of a franchise to open a new “drive in” model A&W restaurant, the franchisor provided “information, including financial projections, which was laden with false data.” These allegations, if true, would mean that A & W provided a financial performance representation (“FPR”) outside of its FDD, in violation of federal and state franchise sales laws.
A&W followed the usual route of trying to get the franchisee’s claims thrown out before trial on the argument that, in light of the disclaimers in Item 19 of the FDD and in various parts of the franchise agreement, as a matter of law the franchisee could not “reasonably rely” on the information provided. The court rejected the argument that the disclaimers could be used to bar the franchisee’s claim that A&W provided misleading information in violation of the Minnesota Franchise Act, because that law (like the Maryland Franchise Registration & Disclosure Law) contains a provision making “void” any waivers of conduct contrary to the franchise sales law. The franchisor will be permitted to use the disclaimers in the contract and the FDD at trial as evidence to persuade the jury that the franchisee could not have reasonably relied on the “projections “.
The court also ruled that the disclaimers could not be used to deny the franchisee a trial on its claim of common law fraud (under Kentucky law) with regard to its claim that the projections provided were based on false data about other locations’ sales or earnings. In the words of the court, “A broadly-worded, strategically placed disclaimer should not negate reliance as a matter of law where A&W allegedly shared objectively false data to induce Defendant to enter into the Franchise Agreement.” Therefore summary judgment was denied and the franchisee’s fraud claim will proceed to trial, with A&W potentially liable for punitive damages if the franchisee prevails on that claim.
Given that the franchisee in this case already owned three (3) other A&W restaurants at the time it purchased the franchise at issue, it would hardly be surprising if it demanded and received specific financial performance information about the other “drive-in” models. A logical question is, if A&W had included sales and earnings data in Item 19 of the FDD that it provided to this franchisee, was it less likely to have faced the allegations made in this case? In this author’s opinion, based on more than fifteen (15) years of representing franchisors and franchisees, A&W would have been in a better position to defend against the allegations had it included such data in Item 19. The reason is that the data would have been reviewed by A&W’s attorneys and probably by upper management, who would be more likely to make sure that the presentation was accurate and not misleading. Once the presentation is in the FDD, most franchise salespeople will be less likely to “go off script” and provide information that is more optimistic than Item 19.
However, even if the franchise seller did provide information beyond the written FPR, at trial the franchisor will be able to point to the data provided in Item 19 and say, “Look, we gave the franchisee the data in the FDD and made it easy for him to investigate further, so it is ridiculous to believe he relied on something are franchise salesperson said.” In that situation it may be more likely than not that the jury would agree with the franchisor. By contrast, by denying its franchise seller use of an Item 19 FPR, A&W made it difficult to comply with the law and convince qualified candidates to purchase the franchise – setting up a scenario where a jury may believe that the franchise seller “went over the line.”
April 24th, 2012
During 2012 Sylvan Learning, Inc. and its corporate affiliates are fighting a claim of violating of the Maryland Franchise Registration & Disclosure Law and fraudulent conduct in its sale of tutoring center franchise rights, after having its motions to dismiss the fraud claims denied by the U.S. District Court in Baltimore.
In Next Generation Group, LLC v. Sylvan Learning Centers, LLC, Case CCB-11-0986 (decided Jan. 5, 2012), the plaintiff franchisee alleged that he agreed to develop and operate a new Sylvan Learning Center in Irving, Texas, in reliance upon representations from Sylvan that it would sell the plaintiff two existing Centers in nearby Arlington and Allen, Texas. According to the Amended Complaint, those representations were made orally by Sylvan’s agent to plaintiff’s principal both before and after the plaintiff signed the franchise agreement for Irving, but several weeks before the Irving location opened, Sylvan’s agent advised plaintiff’s principal “in writing that Sylvan had approved his acquisition of the Arlington and Allen Learning centers, respectively.” The parties executed letters of intent for the sale of both sites about two weeks before the Irving Center opened. However, about three weeks after the Irving Center opened, Sylvan’s same agent “informed [plaintiff] that Sylvan would not sell him the license and assets for any more franchises.” According to the Amended Complaint, Sylvan provided no explanation of its reversal of course. The franchisee claimed that Sylvan fraudulently induced it to develop and open the Irving location.
Sylvan argued for dismissal of the claims on the basis that the Irving franchise agreement contained an “integration clause” that prevented the plaintiff from relying on promises made outside that written agreement. The court rejected this, by quoting a prior court decision stating, “[T]he law in Maryland … is that a plaintiff can successfully bring a tort action for fraud that is based on false pre-contract promises by the defendant even if (1) the written contract contains an integration clause and even if (2) the pre-contractual promises that constitute the fraud are not mentioned in the written contract. Most of our sister states apply a similar rule. Greenfield v. Heckenbach, 144 Md. App. 108, 130, 797 A.2d 63, 76 (2002).” Sylvan’s problem is that the contractual “integration clause” did not disclaim any specific oral representations, and certainly not any concerning Sylvan’s willingness to sell the plaintiff additional existing franchised businesses. Without specific disclaimers as to representations made on that specific topic, the integration clause did not prevent pursuit of the claim.
While Sylvan could use the presence of the integration clause at trial to challenge whether the plaintiff reasonably relied on promises made outside of the Irving franchise agreement, based on the facts alleged the court stated, “there is reason to believe [plaintiff] could reasonably have relied on Sylvan’s representations” concerning the sale of the existing locations. Therefore, the court held that permitting the plaintiff to file a second amended complaint would not be “futile” and granted the plaintiff’s motion to do so.
After the plaintiff filed its Second Amended Complaint, Sylvan immediately moved to dismiss it on essentially the same grounds as asserted previously, and the court once again refused to dismiss the claims for fraud and violation of the Maryland Franchise Registration & Disclosure Law. Accordingly, the parties are now conducting discovery that may take most of 2012 to complete.
It is important to recognize that the proceedings in this case to date solely concern the sufficiency of the plaintiff’s factual allegations as a matter of law, and in later proceedings Sylvan’s representatives will provide information on what occurred with regard to this franchise sale. Nevertheless, the decision reiterates an important point for all Maryland business people – even if promises and statements are excluded from a particular written agreement, they may have legal consequences if the subsequent business relationship fails to meet the other party’s expectations.
March 20th, 2012
In Girl Scouts of Manitou Council, Inc. v. Girl Scouts of the United States of America, Inc.
, 646 F.3d 983 (7th Cir. 2011), the U.S. Court of Appeals for Illinois, Indiana and Wisconsin held that the national Girl Scouts organization, a nonprofit incorporated by an Act of Congress, violated the Wisconsin Fair Dealership Law by dissolving a local Wisconsin chapter of the national organization “without good cause.” The 2011 decision is notable both because of its author, the extremely well-known, respected and conservative Judge Richard Posner, and because of the language used by the Court in rejecting the Girl Scouts of the United States’ arguments for immunity based on its nonprofit mission. This article is designed to help the leaders of nonprofit organizations and associations identify ways to mitigate risks posed by this decision.
Under the Wisconsin law, a “dealer” is one who is granted the right by contract to “use [the grantor's] trade name, trademark, service mark, logotype, advertising or other commercial symbol” and has “a community of interest” with the other party to the contract “in the business of offering, selling or distributing goods or services at wholesale, retail, by lease, agreement, or otherwise.” The Girl Scouts of the United States argued that its contract with the affiliate was not “commercial” and that the affiliate was not “in business.” To that, the Court said:
. . . one doesn’t usually think of nonprofit enterprises as being “commercial” and engaged in “business.” Or didn’t use to–for outweighing these hints is the fact that nonprofit enterprises frequently do engage in “commercial” or “business” activities, and certainly the Girl Scouts do. Proceeds of the sale of Girl Scout cookies are the major source of Manitou’s income. The local councils sell other merchandise as well. Sales of merchandise account for almost a fifth of the national organization’s income, and most of the rest comes from membership fees and thus depends on the success of the local councils in recruiting members; that in turn depends on the councils’ revenues and thus gives the national organization an indirect stake in the cookie sales.
646 F.3d at 987. The Court went on to emphasize that, when competing with for-profit entities in commercial enterprises and endeavors, nonprofits may be held to the same legal standards of conduct.
Laws that prohibit termination or cancellation of a dealer or franchisee, except for “good cause,” are called “franchise relationship” laws. Wisconsin’s definition of a “dealer” is similar to the definition of a “franchise” under the franchise relationship laws of Arkansas, Connecticut, Delaware and New Jersey. Another 11 states have franchise relationship laws, but require the “franchisee” to prove that it was required to pay some sort of “fee” as a condition of selling goods or services under the “grantor’s” trademark. Such “fees” have been deemed charged if the “franchisee” was required to pay the “franchisor” for a policies and procedures manual, for its director to attend a training conference, or even for marketing materials to distribute to prospective customers of the good or service.
The 15 states that have laws regulating the granting of a franchise, typically known as “franchise sales laws,” mandate certain disclosures be provided to prospective franchisees and that the franchisor refrain from certain actions in recruiting franchisees. All of those laws also contain a requirement that the “grantee” directly or indirectly pay some sort of “fee” to the grantor as a condition of operating under the grantor’s trademark. Most of those laws do not require that the fee be paid up front, and thus the fee could be a percentage of the grantee’s cash received in operating the business. However, payments from the grantee to the grantor for products at their “bona fide wholesale price” cannot be franchise fees, and the payment of commissions to the grantee when it has acted as a bona fide sales agent of the grantor are excluded. However, if the fee element is satisfied and there is substantial association with a common name, then Judge Posner’s reasoning on what is a “commercial endeavor” and operation of a “business” could be meaningful in proving the existence of a franchise.
The Federal Trade Commission also has a trade regulation rule that contains disclosure requirements and recruitment prohibitions that are similar to the state franchise sales laws. Fortunately for nonprofit organizations, the FTC has issued several advisory opinions finding that a nonprofit engaging in transactions that would otherwise be considered franchising were exempt from the Franchise Rule provided that (a) the licensor is not engaged in the relationship “for its own profit or the profit of its members,” and (b) the licensees are also bona fide non-profits. The first requirement is driven by the limit of the FTC’s jurisdiction, since it may only regulate a company “which is organized to carry on business for its own profit or that of its members.” 15 U.S.C. § 44. However, when the nonprofit associations of glass makers and insurance agents collaborated to form “The Glass Network” to enable the insurers to obtain lower cost auto glass replacement services and the glass makers access to that market, the FTC staff found that “network” to be covered by the Franchise Rule, notwithstanding its ownership by nonprofits. The Glass Network, LLC, FTC Informal Staff Advisory Opinion 04-4 (2004).
What follows are some key questions to ask in determining whether your chapter or affiliate program could be deemed a franchise system, or should otherwise focus on franchise law matters:
1. Are your members for-profit companies or professionals?
2. Is there an upfront affiliation fee or annual dues to maintain affiliate status, or a requirement that the affiliate purchase certain quantities of goods or services, regardless of customer demand?
3. Do your affiliates pay you a share of membership dues they receive, or does the affiliate receive membership commissions from you?
4. Is your association’s name or logo a prominent or significant part of the affiliate’s name or identity, from the perspective of its members?
5. Do your affiliates provide direct business development opportunities for their members (as opposed to general promotional benefit)?
6. Does a substantial portion of each of your affiliates’ revenues come from the sale of the same type of products or services, and are those products or services also sold by for-profit companies? Examples besides cookies are travel tours, function facility space, summer camps, or sports leagues.
7. Do your affiliates have exclusive territorial rights?
8. Is there a minimum quota of memberships that the affiliate must maintain?
9. Is good cause required to terminate the affiliate’s charter?
10. Is there a covenant not to compete after revocation of the charter, and if so who does it bind (i.e., just the affiliate as a nonprofit entity, or also its officers and directors)?
If a nonprofit organization or association answers “yes” to many of these questions, it may be advisable to review the chapter or affiliate structure – and applicable affiliation agreement – to mitigate the risk of inadvertently being considered to fall within the franchise laws.
November 7th, 2011
A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.
Misrepresentations in Franchise Disclosures
The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.
In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.
The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”
The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.
Jurisdiction in Maryland and Application of New York Franchise Sales Law
The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.
Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.
The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.
The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.
(1) Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.
(2) If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.
(3) New York needs to amend its law to exempt out of state franchise sales from its registration requirements.
May 13th, 2011
A recent case with compelling facts shows that, despite attempts through written agreements and disclosure documents to shield franchisors from liability, deceptive conduct within the franchise relationship can still result in substantial liability for franchisors.
In Holiday Inn Franchising, Inc. v. Hotel Associates, Inc., 2011 Ark.App. 147 (Ark. Ct. Apps. 2011), the franchisee Hotel Associates, Inc. (“HAI”), is owned by J.O. “Buddy” House, one of the early Holiday Inn franchisees who was close friends with the chain’s founder. The court found that, over the course of decades, House had developed a relationship with the executives of Holiday Inn Franchising, Inc. (“Holiday Inn”) founded in “honesty, trust and the free flow of pertinent information”, thereby creating a “special relationship” imposing a duty on Holiday Inn to disclose facts material to the ongoing relationship.
In 1994, HAI, at the suggestion of a Holiday Inn executive, considered purchase of a rundown hotel in Wichita Falls, Texas to convert to a Holiday Inn. House realized that the property would need expensive renovations and requested a 15 or 20 year term in the Holiday Inn franchise agreement. Holiday Inn declined, but its Vice President of Franchising “stated that, if House operated the hotel appropriately, there was no reason to think that he would not receive a license extension at the end of the ten years.”
HAI signed a ten year franchise agreement in early 1995 and made extensive renovations before opening. The hotel was successful and HAI received offers to sell for up to $15 million, but declined based on its belief that the franchise would be extended. Meanwhile, Holiday Inn’s commission franchise salesperson was pursuing conversion of a nearby Radisson hotel at the end of HAI’s term and prepared a business plan for that conversion in 1999.
In 2001, an employee of HAI spoke to a Holiday Inn representative about early relicensure, and was convinced to send Holiday Inn a $2,500 fee to obtain a Property Improvement Plan (“PIP”) for changes needed for relicensure. The PIP required changes costing $2 million dollars, and after going through 2 rounds of Holiday Inn PIPs, HAI spent about $3,000,000 — without ever being informed of the business plan for the Radisson, which continued to be pursued.
In October 2002, when the hotel was fully renovated pursuant to the PIP and received a quality score of 96.05 (out of 100), Holiday Inn informed HAI that the Radisson had applied for a license and was being considered as a possible “partial replacement” for HAI’s facility “if it left the system.” After HAI protested, Holiday Inn stated that the Radisson application had been denied. However, after several more twists and turns, the new franchise development team “prevailed” over the relationship managers, the Radisson was licensed and HAI’s facility was denied relicensure. HAI sold it in 2007 for $5 million, before the real estate crash.
After a jury trial, HAI prevailed on claims against Holiday Inn of fraud and promissory estoppel, which means detrimental reliance on promises. After appeal, HAI’s judgment was for over $10 million in compensatory damages and $12 million in punitive damages. The case is notable because (a) HAI had no right to relicensure under the parties’ written agreement, but (b) the court found a “special relationship” that imposed a duty to disclose to the franchisee material information about the future of the business relationship, and (c) the court found that Holiday Inn’s course of conduct supported a punitive damages award.
August 30th, 2010
(This is the conclusion of the August 23, 2010 post on this Blog.)
Franchising vs. Other Methods of Expansion
The main advantage that franchising has over expanding a business on your own is that you get to invest other people’s time, skills, and money to growing the business instead of borrowing against your business and personal assets or granting stock to outside investors. Having franchisees allow a business to play off of a diverse pool of talent that may attract different types of people to the business.
Many businesses have found that, by granting franchises, they can recruit talented individuals who will be driven to tremendous lengths to make their business a success. While incentives to the managers of company-owned remote locations can drive good short-term results, franchisees who risk their net worth on the enterprise have the ultimate incentive to develop the businesses for long-term profitability.
As the franchisor, your business will be less likely to be held liable for any claims of personal injury or employment discrimination that that may happen on the premises of a franchised unit, as opposed to one opened with borrowed or equity capital. Making sure that this liability shield is effective takes careful planning, but when properly executed it is a substantial benefit of franchising.
It’s not all good news however. After outside lenders or investors are repaid, company units may yield more profit to the brand founder than franchises. It can be more difficult and costly to terminate a misbehaving franchisee than a location manager. Finally, company owned units located near franchises could suffer revenue losses through competition with the franchises.
So You’ve Decided to Franchise…
With all of that in mind, and you’ve decided that your business is ready to franchise, there are a few things you should do before looking for your first franchisee.
- Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
- Put money aside. A thoughtful and responsible business owner should have at least $100,000 available for franchising purposes, including legal, development of training programs and operations manuals, and advertising for franchisees (both creative and placement). Also, a shrewd businessman might put away that money, spend half on the aforementioned items, and keep the rest on hand to show sufficient capitalization to obtain state franchise registration on favorable terms.
- Be prepared to do some hand-holding. Business owners that are looking to franchise need to be realistic when they look at the additional operating costs of getting a franchise up and running. They must spend money and time recruiting and supporting the new franchisees. Time away from the core-business means money for managerial costs for the original businesses that form the “prototype” for the franchises.
Potential franchisors need to accept that franchising successfully will require some short term sacrifices in terms of time and money. Done correctly and thoroughly can mean the growth of your business to larger regional or national markets. Improperly, underfunded, and rushed could mean the loss of the business entirely. Early investment in franchise resources and assistance will give the business a better chance at success and growth within your industry.
June 16th, 2010
Even in the best of franchise relationships, franchisors must be wary of litigation and potential liability arising out of their franchisees’ business operations. Where a franchisor imposes and exercises substantial controls over its franchisees’ operational and administrative methods and procedures, the franchisor may well find itself a defendant in lawsuits brought by customers and employees of its franchised outlets, claiming that the franchisor’s exercise of control makes it liable for its franchisees’ negligence or misconduct.
Two recent cases involving employee and customer claims against Jackson Hewitt shed light on this issue. In one case, a customer of a Jackson Hewitt franchised tax center in Louisiana filed suit against the franchisor based upon a privacy breach committed by the franchisee. In the other, an employee of a Jackson Hewitt franchise in Pennsylvania sued the franchisor for sexual harassment based upon the alleged actions of certain owners and managers of the franchise. In asserting their claims against the franchisor, both plaintiffs relied heavily upon language in Jackson Hewitt’s franchise operations manual and other documentation, and also the direct involvement of Jackson Hewitt representatives in the operations of its franchisees. The courts in both cases were willing to consider the plaintiffs’ claims against Jackson Hewitt despite clear admonitions in the Franchise Agreement and Operations Manual that the franchisee and its employees “shall not be considered or represented [by the franchisee] as [Jackson Hewitt’s] employees or agents” and that franchisee has exclusive responsibility over hiring and matters relating to personnel.
The conclusion to be drawn from the Jackson Hewitt litigation is that franchisors are essentially presented with two options when drafting their franchise agreements and operations manuals. The first option is to impose significant operational controls over their franchisees’ operations, similar to those described above, and assume the attendant risk of facing liability for third-party claims arising from actions taken in accordance with the operational mandates. The other option is to limit the franchise operations manual to providing examples, general guidance and non-mandatory recommendations for operating procedures and specifications.
The first approach allows franchisors to impose greater control over, and have more say in, their franchisees’ operations—which is an attractive proposition for many franchisors. In addition, franchisees may perceive greater value in a franchise system that provides strict operating standards and procedures, which may help to distinguish the franchisor from competing brands. If the franchisor chooses this approach, it should consider increasing the minimum policy limits required for franchisees’ insurance policies and the types of required policies. It may also want to explore direct insurance coverage for the franchisor for all claims arising from franchised operations.
The advantages of the second option are demonstrated by a recent court decision from Illinois, Braucher v. Swagat Group, LLC, Bus. Franchise Guide (CCH) ¶ 14,355 (Mar. 19, 2010), in which Choice Hotels International, Inc. avoided liability in a wrongful death claim for the alleged negligence of one of its franchisees in maintaining its indoor swimming pool and whirlpool. Choice provided very limited operational guidance and controls with regard to swimming areas, and this approach allows a franchisor to avoid potential liability associated with imposing mandatory operational controls over franchises. However, it also carries the potentially negative business implications of allowing franchisees a measured level of discretion in running their businesses under the franchised brand. The term “measured” is important, because the franchise agreement should still include rights of termination or other remedies for acts or omissions that have the potential to cause material detriment to the franchise system’s goodwill. In addition, franchisees may view a franchisor that employs this approach as providing very little in terms of affirmative guidance and support, not acknowledging that the information and non-binding recommendations of a franchisor can provide value in and of themselves, irrespective of whether compliance is deemed mandatory.
A prospective franchisee can also glean guidance from the information provided above. When evaluating a franchise opportunity, a prospective franchisee should seek to review the franchisor’s operations manual, even if its table of contents is provided in the Franchise Disclosure Document (“FDD”). It is acceptable for a franchisor to require the prospect to sign a non-disclosure agreement with regard to the Manual. If the operations manual provides detailed mandatory specifications and procedures, the prospective franchisee should be wary of the likelihood that the franchisor will pursue rigorous enforcement, to account for the assumption of the significant liability risks described above. While the “deep pocket” franchisor’s potential “joint and several” liability for third-party claims may seem like a benefit to the franchisee, the prospect should be aware that indemnification and contribution provisions in the franchise agreement is likely to shift the ultimate financial burden back to the franchisee, unless it can prove that the franchisor’s actions caused the third party’s claim.
If the operations manual provides only examples and recommendations for franchisee policies and operational procedures, as opposed to detailed mandates, the franchisor may be attempting to avoid any direct performance obligations to its franchisees, or it may simply be attempting to limit its exposure. In performing its due diligence, a prospective franchisee should attempt to gain as much information as possible from the franchisor and its active franchisees to discern the quality and operational support the franchisor actually offers.
The operations manual and other forms and operational materials can be valuable tools for franchisors and franchisees alike. But, depending on how they are written, they can expose the franchisor to liability and raise serious questions in the minds of franchisees as to the benefit to be derived from subscribing to a particular franchise. Parties on both sides of the table should be sure to carefully evaluate these documents to ensure that they serve and meet their needs and expectations.
April 28th, 2010
A recent case out of the United States District Court for the Eastern District of Michigan has opened the door for insurance agents to bring claims under the Michigan Franchise Investment Law (“MFIL”). Parting from clearly established precedent in other jurisdictions, the court held in Bucciarelli v. Nationwide Mutual Insurance Co., Bus. Fran. Guide (CCH) ¶ 14,200 (2009), that a Nationwide insurance agent would qualify as a franchisee under the MFIL if it could demonstrate that payments made to Nationwide for allegedly-overpriced furniture and computer equipment constituted a franchise fee.
This decision contrasts with the law in many other jurisdictions, including Florida, Illinois, Missouri, New Jersey, New York and Virginia, in which the courts have held that their states’ franchise laws do not apply to the insurance industry.
Bucciarelli, the plaintiff, was the sole owner of a Nationwide insurance agency located in Michigan, pursuant to an Independent Contractor’s Agent Agreement signed in 2002. Following a series of changes and new implementations in the Nationwide product offerings and independent agent system, Bucciarelli alleged that the Nationwide customer base began to erode, and certain performance goals and other standards for independent agents became unachievable. Based on these allegations, Bucciarelli filed suit against Nationwide claiming, among other things, deceptive trade practices in violation of the MFIL.
State franchise laws commonly provide that, in order to be deemed a “franchisee,” a party must have the authority to offer the franchisor’s products or services for sale. Nationwide argued, and other courts have held, that in order to “offer” products or services, the offering party must have the capability to actually enter into a contract for the proposed sale. In the insurance industry, policies are entered into by the insurance company (e.g., Nationwide) directly, and the independent insurance agents act as commissioned salespersons on behalf of the insurer. Thus, the decisions holding that state franchise laws do not apply to independent insurance agents have generally rested on the theory that insurance agents are “mere order takers,” who contractually cannot actually “offer” insurance products to customers, and therefore cannot qualify as franchisees under the states’ statutory schemes.
However, the court in Bucciarelli held that the actions of independent sales agents may qualify as making an “offer” under the MFIL. The court rested its decision on the fact that the MFIL’s definition of a franchise refers to both the ability to “offer” and to “sell,” and stated that if “offer” were given the meaning prescribed in other jurisdictions, then the word “sell” would be duplicative. As a result, the court interpreted “offer” much more broadly, “to refer to making goods or services available in a practical rather than a legal sense.” Under this interpretation, the court held that an insurance agent could satisfy the statutory elements of the franchise definition. Interestingly, the Maryland Franchise Registration and Disclosure Law also includes this offer/sale dichotomy, and further distinguishes and includes “distributing” the franchisor’s products or services within the franchise definition.
As Nationwide did not dispute that Bucciarelli had the right to substantially associate his business with the Nationwide trademark, the only issue that remained was to determine whether Bucciarelli had paid a “franchise fee” to acquire his Nationwide insurance agency. While the Independent Contractor’s Agent Agreement did not suggest that such a fee had been paid, Bucciarelli’s argument that his purchase of allegedly over-priced furniture and computer equipment from Nationwide satisfied the “franchise fee” requirement was sufficient to get his MFIL claim past Nationwide’s pre-trial motion to dismiss.
While the particular factual scenario in this case only has relevance if the agent will be purchasing physical assets from the insurance agency, the legal analysis applied by the court has the potential to have a sweeping impact in states like Michigan and Maryland where the insurance industry may now be subject to franchise disclosure laws. Though it remains unlikely that franchise implications will arise where the agent does not make any payments to the insurance company in connection with taking over an existing agency, where the agent does make payments—even in exchange for equipment or training—the payments have the potential to be classified as indirect franchise fees. In such cases, the parties’ relationship may now fall within the relevant state statute’s “franchise” definition.
By: Jeffrey Fabian
January 28th, 2010
By David Cahn & Jeffrey Fabian
The relationships involved in two- and three-tiered, multi-unit franchise expansion models raise difficult compliance questions under the Federal Trade Commission (FTC) Franchise Rule (“FTC Rule”) and the various state franchise registration and disclosure laws. Failure to properly disclose all parties involved in the franchise sales process, including intermediate parties, can lead to civil liability, fines and cancellation of franchise agreements.
Franchisees involved in multi-unit expansion typically fall into one of three classes. “Area Developers” are typically a franchisee who is granted the right to open more than one franchise in a defined territory in accordance with a development schedule, as a “multi-unit developer.” Area Developers of this type do not have any franchise disclosure obligations. “Master franchisees,” also known as “Sub-franchisors,” recruit and enter into franchise agreements directly, and pay fees to the franchisor out of the amounts they collect from their franchisees; these parties must issue an FDD and register as franchisors in states that require such filings. The third category, “Area Representatives” or “Development Agents,” are sub-contractors of franchisors, acting as sales agents and performing some post-sale obligations on the franchisor’s behalf in a defined geographic area in exchange for a percentage of franchise fees paid by franchisees in the assigned area. The disclosure and registration obligations concerning Area Developers have created uncertainty in the law.
A recent case still pending in the Washington State court system demonstrates the complexities and obscurity surrounding the registration and disclosure obligations of franchisees involved in a franchisor’s multi-unit expansion efforts. Pinchin v. Nick-N-Willy’s Franchise Pizza Company, LLC involves a franchisee’s claim for rescission of its franchise agreement based upon the franchisor’s failure to disclose its relationship with an area representative who “played a role” in recruiting the franchisee into the Nick-N-Willy’s system. The franchisor’s FDD did not reference the area representative, and the area representative did not prepare his own FDD. The court determined that the area representative was required to be disclosed in the franchisor’s FDD and to independently register as a “subfranchisor” with the Washington Securities Division. As a result, the court awarded the franchisee “rescission” of the franchise agreement, meaning that it was released from all obligations in the agreement (including the covenant not to compete) and granted the right to obtain a refund of all amounts paid to the franchisor, and possibly additional damages to compensate for its losses due to pursuing the franchise. The case is still pending solely for a determination of the franchisee’s monetary damages award.
Under the FTC Rule only true “Sub-franchisors” who enter into agreements with franchisees must prepare their own FDDs. It appears that the area representative relationship in Nick-N-Willy’s is not a subfranchise under the FTC Rule, but the court determined that the area representative was obligated to register as a franchisor under Washington law.
According to Dale Cantone, chair of the Franchise and Business Opportunities Committee of the North American Securities Administrators Association (“NASAA”) and Deputy Securities Commissioner in Maryland, that committee is studying the issue of the disclosure and registration duties of Area Representatives and hopes to provide additional guidance to the states in the near future. Such guidance would be helpful in clarifying an uncertain area of franchise sales law.
In the meantime, however, the Nick-N-Willy’s case is a warning shot directed at franchisors and area representatives who fail to disclose their relationship to prospective franchisees. In states like Washington where the definition of a “subfranchisor” is arguably broader than the definition under the FTC Rule, area representatives may face registration obligations. Franchisors and their development agents in the field should carefully consider whether the area representative’s information should be included in various portions of the Franchisor’s FDD used in the area representative’s state, since such disclosures may be required by the FTC Rule.