Tag: Franchise Rule
October 13th, 2016
Takeaway: Demonstrating our value to early stage franchisors, WTP public comments help eliminate proposed regulations that would have prevented new franchisors from providing profit information.
Generally speaking, the most important type of information that a franchisor can provide to prospective franchisees concerns the profits earned by businesses operating under their brand. This type of information, as well as information on gross revenues, is called a Financial Performance Representation (“FPR”) or “earnings claim” under the laws governing franchise sales in the United States. Unfortunately, while the FTC Franchise Rule requires certain disclosures to prospective franchisees (through provision of a Franchise Disclosure Document or “FDD”), and requires that any FPR that a franchisor provides be included in Item 19 of the FDD, it does not provide substantive guidance on what can and cannot be provided in an FPR. Instead, it simply requires that there be a “reasonable basis” for providing that information to prospective franchisees.
While the FTC does not require filing and approval of the FDD prior to selling franchises, several U.S. states require that the FDD be reviewed and approved before a franchise is sold in that state (a process called “registration”). Among the most prominent registration states are California, Illinois, New York, Maryland and Virginia. Those states’ review of FDDs are informed and guided by policy statements issued by the North American Securities Administrators Association (“NASAA”), of which each state’s franchise regulatory authority is a member. Since 2015 NASAA has been considering issuance of a Financial Performance Representations Commentary.
The original proposed FPR Commentary, issued for public comment on October 1, 2015, contained many useful provisions. However, proposed Section 19.7 would have drastically interfered with new franchisors’ ability to provide truthful, factual information to prospects. It read:
19.7 Item 19 — FPR Disclosing Gross Profit or Net Profit of Company-Owned Outlets When Franchisor Has No Operational Franchises.
QUESTION: If a franchisor has no operational franchises, can the franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?
ANSWER: No. A franchisor with no operational franchises cannot make an FPR disclosing gross profit or net profit based on company-owned outlet data alone.
The proposed commentary’s reason for this blanket ban was a concern that franchisees are likely to incur higher operating costs than company-owned locations, and without operating franchisees the new franchisor would not have a way to know if its costs were lower (or higher) than franchisees would experience. Therefore, to provide net profit information to prospective franchisees based solely on the company-owned data would be misleading.
This proposed commentary, if enacted, would have severely limited the ability for the many early stage franchisors that we represent to compete in recruiting franchisees – which is already tough enough for a start-up! Moreover, while it is appropriate for the commentary to highlight issues that franchisors need to consider when deciding whether its FPR has a “reasonable basis” and is not materially misleading, an outright ban under all circumstances deprives prospective franchisees of information they wish to know.
Accordingly, on October 27, 2015 we submitted our public comments objecting to proposed Section 19.7 on those bases. With our client’s approval, our comment included an early stage franchisor’s net profit FPR, redacted to remove the name of the franchisor and its principal owners. The numerical presentation was accompanied by a paragraph explaining why revenues and expenses increased over a period of years, and also warning about the franchisor principals’ level of experience in the industry and therefore why its business performance probably would exceed that of new franchisees. The public servant who leads the NASAA Franchise Project Group told the author that the example was “particularly helpful.”
On September 14, 2016, after lengthy internal deliberations among the project group members, NASAA issued a revised version of the proposed FPR Commentary for public comment. While not specifically addressing comments received, what is notable is that former Section 19.7 no longer exists. Instead, no distinction is made between franchisors with or without operating franchises, and rather new Section 19.10 reads in part as follows:
19.10 Item 19 — Gross Profit or Net Profit FPR Based on Company-Owned Outlets Alone
QUESTION: Can a franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?
ANSWER: Yes. A franchisor can make an FPR disclosing gross profit or net profit based on company-owned data alone if it has a reasonable basis to make the FPR and includes the following information: (a) gross sales data from operational franchise outlets, when the franchisor has operational franchise outlets; (b) actual costs incurred by company-owned outlets; and (c) supplemental disclosure or adjustments to reflect all actual and reasonably expected material financial and operational differences between company-owned outlets and operational franchise outlets. These differences consist of fees and other expenditures required by the franchise agreement, disclosed in the Franchise Disclosure Document, or that are otherwise known or reasonably should have been known by the franchisor.
The remainder of the answer explains the need to adjust the presentation to disclose franchise royalties and other fees that a company-owned outlet does not pay, and also to adjust the costs of goods sold upward if the company-owned locations receive more favorable pricing from suppliers than franchisees will experience. The latter is a tricky issue and new franchisors either will need to be very careful to make sure that actual franchisee pricing is the same, or increase the costs of goods sold by a specific percentage in the presentation and explain the basis for the increase in footnotes.
Nevertheless, this is a major win for new and early stage franchisors, since they are likely to retain the freedom to provide prospects the information that they desire and to compete in franchise sales. It was our pleasure to be able to influence this regulatory outcome in favor of companies that want to use franchising to grow their brand and create entrepreneurial opportunities in the U.S.A.
June 10th, 2014
Take-away: If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee. Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.
The case: A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.
The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.
As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.
None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD. In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.” In fact, neither statement was accurate.
The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation. However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.
After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.” The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.
In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation. The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.
Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:
Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.
The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD. Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.
The appellate court agreed with the jury, not the trial judge.
There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision. However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury. As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.
In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD – particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.
For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)
That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor. It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.
January 3rd, 2014
The case of Wojcik v. Interarch, Inc., currently pending in the U.S. District Court for the Northern District of Illinois against the fast casual restaurant franchisor Saladworks, LLC, contains a factual scenario that should serve as a valuable reminder for existing franchisors who are updating their Franchise Disclosure Document (“FDD”) for use in 2014, for companies beginning the offer of franchise rights, and for prospective franchisees who are investigating opportunities. Bottom Line: Franchisors need to be careful not to underestimate site development costs, ongoing operating costs, and the challenges of opening locations in geographic areas not familiar with their brands.
During 2011, one of the plaintiffs, David Wojcik of suburban Chicago, investigated development of a Saladworks franchise restaurant. Saladworks is based in suburban Philadelphia, and the bulk of Saladworks locations are within 250 miles of Philadelphia. When Mr. Wojcik attended Saladworks’ “Discovery Day” to learn more about the franchise, Saladworks’ executives took him to their “Gateway” location, which they described as being typical in terms of physical appearance and menu offerings. They also told him that Saladworks’ designated commercial real estate firm Site Development, Inc. (“SDI”) and a designated architecture firm would help Wojcik find a location and design his restaurant.
After reviewing the FDD and going to “discovery day,” Mr. Wojcik convinced his wife Denise that they should sign the franchise agreement and that she should invest $90,000 that they used to purchase a single franchise license plus multi-unit development rights in suburban Chicago. However, it cost the Wojciks substantially more to open their first Saladworks location than the estimated initial investment cost stated in the FDD, and the business failed within six months – both opening and closing during 2012.
The court decision, denying Saladwork’s and SDI’s motions to dismiss for the most part, is interesting on a couple of legal grounds, including the court’s holding that Saladworks could have violated several franchise agreement provisions by failing to “exercise its discretion in good faith,” and also holding that the site selection firm SDI assumed legal duties to the franchisee not to misrepresent its qualifications to provide site selection advice in suburban Chicago. However, more instructive are the failed franchisee’s factual allegations concerning representations made to induce its franchise purchase, including those in the FDD. As the court wrote:
“According to Wojcik, Saladworks misrepresented, among other things, that:
A. “Saladworks had the experience and expertise to support a franchisee’s introduction of its brand in the Chicago market and that Saladworks would be committed to success in this market”;
B. “Wojcik’s Illinois restaurants would basically replicate what he saw on discovery day at the Gateway Restaurant”;
C. InterArch and SDI “would be . . . strong positive factor[s]” in helping him develop his restaurants;
D. Wojcik “would receive a `standard location,'” thus making the financial information Saladworks included in its FDD for franchised restaurants at “standard locations” relevant and meaningful for him.
Wojcik also alleges that Saladworks omitted a number of material facts, including the following:
(1) Saladworks based the projected construction costs disclosed in its FDD on “site locations that did not require any substantial changes in use, e.g., that . . . previously [had] a restaurant on the site. . . .”
(2) “[W]ithin any market there can be material differences between particular sites that will substantially affect the performance of any particular franchise, such that, by inducing franchisees to believe that he or she would receive a `standard location,'” the franchisee was being misled and deceived into believing that SDI and Saladworks had developed some sort of process that eliminated the risk of poor site selection. . . .”
(3) InterArch—Saladworks’ designated architect—”had insufficient familiarity with the local building codes of Schaumburg or the other Illinois communities in which Wojcik was planning to build and InterArch was not licensed in Illinois.”
(4) “[The Saladworks] brand was most successful in a core market area, which included the area covered by an approximate 250-mile radius of Philadelphia. . . . [but] beyond the core market area, most of [Saladworks’] franchises were substantially under-performing in relationship to those that were located within the core market area,” thus making Saladworks’ disclosures about the financial performance of franchised restaurants at “standard locations” deceptive and misleading to a franchisee in Illinois.
(5) The two restaurants for which Saladworks supplied information about average operating costs obtained free labor from new franchisees in training, thus making the average operating costs Saladworks disclosed in its FDD materially misleading.
(6) Saladworks “did not intend to do `brand development advertising’ in Illinois,” and thus, a franchisee in Illinois would receive no benefit from its required contributions to Saladworks’ “Brand Development Fund.”
(7) InterArch, Saladworks’ designated architecture firm, charged a $5,000 “supervision fee,” in addition to its design fee, if the franchisee chose to have InterArch supervise construction of the restaurant.”
This case decision was in the context of Saladworks’ and SDI’s motions to dismiss (the architect, InterArch, had already settled), and many of the allegations recited above may not survive a motion for summary judgment on the failed franchisee’s misrepresentation claims. For example, as the court also points out, the franchise agreement specifically warned the franchisee that its “Brand Development Fund” contributions did not have to be used to promote the franchisee’s restaurant (as opposed to other System restaurants), and a franchisee in a new region typically should negotiate that point.
However, some issues that renewing franchisors should carefully consider are:
(i) Do franchises outside of your core geographic area struggle, as compared to those in the core? If so, your Item 19 Financial Performance Representation probably needs to highlight those differences and conspicuously warn prospects considering a franchise that would operate outside of “the core.”
(ii) If your Item 19 disclosure includes operating costs disclosures, are those impacted at all by the use of trainees in place of paid staff?
(iii) if you feel it is necessary to designate a commercial real estate company or architecture firm, be careful about how you promote their abilities, and consider (a) requiring the real estate firm to work with a local firm with whom it would share its fees, and (b) for states where the architect is not licensed, consider allowing the franchisee to select alternative architects upon payment of a modest review fee to your designated designers.
(iv) Are your Leasehold Improvement or construction estimates in Item 7 based on certain positive assumptions? If so, carefully disclose them, and consider whether the high estimate should not include those optimistic assumptions.
From the point of view of a prospective restaurant or retail franchisee, the lesson of this case is to show the kinds of issues you should carefully consider in your due diligence before purchasing a franchise. While litigation may help you recover if the franchisor is not completely truthful, better to figure it out beforehand!
December 30th, 2013
At the October 2013 American Bar Association Forum on Franchising Convention, the keynote program was entitled “If I had a Wizards’s Wand” and concerned what each of the four presenters would change about franchising and the law, if they could. Rochelle “Shelley” Spandorf’s proposals as part of that program are summarized by reporter Janet Sparks in this BlueMauMau.com article . While Ms. Spandorf’s proposed changes are wonderful as far as they go (if not magical), unfortunately she did not clearly address one of the most important dispute resolution issues in the U.S. legal system, including franchising; the use of mandatory pre-dispute arbitration clauses to blunt weaker parties’ access to civil justice.
Aspects of Shelley’s proposals that seem particularly commendable are requiring all new franchisors to have some base of experience, creating a uniform national regisry of franchise sales registration, mandating the provision of a financial performance representation, and freeing states’ attorney generals to puruse enforcement rather than adminiistering a registration system. Moreover, while such legislation might appear to be substantially more burdensome to franchisors than the current legal regime of franchise sales regulation, the reality is that, even in the so-called “non-registration states” most franchisees do have the ability to pursue private civil actions for material violations of the FTC Franchise Rule; for example, see Final Cut, LLC v. Sharkey, 2012 Conn Super. LEXIS 98, 2012 WL 310752 (Conn. Superior Ct., Jan. 3, 2012) (franchisee prevails under Connecticut Unfair Trade Practices Act in claims that franchise sales were made in material violation of the FTC Franchise Rule).
However, on the issue of dispute resolution, it is unclear whether the proposal that U.S. federal courts have “exclusive jurisdiction” over U.S. franchise law claims would mean that franchisors could not require arbitration instead of court proceedings. This is particularly important with regard to the ability of franchisees to pursue group or class actions. Through many Supreme Court decisions authored by conservative justices, as well as legislation passed by Republican Congressional majorities, plaintiffs seeking class certification face a rigorous burden in U.S. courts. As many an attorney can attest, there are myriad difficulties (both ethical and practical) in representing substantial groups of franchisees pursuing common claims. However, in appropriate circumstances where common questions of fact predominate, particularly on liability, use of a group or class action is the most efficient (and sometimes the ony practical) way for parties who have suffered grievous financial losses to seek a remedy. Supreme Court decisions have made it extremely easy for parties to bar class or group actions by inserting an arbitration clause in their form contracts and refusing to remove them.
While reforms freeing state attorneys’ general to focus on claims enforcement might help improve failed franchisees’ access to justice, experience shows that attorney generals tend to focus on relief for large number of consumers rather than smaller numbers of small business owners. Unless a federal franchise law contains an express exemption from the Federal Arbitration Act for disputes between franchisors and franchisees, its benefits for franchisees may prove to be illusory.
May 10th, 2013
Takeaway: Franchisors cannot rely on disclaimers in the contracts and FDD to protect against claims of providing false financial information.
The Case: In a recent decision, Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky once again showed the danger of a franchisor relying on disclaimers in its 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 flatly 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. Instead, the franchisor will be permitted to use the disclaimers 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 allegation that the projections 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.
Further thoughts: Given that the franchisee in this case already owned three 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, would it have been less likely to have faced the allegations made in this case? In this author’s opinion, based on more than 15 years of representing franchisors and franchisees, A&W would have been in a better position to defend itself if it had 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 have been 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 would have been 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 both 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.”
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.
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
August 14th, 2009
A franchisor may choose to give prospective franchisees information on the sales and/or profits of existing franchises in their official Franchise Disclosure Document. This information can serve as an extremely useful tool in evaluating the potential earning power of owning a franchise. The complexity of these disclosures may range from simple gross sales averages taken straight from monthly royalty reports to complicated charts and pro formas breaking down statistics by months of operation, location, etc.
However, a franchisor is not obligated to provide you with any unit-level financial performance information at all. While franchise sales regulators encourage franchisors to include such information in their FDDs, many franchisors choose not to distribute such information. Common reasons for not doing so are concern that they do not have enough historical information to provide an adequate basis for a claim; that providing any information could expose them to complaints that the data was misleading; that they do not need to provide the information to sell franchises, or because the data will not show favorable performance.
If an “earnings claim” is included, it must comply with specific standards stated in the FTC Franchise Sales Rule. Once the disclosure is included in the FDD, a franchisor can include excerpts of it in franchise sales literature, provided the excerpts are not misleading, and also may provide supplemental information to a prospective franchisee after he or she has received the FDD. The restrictions on providing an “earning claim” does not apply to providing historical financial data for a particular store or unit that a franchisor owns and is offering for sale.
If a franchisor does not provide financial performance information in its FDD, but its salesperson or other representative discusses the sales or profits of franchisees with you, be sure to document exactly what was said, by whom, in what capacity, and the time/date/circumstances. Should the numbers they provide to you orally end up being inaccurate, and you feel you were mislead, the oral statments may provide a basis for recovery of some of your losses.
What have your experiences with regard to earnings claims? Which franchisors are willing to provide earnings claims to prospective franchisees? Have they proved to be a useful tool in your decision to undertake (or not to undertake) a particular franchise?
David L. Cahn