July 16th, 2013
“Do not pass Go, do not collect $200” is a phrase we all remember from the childhood game Monopoly. Like Monopoly, state franchise sales laws have rules and regulations that must be followed. A franchisor’s failure to follow these basic procedural rules for selling franchises can result in self-destruction.
On December 10, 2012, a decision in the case of In Re. Butler demonstrated a strict approach on the policy and procedures that a franchisor must follow for selling a franchise. The U.S. Bankruptcy Court sitting in North Carolina ruled that the owners of a franchise were personally liable to a franchisee for $714,000 plus interest in damages for violating the New York Franchise Law. The court further ruled that the franchise owners’ liability was non-dischargeable in bankruptcy.
Michael and Kathy Butler opened a small retail store to serve the marketing needs of small businesses. After much success, the Butlers formed PRS Franchise Systems LLC (“PRS”). Based in North Carolina, PRS Franchise handled all of the franchising for the PR Stores. PRS had obtained a one year license from New York to sell franchises to its residents, but subsequently PRS did not renew its New York registration on an annual basis.
In 2007, John Mangione, a New York resident, expressed interest in purchasing 20 PR Store franchises in the New York area. Because of Mangione’s interest, PRS submitted an application to renew its registration to sell franchises in New York. Before receiving approval of its renewal application, PRS sold 20 PR Store franchises to Mangione and received $716,000 in initial franchise fees between April and July 2007.
The franchise relationship was not to Mangione’s satisfaction, most of his PR Store locations were unsuccessful, and he ceased operating them by 2009. The Butlers also had a reversal of fortune and by 2009 they had dissolved PRS and filed for bankruptcy.
The Butlers argued that they were permitted to engage in franchise sale transactions while the application of renewal for registration was pending under New York Law. The court rejected this argument on the grounds that, while New York law does permit franchisors to sell franchises while renewal applications are pending, the law also requires the franchisor to give the buyer its last registered offering prospectus (also commonly known as the franchise disclosure document, or “FDD”), escrow the franchise fees paid in a separate trust account and then, once the renewal application is approved, provide the franchisee with the approved new prospectus and an opportunity to rescind the franchise agreement and have the fees returned. The court stated that even if PRS’ application was timely, PRS failed to escrow the initial franchise fees, provide Mangione with the registered prospectus after its approval in August 2007 and offer rescission as required by New York law. Instead, shortly after receiving initial franchise fee payments, PRS distributed the funds as sales commissions to its broker and as salaries for the principals of the company – the Butlers.
Because the Butlers directly engaged in the unlawful sale of the franchises to Mangione, and profited personally from his payments, the court found that the Butlers were personally liable to Mangione. The court stated that the remedies for an unlawful offer or sale of a franchise are: 1) rescission of the Franchise Agreement, 2) damages with 6% interest from the date of the transaction, and 3) reasonable attorney fees and costs. Therefore, the court found that Mangione was entitled to rescission of the franchise agreements and return of the $714,000 paid by him, plus 6% interest from May 7, 2007.
The next issue that the court addressed was whether the Butlers’ debt was dischargeable in bankruptcy. According to the court, a debtor’s debt is non-dischargeable if the money is obtained by “false pretenses, a false representation, or actual fraud.” The court found that the Butlers’ committed fraud by misrepresenting to Mangione that PRS had the legal right to sell franchises in New York, even though its registration was only pending, not approved. The court further stated that a debtor’s debt is non-dischargeable “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The court stated that a debtor must prove: 1) the debt arose while the debtor was acting in a fiduciary capacity, and 2) the debt arose from the debtor’s fraud or defalcation. In this case, the court found that the Butlers’ failure to escrow the franchise fees, and their failure to return the funds to Mangione, each amounted to defalcation.
This case demonstrates the danger to the franchisor’s executives if their company fails to follow franchise sales rules. A violation of such rules can, without additional evidence of factual fraud or misrepresentation, result in those executives being held personally liable to the franchisee and being unable to obtain a discharge of that judgment in their personal bankruptcy proceedings.
AUTHOR’S NOTE: THIS POST WAS CO-WRITTEN BY KATELYN P. VU, A SUMMER ASSOCIATE AT WHITEFORD TAYLOR & PRESTON AND 2015 J.D. CANDIDATE AT UNIVERSITY OF BALTIMORE LAW SCHOOL
June 28th, 2013
For the second straight year the annual International Franchise Expo took place in New York City from June 20 – 22, 2013, and it seemed even bigger and better than ever! This post highlights interesting young franchisors on display at the franchise expo.
One aspect of the Expo that is notably improved is the depth of seminar and educational offerings. I attended a seminar called “Maintaining Brand Standards When Franchising”, presented by Mark Siebert, CEO of the iFranchise Group of franchising consultants and by Harold Kestenbaum, a senior attorney from Long Island. They provided some great “war stories,” but the gist was Siebert’s “Four Pillars of Quality Control,” which are (1) Franchisee Selection, (2) Documentation & Training Tools, (3) Support, and (4) Compliance Program backed by Legal Documents. The most memorable “punch line” was Siebert’s: franchisors are generally better if they choose franchisees who have been married for a long time, because “they can handle pain.”
The exhibit hall featured many well-known large franchisors such as Choice Hotels and 7-Eleven. However, as a counselor for emerging franchisors and for many franchisees of emerging systems, I always find innovative newer brands to be interesting. Here are a few that intrigued me, with the proviso that none of the descriptions are an endorsement of the franchise:
Restoration 1: tested by handling flood, water and mold damage remediation in the very busy south Florida area, this franchise combines high-quality restoration services with unique marketing methods to differentiate itself from incumbants in this industry such as ServiceMaster and ServPro. It also offers large exclusive territories not available from the established restoration services franchisors.
America’s Taco Shop: an authentic Mexican fast casual restaurant founded by America Corrales Bortin, who is originally from Culiachán, Sinaloa, Mexico. This is a repeat from last year, but their food is incredibly great! I once again talked with the founder’s husband Terry who told me about their steady expansion from Arizona. They are owned by Kahala Corp., which is a highly experienced franchisor with a strong team for site selection and location development.
Ping Pong Dim Sum: an apparently hip, upscale version of the traditional Chinese version of “tapas,” with an interesting mix of teas and mixed drinks. There are company owned locations in Washington D.C. (Dupont Corner and Chinatown) plus in London and Dubai.
Cooperstown Connection: a sports apparel and souvenir shop founded in Cooperstown, New York, the home of the National Baseball Hall of Fame. As a baseball fan I like the name, which this franchisor has registered as a trademark. When I asked why there would be an advantage to operating this store, as opposed to many other sports apparel shops, the franchise seller claimed to have a wide variety of custom products as well as strong buying power. Prospects should put them to the test on those selling points!
CPR Cell Phone Repair: Getting quality service at stores that focus on selling smart phones and tablets is not a pleasant experience, and the demand and need for repair of mobile devices just keeps growing. I have no idea the quality of service provided at CPR stores, but this franchise seems intriguing because of the name and the need.
Taziki’s Cafe: a fast casual Greek and Mediterranean Café from Birmingham, Alabama (not a typo). The youthful founders, who definitely sound like Alabama natives, honeymooned in Greece in 1998 and decided to imitate their favorite café when they returned. The franchisor claims average store level gross sales of $1.45 million and average “gross profit” of $502,000.
Grade Power Learning: an off-shoot of the well-established Canadian tutoring chain Oxford Learning, this new U.S. competitor is being franchised by the same team that runs the Minuteman Press franchise system. The company’s literature says, “Our cognitive approach to learning, designed by educational experts, is based on proven scientific research into how children actually learn. Learning is not about memorizing facts. It’s about knowing, really understanding, how to integrate and retain new information.” While this competes in a crowded supplemental education field, the need for this type of service continues to be great.
Web XL: a website developer with a twist – focused on creating efficient e-Commerce and payment gateway solutions, along with Internet marketing support, on a monthly plan basis. While anyone can make a website, if this company really provides efficient e-Commerce solutions, then affiliating with them may be a great opportunity for a good salesperson. The franchisor offers “no money down” one year financing on the Initial Franchise Fee.
Froyo World: yes, I know, what’s interesting about another self-serve frozen yogurt chain? This one’s flavors are unique and the quality is truly outstanding, the most distinctive I’ve tasted.
Bed Bug Chasers – could be an excellent add-on to pest management or disaster restoration.
Churro Mania – mall food court or small location dessert business, specializing in Mexican Churro products, which given U.S. demographics only figure to get more popular!
If you decide to pursue these opportunities or a different one, we stand ready to assist you with due diligence, evaluation of the franchise offering, and contract negotiation.
May 20th, 2013
In the opening General Session of the International Franchise Association (“IFA”) Legal Symposium on May 6, 2013, Aziz Hashim
, President & CEO of NRD Holdings, LLC (Multi-Unit Franchisee of Popeye’s, Checkers, and Domino’s Pizza) & the IFA’s current Secretary, and Kenneth L. Walker
, formerly IFA Chairman and the Chairman of the Board of Driven Brands, Inc. (franchisor of Meineke Car Care businesses), commented on franchise agreements and franchise relationship management in an interview-style program moderated by Joel Buckberg. Their comments, which are summarized below, demonstrate both the promise and the challenges inherent in franchising.
Franchise Agreement “Turn-offs”: Hashim’s “bad marks” when evaluating franchise agreements all relate to the security of the franchisee’s equity investment in the business, and are:
1. Franchisor’s right to a liquidated damages award following termination for any reason;
2. Unlimited personal guarantees required by the franchisee’s owners, particularly after an approved sale of the owner’s interest in the franchisee;
3. Franchisor’s right to require the buyer of a location to sign the franchisor’s then-current form of franchise agreement, which might have higher fees or weakened territorial rights;
4. Franchisor’s right to require “periodic” remodeling, without limitations on the frequency, timing or cost of the facility changes.
Walker did not list any concerns with franchise agreements, which is not surprising given his background as a franchisor executive. However, he did emphasize that one of his biggest “turnoffs” when he was CEO (from 1996 until 2012) was having the first contact in a negotiation coming from a franchisee’s lawyer rather than the franchisee executive himself. He was much more likely to negotiate an issue with a franchisee who first approached him directly, even if the final agreement might be worked through by each party’s counsel.
Use of Marketing Funds: Walker expressed a preference for wide franchisor discretion in deciding how to use franchisee contributions, as long as the uses were devoted to growing franchisees’ businesses. Hashim agreed, but with the caveat that franchisees had to be actively engaged and consulted as to the franchisor’s proposed uses of the monies. Hashim objected to use of such funds to cover part of franchisor’s executive salaries (such as for a Chief Marketing Officer) or to conduct product development analysis. He supported flexible uses such as contributing towards the remodeling and rebranding of franchisee restaurants. Walker agreed that franchisee engagement and “buy-in” is critical, on the basis that it is better to have a somewhat flawed marketing plan that is widely executed than an outstanding plan that the franchisees refuse to implement.
Territorial Rights: With regard to franchisees’ territory protections, Walker argued that if the brand as a whole is losing market share to competitors with its existing network of locations, then it should be able to “backfill” with additional franchises. Hashim seemed to agree, as long as the plan protected franchisees who were properly executing the system and meeting expected revenue targets.
Supply Chain Controls: Hashim argued that franchisors should not require purchases of commonly available supplies or ingredients from more expensive sources, if the franchisees can obtain the same items less expensively through other means. He said that at a minimum, there should be clear disclosure to prospective franchisees of how the franchisor makes money from the supply chain.
Facility Remodeling and “Upgrades”: The panelists agreed that it is critical for franchisors to efficiently monitor the quality of goods and services being provided and to discipline franchisees who are not meeting such standards. However, Hashim argued that franchisors need to “make the business case” as to how facility updates or remodeling are going to benefit the profitability and value of the franchisees’ businesses rather than just drive revenue growth. He also believes that “smart franchisors” help fund the costs of facility updates to obtain rapid adoption by most franchisees.
Transfer: Walker emphasized the need to make sure that approval of a transfer is unlikely to harm the viability of a location. Hashim said that it is critical that the franchisor’s rules for obtaining approval are clear, objective and disclosed to active franchisees, and if the criteria are changed the franchisor should be able to explain why change is necessary. Hashim recommends this simple test: “If you would sell this person a new franchise, then you should approve a transfer to that same person.”
Training and Operations Support: Walker believes that in-person, live training and conventions continue to have value in fostering a team spirit among franchisees and an exchange of best practices information, as compared to Internet “webinars” or recorded trainings. Hashim expressed frustration that the ratio of franchisor field staff or “business consultants” to franchisees has been decreasing over time, and the experience level of those consultants has been decreasing. He said that periodic visits by qualified field representatives play in important role in franchisee satisfaction and success.
Termination and Damages: Despite his broad disapproval of personal guarantees and liquidated damages, Hashim agreed with Walker that, if a franchisee is not in financial distress but simply wants to quit the franchise to stop paying royalties, then it is appropriate to require that franchisee to pay termination compensation to the franchisor.
Concluding Comments: Hashim made the following noteworthy comments to franchisors:
1. Recognize that you are not bestowing franchise rights, but rather recruiting important business partners;
2. Don’t make your franchise agreement so harsh that it scares of good prospective franchisees, since quality franchisees drive a brand’s success;
3. Poll your best franchisees to find out their thoughts about the brand and franchisor staff;
4. Mystery shop your franchise salespeople, to find out what they are saying (and failing to say) to prospects; and
5. Employ a true ombudsman to address franchisee complaints and concerns before they mushroom into disputes.
In many ways this program showed the best that the IFA has to offer, since it brought together franchisor and franchisee perspectives for the purpose of furthering industry best practices. It also highlighted Aziz Hashim as a rising leader in franchising who bears watching in the future.
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.”
November 26th, 2012
In Ford v. Palmden Restaurants, LLC
, the Court of Appeals of California issued a strong reminder to both restaurant franchisees and their franchisors of their potential liability for criminal conduct that takes place on a restaurant’s premises. While the legal principles at issue differ for franchisees and franchisors, this potential liability is one that neither can ignore.
The case involved a Denny’s restaurant in Palm Springs, California, that was operated by Palmden Restaurants, LLC (“Palmden”). Starting during 2002 members of a gang known as the Gateway Posse Crips (“Gateway”) would “take over” the restaurant around 2 a.m. each Sunday, after closing of the club that they “hung out at” on Saturday night. “Taking over” meant:
“Members of the Gateway group refused to wait in line; they would just seat themselves. They were loud; they would use “foul language.” They would “table-hop.” Only a few of them would order food, and the ones who did would leave without paying. Other customers responded by canceling their orders or asking for their food to go and then leaving. Some Gateway members would stay outside in the parking lot, drinking and smoking marijuana. They had had “many fights,” both outside and inside the restaurant.”
In March 2003, there was a significant brawl around 2 a.m. at the restaurant, instigated by members of Gateway. The fight involved injuries to “innocent” female patrons, overturned furniture and a broken window. Police officers recommended to the owner of Palmden that she take several security measures, including installing video cameras and hiring off-duty uniformed police officers. Palmden closed the restaurant for the early a.m. hours only during the first weekend after the brawl, and thereafter Gateway resumed its “take overs.” Palmden did not install security cameras, hire off-duty police officers or take other new substantive security measures.
In April 2004, Terrelle Ford, who was a loan officer, had the misfortune of being at the restaurant with friends on a Sunday at 2 a.m. when the Gateway members arrived. A large group of men began beating one man standing outside the restaurant, and some of Ford’s friends went outside to break up the fight. When Ford saw his cousin being attacked he came outside to protect him and was severely beaten by Gateway members, suffering permanent brain injury. Shortly thereafter Palmden began closing the restaurant on Sundays in the early a.m., and the Gateway gang found a new “after-hours hangout.”
Could the Franchisee Be Liable for the Patron’s Injuries?
The trial court had granted summary judgment in favor of Palmden, finding that it could not be liable for the harms caused by the criminal acts of the Gateway gang members. The appeals court disagreed and reversed, sending the case back for trial.
The court, following well-established precedent, held that all restaurants and other public establishments have an obligation to undertake reasonable steps to secure common areas against the foreseeable criminal acts of third parties that are likely to occur without such precautionary measures: “The more certain the likelihood of harm, the higher the burden a court will impose on a [proprietor] to prevent it; the less foreseeable the harm, the lower the burden a court will place on a [proprietor].” The central question was the extent of Palmden’s duty to take action to prevent gang violence, and the essence of the decision was that Palmden was liable because it adopted no meaningful new security measures after the 2003 gang fight and before Ford’s severe beating. As the court said:
“We emphasize that we are not saying that a business that is plagued by gang members necessarily has to shut down (even for a few hours). It would be perfectly reasonable for it to experiment first with lesser measures, such as surveillance cameras, security guards, or a protective order. [Palmden argues that] it is speculative [whether] these would have been successful. What we can say with certainty is that either these measures would have worked, or else closing down the restaurant would have worked.”
Therefore, Palmden’s failure to act may have been a substantial cause of Ford’s injuries and Ford had a right to have a jury decide Palmden’s liability.
What About the Franchisor?
Ford advanced several arguments as to why DFO, LLC, the Denny’s franchisor; Denny’s, Inc., which leased the restaurant to Palmden; and the parent company of both of those entities, Denny’s Corporation, should be held jointly liable for his damages. The court found that summary judgment could be overturned on the grounds that Palmden was those entities’ “ostensible agent” in operating the restaurant, because Ford was not aware that the Denny’s restaurant was a franchise and his belief that it was a “corporate location” must be reasonable under the circumstances. The court found the following facts important in making that conclusion:
“While some Denny’s restaurants are franchisee-operated, others are corporate-operated; hence, we cannot say it is common knowledge that all Denny’s are necessarily franchises. There was no signage or other indication that the particular Denny’s was actually operated by a franchisee. Finally, Ford testified that he had seen advertisements identifying Denny’s as “a family style restaurant . . . in which a patron could enjoy a good meal in a friendly, safe, and secure environment” and that this led him to conclude that “[h]e and [his] friends could enjoy a meal at the subject Denny’s . . . .” ”
The court also reversed summary judgment in favor of the landlord, Denny’s, Inc., the parent company Denny’s Corporation and other affiliates, on the basis that they might be “alter egos” of the franchisor DFO, LLC. The trial court had granted summary judgment for those entities without analysis and they had not provided the appeals court with support in favor of keeping them out of the case.
If you own a restaurant you have a duty to your patrons and employees to establish security that is reasonable under the circumstances. If the circumstances are as dire as described in this case, your best course of action is to close the restaurant during the dangerous hours, and if you need permission build the case for doing so in writing directed to your franchisor and/or landlord.
If you are a restaurant franchisor, at a minimum make sure that each restaurant has a conspicuous sign identifying who owns the restaurant, as an independent licensee of your company. If the restaurant is run by your affiliate company, then that affiliate should be identified just like a franchisee. Seek to include the words “independently owned” in any local advertising. For casual dining establishments, consider including a place in the menu template to identify the owner, perhaps underneath the logo.
August 16th, 2012
Takeaway: Through effective trade associations and lobbying efforts, during the last century automobile dealer franchises in the United States convinced state governments to give them significant protection against commercial abuse or unfair dealing by the manufacturer or supplier franchisors. Franchisees in other industries could learn from that example.
The strength of the laws protecting dealer franchises was demonstrated by a recent New York court decision in Audi of Smithtown, Inc. v. Volkswagen Group of America, Inc. . The case was brought by one set of Audi dealers charging that Audi’s wholly-owned subsidiary, VW Credit, Inc. discriminated in favor of new dealers to the detriment of the incumbents who brought the case. At issue were incentives that VW Credit put in place for dealerships to purchase vehicles returned by customers at the end of their leases. (For example, if Joe Brown leases an Audi Quattro for 3 years, the vehicle is owned by VW Credit during the lease, so at the end of 3 years, VW Credit has a “pre-owned vehicle” to sell.) The incentive programs were based on the proportion of returning off-lease vehicles that a dealership purchased. However, since incumbent dealerships had more leases, they had more opportunity than new dealers to benefit from the incentives.
To level the playing field, VW Credit automatically granted new dealers a more favorable level of available discounts and bonuses (known as “Champion Level”) for the first three years of the dealership. While this program seems to have a logical business justification – making it easier to open a new dealership, which increases Audi’s presence in the local market — the Court ruled instead that it constituted price discrimination against the incumbent dealers. New York’s law provides: “It shall be unlawful for any franchisor . . . [t]o . . . sell directly to a franchised motor vehicle dealer . . . motor vehicles . . . at a price that is lower than the price which the franchisor charges to all other franchised motor vehicle dealers.” N.Y. Vehicle & Traffic Law § 463(2)(aa).
Audi argued that VW Credit is not a “franchisor” under the statute and therefore no violation could have occurred. The dealers had that covered, however, because in 2008 the New York legislature amended the statute to add references to “captive finance sources” so as to prohibit a motor vehicle franchisor from using “any subsidiary corporation, affiliated corporation, captive finance source, or any other controlled corporation, company partnership, association or person to accomplish what would otherwise be unlawful conduct under this article on the part of the franchisor.” N.Y. Vehicle & Traffic Law § 463(2)(u).
The New York laws prohibiting price discrimination and the use of shell entities to get around the law are similar to those in others states that protect car dealers in their relationships with their franchisors. In Maryland, for instance, the law requires manufacturers to act honestly and observe reasonable commercial standards of fair dealing in performance or enforcement of the franchise agreement. They are also not allowed to:
1. Coerce dealers to do something not required by their franchise agreements, or make them agree to material modifications (for instance, changes to their purchasing or performance requirements), unless the changes apply to all other Maryland franchisees of the same manufacturer.
2. Stop a dealer from offering other manufacturers’ products at the same facility through a franchise agreement granted by another manufacturer.
3. Require a material change to “the dealer’s facilities or method of conducting business if the change would impose substantial financial hardship on the business of the dealer.”
4. Require a franchisee to adhere to performance standards unless, as applied, they are “fair, reasonable, equitable and based on accurate information.”
5. Refuse to permit an individual to be the responsible person of the dealer “unless the individual is unfit due to lack of good moral character or fails to meet reasonable general business experience requirements” — and the manufacturer has burden of proving unfitness.
6. Unreasonably withhold consent to a request to transfer a franchise, and an aggrieved franchisee has a right to an administrative remedy to contest a manufacturer’s refusal to consent.
7. Terminate the dealership for any reason without payment to the dealer of compensation for various types of assets and franchise-specific improvements.
8. Require the dealer to reimburse it for attorneys’ fees in any dispute involving the franchise.
Maryland Transp. Code Sections 15-206.1 through 15-212.2. In addition, aggrieved franchisees have a right to bring an action for damages and reasonable attorneys’ fees incurred in vindicating their rights. Id. at Section 15.-213.
These statutes are not a cure-all for auto dealers who fail to properly execute their responsibilities. And, in any event, the 2009 bankruptcy proceedings of General Motors and Chrysler show that extreme economic circumstances can trump state statutory rights.
But overall, the various state laws protecting automobile dealers show the advantages of a century-old industry, widely dispersed, and generally liked in their local communities. The auto dealers have been able to put their case to their state representatives and win some good protections. This is an example franchisees in other industries could learn from.
June 29th, 2012
For the first time the annual International Franchise Expo took place in New York City from June 15 until June 17, 2012, and it was a revitalized event worthy of The Big Apple. I visited on Friday, which has been the “slow day” of the Expo in the past during which suppliers could mingle and “network” with exhibitors. Accompanied by fellow Baltimoreans Jerry Blumenthal and Nick Courtalis of Business and Commercial Ventures
(business brokers) and Anne Paulus of 3D Signs
(signmakers), I arrived at 11:30 to find a truly packed exhibit hall!
The number of exhibitors was much larger than the sessions the past several years in Washington, D.C., and also included large franchisors such as Choice Hotels and 7-Eleven that I don’t remember seeing in D.C. However, as a counselor for emerging franchisors and for many franchisees of emerging systems, I always find innovative newer brands to be interesting. Here are a few that intrigued me, with the proviso that none of the descriptions are an endorsement of the franchise:
America’s Taco Shop: an authentic Mexican fast casual restaurant founded by America Corrales Bortin, who is originally from Culiachán, Sinaloa, Mexico. I met her husband Terry, who told me that America was named after the local soccer team in her Mexican town and not as any plan to immigrate, start a business or other ulterior motive. Nice coincidence! But seriously, their food is great.
Interpreters Unlimited: the first franchise system for the provision of interpretation services, including in-person, over the telephone, and by video conference, as well as document translation services. The company has some U.S. government contracts that the franchisee could fulfill in local markets. This “work from home” opportunity could be perfect for a good salesperson.
Joshua’s Shoarma Grill: founded by Israelis living in Europe, they have had some success there and are now seeking to grow here through area developers and masters. Have an interesting Middle Eastern fusion and healthy menu in a fast casual setting.
Team Makers: an education concept with group programs for children ages 5 to 12 to prevent bullying and other inappropriate behavior. The franchisee organizes and provides in-school workshops, after-school programs, birthday parties and carnivals or special events. This company is addressing an important societal need, and could be wonderful for a parent seeking to “re-enter the workforce” after focusing on child rearing.
Boneheads: A fast casual restaurant chain with a focus on fresh fish and Piri Piri spices, which are from Mozambique, Africa, were made popular by the Portuguese, and are now “all the rage” in Europe.
Gyu-Kaku: Japanese restaurant with a twist – the customers grill their own meat at the table! Sort of like Hibachi crossed with Fondue.
CRAL: home services with layers – mold remediation, duct cleaning, ventilation, and lead abatement, with the telephone number 1-888-KIL-MOLD. Seems to indicate strong cross-selling possibilities, although also some operational complexity. Could be good for a veteran with strong operations skills – like a sergeant!
Cool De Sac: A “family entertainment center” with a modern healthy menu, “play stations” and birthday parties programs. Sort of like an upscale “Chucky Cheeses”.
The Expo included many educational seminars and other resources for prospective franchisees and those considering the franchising of their own business methods. The same company also has events in Los Angeles in October (West Coast Franchise Expo) and in Miami in January (Franchise Expo South). For more information, visit http://mfvexpo.com/.
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.
April 20th, 2012
An appeals court has held that Doctor’s Associates, Inc., the franchisor of Subway® sandwich shops, could be liable for the payment of workers’ compensation benefits for the injured employee of a franchisee under the Kentucky Workers’ Compensation Act because the franchisee could fit the Act’s definition of a “subcontractor” and Doctors Associates could be considered a “prime contractor”. Uninsured Employers’ Fund v. Brown, et al., Case No. 2010-CA-000283-WC (Ct. App. Ky., Sept. 3, 2010).
The court sent the case back to the lower courts to allow for: (1) presentation of additional proof regarding the nature of the franchisor’s business and whether the work that the franchisee performed was a regular or recurrent part of the franchisor’s business; and (2) additional findings of fact after presentation of that evidence.
In late 2011, the Kentucky Supreme Court reversed the decision to remand the case for further fact-finding and ended it in favor of Doctors Associates, Inc. (“DAI”). However, that court expressly held that franchisors are not immune from scrutiny as a “statutory employer” of franchisees’ employees under Kentucky’s workers’ compensation law. Since Maryland and other states have similar workers’ compensation laws, this principle of law applies to offering a franchise in Maryland or elsewhere. Doctors Associates, Inc. v. Uninsured Employers’ Fund (KY Nov. 23, 2011).
An employee of one of the franchisor’s Kentucky franchisees had sustained injuries while working at the restaurant. The franchisee carried no workers’ compensation insurance at the time. Accordingly, the employee’s medical and disability expenses were paid by the Uninsured Employers Fund which sought indemnity from the franchisor, under a provision of the Act requiring contractors to pay compensation to an injured employee of a subcontractor if the subcontractor did not carry workers’ compensation insurance.
The ALJ concluded that he could not impose liability for workers’ compensation benefits upon the franchisor for the franchisee’s injured employee for a number of reasons. First, the franchisor was a “commercial franchisor”, a category of business not specifically covered by the statute. Second, a contractor-subcontractor relationship existed under the statute only where the contractor paid the subcontractor to perform work. Because the franchisee was paying the franchisor, the franchisee could not be the franchisor’s subcontractor.
The Court Says, “It’s Always an Issue of Fact”
The appellate court reversed the decision because there is no blanket exemption from the worker’s compensation system of “commercial franchisors.” In jurisdictions outside of Kentucky, courts resolved whether franchisors were liable for workers’ compensation benefits based on the specific facts of the cases, rather than by general rules of exemption, the court observed. A natural tension existed between the types of franchisor controls inherent in franchising and the types of control over day-to-day operations that courts traditionally evaluated to determine whether an employment relationship existed. The factual issue to be determined in the context of a franchise is whether the alleged subcontractor has performed work “of a kind which is a regular or recurrent part of the work of the trade, business, occupation, or profession of [the contractor],”.
The resolution of whether the franchisee was performing work for the franchisor under the meaning of the Act required the finder of fact to put aside the fact that the franchisee purchased a franchise from the franchisor, and instead look to the nature of the lasting relationship that was created between the franchisor and franchisee thereafter, the court decided. If the franchisor essentially contracted with the franchisee to perform a function that was a regular and recurrent part of its business, then the arrangement between the franchisor and franchisee was that of contractor and subcontractor and subject to the Act.
Thus, if selling sandwiches to the public was a regular and recurrent part of Doctor’s Associates, Inc.’s business, then the franchisee was unquestionably performing work that Doctor’s Associates, Inc. otherwise would have had to perform for itself and with its own employees, and the franchisee would fit within the Act’s definition of “subcontractor.”
Concurrence Goes Further on Franchisor’s Liability
A concurring option also raised the issue of whether a franchisor that failed to enforce the franchise agreement requirement that the franchisee maintain adequate insurance and name the franchisor as an additional insured, thereby becomes liable to third parties due to the franchisee’s failure to have such insurance. This could open the door to even great legal liability in franchising in Maryland and other states.
Supreme Court reverses due to deference given to Workers Compensation Board
The Kentucky Supreme Court agreed that the ALJ erred in finding that franchisors are immune as a matter of law from being a statutory employer of franchisee’s employees. However, the Supreme Court nevertheless ended the case for the following reason: “The [Uninsured Employers’ Fund] is the claimant bearing the burden of proof to show that DAI is a contractor subject to up-the-ladder liability. The ALJ and the Board found that DAI was in the business of franchising, not the business of selling sandwiches. So the franchisee did not perform a regular or recurrent part of DAI’s business. Substantial evidence supported this finding, and we find that the evidence does not compel a finding for the UEF.”
This court decision demonstrates the importance of franchisors vigorously enforcing its contract provisions regarding insurance coverage, as well as other contract provisions that, if not complied with by the franchisee, may lead to liability to franchisee’s employees and customers. It also supports the notion that entrepreneurs beginning a franchising program should not offer franchises through a company that also operates the business being franchised, but instead create a new company used solely for franchising activities. It is important for companies offering franchises in Maryland to consult with an attorney and minimize this risk.
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.