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.
May 22nd, 2016
by David L. Cahn and Jordan M. Halle
Effective for franchise agreements entered into or renewed this year, new amendments to the California Franchise Relations Act impose significant restrictions on franchisor’s termination or refusal to renew franchise agreements, increase franchisor’s post-termination obligations, and bolster franchisees’ rights to sell their franchised business. These changes make California a somewhat more risky state in which to use franchising as a growth strategy, while arguably bolstering the security of franchisees’ investments in mature brands.
Restrictions on Termination: a franchisor must have “good cause” to terminate a franchise, and “good cause” for termination is limited to a franchisee’s failure to “substantially” comply with the lawful requirements of the parties’ franchise agreement. Generally franchisors must provide at least 60 days, but not more than 75 days, to cure a material default. Franchisors may still terminate for certain “serious” defaults with less than 10 days’ notice, such as failure to pay fees, abandonment, and repeated defaults. New sanctions available to franchisees terminated or refused renewal without good cause include damages in the amount of the fair market value of the franchised business and assets, and preliminary and injunctive relief for a franchisor’s violation of the statute. Expect plenty of litigation over whether there was “substantial” noncompliance and a “material” default by a terminated franchisee.
Post-termination repurchase obligation: California always has been a state where franchisors had to approach a decision to terminate with caution, because of a California statute that prohibits enforcement of covenants not to compete as well as case law making it difficult to collect lost future profit damages from terminated franchisees. Now, absent certain exceptions, a franchisor must buy from the terminated franchisee all inventory, supplies, equipment, fixtures and furnishings that the franchisee had purchased due to a franchise agreement requirement – even if termination is due to the franchisee’s material default. Any money owed by the franchisee to the franchisor may be offset against the repurchase price for such items. Notable exceptions to the repurchase requirement are if the franchisee declined the franchisor’s renewal offer, or if the franchisor permits the former franchisee to retain control of the business location after termination.
Right to Transfer: Franchisors now may not prevent a franchisee from selling the business’s assets or an interest in the business, except if the buyer does not meet the franchisor’s standards for new franchisees or if the franchisee and buyer fail to comply with other reasonable requirements of transfer in the franchise agreement. The franchisor must provide the franchisee and prospective buyer with written standards by which it determines whether a prospective franchisee is acceptable, and if denying transfer approval on the basis of non-suitability must explain why the proposed buyer does not meet one or more of the standards. Franchisors may enforce right of first refusal provisions in the franchise agreement, provided that the franchisor pays equal to or greater than the price offered by the prospective buyer.
Conclusion: The new California laws generate issues with the franchise agreement, franchisor operations, and franchisor/franchisee relations that any franchisor selling franchises in California should have reviewed and addressed by an attorney. Please contact us for further information and advice.
August 6th, 2014
Take-away. A franchisor’s diligence in conducting and documenting quality assurance inspections is as important as ever, particularly if the franchisor seeks to exercise its ultimate weapon – termination of the franchise agreement. Prudent inspection and documentation practices are particularly crucial in the many U.S. states and territories that have statutes requiring a showing of “good cause” in order for a franchisor to terminate a franchise agreement. In such states, a franchisor must furnish evidence demonstrating that the franchisee failed to substantially comply with the material and reasonable franchise requirements; otherwise, a court may well restore the franchise rights and order money damages to the franchisee.
The Case. Pooniwala v. Wyndham Worldwide Corp., a May 2014 decision by the U.S. District Court for the District of Minnesota, is an exemplary demonstration of how a franchisor establishes that one of its franchisees repeatedly violated quality assurance standards so that there was “good cause” to terminate the franchise agreement under state law. The franchisor’s in this case diligently conducted and documented regular quality assurance (“QA”) inspections.
The Facts. Minn. Stat. Section 80C.14, part of the Minnesota Franchise Act, allows a franchisor to terminate an agreement if the franchisor can show “good cause” for termination. Good cause means failure by the franchisee to substantially comply with the material and reasonable franchise requirements imposed by the franchisor, including “any act by or conduct of the franchisee which materially impairs the goodwill associated with the franchisor’s trademark, trade name, service mark, logotype or other commercial symbol.”
Pooniwala involved franchise agreements for two hotels, one a “Super 8,” and the other a “Travelodge.” The franchisee alleged that the franchisors, both of which are affiliated companies within the Wyndham Hotel Group, took retaliatory action against the franchisee because of a lawsuit between the franchisee and Ramada Worldwide Inc., its fellow Wyndham Group affiliate. The franchisors, for their side, argued that their attempts to terminate the franchise agreements were not retaliatory actions, but rather that the franchisee had repeatedly violated QA standards found in the respective franchise agreements, giving each franchisor good cause for termination.
The first attempted termination involved a Super 8 hotel facility in Roseville Minnesota. The franchise agreement for the Roseville Super 8 included quality assurance requirements, as well as provisions allowing Super 8 to inspect the facility to ensure that it was operating in compliance with Super 8’s system standards and QA requirements. The franchisee had failed six consecutive QA inspections at the Roseville Super 8. Each inspection was followed by a letter indicating that the franchisee had received a failing score on the QA inspections. The letters also gave the franchisee notice that it had sixty days to cure the QA deficiencies, the failure of which could result in termination of the franchise agreement. Finally in September 2013 Super 8 notified the franchisee that the franchise would terminate on December 29, 2013, unless the hotel passed a final QA inspection. The franchisee failed that final inspection, and shortly thereafter Super 8 informed the franchisee that termination would take effect on the originally scheduled termination date.
The second termination was for a Travelodge hotel facility in Burnsville, Minnesota. The Burnsville Travelodge agreement contained similar QA requirements, and the franchisee failed eight consecutive QA inspections, receiving letters documenting the failures following each inspection. Finally the franchisee received notice of termination for the Travelodge franchise. The notice described QA deficiencies, and stated that termination would take effect in ninety days, but that another inspection would be scheduled to determine whether the QA violations had been cured. The franchisee failed that inspection, and as a result Travelodge informed the franchisee that termination would take effect on the originally scheduled date.
Preliminary Injunction. It is not a wonder that motions for preliminary injunction are commonplace in hotel franchise termination cases. With the great potential for loss of good will among customers, employees and suppliers, franchisees will not want to give up their rights to franchise logos or their presence on a franchisor’s reservation system. In Pooniwala, the franchisee sought an order for preliminary injunction to stop the franchisors from terminating the franchise agreements before the court heard the case on its merits.
In deciding whether to grant a preliminary injunction, courts have to balance the harm to the two sides. They also consider the requesting party’s likelihood of success on the merits in the underlying claim–here, violation of the good cause requirement of the Minnesota Franchise Act.
In Pooniwala, the court denied the franchisee’s motion for preliminary injunction and ordered it to go ahead with its post-termination obligations, such as removing the franchised brands’ signage. The court found that, given the many QA inspection failures at the two hotels, and the fact that the franchisees had continuing franchise relationships with Wyndham Hotel Group affiliates at other hotel properties, the franchisee did not demonstrate an adequate likelihood of success of proving that the termination was without good cause. Further, the court held that, while the franchisee would suffer obvious harm through loss of the franchise rights, the franchisors were also suffering continuing, irreparable harm as long as the franchisee’s hotels continued to operate under their trademarks while not maintaining brand quality standards.
Conclusion. Hotel franchise agreements typically provide for substantial liquidated damages if the franchisor terminates for cause, meaning that the Pooniwala franchisees are likely to owe hundreds of thousands of dollars. In other franchise cases, the terminated franchisee may be forced to cease operating a similar business due to a covenant not to compete.
The stakes are high, and franchisors can expect a fight. So if they decide to take the drastic step of terminating for cause, they had better have their “ducks in a row.” In Pooniwala, the Wyndham Hotel Group franchisors showed how this is done.
Nicholas Cintron, a law clerk at the firm and a 2016 J.D. candidate at Wake Forest University Law School, contributed to the preparation of this article.
June 19th, 2014
Today the CEO of an residential services company (handyman, cleaning, etc.) posted the following question on the American Bar Association’s Forum on Franchising’s email LISTSERV:
“What are the laws regarding licensing franchises to illegal aliens? What other considerations need to be reviewed before taking such a step?”
I was so facinated by his question that I spent some time looking into it myself. My conclusions were as follows:
Based on my brief Internet research there is not any obvious legal restriction, generally, on doing business with people who do not have a legal immigration status. However, a couple of concerns come to mind:
- Is it conceivable that the franchisee could be considered the franchisor’s employee, in any sense? Government agencies have been aggressive in challenging independent contractor classifications in a variety of areas, so if the franchise owner actually provides a lot of the services offered in a business (such as cleaning or home renovations) then it is not hard to imagine ICE taking the position that they are “employees in disguise” and that a franchisor that knowingly recruits such a person is violating the employment-based restrictions on hiring “illegal aliens”.
- If you know that a person is in the country illegally, then arguably you have a duty under the various franchise disclosure laws to inform the person that he or her illegal status may result in loss of the entire investment in the business. In particular, because the franchisee has to comply with all laws, including obtaining a legitimate tax identification number and paying income taxes, if the franchisee cannot obtain a tax ID number due to lack of immigration status then compliance with the franchise agreement is impossible.
- If the franchisor grants a franchise to someone knowing that, due to immigration status, he or she will have to avoid paying taxes, then isn’t the franchisor participating in tax evasion (or at least “aiding and abetting”)? This would a particularly precarious position for the franchisor if it is at all involved in billing and collection from customers and then remitting net proceeds (after royalties) to the franchisee, since the franchisor is then actively involved in handling funds that it knows are not being reported to the IRS.
- If the franchisee cannot obtain an employer ID number because he or she doesn’t have a social security number, then the franchisee won’t be able to comply with the employment laws in hiring workers. Franchisee probably would try to get around this by hiring “independent contractors” and paying them in cash, since this franchisee isn’t reporting taxes anyway. If the franchisor knows about all of this and lets it go on indefinitely, wouldn’t a plaintiffs’ lawyer pursuing a class-action misclassification case (like in the Coverall case) come after the franchisor too, as “joint employer”?
In short, the potential derivative liability for the franchisor in this scenario is daunting. I suppose that, if your franchise system is simple and low-cost and is attractive to immigrants, you would be best off just not asking for a social security number or any other information that could reveal a prospect’s immigration status. If you don’t have actual knowledge or a reason to know about the person’s status, then it seems like the risk would be vastly reduced – particularly if the franchisee is simply paying a flat periodic fee and the franchisor has little involvement in the details of the franchisee’s operation.
Bottom line: In this scenario it is the franchisee’s responsibility to comply with immigration laws, and in the U.S. an undocumented person is taking a significant risk investing in a franchise (or any other business). However, as shown above, if you are franchising a business of any substantial cost or complexity, it is probably in your best interests to avoid granting franchises to a person who lives in the U.S. but cannot demonstrate a legal right to do so.
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!
January 2nd, 2014
Do you think you’re ready to make your business a franchise? Ready to become the next Subway or Jiffy Lube? In this column, I’ll outline some key factors to consider as you make the important decision of whether and when to franchise your business methods.
Becoming the owner of a franchised business (as the “franchisee”) can be a great option for someone who has entrepreneurial skills and motivation but doesn’t want to start a business “from scratch.” But before you take the plunge and dive headlong into becoming a franchisor, it’s important to keep in mind the most important factors that will determine your success.
Signs That Your Business Is Ready To Franchise
The first hurtle to “franchise-ability” is whether your business has been consistently profitable over a substantial period of time. Typically, if your business is in a mature industry, such as food service or printing, you need to have been in business at least three years and have a steady record of profits. You should also have multiple separate locations to disprove that notion that it’s only a local success.
A different rule applies to “new” industry or niche businesses. If a business presents a truly unique and innovative operating method, and has shown some profitability, then it may be in the business’ best interests to franchise quickly to gain regional recognition as the leader for that niche. For example, a fitness company that offers a new type of program and that has been developed locally should try to get into the market quickly and establish themselves as the dominant brand for that niche.
The second hurtle is having developed a business system that you can teach to franchisees and can be easily replicated in other locations. Disclosures that must be given to prospective franchisees under U.S. and state laws have essentially mandated that a franchisor prepare some sort of “Operations Manual” to loan to active franchisees, and also that it plan out a new franchisee training program in advance of offering franchises. Therefore, before franchising you need to carefully document both how to develop and operate the business you want to franchise, and also plan how you will train others to replicate your methods.
Another important question is whether you have a business name and/or logo that can obtain and maintain trademark protection. Having a “strong Mark” for both marketing and legal purposes is very important to the long-term success of a franchise system, and if that factor is not present then you should carefully consider whether to re-brand and obtain trademark registration in advance of franchising.
Last but not least, will your prospective franchisees be able to obtain the capital that they need to open and operate franchises? A prospective franchisor needs to talk with its bankers to develop a profile for a suitable franchisee that will have sufficient net worth (both total and liquid) to be able to personally qualify for financing. You should then obtain informal commitments from financial institutions to finance candidates who have meet those qualifications and secure suitable locations or geographic territories from which to operate the franchise. You should consider what financing, if any, you would be willing to provide to new franchisees as part of a package to help them obtain a bank loan.
Franchising vs. Other Methods of Expansion
The main advantage that franchising has over expanding a business on your own is that you get to invest other people’s time, skills, and money to growing the business instead of borrowing against your business and personal assets or granting stock to outside investors. Having franchisees allow a business to play off of a diverse pool of talent that may attract different types of people to the business.
Many businesses have found that, by granting franchises, they can recruit talented individuals who will be driven to tremendous lengths to make their business a success. While incentives to the managers of company-owned remote locations can drive good short-term results, franchisees who risk their net worth on the enterprise have the ultimate incentive to develop the businesses for long-term profitability.
As the franchisor, your business will be less likely to be held liable for any claims of personal injury or employment discrimination that that may happen on the premises of a franchised unit, as opposed to one opened with borrowed or equity capital. Making sure that this liability shield is effective takes careful planning, but when properly executed it is a substantial benefit of franchising.
It’s not all good news however. After outside lenders or investors are repaid, company units may yield more profit to the brand founder than franchises. It can be more difficult and costly to terminate a misbehaving franchisee than a location manager. Finally, company owned units located near franchises could suffer revenue losses through competition with the franchises.
So You’ve Decided to Franchise…
With all of that in mind, and you’ve decided that your business is ready to franchise, there are a few things you should do before looking for your first franchisee.
- Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
- Put money aside. A thoughtful and responsible business owner should have at least $100,000 available for franchising purposes, including legal, development of training programs and operations manuals, and advertising for franchisees (both creative and placement). Also, a shrewd businessman might put away that money, spend half on the aforementioned items, and keep the rest on hand to show sufficient capitalization to obtain state franchise registration on favorable terms.
- Be prepared to do some hand-holding. Business owners that are looking to franchise need to be realistic when they look at the additional operating costs of getting a franchise up and running. They must spend money and time recruiting and supporting the new franchisees. Time away from the core-business means money for managerial costs for the original businesses that form the “prototype” for the franchises.
Potential franchisors need to accept that franchising successfully will require some short term sacrifices in terms of time and money. Done correctly and thoroughly can mean the growth of your business to larger regional or national markets. Improperly, underfunded, and rushed could mean the loss of the business entirely. Early investment in franchise resources and assistance will give the business a better chance at success and growth within your industry.
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.
December 20th, 2013
Summary: Recent cases involving attempted enforcement of covenants not to compete by franchisors show the unpredictability of the results in such cases. However, careful reading of the factual circumstances of the cases also supports the adage that “bad facts make bad law.” So it behooves franchisors to check whether they have a sympathetic case on the facts when trying to enforce their non-competes.
In July 2013, in the case of Golden Crust Patties, Inc. v. Bullock, Case No. 13-CV-2241, the U.S. District Court for the Eastern District of New York “threw the book” at a recently terminated Golden Krust Caribbean Bakery & Grill Restaurant franchisee. The franchise was terminated because the franchisee was “not only selling the competitor’s products (i.e., frozen Caribbean-style patties), but were selling those products using Golden Krust packaging.” Thus, the franchisee was engaging in a classic form of trademark piracy, likely to cause harm to the brand. Despite receiving an immediate termination notice, the franchisee only stopped using the trademarks after Golden Krust filed suit. Even then, rather than adopting a new name it put up a sign reading, “Come in. We are Open. Nothing has Changed Only Our Name”; and another sign that read: “Open. Same Great Food, Same Great Service. Thanks for Your Support!!! Come Again.”
Under those circumstances, the court enjoined the former franchisee and her son, who had managed the restaurant, from continued operation of a Caribbean-style restaurant. In its order the court, acting under New York law, enjoined such operations at the former franchised location and within 4 miles of it (rather than 10 miles, as written in the contract), or within 2.5 miles of any other Golden Krust restaurant (rather than 5 miles, as written in the contract). While giving them a bit of a break on the geographic extent of the non-compete, the court overall had no sympathy for the franchisee’s arguments of harm to their livelihood, including the possibility that their landlord would not allow them to operate a different type of restaurant at the leased premises; rather, the court found that to be a harm of the former franchisee’s own making.
In September of this year, in the case of Steak ‘N Shake Enterprises, Inc. v. Globex Company, LLC, the U.S. District Court for the District of Colorado found that the franchisor had good cause to terminate and force its Denver franchisee to cease use of the trademarks, but did not find cause to enjoin the former franchisee from violating the covenant not to compete. The cause for termination was that the franchisee refused to comply with the franchisor’s demand that it offer a “$4 value menu” and instead insisted on charging higher prices. The court held that Steak ‘N Shake had good cause to terminate the franchise and enjoined continued use of the Steak ‘N Shake trademarks, trade dress and menu item names.
However, the court did not order the former franchisee to refrain from operating a similar restaurant, finding that, because the next closest Steak ‘N Shake restaurant was in Colorado Springs (about 100 miles away) and the franchisor had no prospects to open up any Denver area locations in the near future, it could not prove irreparable harm if the former franchisee continued to operate. This decision does not preclude the franchisor from seeking damages due to violation of the covenant not to compete later in this case. While not expressly stated in the opinion, it is quite possible that the court may have been swayed by the fact that Steak ‘N Shake was requiring that an enormous number of meals be offered for $3.99, which likely would mean little or no profit to the franchisee on those sales. In other words, Steak ‘N Shake had a right to insist that restaurants using its name follow its pricing demands, but if it chose to terminate on those grounds it would have to suffer repercussions.
Finally, on August 6, 2013, in the case of Outdoor Lighting Perspectives Franchising, Inc. v. Patrick Harders, the North Carolina Court of Appeals affirmed a state trial court ruling denying enforcement of a post-expiration covenant not to compete by a North Carolina based franchisor against its former franchisee in northern Virginia. In so doing, the court wrote, “During the time in which Mr. Harders operated as an OLP franchisee, entities holding OLP franchises encountered numerous problems with OLP suppliers. Since [Outdoor Living Brands] purchased [the franchisor] in 2008, numerous franchises have closed and the OLP business model has been devalued. Among other things, [the franchisor] failed to provide its franchisees with adequate support, feedback, and product innovation. Although the information provided to Mr. Harders and OLP-NVA by [the franchisor] was alleged to be proprietary, much of it was publicly available and common knowledge in the industry. Similarly, the training that Mr. Harders had received from [the franchisor] was readily available without charge in many national home improvement stores.
Once the court laid out the facts in this manner, it was obvious that it would rule against the franchisor. It did so in a fairly creative manner, seizing on the fact that the non-compete prohibited the non-renewing franchisee from engaging in a “competitive business” within any “Affiliate’s territory.” At the time of the franchise agreement, the franchisor was only involved in Outdoor Lighting Perspectives, but during the term the franchisor was purchased by OUtdoor Living Brands, which also owned the Mosquito Squad® and Achadeck® franchise systems. While the likely purpose of restricting competition with “affiliates” was to protect Outdoor Lighting Perspective businesses owned by the Franchisor’s corporate siblings, and the franchisor was not seeking to enjoin the former franchisee from competing with later-acquired affiliates in unrelated fields, the literal language of the non-compete supported an argument that it was overbroad in its geographic scope.
The court also found that the definition of a prohibited “Competitive Business” under this non-compete was overly broad. It prohibited involvement in “any business operating in competition with an outdoor lighting business” or “any business similar to the Business.” The provision’s scope could prohibit the former franchisee from operating an indoor lighting business or “obtaining employment at a major home improvement store that sold outdoor lighting supplies, equipment tor services as a small part of its business even if he had no direct involvement” in that part of the operation. The appeals court affirmed the trial court’s decision to read the provision literally and therefore refuse to enforce it in any manner, rather than entering a more limited injunction prohibiting the former franchisee from operating or managing an outdoor lighting business.
These court rulings demonstrate the “bad facts make bad law” truism. The Golden Krust franchisor had a sympathetic case and a franchisee acting badly; in the Steak ‘N Shake case, the parties clearly needed to go their separate ways, but the franchisor’s inflexibility persuaded the court to allow the franchisee to operate independently, at least pending a full trial; and the Outdoor Lighting franchisor, despite litigating in its “home court,” apparently had such an unimpressive franchise system that the court was unwilling to fashion an equitable remedy when confronting an overly broad non-compete. These cases should make franchisors think carefully about the situations in which they seek to enjoin competition by their former franchisees.
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