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
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.