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
In Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky issued another decision demonstrating the danger of franchisors relying on disclaimers in their contracts and the Franchise Disclosure Document (“FDD”) to defeat claims that it provided false financial performance information in selling a franchise. The court denied summary judgment for the franchisor of A&W Restaurants, Inc. (“A&W”) and will allow the franchisee’s claims of fraud and violation of franchise sales laws to be decided at trial. The case is particularly noteworthy because the franchise purchased was the claimant’s fourth from the same franchisor.
A&W’s FDD had what is known a “negative disclosure” in Item 19 concerning the provision of information about the sales or profits at existing franchises, specifically saying “[w]e do not make any representations about a franchisee’s future financial performance or past financial performance of company-owned or franchised outlets.” The Minnesota-based franchisee alleged that, in connection with considering purchase of a franchise to open a new “drive in” model A&W restaurant, the franchisor provided “information, including financial projections, which was laden with false data.” These allegations, if true, would mean that A & W provided a financial performance representation (“FPR”) outside of its FDD, in violation of federal and state franchise sales laws.
A&W followed the usual route of trying to get the franchisee’s claims thrown out before trial on the argument that, in light of the disclaimers in Item 19 of the FDD and in various parts of the franchise agreement, as a matter of law the franchisee could not “reasonably rely” on the information provided. The court rejected the argument that the disclaimers could be used to bar the franchisee’s claim that A&W provided misleading information in violation of the Minnesota Franchise Act, because that law (like the Maryland Franchise Registration & Disclosure Law) contains a provision making “void” any waivers of conduct contrary to the franchise sales law. The franchisor will be permitted to use the disclaimers in the contract and the FDD at trial as evidence to persuade the jury that the franchisee could not have reasonably relied on the “projections “.
The court also ruled that the disclaimers could not be used to deny the franchisee a trial on its claim of common law fraud (under Kentucky law) with regard to its claim that the projections provided were based on false data about other locations’ sales or earnings. In the words of the court, “A broadly-worded, strategically placed disclaimer should not negate reliance as a matter of law where A&W allegedly shared objectively false data to induce Defendant to enter into the Franchise Agreement.” Therefore summary judgment was denied and the franchisee’s fraud claim will proceed to trial, with A&W potentially liable for punitive damages if the franchisee prevails on that claim.
Given that the franchisee in this case already owned three (3) other A&W restaurants at the time it purchased the franchise at issue, it would hardly be surprising if it demanded and received specific financial performance information about the other “drive-in” models. A logical question is, if A&W had included sales and earnings data in Item 19 of the FDD that it provided to this franchisee, was it less likely to have faced the allegations made in this case? In this author’s opinion, based on more than fifteen (15) years of representing franchisors and franchisees, A&W would have been in a better position to defend against the allegations had it included such data in Item 19. The reason is that the data would have been reviewed by A&W’s attorneys and probably by upper management, who would be more likely to make sure that the presentation was accurate and not misleading. Once the presentation is in the FDD, most franchise salespeople will be less likely to “go off script” and provide information that is more optimistic than Item 19.
However, even if the franchise seller did provide information beyond the written FPR, at trial the franchisor will be able to point to the data provided in Item 19 and say, “Look, we gave the franchisee the data in the FDD and made it easy for him to investigate further, so it is ridiculous to believe he relied on something are franchise salesperson said.” In that situation it may be more likely than not that the jury would agree with the franchisor. By contrast, by denying its franchise seller use of an Item 19 FPR, A&W made it difficult to comply with the law and convince qualified candidates to purchase the franchise – setting up a scenario where a jury may believe that the franchise seller “went over the line.”
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.
June 29th, 2012
For the first time the annual International Franchise Expo took place in New York City from June 15 until June 17, 2012, and it was a revitalized event worthy of The Big Apple. I visited on Friday, which has been the “slow day” of the Expo in the past during which suppliers could mingle and “network” with exhibitors. Accompanied by fellow Baltimoreans Jerry Blumenthal and Nick Courtalis of Business and Commercial Ventures
(business brokers) and Anne Paulus of 3D Signs
(signmakers), I arrived at 11:30 to find a truly packed exhibit hall!
The number of exhibitors was much larger than the sessions the past several years in Washington, D.C., and also included large franchisors such as Choice Hotels and 7-Eleven that I don’t remember seeing in D.C. However, as a counselor for emerging franchisors and for many franchisees of emerging systems, I always find innovative newer brands to be interesting. Here are a few that intrigued me, with the proviso that none of the descriptions are an endorsement of the franchise:
America’s Taco Shop: an authentic Mexican fast casual restaurant founded by America Corrales Bortin, who is originally from Culiachán, Sinaloa, Mexico. I met her husband Terry, who told me that America was named after the local soccer team in her Mexican town and not as any plan to immigrate, start a business or other ulterior motive. Nice coincidence! But seriously, their food is great.
Interpreters Unlimited: the first franchise system for the provision of interpretation services, including in-person, over the telephone, and by video conference, as well as document translation services. The company has some U.S. government contracts that the franchisee could fulfill in local markets. This “work from home” opportunity could be perfect for a good salesperson.
Joshua’s Shoarma Grill: founded by Israelis living in Europe, they have had some success there and are now seeking to grow here through area developers and masters. Have an interesting Middle Eastern fusion and healthy menu in a fast casual setting.
Team Makers: an education concept with group programs for children ages 5 to 12 to prevent bullying and other inappropriate behavior. The franchisee organizes and provides in-school workshops, after-school programs, birthday parties and carnivals or special events. This company is addressing an important societal need, and could be wonderful for a parent seeking to “re-enter the workforce” after focusing on child rearing.
Boneheads: A fast casual restaurant chain with a focus on fresh fish and Piri Piri spices, which are from Mozambique, Africa, were made popular by the Portuguese, and are now “all the rage” in Europe.
Gyu-Kaku: Japanese restaurant with a twist – the customers grill their own meat at the table! Sort of like Hibachi crossed with Fondue.
CRAL: home services with layers – mold remediation, duct cleaning, ventilation, and lead abatement, with the telephone number 1-888-KIL-MOLD. Seems to indicate strong cross-selling possibilities, although also some operational complexity. Could be good for a veteran with strong operations skills – like a sergeant!
Cool De Sac: A “family entertainment center” with a modern healthy menu, “play stations” and birthday parties programs. Sort of like an upscale “Chucky Cheeses”.
The Expo included many educational seminars and other resources for prospective franchisees and those considering the franchising of their own business methods. The same company also has events in Los Angeles in October (West Coast Franchise Expo) and in Miami in January (Franchise Expo South). For more information, visit http://mfvexpo.com/.
April 24th, 2012
During 2012 Sylvan Learning, Inc. and its corporate affiliates are fighting a claim of violating of the Maryland Franchise Registration & Disclosure Law and fraudulent conduct in its sale of tutoring center franchise rights, after having its motions to dismiss the fraud claims denied by the U.S. District Court in Baltimore.
In Next Generation Group, LLC v. Sylvan Learning Centers, LLC, Case CCB-11-0986 (decided Jan. 5, 2012), the plaintiff franchisee alleged that he agreed to develop and operate a new Sylvan Learning Center in Irving, Texas, in reliance upon representations from Sylvan that it would sell the plaintiff two existing Centers in nearby Arlington and Allen, Texas. According to the Amended Complaint, those representations were made orally by Sylvan’s agent to plaintiff’s principal both before and after the plaintiff signed the franchise agreement for Irving, but several weeks before the Irving location opened, Sylvan’s agent advised plaintiff’s principal “in writing that Sylvan had approved his acquisition of the Arlington and Allen Learning centers, respectively.” The parties executed letters of intent for the sale of both sites about two weeks before the Irving Center opened. However, about three weeks after the Irving Center opened, Sylvan’s same agent “informed [plaintiff] that Sylvan would not sell him the license and assets for any more franchises.” According to the Amended Complaint, Sylvan provided no explanation of its reversal of course. The franchisee claimed that Sylvan fraudulently induced it to develop and open the Irving location.
Sylvan argued for dismissal of the claims on the basis that the Irving franchise agreement contained an “integration clause” that prevented the plaintiff from relying on promises made outside that written agreement. The court rejected this, by quoting a prior court decision stating, “[T]he law in Maryland … is that a plaintiff can successfully bring a tort action for fraud that is based on false pre-contract promises by the defendant even if (1) the written contract contains an integration clause and even if (2) the pre-contractual promises that constitute the fraud are not mentioned in the written contract. Most of our sister states apply a similar rule. Greenfield v. Heckenbach, 144 Md. App. 108, 130, 797 A.2d 63, 76 (2002).” Sylvan’s problem is that the contractual “integration clause” did not disclaim any specific oral representations, and certainly not any concerning Sylvan’s willingness to sell the plaintiff additional existing franchised businesses. Without specific disclaimers as to representations made on that specific topic, the integration clause did not prevent pursuit of the claim.
While Sylvan could use the presence of the integration clause at trial to challenge whether the plaintiff reasonably relied on promises made outside of the Irving franchise agreement, based on the facts alleged the court stated, “there is reason to believe [plaintiff] could reasonably have relied on Sylvan’s representations” concerning the sale of the existing locations. Therefore, the court held that permitting the plaintiff to file a second amended complaint would not be “futile” and granted the plaintiff’s motion to do so.
After the plaintiff filed its Second Amended Complaint, Sylvan immediately moved to dismiss it on essentially the same grounds as asserted previously, and the court once again refused to dismiss the claims for fraud and violation of the Maryland Franchise Registration & Disclosure Law. Accordingly, the parties are now conducting discovery that may take most of 2012 to complete.
It is important to recognize that the proceedings in this case to date solely concern the sufficiency of the plaintiff’s factual allegations as a matter of law, and in later proceedings Sylvan’s representatives will provide information on what occurred with regard to this franchise sale. Nevertheless, the decision reiterates an important point for all Maryland business people – even if promises and statements are excluded from a particular written agreement, they may have legal consequences if the subsequent business relationship fails to meet the other party’s expectations.
April 20th, 2012
An appeals court has held that Doctor’s Associates, Inc., the franchisor of Subway® sandwich shops, could be liable for the payment of workers’ compensation benefits for the injured employee of a franchisee under the Kentucky Workers’ Compensation Act because the franchisee could fit the Act’s definition of a “subcontractor” and Doctors Associates could be considered a “prime contractor”. Uninsured Employers’ Fund v. Brown, et al., Case No. 2010-CA-000283-WC (Ct. App. Ky., Sept. 3, 2010).
The court sent the case back to the lower courts to allow for: (1) presentation of additional proof regarding the nature of the franchisor’s business and whether the work that the franchisee performed was a regular or recurrent part of the franchisor’s business; and (2) additional findings of fact after presentation of that evidence.
In late 2011, the Kentucky Supreme Court reversed the decision to remand the case for further fact-finding and ended it in favor of Doctors Associates, Inc. (“DAI”). However, that court expressly held that franchisors are not immune from scrutiny as a “statutory employer” of franchisees’ employees under Kentucky’s workers’ compensation law. Since Maryland and other states have similar workers’ compensation laws, this principle of law applies to offering a franchise in Maryland or elsewhere. Doctors Associates, Inc. v. Uninsured Employers’ Fund (KY Nov. 23, 2011).
An employee of one of the franchisor’s Kentucky franchisees had sustained injuries while working at the restaurant. The franchisee carried no workers’ compensation insurance at the time. Accordingly, the employee’s medical and disability expenses were paid by the Uninsured Employers Fund which sought indemnity from the franchisor, under a provision of the Act requiring contractors to pay compensation to an injured employee of a subcontractor if the subcontractor did not carry workers’ compensation insurance.
The ALJ concluded that he could not impose liability for workers’ compensation benefits upon the franchisor for the franchisee’s injured employee for a number of reasons. First, the franchisor was a “commercial franchisor”, a category of business not specifically covered by the statute. Second, a contractor-subcontractor relationship existed under the statute only where the contractor paid the subcontractor to perform work. Because the franchisee was paying the franchisor, the franchisee could not be the franchisor’s subcontractor.
The Court Says, “It’s Always an Issue of Fact”
The appellate court reversed the decision because there is no blanket exemption from the worker’s compensation system of “commercial franchisors.” In jurisdictions outside of Kentucky, courts resolved whether franchisors were liable for workers’ compensation benefits based on the specific facts of the cases, rather than by general rules of exemption, the court observed. A natural tension existed between the types of franchisor controls inherent in franchising and the types of control over day-to-day operations that courts traditionally evaluated to determine whether an employment relationship existed. The factual issue to be determined in the context of a franchise is whether the alleged subcontractor has performed work “of a kind which is a regular or recurrent part of the work of the trade, business, occupation, or profession of [the contractor],”.
The resolution of whether the franchisee was performing work for the franchisor under the meaning of the Act required the finder of fact to put aside the fact that the franchisee purchased a franchise from the franchisor, and instead look to the nature of the lasting relationship that was created between the franchisor and franchisee thereafter, the court decided. If the franchisor essentially contracted with the franchisee to perform a function that was a regular and recurrent part of its business, then the arrangement between the franchisor and franchisee was that of contractor and subcontractor and subject to the Act.
Thus, if selling sandwiches to the public was a regular and recurrent part of Doctor’s Associates, Inc.’s business, then the franchisee was unquestionably performing work that Doctor’s Associates, Inc. otherwise would have had to perform for itself and with its own employees, and the franchisee would fit within the Act’s definition of “subcontractor.”
Concurrence Goes Further on Franchisor’s Liability
A concurring option also raised the issue of whether a franchisor that failed to enforce the franchise agreement requirement that the franchisee maintain adequate insurance and name the franchisor as an additional insured, thereby becomes liable to third parties due to the franchisee’s failure to have such insurance. This could open the door to even great legal liability in franchising in Maryland and other states.
Supreme Court reverses due to deference given to Workers Compensation Board
The Kentucky Supreme Court agreed that the ALJ erred in finding that franchisors are immune as a matter of law from being a statutory employer of franchisee’s employees. However, the Supreme Court nevertheless ended the case for the following reason: “The [Uninsured Employers’ Fund] is the claimant bearing the burden of proof to show that DAI is a contractor subject to up-the-ladder liability. The ALJ and the Board found that DAI was in the business of franchising, not the business of selling sandwiches. So the franchisee did not perform a regular or recurrent part of DAI’s business. Substantial evidence supported this finding, and we find that the evidence does not compel a finding for the UEF.”
This court decision demonstrates the importance of franchisors vigorously enforcing its contract provisions regarding insurance coverage, as well as other contract provisions that, if not complied with by the franchisee, may lead to liability to franchisee’s employees and customers. It also supports the notion that entrepreneurs beginning a franchising program should not offer franchises through a company that also operates the business being franchised, but instead create a new company used solely for franchising activities. It is important for companies offering franchises in Maryland to consult with an attorney and minimize this risk.
November 7th, 2011
A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.
Misrepresentations in Franchise Disclosures
The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.
In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.
The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”
The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.
Jurisdiction in Maryland and Application of New York Franchise Sales Law
The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.
Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.
The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.
The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.
(1) Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.
(2) If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.
(3) New York needs to amend its law to exempt out of state franchise sales from its registration requirements.
September 27th, 2011
In its recent decision of Meineke Car Care Centers, Inc. v. RBL Holdings, LLC, et al., Case No. 09-2030, Case No. 09-2030, Bus. Franchise Guide (CCH) ¶ 14,586 (decided April 14, 2011), the United States Court of Appeals for the Fourth Circuit provided valuable guidance on one of the most important legal issues for franchisors and franchisees. Specifically, if a franchisee closes franchised businesses that it can no longer afford to operate, can its franchisor obtain a judgment for “lost future royalties” that it would have earned had the businesses continued to operate?
In this Meineke case, the trial court had granted summary judgment dismissing the franchisor’s claim, on the bases that: (1) the franchise agreement did not state that the franchisee would be liable for royalties even if the business closed, and (2) even if Meineke had the right to seek lost future profits due to the franchisee’s closure of the stores, the claim failed because Meineke could not prove that it was “reasonably certain” that such profits would have been realized if the stores had not been closed. The U.S. Court of Appeals disagreed on both points and remanded the case for trial on Meineke’s claim.
On the first point, the court held that the parties are not required to specify in the Franchise Agreement all categories of potential damages each could seek as a result of the other’s breach. Rather, the standard is whether, at the time of entering into the agreement, “lost profits may reasonably be supposed to have been within [the parties’] contemplation as a probable result of [the franchisee’s] premature closure of the Shops.” A specific statement in the Franchise Agreement that the franchisee would be liable for all royalties throughout the term of the agreement would have been powerful evidence of the parties’ understanding when they signed the contracts. However, it was not the only admissible evidence of the parties’ “contemplation” on that issue, and therefore a factual dispute on that point existed – making it an issue for the jury to decide.
On the second point, the court emphasized that the royalties payable to Meineke were calculated from a percentage of the Stores’ gross revenue, not net profits. The court found that Meineke had demonstrated “with reasonable certainty” that, except for the franchisee’s breach of the agreements by closing the Shops, some revenue and therefore some lost royalties would have been realized. Thus, a trial was necessary to determine the amount of those lost “profits” with reasonable certainty.
However, at the trial, it would be relevant in making that determination how long it would have been “commercially feasible” to continue to operate each of the Shops, based on its historical net profits to the owner. In other words, the fact finder’s decision of how long it was “commercially feasible” to expect the franchisee to keep the doors open would determine the amount of the lost future royalties damages.
(1) the only way that a franchisee and its personal guarantors can be sure that they will not be liable for lost future royalties if the franchise fails is to insist upon language in the franchise agreement eliminating (or limiting) the franchisor’s right to those damages.
(2) if a franchised store ceases operations and truly “goes dark” due to ongoing net operating losses, at trial on a claim for lost future royalties the franchisor will need to be able to demonstrate that it was “commercially feasible” for the franchisee to remain open and, if so, provide some reasonable basis for the fact finder to determine how long the store should have remained open.
Given the uncertainty and fact intensive nature of such a case, it is probably in the best interests of both the franchisor and the franchisee to directly address the issue in the written agreement the franchisor’s right to “lost future royalties” and an agreed upon method to calculate those “damages.”
The full opinion can be viewed at http://pacer.ca4.uscourts.gov/opinion.pdf/092030.U.pdf
August 30th, 2010
(This is the conclusion of the August 23, 2010 post on this Blog.)
Franchising vs. Other Methods of Expansion
The main advantage that franchising has over expanding a business on your own is that you get to invest other people’s time, skills, and money to growing the business instead of borrowing against your business and personal assets or granting stock to outside investors. Having franchisees allow a business to play off of a diverse pool of talent that may attract different types of people to the business.
Many businesses have found that, by granting franchises, they can recruit talented individuals who will be driven to tremendous lengths to make their business a success. While incentives to the managers of company-owned remote locations can drive good short-term results, franchisees who risk their net worth on the enterprise have the ultimate incentive to develop the businesses for long-term profitability.
As the franchisor, your business will be less likely to be held liable for any claims of personal injury or employment discrimination that that may happen on the premises of a franchised unit, as opposed to one opened with borrowed or equity capital. Making sure that this liability shield is effective takes careful planning, but when properly executed it is a substantial benefit of franchising.
It’s not all good news however. After outside lenders or investors are repaid, company units may yield more profit to the brand founder than franchises. It can be more difficult and costly to terminate a misbehaving franchisee than a location manager. Finally, company owned units located near franchises could suffer revenue losses through competition with the franchises.
So You’ve Decided to Franchise…
With all of that in mind, and you’ve decided that your business is ready to franchise, there are a few things you should do before looking for your first franchisee.
- Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
- Put money aside. A thoughtful and responsible business owner should have at least $100,000 available for franchising purposes, including legal, development of training programs and operations manuals, and advertising for franchisees (both creative and placement). Also, a shrewd businessman might put away that money, spend half on the aforementioned items, and keep the rest on hand to show sufficient capitalization to obtain state franchise registration on favorable terms.
- Be prepared to do some hand-holding. Business owners that are looking to franchise need to be realistic when they look at the additional operating costs of getting a franchise up and running. They must spend money and time recruiting and supporting the new franchisees. Time away from the core-business means money for managerial costs for the original businesses that form the “prototype” for the franchises.
Potential franchisors need to accept that franchising successfully will require some short term sacrifices in terms of time and money. Done correctly and thoroughly can mean the growth of your business to larger regional or national markets. Improperly, underfunded, and rushed could mean the loss of the business entirely. Early investment in franchise resources and assistance will give the business a better chance at success and growth within your industry.
August 23rd, 2010
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. Part 1 focuses on signs that a business is “franchisable”. Part 2 will focus on franchising vs. other methods of expansion, and steps necessary to franchise.
One thing is for sure – given the number of jobs lost over the past two years, there are many potential franchise owners “out there” who are eager to find their next opportunity. 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 their 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.