Frequently Asked Questions for Franchising Lawyers

Frequently Asked Questions

I'm thinking of buying a franchise...Can the Franchisor give me information on earnings? How can I find out this information?

We would like to provide prospective franchisees with earnings claims, but are worried about the reprocussions of doing so....what can we do?

My franchised business is losing money -- can I just quit the franchise?

Our main product vendors pay our Franchisor a lot of money because we buy from them...Is this legal?

What if my Franchise Agreement is silent on protected territories or the franchisor opened a new location right outside my protected territory?

If I buy a franchise, do I have any protection from the franchisor opening a location close by?

How can I be sure that my noncompetition agreement will be enforced?

Obviously we want to maximize our profits from franchising...so do we have to pay sales taxes on our royalty fees?

I sell a lot of franchises to non-English speaking individuals does this raise any unique legal issues I need to be aware of?

Our franchisor requires us to purchase essential products and equipment exclusively from them...is this legal?

Q: I'm thinking of buying a franchise...Can the Franchisor give me information on earnings? How can I find out this information?

A: Absolutely! A franchisor may certainly choose to give you information and the sales and/or profits of existing franchises. These reports can serve as an extremely useful tool in evaluating franchise systems and as a way to access your franchised business' potential earning power. The complexity of these statements may range from simple gross sales averages taken straight from monthly royalty reports to complicated charts and pro formas breaking down statistics by months of operation, location, etc.

However, a franchisor is not obligated to provide you with any earnings claims at all. While franchise sales regulators encourage franchisors to distribute information on unit-level financial performance, many franchisors choose not to distribute such information. Common reasons for not doing so are concern that they do not have enough historical information to provide an adequate basis for a claim; that providing any information could expose them to complaints that the data was misleading; that they do not need to provide the information to sell franchises, or because the data will not show favorable performance.

If an earnings claims is provided, to comply with the law the franchisor must put it in writing in the UFOC document. However, should the salesperson or other representative provide oral earnings claims, be sure to document exactly what was said, by whom, in what capacity, and the time/date/circumstances. Should the numbers they provide to you orally end up being way off, and you feel you were mislead, the oral statments may provide a basis for recovery of some of your losses.

What have your experiences with regard to earnings claims? Which franchisors are willing to provide earnings claims to prospective franchisees? Have they proved to be a useful tool in your decision to undertake (or not to undertake) a particular franchise? Email us with your answer

Q: We would like to provide prospective franchisees with earnings claims, but are worried about the reprocussions of doing so....what can we do?

A: The question most frequently asked by prospective franchisees is "How much money can I expect to make?" This question, as may be well aware, poses many problems for franchisors. Of course you should want to provide this information, since what active franchisees earn is a useful indicator of your franchise's value.

Franchisors can present information on actual or projected sales or earnings of the franchised business, or "earnings claims," provided that they comply with the relevant federal and state regulations concerning such presentations. In fact, franchise sales regulators encourage franchisors to provide earnings claims to potential franchisees, in compliance with such rules. To provide such information, the franchisor must:

Provide the "earnings claims" in writing and disclosed the full "claim" in Item 19 of the Franchise Offering Circular
Verify that the earnings claims have a reasonable basis
Make sure that the earnings claim will not be misleading or be prone to misinterpretation

Failure to follow these three simple rules can expose franchisors to liability for their franchisees' losses. Within these rules franchisors can choose any format they wish as far as disclosing earnings claims. The simplest earnings claim can simply be the average gross sales number taken from your system's monthly royalty reports. More complex reports can break down numbers based on duration of operation, geographically, etc...

When designing an earnings statement, you must keep your purpose in mind. You want prospective franchisees to see that if they work hard they have the potential, after their business has established itself, to earn a certain amount of money. You do not want to give the impression that as soon as they open their doors they will make money. This impression will devalue your system as a whole and will lead to disappointed franchisees who try to pursue claims against you for their losses. You also want to take this opportunity to reinforce the idea that their hard work and perseverance will lead to profits.

As you decide what image and figures you want to be able to distribute to prospective franchisees, you should be consulting with an attorney who has experience litigating these issues and an accountant who has experience designing pro formas and earnings claims.

What do you want your franchisees to know? How have you presented your data to prospective franchises? What obstacles have you faced in offering earnings claims? Email us with your answer

Q: My franchised business is losing money -- can I just quit the franchise?

A: Of course, the answer is "Maybe."

As a practical matter, the most important issue is what you plan to do with the business if you leave the franchise system. Your legal situation probably will be most risky if you continue to operate the same type of business from the same location as an "independent," since most franchise agreement have a Covenant Not To Compete that forbids you from operating a similar business at that location or within a certain distance from it for a specified period of time after termination. Depending on the terms of this agreement and your particular state's law, the covenant may or may not be enforceable, and the issue requires careful analysis by a franchise attorney.

However, even if the Franchisor cannot stop you from operating a "competing" business, this does not mean that "going independent" would be without risk because the Franchisor may have a claim against you for damages in the form of "lost future royalties" for the remainder of term of the agreement. The best way to defeat such a claim is to have terminated in compliance with a provision of the franchise agreement giving you the right to do so. If that is not feasible, then you will have to build a case that the franchise agreement is unenforceable to defeat the claim.

As a practical matter, if you are not looking to "go independent," but rather just want to get out of the business, it should be easier to obtain a negotiated resolution with your franchisor. It is possible the Franchisors may be willing to work on creative solutions to help you remain in operation and eventually sell the business, and if a sale is simply not feasible to shut down the failing business in an orderly manner without further payment to the Franchisor.

Q: Our main product vendors pay our Franchisor a lot of money because we buy from them...Is this legal?

A: This sort of arrangement often comes as a surprise to many franchisees; however, it is a common practice among franchisors. In negotiating supply contracts vendors often will provide incentives and rebates to franchisors who require their franchisees to purchase from the vendor.

This arrangement generally is legal in the franchise context as long as the franchisor provides adequate discloses of the arrangement in the appropriate section of the UFOC. Moreover, even if the disclosure is of questionable adequacy, if the prices that the vendor charges you are less than those you would receive as an independent business then you probably will not be able to pursue damages due to the rebates.

If you discovered this arrangement on your own and you also learn that the supplier is charging you a substantially higher price than you would receive as an "independent," then you should seek the advice and counsel of a qualified franchise attorney to evaluate any potential claims you may have.

Q: What if my Franchise Agreement is silent on protected territories or the franchisor opened a new location right outside my protected territory?

A: Unfortunately, in this case, in most jurisdictions, you will be out of luck. There has been a small anomoly where a small number of courts have adopt the approach utilized in Scheck v. Burger King. In Scheck the court recognized an implied covenant of good faith and fair dealing in franchise agreements and found that even though Burger King's agreement explicitly disclaimed any territorial protections, the court found that by opening a new location in proximity to the existing franchisee, Burger King violated the covenant of good faith and fair dealing. Even though most courts have rejected this notion, if your particular situation was egregious on the part of the franchisor, it still will pay to consult with a franchise attorney to determine if any arguments are available in your jurisdiction.

Q: If I buy a franchise, do I have any protection from the franchisor opening a location close by?

A: Maybe.

The answer to this question should be found in your Franchise Agreement. Your Franchise Agreement will probably contain a section that outlines what territorial protections you have, if any. Hopefully, you discussed this with your franchise attorney and with the franchisor as you were negotiating terms and reviewing the UFOC.

Generally, the area encompassed by your protected territory is the only protection you have from encroachment and your franchisor opening new locations.

Q: How can I be sure that my noncompetition agreement will be enforced?

A: Noncompetition clauses are a staple in virtually all standard franchise agreements. Franchisors obviously want to protect themselves, their intellectual property and their goodwill as comprehensively as possible; but they must also recognize that overly broad noncompetition agreements are commonly found unenforceable, leaving the franchisor with no control over the former franchisee’s new business, and only statutory remedies to protect their trademarks, trade secrets, copyrights and patents. Thus, when contemplating noncompetition agreements, franchisors must be careful to tailor the scope of such agreements to reasonably protecting only their legitimate business interests. While there is no failsafe formula for drafting an impenetrable noncompetition clause, careful drafting and due care are the best tools for avoiding judicial non-enforcement.

Common problems that make noncompetition clauses unenforceable include an unreasonably long duration, unreasonably broad areas of restriction, placement of an undue burden on the franchisee, and lack of a legitimate business interest protected by the agreement. Any one of these in and of itself is grounds for unenforceability; but courts often consider several of these together, analyzing the overarching reasonableness of the noncompetition covenant.

In a recent case, a Florida court dismissed a franchisor’s motion for summary judgment on its claim for violation of a noncompetition agreement because it was unable to prove that the agreement protected a legitimate business interest. In doing so, the court did not rely on the terms of the covenant, but rather noted that the franchisor had not opened and expressly did not have any plans to open any other franchises or company-owned businesses within 150 miles of the former franchisee’s location. Because of this, in the absence of any trademark violation by the former franchisee, its operation of a similar business from the location of the former franchise was not competition that could be validly restricted. Since the franchisor was not competing for business in the former franchisee’s area, it did not have a legitimate interest in restricting the former franchisee’s operation of a similar business there.

Following this case, it is clear that, regardless its terms, a noncompetition agreement may be held unenforceable if the franchisor does not own or intend to open a business that would be forced to compete with the former franchisee’s new business. This may pose a problem to franchisors, particularly new ones, that do not have a dense population of franchisees or company-owned businesses (although, a former franchisee operating in a remote location without using the franchisor’s marks may not in reality pose much of a threat, and statutory remedies would still be available to enjoin a former franchisees who was making unauthorized use of a franchisor’s trademarks). In order to protect themselves to the fullest extent possible, franchisors should incorporate reasonably narrowly-tailored noncompetition covenants into their franchise agreements, and be careful not to express any lack of intent to open additional businesses in the vicinity of their franchisees. In addition, franchisors should maintain current registration in the registration states they franchise in order to avoid the appearance of a lack of intent to franchise in those states in the future. With these safety measures in place, franchisors will be in a strong position to prevent direct competition from franchisees who leave their system.

What have been your experiences with judicial enforcement of your noncompetition covenants? Have any of your franchisees avoided enforcement of your noncompetition covenant for the reason described in the case above? Email us with your answer

Q: Obviously we want to maximize our profits from franchising...so do we have to pay sales taxes on our royalty fees?

A: All franchise agreements are drafted with the intent to maximize the franchisor’s profits, given the conditions of the market and the reasonable needs and sensibilities of prospective franchisees (or their attorneys). The most important provision in terms of profits in any franchise agreement is the royalty fee. Going beyond the franchise agreement, however, the implications of state sales tax laws may affect the profits franchisors are able to realize from their royalty fees.

It may surprise many franchisors (and perhaps their lawyers) that the language used in their franchise agreements can be determinative as to whether or not a sales or gross receipts tax will be imposed on their royalties. For example, when South Dakota’s Department of Revenue performed an audit of Subway, it determined that Subway’s entire 8% royalty fee received from its franchisees constituted taxable gross receipts. In doing so, it relied on language in Subway’s franchise agreement which stated that Subway provides tangible personal property and services to its franchisees, and that the royalty fees were consideration for allowing the franchisees access to Subway’s body of knowledge, among other things. The state’s determination was upheld in Doctor’s Associates, Inc. v. Department of Revenue and Regulation on the same reasoning. Thus, it appears that careful and strategic drafting by franchisors may enable them to avoid such liability.

The court noted that this finding did not obligate Subway to pay taxes on the entire 8% royalty fee, but because Subway failed to timely submit evidence supporting reduction, deduction or exemption of the royalty the tax was imposed on the entire 8%.

Is your franchise agreement exposing you to unnecessary tax liabilities? Are you facing state sales or income tax audits…and are you providing timely responses to mitigate your liability? Email us with your answer

Q: I sell a lot of franchises to non-English speaking individuals does this raise any unique legal issues I need to be aware of?

A: Parties are generally held to the contracts they competently agree to. However, if a franchisee cannot read English, and doesn’t understand the terms of the agreement, then he or she is unable to give informed consent to be bound by a franchise agreement. Thus, a franchisor who regularly sells franchises to individuals who do not speak English face should take extra steps to make sure that its franchise agreements are enforceable against non-English speaking franchisees.

If a franchisee is unable to comprehend the written agreement, it may have much more success in litigation claiming that he or she relied on oral promises that were inconsistent with the franchise agreement. For example, in Diniz v. Heits Building Systems, Inc., a New Jersey state court held that a franchisor’s incomplete and misleading explanation of its franchise agreement to a non-English speaking prospective franchisee was sufficient to void the franchise agreement. In disregarding the general principle disfavoring reliance on oral promises that are contrary to written agreement terms, this court clearly went out of its way to protect a non-English speaking franchisee who signed a franchise agreement despite not being able to read it.

One option is to provide a translated version of the franchise agreement to non-English speaking prospective franchisees for their review prior to signing the English version of the franchise agreement. For example, franchisors who commonly sell franchises to Latino immigrant franchisees might maintain current translated versions of their franchise agreements in Spanish. It is important to be certain that your franchise agreement is precisely translated in order to ensure that the foreign franchisee understands and accepts the terms of the agreement as set forth in the English version of the agreement.

If translation of the agreement is not practical, a franchisor that is unsure about a prospective franchisee's ability to read English might also consider signing the franchise agreement at an in-person meeting, making an audio recording of that meeting (with franchisee's consent), and interviewing the franchisee before the signing to make sure that her or she (a) has read and understood the franchise agreement, and (b) is not relying on material outside the agreement or the UFOC.

Have you had any franchise relationships turn sour because of this issue? How have you protected yourself in this type of situation? Email us with your answer

Q: Our franchisor requires us to purchase essential products and equipment exclusively from them...is this legal?

A: Franchise agreements often require the franchisee to purchase certain products exclusively from the franchisor or a designated supplier. This may raise concerns for some franchisees—how can we be sure we are getting the best price for these products, and not merely feeding extra money to the franchisor? Unfortunately, franchisees seeking to challenge such arrangements are likely to be unsuccessful.

The reason lies in the recent trend in the courts to loosen the antitrust restraints on so-called “tying contracts.” In order for an exclusive supplier provision in a franchise agreement to constitute an illegal anticompetitive arrangement, the products supplied must be of value to the franchisee separate and apart from its ownership of the franchise. More importantly, the franchisee must also be able to show that the franchisor “engaged in exploitation that reasonable franchisees could not reasonably anticipate.” This second requirement provides substantial protection to the franchisor, since Uniform Franchise Offering Circulars (UFOCs)—particularly in states, such as Maryland and Virginia that require registration of UFOCs—typically will expressly reserve the franchisor’s right to designate and use exclusive suppliers. And even where there is no such reservation, courts may be willing to imply a reasonable expectation on the part of franchisees that their franchisor may seek to promote uniformity in the franchised system.

Applying this analysis, a U.S. district court in Subsolutions, Inc. v. Doctor’s Associates, Inc. held that no illegal tying arrangement existed where Subway required its franchisees to purchase point-of-sale computer systems from its wholly-owned subsidiary. Because the Subway-specific POS systems were only useful to individuals owning Subway franchises, they were not “separate” from the franchise, and thus there was no interest in the POS systems on the part of the franchisees apart from their ownership of Subway franchises. The court also addressed the requirement that the franchisor engage in unreasonable exploitation in imposing the requirement for the purchase of the tied product, stating that the requirement that franchisees purchase the POS system exclusively from the franchisor could have been anticipated because the UFOC stated that the franchisor reserved the right to require its franchisees to purchase products from particular vendors.

In sum, where the type of product involved in an exclusive supplier provision is reasonably essential or important to the uniformity of the franchisor’s system, even absent express language in the UFOC, the provision will likely be enforced. What have been your experiences with attempting to avoid enforcement of exclusive supplier provisions? Email us with your answer