Category: franchising

Signal 88 Security case illustrates the Challenge of Obtaining A Preliminary Injunction to Enforce a Franchise Non-Compete

August 4th, 2017

A covenant not to compete is typically included in a franchise agreement to ensure that customer goodwill, once developed in the name of franchise, is not destroyed by former franchisees. The ultimate weapon for a franchisor to enforce a covenant not to compete is obtaining a preliminary injunction against the former franchisee. However, many courts place a heavy burden on the franchisor to prove that a preliminary injunction is proper.  The recent case of Colorado Security Consultants, LLC v. Signal 88 Franchise Group,  decided in March 2017 by the U.S. District Court for the District of Nebraska, illustrates how difficult that burden can be to meet under unfavorable facts.

Colorado Security Consultants, LLC (CSC), had a three year franchise agreement with franchisor, Signal 88 Franchise Group, Inc., to provide on-site security guard services within a territory in Colorado Springs. CSC also had a right of first refusal over additional franchises to be added within a radius of Colorado Springs. At the end of the initial term, the franchisor and franchisee continued the franchise agreement on a month-to-month basis, subject to 30-day notice of termination.  Signal 88 informed CSC that another person, Rebecca Resendes, wished to enter into a franchise agreement for a territory in the right of first refusal area where CSC had developed contracts with some customers.  Resendes and CSC negotiated for several months over her either purchasing CSC’s franchise or compensating CSC for customers it had developed in her contemplated territory.  When no agreement was reached Resendes signed a direct franchise agreement with Signal 88.  After additional negotiations between CSC and Resendes failed, Signal 88 told CSC that it had to stop serving customers in Resendes’ territory and then terminated CSC’s franchise entirely.  CSC began providing security services under the name “Guardhail”, and then Signal 88 sued CSC for violation of the 2 year post termination non-compete and sought an injunction to stop it from providing any security services.

To obtain an injunction Signal 88 had to demonstrate the following: (a) without an injunction it would suffer irreparable harm greater than the harm the franchisee would suffer from its issuance; (b) it had more than 50% likelihood of demonstrating violation of an enforceable non-compete by CSC, and (c) the injunction would serve the public interest.

Signal 88 alleged that CSC was causing it irreparable harm because it “contacted Signal 88’s customers, undercut Signal 88 on price, and caused a number of customers to cancel contracts with Signal 88.” CSC responded that it did not use “any of the names or trademarks of Signal 88” nor did they use any confidential materials.  All customer contracts in the Signal 88 system are entered into in the name of the franchisor, which also does billing and collection. So if Guardhail sought to continue to serve the customers that CSC recruited for Signal 88 (as seems likely) then CSC would have had to utilize the customer contact information and likely would have made offers that were more attractive than the pricing offered under the franchise.

Nevertheless, in declining to issue a preliminary injunction, the Court determined that Signal 88 failed to show that the “harm is certain and great and of such imminence that there is a clear and present need for equitable relief,” because Signal 88 failed to show that in the harm of CSC’s actions “threatened the very existence” of Signal 88’s business. Accordingly, even if there is a loss of customers and revenue for Signal 88, money damages would still suffice without the “extraordinary” measure of a preliminary injunction.

Signal 88 also argued that failing to enforce the non-compete would cause “irreparable harm to its franchise system”, presumably by encouraging other franchisees to not renew and to flout the non-compete. The court said that Signal 88 had no evidence to back up that general supposition.  Since a preliminary injunction would effectively put CSC out of business and would moot the parties’ claims before addressing the merits of the case, including CSC’s breach of contract counterclaim, the court found that the balance of hardships heavily favored CSC.

Despite the case being heard in Signal 88’s hometown of Omaha and the franchise agreement stating that Nebraska law governed, the Court held that Colorado had a greater material interest in the franchise agreement and therefore its laws regarding non-competes applied. Under Colorado law non-compete provisions are disfavored except to protect trade secrets or if issued when selling one’s business. The Court found that the evidence presented did not demonstrate CSC’s use of Signal 88’s trade secrets with any specificity.  Moreover, CSC argued that, as Signal 88’s selling and servicing agent when dealing with the customers, its principals were Signal 88’s employees – an allegation that, if proven, would cause the non-compete being held to very strict scrutiny under applicable law.  Since that determination is fact-specific the Court would not make such a decision at the preliminary injunction stage.

It is likely that these factors heavily influenced the Court’s denial of the preliminary injunction: (a) CSC recruited and developed the Signal 88 security customers in Colorado Springs, probably through the sales efforts of its owners more than franchisor-provided marketing; (b) accordingly CSC was not provided a customer list and did not inherit a list of long-standing Signal 88 customers, so the Colorado Springs customer list was not trade secret provided by Signal 88; and (c) Signal 88 terminated its relationship with CSC, apparently without cause, and allowed new franchisee Resendes to service all of CSC’s contracts without requiring her to pay for the goodwill that CSC had developed in them.

As this case shows, absent favorable facts it is very difficult for a franchisor to obtain a preliminary injunction enforcing a non-compete. Accordingly, certain franchisors may be well-served by adding a provision requiring a former franchisee that violates a post-expiration covenant not to compete to pay 2 years’ worth of continuing franchise fees.  Such a liquidated damages provision is more easily enforced and represents a fair compromise between franchisor’s interest in retaining customer goodwill and franchisees’ interests in making sure that the franchisor’s brand and business system continue to provide value.

“Earnings Claims” Regulation – Public Comments Help Prevent Unfair Restrictions

October 13th, 2016

Takeaway: Demonstrating our value to early stage franchisors, WTP public comments help eliminate proposed regulations that would have prevented new franchisors from providing profit information.

Generally speaking, the most important type of information that a franchisor can provide to prospective franchisees concerns the profits earned by businesses operating under their brand.  This type of information, as well as information on gross revenues, is called a Financial Performance Representation (“FPR”) or “earnings claim” under the laws governing franchise sales in the United States.  Unfortunately, while the FTC Franchise Rule requires certain disclosures to prospective franchisees (through provision of a Franchise Disclosure Document or “FDD”), and requires that any FPR that a franchisor provides be included in Item 19 of the FDD, it does not provide substantive guidance on what can and cannot be provided in an FPR.  Instead, it simply requires that there be a “reasonable basis” for providing that information to prospective franchisees.

While the FTC does not require filing and approval of the FDD prior to selling franchises, several U.S. states require that the FDD be reviewed and approved before a franchise is sold in that state (a process called “registration”).  Among the most prominent registration states are California, Illinois, New York, Maryland and Virginia.  Those states’ review of FDDs are informed and guided by policy statements issued by the North American Securities Administrators Association (“NASAA”), of which each state’s franchise regulatory authority is a member.  Since 2015 NASAA has been considering issuance of a Financial Performance Representations Commentary.

The original proposed FPR Commentary, issued for public comment on October 1, 2015, contained many useful provisions.  However, proposed Section 19.7 would have drastically interfered with new franchisors’ ability to provide truthful, factual information to prospects.  It read:

19.7 Item 19 — FPR Disclosing Gross Profit or Net Profit of Company-Owned Outlets When Franchisor Has No Operational Franchises.

QUESTION: If a franchisor has no operational franchises, can the franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: No. A franchisor with no operational franchises cannot make an FPR disclosing gross profit or net profit based on company-owned outlet data alone.

The proposed commentary’s reason for this blanket ban was a concern that franchisees are likely to incur higher operating costs than company-owned locations, and without operating franchisees the new franchisor would not have a way to know if its costs were lower (or higher) than franchisees would experience. Therefore, to provide net profit information to prospective franchisees based solely on the company-owned data would be misleading.

This proposed commentary, if enacted, would have severely limited the ability for the many early stage franchisors that we represent to compete in recruiting franchisees – which is already tough enough for a start-up! Moreover, while it is appropriate for the commentary to highlight issues that franchisors need to consider when deciding whether its FPR has a “reasonable basis” and is not materially misleading, an outright ban under all circumstances deprives prospective franchisees of information they wish to know.

Accordingly, on October 27, 2015 we submitted our public comments objecting to proposed Section 19.7 on those bases.  With our client’s approval, our comment included an early stage franchisor’s net profit FPR, redacted to remove the name of the franchisor and its principal owners.  The numerical presentation was accompanied by a paragraph explaining why revenues and expenses increased over a period of years, and also warning about the franchisor principals’ level of experience in the industry and therefore why its business performance probably would exceed that of new franchisees.  The public servant who leads the NASAA Franchise Project Group told the author that the example was “particularly helpful.”

On September 14, 2016, after lengthy internal deliberations among the project group members, NASAA issued a revised version of the proposed FPR Commentary for public comment.  While not specifically addressing comments received, what is notable is that former Section 19.7 no longer exists.  Instead, no distinction is made between franchisors with or without operating franchises, and rather new Section 19.10 reads in part as follows:

19.10 Item 19 — Gross Profit or Net Profit FPR Based on Company-Owned Outlets Alone

QUESTION: Can a franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?

ANSWER: Yes. A franchisor can make an FPR disclosing gross profit or net profit based on company-owned data alone if it has a reasonable basis to make the FPR and includes the following information: (a) gross sales data from operational franchise outlets, when the franchisor has operational franchise outlets; (b) actual costs incurred by company-owned outlets; and (c) supplemental disclosure or adjustments to reflect all actual and reasonably expected material financial and operational differences between company-owned outlets and operational franchise outlets. These differences consist of fees and other expenditures required by the franchise agreement, disclosed in the Franchise Disclosure Document, or that are otherwise known or reasonably should have been known by the franchisor.

The remainder of the answer explains the need to adjust the presentation to disclose franchise royalties and other fees that a company-owned outlet does not pay, and also to adjust the costs of goods sold upward if the company-owned locations receive more favorable pricing from suppliers than franchisees will experience. The latter is a tricky issue and new franchisors either will need to be very careful to make sure that actual franchisee pricing is the same, or increase the costs of goods sold by a specific percentage in the presentation and explain the basis for the increase in footnotes.

Nevertheless, this is a major win for new and early stage franchisors, since they are likely to retain the freedom to provide prospects the information that they desire and to compete in franchise sales. It was our pleasure to be able to influence this regulatory outcome in favor of companies that want to use franchising to grow their brand and create entrepreneurial opportunities in the U.S.A.

New California Franchise Law Provides More Rights to Franchisees, Burdens for Franchisors

May 22nd, 2016

by David L. Cahn and Jordan M. Halle

Effective for franchise agreements entered into or renewed this year, new amendments to the California Franchise Relations Act impose significant restrictions on franchisor’s termination or refusal to renew franchise agreements, increase franchisor’s post-termination obligations, and bolster franchisees’ rights to sell their franchised business. These changes make California a somewhat more risky state in which to use franchising as a growth strategy, while arguably bolstering the security of franchisees’ investments in mature brands.

Restrictions on Termination:  a franchisor must have “good cause” to terminate a franchise, and “good cause” for termination is limited to a franchisee’s failure to “substantially” comply with the lawful requirements of the parties’ franchise agreement.  Generally franchisors must provide at least 60 days, but not more than 75 days, to cure a material default.  Franchisors may still terminate for certain “serious” defaults with less than 10 days’ notice, such as failure to pay fees, abandonment, and repeated defaults.  New sanctions available to franchisees terminated or refused renewal without good cause include damages in the amount of the fair market value of the franchised business and assets, and preliminary and injunctive relief for a franchisor’s violation of the statute.  Expect plenty of litigation over whether there was “substantial” noncompliance and a “material” default by a terminated franchisee.

Post-termination repurchase obligation: California always has been a state where franchisors had to approach a decision to terminate with caution, because of a California statute that prohibits enforcement of covenants not to compete as well as case law making it difficult to collect lost future profit damages from terminated franchisees.  Now, absent certain exceptions, a franchisor must buy from the terminated franchisee all inventory, supplies, equipment, fixtures and furnishings that the franchisee had purchased due to a franchise agreement requirement – even if termination is due to the franchisee’s material default.  Any money owed by the franchisee to the franchisor may be offset against the repurchase price for such items.  Notable exceptions to the repurchase requirement are if the franchisee declined the franchisor’s renewal offer, or if the franchisor permits the former franchisee to retain control of the business location after termination.

Right to Transfer:  Franchisors now may not prevent a franchisee from selling the business’s assets or an interest in the business, except if the buyer does not meet the franchisor’s standards for new franchisees or if the franchisee and buyer fail to comply with other reasonable requirements of transfer in the franchise agreement.  The franchisor must provide the franchisee and prospective buyer with written standards by which it determines whether a prospective franchisee is acceptable, and if denying transfer approval on the basis of non-suitability must explain why the proposed buyer does not meet one or more of the standards.  Franchisors may enforce right of first refusal provisions in the franchise agreement, provided that the franchisor pays equal to or greater than the price offered by the prospective buyer.

Conclusion: The new California laws generate issues with the franchise agreement, franchisor operations, and franchisor/franchisee relations that any franchisor selling franchises in California should have reviewed and addressed by an attorney.  Please contact us for further information and advice.

“What’s the Hot Franchise, 2015?”

October 9th, 2015

I am often asked “What’s The Hot Franchise?” or “What’s Hot in Franchising?”  As a good lawyer I am reluctant to answer because don’t want to be seen as endorsing anything!  But Franchise Times magazine has provided data to support a reasonable answer to this question circa 2015.  So, using that data and my own experience interacting with franchisees and franchisor executives of various brand, below is my subjective list of “What’s Hot”:

  • Paul Davis Restoration (disaster cleanup)
  • BrightStar Care (in home care for seniors and disabled)
  • Right at Home (same)
  • Anytime Fitness (24 hour limited service gym)
  • Massage Envy Spa
  • Sport Clips (barbershop)
  • Buffalo Wild Wings (casual dining)
  • Dickey’s BBQ (“fast casual”)
  • Smashburger (same)
  • Popeye’s Louisiana Kitchen (QSR, great same store sales increases)
  • Jimmy John’s (sub shop)
  • Firehouse (same)
  • Jersey Mike’s (same)
  • Holiday Inn Express

And a special shout-out to a client of ours who is not in Franchise Times, but is growing like wild fire: Hissho Sushi, to go sushi bars mostly within supermarkets, 53.4% unit growth in 2014 up to 741 locations (72% franchises).  The brand has continued to grow and expand in 2015, and should be on Franchise Times’ radar for its 2016 edition!

NLRB Issues Advice Memo Finding That Franchisor Is Not Joint Employer

May 13th, 2015

On April 28, 2015 the National Labor Relations Board (“NLRB”), Office of the General Counsel, issued an Advice Memorandum to the NLRB’s Chicago area regional office finding that a restaurant franchisor and its Chicago area development agent are not joint employers with a Chicago franchisee. This is an important development in light of the current pursuit by the NLRB’s General Counsel of joint employer cases against McDonald’s Corporation.

The Advice Memo, in the case of In Re. Nutritionality, Inc. d/b/a/ Freshii, involves a union organizing effort at a Freshii “fast casual” restaurant owned in Chicago by single unit franchisee. The franchisee terminated employees who were attempting to organize a union for the employees of the restaurant. The Region requested advice as to whether franchisor Freshii Development, LLC (“Freshii”) or its development agent for the “Chicagoland” region is a joint employer.

The essential thrust of the Advice Memo is that Freshii’s control over the franchisee’s operations, as implemented through the development agent, “are limited to ensuring a standardized product and customer experience, factors that clearly do not evince sharing or codetermining matters governing the essential terms and conditions of employment.” While this was a sufficient conclusion under the NLRB’s current “joint employer” standard, the Advice Memo held that even under the more inclusive “industrial realities” standard advocated by the General Counsel in the McDonald’s cases, Freshii and the development agents are not joint employers.

The Facts That Determined The Outcome

Freshii’s franchise agreement expressly disclaims any involvement in the franchisee’s employment or labor relations practices. More specifically, while the franchisee must comply with “System Standards,” on pain of potential termination if it fails to cure a breach of the standards within 30 days of receiving a default notice, the franchise agreement, “the franchise agreement specifies that System Standards do not include ‘any personnel policies or procedures or procedures,’ which Freshii may make available for franchisees’ optional use, and that the franchisee alone will ‘determine to what extent, if any, these policies and procedures might apply’ to its restaurant operations.”

While Freshii’s Operations Manual contains advice on human resources, such as hiring and scheduling employees, how to calculate “labor cost percentage” and how to project labor costs in scheduling, all of this falls in the realm of training and the franchisee is free to accept or reject the advice. While Freshii provides a sample employee handbook, many of its franchisees (including the development agent) obtain other handbooks containing different employment policies.

The development agent provides extensive training to the franchise owner before store opening, and some direct training to the restaurant’s staff around the grand opening, but thereafter the franchisee is solely responsible for training and supervising its staff. The development agent conducts monthly store inspections and also informally “drops by” Freshii restaurants to monitor things like whether the employees are wearing uniforms, store cleanliness, and food preparation, and provides reports to both the franchisee and the franchisor if there are deviations from standards. On one occasion the development agent told a different franchisee that there were too many employees working during a slow time of day, but the franchisee was not required to change its scheduling policies.

While Freshii has a section of its website where prospective employees can apply for a job at a specific location, the only thing Freshii does with the information is forward it to the franchise owner. The franchisee exclusively decides who to hire as its employees.

Freshii has no standard software to monitor employee scheduling or labor costs. This is a substantial difference from the facts alleged in the McDonald’s cases. Individual franchisees are exclusively responsible for setting employee wages and benefits, and the complaining employees (and the union sponsoring them) were unable to produce any evidence that franchisees need to consult with Freshii or the development agent to grant wage increases, decreases, or changes to benefits.

While the development agent can raise an issue about an employee’s performance in a review, there was no evidence that any employee had ever been disciplined or discharged by a Freshii franchisee because of a development agent’s comments. By contrast, Nutritionality (the franchisee) has disciplined and discharged employees without consulting Freshii or the development agent.

Finally, and most pertinently, the evidence was that when the union began to organize at Nutritionality’s store, Nutritionality’s owner told the development agent about it. The development agent did not respond but reported it to Freshii, and neither Freshii nor the development agent communicated with Nutritionality about the organizing effort.

Legal Conclusions

Under the NLRB’s existing standard, the alleged joint employer “must meaningfully affect matters relating to the employment relationship such as hiring, firing, discipline, supervision and direction.” Since neither Freshii nor the development agent has any meaningful impact over Nutritionality’s hiring, compensation, scheduling, discipline, or ongoing supervision, the conclusion that they are not joint employers was self-evident.

Under the standard proposed in the McDonald’s cases and in a case pending against Browning-Ferris Industries of California, the NLRB would examine “the totality of the circumstances, including the way that separate entities have structured their commercial relationship,” to determine whether “the putative joint employer wields sufficient influence of the working conditions of the other entity’s employees such that meaningful [collective] bargaining could not occur in its absence.” This is referred to as the “industrial realities” test. Even under that relaxed standard, the Advice Memo states, “[B]ecause Freshii does not directly or indirectly control or otherwise restrict the employees’ core terms and conditions of employment, meaningful collective bargaining between Nutritionality and any potential collective bargaining representative of the employees could occur in Freshii’s absence.”

Take Away

By finding that they are not, the effect is that the unfair labor practice claims against the franchisor and development agent will be dismissed. This obviously does not suit the agenda of the union conducting the organizing drive, since it wants to organize all employees of stores operating under a trademark – regardless of franchise ownership. Organizing the few employees in a single store is unlikely to yield sufficient union dues to be worth the time devoted by union staff.

However, this is potentially a huge win for franchising. The decision affirms that a restaurant franchisor’s “requirements regarding food preparation, recipes, menu, uniforms, décor, store hours, and initial employee training prior to a franchise opening are not evidence of control over [its franchisees’] labor relations but rather establish [its] legitimate interest in protecting the quality of its product and brand.” If the NLRB follows this reasoning going forward, this sort of ruling will mean that “the sky is not falling” on traditional and reasonable franchising practices.

Enforcing Quality Standards in Hotel Franchise Agreements

August 6th, 2014
David Cahn

David Cahn

Take-away. A franchisor’s diligence in conducting and documenting quality assurance inspections is as important as ever, particularly if the franchisor seeks to exercise its ultimate weapon – termination of the franchise agreement. Prudent inspection and documentation practices are particularly crucial in the many U.S. states and territories that have statutes requiring a showing of “good cause” in order for a franchisor to terminate a franchise agreement. In such states, a franchisor must furnish evidence demonstrating that the franchisee failed to substantially comply with the material and reasonable franchise requirements; otherwise, a court may well restore the franchise rights and order money damages to the franchisee.

The Case.  Pooniwala v. Wyndham Worldwide Corp., a May 2014 decision by the U.S. District Court for the District of Minnesota, is an exemplary demonstration of how a franchisor establishes that one of its franchisees repeatedly violated quality assurance standards so that there was “good cause” to terminate the franchise agreement under state law. The franchisor’s in this case diligently conducted and documented regular quality assurance (“QA”) inspections.

The Facts. Minn. Stat. Section 80C.14, part of the Minnesota Franchise Act, allows a franchisor to terminate an agreement if the franchisor can show “good cause” for termination. Good cause means failure by the franchisee to substantially comply with the material and reasonable franchise requirements imposed by the franchisor, including “any act by or conduct of the franchisee which materially impairs the goodwill associated with the franchisor’s trademark, trade name, service mark, logotype or other commercial symbol.”

Pooniwala involved franchise agreements for two hotels, one a “Super 8,” and the other a “Travelodge.” The franchisee alleged that the franchisors, both of which are affiliated companies within the Wyndham Hotel Group, took retaliatory action against the franchisee because of a lawsuit between the franchisee and Ramada Worldwide Inc., its fellow Wyndham Group affiliate. The franchisors, for their side, argued that their attempts to terminate the franchise agreements were not retaliatory actions, but rather that the franchisee had repeatedly violated QA standards found in the respective franchise agreements, giving each franchisor good cause for termination.

The first attempted termination involved a Super 8 hotel facility in Roseville Minnesota. The franchise agreement for the Roseville Super 8 included quality assurance requirements, as well as provisions allowing Super 8 to inspect the facility to ensure that it was operating in compliance with Super 8’s system standards and QA requirements.  The franchisee had failed six consecutive QA inspections at the Roseville Super 8.  Each inspection was followed by a letter indicating that the franchisee had received a failing score on the QA inspections. The letters also gave the franchisee notice that it had sixty days to cure the QA deficiencies, the failure of which could result in termination of the franchise agreement. Finally in September 2013 Super 8 notified the franchisee that the franchise would terminate on December 29, 2013, unless the hotel passed a final QA inspection. The franchisee failed that final inspection, and shortly thereafter Super 8 informed the franchisee that termination would take effect on the originally scheduled termination date.

The second termination was for a Travelodge hotel facility in Burnsville, Minnesota. The Burnsville Travelodge agreement contained similar QA requirements, and the franchisee failed eight consecutive QA inspections, receiving letters documenting the failures following each inspection. Finally the franchisee received notice of termination for the Travelodge franchise. The notice described QA deficiencies, and stated that termination would take effect in ninety days, but that another inspection would be scheduled to determine whether the QA violations had been cured. The franchisee failed that inspection, and as a result Travelodge informed the franchisee that termination would take effect on the originally scheduled date.

Preliminary Injunction. It is not a wonder that motions for preliminary injunction are commonplace in hotel franchise termination cases. With the great potential for loss of good will among customers, employees and suppliers, franchisees will not want to give up their rights to franchise logos or their presence on a franchisor’s reservation system. In Pooniwala, the franchisee sought an order for preliminary injunction to stop the franchisors from terminating the franchise agreements before the court heard the case on its merits.

In deciding whether to grant a preliminary injunction, courts have to balance the harm to the two sides. They also consider the requesting party’s likelihood of success on the merits in the underlying claim–here, violation of the good cause requirement of the Minnesota Franchise Act.

In Pooniwala, the court denied the franchisee’s motion for preliminary injunction and ordered it to go ahead with its post-termination obligations, such as removing the franchised brands’ signage. The court found that, given the many QA inspection failures at the two hotels, and the fact that the franchisees had continuing franchise relationships with Wyndham Hotel Group affiliates at other hotel properties, the franchisee did not demonstrate an adequate likelihood of success of proving that the termination was without good cause. Further, the court held that, while the franchisee would suffer obvious harm through loss of the franchise rights, the franchisors were also suffering continuing, irreparable harm as long as the franchisee’s hotels continued to operate under their trademarks while not maintaining brand quality standards.

Conclusion. Hotel franchise agreements typically provide for substantial liquidated damages if the franchisor terminates for cause, meaning that the Pooniwala franchisees are likely to owe hundreds of thousands of dollars. In other franchise cases, the terminated franchisee may be forced to cease operating a similar business due to a covenant not to compete.

The stakes are high, and franchisors can expect a fight. So if they decide to take the drastic step of terminating for cause, they had better have their “ducks in a row.” In Pooniwala, the Wyndham Hotel Group franchisors showed how this is done.

 Nicholas Cintron, a law clerk at the firm and a 2016 J.D. candidate at Wake Forest University Law School, contributed to the preparation of this article.

Can you grant a franchise to an “illegal alien”?

June 19th, 2014

Today the CEO of an residential services company (handyman, cleaning, etc.) posted the following question on the American Bar Association’s Forum on Franchising’s email LISTSERV:

“What are the laws regarding licensing franchises to illegal aliens? What other considerations need to be reviewed before taking such a step?”

I was so facinated by his question that I spent some time looking into it myself.   My conclusions were as follows:

Based on my brief Internet research there is not any obvious legal restriction, generally, on doing business with people who do not have a legal immigration status.  However, a couple of concerns come to mind:

  1. Is it conceivable that the franchisee could be considered the franchisor’s employee, in any sense?  Government agencies have been aggressive in challenging independent contractor classifications in a variety of areas, so if the franchise owner actually provides a lot of the services offered in a business (such as cleaning or home renovations) then it is not hard to imagine ICE taking the position that they are “employees in disguise” and that a franchisor that knowingly recruits such a person is violating the employment-based restrictions on hiring “illegal aliens”.
  2. If you know that a person is in the country illegally, then arguably you have a duty under the various franchise disclosure laws to inform the person that he or her illegal status may result in loss of the entire investment in the business.  In particular, because the franchisee has to comply with all laws, including obtaining a legitimate tax identification number and paying income taxes, if the franchisee cannot obtain a tax ID number due to lack of immigration status then compliance with the franchise agreement is impossible.
  3. If the franchisor grants a franchise to someone knowing that, due to immigration status, he or she will have to avoid paying taxes, then isn’t the franchisor participating in tax evasion (or at least “aiding and abetting”)?   This would a particularly precarious position for the franchisor if it is at all involved in billing and collection from customers and then remitting net proceeds (after royalties) to the franchisee, since the franchisor is then actively involved in handling funds that it knows are not being reported to the IRS.
  4. If the franchisee cannot obtain an employer ID number because he or she doesn’t have a social security number, then the franchisee won’t be able to comply with the employment laws in hiring workers.  Franchisee probably would try to get around this by hiring “independent contractors” and paying them in cash, since this franchisee isn’t reporting taxes anyway.  If the franchisor knows about all of this and lets it go on indefinitely, wouldn’t a plaintiffs’ lawyer pursuing a class-action misclassification case (like in the Coverall case) come after the franchisor too, as “joint employer”?

In short, the potential derivative liability for the franchisor in this scenario is daunting.  I suppose that, if your franchise system is simple and low-cost and is attractive to immigrants, you would be best off just not asking for a social security number or any other information that could reveal a prospect’s immigration status.  If you don’t have actual knowledge or a reason to know about the person’s status, then it seems like the risk would be vastly reduced – particularly if the franchisee is simply paying a flat periodic fee and the franchisor has little involvement in the details of the franchisee’s operation.

Bottom line:  In this scenario it is the franchisee’s responsibility to comply with immigration laws, and in the U.S. an undocumented person is taking a significant risk investing in a franchise (or any other business).  However, as shown above, if you are franchising a business of any substantial cost or complexity, it is probably in your best interests to avoid granting franchises to a person who lives in the U.S. but cannot demonstrate a legal right to do so.

Appeals Court Upholds “Silent Fraud” Jury Verdict under Franchise Investment Law

June 10th, 2014
David Cahn

David Cahn

Take-away: If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee. Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.

The case: A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.

The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.

As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.

None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD. In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.”   In fact, neither statement was accurate.

The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation. However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.

After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.” The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.

In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation. The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.

Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:

Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.

The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD. Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.

The appellate court agreed with the jury, not the trial judge.

There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision. However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury. As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.

In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD – particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.

For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)

That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor. It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.

Restaurant and retail franchisors: could this be you in 2014?

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!

How Can You Know If Your Business Is Ready To Franchise?

January 2nd, 2014

David Cahn

David Cahn

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.

  1. Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
  2. 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.
  3. 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.

Conclusion

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.