Tag: investigation

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.

Hashim and Walker Provide Valuable Insight on Franchise Agreement and Relationship Priorities

May 20th, 2013

David Cahn

David Cahn

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.

Talking to Your Competitors Can Be Risky

September 13th, 2011

Talking to your competitors can be risky

Criminal Price-Fixing Conspiracy Convictions Highlight Dangers

Two recent guilty pleas announced by the U.S. Department of Justice’s Antitrust Division highlight an underappreciated area of serious legal liability – price coordination in violation of the Sherman Act.

On August 24, 2011,the Justice Department announcedthe guilty plea of Great Lakes Concrete, one of four Iowa companies that sell “ready-mix concrete” for construction projects and have plead guilty to reaching agreements regarding their respective price lists and project bids and then accepting payment for those sales at prices artificially increased due to collusion. The press releaseemphasizes the maximum fine that may be imposed for the conviction, which is the greater of $100 million, twice the gain derived from the crime or twice the loss suffered by the victims of the crime. In addition, the president of Great Lakes Concrete was sentenced to serve a year and a day in prison.

On August 31, 2011, the Justice Department announced a guilty plea by a California company, Sabry Lee (U.S.A.) Inc., in “a global conspiracy to fix the prices of aftermarket auto lights.”The company is the U.S. distributor for a Taiwan producer of the auto lights, which are most commonly installed in vehicles after collisions. The alleged conspiracy was apparently between several Taiwan based manufacturers of auto lights and their U.S. distributors, who “met and agreed to charge prices of aftermarket auto lights at certain predetermined levels” and “issued price announcements and price lists in accordance with the agreements reached, and collected and exchanged information on prices and sales of aftermarket auto lights for the purpose of monitoring and enforcing adherence to the agreed-upon prices.” Executives of two of the U.S. distributor companies have pled guilty to price-fixing charges, and the second ranking officer of one of the Taiwan manufacturers was arrested in the U.S. and has been indicted.

While the press release leads one to believe that the executives in these cases knowingly intended to fix prices at artificially high levels, it is quite possible that at least some of them were not completely aware of the legal implications of their conversations. However, any communications between competing companies concerning prices are legally risky.

The Takeaway: Business people should seek pricing intelligence from customers, service providers, or independent websites — but not from direct communications with their competitors. This is particularly true for industries in which formal competitive bidding is common or in which a relatively small number of companies make a large percentage of the total sales.

Beyond that basic rule, certain types of communications and collaborationsbetween competitors are permitted and even encouraged by U.S. antitrust law. Each situation needs to be analyzed based on the particular facts and reasons for your collaborative effort.

Franchisee Selection from Both Sides of the Table — conclusion

August 13th, 2010

The final installment in this series focusses on the Franchisor’s selection of franchisees.

Evaluation of Franchise Prospects by Franchisors

 In the recent economic climate, franchisors have been tempted to ease their qualifications for new franchise prospects. However, franchisors need to remember that they are investing in their franchisees just as much as their franchisees are investing in them, and must resist compromising their brand’s long-term growth for short-term cash flow.

 The following considerations are frequently cited by industry experts as fundamental criteria for evaluating prospective franchisees. Regardless of the economic conditions a franchisor may be facing, it should remain loyal to these fundamental principles for determining the viability of candidates:

  • Ability to learn and follow the franchisor’s system;
  • Fitting with the franchise system’s “culture”;
  • Having relevant business experience or general business acumen;
  • Being located in a geographic and demographic area that favors the franchise concept;
  • Having access to capital; and
  • Having grounded and realistic expectations.

 While the specific traits and skills needed to succeed in any particular franchise system obviously will vary, these fundamental requirements can generally be applied broadly across all franchise systems, regardless of the industry they are in.

 The need to select quality prospects as franchisees is particularly important for new and early-stage franchisors, though it obviously remains critical for highly-developed franchise systems as well. While one “bad apple” may not be as detrimental to the brand image or the ability to sell franchises for larger systems, unsuccessful franchisees can cause significant administrative burdens, and quite possibly legal fees, for franchisors of all sizes. Signing an under-qualified franchisee as one of the first non-affiliated representatives of a franchise system may have dire effects on a new system’s ability to attract qualified franchisees. When counseling prospective franchisees, we recommend that they speak with as many existing and former franchisees as possible when performing their due diligence, and one or a few franchisees who are unhappy or unsuccessful, or who are simply unimpressive as people, can impact a prospect’s view of the franchise system as a whole.

By carefully screening and interviewing franchise prospects, franchisors can protect the quality and value of their franchise systems, enhance their ability to sell additional franchises, and avoid the headaches of franchise terminations and legal disputes. We regularly counsel our new franchisor clients that selecting quality franchisees must be a top priority for their long-term success.

Individual franchised outlets and franchise systems as a whole stand a greater chance of success if they are built around committed franchise owners who trust and believe in the franchisor and everything it has to offer. Franchisees and franchisors both benefit substantially when they carefully evaluate each other during the pre-sale courting process.

Franchise Selection from Both Sides of the Table — part 2

August 6th, 2010

Part 2 of this series focuses on how a prospective franchisee should investigate a specific Franchise Opportunity, after narrowing focus through self-evaluation:

After examining your capabilities and ambitions, the next step is to perform your due diligence and fully investigate the franchise opportunity you are considering. In addition to researching the opportunity directly, this also involves investigating competitive opportunities to make sure that the one you choose is the best fit for you. You should carefully read the franchisor’s Franchise Disclosure Document (“FDD”), and you should prepare questions and talk with the franchisor’s representatives regarding any issues or concerns you may have.

You also should contact existing franchisees to find out how their business is doing and what they feel the benefits are of being involved with the franchisor’s system and brand name. Franchisors are often willing to “assist” with this process, by referring prospects to their most successful franchisees. What may go overlooked, however, is the opportunity to gain information from former franchisees. The third table in Item 20 of the FDD provides valuable information concerning former franchisees. Franchisors are required in this table to list the numbers of terminations, non-renewals and reacquisitions during each of the three prior calendar years, as well as the number of franchisees who “Ceased Operations – Other Reasons”—which often means that the franchisee was simply forced to close their doors because they were unable to turn a profit. In addition, franchisors are required to provide contact information for all current franchisees and former franchisees who left the system during the past year. Both current and former franchisees can provide first-hand insight into numerous qualitative aspects of a franchisor’s system.

If the franchise system has been in existence for at least five years, also consider researching the availability of existing franchises through the Internet. It is a bad sign if many franchises are for sale and at low prices. It is a good sign if relatively few are for sale and at high prices. If you find no information through the Internet on this topic, then you should ask franchisees in locations near you about purchasing their business; and, if they express interest, pursue the topic to see their level of interest in “getting out” and their reasons for wanting to do so.

Other, often overlooked, aspects of a franchise system that can ultimately have a significant effect on franchisees’ profitability include supply and purchase arrangements established by the franchisor. A powerful purchasing cooperative can significantly improve a system’s franchisees’ bottom line. Among the required disclosures in the FDD, franchisors are required to state in Item 8 whether they receive rebates or commissions based on franchisees’ purchases of goods and services from suppliers. In a successful franchise system, the bulk of the franchisor’s revenue should come from franchisee royalties, and not from franchisees’ mandatory purchases from outside vendors. Moreover, quality franchisors do not force their franchisees to pay a premium over the fair market price for ingredients and other products central to the operation of the business.

Finally, is equally, if not more important to your potential for long-term success, to look beyond the FDD and the franchise system’s historical performance, and evaluate the current and future market for the franchisor’s goods or services. Just because you have a strong interest in a particular field or product and fall in love with a franchisor’s system and business methods does not mean that the general public will do the same. In addition, while joining a regional, national or international franchise system typically will have immediate name-recognition benefits, this may not be the case with a newer or smaller franchisor. If the franchisor’s name has little or no value, and the franchisor’s system is not unique or distinctive from the competition, then you should consider whether their franchise is worth the investment.

Franchise Selection from Both Sides of the Table — part 1

July 30th, 2010

A successful franchise relationship requires commitments and dedication on both sides of the table. Ultimately, franchisors and franchisees alike benefit from the franchisee’s operations only when those operations are profitable. Success in franchising requires matching the right franchise prospect with the right opportunity.

This series of posts discuss steps to be taken by franchisees and franchisors to help guide them to matches with real possibilities for success.

Self- Evaluation Comes First for the Prospective Franchisee

When evaluating the purchase of franchise rights and ultimately selecting a particular opportunity to pursue, a prospective franchisee should use a deliberate process that examines your personal aspirations and capabilities, and then the value and benefits associated with particular franchise opportunities in your geographic market.

Preliminary Self-Evaluation

Many prospective franchisees get caught up in the dream of owing their own business or in the hype of a franchisor, and they may rush into an opportunity without truly evaluating their own capabilities and the long-term consequences of entering into a franchise relationship. Before diving into evaluation of individual franchise opportunities, you should ask yourself questions like: “Am I prepared to take on the risks and stresses of owning a business?” and, “Am I ready for the long-term time commitment of owning a business?” In addition, while many entrepreneurs may say that, from an ownership perspective, “a business is a business,” when selecting a franchise opportunity that will become and support your livelihood, you should carefully evaluate what industries match your skills and interests. While building toward an exit strategy may be your ultimate goal, you will have a much greater chance at success if you enjoy working in the business that you are growing.

Equally important with answering these basic questions is making sure that you have the funds necessary to finance the business’s development and to support you and your family through the initial stages of operations. There are several financing methods available to start a new business, and some franchisors offer financing of the initial franchise fee. You should investigate all of your financing options and choose the one that makes the most sense for you. In addition, determining how well your franchise needs to do for you to make a satisfactory living should involve a critical analysis of your unique circumstances and the historical performance of the franchise system: How much money do you need to be able to pull from the business? What have other franchisees told you? What information were you able to obtain from the franchisor? What have financing companies said? What have you figured out in your business plan? Analyzing the answers to all of these questions will be critical to determining whether you will be able to succeed as a franchisee.

If the initial investment will be over $100,000, you should seek an SBA-guaranteed bank loan, not only because it can be a good form of financing, but also because the loan officer will provide valuable feedback on whether the particular franchise under consideration is a path you should pursue. It is true that many large banks will not make loans for start up businesses, even those backed by a franchise. However, iIf a bank funds start-ups in the franchisor’s industry, but dismisses your application out of hand, then perhaps you should consider alternate opportunities.

Next week’s post will discuss investigation of specific opportuntites by a prospective franchisee who has complete his or her self-evaluation.

Lessons for Both Sides of the Table from the Recent Jackson Hewitt Franchisor Liability Cases

June 16th, 2010

Even in the best of franchise relationships, franchisors must be wary of litigation and potential liability arising out of their franchisees’ business operations. Where a franchisor imposes and exercises substantial controls over its franchisees’ operational and administrative methods and procedures, the franchisor may well find itself a defendant in lawsuits brought by customers and employees of its franchised outlets, claiming that the franchisor’s exercise of control makes it liable for its franchisees’ negligence or misconduct.

Two recent cases involving employee and customer claims against Jackson Hewitt shed light on this issue. In one case, a customer of a Jackson Hewitt franchised tax center in Louisiana filed suit against the franchisor based upon a privacy breach committed by the franchisee. In the other, an employee of a Jackson Hewitt franchise in Pennsylvania sued the franchisor for sexual harassment based upon the alleged actions of certain owners and managers of the franchise. In asserting their claims against the franchisor, both plaintiffs relied heavily upon language in Jackson Hewitt’s franchise operations manual and other documentation, and also the direct involvement of Jackson Hewitt representatives in the operations of its franchisees. The courts in both cases were willing to consider the plaintiffs’ claims against Jackson Hewitt despite clear admonitions in the Franchise Agreement and Operations Manual that the franchisee and its employees “shall not be considered or represented [by the franchisee] as [Jackson Hewitt’s] employees or agents” and that franchisee has exclusive responsibility over hiring and matters relating to personnel.

Jackson Hewitt provided its franchisees with detailed mandatory policies and procedures for center operations. It required all franchisees to provide customers with a copy of the “Jackson Hewitt Privacy Policy” promising that the confidentiality of personally identifying information (e.g., social security numbers) would be safeguarded. It also provided franchisees’ employees with a Code of Conduct, which made no reference to the existence of franchises, and which included numerous references to the reader as an “employee” of Jackson Hewitt. Jackson Hewitt also operated an Intranet site through which franchise employees could apply for employment positions with other Jackson Hewitt offices, could obtain Jackson Hewitt policies, and could communicate with Jackson Hewitt representatives. In addition, franchise employees were directed to call Jackson Hewitt’s corporate office to resolve issues with tax returns. All of these factors weighed in favor of establishing a sufficient level of control over franchisees’ operations to impose liability on Jackson Hewitt. The court also found significant control in the Jackson Hewitt system relating to training and termination of employees of the franchises.

The conclusion to be drawn from the Jackson Hewitt litigation is that franchisors are essentially presented with two options when drafting their franchise agreements and operations manuals. The first option is to impose significant operational controls over their franchisees’ operations, similar to those described above, and assume the attendant risk of facing liability for third-party claims arising from actions taken in accordance with the operational mandates. The other option is to limit the franchise operations manual to providing examples, general guidance and non-mandatory recommendations for operating procedures and specifications.

The first approach allows franchisors to impose greater control over, and have more say in, their franchisees’ operations—which is an attractive proposition for many franchisors. In addition, franchisees may perceive greater value in a franchise system that provides strict operating standards and procedures, which may help to distinguish the franchisor from competing brands. If the franchisor chooses this approach, it should consider increasing the minimum policy limits required for franchisees’ insurance policies and the types of required policies. It may also want to explore direct insurance coverage for the franchisor for all claims arising from franchised operations.

The advantages of the second option are demonstrated by a recent court decision from Illinois, Braucher v. Swagat Group, LLC, Bus. Franchise Guide (CCH) ¶ 14,355 (Mar. 19, 2010), in which Choice Hotels International, Inc. avoided liability in a wrongful death claim for the alleged negligence of one of its franchisees in maintaining its indoor swimming pool and whirlpool. Choice provided very limited operational guidance and controls with regard to swimming areas, and this approach allows a franchisor to avoid potential liability associated with imposing mandatory operational controls over franchises. However, it also carries the potentially negative business implications of allowing franchisees a measured level of discretion in running their businesses under the franchised brand. The term “measured” is important, because the franchise agreement should still include rights of termination or other remedies for acts or omissions that have the potential to cause material detriment to the franchise system’s goodwill. In addition, franchisees may view a franchisor that employs this approach as providing very little in terms of affirmative guidance and support, not acknowledging that the information and non-binding recommendations of a franchisor can provide value in and of themselves, irrespective of whether compliance is deemed mandatory.

A prospective franchisee can also glean guidance from the information provided above. When evaluating a franchise opportunity, a prospective franchisee should seek to review the franchisor’s operations manual, even if its table of contents is provided in the Franchise Disclosure Document (“FDD”). It is acceptable for a franchisor to require the prospect to sign a non-disclosure agreement with regard to the Manual. If the operations manual provides detailed mandatory specifications and procedures, the prospective franchisee should be wary of the likelihood that the franchisor will pursue rigorous enforcement, to account for the assumption of the significant liability risks described above. While the “deep pocket” franchisor’s potential “joint and several” liability for third-party claims may seem like a benefit to the franchisee, the prospect should be aware that indemnification and contribution provisions in the franchise agreement is likely to shift the ultimate financial burden back to the franchisee, unless it can prove that the franchisor’s actions caused the third party’s claim.

If the operations manual provides only examples and recommendations for franchisee policies and operational procedures, as opposed to detailed mandates, the franchisor may be attempting to avoid any direct performance obligations to its franchisees, or it may simply be attempting to limit its exposure. In performing its due diligence, a prospective franchisee should attempt to gain as much information as possible from the franchisor and its active franchisees to discern the quality and operational support the franchisor actually offers.

The operations manual and other forms and operational materials can be valuable tools for franchisors and franchisees alike. But, depending on how they are written, they can expose the franchisor to liability and raise serious questions in the minds of franchisees as to the benefit to be derived from subscribing to a particular franchise. Parties on both sides of the table should be sure to carefully evaluate these documents to ensure that they serve and meet their needs and expectations.