Tag: registration

“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.

Severe Consequences for Franchisor Executives: Personal Liability and Non-dischargeable debt

July 16th, 2013
David Cahn

David Cahn

“Do not pass Go, do not collect $200” is a phrase we all remember from the childhood game Monopoly. Like Monopoly, state franchise sales laws have rules and regulations that must be followed. A franchisor’s failure to follow these basic procedural rules for selling franchises can result in self-destruction.

On December 10, 2012, a decision in the case of In Re. Butler demonstrated a strict approach on the policy and procedures that a franchisor must follow for selling a franchise. The U.S. Bankruptcy Court sitting in North Carolina ruled that the owners of a franchise were personally liable to a franchisee for $714,000 plus interest in damages for violating the New York Franchise Law. The court further ruled that the franchise owners’ liability was non-dischargeable in bankruptcy.

Michael and Kathy Butler opened a small retail store to serve the marketing needs of small businesses. After much success, the Butlers formed PRS Franchise Systems LLC (“PRS”). Based in North Carolina, PRS Franchise handled all of the franchising for the PR Stores. PRS had obtained a one year license from New York to sell franchises to its residents, but subsequently PRS did not renew its New York registration on an annual basis.

In 2007, John Mangione, a New York resident, expressed interest in purchasing 20 PR Store franchises in the New York area. Because of Mangione’s interest, PRS submitted an application to renew its registration to sell franchises in New York. Before receiving approval of its renewal application, PRS sold 20 PR Store franchises to Mangione and received $716,000 in initial franchise fees between April and July 2007.

The franchise relationship was not to Mangione’s satisfaction, most of his PR Store locations were unsuccessful, and he ceased operating them by 2009. The Butlers also had a reversal of fortune and by 2009 they had dissolved PRS and filed for bankruptcy.

The Butlers argued that they were permitted to engage in franchise sale transactions while the application of renewal for registration was pending under New York Law. The court rejected this argument on the grounds that, while New York law does permit franchisors to sell franchises while renewal applications are pending, the law also requires the franchisor to give the buyer its last registered offering prospectus (also commonly known as the franchise disclosure document, or “FDD”), escrow the franchise fees paid in a separate trust account and then, once the renewal application is approved, provide the franchisee with the approved new prospectus and an opportunity to rescind the franchise agreement and have the fees returned. The court stated that even if PRS’ application was timely, PRS failed to escrow the initial franchise fees, provide Mangione with the registered prospectus after its approval in August 2007 and offer rescission as required by New York law. Instead, shortly after receiving initial franchise fee payments, PRS distributed the funds as sales commissions to its broker and as salaries for the principals of the company – the Butlers.

Because the Butlers directly engaged in the unlawful sale of the franchises to Mangione, and profited personally from his payments, the court found that the Butlers were personally liable to Mangione. The court stated that the remedies for an unlawful offer or sale of a franchise are: 1) rescission of the Franchise Agreement, 2) damages with 6% interest from the date of the transaction, and 3) reasonable attorney fees and costs. Therefore, the court found that Mangione was entitled to rescission of the franchise agreements and return of the $714,000 paid by him, plus 6% interest from May 7, 2007.

The next issue that the court addressed was whether the Butlers’ debt was dischargeable in bankruptcy. According to the court, a debtor’s debt is non-dischargeable if the money is obtained by “false pretenses, a false representation, or actual fraud.” The court found that the Butlers’ committed fraud by misrepresenting to Mangione that PRS had the legal right to sell franchises in New York, even though its registration was only pending, not approved. The court further stated that a debtor’s debt is non-dischargeable “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” The court stated that a debtor must prove: 1) the debt arose while the debtor was acting in a fiduciary capacity, and 2) the debt arose from the debtor’s fraud or defalcation. In this case, the court found that the Butlers’ failure to escrow the franchise fees, and their failure to return the funds to Mangione, each amounted to defalcation.

This case demonstrates the danger to the franchisor’s executives if their company fails to follow franchise sales rules. A violation of such rules can, without additional evidence of factual fraud or misrepresentation, result in those executives being held personally liable to the franchisee and being unable to obtain a discharge of that judgment in their personal bankruptcy proceedings.

AUTHOR’S NOTE: THIS POST WAS CO-WRITTEN BY KATELYN P. VU, A SUMMER ASSOCIATE AT WHITEFORD TAYLOR & PRESTON AND 2015 J.D. CANDIDATE AT UNIVERSITY OF BALTIMORE LAW SCHOOL

Is That Really My Problem? Case Highlights Need to Verify Franchise Disclosure Data

November 7th, 2011

A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.

Misrepresentations in Franchise Disclosures

The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.

In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.

The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”

The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.

Jurisdiction in Maryland and Application of New York Franchise Sales Law

The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.

Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.

The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.

The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.

The takeaways:

(1) Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.

(2) If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.

(3) New York needs to amend its law to exempt out of state franchise sales from its registration requirements.

Michigan Case Opens Door for Franchise Law Claims by Insurance Agents

April 28th, 2010

A recent case out of the United States District Court for the Eastern District of Michigan has opened the door for insurance agents to bring claims under the Michigan Franchise Investment Law (“MFIL”). Parting from clearly established precedent in other jurisdictions, the court held in Bucciarelli v. Nationwide Mutual Insurance Co., Bus. Fran. Guide (CCH) ¶ 14,200 (2009), that a Nationwide insurance agent would qualify as a franchisee under the MFIL if it could demonstrate that payments made to Nationwide for allegedly-overpriced furniture and computer equipment constituted a franchise fee.

This decision contrasts with the law in many other jurisdictions, including Florida, Illinois, Missouri, New Jersey, New York and Virginia, in which the courts have held that their states’ franchise laws do not apply to the insurance industry.

Bucciarelli, the plaintiff, was the sole owner of a Nationwide insurance agency located in Michigan, pursuant to an Independent Contractor’s Agent Agreement signed in 2002. Following a series of changes and new implementations in the Nationwide product offerings and independent agent system, Bucciarelli alleged that the Nationwide customer base began to erode, and certain performance goals and other standards for independent agents became unachievable. Based on these allegations, Bucciarelli filed suit against Nationwide claiming, among other things, deceptive trade practices in violation of the MFIL.

State franchise laws commonly provide that, in order to be deemed a “franchisee,” a party must have the authority to offer the franchisor’s products or services for sale. Nationwide argued, and other courts have held, that in order to “offer” products or services, the offering party must have the capability to actually enter into a contract for the proposed sale. In the insurance industry, policies are entered into by the insurance company (e.g., Nationwide) directly, and the independent insurance agents act as commissioned salespersons on behalf of the insurer. Thus, the decisions holding that state franchise laws do not apply to independent insurance agents have generally rested on the theory that insurance agents are “mere order takers,” who contractually cannot actually “offer” insurance products to customers, and therefore cannot qualify as franchisees under the states’ statutory schemes.

However, the court in Bucciarelli held that the actions of independent sales agents may qualify as making an “offer” under the MFIL. The court rested its decision on the fact that the MFIL’s definition of a franchise refers to both the ability to “offer” and to “sell,” and stated that if “offer” were given the meaning prescribed in other jurisdictions, then the word “sell” would be duplicative. As a result, the court interpreted “offer” much more broadly, “to refer to making goods or services available in a practical rather than a legal sense.” Under this interpretation, the court held that an insurance agent could satisfy the statutory elements of the franchise definition. Interestingly, the Maryland Franchise Registration and Disclosure Law also includes this offer/sale dichotomy, and further distinguishes and includes “distributing” the franchisor’s products or services within the franchise definition.

As Nationwide did not dispute that Bucciarelli had the right to substantially associate his business with the Nationwide trademark, the only issue that remained was to determine whether Bucciarelli had paid a “franchise fee” to acquire his Nationwide insurance agency. While the Independent Contractor’s Agent Agreement did not suggest that such a fee had been paid, Bucciarelli’s argument that his purchase of allegedly over-priced furniture and computer equipment from Nationwide satisfied the “franchise fee” requirement was sufficient to get his MFIL claim past Nationwide’s pre-trial motion to dismiss.

While the particular factual scenario in this case only has relevance if the agent will be purchasing physical assets from the insurance agency, the legal analysis applied by the court has the potential to have a sweeping impact in states like Michigan and Maryland where the insurance industry may now be subject to franchise disclosure laws. Though it remains unlikely that franchise implications will arise where the agent does not make any payments to the insurance company in connection with taking over an existing agency, where the agent does make payments—even in exchange for equipment or training—the payments have the potential to be classified as indirect franchise fees. In such cases, the parties’ relationship may now fall within the relevant state statute’s “franchise” definition.

By: Jeffrey Fabian

Area Representative Disclosure Obligations In Flux

January 28th, 2010

By David Cahn & Jeffrey Fabian

The relationships involved in two- and three-tiered, multi-unit franchise expansion models raise difficult compliance questions under the Federal Trade Commission (FTC) Franchise Rule (“FTC Rule”) and the various state franchise registration and disclosure laws. Failure to properly disclose all parties involved in the franchise sales process, including intermediate parties, can lead to civil liability, fines and cancellation of franchise agreements.

Franchisees involved in multi-unit expansion typically fall into one of three classes. “Area Developers” are typically a franchisee who is granted the right to open more than one franchise in a defined territory in accordance with a development schedule, as a “multi-unit developer.” Area Developers of this type do not have any franchise disclosure obligations. “Master franchisees,” also known as “Sub-franchisors,” recruit and enter into franchise agreements directly, and pay fees to the franchisor out of the amounts they collect from their franchisees; these parties must issue an FDD and register as franchisors in states that require such filings. The third category, “Area Representatives” or “Development Agents,” are sub-contractors of franchisors, acting as sales agents and performing some post-sale obligations on the franchisor’s behalf in a defined geographic area in exchange for a percentage of franchise fees paid by franchisees in the assigned area. The disclosure and registration obligations concerning Area Developers have created uncertainty in the law.

A recent case still pending in the Washington State court system demonstrates the complexities and obscurity surrounding the registration and disclosure obligations of franchisees involved in a franchisor’s multi-unit expansion efforts. Pinchin v. Nick-N-Willy’s Franchise Pizza Company, LLC involves a franchisee’s claim for rescission of its franchise agreement based upon the franchisor’s failure to disclose its relationship with an area representative who “played a role” in recruiting the franchisee into the Nick-N-Willy’s system. The franchisor’s FDD did not reference the area representative, and the area representative did not prepare his own FDD. The court determined that the area representative was required to be disclosed in the franchisor’s FDD and to independently register as a “subfranchisor” with the Washington Securities Division. As a result, the court awarded the franchisee “rescission” of the franchise agreement, meaning that it was released from all obligations in the agreement (including the covenant not to compete) and granted the right to obtain a refund of all amounts paid to the franchisor, and possibly additional damages to compensate for its losses due to pursuing the franchise. The case is still pending solely for a determination of the franchisee’s monetary damages award.
Under the FTC Rule only true “Sub-franchisors” who enter into agreements with franchisees must prepare their own FDDs. It appears that the area representative relationship in Nick-N-Willy’s is not a subfranchise under the FTC Rule, but the court determined that the area representative was obligated to register as a franchisor under Washington law.

According to Dale Cantone, chair of the Franchise and Business Opportunities Committee of the North American Securities Administrators Association (“NASAA”) and Deputy Securities Commissioner in Maryland, that committee is studying the issue of the disclosure and registration duties of Area Representatives and hopes to provide additional guidance to the states in the near future. Such guidance would be helpful in clarifying an uncertain area of franchise sales law.

In the meantime, however, the Nick-N-Willy’s case is a warning shot directed at franchisors and area representatives who fail to disclose their relationship to prospective franchisees. In states like Washington where the definition of a “subfranchisor” is arguably broader than the definition under the FTC Rule, area representatives may face registration obligations. Franchisors and their development agents in the field should carefully consider whether the area representative’s information should be included in various portions of the Franchisor’s FDD used in the area representative’s state, since such disclosures may be required by the FTC Rule.