Franchising in the United States during 2017 experienced somewhat ‘mixed’ results, and while continued growth can be reasonably anticipated for 2018, some concerns still remain. While US gross domestic product (GDP) increased by approximately 3.2 per cent during 2017, increased GDP in the US franchising field during that period was almost 2 per cent higher. Fast food (as usual) and personal services were at the top of the franchising heap in 2017 (especially in the more temperate climate areas), but the potential for government restrictions on immigration may prove to be problematic as restaurateurs search for other sources to fill staff needs.
Savvy real estate developers anticipate a downturn in the domestic retail market as a result of the emergence of internet sales as the prime competitive factor for that portion of consumer spending that had previously found its way into the cash registers of franchised retail outlets. Some reports have predicted that as many as 20 per cent to 25 per cent of shopping centres in the United States, about 275 in total, will close within the next five years. If this prediction proves to be accurate, US franchising is certain to be negatively impacted.
Despite these hurdles, the United States franchise industry remains, and is likely to continue to remain, the most vibrant in the world and is the favoured destination for entrepreneurs, worldwide. The US franchise market is complex and challenging, but for both domestic and international companies that hope to achieve brand recognition and to maximise growth and expansion, it is the one market that cannot be ignored and must be explored.
II MARKET ENTRY
i Restrictions and factors applicable to market entry
Many international franchisors salivate at the opportunity to enter the US franchise market, because it has the largest consumer market in the world. However, foreign franchisors considering entering the US market would be well served to approach this decision carefully and strategically, because entering the US franchise market is a costly and extremely complex process. Non-US franchisors must navigate an intricate framework of federal and state franchise disclosure and registration laws, accounting standards that require strict transparency, the requirements for state registrations, regulations covering advertising, trademark protection and common law torts, as well as employment law and tax law issues. International franchisors must also take into consideration the multicultural differences between the country from which the franchisor originates and US culture; barriers between the language of the franchisor’s native country and the US English language; the fierce competition that the franchisor may face in the US franchise market; and the difficulty in developing brand awareness in such a large territory.
While foreign franchisors do not generally face governmental restrictions when entering the US franchise market, there are certain industries or businesses that, because of the nature of their business, are statutorily required to make certain disclosures or that are subject to foreign investment limits, particularly businesses that have a potential impact on national security (e.g., technology, weapons manufacture, maritime industries, aircraft, banking, energy resources, etc.) Since franchise opportunities rarely involve industries that could impact national security, such restrictions are not usually applicable to foreign franchisors seeking to operate in the United States. With respect to real estate, there are no restrictions in the United States on foreign owners, including franchisors, owning real property in the United States. Under federal law, foreign owners of US real estate that is ‘effectively connected’ to a US trade or business are subject to the same tax restrictions and obligations as domestic owners.
When a foreign franchisor elects to enter the US market, the franchisor should amass a team of advisers, including accountants and attorneys (as well as knowledgeable US franchise counsel) to put together a comprehensive franchise programme that will establish, among other things: (1) the proper corporate structure for the franchisor and its affiliates; (2) the method by which the franchisor will market its franchises (e.g., whether through direct franchising, area development arrangements or master franchise opportunities, or a combination of the three approaches, to investors or franchisees); and (3) the form of franchise documents that prospective franchisees will be required to sign upon purchasing a franchise or multi-unit development rights.
ii Foreign exchange and tax
An important factor that franchisors looking to enter the US market must consider is the tax implications on cross-border franchising from both the franchisor’s native country and the United States. Because of the complexity of the US tax code, it is strongly advised that a foreign franchisor entering into the US market consult with accountants and other financial advisers who specialise in US tax law, to clearly understand the impact that the US tax laws will have on its franchise business. Any tax implications that a franchisor may face will strictly depend upon the structure of the franchise that it elects to utilise to establish its brand in the United States. Non-US franchisors looking to enter the US market will have to decide which corporate structure best addresses its needs. Most foreign franchisors will either grant master franchise rights for the entire US territory or establish and operate a US-based wholly owned subsidiary that will offer and sell single unit franchises or multi-unit development rights to designated geographical areas within the United States. However, they may choose to enter into a joint venture with a business partner or engage in direct cross-border franchising. Regardless of the franchise structure that a foreign franchisor uses, it is imperative that the franchisor understand and abide by the applicable US tax laws. The failure to abide by the applicable tax laws or treaties that accompany each structure can result in substantial fines or even, in unusual cases, imprisonment (see Section V).
Other than the requirements of the Office of Foreign Asset Control (OFAC) (which may limit or prohibit payments to certain restricted persons or jurisdictions subject to economic or trade sanctions), US law does not generally impose any exchange control restrictions on the transfer of money by a US-based franchisee to a foreign franchisor, so long as the overseas franchisor and the franchisor’s country of residence are not subject to any US economic sanctions. However, under the Bank Secrecy Act, a US financial institution that wires payment in excess of US$10,000 must comply with certain reporting requirements.
III INTELLECTUAL PROPERTY
i Brand search
While the franchisor having a proven business model with clearly defined procedures and operating guidelines is an important factor in purchasing a franchise, part of the ‘franchise allure’ is the strength of the franchisor’s brand. Intellectual property is the cornerstone of a franchise system and, although intellectual property is an intangible asset, its value has a real impact on the franchisor’s likelihood of success. A franchisor’s intellectual property, including its trademarks, patents, trade dress (colour schemes and the ‘look’ of a brand), etc. are critical to how a customer perceives, identifies and chooses the franchisor’s goods or services over those of another brand. Therefore, brand identification is one of the most critical aspects of building a successful franchise.
A trademark is a word, phrase, symbol, tagline, design, drawings, the shape and packaging of goods, sound or scent (or a combination of the foregoing) that identifies and distinguishes the source of the goods of one party from those of others. A service mark identifies and distinguishes the source of a service rather than goods (the term ‘trademark’ is often used to refer to both trademarks and service marks).
Trademarks are registered at both the federal and state levels. The United States Patent and Trademark Office (USPTO) is the US federal agency responsible for granting US patents and registering trademarks. Individual states also have their own trademark registration offices. In addition, most states have registration requirements for business entities, and each entity must register its name (and often also any associated trade names, or ‘doing business as’ names) as part of the entity registration process necessary to conduct business within the state.
Unlike many other jurisdictions, in the United States, a party can also establish and acquire ‘common law’ rights to a trademark simply through usage of the mark in commerce. Common law rights to a mark, especially if it is in use prior to another party’s registration of that mark, can be superior to registration (provided that the registration is challenged properly). To secure common law rights to a mark, the mark is required to be used not only ‘first in time’, but also consistently in commerce, and not just on a casual or sporadic basis. While trademarks do not have to be registered, federal registration with the USPTO acts as ‘notice to the public’ of the franchisor’s claim on the mark, which creates a legal presumption of ownership nationwide, and the exclusive right to use the mark on or in connection with the goods or services detailed in the registration. Inherent in the owner’s exclusive right to use the mark, is the right to license the mark to third parties in exchange for payment. This exclusive right is generally granted for an initial 10-year period, but is perpetually renewable.
Once a franchisor has identified what it would like its trademarks to be (the ‘look’ and ‘feel’ of their branding), it must engage in a sophisticated and careful search (a ‘trademark clearance’ search), including an analysis of the internet, federal, state and local databases, etc., to ensure that its trademarks are indeed unique; that no one else has registered them; or that no one is otherwise using them (or whether any use is within the same industry or geographic area). In the case of trademarks, the USPTO has a searchable online database of registered trademarks (the Trademark Electronic Search System), a review of which should be the first step in searching for trademarks. This should allow the reviewer to ascertain if a desired mark is available for federal registration, or if some other party is already using the mark (or a similar mark). However, because local registration is also possible, each state, especially states in which a franchisor is planning to engage in business, should also be searched. Finally, because of the potential existence of common law trademark rights, internet searches and other methods of searching for competing usage of a mark should be performed, even if no ‘registered’ mark has been found. Most law firms that provide trademark registration services (as well as private search companies) can be hired to perform these types of trademark clearance searches. If a trademark clearance search reveals that there may be competing persons or entities with the same or a similar mark, a franchisor should carefully consider whether or not to try to register a mark. Under such circumstances, it may be more prudent to utilise a different, more distinctive and unique mark. In searching trademarks, it is important to remember the USPTO’s standard in electing to register a trademark. There cannot be a ‘likelihood of confusion’ between the franchisor’s proposed mark and those marks currently registered with the USPTO. If the marks are confusingly similar, then the franchisor should avoid using the proposed mark since the USPTO will more than likely conclude that the franchisor’s proposed mark is infringing upon another company’s trademark.
While trademark conflicts do arise, registration, especially with the USPTO, can significantly minimise risk. Since common law usage grants a trademark holder common law rights, the first person in time to utilise a mark generally has superior rights to all others. However, such rights are limited, including being limited by geographic area and by the industry in which the mark is utilised. Also taken into account is the fact that the possible difficulties of establishing such usage stand in contrast with the ‘bright-line’ registration offered by the USPTO. Once established, federally registered trademarks provide for national usage and clear protection for the marks ‘as registered’. Federal law grants enhanced legal remedies for federally registered marks. Further, once registered, the federal mark holder has a presumptive argument that it was first in time as of the date of its registration, and, if the mark has been granted, it is very difficult for a common law mark holder to overcome the federal registration.
An important factor to consider in selecting a trademark (besides its marketability) is how distinctive the mark is (referred to as the ‘strength’ of the mark), including how similar it may be to other marks, especially in the industry in which the services or goods are being offered. A ‘weak’ mark may (1) not be distinctive; (2) look confusingly similar to other marks; (3) contain generic terms; and (4) be merely descriptive of the goods or services. It is easier to obtain trademark protection for a strong mark, and a strong mark may be granted broader protection than will be provided for a weak one. Strong trademarks are inherently distinctive. Marks that include ‘made up’ or arbitrary words and phrases are more distinctive than marks that contain generic or descriptive words and phrases.
While trademarks are typically the most prominent type of intellectual property found in a franchise, a franchisor may have other intellectual property it seeks to protect, such as a unique process or invention it may wish to patent. Patents are registered on the federal level, again through the USPTO. A patent is a ‘limited duration property right relating to an invention’, granted by the USPTO. The USPTO has several searchable databases (such as PatFT, the Patent Full-Text and Image database). These databases can be searched to ascertain if any similar or identical patents have been filed. Patent law is a specialised legal practice in the United States, and franchisors should consult with attorneys who have passed the Patent Bar Exam if they need representation before the US Patent Office. However, if a franchisor is contemplating seeking patent protection, it ought to search generally, and on the USPTO’s websites (and early in the process), to see if a similar patent has already been granted (or rejected), as the case may be.
Trade secrets are a type of intellectual property that consist of a formula, practice, process, design, device, mechanism, instrument, pattern, technique, pattern, commercial method, compilation of information, sales or distribution methods, consumer profiles, advertising strategies, lists of suppliers and clients not generally known or reasonably ascertainable by others and that give a business an economic advantage over its competitors or customers. Trade secrets can include the ingredients to a restaurant’s ‘secret sauce’ or a computer program’s source code, to name just a few typical categories. Trade secrets are an invisible asset with great value to company owners, and therefore company owners will go to great lengths to protect their trade secrets and maintain their confidentiality. If you look at the term ‘trade secret’, the word ‘secret’ underscores the importance of the confidentiality of this kind of information. This is problematic in franchising, since the foundation of franchising is based upon giving franchisees access to this secret information to replicate the service or product being sold to customers. Therefore, the protection of this information will primarily lie in the terms and conditions of the franchise agreement, particularly the confidentiality restrictions imposed upon franchisees.
Trade dress is one of the least discussed intangible assets that many franchisors own. Trade dress refers to the packaging of a product and its overall appearance (including features such as size, shape, colours and colour schemes, and graphics) with respect to a certain product, restaurant or store atmosphere. Trade dress can be registered both federally and on the state level. Examples of trade dress include, the blue packaging used by Tiffany & Co, the 7-Eleven and Dunkin’ Donuts store concepts and the McDonald’s Happy Meal packaging. The probability of a franchisor registering its trade dress will increase if the franchisor can establish that the overall appearance of the product or service is distinctive. A search for trade dress can be conducted on the USPTO’s Trademark Electronic Search System or a franchisor can hire a law firm or IP search company to perform the search.
ii Brand protection
Once a franchisor has decided upon a trademark that it wishes to register, it must then decide where it intends to conduct business and seek to register its trademark in those jurisdictions. The United States is a party to international treaties that govern international trademarks, including the Paris Convention and Madrid Protocol, which allow a trademark to be registered internationally with member nations through a uniform process (an international application, which is managed by the World Intellectual Property Organization (WIPO)). If a franchisor is contemplating selling franchises in several different countries, the Madrid Protocol is an efficient means of seeking trademark protection across international borders.
By using the Madrid Protocol, a trademark can first be registered in any member nation (such as the United States). If it is approved by the member nation, it can then be submitted to the WIPO for international approval and registration. Once approved internationally by the WIPO, the trademark can then be submitted to any other member nation where the franchisor wants to obtain trademark protection. Then that particular nation will review the mark and decide whether or not to grant approval for trademark protection. The Madrid Protocol provides a uniform and efficient method for streamlining multiple trademark registrations in multiple countries.
In the United States, the USPTO is the federal agency responsible for registering trademarks. Franchisors can file online with the USPTO for trademark registration. The USPTO’s online system should be regularly monitored throughout the registration process, and registrants should promptly respond to enquiries and issues as they arise. The USPTO will first review the application to ensure it has met the USPTO’s filing requirements. If so, then the application will be assigned to an ‘examining attorney’ to review the application, and the USPTO will search for conflicting marks or other problems in the application. If a problem arises, the USPTO will issue a letter that explains the reason for refusing the registration, or explaining the deficiency, thereby commencing what is known as an Office Action, whereby a registrant may take steps to address the USPTO’s concerns. A registrant must respond within six months, or the mark will be ‘abandoned’. If the mark is approved, or overcomes the Office Action, the USPTO will then ‘publish’ the mark. After the mark is published, any third party may issue a challenge or objection within 30 days. (Notably, it is good practice to ensure that all parties that may hold potentially conflicting marks, such as those that might be discovered in a trademark clearance search (discussed above) should be identified, and given notice of the objection process, so as to avoid potential challenges to the process at a later date.) If no objection is successful, the USPTO’s process then proceeds to the formal registration stage, which generally takes several more months. Importantly, after a federal trademark has been obtained, a franchisor must take steps to maintain its registrations, including renewal of the mark (approximately every 10 years), and the filing of a ‘declaration of use’, between five and six years after registration, failing which the mark may be cancelled.
Many of the individual states also have their own trademark registration offices (with their own registration process). However, while individual state registration is better than not registering at all or relying upon common law trademark rights, franchisors should seek federal registration of their trademarks to obtain the benefits of federal registration.
If a franchisor wishes to protect an invention or unique process it has developed, it may apply for a patent with the USPTO. However, patents are difficult to obtain, and the categories of inventions or processes that rise to the level of patent protection are limited. An applicant may consider utilising the ‘provisional’ patent application process with the USPTO, which can, for a limited period, give an applicant a lower-cost ‘first patent filing in the United States’ to obtain first-in-time status, or if exigency is required. The patent process is outlined by the USPTO on its website, www.uspto.gov, and specialised counsel who have passed the special Patent Bar Exam should be consulted if a franchisor wishes to file for a patent.
Franchisors should also take steps to protect their other intellectual property, such as operations or procedural manuals, proprietary systems and software, and customer lists, as proprietary and confidential. They should also require all recipients (including franchisees) to treat such items as confidential, including through specific provisions in franchise agreements and separate confidentiality and non-disclosure agreements, as applicable. Much of a franchisor’s confidential intellectual property, even if it is not protectable as a trademark or patented invention, will still be protectable as a trade secret, or at common law, as long as the proper steps are taken. New or prospective franchisors should be wary before they start sharing their ideas or intellectual property with others in their process of formation or the implementation of their franchised business (including with potential investors or business partners). Non-disclosure and confidentiality agreements are generally enforceable, and should be entered into prior to having significant conversations with third parties. Such agreements should always be considered, especially where the prospective franchisor has a trade secret or idea that is unique and worth protecting. Publications by the franchisor, including operations manuals and policy and procedure manuals, as well as proprietary computer programs, may also be protected by federal copyright law.
In the United States, while enforcement powers are granted to federal and state agencies, and an aggrieved party can certainly report theft and misappropriation to the appropriate law enforcement agency, generally, as a practical matter, the owner of any intellectual property that is being infringed upon must bring a private action to effectively protect its rights.
Since the most important intellectual property a franchisor owns is likely to be its trademark, franchisors must be vigilant in protecting their trademark rights. A trademark holder in the United States is generally required to ‘police’ its mark by actively monitoring the market to discover infringement, and then to take action against infringers to protect its mark. A franchisor who fails to take timely action against infringers may lose its right to obtain any relief (because of, inter alia, affirmative defences of laches, acquiescence or waiver). Therefore, it is important for a franchisor to diligently search and discover if someone is improperly using its marks, and demand that any improper usage cease immediately (cease and desist). Should a party fail to cease utilising an infringing mark, a trademark infringement action may be brought in federal or state court. A franchisor may employ the Lanham Act (15 USC Section 1051 et seq.), which provides remedies for trademark violation in this regard. State statutes and common law may apply as well. Notably, former franchisees who are still utilising a mark after termination of their right to do so (which may occur when a franchise has expired or been terminated) are violating that trademark, and a prudent franchisor should diligently and promptly seek to force a former franchisee to stop infringing that mark, or risk being barred by waiver, estoppel or acquiesce for failure to promptly police its mark.
If a franchisor discovers that a third-party website domain name is improperly utilising the franchisor’s mark (or a confusingly similar permutation thereof), it may initiate a proceeding under the Uniform Domain-Name Dispute-Resolution Policy in one of several arbitration forums, seeking to ‘shut down’ or even ‘seize’ the offending domain name. The process differs between arbitration forums, but it is usually a streamlined proceeding, and may be conducted entirely by paper submission. Such a process may be preferable to attempting to obtain the same relief in court if the only offending infringement is usage of a domain name, or where the loss of the domain name will result in the elimination of the infringing activity.
The United States Uniform Trade Secrets Act (UTSA), which was drafted by the National Conference of Commissioners on Uniform State Laws in 1970 and amended in 1985, provides the basic principles of common law trade secret protection, and it has been adopted by virtually every state, with the exception of New York, Massachusetts and North Carolina. The UTSA was written in an effort to harmonise the laws of the states. Under the UTSA, companies whose trade secrets have been misappropriated are entitled to injunctive relief in addition to damages, the amount of which is limited to the actual wilful losses suffered by the franchisor as a result of the misappropriation. If the misappropriation is deemed to be wilful and malicious, then the franchisor would be entitled to attorney’s fees. On 11 May 2016, federal protection was afforded to trade secrets through the enactment of the Defend Trade Secrets Act of 2016 (See 18 USC Section 1831 et seq.) (DTSA).
The DTSA is a new federal statute that provides uniform federal protection to trade secrets and, perhaps most importantly, creates a private civil right of action (which may be brought in federal court) for theft or misappropriation of trade secrets. A party can seek damages, and if a violation is wilful and malicious, double damages and attorney’s fees. A party can also use a specialised form of ex parte injunctive relief, allowing a federal court to issue an order for expedited seizure of the trade secret under certain circumstances (see 18 USC Section 1836). The DTSA also can apply to violators outside the United States (see 18 USC Section 1837). Notably, each state’s common law trade secret protection also still applies (and there can be significant variation between states). One guiding principle is that the party seeking protection of a trade secret must make a showing that it sought to maintain the secrecy of that information. As discussed above, it is very important that franchisors implement confidentiality policies and procedures designed to prevent the disclosure of confidential information, including franchisee non-disclosure agreements (which also apply to employees and agents) and by including confidentiality provisions in their franchise agreements.
iv Data protection, cybercrime, social media and e-commerce
The advent and proliferation of the internet and e-commerce have altered traditional franchising, necessitating an increased level of awareness by franchisors regarding the myriad laws governing data protection and privacy for customers, new methods of advertising, supplying goods and services, and maintaining the protected areas of its franchisees. E-commerce has increased both the benefits and risks of conducting business, both in franchising and in business, generally.
A franchisor must take care to ensure that its franchise agreement does not permit a franchisee to engage in e-commerce to the detriment of either the franchisor or other franchisees. Because the internet enables a business to reach geographically wider audiences, a franchisor may wish to place geographic limitations on a franchisee’s ability to advertise, solicit, sell or distribute goods on the internet. In failing to do so, a franchisor may become vulnerable to lawsuits from franchisees whose protected areas are being infringed upon.
Another potential source of liability for franchisors in the current age of e-commerce is the protection and security of customer information exchanged during online transactions. Franchisors engaging in e-commerce must take special care to develop policies and procedures for their franchisees to adequately secure all customer information, and to protect against hackers and viruses. Failure to do so may leave a franchisor and its franchisees vulnerable to lawsuits from customers whose private information has been hacked or stolen.
Brand protection has also become more unwieldy in the context of e-commerce. To protect the franchisor’s brand, the franchise agreement should explicitly reserve the franchisor’s right to review all online content on social media sites, blogs, in electronic communications and on other online sites where its trademarks are used. To that end, the franchisor may require that various types of marketing or advertising utilise a specific format and that franchisees obtain the franchisor’s prior consent before filing for registration of any proposed trademarks to be used in electronic commerce, including any internet or website address domain names. A franchisor should require that upon the expiration or termination of the franchise agreement, any internet or web addresses and domain names should be transferred to the franchisor or to an affiliate, sometimes by the franchisor having the right to execute the applicable documents as agent or attorney in fact for the franchisee.
As the United States does not, on the federal level, have any single unified comprehensive legislation protecting data, the privacy and protection of customer’s information is ensured through various laws. The United States does not have a cohesive federal law governing data protection and privacy. As a result, businesses must address a collection of federal and state laws, rules and requirements. Therefore, a franchisor must be aware of the complex variety of federal and state laws that may affect its collection, access, use and disclosure of personal information, since it may be held liable for its failure to properly secure and protect the personal information of its customers and franchisees. Many of these issues are regulated by separate laws specific to certain industries, several of which may come under the franchise umbrella. Some examples of these laws include the Telephone Consumer Protection Act of 1991 (TCPA), the Children’s Online Privacy Protection Act (COPPA) and the Fair Credit Reporting Act (FCRA). The TCPA, among other things, regulates telemarketing and robocalls to wireless and residential phone numbers. The FCRA regulates the compilation and use of consumer reports and credit reports, requiring companies that use credit reports to notify consumers when their credit report is used, for example, to deny an application for credit. COPPA regulates the collection, dissemination or usage of data concerning minors under 13 over the internet without parental permission. A seemingly innocuous educational or social media app, when appropriate safeguards are not implemented, can create COPPA liability risks. While the Federal Trade Commission Act (the FTC Act) prohibits unfair or deceptive practices, the FTC has applied this Act against companies that fail to comply with their posted privacy policies and that permit the unauthorised disclosure of customers’ personal data. Although there is no comprehensive single compliance source, the FTC’s Franchise Rule Compliance Guide provides information regarding the risks and obligations with regard to e-commerce. This area of the law is rapidly developing, and franchisees and franchisors should keep abreast of industry-specific data and privacy regulations that may apply to their franchise systems, at both federal and state levels.
IV FRANCHISE LAW
Franchising is a heavily regulated industry in the United States and for many foreign franchisors understanding the complexity of the framework of federal and state franchise laws is critical to successful entry into the US market. Many foreign franchisors are surprised to find that there is no single body of laws that regulate franchising in the United States but that they must educate themselves on upwards of 40 different federal and state franchise laws, rules and regulations that were enacted to prevent franchisors from engaging in unfair or deceptive practices (such as making false statements, wilfully omitting pertinent information and employing schemes to defraud) in the offer and sale of franchises. At the federal level, the US FTC is charged with overseeing and governing the franchising industry. Under the auspices of this authority, the FTC enacted the FTC Franchise Rule (16 CFR Part 436) on 21 October 1979, and amended it in 2007. Through the FTC Franchise Rule, the FTC regulates the offer and sale of franchises in all 50 states in the United States, as well as Washington, DC and all US territories. The FTC Franchise Rule imposes mandatory disclosure obligations on franchisors in connection with the sale of any franchise, to ensure that franchisors provide prospective franchisees with the information necessary to permit them to make an informed decision about the franchise opportunity being offered.
Under federal law, there are three elements to a franchise: (1) the franchisee is granted the right to sell goods or services under the franchisor’s trademark, service mark, trade name, logo or other commercial symbol; (2) the franchisor has significant control over the franchisee’s method of operation; and (3) the franchisee is required to pay to the franchisor (with certain exceptions) a franchise fee of at least US$500. Sometimes business arrangements or relationships that are intended to be ‘licences’ or ‘dealerships’ may fall within the definition of ‘franchise’. Therefore, it is imperative that businesses seeking to expand into the US market determine whether or not their business model constitutes a franchise. The FTC Franchise Rule (see below) as well as any applicable state laws should be reviewed in this regard.
Under the FTC Franchise Rule, franchisors must provide prospective franchisees, area developers and master franchisees with detailed disclosures (including 23 mandatory disclosure items that relate to a wide range of information) at least 14 days prior to either the execution of a contract regarding the offer or the payment of money relating to the franchise relationship. These disclosures are memorialised in a voluminous document (sometimes comprising upwards of 200 pages) called a franchise disclosure document (FDD), which includes a variety of information, including: (1) information about the franchisor, its parent, affiliates and key officers, along with any past or pending litigation and bankruptcies; (2) the fees and costs associated with developing and operating a franchised business (including the franchise fee and the estimated initial investment in the business); (3) the territory in which the prospective franchisee will operate, along with any rights retained by the franchisor to operate or permit a third party to operate within that territory; (4) the franchisor’s pre-opening and post-opening obligations; (5) registered and pending trademarks and patents that will be used in connection with the operation of the franchised business; (6) restrictions on the sources of products and services used in connection with the business, and on the products and services the prospective franchisee would be permitted to sell; (7) the franchisor’s and prospective franchisee’s rights and obligations in the event that the other party defaults in their obligations under the franchise or multi-unit development agreement; (8) exit strategies available to both the prospective franchisee and the franchisor; (9) the manner in which disputes will be resolved; (10) representations with respect to the franchisor’s financial performance; and (11) the franchisor’s audited financial statements, etc. The Franchise Rule is designed to enable potential franchisees to inform and protect themselves before investing, by providing them with information that is essential to: an assessment of the potential risks and benefits; meaningful comparisons with other investments; and further investigation of the franchise opportunity. The FDD must be updated annually or more frequently if there are any ‘material’ or significant changes.
Many franchisors utilise a multi-state FDD, which they provide to prospective franchisees regardless of which state the franchisee resides in. However, franchisors typically supplement their FDD with state-specific addenda to comply with state laws that require additional state-specific disclosures. The FDD may be delivered to the prospective franchisee in either hard copy format or electronically (for example, by email, website download or CD-ROM), as long as the FTC Franchise Rule’s procedural requirements are met. Also, there are limited exemptions to the FTC Franchise Rule’s disclosure requirements. For example, where a franchisee is an officer, director, general partner or manager of the franchisor an exemption may apply. A franchisor that qualifies for an exemption under the FTC Franchise Rule should also confirm that it is exempt under any applicable state law.
In addition to the disclosure requirements under the FTC Franchise Rule, foreign franchisors (like US franchisors) must comply with the franchise laws of the states in which they choose to conduct business. State and federal laws are not coextensive, and 15 states have registration franchise laws that require franchisors to register their franchise opportunities before they are permitted to ‘offer’ or ‘sell’ franchises either from that state or to its residents. Under these state franchise registration laws, franchisors are also required to renew their franchise registration annually and to file amendments to their FDDs in the event that a material change occurs (i.e., where a franchisee would reasonably want to have this additional information when considering whether or not to purchase or renew the franchise). As with the FTC Franchise Rule, many state franchise registration or disclosure laws also prohibit franchisors from engaging in fraudulent or deceptive conduct in connection with the offer or sale of franchises. Another 26 states in the United States have business opportunity laws that require pre-sale disclosures similar to the disclosures set forth in the FDD. Approximately 20 of these business-opportunity states require the franchisor either to register or notify the state before being permitted to advertise or sell franchises in those states. Approximately one half of the states, as well as Washington, DC and the US territories of Puerto Rico and the US Virgin Islands, have enacted relationship laws that govern the franchisor–franchisee relationship, and in particular: (1) the termination, renewal and transfer of franchise rights; (2) a franchisee’s right to form a franchisee association; and (3) a franchisor’s obligation to repurchase a franchisee’s inventory in the event of termination. In addition to state franchise relationship laws, more than half of the states have promulgated Little FTC Acts that give aggrieved ‘consumers’ (including franchisees) a private right of action for a franchisor’s violation of the FTC Franchise Rule. Basically, under the Little FTC Acts, a franchisor’s violation of the FTC Franchise Rule will be deemed to be per se a violation of that state’s Little FTC Act or evidence of a violation. While the FTC oversees franchising on the federal level by imposing a comprehensive pre-sale disclosure requirement, it is relatively rare for the federal government to step in to ensure the compliance with or enforcement of the FTC Franchise Rule. Thus, the regulation of franchise activities and overseeing the enforcement of laws affecting the franchisor–franchisee relationship is largely left up to the states.
ii Pre-contractual disclosure
The FTC Franchise Rule and states with disclosure or registration laws impose a pre-contractual disclosure requirement upon franchisors. This requirement mandates that franchisors provide prospective franchisees with specific material information (including, but not limited to, background information on the franchisor, the costs associated with acquiring and operating a franchise and the legal obligations of the franchisor and franchisee) prior to the offer of a franchise opportunity or the consummation of the sale of a franchise. In addition to imposing a pre-contractual disclosure requirement, state disclosure or registration laws also typically prohibit franchisors from engaging in ‘fraudulent and unlawful practices’, such as making false statements of material facts (or wilfully omitting any such material fact) in connection with the registration or disclosure process; employing any scheme to defraud franchisees; or engaging in any act or practice that would operate as a fraud or deceit upon a prospective franchisee.
Violations of disclosure or registration laws can carry serious consequences, both criminal and civil, for franchisors. Under the FTC Franchise Rule, a violation of the disclosure requirement constitutes a violation of the US Federal Trade Commission Act, and gives the FTC the right to sue franchisors in federal court and seek any or all the following remedies: (1) civil penalties of up to US$11,000 per violation; (2) injunctive relief with respect to violations of the FTC Franchise Rule, including barring franchise sales in the United States; and (3) restitution, rescission, or damages on behalf of the affected franchisees. While the FTC Franchise Rule gives the FTC a right to bring an action against franchisors who violate the Rule, it does not give aggrieved franchisees a right of private action. Only the FTC can commence an enforcement action against a franchisor that has violated the FTC Franchise Rule.
State disclosure or registration laws that impose pre-contractual disclosure obligations incorporate an enforcement structure, which gives that state’s state administrator or attorney general the right to investigate and prosecute violations by franchisors. If a state administrator or attorney general suspects that a franchisor has violated that state’s franchise laws, then the state administrator or attorney general may bring an enforcement action against the franchisor seeking: (1) to deny or revoke the franchisor’s registration in that state (which would preclude the franchisor from offering or selling franchises in that particular state); (2) to impose fines and civil penalties; (3) rescission of the franchise agreement; (4) actual damages and, at times, consequential damages; and (4) to enjoin the franchisor from continuing to engage in franchise activities. Under certain circumstances, the state administrator or attorney general may seek criminal penalties against the franchisor and, in some cases, against the officers, directors or senior management of the franchisor, if those persons engaged in the proscribed conduct. Unlike the FTC Franchise Rule, state disclosure or registration laws also give aggrieved franchisees the right to assert a private right of action against the franchisor for rescission of the franchise agreement or actual damage suffered by the franchisee.
Some states have franchise disclosure or registration statutes or franchise investment or relationship laws that allow aggrieved franchisees to assert statutory fraud claims for material misrepresentations or omissions of fact in an FDD. Under such claims, aggrieved franchisees must plead with particularity and prove with clear and convincing evidence: (1) a material misrepresentation of a presently existing or past fact; (2) knowledge or belief by the other person of its falsity; (3) an intention that the other person rely on it; (4) reasonable reliance thereon by the other person; and (5) resulting damage. Some state franchise laws require aggrieved franchisees to prove that the franchisor intended to commit the violation, but some states will hold franchisors strictly liable for merely making an untrue statement of a material fact.
Aggrieved franchisees that are not protected by a state disclosure or registration statute may find protection under that state’s unfair or deceptive trade practices statutes (Little FTC Acts). State Little FTC Acts provide that any violation of the federal FTC Act or related regulations, including the FTC Franchise Rule, is per se a violation of that state’s Little FTC Act. Such violations give aggrieved franchisees a private right of action against franchisors who have engaged in unfair trade practices. However, not all state Little FTC Acts are created equal. Little FTC Acts protect consumers against unfair and deceptive trade practices, but some states do not deem franchisees to be ‘consumers’ because of the purported level of sophistication necessary for the purchase of a franchise. Therefore, aggrieved franchisees in those statutes will be precluded from asserting an action under that state’s Little FTC Act. Franchisees that can bring claims under state Little FTC Acts may be able to recover damages (including, treble damages and reasonable attorneys’ fees).
The enforcement provisions incorporated in federal and state franchise laws should make it clear to franchisors that the FDD is not merely a disclosure document but a liability document that can give rise to causes of actions for: (1) the franchisor’s failure to comply with federal and state disclosure laws (and registration requirements, as applicable); and (2)the franchisor’s misrepresentations or omissions (albeit negligent). Such violations can be used against the franchisor to award damages, rescission and injunctive relief (to name a few remedies) to aggrieved franchisees. On the other hand, proper disclosure by the franchisor may act as a shield against lawsuits or arbitration proceedings brought by aggrieved franchisees who find themselves unable to overcome the franchisor’s defence that the franchisee was given the subject information in the FDD.
The FDD contains 23 specific disclosure items that each provides prospective franchisees with pertinent information about the franchisor and the franchise system. That said, particular attention should be paid to the disclosures made in Item 7 – Estimated Initial Investment, and Item 19 – Financial Performance Representations. Both governmental and aggrieved franchisees have, more often than not, used the information disclosed (or not disclosed) in these items as the basis for lawsuits against the franchisor. Under Item 7, franchisors must set forth an estimate of the franchisee’s initial investment necessary for the franchisee to commence operations (which should be based upon the franchisor’s experience). Item 19 provides franchisors with the opportunity, if they so elect, to make financial performance representations (earnings claims) about the actual or projected financial performance of their franchised or company-owned outlets, provided that there is a reasonable basis for making the representation and the franchisor can substantiate the basis in writing. Misrepresentations and omissions under Item 7 or improper earnings claims under Item 19 may give rise to a governmental action under federal or state law and can also form the basis for private causes of action (lawsuits or arbitration proceedings depending on the terms of the franchise agreement). Statements that indicate that a franchisee can expect to make a specific profit or generate a certain sales volume of goods or services are typical of the types of representation that can give rise to such causes of action, if the franchisor has not disclosed (in the FDD) the basis for the representations. However, mere puffery does not fall under the FTC Franchise Rule’s definition of financial representation. Exaggerations or statements that no reasonable person would take literally, like ‘this franchise opportunity is a gold mine’, or ‘this franchise is an opportunity of a lifetime’ are not actionable under Item 19.
After disclosures have been made to a prospective franchisee and the requisite disclosure period has elapsed (10 business days in New York), the franchisee may sign the franchise or multi-unit development agreement or pay the initial franchise fee to the franchisor. However, prior to consummating the franchise purchase, prospective franchisees (through franchisee counsel) will seek to negotiate certain terms and conditions contained in the franchise agreement. Some franchisors may elect to negotiate certain terms and conditions, while others will contend that it is their ‘policy’ not to negotiate any changes to their form of franchise agreement.
While the FTC Franchise Rule mandates franchisors to provide certain pre-sale disclosures prior to that franchisor having the right to engage in franchise activities in that state, 15 states in the United States (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin) have franchise filing or registration laws that require a franchisor to either: (1) register its FDD; or (2) file a notice of intent to engage with the appropriate regulatory authority prior to any offer or sale of a franchise opportunity within the state. The state registration and disclosure statutes strictly regulate how, when and under what circumstances franchises can be offered and sold in that state. In ‘registration states’ the franchisor and the disclosure document must be registered and approved by the appropriate state agency before the franchisor can commence any franchise sales activity. Further, under these state registration laws, franchisors are required to renew their franchise registrations annually and to file amendments to the FDDs in the event that a material change occurs (i.e., where a franchisee would reasonably want to have this additional information when considering whether or not to purchase or renew the franchise). In some instances, state disclosure and registration laws require franchisors to register any franchise brokers or sellers that will be offering and selling franchise opportunities on that franchisor’s behalf. Other than the registration requirements imposed by the registration states identified above, franchisors are not subject to any franchise registration requirements.
However, there are general business requirements that a franchisor must comply with to conduct business in any state. One of the definitional elements of a franchise is the requirement that franchisees offer and sell goods and services associated with a federally registered trademark. Therefore, franchisors will need to register their trademarks prior to commencing the offer or sale of franchises. As a general business matter, franchisors (who commonly operate their business through an operating entity) will need to register any assumed business names with the appropriate state regulatory agency to protect their right to use that name within that particular state.
iv Mandatory clauses
The franchise agreement is the legal contract that governs the franchisor–franchisee relationship. While there is no ‘form’ of uniform franchise agreement, there are several key provisions or sections that can typically be found in most franchise agreements. An explanation of these clauses is given below.
Protected (or exclusive) territory clause
The protected territory clause demarcates the franchisee’s customer source by setting forth the territory in which the franchisee may offer and sell goods and services. Protected or exclusive territories may be defined by radius (in miles), postal zip codes, municipalities, cities, population size or just the address of the franchised location. This clause also sets out whether the territory is exclusive. It is important to note that not all franchise agreements designate a protected territory. If the franchise agreement grants a protected territory, the protected territory clause will provide that the franchisor will not operate or permit another franchisee to operate a franchised business within that territory, except under certain circumstances. Although a franchise agreement may provide that a franchisee’s designated territory is exclusive, the exclusivity of the territory is usually not absolute. Typically, the exclusivity of a protected territory is contingent upon the franchisee being in full compliance with the terms and conditions of the franchise agreement. Even if the franchisee is in full compliance with the franchise agreement, the exclusivity of the franchisee’s territory will be subject to certain rights that the franchisor may reserve for itself. Some rights that a franchisor will reserve for itself include the right to: (1) sell the franchised goods and services in alternate channels of distribution, such as the internet, mail-order catalogues, grocery stores, etc.; (2) sell the franchised goods and services in certain ‘non-traditional’ locations, such as airports, sports stadiums, colleges, hospitals, etc.; and (3) to acquire or merge with competing franchises or chains and operate them under the same or a different trademark, etc. The protected territory is sometimes negotiated between the franchisor and franchisee. Protected territories are sometimes modified or adjusted upon renewal.
Royalties and other fees
One of the most important factors for entrepreneurs looking to own a franchise is the start up and ongoing costs for owning and operating a franchise. Typically, the franchise agreement will set out the various fees that the franchisee is required to pay to the franchisor. These fees usually include: (1) an initial franchise fee; (2) an ongoing royalty fee; and (3) advertising fund contributions. Typically, the initial fee is paid up front simultaneously upon the execution of the franchise agreement. Many people view the initial franchise fee as the price of admission as a member in the franchise system, and the royalties as the ongoing membership fees. Franchisees pay royalty fees, typically on a monthly basis, for their ongoing use of the franchisor’s trademarks and for the services that the franchisor provides. The typical range for royalties may be from 4 per cent to 8 per cent of the franchisee’s gross revenues, although sometimes flat-rate fees are charged. As many franchisors in the United States create a national advertising fund (or sometimes a regional advertising fund), franchisees are often required to make regular contributions to the fund. The typical range of these fees is from 1 per cent to 3 per cent of the franchisee’s gross revenues, with 2 per cent being fairly common.
Use of marks, etc.
The franchise agreement grants franchisees a non-exclusive licence to use the franchisor’s trademarks, service marks or trade names in strict compliance with the terms and conditions contained in the agreement. The franchise agreement will usually spell out the manner in which the franchisee is authorised to use the franchisor’s marks. Any unauthorised use by the franchisee of the franchisor’s marks is typically grounds for the franchisor to immediately terminate the franchise agreement, among other forms of legal recourse that the franchisor may have (including the obligation for the franchisee to indemnify and defend the franchisor against any third-party claims involving unauthorised use of the marks).
Products and services
Franchise agreements usually provide what products and services must be purchased from the franchisor (or its affiliates) or from an approved supplier. The agreement also typically sets forth the limitations on the franchisee’s use, sale or distribution of products or services in connection with the franchised business.
Usually franchise agreements will grant franchisees the right to renew the franchise term for a designated number of successive terms (however, some franchisors grant perpetual renewal terms), provided that the franchisee satisfies certain conditions. This right to renew is usually conditional. Some of these conditions include, without limitation: (1) the franchise providing timely written notice to the franchisor of its intent to renew; (2) the franchisee being in full or substantial compliance with the terms and conditions of the franchise agreement; (3) the franchisee paying a renewal fee; and (4) the franchisee’s execution of a release and franchisor’s then current form of franchise agreement, which may materially differ from the terms and conditions of the franchisee’s current franchise agreement. Protected territories are sometimes modified or adjusted upon renewal.
Transfer and assignment
The franchise agreement will typically prohibit a franchisee from selling its franchised business or transferring or assigning its rights under the franchise agreement, without the franchisor’s prior written consent. In this section, the franchise agreement will detail: (1) what constitutes an assignment; (2) the circumstances in which the franchisee can assign its rights and obligations under the franchise agreement; and (3) any fees associated with such an assignment. If a franchisee wishes to sell its franchised business and transfer its rights under the franchise agreement, the franchisor will normally have a right of first refusal. Pursuant to this right of first refusal, the franchisee is obligated to inform the franchisor of its desire to sell its franchised business and transfer its rights under the franchise agreement. Once the franchisee has identified a potential buyer and terms upon which it will sell its franchised business, the franchisor will have the right to purchase the franchised business upon the same terms. Rights of first refusal tend to create an unreasonable ‘cooling effect’ on a franchisee’s ability to market and sell its franchise. For example, it is not practical to think that a businessman will invest the time, effort and attorneys’ fees, do the evaluations, consult with family members and partners, deal with accountants, bankers, etc., only to find that he may not end up being the purchaser after all, but that the franchisor is going to take the deal instead. A viable alternative to a right of first refusal is a right of first purchase. In the event that a franchisee desires to transfer, sell or assign its franchised business or a controlling interest therein, other than to: (1) any partner, co-shareholder, or member of the franchisee; or (2) any member of the immediate family thereof or trusts for the benefit of any such family member, then the franchisee will have to first notify the franchisor. In its notification, the franchise must set forth the price and terms upon which it is willing to sell, transfer or assign its franchised business or its interests in the franchised business (the Offer). The franchisor will have a period from the date it receives the franchisee’s Offer to decide whether it wishes to purchase the franchisee’s business or interests therein. If the franchisor elects not to purchase, then the franchisee would have the freedom to solicit bona fide third-party purchasers. However, the franchisee must sell its business or interests, at the same (or higher) price and upon the same (or less favourable) terms as that set forth in the franchisee’s Offer to the franchisor. If the franchisee cannot get a purchaser to agree upon the price and terms in the Offer, but is able to secure a buyer that will purchase the franchisee’s business or interests therein at a lower price or on more favourable terms, then the franchisee must re-offer the ‘deal’ to the franchisor. If no transaction occurs within a set time frame, such as a year, the process starts over again.
Franchisors will entrust certain proprietary information to its franchisees to be used in connection with the operation of its franchisees’ franchised businesses. To protect themselves from unfair competition, franchisors will require franchisees to maintain the confidentiality of that information during and after the term of the franchise agreement. Typically, franchisors will require that the franchisee (and any other personnel that will have access to the franchisor’s proprietary information) execute a confidentiality agreement that will obligate the franchisee (and its representative) to maintain the confidentiality of the information contained within these manuals during the franchise term and thereafter. A violation of this clause may result in the franchisee being enjoined from violating or continuing to violate the confidentiality clause, or even require the franchisee to pay liquidated damages to the franchisor. These remedies are in addition to any other remedies that the franchisor may have under the law.
Most franchise agreements contain non-competition clauses (sometimes referred to as restrictive covenants) that prohibit the franchisee (including, its owners, operating owners, officers, directors, personal guarantor, the spouse, family member, business associate of an owner or an affiliate partnership or corporation) from owning or being involved with a ‘competitive business’ during the franchise term and for a period (usually two years) following the expiration or termination of the franchise term, so long as the competitive business is located within a designated radius of the franchisee’s location and, frequently, any other franchised location. A competitive business is usually a business that offers goods or services that are either identical (or confusingly similar) to or competitive with the goods or services offered under the franchise system. Some franchisors also require their franchisees to have the franchisee’s key employees enter into similar non-competition agreements. (See also Section VI.vi, on restrictive covenants.)
Default or termination of franchise
Generally, the franchise agreement will detail: (1) what actions or inactions constitute a default under the franchise agreement, and (2) the period within which the franchisor or franchisee has to cure such a default (provided that the franchise agreement provides that the default is curable). If the franchisee fails to comply with the terms of the franchise agreement and is deemed to be in default, the failure to cure any curable default will normally give rise to the franchisor’s right to terminate the franchise agreement upon written notice. However, some defaults are not curable by their nature (i.e., making an unauthorised use of the franchisor’s trademarks) and, subject to applicable state law, the franchisor may immediately terminate the agreement following the occurrence of a designated ‘non-curable’ default under the agreement (without providing the franchisee with notice or an opportunity to cure). After the agreement is terminated or expires, the franchisee is required to comply with certain enumerated post-term obligations, including having to ‘de-identify’ its business to prevent it from being associated with the franchisor’s brand in all respects. Some franchise agreements contain a liquidated damages provision that seeks to compensate the franchisor, usually pursuant to a specific formula or calculation, for its lost future royalty stream in the event that the agreement is terminated.
Upon the expiration or termination of the franchise agreement, the franchisee is obligated to, among other things: (1) de-identify the franchised business; (2) cease its use of the franchisor’s trademarks; and (3) comply with the restrictive covenants set forth in the franchise agreement (including the covenant not to compete and to maintain the confidentiality of the franchisor’s proprietary information).
In the event that a franchisee breaches its in-term or post-term restrictive covenant or a franchisor terminates the franchise agreement for ‘cause’ (such as: (1) the franchisee’s unauthorised use of the franchisor’s marks or proprietary information; (2) the franchisee filing for bankruptcy, being deemed to be insolvent or making a general assignment for the benefit of creditors; or (3) the principals of the franchisee being convicted of or pleading no contest to a felony or other crime or offence that would be likely to adversely affect the reputation of the franchisee, the franchisor or the franchised business), the franchise agreement may provide that the franchisor will be entitled to liquidated damages. While the formulae for determining liquidated damages will vary, the calculation used to determine the liquidated damages owed to the franchisor will typically utilise some multiple of the average monthly royalty fees that the franchisee paid (or should have paid) during the 24 months of operation prior to the termination. By including a liquidated damages provision in a franchise agreement, the franchisor is trying to ensure that it will be adequately compensated in the event that a franchisee breaches the franchise agreement. Liquidated damages provisions also allow franchisors to avert having to engage in prolonged and expensive litigation.
Choice of law and venue
The franchise agreement will almost always include a choice of law and venue provision that sets out which laws will govern the agreement and any disputes that arise in connection with the agreement, as well as the jurisdiction in which disputes will be heard. Usually the franchisor will select: (1) the state in which it is located as the state whose laws will govern the franchise agreement and any disputes that derive therefrom; and (2) the state and county in which the franchisor is located as the venue where any and all related disputes are heard. It is, therefore, crucial that the franchisor understand the franchising laws of the state that governs the franchise agreement, as well as the laws of the state in which the franchisee resides or in which the franchised business is located.
In the event that a dispute arises between the franchisor and franchisee, the dispute resolution clause will set forth the manner in which the disputes will be resolved. Many franchise agreements require the parties to arbitrate their disputes, because most franchisors view arbitration as a cost-efficient manner for resolving disputes. Arbitration awards are binding upon the parties, and effectively preclude the unsuccessful party from appealing the arbitrator’s decision. A three-step method for resolving disputes, which begins with good-faith negotiation between the parties, followed by mediation and then by arbitration or litigation (if mediation is unsuccessful), is typically found to be more beneficial.
The negotiations can be conducted in person or via teleconference. Mediation will usually be held in the city in which the franchisor is located, but some franchisors will agree to hold it in the county of the franchisee’s principal place of business to help defray the franchisee’s costs associated with such mediation. The costs of the mediation are often equally divided between the franchisor and franchisee. Arbitration is generally held in the county in which the franchisor has its principal office, and the associated fees are frequently shifted to the non-prevailing party.
The franchise agreement will usually require that the franchisee waive its right to initiate or participate in a class action or arbitration in any forum. Under this provision the franchisee is typically relegated to bringing any actions arising out of or related to the franchise agreement or the transactions contemplated thereunder on an individual and not a class-wide basis. This clause also typically precludes any proceedings in which the franchisor and franchisee are parties from being consolidated with any other proceedings between the franchisor and any other third party.
Typical franchise documents
Under the FTC Franchise Rule, franchisors are required to include copies of ‘all agreements proposed for use or in use regarding the offering of a franchise’. This includes copies of the franchise agreement and multi-unit development agreement, and all other agreements prepared in connection with the franchise offering and that prospective franchisees may be required to execute. In Item 22 of the FDD, Franchisors are required to list the agreements that a prospective franchisee or multi-unit developer will have to execute to consummate the franchise purchase. Some franchise documents or agreements that are typically attached to the FDD include, but are not limited to, the: (1) franchise agreement; (2) multi-unit development agreement; (3) personal guaranty and assumption of obligations; (4) confidentiality and non-competition agreement; (5) operations manual table of contents; (6) general release; (7) lease rider; (8) collateral assignment of lease; (9) multi-state addenda; and (10) electronic funds transfer authorisation agreement; as well as other agreements, where appropriate.
The franchise agreement is the cornerstone of the franchisor–franchisee relationship, because it governs and defines the franchise relationship. Within the franchise agreement, the franchisor legally grants the franchisee the right to develop and operate a franchised business under the franchisor’s name and trademark, provided that the franchisee operates that business in strict compliance with the standards and specifications and pays an ongoing royalty to the franchisor. The agreement explains in great detail the franchisor’s and franchisee’s respective rights, duties and obligations arising out of their relationship. Since the terms and provisions of a franchise agreement are likely to vary depending on the type of franchise opportunity being offered and the franchisor’s industry, there is no standard form of franchise agreement. However, there are several key provisions that US franchisors commonly include in their franchise agreements. These provisions address: (1) the franchisee’s territorial rights and restrictions; (2) the duration of the franchise term; (3) royalties and other fees; (4) contributing to an advertising fund; (5) franchisor’s training of and ongoing support to franchisees; (6) franchisee’s renewal rights; (7) restrictive covenants; (8) assignment; (9) defaults and termination rights; (10) post-termination obligations; and (11) dispute resolution. In addition to these common provisions, franchise agreements will typically be accompanied by various ancillary agreements, which may include: (1) personal guaranty; (2) confidentiality and non-competition agreement; (3) lease rider; (4) electronic transfer of funds agreement; and (5) collateral assignment of lease (see Section IV.iv). For franchisors operating in the United States, the franchise agreement dictates, to a certain extent, the manner in which franchisees are to operate their franchised business – in accordance with the franchisor’s system and standards. However, when drafting the franchise agreement (and other related agreements) it is imperative that the franchisor does not appear to exert too much control over the franchisee’s day-to-day operations, because, as recent US court decisions have indicated, it can potentially expose the franchisor to liabilities, including being considered a ‘joint employer’ along with the franchisee.
For franchisors looking to enter the US market, multi-unit development may be an attractive option because it assists the franchisor in developing designated markets within the United States. The multi-unit development agreement will typically grant the developer the right to open a certain number of units by a specified date within a given, exclusive development area. The relationship between the franchisor and multi-unit developer will be governed by a multi-unit development agreement that will contain most of the same key provisions found in (and ancillary agreements that accompany) franchise agreements. In addition to these provisions and ancillary agreement, the multi-unit development agreement will also include a development schedule pursuant to which the multi-unit developer is obligated to open a certain number of units within a designated time frame. Four of the most heavily negotiated issues in a multi-unit development deal concern: (1) the development schedule; (2) what happens to the territory when a multi-unit developer defaults in its development obligations; (3) what happens to the territory when the multi-unit development agreement expires or is terminated; and (4) the inclusion of cross-default provisions, particularly the impact that the default in one franchised unit will have with respect to the other units.
v Guarantees and protections
Often franchisees and multi-unit developers are newly formed entities with little or no financial history or significant assets. Consequently, most franchisors require the principals of the franchisee entity to execute a personal guaranty, guaranteeing all the franchisee’s contractual commitments (including, any financial obligations and restrictive covenants) because the guaranty provides franchisors with additional security in the form of the guarantor’s personal assets. Without the guaranty, might have to chase after franchisee entities that may have little to no assets. Typically, franchisors will use the guarantee to, among other things: (1) recover monies the franchisee owes to the franchisor; (2) protect the franchisor’s trademarks and proprietary information; and (3) enforce the restrictive covenants. Generally, courts will uphold the enforceability of a personal guarantee.
i Franchisor tax liabilities
Generally, a foreign franchisor, like any foreign corporation, must pay US federal taxes at the graduated corporate tax rate if it is ‘engaged in trade or business’ within the United States during the tax year and generates business income that is ‘effectively connected with a US trade or business’.2 The tax implications for a foreign franchisor entering into the US market will depend on the ownership structure that the franchisor elects to utilise. If the foreign franchisor elects to directly enter into franchise, multi-unit development or master agreements with a US business or citizen, then it is more than likely that the franchisor will be taxed as an entity that is deemed to be engaged in US trade or business. This means that under 26 US Code Section 882, the franchisor will have to pay taxes on all income that is ‘effectively connected with the conduct of a trade or business within the United States’. The foreign franchisor will be deemed to engage in trade or business within the United States if it is actively involved in ‘considerable, continuous and regular’ business activities on US soil.3 Thus, all franchise fees and other fees (including, the costs for products or services that franchisees are required to acquire from the franchisor) would be considered taxable income. In addition to taxing the foreign franchisor’s US-based income, 26 US Code Section 884(a) imposes a second tax at the rate of 30 per cent for all income that is transferred from the United States to the franchisor’s office in its native country. A foreign franchisor may be able to alleviate this tax liability, if the franchisor’s native country has a tax treaty with the United States. If there is a tax treaty between the franchisor’s home country and the United States, then the franchisor’s liability will depend on whether the franchisor is considered to have a permanent establishment in the United States. The definition of ‘permanent establishment’ will vary from treaty to treaty. If the franchisor’s country has a permanent-establishment provision in its treaty, then the franchisor will be required to file taxes and pay the applicable tax rate on the income attributable to the permanent establishment. So it is imperative for the franchisor to ascertain competent tax counsel and accountants that can advise with respect to this issue. A third tax that may be imposed on the income generated by a foreign franchisor would be income that the United States considers to be fixed or determinable annual or periodic income (the FDAP Income) rather than income that is effectively connected to the business the franchisor is conducting in the United States. In this case, such FDAP Income would be subject to a 30 per cent US withholding tax. This tax would normally apply to royalty payments, requiring the US franchisee to withhold 30 per cent of its royalty payments to the foreign franchisor. Again, if there is a tax treaty in place, this withholding tax can be reduced to as little as 10 per cent.
If the foreign franchisor elects to operate its business through a wholly owned US-based subsidiary, then the subsidiary’s profits would be liable to a tax of up to 35 per cent. In addition to paying taxes on the profits generated, any dividend distributions that the subsidiary pays to the foreign franchisor would be subject to a 30 per cent withholding tax. However, any tax treaty that is in place between the franchisor’s country of origin and the United States may reduce the percentage of tax required to be withheld.
The application of US federal tax laws to an overseas franchisor selling franchises in the United States is impacted by the terms of any income tax treaty or convention between the United States and the franchisor’s country of residence that may be in effect. As long as the treaty-country franchisor does not maintain a ‘permanent establishment’ in the United States, the applicable treaty will reduce or eliminate altogether the franchisor’s obligation to pay income tax on certain income earned in the United States.4 Where the franchisor maintains a permanent establishment in the United States, or where there is no applicable treaty, taxes must be paid as required by US law.5
A foreign franchisor may, of course, take advantage of any legal means at its disposal to minimise its US tax obligations. However, a franchisor may not manipulate the pricing or allocation of funds in self-dealings with its affiliates as a means of minimising taxes for the entities as a whole. To prevent tax evasion and to clearly reflect the income of each entity, the Internal Revenue Service (IRS) is authorised to ‘distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among [. . . ] organizations, trades, or businesses [that are owned or controlled directly or indirectly by the same interests] if [. . . ] necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses’.6
At the state level, franchisors are also responsible for paying state income taxes to the extent that they conduct business in a US state that imposes such a tax. The analysis for determining whether a franchise is ‘doing business’ within a particular state varies by state. An increasingly important and fluid issue in recent years is the extent to which some states assert claims for income taxes due where the franchisor’s only operations in a particular state are through its franchisees.
The Internal Revenue Code Section 1253 (Transfers of Franchises, Trademarks, and Trade Names) addresses specific tax issues governing the sale of a franchise and the related fees paid by the franchisee to the franchisor. Upfront franchise fees and royalty payments received by a franchisor are generally taxed as income at the time they are received. Advertising fees, in contrast, are usually business expenses and are not generally subject to income tax if expended for legitimate advertising or marketing purposes.
A franchisor can usually treat the transfer of rights to a franchisee as a sale or exchange of a capital asset (and the payments as capital gains) if the franchisor does not maintain a ‘significant power, right, or continuing interest’ in the franchise or trademark. This is also the case when a franchisee transfers its interest in a franchise to another franchisee. Pursuant to Section 1253 of the Code, a significant power, right, or continuing interest includes, but is not limited to: (1) a right to disapprove any assignment of such an interest, or any part thereof; (2) a right to terminate at will; (3) a right to prescribe the standards of quality of products used or sold, or of services furnished and of the equipment and facilities used to promote such products or services; (4) a right to require that the transferee sell or advertise only products or services of the transferor; (5) a right to require that the transferee purchase substantially all the transferor’s supplies and equipment from the transferor; and (6) a right to payments contingent on the productivity, use or disposition of the subject matter of the interest transferred, if such payments constitute a substantial element under the transfer agreement.
Congress is currently in the process of revising the current tax laws, and the proposed changes, if passed, will likely have an impact on some, and possibly many, of the tax liabilities and the level of taxes described in this Section.
ii Franchisee tax liabilities
While a franchisee is granted a business opportunity by a franchisor, the franchised business is like any other typical small business that has to pay taxes on its profits. Franchised businesses must abide by the same federal, state and local tax laws as all other small businesses. While franchisees must pay taxes on the profits it generates, franchise royalties are generally deductible by franchisees in the year that they are paid or accrued. However, upfront franchise fees are not fully deductible by franchisees at the time of payment. Rather, franchise fees are typically amortised in equal annual deductions over a 15-year period irrespective of the term of the franchise agreement.
Royalty payments are considered US sourced ‘fixed or determinable annual or periodic’ income (FDAP income), which is taxed at the 30 per cent tax rate. Accordingly, franchisees are required to withhold tax at a 30 per cent rate on royalty payments made to the foreign franchisor. Payments to a foreign franchisor in exchange for the right to use its intellectual property (e.g., trademarks, copyrights) and technology, as well as fees for management services, qualify as ‘royalty’ payments for tax purposes and are subject to the 30 per cent withholding tax rate. If the United States has an income tax treaty with the franchisor’s country of residence, however, the foreign franchisor will benefit from either a reduced withholding tax rate or a full exemption. If the foreign franchisor has set up a US franchising entity, or if payments are made to a master franchisee, the withholding tax would not apply.
iii Tax-efficient structures
Most franchisors and franchisees will utilise a corporation, limited liability company (LLC) or limited liability partnership to operate their business. The franchisor and franchisee’s respective decisions as to the entity structure under which they operate their respective businesses will solely depend upon the level of personal liability the principals of the business will face in the event they are sued, as well as the amount of taxes they will be required to pay.
For franchisors and franchisees who elect to use a corporation as its operating entity, the corporation will be recognised as a legal entity separate and distinct from its owners (shareholders). A corporation has its own legal rights, independent of its shareholders. This separation of identity relieves the corporation’s shareholders from personal liability, with certain exceptions. Generally, the owners’ liability for the payment of the corporation’s debts, obligations and from liabilities is limited. The personal assets of shareholders of corporations are typically protected and their liability is limited to the amount the shareholder invested in the corporation. With corporations, not only are the personal assets of the shareholders protected but that protection extends to the assets of the corporation’s directors, officers, shareholders and employees. This liability protection precludes creditors from pursuing the personal assets of a shareholder (or the corporation’s directors, officers, shareholders and employees), such as personal bank accounts or real estate, to pay business debts. In exchange for this shield of protection, shareholders entrust the management of the corporation’s business affairs to its board of directors.
Generally, the profits of C corporations (which are typically used by publicly traded companies), as opposed to ‘S corporations’, are subject to double taxation. This means that the corporation is taxed on its income and the corporation’s shareholders are separately taxed on the profit distributions they individually receive as ‘dividends’. The double-taxation aspect of C corporations is what makes this entity structure unappealing to many franchisees and franchisors. To avoid double taxation many franchises elect to become S corporations. Under 26 US Code Section 1366 of the Internal Revenue Code, S corporations are treated as pass-through entities. Instead of corporations being taxed on their business income, any business income or loss is ‘passed through’ to shareholders who report it on their personal income tax returns, which is an extremely appealing aspect of S corporations. With this pass-through tax treatment, business losses can offset other income on the shareholder’s tax returns. However, not all corporations can elect to be an S corporation. To qualify as an S corporation, the corporation must be a domestic corporation that only offers one class of stock with no more than 100 shareholders, none of whom can be non-resident aliens; this last qualification presents a problem for many foreign franchisors. Thus foreign franchisors wishing to utilise a corporation will probably have to form a C corporation and be subject to double taxation. Franchisors using corporations must strictly adhere to the various corporate governance requirements imposed by state law, which may include but are not limited to: (1) adopting by-laws; (2) holding shareholders’ and board of directors’ meetings; and (3) maintaining corporate minute books. Failure to observe these requirements may result in ‘piercing the corporate veil’ and can expose shareholders to personal liability for the obligations of the corporation.
A foreign franchisor looking for a more flexible type of business entity may prefer to utilise an LLC as its franchising entity. LLCs are a great option for franchisors who want operational flexibility. The members of an LLC generally have control over the business, whereas a board of directors elected by the shareholders makes the major decisions on the corporation’s behalf. Similar to a corporation, an LLC is a legal entity separate from its owners (members). Usually the amount of a member’s investment constitutes the limit of the liability for which the member is responsible. For taxation purposes, LLCs are treated as pass-through entities, unless they elect to be taxed as a C corporation. Therefore, all the profits and losses of the LLC pass through the business to the LLC members. The members report these profits and losses on their personal tax returns; thus, the LLC does not pay federal income taxes; however, some states do charge the LLC itself a tax. Therefore, double taxation is avoided. Unlike corporations, LLCs: (1) can have an unlimited number of domestic or foreign members with different classes of ownership and who can (if they so elect) manage the LLC’s business affairs; and (2) are not subject to strict corporate governance requirements, such as scheduling regular owners’ meetings and maintaining corporate minute books. Although, the laxity in LLC corporate governance requirements may be appealing, it can, as with corporations, be a double-edged sword in that it may be used to pierce the corporate veil. Recently, aggrieved franchisees have used this approach and have persuaded courts to peel away the protections afforded by LLCs. Thus, it is advisable that franchisors implement a strict corporate governance practice. A drawback of an LLC is that the managing members’ share of the LLC’s profits is considered earned income, and therefore subject to self-employment tax.
In determining the appropriate corporate structure, some franchisors may elect to use a two-tiered or multi-tiered corporate structure to protect the assets of the business. This type of structure will typically comprise a holding company and several wholly owned subsidiary operating entities. The holding company will serve as the parent, and separate operating entities can be formed to, among other things: (1) serve as the franchisor; (2) own the intellectual property associated with the franchise system; (3) offer services to franchisees; (4) manage company-owned units; (5) own and lease real estate; and (6) purchase, sell or lease equipment, etc. Many franchisors (and even franchisees, particularly, those who own multiple franchises) will find the use of a multi-tiered structure to be extremely beneficial to the business, particularly as it relates to liabilities and creditor claims. In general, with a tiered corporate structure, the liabilities and any creditor claims stay with that subsidiary and cannot be passed on to the parent company because the two entities are considered to be separate legal entities. Therefore, the liabilities of the franchisor operating entity will not be passed to the holding company entity, so the assets of the holding company cannot be reached. An important factor in establishing a tiered corporate entity is understanding the manner in which entities can own each other. For example, an LLC may own another LLC or a C corporation, but it cannot be an S corporation shareholder. A C corporation and an S corporation can both own an LLC, but there is little reason for an LLC to own an S corporation since both are pass-through entities.
VI IMPACT OF GENERAL LAW
i Good faith and guarantees
The common law of many states automatically incorporates an implied covenant of good faith and fair dealing (GF&FD) into every contract, including franchise agreements. There is some variation among jurisdictions, but GF&FD generally requires that where one party has discretion to act in a certain way it should not unfairly enrich itself, or act in an overly arbitrary or capricious manner so as to eliminate the other party’s benefit of the contact. By imposing the implied covenant of good faith and fair dealing, the states are looking to ensure that the contracting parties are getting the benefit of their bargain.
There are limits on GF&FD. The requirement that parties (particularly, the franchisor, in this case) act in good faith and deal fairly is not a requirement that the franchisor act against its own economic self-interest in favour of the franchisee. Parties are free to enter into such contractual provisions as they may choose, especially where both parties are sophisticated and represented by counsel. A franchisee may knowingly enter into a bad economic arrangement, and if the contract is clear, the implied covenant of good faith and fair dealing will not be permitted to contradict the express terms of the agreement. Consequently, a detailed and properly drafted franchise agreement will eliminate most circumstances where GF&FD might otherwise arise, as there will be an express contractual term addressing the particular issue. However, as parties may not anticipate every potential issue, and since the application of GF&FD is a fact-driven analysis, the ‘implied covenant’ is a meaningful litigation tool.
There are also state franchise statutes that require good faith on the part of a franchisor. A franchisor’s conduct, if it is sufficiently unfair, may also become ‘unfair and deceptive’ under other statues (such as under the FTC Act, provided the circumstances warrant it).
Regardless of whether a good-faith obligation is legally required in a particular instance, a franchisor that takes unfair advantage of its franchisees may find itself unable to sell new units if the system’s franchisees are unsuccessful or unhappy and they convey these feelings to prospective franchisees who enquire. Negative reviews or, worse, litigation by disgruntled franchisees against a franchisor (which generally must be disclosed in an FDD) can have a real impact upon franchisors. Therefore, even though there may not be a legal requirement to act fairly and reasonably in every instance, prudent franchisors should consider accommodating a struggling franchisee in the interest of the long-term health of the system.
ii Agency distributor model
Each state has its own body of common law regarding agency, and an agency relationship may be implied, or imposed by law, even if not directly created by contract. Since franchisees sell services or products under the franchisor’s name subject to the terms and conditions set by the franchisor, there is a risk that an agency relationship (whether actual or apparent) will be found to exist between a franchisor and a franchisee. If a court determines that there is an agency relationship between a franchisor and its franchisees, a franchisor may become vicariously liable for harm directly caused by a franchisee to a third party.
In determining if actual agency or general agency exists, courts will examine whether an actual principal–agent relationship exists, and may also find general agency will attach, if factors exist that are relevant to the degree of control exerted by the franchisor over the franchisee’s general day-to-day operations. General agency, however, is not likely to be an issue if a franchisor has an appropriate franchise agreement in place that specifically references the fact that a franchisee is an independent contractor, and the franchisor does not exert so much control over the operations of the franchisee, generally, that it can be considered its agent for all intents and purposes.
Apparent agency may be found by a court if a plaintiff seeking to hold a party liable on the basis of an agency theory reasonably believed the franchisee to be an agent of the franchisor; and reasonably relied upon that belief to its detriment. The risks of liability due to apparent agency can be minimised by distancing the franchisor and franchisee in the eyes of the consumer. For example, requiring that franchisees utilise visible and conspicuous signage in a franchisee’s location stating that each franchise is independently owned and operated, and requiring similar disclaimers in advertisements, may undermine an apparent authority argument.
A franchisor may also be found to be vicariously liable for the acts or omissions of its franchisees (or its franchisees’ employees). However, vicarious liability, as a general rule (again, there is variation depending upon the jurisdiction) will only attach where a franchisor exerts sufficient ‘control’ over the franchisee’s performance of the specific process or activity that is being complained of such that the franchisor will be deemed to be jointly responsible. There may be specific situations or statutes, particularly in the employment context (discussed below) where vicarious or joint liability can attach in a particular context. However, in general, courts have become increasingly adverse to over-application of vicarious liability in the specialised context of franchises, and are less likely to find vicarious liability based upon practices that are typical of the franchisor–franchisee relationship. Practically every common law jurisdiction has found that general operation or procedure manuals, or compliance with a franchisor’s general franchise system, will not, in and of itself, result in vicarious liability. Nonetheless, when a franchisor has required a franchisee to comply with a specific practice or policy that is directly responsible for the harm, there is a significant risk that vicarious liability will attach.
Therefore, franchisors should balance the need to provide a cohesive and comprehensive franchise system to their franchisees (including the utilisation of operation and procedure manuals) against exerting too much control over the day-to-day operations of franchisees, which can result in a risk of vicarious liability. Whenever a detailed instruction or requirement is not truly necessary to maintain quality control, such micromanaging should be avoided. To further minimise potential exposure, franchisors are well advised to: (1) incorporate an indemnification clause in their franchise agreement that would protect them against losses to which they may be exposed that may arise out of the operation of the franchisee’s business; (2) require that franchisees maintain adequate insurance coverage (which names the franchisor and its principals and affiliates as additional insured parties), especially where necessary to protect against particular liability concerns that could result in vicarious liability; (3) include a provision in the franchise agreement that clearly states that the franchisee is an independent contract and not an agent of the franchisor; and (4) require franchisees to conspicuously post notices in its establishment and advertisements that notify the public that the franchisee is an independent contractor and not an agent of the franchisor.
iii Employment law
The franchise community in the United States has become increasingly concerned with the issue of joint employer liability – the potential for franchisors to be held jointly liable (along with their franchisees) for employment claims brought by a franchisees’ employees. It should be noted, however, that the joint employer doctrine only applies in connection with violations of employment law (for example, violations of the Fair Labor Standards Act, 29 USC 201 et seq., or National Labor Relations Act, 29 USC Section 151 et seq.). The joint employer doctrine is an exception to the general rule that a franchisor and a franchisee are independent contractors and the actions of the franchisee do not expose the franchisor to liability. This doctrine, in the franchise context, essentially finds that franchisors who exert too much control over the ‘terms and conditions of employment’ that their franchisees impose upon their employees (e.g., by setting ‘standard’ work hours, wage and salary levels, employment practices and policies, and resisting unionisation of employees) run the risk of being held jointly liable with their franchisees for employment claims.
While the joint employer doctrine has been utilised in the employment context for decades, recently regulators, including notably the National Labor Relations Board (NLRB) and the US Department of Labor (DOL) Wage and Hour Division, have aggressively utilised it to reach franchisors, even for a franchisor’s ‘indirect’ control over the terms and conditions of employment of franchisees’ employees. This presents a conflict, as the franchisor–franchisee relationship, by its very nature, requires a franchisee to adhere to the franchisor’s system or business model and to follow certain procedures. As a result, the unwary franchisor, by over-regulating what the franchisee’s employees do, may find itself to be liable for employment law violations as a joint employer. This is a rapidly developing area of law and conflicting decisions from different regulatory agencies and courts have made the landscape confusing at best. The bottom line is that prudent franchisors, wherever possible, should avoid exerting excessive control over the terms and conditions of employment of their franchisees’ employees, balancing levels of control against maintaining system standards.
Another issue regarding employment law and franchising occasionally arises in the context of ‘misclassification’ under labour law, where a franchisee (typically a single-person franchise) will be found by a court or regulator to be an employee of the franchisor, and not an independent contractor or franchisee. There are requirements under US federal law (e.g., the Fair Labor Standards Act) and state common law (e.g., state wage and hour statutes) that generally use a multi-factored test to determine whether, even if the parties may call a relationship a franchisor–franchisee relationship, it is in fact, de facto employment. Franchisors should be clear, especially when working with single-person franchisees, to maintain an independent contractor relationship (typically problematic areas are single-person franchisee ‘black car’ drivers or franchisees of delivery distribution routes). Franchisors should avoid excessive control over a franchisee to the point where a court might decide that what was intended to be a franchise relationship is in actuality one of employment directly with the franchisor.
iv Consumer protection
In general (there is significant variation between common law jurisdictions, and exceptions), franchisees are not considered to be ‘consumers’ in the sense that they will not normally fall under common law or state statutory consumer protection statutes, especially in jurisdictions where there is an existing law specifically regulating franchises. As noted above, the FTC Act does regulate the offer and sale of franchises (see Section IV.i–iii), and many states also regulate the offer and sale of franchises, as well as the franchise relationship (id.), and may additionally provide for private rights of action (which the FTC Act does not). Nonetheless, in some jurisdictions, a franchisee may be able to utilise the FTC Act in conjunction with state common law and state statutes to qualify as a consumer deserving of protection in the franchise context. The FTC Act contains a broad prohibition against ‘unfair and deceptive acts or practices’; for example, see Section 15 USC 45 (‘Unfair methods of competition in or affecting commerce, and unfair or deceptive acts or practices in or affecting commerce, are hereby declared unlawful.’) Since many states also have enacted similar statutory regulations prohibiting unfair or deceptive trade practices, there may be circumstances in certain jurisdictions where an offer or sale of a franchise, or other act that would be considered an unfair or deceptive act or practice under an analogous state law (Little FTC Acts) can give rise to a private right of action.
v Competition law
In the United States, competition law is generally known as antitrust law and it prohibits agreements that unreasonably restrain trade. The federal antitrust statutes that are most likely to apply in a franchise context are the Sherman Act. (15 USC Section 1 et seq.) (prohibiting ‘anticompetitive or monopolistic conduct’), and the Clayton Antirust Act (15 USC Section 12 et seq.) (prohibiting, inter alia, anticompetitive ‘price discrimination’, ‘exclusive dealing’, and ‘tying’). In addition to the federal antitrust statutes, almost every state in the United States has enacted its own antitrust laws, which are often modelled after the federal antitrust statutes. Since, however, there may be significant differences among the state statutes, the law of each state (where a franchise will be conducting business) should be analysed along with applicable federal laws. The ultimate purpose of federal and state antitrust laws is to preserve and promote competition in relevant markets.
Antitrust was once a major area of litigation and concern for both franchisors and franchisees, particularly with respect to the issues of: (1) price-fixing (e.g., franchisors setting maximum or minimum prices); (2) exclusive dealing requirements (e.g., requiring franchisees to deal only with particular designated suppliers); and (3) tying (e.g., requiring that franchisees purchase products or services not directly related to the trademarked franchised product or service). However, in the past few decades, courts have significantly reduced the applicability of antitrust laws in the franchise context by narrowly interpreting the definition of the applicable ‘market’ for antitrust claims so as to exclude franchises. In short, many courts have found that the market for antitrust analysis purposes should be limited to the sale of the franchise itself, and as long as a franchisee was properly advised of the restrictions applicable to its trade (e.g., disclosed in an FDD) before it became a franchisee, it could not seek antitrust protection after agreeing to the terms of the franchise agreement. Further, courts are increasingly using the more permissive ‘rule of reason’ test in analysing the permissible conduct of a franchisor in areas that had been considered per se antitrust violations. Therefore, a franchisor’s ability to point to a reasonable economic justification for the complained of conduct will usually be sufficient to defeat an antitrust claim.
Consequently, as the law now stands in most jurisdictions, including in most federal courts, a well-drafted franchise agreement, and FDD, which contain sufficient disclosure of any contractual requirements to purchase certain goods or services, restraints on a franchisee’s ability to freely conduct business, or requirements that franchisees deal with specific vendors, will defeat most antitrust claims.
vi Restrictive covenants
It is typical for a franchisor to impose a non-competition restriction upon the franchisee during the franchise term and after the expiration or termination of the franchise term, as well. In these non-competition clauses, franchisors will require franchisees to refrain from directly or indirectly owning, engaging in or associating with any business that directly competes with the franchisor’s system. Non-competition clauses will also preclude franchisees from hiring current or former employees of the franchisor, the franchisee or the franchisor’s other franchisees or soliciting business from the franchisor or other franchisees. To be enforceable, it is important that the non-competition clause is reasonable in duration and geographical scope. Non-competition clauses that impose a restriction during the term of the franchise agreement and one to three years after the expiration or termination of the franchise agreement, with a geographical scope encompassing a radius of 10 to 20 miles surrounding the franchisee’s ‘unit’ and, perhaps, other existing units within the geographic area in which the franchised unit was located are not uncommon. If a franchisee violates the non-competition clause, the franchise agreement will usually provide that the franchisee consents to the franchisor having the right to obtain an injunction against the franchisee without the need for the franchisor to prove the merits of its case. Violation of the non-competition clause may result in the franchisee having to pay liquidated damages to the franchisor (see Section VI.vii).
Franchise agreements typically contain provisions whereby a franchisor, under certain circumstances, may terminate a franchise. Usually, the franchise agreement will require that the franchisor or franchisee have ‘cause’ to terminate the franchise agreement, but this is not always the case. Generally, the franchise agreement will detail: (1) what actions or inactions constitute a default under the franchise agreement (an event of default), and (2) the period within which the franchisor or franchisee has to cure such a default (provided the franchisor deems the default to be curable). If an event of default has occurred, the franchisor will provide the franchisee with either: (1) written notice of the default and provide the franchisee with an opportunity to cure the default within the requisite cure period; or (2) written notice of termination if the default is incurable, such as in the case where a franchisee uses the franchisor’s trademarks in an unauthorised manner or discloses the franchisor’s confidential or proprietary information without the franchisor’s prior written consent.
While no federal law regulates the relationships between franchisors and franchisees, approximately half of the states in the United States (as well as US territories Puerto Rico and the US Virgin Islands) have relationship laws, which vary from state to state. While they usually relate to several aspects of the franchise relationship, the most significant is the franchisor’s ability to terminate or fail to renew a franchisee’s franchise agreement. Many relationship laws require franchisors to have good cause before they are permitted to terminate, or fail to renew, a franchise. While there is no standard definition of ‘good cause’, typically, good cause will exist if the franchisee has breached a material obligation of the franchise agreement. Relationship laws generally require the franchisor to provide the franchisee with written notice that it seeks to terminate (or will not renew) the franchise agreement. Franchisees typically have between 30 and 90 days to cure the alleged default and avoid termination. However, where the default is based upon events that should not require an extended period to cure (e.g., health violations in a food-related franchise or the franchisee’s failure to pay royalties or other sums owed to the franchisor), the franchisor is often permitted to provide the franchisee with a much shorter period to cure the defaults and avoid termination. Where certain defaults are alleged that are perceived to be egregious (e.g., unauthorised use of the franchisor’s trademarks, or otherwise seriously impairing the franchisor’s brand and reputation), or where certain exigent circumstances exist (e.g., franchisee’s loss of its right to occupy its premise), some relationship laws permit the franchisor to terminate the franchise immediately and without providing the franchisee with any opportunity to cure the alleged default.
Often, franchises make large investments of both time and money in connection with their franchises, and relationship laws were passed to provide franchisees with some protection against the loss of their franchise investment through no fault of their own. Of the states that have relationship laws, some incorporate relationship law provisions into a broad franchise disclosure or registration statute; some have a relationship law that is separate from the state’s disclosure or registration law; and others have relationship laws but have no franchise disclosure or registration statute. Any inconsistent or contrary provision that is contained in a franchise agreement will be set aside and superseded by an applicable relationship law. Thus, if the franchisor is operating in a relationship state, it will likely have to establish good cause for termination, even if the franchise agreement allows the franchisor to terminate the franchise agreement with or without cause.
In the event that the franchise agreement expires or terminates, the franchise agreement will set forth the franchisor and franchisee’s rights and obligations thereafter, including: (1) the franchisee’s obligation to de-identify its business and cease using the franchisor’s trademarks; (2) the franchisor’s right to purchase the franchisee’s franchised business; and (3) the franchisor’s right to replace the franchisee as lessee under any lease.
Almost all franchise agreements contain post-term restrictive covenants that seek to prevent the franchisee from operating, owning or being involved in a business that competes with the franchisor. Franchisors typically seek to impose such restrictions because they assert they are necessary to protect their ‘legitimate business interests’, which, for example, would include the protection of confidential or proprietary information or the goodwill that has been developed by the franchisor over time. While such restrictions were disfavoured in the early years of modern franchising (i.e., the 1980s and 1990s), the more current trend has seen courts broaden their view of franchisors’ legitimate interests and to expand the enforceability of such restrictive covenants within ‘reasonable’ limits. Generally, the ‘reasonableness’ standard will focus on three major aspects of the provision: (1) what kinds of businesses are said to be ‘competitive’ and therefore prohibited; (2) the geographic area covered by the restriction; and (3) the duration of the restriction. Currently, most states in the United States, with the major exception of California, will enforce such reasonable post-term restrictive covenants. This issue is almost always determined as a matter of state common law, although some states have passed legislation that addresses this issue. (These restrictions almost never run afoul of federal antitrust laws because they rarely, if ever, affect competition in a relevant market.) Many states permit their courts to utilise some form of blue-pencilling to either strike out certain portions of a restrictive covenant that the court may deem to be ‘overreaching’ or to otherwise modify and more narrowly tailor such a restriction that has been deemed by the court to be overly broad. Other states will simply strike down as unenforceable a restrictive covenant provision that is deemed to violate that state’s statutory or common law.
Many franchise agreements contain provisions by which the franchisor reserves the right to take over the operation and management of a franchisee’s business under certain circumstances, such as where a principal owner and manager of the franchise passes away and no ‘certified’ manager is available to properly manage the business. Sometimes this is referred to as a ‘step-in right’. Other circumstances where franchisors may try to assert a step-in right include where the franchisee has failed financially and has closed the franchised location, where the franchisee has committed an incurable default such as engaging in the unauthorised use of the franchisor’s trademarks or the unauthorised disclosure of the franchisor’s proprietary information, or where the franchisee has under-reported royalties that are owed to the franchisor. Where franchise agreements provide that the franchisor has the right to effectuate an assignment of the franchisee’s lease upon the termination or expiration of the franchise agreement and the landlord has agreed to this provision in a lease rider, then the franchisor may be able to take over the franchised location. While most franchise agreements provide for payment by the franchisor to the franchisee for the franchisee’s assets, the pricing formulae utilised vary from, among many, the fair market value of the business as a going concern to the depreciated cost of the ‘hard assets’. Where the franchise agreement does not contain such a right, or where the landlord has not agreed to such a right, then the franchisee or the landlord may object to the franchisor’s attempts to step in and take over the location. In such a situation, the franchisor may not be permitted under state law to use ‘self-help’ to take over the location and it is likely that the franchisor would be forced to seek relief in the courts before it takes such action.
Where a franchisor seeks to assert step-in rights to take over the franchisee’s location, a franchisee may pre-emptively file for bankruptcy protection under the US Federal Bankruptcy Code. Under bankruptcy law, generally, the filing of a bankruptcy petition results in what is called an ‘automatic stay’, which protects the debtor (in this case the debtor or franchisee) from acts or actions by creditors seeking to enforce claims against the debtor. Under such circumstances the franchisor would have to petition the bankruptcy court for relief, a process (which may not move very quickly) with no certainty of success.
While many franchise agreements provide that the franchisor may terminate the franchise agreement if the franchisee becomes insolvent or if it files for bankruptcy, provisions permitting the franchisor to terminate the franchise agreement where the franchisee files for bankruptcy protection may not be enforceable under the US Bankruptcy Code (see 11 USC Section 365(e)(1)(A)). In the event that a franchisee files for bankruptcy protection before its franchise agreement has been properly and effectively terminated by the franchisor (or prior to the franchisee’s lease having been properly terminated by the landlord), then the franchise agreement or lease becomes part of the debtor or franchisee’s ‘bankruptcy estate’. Where a debtor or franchisee seeks to ‘reject’ the franchise agreement or lease in its bankruptcy petition, the franchisor may be able to obtain quick relief from the bankruptcy court permitting it to take over the franchised business or location. However, where the debtor or franchisee wishes to continue operating its business and to ‘assume’ the obligations under the franchise agreement or its lease, it may not be easy for a franchisor to quickly take over the business or location where the debtor or franchisee was not otherwise in default of the franchise agreement or its lease (other than for the filing for bankruptcy) and where the bankruptcy court deems the assumption of the franchise agreement or lease to be in the best interests of the estate and its creditors. It will be more difficult for the debtor or franchisee to persuade the bankruptcy court to permit the debtor or franchisee to assume the franchise agreement or lease if the debtor or franchisee was also in material default of the terms and conditions of the franchise agreement or lease at the time the bankruptcy petition was filed.
viii Anti-corruption and anti-terrorism regulation
Franchisors that globalise their business operations must familiarise themselves with US federal anti-corruption and anti-terrorism laws and implement system-wide safeguards to ensure that they do not enter into franchise agreements with, or support franchisees who; (1) bribe foreign officials; (2) launder money; or (3) conduct business that supports terrorists. A franchisor that fails to do its due diligence and properly monitor its system risks being held civilly and criminally liable for its franchisees’ illegal conduct, at a potentially devastating cost to the franchise system.
Pursuant to the Foreign Corrupt Practices Act of 1977 (FCPA),7 companies and individuals are prohibited from bribing foreign government officials (i.e., providing money or anything else of value to a foreign public official in exchange for any assistance in obtaining or retaining business). A company can be liable for an FCPA anti-bribery violation committed by one of its employees or by a third-party individual acting as an agent of the company if the company knew or should have known about the violation.
The Department of Justice (DOJ) and the Securities and Exchange Commission have been particularly aggressive in enforcing the FCPA’s anti-bribery provisions and have been successful in extracting millions upon millions of dollars in penalties and settlements.8 DOJ officials were reported as saying in 2009 that ‘enforcement of the FCPA is second only to fighting terrorism in terms of priority’. Accordingly, franchisors are well advised to adopt anti-corruption compliance measures or conduct due diligence on their foreign franchisees to protect against any FCPA violations and to shield themselves from any exposure.
Franchisors should carefully monitor their business dealings and comply with US anti-money laundering and anti-terrorism laws, which are strictly enforced as well. The Bank Secrecy Act (BSA),9 as amended over the years and as augmented in the regulations issued by the US Department of Treasury,10 requires that US financial institutions; (1) maintain appropriate records of their customers’ currency transactions and banking activity; and (2) file reports, including the currency transaction report for transactions over US$10,000 and the suspicious activity report for transactions suspected of being in violation of federal criminal law, with the Department of Treasury’s Federal Crimes Enforcement Network. Also known as the ‘anti-money laundering (AML) law’, the BSA was initially designed as a tool to combat tax evasion and money laundering. In recent years, the reports generated by banks to meet their BSA reporting requirements have been increasingly used by law enforcement officials to detect and prevent drug trafficking and terrorist financing activity.11
In October 2001, Congress responded to the 9/11 attacks by passing an amendment to the BSA, known as the USA PATRIOT Act, which strengthened the BSA’s AML and anti-terrorism financing provisions. The USA PATRIOT Act requires, inter alia, that financial institutions establish their own AML programmes to detect money laundering schemes; and create customer identification programmes to verify customer identities.
The Office of Foreign Assets Control (OFAC) of the US Department of the Treasury administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries and regimes, terrorists, international narcotics traffickers, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United States.12
Franchisors operating abroad must keep current with OFAC’s published list of sanctioned individuals (Specially Designated Nationals) and targeted countries (e.g., North Korea and Sudan) and avoid conducting business with any listed countries and individuals, and their entities.
To ensure compliance with the anti-corruption and anti-terrorism laws, franchisors should incorporate anti-corruption and anti-terrorism provisions within their franchise agreements. These provisions should: (1) obligate the franchisee to comply and assist the franchisor in complying with all applicable anti-corruption and anti-terrorism regulations and executive orders; (2) restrict franchisees from entering into prohibited transactions; (3) require franchisees to comply with all applicable currency reporting laws; and (4) require franchisees to guarantee to the franchisor that no owners or key personnel have been designated as (or associated or affiliated with) a terrorist or suspected terrorist.
ix Dispute resolution
The US judicial system generally follows a common law adversarial model, where each party must argue its position before a neutral judge or arbitrator, who will then decide the issue on the basis of the arguments and evidence presented. While juries may also determine factual issues in the US court system, most franchise agreements provide that the franchisee waive the right to a jury trial. In general, each party must bear its own legal costs and expenses, including attorneys’ fees, and disputes can be costly, even if a party prevails. Therefore, both franchisors and franchisees are well advised to take steps, such as hiring competent franchise counsel to review agreements and key legal documents, and complying with all applicable rules and regulations, to minimise the likelihood of having disputes. Further, when disputes do arise, parties are similarly advised to attempt to try to resolve them amicably, as the cost of litigating over an issue will often be significant.
There is not a uniform forum in the United States where all franchise disputes are litigated. Which court has jurisdiction (e.g., federal or state court) can be a complex question depending on a variety of factors, including the types of claim brought, the amount in controversy, who the parties are, where they are located and whether they have agreed to a specific forum for resolving their claims. Choice of law provisions, and forum selection provisions, including those that require international forums and choice of law, are generally upheld, but can be challenged in court, normally in the context of a motion to compel arbitration, or to stay arbitration (often under the Federal Arbitration Act (FAA), 9 USC Section 1 et seq.). The United States is a signatory to the UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards, and courts will normally recognise foreign arbitral awards from other Convention Member States.
Private parties can also mutually agree to resolve their disputes outside court, and often do so. This is generically referred to as alternate dispute resolution (ADR). Common forms of ADR are arbitration and mediation (discussed further below). Usually the specific form of ADR (if any), along with applicable procedures and rules, are detailed in the franchise agreement (generally called dispute resolution provisions). Parties can agree to waive certain types of damages (e.g., waive punitive and consequential damages), limit the amounts that can be recovered under certain circumstances (e.g., liquidated damages provisions) or agree that attorneys’ fees, or arbitrators’ fees, and other costs shall be paid by the losing party (fee-shifting), agree to litigate or arbitrate a dispute at a specific location (a forum-selection clause), agree to a choice of law (e.g., only New York State law will apply), limit or reduce the period in which to file a lawsuit (a shortened statute of limitations), agree to waive their rights to bring any collective or class actions (a class action waiver) and to engage in ADR (e.g., agree to arbitrate or mediate a dispute). There are limits to what a party can contract to. There are some public policy exceptions, a waiver must be knowing and voluntary, and some rights cannot be waived or altered (for example, many state franchise statutes do not allow parties to waive their rights under those statues).
Arbitration is a form of ADR that is binding. The parties agree, by contract or consent, to submit their dispute to a neutral arbitrator (or panel of arbitrators), who is empowered to make a determination. The Federal Arbitration Act, 9 USC Section 1 et seq. is a statute that governs arbitration and provides that arbitration is generally favoured and that arbitration clauses, and arbitrators’ rulings, will usually be enforced (with some rare exceptions). After the arbitrators make a ruling, the prevailing party may turn that ruling into a court judgment by having it confirmed by a court and the non-prevailing party can seek to have the award vacated. However, the ability for an unsuccessful party to overturn, or vacate, an arbitration award is limited and extremely difficult to achieve. Arbitration is a ‘creature of contract’, meaning that the parties can determine by agreement what the rules are and how the arbitration will be conducted. Typically, however, parties will agree to conduct their arbitration through a nationally recognised arbitration service, which will have well-established rules and procedures for conducting the arbitration (such as the American Arbitration Association or the International Institute for Conflict Prevention and Resolution). It is imperative that the arbitrator have experience in franchise law, and having been a practitioner in the field is certainly a plus. Arbitration is generally held in the county in which the franchisor has its principal office, and the associated fees are often shifted to the non-prevailing party.
There is no ‘correct’ answer as to which forum is ‘better’ for franchise disputes, and there are positive and negative aspects to each method of dispute resolution. In general, arbitration is less formal than litigation, involves less discovery and motion practice, and does not necessarily follow formal rules of procedure or evidence. Therefore, arbitration can be less expensive and time-consuming than litigating before a court. Arbitration proceedings are also usually private and confidential. In contrast, court proceedings are generally open to the public. Therefore, arbitration is a very popular forum (especially for franchisors), and many franchise agreements contain dispute resolution provisions requiring arbitration. However, in recent years, arbitration costs have increased, and arbitration has increasingly incorporated more discovery, rules and motion practice (thereby becoming more like court litigation). Arbitrators are also not necessarily bound to strictly follow the law, so long as they do not make a decision in ‘manifest disregard’ of the law. Litigation may be preferable where a party can quickly resolve a dispute (that has little or no legal basis) through motion practice (e.g., through a motion to dismiss), which can eliminate baseless claims quickly and efficiently.
Mediation is a form of ADR that is non-binding, and typically involves the parties agreeing to submit their dispute to a neutral person, who in turn will attempt to help the parties reach a settlement. While many ADR forums provide mediation services, the parties may also select their own private mediator. The mediator is not empowered to decide the dispute, but rather seeks to facilitate the parties’ efforts in reaching a settlement. Therefore, unless the parties settle, the dispute is not resolved, and the parties will return to litigating or arbitrating the dispute. Nonetheless, mediation is an excellent means of trying to resolve disputes without incurring the cost of litigation, and a sophisticated, experienced and knowledgeable neutral mediator can be invaluable in resolving disputes by providing an unbiased view of each party’s position. Many franchise agreements require mediation, then arbitration or litigation if mediation is unsuccessful. Mediation can take place at any time during a legal proceeding, not only prior to its commencement. Mediation will usually be held in the city in which the franchisor is located, but some franchisors will agree to hold it in the county of the franchisee’s principal place of business to help defray the franchisee’s costs associated with such mediation. The National Franchise Mediation Program (NFMP), in which many of the larger US franchisors participate, encourages this approach. The costs of the mediation are often equally divided between the franchisor and franchisee.
Notably, regulatory actions (those where a governmental entity is bringing an action) are not private lawsuits (and do not typically allow parties to engage in arbitration), and may require a party to appear in a specialised forum or proceeding before that regulatory body. Examples are the FTC, which regulates franchises, or the NLRB; these have their own regulatory forums and proceedings, and may also bring certain actions in federal court.
Actions for temporary restraining orders, preliminary injunctions and permanent injunctions (commonly called injunctive relief) can be brought in federal or state courts (depending on the circumstances) to obtain emergency relief. Injunction actions will usually only be granted if, without an injunction, a party will suffer ‘irreparable harm’. Common examples in the franchise context include protection of intellectual property (such as protection of a franchisor’s trademark or confidential operations manual being used without permission), instances where irreparable damage, not compensable by monetary damages alone, will result in the complete loss of a business (e.g., a franchisee who is being improperly terminated, or not being ‘renewed’, and as a result their entire business will be destroyed) or cases where a party seeks by injunction to stay a litigation (put it ‘on hold’) and ‘compel’ a party to arbitrate, where arbitration is required by the FAA.
Where a former franchisee continues to improperly utilise the franchisor’s registered trademark, a franchisor can initiate an injunction action, alleging violations of the federal Lanham Act by the former franchisee, and apply for immediate relief, asking a court to issue a preliminary order enjoining or preventing the former franchisee from utilising the mark, and forcing it to de-identify (without having to go through the formal and more lengthy process of litigating or arbitrating the entire dispute). The newly enacted Defend Trade Secrets Act (DTSA) also provides for injunctive relief and expedited ex parte relief (including orders for seizure of trade secret materials), and has extra-territorial (international) application. Therefore, while the DTSA is a relatively new statute without many decisions interpreting it, it has significant potential for use in the franchise context, especially in the circumstance where a terminated franchisee continues to improperly utilise a franchisor’s trade secrets.
Many franchise agreements with dispute resolution provisions requiring arbitration contain ‘carveouts’ – specific clauses allowing injunction actions to be brought in court even though the balance of the dispute must be arbitrated. Recently, a number of arbitration forums have built into their standard rules an injunction procedure, allowing for expedited or interim relief akin to an injunction action. However, the enforceability, speed and effectiveness of these new provisions has yet to be vetted, particularly since, to enforce an arbitrator’s decision, a prevailing party must generally first confirm an arbitration award.
x Real estate matters
Whether offering single-unit franchise opportunities, area development rights, master franchise opportunities or area representative arrangements, a factor crucial to the successful expansion of a franchise system is the location of its units. Most franchise systems will require its franchisees to operate from a commercial property. If the franchisee does not own a commercial property (which typically they do not), then the franchisee will need to lease a commercial space to operate the franchised business. The franchise agreement will often require the franchisee to obtain first the franchisor’s approval of the location before the franchisee can commence lease negotiations. Once the franchisee has notified the franchisor of its proposed location, the franchisor, or its representative, would be likely to visit the location to assess whether it satisfies the franchisor’s location criteria. Once the franchisor has approved a location, the next step is to negotiate the lease.
Negotiating a lease where the commercial tenant is also a franchisee can be challenging since the lease must protect not only the landlord’s and tenant’s interest, but also that of the franchisor. While the franchisor, franchisee and landlord share the common goal of negotiating a successful lease arrangement, each party has distinct, conflicting issues that they must reconcile to protect their respective interests. Some of these conflicting issues include: (1) the permissible uses of the commercial premises; (2) franchisee default notification and the franchisor’s right to cure any such default; (3) assignment clauses and the ability to assign to the franchisor (or its affiliates) or another franchisee, whether on sale or upon a default under the franchise agreement; (4) restrictions on the landlord leasing to the franchisor’s competitors; and (5) franchisee’s signage, decor and future remodelling obligations.
To protect its brand, the franchisor will frequently utilise a lease rider that will require the landlord to inform the franchisor of the franchisee’s failure to meet its lease obligations and will give the franchisor the right to cure the defaults, if it elects to do so. The lease rider may also include language granting the franchisor the right to either: (1) step into the franchisee’s position under the lease; or (2) substitute another franchisee to operate the store without the landlord’s consent. Some landlords will simply consent to such a provision in a three-party rider or addendum to the lease, which is signed by the franchisor, franchisee or tenant and the landlord. While other landlords may require franchisors to cure any defaults (including outstanding rent or additional rent) before the franchisor or another franchisee can take over the lease. Whether the franchisor will enter into the lease directly and sublet to the franchisee or have the franchisee enter into its own lease is a business decision franchisors must address, as is the issue of whether or not a franchisor will provide a lease guaranty (not often the case). The franchisor’s ability to take over the franchisee’s location upon the expiration or termination of the franchise agreement is also an issue about which franchisors and franchisees are likely to have differing views.
xi Franchisee associations
In recent years, franchisees have increasingly sought to form associations that allow them to interact with the franchisor as a group rather than on a one-to-one basis. True franchisee associations are independent and are formed and financed by the franchisees themselves as opposed to franchise advisory councils or other franchisor-designated groups or committees.
Since the relationship between a franchisor and its franchisees is generally not between financial equals, and since the parties’ franchise agreement typically favours franchisors and seeks to protect the franchisors’ rights and interests, having an active and effective independent franchisee association can help franchisees to level the playing field to some extent when interacting with the franchisor.
When a franchise system has an independent franchisee association, it often results in meaningful benefits to the system as a whole. For example, a well-organised franchisee association will enable a system’s franchisees to report issues and concerns that they have to the franchisor relatively quickly after they arise. Where both sides discuss these issues openly (at scheduled meetings, for example), and where good-faith efforts are undertaken to find acceptable resolutions, potential conflicts between the franchisor and its franchisees can be addressed and averted. Where franchisees are provided with an opportunity to communicate with each other and to exchange ideas with the franchisor on a collaborative basis, it can be beneficial to the system and the franchisor’s brand. Prospective franchisees who are considering entering the franchise system may perceive the existence of an independent franchisee association to be a positive factor. If a given franchise system has a franchisee association, it is recommended that prospective franchisees contact the franchisee association’s leaders (as well as a number of franchise owners and even former franchise owners) when doing their due diligence (prior to making the franchise investment) to gain insights and information about the pros and cons of how the franchisor operates its system and to get a sense of the satisfaction (or dissatisfaction) levels that many of the franchisees have.
Several states have enacted franchise relationship laws that prohibit franchisors from interfering with or restricting their franchisees from forming independent franchisee associations. The trend in the law and in the US franchising industry generally is that the continued recognition and increasing acceptance of such independent franchisee associations will have an overall positive impact on franchise systems.
xii Private equity deals
Once upon a time, private equity funds held little interest in investing in the franchise industry, but times have changed. The predictable cash flow, favourable investment returns and growth opportunities in franchising have made the industry an attractive investment option for private equity funds. Private equity funds are looking to invest not only in franchisors, but also in franchisees. Recently, Sun Capital Partners Inc purchased CCW LLC, a HuHot Mongolian Grill franchisee with just 21 total locations. This added to its investment portfolio, which includes Boston Market, Captain D’s Seafood Kitchen and Fazoli’s Restaurants. Investors are attracted to large, well-known brands that are sure to be profitable, and both franchisors and franchisees are attracted to the reliable, large amounts of capital that private equity firms can provide. Both franchisors and franchisees often use this interest by private equity firms to their advantage, because private equity groups can: (1) provide skilled expertise; (2) expose the franchise system to new business contacts; and (3) implement efficiency enhancing protocols, which may increase the overall value of the franchise system by making it more competitive and more profitable. The large amount of reliable capital allows them to acquire more units and ultimately provides more leverage in the franchise relationship and more leverage with suppliers. This option is particularly attractive to area developers and multi-unit operators, who need more capital to operate numerous locations within their area.
When private equity investors enter into an agreement with a franchisee (usually a multi-unit developer), the franchisor’s concerns must be addressed. This is usually done when the franchisee and franchisor initially enter into their contract. An operating agreement may allow a franchisee the option to enter into deals with investors, but the franchisor will usually require the franchisee to maintain full managerial and operating control over the company and, frequently, a controlling interest in the company. However, franchisors are often open to private equity relationships between the franchisee and the investor because the private equity investment makes it more likely that the franchisor will continue to receive its royalties and fees on time and in accordance with the agreement between franchisor and franchisee, and that the area developer will have the ability to open more units.
Franchisors and franchisees can face complications in soliciting investors, and the process can be time-consuming. When entering into an agreement with investors, the franchisor or franchisee must prepare a deal prospectus and a private placement offering memorandum that outlines (for potential investors) the terms of the investment and will include a copy of the operating document between the franchisor and franchisee. Taking on investors can also present a change of pace for the entrepreneurial franchisor or franchisee (who is often accustomed to working independently) since the investment may require the franchisor or franchisee to be at least partially beholden to the investors providing loans or capital (or both) for the business. Careful planning and the delineation of parameters of control, responsibility and financial matters at the outset will govern the private equity relationship, and are crucial to ensuring a profitable and healthy relationship between all parties going forward.
Private equity deals can provide exit strategies for foreign-based investors and can, if necessary, save a franchisor facing financial uncertainty. Mergers can also provide similar relief and benefits for franchisors looking to increase in size or obtain financial strength or a greater market presence.
VII CURRENT DEVELOPMENTS
i Joint employer liability
The application of joint employer liability has been a hot-button issue in the franchise industry ever since the National Labor Relations Board (NLRB) issued its 27 August 2015 decision in Browning-Ferris Indus of California, Inc. In that decision the NLRB announced a new standard for determining whether two separate employers constitute a joint employer under the National Labor Relations Act. Prior to this announcement, the NLRB had held that joint employer liability existed if ‘one employer, while contracting in good faith with an otherwise independent company, has retained for itself sufficient control of the terms and conditions of employment of the employees who are employed by the other employer’. In applying this standard, the NLRB and the courts primarily focused on whether a putative joint employer’s control over another company’s employment matters is ‘direct and immediate’. In 2015, that long-standing analysis was reversed and a new standard instituted. This new standard no longer required a putative employer to have direct and immediate control of the terms and conditions of employment of another employer’s employees. Instead, indirect control was now sufficient to establish a joint employer relationship, thereby potentially ensnaring franchisors in the joint employer liability net. To date, no courts have followed the NLRB’s decision, and it looks as if the NLRB’s expansion of joint employer liability is going to be scaled back under the Trump administration. On 7 June 2017, the US Secretary of Labor announced the DOL’s withdrawal of guidance on independent contractors and joint employer liability issued in 2015 and 2016 by the DOL under the Obama administration, which indicates that the Trump administration will likely take a more pro-employer stance on the joint employer issue. This was a minor victory for businesses (particularly, franchisors), because the DOL’s announcement did not rescind the NLRB’s interpretation of joint employer liability. Thus, the NLRB could (as of the date of that announcement) still apply its interpretation of joint employer liability against companies despite the Board’s withdrawal of its guidance on joint employer liability. However, as of the finalisation of this chapter, that minor victory turned into a major victory for businesses. On 14 December 2017, in a three-two decision, the NLRB reversed the Board’s 2015 decision in Browning-Ferris Indus of California, Inc. In its decision, the Board held that ‘in all future and pending cases, two or more entities will be deemed joint employers under the National Labor Relations Act (NLRA) if there is proof that one entity has exercised control over essential employment terms of another entity’s employees (rather than merely having reserved the right to exercise control) and has done so directly and immediately (rather than indirectly) in a manner that is not limited and routine’. Thus, ‘proof of indirect control, contractually reserved control that has never been exercised, or control that is limited and routine will not be sufficient to establish a joint-employer relationship’. US franchisors will now emit a long sigh of relief, and franchise pundits who have been writing about this for two years may actually have to find another topic to write about.
ii Financial representations made under Item 19
One of the essential factors that prospective franchisees and multi-unit developers take into consideration in evaluating whether a franchise opportunity is the right one for them is disclosed in Item 19, which addresses the question (albeit indirectly) ‘How much money can I expect to make?’ Under Item 19, franchisors may (but are not obligated to) provide prospective franchisees with financial performance information (such as past or projected revenues or sales, gross income, net income or profits) concerning existing franchised and company-owned units, provided that there is a reasonable basis for the information, and that information can (and has, in many instances) give rise to a governmental or private cause of action under federal, state or common law. As a general rule, franchisors are precluded from providing prospective franchisees and developers with any financial representations that are not disclosed in the franchisor’s FDD, with the exception that: (1) franchisors can provide the actual operating results of a specific unit that the franchisor is offering for sale, provided that the information is given only to potential purchasers of that unit; and (2) if a franchisor has furnished an Item 19 disclosure, it may furnish a prospective franchisee with a supplemental financial performance representation pertaining to a particular location. Until recently, there was little guidance concerning the manner in which franchisors made financial performance representations. However, on 8 May 2017, the North American Securities Administrators Association (NASAA) adopted guidelines regarding how franchisors are to make and substantiate any financial performance representation they disclose under Item 19. The guidelines, among other things: (1) restrict the information that a franchisor can use as the basis for its projection or forecast; (2) require franchisors disclosing the average of gross sales or a median between gross sale levels to also include the highest and lowest number in the range; and (3) require that franchisors also disclose its worst performers, if it elects to disclose its best performing outlets. The guidelines become effective 180 days after the date NASAA adopted them, or 120 days after a franchisor’s next fiscal year end, if the franchisor has an effective FDD as of the date of adoption of the guidelines by NASAA. This means that franchisors renewing their FDDs for 2018 must make sure that they comply with NASAA’s guidelines. Therefore, it is even more imperative for franchisors to retain knowledgeable franchise counsel who are familiar with and understand the new NASAA guidelines.
iii The impact of the internet on franchising, shopping-centre development and real estate
The rise of e-commerce has changed the face of the retail industry. With more consumers opting to purchase goods and services online in lieu of waiting in line to purchase items at a brick-and-mortar store, there has been an influx of brick-and-mortar store closures, which has already impacted and, inevitably, will continue to impact a variety of factors relating to franchised retail locations). A report issued by Credit Suisse on 31 May 2017 predicts that between 20 per cent and 25 per cent of shopping malls in the United States, some 275 shopping centres, will close within the next five years. This staggering (potential) occurrence could have a cataclysmic effect on franchising at the retail level. While this is not the death of franchising, it may call for some modification of the typical franchise model. Most franchise agreements have a carveout that gives the franchisor the right to sell its goods (or services, where applicable) at certain types of venues within the franchisee’s territory. Internet sales are universally included in this carveout. As internet sales of goods typically sold at retail by franchisors rise, the viability of retail franchised locations will be placed in jeopardy. Franchisors may be forced to consider giving franchisees a relatively small percentage of the gross online sales revenues generated within the franchisee’s territory, to keep the franchise system alive. This profit-sharing formula would take into account the profit that the franchisee would have generated in its retail store from the ‘lost sale’, as well as the fact that the franchisee would incur virtually no overhead expenses with respect to the income received.
iv Franchising and crowdfunding offerings
Franchisors and franchisees are both always looking for ways to inject capital into their businesses. The Jumpstart Our Business Startups Act (the JOBS Act), enacted on 5 April 2012, established a regulatory structure for startups and small businesses to raise capital through securities offerings using the internet through crowdfunding. The crowdfunding provisions of the JOBS Act were intended to help provide start-ups and small businesses with capital by ‘making relatively low dollar offerings of securities featuring relatively low dollar investments by the “crowd”’ less costly. Not only franchisors, but also multi-unit developers, franchisees and small franchise systems may find this to be an attractive alternative to conventional methods of raising capital, but they must be mindful that they will have to comply with certain statutory disclosure and regulatory requirements. In particular, issuers must file a Form C with the Securities and Exchange Commission (SEC), wherein the issuer must provide information about its: (1) principal owners (i.e., beneficial owners of at least 20 per cent of outstanding voting ownership interest) and directors; (2) a business plan; (3) the intended use of the funds being raised through the offering; and (4) audited financial statements. This same information must be provided to all prospective investors. For franchisors, meeting this criteria will be fairly simple since virtually all this information is contained in the franchisor’s FDD. However, franchisees and multi-unit developers looking to use crowdfunding will first have to obtain the franchisor’s consent and, if granted, retain knowledgeable counsel to prepare the necessary disclosures and ensure compliance with the SEC’s regulations. Moreover, crowdfunding does not permit issuers to raise unlimited capital. Issuers of this type of offering are limited to raising a maximum of US$1million during any 12-month period. While crowdfunding lessens the restrictions on securities offerings, it has its limits and will require franchisors, franchisees and their counsel to be familiar with and to fully understand the pros and cons of raising capital through this method.
v Elder-care franchises and elder abuse
The US population continues to age and a large segment of the population now needs ‘elder care’, ‘home health care’, or other services targeted towards assisting the elderly. Franchised businesses targeting this segment of the population present attractive opportunities for prospective franchisees. However, these opportunities offer the potential to be exploited by those seeking to prey on the elderly community. Recently, President Trump signed the Elder Abuse Prevention and Prosecution Act of 2017, which is aimed at combating elder abuse. The legislation, among other things: (1) designates at least one US attorney in every federal district to prosecute elder abuse cases; (2) imposes stiffer criminal penalties for email and telemarketing fraud against seniors; and (3) provides comprehensive training for those conducting elder-care abuse investigations. It is, therefore, important that franchisors carefully vet their prospective franchisees and advise them to carefully vet their employees to guard against those who may target elder-care businesses as a means to take advantage of this vulnerable community.
1 Richard Rosen is the managing partner, Leonard Salis and John Karol are partners and Michelle Murray-Bertrand and Avi Strauss are associates at the Richard L Rosen Law Firm PLLC.
2 See 26 USC Section 882(a)(1). See also 26 USC Section 864 (definitions).
3 Will K Woods, ‘Tax Considerations Related to Cross-Border Franchise Transactions’ in Fundamentals of International Franchising, ch. 3 (2nd edn, 2013).
5 See generally George J Eydt et al., ‘Bringing a Foreign Franchise System to the United States 7-11’ (ABA 32nd Annual Forum on Franchising, 14 October 2009).
6 26 USC Section 482.
7 15 USC Section 78dd-1 et seq.
8 See, e.g., NY Times, at B1 (18 November 2016), available at www.nytimes.com/2016/11/18/business/dealbook/jpmorgan-chase-to-pay-264-million-to-settle-foreign-bribery-charges.html?_r=0 (reporting on the settlement agreement between JPMorgan Chase and the DOJ for US$264 million relating to an alleged bribery scheme involving the bank’s practice of hiring Chinese officials’ children).
9 31 USC Section 5311 et seq.
10 See 31 CFR Part 103.
11 See FDIC Risk Management Manual of Examination Policies, Section 8.1-1, available at www.fdic.gov/regulations/safety/manual/section8-1.pdf.