The Franchise Law Review: USA
The coronavirus pandemic has had a significant impact on the franchising industry in the United States. Prior to covid-19, the United States was home to 2,500 franchise systems that operated 800,000 franchised establishments in 300 different industries. These franchised businesses supported over 7.6 million direct jobs, US$674 billion in direct economic output for the US economy and 2.5 per cent of the US gross domestic product. It was estimated that franchising accounted for 50 per cent of all retail sales in the United States. However, due to the covid-19 outbreak, as at August 2020, an estimated 32,700 franchised businesses closed – 10,875 permanently and 21,834 temporarily. Further, the franchising market experienced an estimated loss of 1.4 million jobs because of the pandemic, of which 40 per cent are projected to be permanent job losses. The franchising industry is known for its resilience and innovation, but it remains to be seen how quickly the industry will bounce back once the pandemic has subsided.
The 10 largest franchise systems in terms of worldwide sales are based in the United States: McDonald's, 7-Eleven, KFC, Burger King, Ace Hardware, Subway, Domino's, Pizza Hut,Chick-fil-a and Circle K. These franchise systems accounted for more than US$300 billion in annual sales prior to the pandemic. Much of the growth in the United States franchise industry is attributable to multi-unit ownership, which constitutes 55 per cent of all franchise locations in the United States. While most well-established franchise brands are growing, much of the growth during the past 10 years is due to the expansion of new and emerging concepts.
The interests of franchise brands in the United States are represented by the International Franchise Association (IFA). Based in Washington, DC, the IFA is the oldest and largest organisation representing franchising worldwide. The IFA works through its government relations, public policy, media relations and educational professionals to protect and enhance the franchise business model. The outlook for the franchise sector remains strong, despite a variety of regulatory issues, legislative proposals and economic challenges.
The decision to begin franchising in the United States should not be taken lightly. Such a decision should be strategic, as it will require a significant commitment of resources by the franchisor. Franchisors planning to enter the US market must satisfy several legal requirements and will incur a variety of compliance costs. Most importantly, the franchisor will have to register and protect its trademarks in the United States and adapt its franchise agreement as necessary to account for local laws, language, currency and the US market. There is also a requirement under the Federal Trade Commission (FTC) Franchise Rule to provide pre-contractual disclosures to a prospective franchisee by providing a franchise disclosure document (FDD). The FDD will have to satisfy a variety of state franchise disclosure laws in addition to the FTC Franchise Rule. Moreover, 15 states require that franchisors register their FDDs (and an additional seven states require a filing) prior to offering or selling franchises in those states. The disclosure and registration requirements are intended to protect franchisees and prospective franchisees.
The cost of providing support and assistance in the United States is likely to be higher than in many other countries. This is due to a variety of factors, such as the need for greater training and assistance, the introduction of a new concept in a foreign market and adaptation of the franchised concept to the US market. In addition, a key to the successful launch of a brand in the United States is the development of a secure, high-quality supply chain. It will be necessary for the franchisor to determine whether products and supplies must be imported from the home country into the United States – with the added expense of transportation and logistics services and the payment of customs duties – or whether proper suppliers and manufacturers can be located in the United States. Inevitably, a franchisor's personnel will need to travel to the United States to identify suppliers and franchise prospects, train personnel, inspect proposed sites, provide operational assistance and monitor franchisees' operations to ensure that they are operating in accordance with system requirements. The methodical franchisor should seek to budget for these expenses and should structure both its initial and ongoing fees accordingly. Of course, the size of the US market makes franchising attractive, even though the cost of doing business is substantial.
ii Foreign exchange and tax
Foreign-based franchisors do not face any significant barriers in obtaining payment of royalties and other fees and payments from US franchise operations. The US government does not restrict franchisees in the United States from remitting royalty payments abroad, although cash payments may be subject to anti-money laundering rules. Foreign exchange risks involving the US dollar historically have been equally low.
A franchisor entering the United States should seek tax advice to determine whether any special taxes will affect the financial terms of the franchise relationship. The US tax implications of a franchisor entering the US market depend upon the ownership structure of the franchise. Foreign franchisors may enter the US market by either entering into a franchise agreement, area development agreement, or master franchise agreement directly with an unrelated party; or by forming a US subsidiary to serve as a base of operations in the United States or as a joint venture partner. Each structure will have different tax implications, so it is advisable to seek advice from a qualified accountant or tax lawyer to create a tax-efficient structure. In addition, the effect of tax treaties must be considered.
i Brand search
While a proven business model with clearly defined procedures and operating guidelines is an important factor for evaluating a franchise, the cornerstone of most franchise systems is the power of the franchisor's brand. A franchisor's brand is itself composed of intellectual property – which is an intangible asset that has a major impact on the franchise system's likelihood of success. A franchisor's intellectual property, including its trademarks, trade names, patents and trade dress, has a critical influence on how customers perceive, identify and choose the franchisor's goods or services over those of another brand. Not surprisingly, brand identification is one of the most important aspects of building a successful franchise.
Unlike in many countries, trademark rights in the United States are based on use under common law rather than arising from trademark registration. This means that from the moment that an owner begins to use a trademark on or in connection with a good or service, the owner owns rights in the mark and it generates associated goodwill. This is true regardless of whether the owner has applied for a federal registration of the trademark with the US Patent and Trademark Office (USPTO) or state trademark authority. As a result, trademark counsel will routinely recommend that a franchisor run a full trademark clearance search to ascertain whether any third parties are using marks that are the same or confusingly similar to the franchisor's mark. A full clearance search typically includes a search of all federal and state trademark registers and common law uses, which can be found through internet searches and other publicly available materials. Trademark counsel analyse the search results on the basis of likelihood of confusion of the proposed mark with marks disclosed in the search.
Likelihood of confusion is based on balancing a series of factors. Among the more important factors widely recognised by the USPTO and the courts are: the similarity of the two marks in appearance, sound and meaning; the similarity and relatedness of the respective goods or services and their channels of trade; the strength or distinctiveness of the marks; the price of the goods or services and degree of likely consumer care in the purchase process; and any evidence of any actual confusion. A search will also assist in ascertaining the distinctiveness and, hence, the scope of protection that may be accorded the franchisor's mark. For example, if the search reveals several similar marks for related goods or services exist, it is likely that the franchisor's mark will be considered a 'weak' mark and afforded a narrow scope of protection. As another example, if the mark is a word that has been 'disclaimed' in registrations for similar goods or services offered by the franchisor, it will likely be difficult to obtain a registration for that word as a mark. In that instance, trademark counsel may recommend using the word in combination with other words or in a stylised form, which may render the mark distinctive enough that a registration can be obtained.
While trademark conflicts do arise, registration 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. Such rights are limited, however; including being limited by geographic area and by the industry in which the mark is utilised. Once established, federally registered trademarks provide for national usage and clear protection for the marks 'as registered'. 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 registration, it is very difficult for a common law mark holder to overcome the presumptions in favour of the federal registrant.
ii Brand protection
In the United States, common law trademark rights are limited to the geographical locations in which the mark is used, but federal registration of a mark affords nationwide rights in the mark regardless of where it is being used. Such registration confers nationwide priority as of the application filing date, contingent on the successful registration of the trademark.
Because trademark rights are based on priority of use, the franchisor's nationwide rights are limited to the extent that a third party can establish common law rights through prior use of the same or similar mark on, or in connection with, similar or related goods or services. A federal registration, however, would restrict those third-party rights to the areas of use as of the application filing date of the franchisor's mark. A franchisor can file an application following use of the trademark in commerce, or prior to use, as long as the applicant declares (under penalty of perjury) a bona fide intent to use the trademark in commerce. Where there is only a bona fide intent to use the mark, the registration will not be issued until the franchisor establishes use in commerce and the franchisor files a statement of use with a specimen of the trademark as used. The benefit of filing an intent-to-use application is that once the registration is issued, the effective date of the registration is the filing date of the application rather than of its first use in commerce. One exception to this rule is that an application trademark may be based on a pre-existing foreign registration or application under the Paris Convention or the Madrid Protocol.
Images, designs, software and other works protectable under copyright can attain protection from the moment of creation. As such, in addition to trademark protection, franchisors should consider obtaining copyright protection under the US Copyright Act by registering the copyright with the US Copyright Office. If a franchisor wishes to protect an invention or unique process it has developed, it may apply for a patent with the USPTO. Patents are generally more difficult to obtain than trademark and copyright registration, and the categories of inventions or processes that rise to the level of warranting patent protection are limited.
In addition to a franchisor using its mark, a franchisor must also enforce its mark against infringement. If a franchisor does not take steps to enforce its trademark rights, its rights in the mark may weaken and – in extreme cases – be forfeited. Enforcement of a trademark is imperative to maintain a strong and distinctive mark. A trademark enforcement strategy often begins with retaining a trademark watch service. Depending upon available resources, the watch service could cover filed federal applications, published applications, use of similar trademarks or names in commerce, and domain name registrations. Infringing uses are also often identified by internet searches and advertisements, and through the franchisor's franchisees, contacts or customers. An effective enforcement strategy typically entails a cease-and-desist letter, which identifies the franchisor's trademark rights, including identification of any federally registered marks, and demands that the infringer cease all use of the infringing mark.
In the event that a cease-and-desist letter does not resolve the infringement, the franchisor may decide to file a trademark infringement action. A trademark infringement suit can be commenced in either federal or state court, although federal court is usually preferred because of the greater familiarity of federal judges with trademark law. The same is true of suits alleging unfair competition or false designation of origin. A trademark owner does not have to hold a trademark registration to sue for trademark infringement. A trademark infringement action can be based on common law trademark rights.
To the extent trademark infringement arises from unauthorised use of a trademark in a website domain name, the franchisor owner may opt for a streamlined mechanism under the Uniform Dispute Resolution Policy. This policy, administered through the World Intellectual Property Organization, the National Arbitration Forum and others, offers limited relief (the cancellation or transfer of an offending domain name) to the extent that the franchisor can demonstrate bad-faith registration of a domain name that incorporates the franchisor's mark or a confusingly similar variation thereof. Use of this mechanism 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.
Additionally, franchisors should enforce their marks with the USPTO by preventing third parties from applying to register, or maintaining a registration for, the same or similar marks for use on or in connection with similar or related goods and services. The franchisor can do this by filing an opposition proceeding (commenced after an application for an infringing mark is published) or a cancellation proceeding (commenced after an infringing trademark is registered).
iv Data protection, cybercrime and e-commerce
In the age of e-commerce, franchisors and franchisees must also be ever vigilant regarding 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, viruses and malware. Failure to do so may leave a franchisor and its franchisees vulnerable to lawsuits from customers whose private information has been hacked or stolen. In addition, the FTC, the federal agency responsible for protecting consumers and promoting competition, enforces a wide variety of laws and regulations that require businesses to secure and protect the personal information that is collected, stored, analysed, shared, accessed, used, disclosed and discarded. Further, all 50 states have enacted laws to protect the privacy, security and confidentiality of personal data, some of which are more stringent than federal law. For example, the California Consumer Privacy Act of 2018 (CCPA), which became effective on 1 January 2020, is the most comprehensive data protection law in the United States, and the California Online Privacy Protection Act is the most restrictive online privacy protection law in the United States. In addition to government enforcement actions, private plaintiffs can bring lawsuits, including class actions, under these statutes. Several other states, including New York and Massachusetts, are considering passing data privacy laws similar to the CCPA. Meanwhile, two bills proposing a national federal law are currently pending in the US Congress.
There are also a variety of federal statutes that provide consumer protections in specific industries or with respect to specific kinds of transactions or interactions businesses have with consumers. For example, the Telephone Consumer Protection Act of 1991 (TCPA) governs a range of telecommunications activities. Among other things, the TCPA regulates the use of automated telephone dialling systems and pre-recorded and artificial voice phone messages that are delivered to consumers. The TCPA regulates telemarketing calls, robocalls and text messages delivered to both residential and wireless telephone numbers. The statute also operates in conjunction with the FTC's Telemarketing Sales Rule and the Do Not Call Implementation Act, which forbid telemarketers from calling phone numbers that have been registered on the national Do Not Call Registry.
The Fair Credit Reporting Act (FCRA) is another important consumer protection statute. It regulates businesses that compile 'consumer reports' as well as persons who use such reports and businesses that provide information to credit reporting agencies. It requires companies that use credit reports to give consumers notice when their credit report is investigated or used as part of an adverse decision, such as to deny an application for credit. In addition to actual damages, a violation can result in statutory damages of up to US$2,500 per violation. Franchisors must comply with the FCRA when obtaining credit checks on prospective franchisees.
In addition to the federal laws listed above, there are federal statutes that (1) regulate, with specific opt-out requirements, the delivery of emails in which the primary purpose is the commercial advertisement of a product or service; (2) require operators of websites or mobile applications directed at children under the age of 13 to provide a detailed privacy notice and obtain prior verifiable parental consent before collecting information from children under the age of 13; and (3) require financial institutions to give customers notice of the institutions' privacy practices and to safeguard customers' non-public personal information.
Because of the evolving nature of technology and the ever expanding laws protecting data privacy and security, franchisors should draft franchise agreement provisions relating to technology and data privacy and security as broadly as possible to allow for these future changes in the law, as well as changes in technology.
Franchising in the United States is regulated at both the federal and state levels. Therefore, it is imperative for a business considering expansion into the United States to determine whether its business arrangement constitutes a 'franchise' or 'business opportunity' and, if it does, to comply with all applicable federal and state laws.
Federal franchise legislation
As noted above, the FTC regulates franchising at the federal level under the FTC Franchise Rule.2 The FTC Franchise Rule (the FTC Rule) governs franchise offerings in each of the 50 states, the District of Columbia and all US territories. Under the FTC Rule, a business or licensing arrangement will be regulated as a franchise if it has three elements: (1) the franchisor grants the franchisee a right to use the franchisor's trademark; (2) the franchisor exerts or has the authority to exert a significant degree of control or assistance over the franchisee's method of operation; and (3) the franchisee pays the franchisor a fee of at least US$615. Even if the parties to a contract call it a licensing agreement, a distribution agreement or explicitly state that it is not a franchise arrangement, if the three elements are present, then US franchise law will apply.
The FTC Rule requires that franchisors provide certain pre-contractual disclosures to potential franchisees.3 In addition, the FTC Rule prohibits certain unfair and deceptive trade practices, such as contradicting the information provided in an FDD. The FTC Rule is a disclosure-only rule. It does not impose a federal registration obligation, nor does it regulate the franchise relationship after the sale. Importantly, the FTC Rule does not include a private right of action and, therefore, only the federal government has standing to enforce the FTC Rule.4 The FTC is currently considering a number of amendments to the FTC Rule, but the FTC is not subject to any deadline for making a decision on amending the FTC Rule.
State franchise legislation
Certain states have passed franchise laws that build upon the federal franchise rules. These state franchise laws may regulate the offer and sale of franchises, impose additional FDD requirements, prohibit certain franchise agreement provisions, impose state registration obligations, or otherwise regulate the ongoing franchise relationship. Approximately 15 states have laws that regulate the offer and sale of franchises. Nine additional states have franchise laws that regulate various aspects of the ongoing franchise relationship. Because the federal and state definitions of a franchise differ, franchisors contemplating sales activity in multiple states must evaluate each state's franchise act to determine the applicability and requirements of state law. To complicate matters further, franchise acts of multiple states may apply to a single franchise offering depending on where the franchise is to be located, the residence or domicile of the prospective franchise and where the offer was made and accepted.
Federal and state business opportunity laws
Finally, businesses considering US expansion must also comply with applicable business opportunity laws at the federal and state levels. The FTC, under the FTC Business Opportunity Rule, and approximately 26 states regulate the sale of business opportunities. The FTC Business Opportunity Rule defines a business opportunity as a commercial arrangement in which:
- a seller solicits a prospective purchaser to enter into a new business;
- the prospective purchaser makes a required payment; and
- the seller represents to the prospective purchaser that the seller will:
- provide locations for the use or operation of equipment, displays, vending machines, or similar devices, owned, leased, controlled or paid for by the purchaser;
- provide outlets, accounts or customers, including, but not limited to, internet outlets, accounts or customers for the purchaser's goods or services; or
- buy back any or all the goods or services that the purchaser makes, produces, fabricates, grows, breeds, modifies or provides.
While the state definitions of business opportunities differ, most business arrangements that qualify as franchises will also meet the definition of at least some business opportunity laws. Like franchise sales laws, business opportunity laws typically require disclosure or registration, or both. However, most provide an exemption for franchises if the franchise offerings comply with the franchise registration and disclosure requirements under state and federal franchise laws.
ii Pre-contractual disclosure
Federal and state franchise laws impose pre-sale disclosure obligations and restrictions. First, the FTC Rule and most states require franchisors to provide prospective franchisees with the FDD upon reasonable request by the prospective franchisee, and no later than 14 calendar days before any agreement is signed or any money is paid. New York requires delivery of the FDD at the earlier of (1) the franchisor and prospective franchisee's first personal meeting or (2) 10 business days prior to the execution of any agreement or payment of any consideration.
The FTC Rule also requires advance disclosure of the specific franchise agreement to be executed by the parties. If no modifications have been made to the form franchise agreement included as an exhibit to the FDD (including filling in material terms), no additional disclosure requirements apply. If, however, the franchisor unilaterally and materially alters the form franchise agreement, the FTC Rule requires a secondary disclosure process and a seven-calendar-day waiting period before the agreement is signed or consideration paid. There are two exceptions to this requirement. First, the seven-day period does not apply to non-substantive 'fill-in-the-blanks' provisions. Second, if the franchisee initiates negotiations regarding changes to the franchise agreement, the seven-day period is unnecessary.
Finally, the FTC Rule and many state franchise acts identify certain pre-signing actions and conduct as 'unfair and deceptive'. One of the most commonly litigated pre-signing disclosure violations is an illegal financial performance representation. A financial performance representation includes any oral, written or visual representation that states or implies a specific range of actual or potential sales, income, gross profits or net profits that a franchisee can expect to achieve. Except in limited circumstances, financial performance information may only be provided to prospects in Item 19 of the FDD. Sharing financial performance information with prospective franchisees outside Item 19 constitutes an unfair and deceptive practice under the FTC Rule and violates most state franchise acts.
Although the FTC Rule does not impose a federal registration requirement, 15 states require registration of the franchise offering prior to the offer or sale of a franchise – California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. The registration process varies by state but generally requires franchisors to pay fees, submit a copy of their FDDs or file certain state-specific registration forms and documents, or a combination of these requirements. The registration states can be divided into 'notice' states and review states. Indiana, Michigan, South Dakota and Wisconsin are considered notice states, with the franchise offering considered 'effective' the day the complete application is received by the state. The remaining registration states undertake some level of review of the franchisor's FDD. As part of the registration process, each state reviewing the FDD application may require changes to the FDD to ensure that the FDD complies with state law. Franchisors that intend to offer franchises in multiple states typically prepare multi-state FDDs that include state-specific addenda to comply with any state-specific requirements that may be imposed during the registration process. Depending on the state, franchise registrations are granted either for a period of one year, or until a certain number of days following the franchisor's fiscal year end. To maintain a franchise registration and continue offering and selling franchises, franchisors must renew their registrations before the prior registration expires, by updating and filing their new FDD. In addition to the renewal requirements, a franchisor must also amend its franchise registration in the event of a material change to information contained in its FDD. Generally, a change to the franchise system that a prospective franchisee would reasonably want to know about before purchasing a franchise is considered material.
Besides ensuring compliance with state franchise registration requirements, franchisors must also comply with or be exempt from business opportunity registration requirements. As mentioned in Section IV.i, most franchisors will qualify for exemption from state business opportunity laws if the franchise offering complies with the FTC Rule and the franchisor has a registered trademark. Certain states, however, require a notice filing to claim exemption. Specifically, Kentucky, Nebraska and Texas require a one-time exemption filing, while Florida and Utah require annual exemption filings. If the franchise programme does not have a federally registered trademark, additional filing requirements will need to be satisfied to claim exemptions in states such as Connecticut, Georgia, Louisiana, Maine, North Carolina and South Carolina.
Because of these complex pre-sale disclosure and registration requirements, foreign-based franchisors that intend to enter the US market through the sale of unit or area development franchises should engage experienced US franchise counsel and establish an internal franchise sales compliance programme. The programme should serve to help establish internal procedures to track prospective franchisee leads and otherwise satisfy disclosure and registration requirements, identify appropriate record-keeping requirements and organise periodic training for all franchise sales personnel and management.
iv Mandatory clauses
At the federal level, the FTC Rule requires franchisors to prepare an FDD that contains several mandatory disclosure items. The FTC Rule also prohibits certain statements and types of contractual provisions. For example, the FTC Rule considers it an unfair and deceptive practice for franchisors to disclaim or require prospective franchisees to waive reliance on any representations made in FDDs. Franchisors must be mindful of this prohibition when crafting an integration clause to ensure that the disclosures contained in the FDD are not disclaimed or waived.
At the state level, there are a variety of state-specific requirements and restrictions for FDDs and restrictions for franchise contracts. Certain state franchise acts prohibit franchisors from, inter alia, waiving application of the state's franchise law, waiving franchisees' right to jury trials, limiting damages claims and requiring franchisees to consent to litigation in a forum outside the franchisees' state. Franchisors engaged in multi-state offerings may use state-specific addenda to accommodate the varying state-specific requirements.
Other than the restrictions noted above, there are no mandatory contractual provisions required by either the FTC Rule or state statute. However, foreign franchisors should be aware that US franchise contracts are often more detailed regarding the rights of the parties than other jurisdictions because, under US law, any ambiguities will generally be resolved in favour of the non-drafting party. Franchisors operating in the United States generally address the following items in their franchise agreements: territorial rights and restrictions, product and service sourcing restrictions, default and termination rights, post-termination obligations and dispute resolution. For example, if a franchisor offers territorial protection, any limitations, exclusions or rights reserved to the franchisor should be expressly stated. US franchisors often reserve for themselves, and exclude from the franchisee's territorial rights, the development of franchises at certain 'non-traditional venues' and sales through alternative channels of distribution, including the internet, catalogue sales and direct retail distribution.
Likewise, it is often critical from a system-standard perspective for franchisors to restrict or limit the source from which franchisees may obtain products or services. Franchisors operating in the United States commonly reserve the right to designate single-source suppliers or approved suppliers (which may include themselves or an affiliate) or specify product standards and requirements in the franchise agreement to ensure a consistent consumer experience.
The inclusion of default and termination provisions, and specifying a franchisee's post-termination obligations in the franchise agreement, are crucial. When drafting default and termination provisions, as well as provisions governing non-renewal, franchisors should note that many states have enacted franchise relationship laws that can affect the enforceability of the contractual language. Drafting a default and termination provision and a renewal provision that accounts for common provisions of relationship laws, including incorporating 'good-cause' and 'opportunity-to-cure' language, can increase the franchisor's ability to enforce terminations and non-renewals.
v Guarantees and protection
If the franchisee is a legal entity rather than an individual, the franchisor will typically require each of the entity's owners to provide a personal guarantee for the franchisee's obligations under the franchise agreement. In some cases, should the franchisee entity have a corporate parent or affiliate, it may be possible to obtain a corporate guarantee from the legal entity. The purpose of the guarantee is to ensure that if the franchisee entity fails to pay or perform under the franchise agreement, the guarantors must do so. A guarantee is normally broad in scope and covers not only the franchise agreement obligations, but also the obligations of the franchisee under any related agreements with the franchisor or its affiliates. No special guarantee form is required by law, and a guarantee's execution does not require witnessing or notarisation. Letters of credit, which are widely used in many countries, are rarely used in the United States. On occasion, a franchisor will accept a letter of credit in lieu of multiple guarantees from an owner of multiple franchise units in the event that the owner seeks to cap its potential liability at a specific amount.
i Franchisor tax liabilities
Franchisors will generally be responsible for US federal income tax on income earned in the United States and for withholding and payroll taxes for their US employees. Franchisors also will be responsible for state income taxes to the extent that they conduct business in 40 or more US states that impose such taxes. The 2017 Tax Cuts and Jobs Act (the Tax Act) significantly reduced corporate tax rates, which went from graduated rates, ranging from 15 per cent to 35 per cent, to what is now a flat rate of 21 per cent. State corporate income marginal taxes generally range from 3 to 12 per cent.
A significant tax issue franchisors face in the United States is the extent to which a state may conclude that a franchisor is 'doing business' in that state and hold a franchisor responsible for state income taxes if the franchisor's only operations in a state are through its franchisees. Although the presence of franchisees in a particular state is not usually conclusive evidence that a franchisor is doing business in a state, some states are asserting that franchisors are subject to state tax, even with relatively minor business contacts with a particular state. While this state activity merely results in re-allocation of tax revenue among different states, franchisors can face stiff penalties if they do not properly report and pay state tax liabilities.
Other tax issues involve the timing of tax recognition and tax liabilities involving advertising funds. Upfront franchise fees received by franchisors are generally fully taxable at the time received by the franchisor at ordinary income tax rates. In addition, royalties (contingent payments) received by a franchisor during the franchise term are taxable when received. As for advertising fees that a franchisor collects for placement in an advertising fund, courts generally have concluded that those fees are not income to the franchisor to the extent the fee revenue can be used only for advertising purposes.
ii Franchisee tax liabilities
Franchisees are subject to the same overlay of federal and state taxation, at the same rates as franchisors. Upfront franchise fees paid by franchisees are not fully deductible at the time of payment. Rather, and regardless of the duration of the franchise term, franchise fees are amortised over a 15-year period. Franchise royalties are generally deductible by franchisees in the year paid or accrued.
iii Tax-efficient structures
Franchisor and franchisee entities generally are formed either as taxable corporations or as 'pass-through' entities, such as limited liability companies or partnerships. Corporations pay tax at the entity level. Shareholders of a corporation generally have no liability for taxes owed by the corporations. Pass-through entities do not pay tax at the entity level as the income flows through to the owners, who are taxed directly on their share of the pass-through entity's taxable income. Foreign-based franchisors should determine whether certain pass-through entities receive similar tax treatment in their home countries. There is no single preferred tax structure for a franchisor or franchisee, whether US-based or foreign-based. The optimum structure is best determined after considering the tax status and jurisdiction of the foreign-based franchisor.
One noteworthy change brought by the Tax Act is that, in addition to corporate tax rate reduction, the new law has deductions for pass-through businesses, which could apply to many franchises. Under the previous law, net taxable income from pass-through businesses entities (such as partnerships, S corporations and limited liability companies) was passed through to owners and then taxed at the owners' applicable tax rates. There was no special treatment applied to pass-through income recognised by business owners. The Tax Act now allows pass-throughs to deduct up to 20 per cent of income, subject to certain other limitations and restrictions. One notable exception to this business income reduction is for service-based businesses, such as realtors, doctors and lawyers, in which the 20 per cent deduction is only available for married couples filing jointly with incomes up to US$315,000 or to US$157,500 for single taxpayers. The pass-through deduction was included as an individual income tax provision, which expires at the end of 2025. The new 20 per cent deduction for pass-through businesses will mean an estimated annual tax savings of US$2.5 billion for the franchise community, according to the International Franchise Association.
Impact of general law
i Contract law
US courts have developed equitable principles to promote fairness in contractual relationships, to prevent parties from taking unfair advantage of each other and to prevent a party from abusing the discretion granted to it under the contract. One of the most important of these principles is the implied covenant of good faith and fair dealing in the performance of commercial contracts. Under this covenant, US courts expect that contracting parties will deal with each other honestly and fairly, and that neither party will do anything having the effect of destroying or injuring the right of the other party to receive the benefits of the contract. Conduct is generally considered to be in bad faith when it 'violates community standards of decency, fairness, or reasonableness'.5 The covenant of good faith and fair dealing also helps to interpret the intent of the parties when the contract is silent on a particular subject.
The implied covenant of good faith and fair dealing has been adopted by nearly every US state and is applicable to many types of contracts, including franchise agreements. There are, however, significant limitations on the scope of the covenant. Most importantly, the US courts have generally held that the covenant of good faith cannot contradict the express terms of the contract. Moreover, the covenant cannot create rights and duties that are not otherwise provided for in the contract; it arises only out of a party's conduct related to its existing contractual obligations. In addition, in many US states, the covenant only applies where the contract gives the party whose conduct is at issue some kind of discretion. In those circumstances, US courts recognise that the dependent party must rely on the good faith of the other party.
Implied-covenant-of-good-faith claims are frequently raised by franchisees against franchisors, often in the context of challenges to franchise terminations, decisions by franchisors to deny transfers of franchise ownership and challenges to conditions placed on franchise agreement renewals. Such a claim may also be raised either as an affirmative cause of action or counterclaim when the franchisor's decision at issue has adversely affected a franchisee. Because of the significant limitations US courts have imposed on the implied covenant of good faith and fair dealing, however, franchisee claims based on this covenant have largely failed.
To deter potential franchisee claims for breach of the implied covenant of good faith and fair dealing in US contracts, franchisors should exercise care in drafting franchise agreements. Unlike franchise agreements governed by civil law jurisdictions, agreements subject to US law are often comprehensive and contain detailed provisions. Although the implied covenant of good faith and fair dealing cannot directly contradict the express terms of the franchise agreement, to limit the potential application of the implied covenant, when drafting franchisors should avoid the use of language that gives either party unfettered discretion. By using such drafting techniques, franchisors may minimise the risk of claims based on the implied covenant of good faith and fair dealing.
ii Agency distributor model
In the United States, there is law based on federal trade regulation rules and there are certain state laws that regulate franchising. There are no similar laws of general applicability directly regulating agents or distributors, but various laws often affect the distribution of goods or services by agents or distributors, or both. These include franchise disclosure, registration notice laws and regulations, business opportunity laws, termination and non-renewal or relationship laws, a number of special industry laws (e.g., automobile dealerships or alcohol distributorship laws) as well as laws regulating the sales representative relationship. A company that sells products or services for resale cannot ignore these laws and regulations; in fact, a company that fails to comply with these laws or regulations exposes itself – and its officers, directors and other persons engaged in the sales process – to damages, injunctions, rescission orders and civil or criminal penalties.
iii Employment law
The franchise community in the United States has become increasingly concerned with two sets of employment law issues in recent years. One issue relates to the potential for franchisors to be held jointly liable (along with their franchisees) for employment claims brought by a franchisees' employees. The standard for determining potential joint employment liability has fluctuated in recent years. For many years, the general rule was that an employer could be found to be a joint employer of another employer's employees only if the employer possessed and exercised substantial, direct and immediate control over the essential terms and conditions of employment, such as wages, benefits, hours of work, hiring, discharge, discipline, supervision and direction, and did so in a manner that was not limited and routine. US franchisors typically avoid any direct control of franchisees' employees to avoid potential liability based on this joint employment standard. However, in 2014 and 2016, federal and state authorities alleged joint employment liability against two high-profile US franchisors. In addition, in 2015, the National Labor Relations Board (NLRB), the federal agency charged with protecting individuals' right to organise unions, issued a decision in Browning-Ferris Indus of California, Inc,6 which held that joint employment liability may be found where the right to control the terms of employment was reserved or exercised indirectly through an intermediary. Although this decision was effectively reversed and clarified through an NLRB rule-making procedure as of 27 April 2020, the issue has gained political traction and may be the subject of changing state and federal standards in the coming years. For example, at least 19 states have independently enacted legislation to codify the more traditional and narrower 'direct and immediate control' standard that prevailed in the United States for many years, while plaintiffs in various state and federal litigation have argued for the application of the broader standard.
A number of significant legal consequences can result from a franchisor being found to be its franchisees' employer or joint employer, including:
- liability for tax withholding from franchisees' employees and timely payment of those withheld amounts to government taxing authorities;
- payment of franchisees' employees' benefits;
- payment of franchisees' employees' wages and overtime pay;
- payment of franchisees' employees' unemployment and social security taxes;
- liability for franchisees' employment discrimination;
- liability for franchisees' workers' compensation insurance;
- vicarious liability to third parties for franchisees' actions; and
- liability for income taxes to each state in which a franchisee is located based on having a 'presence' in that state.
The second employment issue relates to worker misclassification claims, which have also become increasingly common. Misclassification claims in the franchise context first gained significant notoriety in 2006 when a Massachusetts franchisee successfully sought unemployment insurance after her franchise was negatively affected by a customer decision. That case became the basis for several follow-on cases in the franchised janitorial service market seeking to reclassify franchisees as employees. These cases have generally had limited success when evaluated using the common law 'right-of-control' test. However, a number of states have begun applying tests that are more stringent and generally more onerous for franchisors. For example, more recently, in April 2018 a California court, in a non-franchise case, Dynamex Operations West Inc v. The Superior Court of Los Angeles County,7 embraced an expansive misclassification test (this test is known as the 'ABC' test and is the same test applied by the court in the Massachusetts case), which effectively starts with a presumption that a worker is an employee and not an independent contractor). The Dynamex decision was codified in California on 18 September 2019, when the governor of California signed California Assembly Bill 5 (AB5)8 into law. AB5 was heavily backed by labour groups and intended to provide more protection to 'gig-economy' workers, which are typically classified as independent contractors. Unfortunately for franchisors, the language of AB5 is broad enough that it may apply to franchise relationships. Notably, the IFA unsuccessfully lobbied the California legislature for an exemption for franchising from AB5. Because AB5 applies across the entire California Labor Code, franchisors could be subject to misclassification-based claims by franchisees and employees of franchisees for unpaid overtime, missed meal and rest breaks, and operational costs and expenses. On 17 November 2020, the IFA initiated a lawsuit claiming that AB5 is unlawful because it is pre-empted by the FTC Rule and the Lanham Act, the primary federal trademark law.
In light of the changing landscape, determining the extent of control a franchisor may exercise over its franchisees' operations without exposing itself to additional liability presents a difficult problem for many franchising systems. It is necessary to establish and maintain brand standards; indeed, to maintain ownership over trademarks, US law requires mark owners to exercise control over the quality of the goods or services offered under such marks. Franchisors usually balance these competing requirements by limiting control over franchisees' employees and employment-related decisions while exercising control over only brand-specific matters, but this may no longer be enough. It is important to closely examine the proper balance for each franchise system.
iv Consumer protection
Consumer protection and unfair and deceptive trade practices acts have been adopted at the federal level and in every state. For the most part, these statutes are aimed at 'immoral, unethical, oppressive or unscrupulous' business practices that have resulted in 'substantial injury' to consumers. Although these statutes typically were enacted to protect ordinary consumers, franchisees have sometimes qualified as a consumer who is deserving of protection against violations of these statutes by franchisors. Those decisions significantly expand the rights afforded to franchisees under their franchise agreements and usually allow consumers who have been harmed to obtain double or triple damages awards along with their attorneys' fees.
v Competition law
Franchising has always been a focus of antitrust, or competition, law because franchisors want to have uniformity throughout their franchise systems and have to enforce standards and maintain quality. Accordingly, there is a real business need to control pricing, to control the supply chain, to control locations and to position the franchise system for inter-brand competition (rather than intra-brand competition). These are the types of restrictions often encompassed by antitrust laws.
The primary antitrust risk that franchisors face is vertical price-fixing (also known as resale price maintenance or RPM), when they exert too much control over the prices charged by franchisees. Franchisors have a legitimate interest in the prices at which franchisees sell their products and services, and in the margins earned by franchisees. Many franchisors believe that franchisee pricing is the key to the success or failure of their franchisees and, ultimately, to the success or failure of the franchisor. Consistent pricing throughout a franchise system is critical to the uniformity and brand-building that many franchisors desire. In addition, franchisors do not like to see price wars among their own franchisees – they want their franchisees to focus on inter-brand competition.
Prior to 2007, it was automatically – or per se – illegal for a franchisor to require or coerce its franchisees into reselling goods either at a specified price or above a certain minimum price, meaning that it was per se illegal to prevent franchisees from discounting. However, these vertical price-fixing agreements are now governed by a rule of reason in which legality or illegality is dependent upon whether the RPM programme unreasonably restricts trade in a defined market. Despite this new, relaxed standard, many franchisors have been reluctant to implement RPM in their franchise systems, for a variety of reasons.
First, RPM may be found unlawful under the rule-of-reason standard if a franchisor is deemed to have market power or if a pricing agreement was entered into by the franchisees themselves (horizontally) and in effect was foisted upon the franchisor by a franchisee cartel. Second, although RPM is analysed under a rule of reason under federal antitrust law, RPM is still per se illegal under a number of state antitrust laws, including California, Maryland and New York. Third, franchisors may be able to take advantage of other pricing techniques that have greater legal certainty. These include the use of suggested resale prices, unilateral pricing policies (known as Colgate policies), minimum advertised price policies (known as MAP policies) and an agency model. Even though these techniques are not as rigid as an RPM policy, many franchisors are willing to sacrifice some degree of pricing control for the reduced legal risk provided by the avoidance of the RPM policy.
Mandatory purchasing programmes and other restrictive supply policies may give rise to illegal tying arrangements. In recent years, however, franchisors have been able to avoid antitrust liability for their restrictive supply policies by providing detailed pre-sale disclosure about the policies in the FDD provided to prospective franchisees.
vi Restrictive covenants
Franchise agreements typically contain in-term and post-term covenants prohibiting franchisees from engaging in any business activities of the same type as the franchised business. For example, franchise agreements for restaurants often impose a non-competition restriction on the franchisee during the franchise term and after the expiration, termination or transfer of the franchise agreement, which prevents franchisees from directly or indirectly owning or having any involvement in food establishments offering, as the primary menu item, the same or similar menu items as offered at the franchised restaurants. In-term non-compete obligations are widely enforced in the United States because the courts recognise the franchisors' interests in protecting their trade secrets and goodwill. Post-term non-compete obligations are also enforceable in most states so long as the prohibition is (1) reasonable in duration, geographic scope and the prohibited conduct, and (2) only as broad as is necessary to protect the franchisor's legitimate business interest.
If a franchisee violates a non-competition prohibition, franchisors generally reserve the right to pursue various remedies, including immediately terminating the franchise agreement, seeking injunctive relief to quickly halt any violating conduct or payment of liquidated damages by the franchisee.
A franchisor's right to terminate a franchise agreement is governed, for the most part, by the terms of the franchise agreement, which typically identify the breaches that can lead to termination. Most franchise agreements place breaches into two categories: those that can be cured by the franchisee following written notice, and those that cannot be cured and can lead to immediate termination. Incurable breaches typically involve those that go to the heart of the franchisor–franchisee relationship, including the intentional under-reporting of sales, violation of in-term covenants not to compete or a franchisee's conviction of a crime. Franchise agreements commonly set out detailed procedures for termination, the obligations of the parties related to shutting down the business, and the franchisee's post-termination obligations once the termination goes into effect. Although the FTC Franchise Rule does not regulate the ongoing franchise relationship, approximately half of all states have franchise relationship statutes that outline rules governing the termination of the franchise relationship and take precedence over the terms of the franchise agreement. Most of these statutes, for example, require a franchisor to have 'good cause' to terminate the agreement, although there is no consensus on this standard from state to state. In addition, some states require a franchisor to provide the franchisee with a minimum notice period and opportunity to cure before the termination goes into effect.
Post-termination non-compete covenants are commonly included in franchise agreements. Courts often take the position that, to enforce these restrictions, they must be reasonable in terms of the scope of activities the former franchisee is prohibited from engaging in, the geographical area to which the restriction applies and the length of time the covenant is in effect. This determination is highly fact-specific and depends on the circumstances surrounding each case as well as the state law applicable to the covenant. As a result, restrictions that are effective for a longer period, cover a wider scope of prohibited activities and are broader in geographical reach are less likely to be enforceable. Franchisors should also be mindful that a handful of states, by statute or judicial precedent, do not acknowledge or severely limit the enforceability of post-termination covenants not to compete.
viii Anti-corruption and anti-terrorism regulations
Franchisors and other businesses operating in the United States must be cognisant of US laws governing corruption and bribery. Corruption and bribery encompass a range of conduct. They include the offering, giving or soliciting of something of value for the purpose of influencing the action of an official in the discharge of his or her public or legal duties. Guarding against and eliminating corruption in the United States is a high enforcement priority, second only to eradicating terrorism in the homeland. A foreign franchisor's inability to negotiate the US anti-corruption landscape can lead to significant financial penalties, potential prison time for individuals and collateral damage such as brand devaluation and threat to reputation.
The most significant law promulgated to deter corporate corruption is the US Foreign Corrupt Practices Act (FCPA). The FCPA is intended 'to halt corrupt practices, create a level playing field for honest businesses and restore public confidence in the integrity of the marketplace'. It is the 'single most significant compliance challenge for companies operating internationally' including foreign-based franchisors looking to establish franchise relationships in the United States. Jurisdictionally, the FCPA extends to foreign nationals and companies, including foreign-based franchisors, operating or doing business in the United States.
There are two primary provisions under the FCPA: the anti-bribery provision and the accounting provision. The accounting provisions require corporations to make and keep accurate books and records and devise and maintain a system of internal accounting controls. Liability under the anti-bribery provision of the FCPA is premised on the conduct of company employees and third parties acting on behalf of the company, such as consultants. As a general matter, this provision prohibits direct or indirect payments to foreign officials for the purpose of obtaining or retaining business. The FCPA applies to any individual, firm, company, officer, director, employee, agent of a company, or stockholder acting on behalf of a firm. Individuals and firms can also be penalised if they order, authorise, influence, induce or assist someone else to violate the anti-bribery provisions or if they conspire to violate those provisions. An exception to this bribery proscription includes instances where facilitating or expediting payments are made to a foreign official, political party or party official to accelerate or to secure the performance of a routine governmental action by a foreign official, political party or party official. To the extent companies and individuals are found to be in violation of the FCPA, they may be subject to criminal and civil penalties, which may include fines and imprisonment.
Franchisors should also have an awareness of other US anti-bribery laws as they look to do business in the United States. The federal official bribery and gratuity statute prohibits, among other things, the giving of gifts, gratuities or anything of value either directly or indirectly to public officials 'with intent . . . to influence any official act; or to influence such public official or person who has been selected to be a public official to commit or aid in committing, or collude in, or allow, any fraud, or make opportunity for the commission of any fraud, on the United States; or to induce such public official or such person who has been selected to be a public official to do or omit to do any act in violation of the lawful duty of such official or person'. A violation of this anti-bribery statute could result in fines as much as three times the monetary equivalent of the thing of value being offered, or imprisonment of up to 15 years.
Franchisors must also comply with certain laws designed to exclude from commerce those individuals and entities seeking to engage in terroristic threats against the United States. This includes 'criminal acts intended or calculated to provoke a state of terror in the general public, a group of persons or particular persons for political purposes'. Awareness of anti-terrorism laws such as the USA PATRIOT Act requires franchisors to closely examine their business relationships. In the absence of vigilance, franchisors can find themselves unknowingly supporting terrorist operations, both at home and abroad in violation of this law. An essential component of the Act, of which foreign-based franchisors should be cognisant, is the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001. This component of the Act is intended to facilitate the prevention, detection and prosecution of international money laundering and the financing of terrorism.
Franchisors should also be aware of US Department of the Treasury's Office of Foreign Assets Control (OFAC) policies against terrorists. OFAC administers and enforces economic and trade sanctions based on US foreign policy and national security goals against targeted foreign countries and regimes, terrorists and international narcotics traffickers. OFAC also focuses on 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. To ensure that business is conducted with reputable persons, franchisors should pay attention to OFAC's 'specifically designated nationals' or 'SDNs' list of individuals and companies. Included on this list are known or suspected terrorists and narcotics traffickers, owned or controlled by, or acting for or on behalf of, targeted countries. Failure to comply with OFAC by engaging in business with those who are sanctioned as a result of having been specifically designated can result in significant civil and criminal penalties.
As foreign-based franchisors enter the US marketplace, their liability may be based on the conduct of their employees, franchisees, agents and other third parties acting on the franchisor's behalf. To manage this risk, foreign-based franchisors are advised to become actively involved in their US operations.
ix Dispute resolution
Parties to franchise relationships usually provide for dispute resolution in their franchise and related agreements. Sometimes their written agreements provide for arbitration or mediation as a condition precedent to litigation, and sometimes they chose neither and specify a venue for any litigation between franchisor and franchisee. Mediation is a recognised form of alternate dispute resolution that is especially well-suited for franchise disputes because of the relationship between franchisor and franchisee. The contractual obligations to mediate and arbitrate are generally enforceable under the Federal Arbitration Act. Should a party contest its obligation to arbitrate, a court will usually require that issue to be presented to an arbitrator for disposition. In the past several years, the Supreme Court has clarified that class action waivers will generally be enforced in arbitration proceedings. See AT&T Mobility LLC v. Concepcion,9 and American Express Co. v. Italian Colors Restaurant.10 Unless the parties have agreed to arbitration, the courts will not require them to arbitrate. The same can be said for mediation except that many jurisdictions as a matter of course require litigation parties to mediate at some point before a case is called to trial. While mediation is voluntary, parties who are ordered by a court to mediate must participate in good faith.
Venue selection clauses in franchise agreements, and commercial contracts generally, are upheld as a matter of course. Since the Supreme Court's decision in Atlantic Marine Construction Co, Inc v. US District Court for the Western District of Texas,11 in most cases, parties are held to their contractual venue choice irrespective of later claims of inconvenience. As to choice-of-law or governing-law clauses, in the absence of conflict-of-laws issues, the parties' choice of law will be applied so long as the chosen law has a relationship to the parties and their dispute. In franchise cases, it should be noted that state relationship laws governing the franchise relationship in several jurisdictions may prohibit or limit the application of a foreign state law to a franchise dispute as a matter of public policy.
There is no industry practice or trade association rule that specifically governs the procedures for resolution of franchise relationship disputes. If the parties have not chosen in their written franchise agreement to arbitrate their disputes privately, they will be bound by the rules of procedure of the court (state or federal) in which they present their claim for adjudication. Those rules generally require a written summons or complaint to institute an action (and toll the applicable statute of limitations), and then provide the defending party, after service of summons or complaint, a period to respond by motion or answer. Once the issues presented by the dispute are joined by the filing of an answer, the parties typically engage in discovery of documents and depositions of witnesses before presenting the case to the court for ruling, either by motion for judgment without trial (summary judgment) or by trial either with or without jury. A jury trial is generally available to litigants in federal and state courts as a matter of constitution, except when the parties have by written agreement waived their right to jury trial. Rules of procedure differ from courthouse to courthouse, and a prudent practitioner will familiarise herself or himself with local rules before taking on an engagement. If the parties have instead chosen to arbitrate their dispute, they will be bound by the rules of the administering arbitral body they have chosen; if there is no administering arbitral body provided for in the franchise agreement, the disputing parties must agree upon a set of procedural rules to apply to their dispute.
If the parties have chosen to mediate their dispute, they are largely in charge of mediation procedures, except for some key elements that apply universally to mediation – the mediator is neutral and has no authority to decide the parties' dispute; all contents of the mediation are confidential and cannot be used by any party in any other proceeding; and the mediator will not share with any party communications from another party without the express consent of the communicating party.
The same remedies are available in franchise disputes as in any other commercial dispute – monetary damages for legal claims (such as breach of contract or violations of applicable statutes) or injunctive relief to prevent conduct for which an award of monetary damages would be inadequate. Contract damages require specificity and cannot be based on conjecture or speculation. In a written contract, parties may, and often do, waive certain types of monetary damages – often punitive, multiple or exemplary damages and consequential damages. Monetary damages sought by franchisors generally involve claims for unpaid royalties and other fees due under the franchise agreement and may include lost future royalty fees when a location closes prior to the end of its term. Monetary damages sought by franchisees generally involve claims for lost profits in the event of failure, under-performance or wrongful termination by the franchisor of the franchise business.
Injunctive relief is available where a party will suffer 'irreparable harm' that cannot be redressed through monetary damages. In franchise litigation, this usually involves claims for unauthorised use of a trademark, misappropriation of trade secrets and confidential information, and enforcement of a restrictive covenant prohibiting operation of a business similar to the franchise for a time and place certain. In the event that a former franchisee continues to use a franchisor's trademark after termination of a franchise agreement, injunctive relief to prohibit such use is generally available in both state and federal courts under the federal law governing trademarks, the Lanham Act12 or state laws governing trademarks. Trade secret misappropriation – the unauthorised use or disclosure of a franchisor's proprietary systems or confidential information – is traditionally a creature of state law. Recent federal law has, however, expanded jurisdiction of such claims to federal courts and enhanced available remedies.13 Enforcement of restrictive covenants against post-term competition is more difficult to obtain. The laws governing such covenants vary from state to state, and proof of irreparable harm is often difficult to provide, especially since the Supreme Court's decision in eBay Inc v. MercExchange, LLC.14 Generally, in states that permit enforcement of post-term covenants, a franchisor must show that the scope of the prohibited business activity is reasonable, that the length of time and geographical scope are reasonable and that there is some 'protectable interest' worthy of protection, such as trade secrets or customer goodwill.
The Federal Arbitration Act, Chapter 2, of the United States Code provides for the recognition of foreign arbitral awards and incorporates the New York Convention.
In 2020, key legal developments affecting the US franchise industry included continuing changes to the law of joint employment and worker misclassification, increased scrutiny of anti-poaching provisions and restrictive covenants in franchise agreements, new disclosure rules issued by the North American Securities Administrators Association (NASAA) and privacy developments.
i Continued joint-employer and misclassification developments
In 2020, the risks for franchisors related to joint-employer liability and misclassification claims remained unclear. As discussed in more detail in Section VI.iii, some recent decisions appear to expose franchisors to more potential liability from their franchisee's employee's employment-related claims. At the same time, other decisions and legislative efforts seek to contain such risks to those cases in which the franchisor is exercising direct and immediate control over its franchisee's employees.
ii Restrictions on anti-poaching provisions and non-competition covenants
Historically, many standard US franchise contracts contained provisions that prohibited franchisees from soliciting or hiring employees from one another ('anti-poaching' provisions). Although rarely enforced, these provisions promoted harmony within a franchise system. Similarly, many standard US franchise agreements impose in-term and post-term non-competition covenants on franchisees. These provisions prevent franchisees from using the franchisor's proprietary information and know-how to compete with the franchise brand. In recent years, there has been an increasing trend towards limiting the enforceability of both anti-poaching provisions and non-competition clauses.
Many US officials have begun to regard anti-poaching provisions as anticompetitive and argue that such provisions depress wage growth for low-wage workers by preventing departing workers from getting the very jobs for which they are most qualified. As a result, many large franchisors have received demands from officials or agencies seeking information regarding their anti-poaching contractual provisions and practices. In particular, the Washington Attorney General launched investigations into several high-profile franchise systems during 2018 and 2019, generally resulting in settlements in which the franchisors agreed to remove the provisions from future franchise agreements and to amend existing agreements to remove such provisions. By late 2019, more than 150 franchise systems had entered into agreements with the state of Washington. In addition to governmental actions, some states have enacted or are considering legislation that prohibits the use of anti-poaching provisions. For example, House Bill 1450 (HB 1450) was signed into law in the state of Washington in 2019. The new law, which took effect on 1 January 2020, provides that '[n]o franchisor may restrict, restrain, or prohibit in any way a franchisee from soliciting or hiring any employee of [another] franchisee of the same franchisor . . . [or] may restrict, restrain, or prohibit in any way a franchisee from soliciting or hiring any employee of the franchisor.'15
In addition to restricting anti-poaching provisions, HB 1450 also represents a trend of increasing limitations on non-competition agreements. There are a growing number of states, such as California, Illinois, Maine, Maryland and New Hampshire, that either prohibit non-competition agreements entirely, or significantly limit non-competition requirements that can be enforced against low-wage workers.
iii New franchise disclosure document state cover page
NASAA adopted new Franchise State Cover Sheets Instructions that update the state cover page section of its Commentary on 2008 Franchise Registration and Disclosure Guidelines. The new instructions clarify the proper use of the 'State Effective Dates' page used in multi-state FDDs and relocate the State Effective Dates page to the end of the FDD. The new instructions also replace the old State Cover Page with three preliminary pages: a first page, entitled 'How to Use This Franchise Disclosure Document', with standard information about where to find key information within the disclosure document; a second page entitled 'What You Need to Know About Franchising, Generally', with general information about franchising; and a third page entitled 'Special Risk(s) to Consider about This Franchise', which contains risk factor information in a more standardised and streamlined format. These rules will apply to all disclosure documents issued on or after 1 January 2020.
iv Privacy developments
Following the lead of the European Union and the General Data Protection Regulation, various US jurisdictions are considering or have adopted new laws intended to safeguard consumer data and protect privacy. As described in Section III.iv, the CCPA of 2018 is the most comprehensive privacy law in the United States and became effective on 1 January 2020. Other states are considering similar legislation, and national legislation has been introduced in the US Congress.
1 Steven Feirman, Daniel Deane, Keri McWilliams and Kendal Tyre are partners, Nathan Warecki is an associate and Brad Steinbrecher is a department attorney at Nixon Peabody LLP. The authors would like to thank Samantha Lopes and Tamie Tobe, who provided valuable assistance in producing this chapter.
2 16 CFR Part 436 et seq.
3 The FTC Rule exempts certain franchise offerings from the FTC Rule disclosure requirements. For example, a franchise offered to a large franchisee (a business in operation for at least five years with a net worth of at least US$6,165,500) is exempt from the FTC Rule's disclosure obligations. Franchisors that qualify for an exemption under the FTC Rule must, however, ensure that a similar or separate exemption is available at state level.
4 While no private right of action exists under the FTC Rule, most states have 'Little FTC Acts' that provide franchisees with standing to sue for unfair and deceptive conduct, which could include a violation of the FTC Rule.
5 Restatement (Second) of Contracts, Section 205, comment a (1981).
6 Browning-Ferris Indus. of California, Inc., 362 NLRB No. 186 (Aug. 27, 2015).
7 Dynamex Operations West Inc. v. The Superior Court of Los Angeles County, 4 Cal.5th 903 (Cal. 2018).
8 A.B. 5, 2019 Assemb. Sess. (Cal. 2019).
9 AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011).
10 American Express Co. v. Italian Colors Restaurant, 570 U.S. 228 (2013).
11 Atlantic Marine Construction Co., Inc. v. U.S. District Court for the Western District of Texas, 571 U.S. 49 (2013).
12 Lanham Act, 15 U.S.C. § 1051 et seq.
13 Defend Trade Secrets Act of 2016, 18 U.S.C. § 1836 et seq.
14 eBay Inc. v. MercExchange, LLC, 547 U.S. 388 (2006).
15 H.B. 1450, 66th Leg., 2019 Reg. Sess. (Wash. 2019).