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Apr 03

New Channels of Distribution – Is A Potential Lawsuit Waiting?

By Richard Duell lll Newsletter

Do you have a dynamite new idea for distribution that will allow you to become the next “Super Franchisor”? You may be the entrepreneur who started the company. Or perhaps your company is larger and has a marketing department that comes up with new ways of getting your goods and services to market. Whether small or large, a franchisor’s ability to open new channels of distribution will depend upon how well they negotiate the legal minefield that awaits.

Before implementing a new distribution channel, you must first consider whether your franchise agreement permits you to do so. Begin by looking at the express terms of your agreement in order to determine what rights are granted to franchisees. Provisions restricting your right to compete will usually be enforced against you. If your agreement preserves your right to distribute goods and services, courts will respect your contract but will look closely at your agreement to ensure you have not overstepped your contractual rights. Contracts which are silent leave the door open for courts and franchisees to contest implementation.

Some courts will look at your motive for opening a new distribution channel. The more business a new distribution channel takes away from your franchisees, the greater the likelihood courts will side with your franchisees. If you are concerned that there may be express or implied restrictions on your ability to implement a new distribution method, consider working with your franchisees. Usually before a franchise system can be successful, the franchisor and franchisees must be on the same team, working together.

Outside the franchise agreement, (including the FDD, your website and advertising materials, etc.) the minefield continues for franchisors. Check your FDD to see what is said about territorial rights. Misleading disclosures or non-disclosure of material facts in your FDD could expose you to liability via little “FTC Acts,” which allow private lawsuits and provide for attorney fees and treble damages (a statute that permits a court to triple the amount of the actual/compensatory damages to be awarded to a prevailing plaintiff).

And don’t forget the old Plaintiff Lawyer’s ally – “Fraud.” Even when no statute is applicable, if you make a representation or indication that you will not compete, a smart franchisee lawyer may use this against you and assert a fraud claim.

“State Relationship Laws” can be another bomb in your liability minefield. These laws are designed to prevent franchisors from engaging in certain competitive activities, to the detriment of their franchisees. In addition, franchisees may assert claims such as Section 1 and 2 of the Sherman Act Anti-Trust actions allowing your new plan to be construed as a conspiracy to restrain trade by eliminating competition, i.e., eliminating your franchisees. Alternatively, your plan might be considered an attempt to monopolize. If favorable terms are offered to alternate distributors, your company may also be subject to a Robinson-Patman action.

The list of obstacles goes on, and the minefield can become more dangerous. The journey is certainly not for the novice. But the minefields can be avoided by paying close attention to the wording in your agreements and even considering at the beginning of your journey how to make both you and your franchisees winners. By taking these steps, your company may truly become the next Super Franchisor!

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Mar 13

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Your Operations Manual – Is It A Legal Minefield?

By Richard Duell lll Newsletter

The judges in our courtrooms have become much better educated about the requirements of the Federal Trade Commission’s Amended Franchise Rule (“Disclosure Requirements and Prohibitions Concerning Franchising”) and are often very aware that a Franchise Disclosure Document (“FDD”) must be provided to a prospective franchisee prior to purchasing a franchise. The requirements for Item 11 of the Amended Franchise Rule supports the supposition that prospective franchisees are entitled to rely on the information within the Operations Manual, particularly those areas identified in the manual’s Table of Contents set out in Item 11 of a franchisor’s FDD. Yet the most important document that acts as a road map of a franchisor’s entire system, houses a franchisor’s trade secrets, and governs much of the working relationship with franchisees, receives very little, if any, review from a company’s franchise counsel.

To avoid being trapped, franchisors and counsel must conduct a legal review of the franchisor’s Operations Manual. It is suggested that a review encompass, at a minimum, the following areas:

Joint Employer Liability
- Avoid any employment related advice involving hiring, firing, wages, or discipline of franchisee’s employees.
Discrimination Clauses
- Title VII of the Civil Rights Act of 1964 prohibits discrimination in any aspect of employment. The power of a franchisor to control operations should be reviewed as a potential liability issue.
Good Faith Standard
- Any Operations Manual may fuel claims that a breach of the covenant of good faith and fair dealing occurs where the Franchise Agreement and Operations Manual conflict.
Safety and Security
- A franchisor may be held liable for any harm suffered by third parties based upon both policies set forth in the Operations Manuals, and for the lack of policies.
Environmental Laws
- Franchisors may be found liable for negligent advice contained in the Operations Manual covering environmental issues.
Anti-Trust Liability
- Pricing information in the Operations Manual can create legal issues and has been used by courts to find anti-trust liability.
Deficient Manuals
- Courts have found liability where manuals were not delivered at all or not delivered timely. I believe it is only a matter of time until an educated plaintiff’s attorney is able to take an Item 11 disclosure in the FDD and the section of a franchisor’s Franchise Agreement dealing with the Operations Manual and convince a court that the Operations Manual given its franchisee is deficient or that it is not properly updated, supplemented, or revised.
Copyright
- For the small Franchisor that outsources the Operations Manual, be careful. The company you hired may own the copyright. The owner of the copyright has exclusive authority to authorize reproduction and distribution of the manual, not the franchisor.

CONCLUSION

Operations Manuals are an integral part of a franchise system. Franchisors who fail to include their franchising counsel in the development of all manuals may be easy prey for the hungry plaintiff lawyers.

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Feb 10

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Do You Have Underreporting Franchisees?

By Richard Duell lll Newsletter

“Oh what a tangled web we weave when at first we practice to deceive.” I am always amazed at how creative some franchisees can be when they direct all their energy into deceiving their franchisor about gross receipts and royalties due.

A number of years ago, I was involved in a case representing the franchisor whose franchisee sent in royalty reports and cash register tapes (now we use modems) that appeared to match his deposits and returns. The franchisor knew something was amiss but on the surface could not pinpoint the methodology of the underreporting. Because the Franchise Agreement permitted the franchisor or its agents to initiate an inspection or audit without notice, my first step was to engage the services of two individuals who were formally with the IRS and were very experienced on the criminal and civil side of investigations for fraud. Having drafted the Franchise Agreement, we had included a provision that the franchisee would pay for the cost of professionals, investigators, accountants, and attorneys associated with an investigation if a shortfall was discovered. We therefore felt comfortable knowing that the franchisee would be responsible for the cost of proving his deception.

When the investigators were kept from running a grand total for each cash register, they knew it was only a matter of time before the franchisee’s methodology of underreporting would be discovered. After interviewing former employees and managers, the pattern was set and, once the franchisee’s suppliers’ records were obtained and examined against the cash register grand totals, the fox was in the cage.

In discovering underreporting, your Franchise Agreement should be drafted to enable you to initiate the steps required to discover fraud. Always review your plan to investigate underreporting with your attorney because you don’t want to be faced with a suit for unlawful inspection or bad faith violation of the right of privacy.

One of the lessons my client learned was the importance of periodic inspections which help franchisees to stay honest. After my client’s shock of learning the amount underreported, we took steps to solidify systems for future franchisees which would help the franchisor monitor reporting activity.

Every franchise business is unique, but they all have common traits. By having proper controls in place and taking a proactive approach, you can trim any dishonesty out of your system to help curb underreporting franchisees.

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Jan 04

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Personal Liability in Franchising

By Richard Duell lll Newsletter

In the traditional corporate environment, the corporate umbrella shelters individuals from personal liability while conducting business. Franchising, however, is not your traditional corporate setting. With the abuses that once occurred in franchising, the federal government and many states determined that the unsophisticated purchaser required additional protection. As a result, franchise law evolved from an amalgamation of common law principles, federal and state statues and judicial decisions. Blended together, these legal precepts override the traditional corporate umbrella protection and make individual liability a very real concern for everyone involved in the Franchise process.

At the Federal level, individuals within the Franchise Company face personal liability from Section 5 of the Amended FTC Act, which makes unlawful any unfair method of competition or deceptive act or practice in or affecting commerce.

While the FTC Act sets minimum standards, most states have enacted their own legislation affecting Franchising and at the same time, exposed individuals in franchising to personal liability. These state statutes also provide for both governmental enforcement and private action.

If an unsatisfied franchisee files suit, their claims usually appear in multi-count complaints which not only include statutory claims, but also common law remedies against both the franchisor and individuals employed by the franchisor in the area in which the franchisee’s claims arose. Examples of areas where individuals could be exposed to personal liability occur in the sales process, real estate, inspection, build-out, training and support. Suits also normally include the officers and/or directors overseeing the area where the claims arose. Because the claims are intentional in nature, many states allow punitive or exemplary damages which can far exceed the actual out-of-pocket loss claimed. How can Franchisors and their employees protect themselves? Skilled drafting of every franchise document can help shield officers, directors and employees from personal liability. At risk individuals can further obtain protection by entering into indemnity agreements with their Franchise company. Franchise companies should also consider initiating programs to obtain written acknowledgements from Franchisees at every step of the franchise process. Additionally, all franchise companies should consider “D&O” insurance to protect officers and directors.

Perhaps the best safeguard to prevent individual liability is the implementation of a personal liability analysis as part of each franchise company’s annual legal checkup. For clients we work with in completing annual renewals, we incorporate this liability analysis into our clients annual renewal review.

The rapid growth of franchising has contemporaneously produced greater Franchise litigation and with it, personal exposure of individuals involved with the franchise process. Make sure you have initiated your annual legal check-up to protect those individuals who might be at risk.

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Dec 09

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Trademark Law for Non-Lawyers

By Richard Duell lll Newsletter

Trademarks are the banner for a franchise concept, enabling franchisors to operate under one distinct name which is, or becomes, well known to consumers or third parties.

In other words, trademarks lend a particular image to the franchise company. Like brand recognition, your trademark provides you with an identity associated with the franchised goods or services.

Many franchisors commonly use the term “trademark” to encompass both service marks and trademarks, either of which can be afforded federal and state protection under the federal Trademark Act of 1946 (“Lanham Act”) or various state statutes. Although the terms service mark and trademark are often used interchangeably, they actually are quite distinct. A trademark is technically a name or symbol associated with a good or product that distinguishes itself from another manufacturer, while the term service mark refers only to services. Both, trademark and service mark, allow the consumer to recognize and identify the product or service from one franchisor to another.

To be registered with the U.S. Patent and Trademark Office, the mark must identify a single source, distinguishing it from that of another party. To be distinguishable, the mark cannot be a generic term or confusingly similar to another mark or trade name. It cannot be the name, portrait or signature of a living individual or deceased person without express permission of the deceased representative, nor can it compromise our flag. It also cannot be a coat of arms or insignia of another country or state or contain scandalous, deceptive or immoral matter.

Trademarks and service marks provide protection from others attempting to establish recognition through your company’s identity, recognition being the “key” to any successful franchise system. Once your trademark or service mark is registered on the Principal Register of the U.S. Patent and Trademark Office, you acquire national recognition, conferring superior rights.

Even after registration, you must file affidavits of continued use with the U.S. Patent and Trademark Office to maintain your registration. If you fail to file the continued use affidavits, you may lose your rights to the registered mark. Therefore, make sure you track all registered marks for your franchise and make sure they are timely renewed.

If you would like to find out more information on federal and state registrations, please call or e-mail us.

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Nov 04

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Before You Terminate

By Richard Duell lll Newsletter

Your patience is exhausted. You have done everything in your power to help your unappreciative franchisee. You may have even suggested the best course might be to sell the franchise and you would be willing to refer your franchisee leads for his/her territory. The franchisee still will not comply with his or her franchise agreement. Perhaps the franchisee is the type that believes their way is better than yours and their conduct is starting to have a detrimental effect on your franchise system. Whatever the reason, you have reached a point of no return for this particular franchisee and believe he or she must be expunged from the franchise system.

What should you know and do before making the decision to terminate? The starting point for termination is to look at your Franchise Agreement and determine the conduct of your franchisee that constitutes a default and grounds for termination. Next, determine if you have adequate documentation to prove the violation. If you are terminating for a reason other than a standard violation (for example, failure to meet sales requirements) consult us; there are special rules which apply and careful contract drafting is essential. Review all of your contractual obligations to make sure you have fully complied with your side of the bargain; for example, if you are providing a product, has it always been timely supplied? Also, review what your prior course of dealing has been with other similarly situated franchisees. You may have modified your contractual rights. Believe it or not, there are states that permit written agreements to be modified without a subsequent writing even if the contract provides otherwise. Be prepared for your franchisee’s argument that the covenant of good faith and fair dealing requires uniform treatment and he or she is being singled out.

Make sure you are familiar with applicable state franchise protection statutes. There are at least 17 states that require a type of good cause for termination and/or an opportunity to cure. Keep in mind that many states ignore contractual choice of law provisions if that state franchise law would otherwise be circumvented. Some states, like Texas, have a Deceptive Trade Practices Act holding the franchisor liable for certain business conduct.

Make sure you have not given your franchisee any arguments that assist him or her in claiming you have caused a defacto termination because you are in violation of the agreement or that you are actually terminating the franchisee as a penalty for his or her refusal to participate in illegal activity; for example, an unlawful tying or price fixing scheme in violation of antitrust law and “little FTC Acts.”

The main point I want to stress is the importance of knowing how to build your file before termination. Correctly done, the integrity of your franchise system will be preserved.