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Oct 05

Can Franchisees Be Treated Differently?

By Richard Duell lll Newsletter

If a politician were to answer the question posed in this issue of Franchisor Alert, he or she might give the retort, “it depends.” This answer would certainly be politically correct, as there are many facets of law which must be considered before a definitive answer to the question can be given. But the politically correct answer certainly does not help the franchise company make a decision on whether to discriminate among its franchisees. Hopefully, this issue will help franchisors by providing the process that a company must undergo before reaching the answer to a most difficult question about franchise discrimination.

The process of reaching a decision on whether a franchising company can treat franchisees differently starts with a franchisor’s own review of whether there exists a rational basis for different treatment. Can a franchisor pass the test that its conduct is not arbitrary? Justification might be premised upon such necessities as market conditions. Franchisors are often required to make competitive decisions responding to changing circumstances in the marketplace. For instance, a franchisor might provide a franchisee price concessions on products purchased where the franchisee is attempting to respond to a price war in a specific territory or the franchisor may allow certain franchisees to add additional menu items to a specific area to meet ethnic taste. If a franchisor has no quantifiable basis for discriminating among its franchisees, it should slam on the brakes and go no further. If however, the first step in our process receives a positive response from the franchisor, then we are ready for stage two.

Stage two consists of a legal analysis. Starting with the company’s franchise agreement and other relevant legal documents, legal counsel should review contractual language to determine if the franchising company has the contractual ability to treat franchisees differently. Is the language overbroad or are specific circumstances carved out when franchisees may be treated differently? Contractual language must also be reviewed in light of state statutory and common law.

There are at least 36 states with statutory provisions relating to franchise discrimination.

Many state laws are industry specific and require the review of a knowledgeable franchise attorney. Most franchise contracts contain a choice of law provision and if the franchisor has chosen a state with a strong anti-discrimination statute, the consequences could be disastrous to the company. As part of the legal analysis, counsel should review how anti-trust law might affect different treatment of franchisees. The principal area of concern being price discrimination. In addition, counsel should consider a franchisor’s downside and what the potential damages might be. Obviously, the franchisee receiving special treatment has no cause to complain, but to the extent another franchisee is harmed by special treatment, a franchisor’s risk escalates.

Perhaps the Indiana Act sums up our analysis in Stage One and Stage Two most succinctly. The Act makes it unlawful to discriminate “unfairly” among franchisees. Some franchisee discrimination is by definition “fair” as long as franchisees are not similarly situated.

At the very beginning of this post, we chastised politicians answer to the question – “Can Franchisees Be Treated Differently?”, but after a thorough legal examination we find that the answer “it depends” to be very accurate. Feel free to call or email me with your questions. I’ll be glad to help guide you through the uncertainty and maze.

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Aug 06

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Steps to Protect Your Trade Secrets

By Richard Duell lll Newsletter

Last month’s post highlighted the requirements for defining trade secrets.

Conceptually, the trade secret grant in a Franchise Agreement is a license, which confers rights and duties on a franchisee very similar to a trademark license. Those rights and duties should be specified in your Franchise Agreement and other ancillary agreements to protect your trade secrets. I suggest, at a minimum, that you address the following specific areas:

All your agreements should protect against unauthorized disclosure of trade secret information;
The Franchise Agreement should identify the trade secret information to be disclosed in separate documents, such as your confidential operations manual;
The franchisee must acknowledge a Franchisor’s ownership of trade secrets and that the trade secret information is only disclosed because of his/her relationship as a franchisee;
The franchisee must further acknowledge that the trade secret information is not generally known to the public or trade, and the franchisee had no previous knowledge of the trade secrets;
The Franchise Agreement should contain language that is flexible enough to include future developments to be included in your ancillary documents;
A franchisee should further acknowledge that the trade secret information is only loaned to the franchisee during the term of the franchise and is to be used in conjunction with the franchise;
Your Franchise Agreement should also limit the franchisee’s right to disclose trade secret information to key employees on a need-to-know basis, and require that key employees sign confidentiality agreements;
The franchisee should agree to observe and implement all reasonable precautions against disclosure which you may implement from time to time;
The franchisee should be required to report unauthorized disclosures or uses of trade secrets; and
The trade secret provisions in your Franchise Agreement should be tied to both in-term and post-term covenants not to compete and non-use.

Contractual provisions are not enough without a pro-active strategy on the part of Franchisors to monitor franchisee compliance. Because of employee mobility, franchisee turnover, and uncertainty of courts, it is imperative that your company implement a checks and balance system to ensure strict confidentiality. Your trade secrets are the heart of the franchise system. Make sure you devote the resources to protect your investment and to protect your trade secrets.

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Jul 12

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Your Trade Secrets: What Are The Questions?

By Richard Duell lll Newsletter

How many franchisors have ever taken the time to actually define the trade secrets of their company? In many franchising companies, the general consensus is that trade secrets are those mystical items comprising their “system.” They then throw it in the attorney’s lap and say “I am not sure what they are, but I want them protected.”

It is not uncommon to find franchise marketing materials and franchise agreements which recite the uniqueness of the “system” and then claim the overall make-up of the franchise system constitutes a trade secret. Such broad recitals certainly attest to the misperception of what is legally protectable. Much of what a franchisor provides its franchisees are operating methods commonly known in the trade or industry and are not protectable. In fact, an agreement which seeks to restrict the use of an alleged trade secret and which fails to qualify as such is unenforceable against public policy. Some courts have even held allegations that clearly mistake trade secret status may constitute predatory practices under antitrust laws.

While various courts in the past have used numerous definitions of what was protectable as a trade secret, most states have now passed trade secret legislation. Generally state trade secret legislation is based upon either the Restatement of Torts format or the Uniform Trade Secrets Act. The majority of states have adopted, with some state variations, the Uniform Trade Secrets Act format. This act defines “trade secrets” as:

“[I]nformation, including a formula, pattern, compilation, program, device, method, technique or process that:

Derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through appropriate means by other persons who can obtain economic value from its disclosure or use; and
Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.”

Obviously not all information provided to franchisees can be protected. But where a franchising company has customized information and taken measures to ensure it is inaccessible to others, such information is protectable. An example of customized information might include, specially arranged recipes and formulas, special software programs, pricing lists, cost data, list of sources of raw materials and technology sensitive research.

Franchisors should work with legal counsel to ascertain what part of their system is a trade secret and therefore, protectable. Secondly, franchisees should acknowledge either in the franchisor’s confidential manuals or elsewhere, those items in the system which are classified as a trade secret. Finally, Franchisors must take active steps to protect their trade secrets. Our next post discusses many of the steps a franchisor should use to protect its trade secrets.

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Jun 06

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A Practical Look at Arbitration vs. Litigation in Franchising

By Richard Duell lll Newsletter

Ask Franchisors whether they prefer arbitration or litigation and you will get quite an array of viewpoints. Occasionally, opinions are based upon experience, but more often than not, mere perception.

Because each franchisor’s business is unique, what works for one company may not work for another. In order to make an informed decision on whether to use litigation or arbitration, a franchisor must understand the advantages and disadvantages of each forum. To do this, a franchisor needs the benefit of legal counsel with a knowledge about franchising. Additionally, legal counsel must know how your business actually functions. All too often when I review a new client’s franchising program, the client never had any meaningful input about the decision on whether to use arbitration or litigation. There was never a discussion on the advantages or disadvantages of each format, particularly when considering how each format relates to that client’s unique business.

The choice of litigation may be beneficial for one client and detrimental to another. There aren’t any “cookie cutter” molds to facilitate your decision. There are however, some relevant questions to answer in guiding your decision.

Paramount to any decision should be the cost of each approach. Litigation often involves expensive discovery consisting of motions ad infinitum and depositions that rob a growing franchisor of its most precious resource – key people.

On the other hand, arbitration may be extremely expensive. When looking at arbitration filing fees and the cost per day of each arbitrator hearing a dispute, the price can quickly rise to thousands of dollars.

This disadvantage may, however, work as an advantage for some franchisors.

Cost for a franchisee to initiate arbitration can be a deterrent to a franchisee’s aggressiveness. It is amazing, but many litigious franchisees will think twice about initiating arbitration when they are advised about its costs and are unable to find an attorney to represent them on a contingency fee basis.

An important area to consider in a franchisor’s decision on whether to use litigation or arbitration is whether a franchisor has any avenue of appeal if it does not believe the decision follows legal precedent. Litigation is structured and a judge must follow the law and, if not, there are appellate courts to ensure compliance with the law. Unfortunately in arbitration, appellate review is very limited. We sometimes find arbitrators who believe their function is to provide equity, and in doing so, they tend to compromise. With limited appellate review, there may be no viable avenue for a franchisor to appeal the arbitration decision. This would appear to be a definite strike against arbitration, but it must also be weighed in conjunction with a survey finding that the average and median jury verdicts against franchisors were dramatically higher (almost seven times) than the awards judges and arbitrators rendered against franchisors.

Whether to utilize arbitration or litigation requires a thorough knowledge of the advantages and disadvantages of both concepts. As a franchisor, be diligent in learning all the pluses and minuses of each process. Don’t fall into the trap of one size fits all.

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May 05

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System Standards and Stopping Defaults

By Richard Duell lll Newsletter

The cornerstone of every successful franchise system depends upon the uniformity of its operations. Without consistently enforcing system standards among all franchisees, a franchisor’s brand identity and goodwill are at risk. There are two steps a Franchisor should initiate to build system compliance. The cornerstone of every successful franchise system depends upon the uniformity of its operations. Without consistently enforcing system standards among all franchisees, a franchisor’s brand identity and goodwill are at risk. There are two steps a Franchisor should initiate to build system compliance.

Enforcement of system standards should start with a franchisor’s consistent inspection of franchisee operations, using trained inspectors. Each inspector should use the franchisor’s standard inspection form which lists each category and area to be inspected. The inspection report when used correctly provides a Franchisor with a blueprint for insuring compliance and additionally, helps a Franchisor assist its franchisees to improve the franchised business. At the conclusion of an inspection, a copy of the report which lists any deficiency or failure to follow system standards should be provided to the franchisee. The franchisee should be instructed on the means to correct violations and then given a time within which all violations must be corrected. If the franchisee is not present at the inspection then the operations manager should be advised of violations and should be required to sign the report. Thereafter, a copy of the report should be sent to the franchisee pursuant to the required notice section of the franchise agreement. As part of a Franchisor’s compliance program a copy of the signed report should be scanned into the franchisee’s electronic file along with proof of required notice to the franchisee. If violations are material, a Franchisor should have its attorney send the franchisee a “Notice to Cure” letter.

An additional tool a Franchisor may employ to insure system compliance is the use of electronic access to a franchisee’s operations. One common method of electronic access is logging into the POS system. A Franchisor should assign one of its staff members with responsibility for obtaining financial information, all purchasing and sales data and any number of other categories of information. The Franchisor should develop a pro forma model from a select number of franchisees or company facilities. By comparing data from other franchisees it is easy to set up red flags when a particular franchisee falls outside the parameters established from the operation of other franchisees. When coupled with other reporting mechanisms, a Franchisor can help to ensure system compliance and not let dissident franchisees go too far before curing a violation or facing termination of their agreement.

Making a true commitment to developing, communicating and enforcing system standards ensures the consistent quality of a franchise – failure to do so ensures erosion of the system and ultimately its collapse.