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Modifying The Franchise System

By Newsletter

If there is one thing you can be sure of, it is the fact that change is imminent. In Franchising, if you don’t stay in touch with the market or consumer demands, you are setting a course for extinction. I am sure everyone can think of multiple examples of companies that remained static and are no longer with us today.

As a Franchisor, you are constantly evaluating and modifying the Franchise System to determine how new products, advancing technologies and changing consumer demands might affect your bottom line. Modifying the Franchise Systems occur in many forms. At one point, McDonalds did not serve breakfast. The modification of their Franchise System required a major investment by both Franchisees and McDonalds, with new equipment, advertising, additional labor cost and additional training. Almost all of the pizza franchises added delivery service to their system. Today you see many concepts that co-brand with other Franchise concepts. When you walk into a convenience store there are usually several franchise concepts in place under one roof. Computer technology has required many companies to modify a Franchisor’s system to stay abreast of competition.

Unfortunately, no matter how hard you work to lay the groundwork for changes to your Franchise System, there will always be one or more hostile franchisees who, even though they bought the franchise for your expertise, think they know more than expire. Be prepared for the argument that your modifications have caused a constructive termination of their Franchise Agreement or that you have modified or amended the original contract without their required written consent or that you have violated the covenant of good faith and fair dealing.

Fortunately, the good news is that courts around the country generally uphold a Franchisor’s right for modifying the Franchise System – when the Franchisor has reserved the right to do so in its Franchise Agreement.  The key is reserving your right to make modifications. It is important that your franchising counsel is part of your planning team so that counsel knows what your future expectations are and can help build your documents to avoid franchisee disputes.  Before making modifications to your Franchise System, be sure you have the legal ability to implement the system change.  If the subject of your future Franchise System Modifications is not already on your list, make sure to add it to our annual legal checkup review.

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Do You Have Underreporting Franchisees?

By 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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Before You Terminate

By 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.

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Steps to Protect Your Trade Secrets

By 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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