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Promotional Contests: Winners or Losers?

By Newsletter

Traditionally, consumer promotions featuring games of chance, lotteries and sweepstakes have generated new sales and given Franchisors increased brand name recognition. In fact, an article in The Wall Street Journal noted sweepstake sites were a growing segment of the Internet. Sounds like a winner doesn’t it? It can be a winner if your company follows the rules.

Almost every state has codified a set of rules to regulate promotional contests. At the federal level, various agencies are empowered to initiate enforcement actions where prize, chance and consideration are inherent in the contest.  Internationally, our neighbors to the north in Canada prohibit any pure game of chance. In Latin America countries like Mexico, Brazil, Argentina, Venezuela and Columbia, promotional contests require prior governmental approval. This is also true of many European and Asian countries.

In a world filled with complex governmental regulations and judicial decisions, which vary from one area to the next, is there a “bright-line rule” to guide us? Fortunately, the answer is yes. As a general rule, to fall within a regulated activity the promotion must encompass each of the following: 1) a prize; or 2) chance, with mandatory consideration. A prize usually connotes anything of value awarded to the contestant. The value only has to be minimal. Thus, even discount coupons awarded may be sufficient to fulfill the definition. Chance refers to some random means of determination.  Perhaps the most striking example of this random determination is the Reader’s Digest and Publisher’s Clearing Sweepstakes. Consideration may be the most unsettled area of the “bright-line rule” because one would normally believe it had to be in a monetary form, for example, the purchase  of  a  product. This  approach  is actually followed in the majority of states. But there are several states that have taken the approach that the consideration may also be non-monetary. In these states the mere completion of an informational questionnaire may trigger the state’s definition of consideration.

To ensue compliance with our “bright-line rule,” creative marketers have skillfully crafted contests which focus on eliminating either chance or mandatory consideration. By making the contest a game of skill, the contestant is judged on their ability to perform an act. For instance, a contest involving “trivia” judges a contestant on their ability to correctly answer questions, thus the element of chance is eliminated. The second method commonly used is the elimination of mandatory consideration. By offering consumers a choice, the criteria of “mandatory” is eliminated. We all have seen this approach in the Pepsi and Coca-Cola games of chance or in any number of franchised fast food restaurant games. The customer is provided a game card when they make a purchase, but the contest also allows anyone to send off for a free card without any purchase. Thus, there is an alternative means of entering the promotional contest without any required purchase – no mandatory consideration.

CONCLUSION

Promotional contests can be a big winner for your franchise company and your franchisees if you have properly planned in advance. Begin your plan by making sure franchise legal counsel is a part of your planning team. A well-laid plan will make your company a winner rather than the next defendant in a lawsuit.

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Multi-Unit Franchising – Is It for You?

By Newsletter

Every Franchisor dreams of expanding its franchise system. But what is the most effective way to expand and how quickly do you expand? These are the two questions which plague most Franchisors. Picking the right format can make a franchise company the top player or the next casualty.

One method of expansion which has a consistently winning track record is that of multi-unit franchising. In fact, IFA studies have found that although multi-unit Franchisors make up a fraction of the total franchisee population, they account for more than 50% of all franchise units.But not all concepts are suited for multi-unit franchising. The following are pluses and minuses you should consider when deciding whether your company is a candidate for multi-unit franchising:

Pros:

  • Accelerated Growth – The ability to expand at a much faster rate than through the sale of single units. This also enables a Franchisor to obtain a quick injection of cash into the system.
  • Attract Potential Franchisees – Usually the multi-unit purchaser is more sophisticated with more liquidity and has an infrastructure already in place. This is especially true of existing multi-unit franchisees looking to expand via other franchises within an area they are already operating in.
  • Operating Market Efficiencies – A multi-unit franchisee usually has a well-organized professional management team. It may take a single-unit franchisee years to obtain similar efficiencies.
  • Market Penetration – Location! Locations! Location! A multi-unit operator often has a distinct advantage of obtaining prime retail locations with the liquidity to open multiple locations at the same time.
  • Reduction of Training Assistance – Even if the first store opening requires the Franchisor to fully train the multi-unit operator, additional training and assistance for subsequent locations is normally minimal.
  • Reward to Productive Franchisees – Perhaps no bigger win-win scenario can be found than to reward successful franchisees with the ability to open multiple locations. A productive franchisee can replicate success at other locations, thus enhancing a Franchisor’s chance of having more successful stores and greater royalty income.

Cons:

  • Loss of Capital – There is no bigger detriment to a franchise system than a franchisee which is too big for a Franchisor to control. Litigation with a large multi-unit franchisee could destroy the franchise system.
  • Loss of Prime Territory – Although the development of prime territories can be advantageous, the elimination of prime territory can be a distinct disadvantage. A Franchisor normally requires a multi-unit franchisee to develop a territory with a pre-determined minimum number of locations over a set period of time. The period for opening new locations is generally a number of years and thus the territory is taken off the market for years in the future. If a Franchisor has a number of long-term development contracts, large territories are not available and other potential franchisees will go to other competing Franchisors or other unrelated franchise concepts.
  • Impact on System Franchisees, Vendors, and Suppliers – The franchising grapevine has no equal. When a dominant franchisee in the system creates ill-will, it permeates the entire franchise system.
  • Problems Addressing Defaults and Terminations Quite often the multi-unit franchisee consists of multiple entities and without proper cross-default provisions, a Franchisor may find itself in a quagmire trying to address defaults and terminations. This becomes even more complicated when a multi-unit franchisee is conducting business in more than one state.

Conclusion:

So many Franchisors jump into multi-unit franchising without knowing the pros and cons of this method of expansion.  The uniformed decision to implement multi-unit franchising can and sometimes does speak trouble. In our next post we will address “When is a Franchisor Ready for Multi-Unit Franchising?”; Qualifying Multi-Unit Franchisees; and More!

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Your Operations Manual – Is It A Legal Minefield?

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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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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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Your Trade Secrets: What Are The Questions?

By 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:

  1. 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
  2. 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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