Author: Mary Beth Gettins

One of the foremost questions prospective franchisees ask is ‘How much will I make?’  Unless you include an item 19, Financial Performance Representation [FPR], you must say ‘I am not at liberty to tell you that’ or you can say: ‘Don’t ask me.  Ask them.’  Them referring to existing franchisees.  Either way is not a good answer.  More and more franchisors are including an FPR in the franchise disclosure document [FPR] enabling them to ask this question and to further sales conversations with prospective franchisees.
As discussed on our Blawg previously, the NASAA [North American Securities Admiration Association] has come forth with guidance regarding an FPR.  While the guidance is not set to be effective until next year, state examiners and drafters of the NASAA guidelines take the position that the guidance embodied is the Rule and should be adhered to now!
At the ABA Franchise Legal Symposium back in November, Dale Cantone from the Maryland Attorney General’s Office and lawyers from Witmer, Karp, Warner & Ryan LLP and Gray Plant Mooty presented some wonderful feedback and takeaways from the NASAA guidance.
Here is list of the common mistakes taken from the ABA Legal Symposium materials:

http://www.americanbar.org/content/dam/aba/images/franchising/annual16/course-materials-16/w13-advanced-drafting.pdf
 

Historically, when funding franchisee startups, the federal Small Business Administration [SBA] would examine the franchisor specific franchise agreement, and draft an individualized franchise specific addendum.  The process was laborious.  Each franchise agreement was reviewed.  A franchise addendum was crafted for each specific franchise agreement.  The crafting of the franchise specific addendum sometimes included jockeying over the exact verbiage.  All this took time.  The SBA complains it was draining on SBA resources.  And, for prospective franchisees, it delayed the sales and franchise startup.
No more.  Gone are the days of the franchise specific SBA addendums.  The SBA has adopted a franchise agreement addendum template- One Size Fits All.  It is a plain, simple, 1 ½ page document.  It covers only 4 provisions:
Employment– Franchisor CANNOT hire, fire or schedule franchisee employees
Real Property Leasing– Franchisor MAY NOT record environmental restrictions of use or branding requirements if the property is the franchisor owns the property
Forced Asset Sales-the purchase price must be set by mutual agreement or by appraiser selected by franchisor and franchisee
Change of Owner– Franchisor shall not unreasonably hold consent for franchisee transfer and franchisor shall have first right of refusal for partial transfers among existing franchisees.

Note:  the amended and abridged franchise addendum process does not alter SBA eligibility requirements.  Franchisors and Franchisee have to follow the same eligibility process and requirements.  Per the SBA addendum:
Note to Parties: This Addendum only addresses ‘affiliation’ between the Franchisor and Franchisee.  Additionally, the applicant Franchisee and the franchise system must meet all SBA eligibility requirements.
 

 
A pilot program launched in 2012 by the United States Patent and Trademark Office (USPTO), suggests that many trademarks registered may not actually be used.  Per remarks by the Trademark Commission regarding the pilot program,  more than half of the trademark registrations selected in the pilot program were unable to verify the actual use of the mark for the goods or services queried.

To date, in just over half of the registrations selected for the pilot, the trademark owners failed to meet the requirement to verify the previously claimed use on particular goods and/or services.  173 of the registrations, or 35%, involved deletions of the goods and/or services queried under the pilot.  In another 80 registrations, or 16%, the trademark owners failed to respond to the requirements of the pilot and any other issues raised during examination of the underlying maintenance filing, resulting in cancellation of the registration.  Accordingly, of the 500 registrations selected for the pilot, to date a total of 253 registrations, or 51%, were unable to verify the previously claimed use in their Section 8 or 71 Declarations.  Post Registration Proof of Use Pilot Status Report

The Trademark Commissioners on the blog remarked:

When selecting a mark for a new product or service, a business will search the USPTO database of registered marks to determine whether a particular mark is
available. Registered trademarks that are not actually in use in commerce unnecessarily block someone else from registering the mark.

The gap between the use of trademarks and registrations detracts from the validity of the trademarks registration status and dilutes the trademarks processes.
Renewal filing requirements are meant to preclude this exact problem.  5 years from initially registering a trademarks and every 10 years thereafter, trademark owners are required to submit use samples [referred to as specimens] to the USPTO.
In response to the widespread issue of false renewal trademarks, the USPTO has changed the renewal process.  As part of the renewing trademarks every 5 and 10 years, trademark owners have always been required to sign a sworn declaration saying that the mark is being used.  The USPTO has made the sworn declaration easier to read and more blatant.

Old Attestation

 

New Attestation

To the further address this issue, the USPTO is looking at instituting a new ‘Expungement’ status for trademarks that have never been used and streamlining procedures to delete trademarks that has been abandoned or that use-requirements were not met.
Based on the pilot program findings, the USPTO has announced its intention to continue random on-going checks of registered trademarks.
 

 
What are sufficient grounds for terminating a franchise?

• Franchisee adds unauthorized food items to the menu.
• Franchisee make takes artistic liabilities with the Brand Logo in published advertisements
• Franchisee fails to name the franchisor as an additional insured on its insurance policies.

Are these sufficient grounds for the franchisor to terminate the franchise agreement?  An arbitration panel deciding question followed a two-step process to determine the answer.

• Does the franchise agreement allow termination for these violations?
• Is there a lesser available alternative to termination?

The case was Benihana, Inc. [BI] v.  Benihana of Tokyo, LLC [BOT].  The franchise agreement at issue had two applicable termination provisions.

If [BOT] violates any [] substantial term or condition of this Agreement and [BOT] fails to cure such violation within thirty [30] days after written notice from [BI] to cure same; [or]

If [BI] gives [] three [] notices of any default hereunder [and such defaults are thereafter cured], within any consecutive twelve [] month period ….

The arbitration panel majority found that the franchisor had a contract right to terminate the franchise agreement, but failed uphold a termination of the franchise agreement saying that a less harsh alternative of injunction compelling the franchisee compliance existed.   This is a bizarre finding by the arbitration panel, which the court reviewing the case questioned, but was powerless to change.
This case highlights the uncertainty associated with the arbitration and court reviews of the franchise terminations and defaults.  Though questionable, uncertain, bizarre, and perhaps not required, the arbitration panel’s process of asking about less harsh alternatives to termination is worth consideration.  Franchise termination carries a high probability for arbitration or litigation challenges and the outcome of such challenges is never certain.

http://eepurl.com/cpZain

To resolve a litigation dispute, franchisor and franchisee enter into settlement agreements.  Settlement Agreements can be a way to avoid costs and time of litigation.  An added benefit is confidentiality.  Litigation is a matter of public record, but settlements can include a confidentiality provisions that prevent the parties from discussing the particulars of case and terms of settlement. Covenants of confidentiality can be a great incentive for entering into a settlement. 
Franchisors may not want the terms of the settlement released or discussed for fear that other franchisees will want that same deal.  Franchisors likewise most likely don’t want prospective franchisees to learn any more about the case than what is required to be disclosed in the FDD.  The inverse may also be true.  Franchisees, may not want their business wrongdoings and possible loss of franchise business discussed with others. 
Both rely on the confidentiality provision in settlement agreement.  What if the confidentiality is broken or violated?  The person with loose lips should be held responsible, right.  They should be made to pay.  Not in the case of Jana Caudill, et al., Plaintiffs-Appellants v. Keller Williams Realty, Inc. In this case, the Franchisor distributed the FDD [Franchise Disclosure Document] to 2,000 persons.  This is overwhelming beyond the persons and entities required to be disclosure to under the FTC Rule and other franchise disclosure laws.  As part of the FTC franchise disclosure laws, franchisors must outline in item 3, claims filed by and against the franchisor, including the claims, demands, and outcome. 
Because the franchisor gave the FDD to more people than required by franchise disclosure laws, the franchisee asserted this constituted a breach of the confidentiality agreement in the settlement agreement.  The court agreed, but refused to award the franchisee liquid damages.  For each incident violation, damages would have totaled $20 million.  The court said there was no evidence that the franchisee suffered any actual monetary damages and without a showing that the franchisee suffered monetary losses, the court awarded the franchisee nothing.  The court simply issued a permanent injunction preventing the franchisor from disclosing or publishing the FDD beyond what is required under the FTC Franchise Disclosures laws.
Disturbing outcome.  To fend against such an outcome, make sure to build-in contractual incentives into settlement agreements aimed at fostering adherence to confidentiality provision.   And, if violations occurs, be prepared to site actual evidence of monetary loses caused by the violation. 
 

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The American Legal System is based on the right to enter into legal contracts freely.  Individuals and businesses are free to contract with whomever they choice. And, so long as the contract is not unlawful, the courts will give deference to the agreement- contact.
Hence the case of  H.B. Automotive Group, Inc, d/b/a Kia of the Bronx, and Major Motors of Long Island City, Inc., d/b/a Major Kia of Long Island City [Dealership Franchisee or Kia Motors of the Bronx ] v.  Kia Motors America [Kia Motors].  Dealership Franchisee  was in violation of their dealership franchise agreement with Kia Motors.  Kia Motors could terminate the Dealership Franchisee’s franchise agreement, but settlement was entered instead.  Under the settlement, the termination was delayed in order to allow the Dealership Franchisee to transfer the franchise to another franchisee.
Franchisee presented 2 prospective buyers or transferees.  The franchisor rejected both saying that they have poor satisfaction ratings [and other things].  Dealership Franchisee presented a third, but time was up under the settlement agreement. Kia Motors terminated the Franchise Agreement.
The case is in New York.  And the court said editing the New York law:

[i]t shall be unlawful for any franchisor directly or indirectly to impose unreasonable restriction on the franchised motor vehicle dealer relative to transfer, sale … or termination of a franchise ….

But, the court goes on to explain, relaying prior cases, settlement agreements can act as a waiver.  Yes, waiver. Hence, settlements are like a- free pass.  Kia Motors did not have to be reasonable when it rejected the third transfer request, because under the settlement agreement, the time to get a transfer approved was up.  Under the settlement agreement, if transfer was not approved by September 1, 2013, the franchise agreement terminated.  The third buyer’s application was not completed till September 11, 2013.  The franchise agreement termination stands.

As dicta, the franchise rejected all three proposed transfers on grounds that the prospective buyers  or transferees’ satisfaction ratings were substandard.  Otherwise stated the franchisor would not approve proposed transfers of the Dealership Franchisee’s franchise agreement, because the buyer [other existing dealerships] had deficient customer service scores below the average satisfaction scores of all Kia Motor dealerships in the Kia Motors System and this was sufficient reasonable grounds for   denying the transfer per the court.  So, the important dictation note from the court is that poor satisfaction rating scores of existing prospective franchisee buyers can be reasonable good cause grounds for a franchisor to deny a franchisee transfer. 
Returning to the holding in the case, settlement can be a wonderful thing for both franchisors and franchisees.  What ordinarily would have been the rule, under franchise laws and statutes, can be void if there is a properly written settlement agreement.  In this case it was the obligation to approve or disapprove a transfer.  But, settlement agreements can also operate as a release of claims, when the release is forbidden by the law.  Settlement agreements can also operate as an enforceable agreement that a material default under the franchise agreement is present and termination of the franchise agreement is permissible and enforceable.  When looking at the options, know the power of the settlement.

It is a story that is not unique.  Franchisee fails to pay royalties as required under a franchise agreement.  Franchisor terminates franchisee.  Franchisee continues to operate.  Franchisor sues franchisee.  This scenario is not in of itself ‘blog worth.’
What makes it ‘blog worthy’ is the franchisor’s claims against the former franchisee.  The franchisor’s complaint against the franchisee, asserts trademark infringement.  Trademark infringement has some teeth.  If a trademark infringement is found, the franchisor could be entitled to attorney fees and cost.  And, the franchisee would be disgorged of all profits from using the name improperly.

Disgorgement is a wonderful graphic word. Disgorgement is [a] remedy requiring a party who profits from illegal or wrongful acts to give up any profits he or she made as a result of his or her illegal or wrongful conduct. The purpose of this remedy is to prevent unjust enrichment.
Under the franchise agreement, the franchisor is entitled to a percentage royalty or flat fee royalty of revenues, which is typically a small percentage of all revenues.  Disgorgement is something greater.  It is all profits.  And, at the end of the day, it was what is.  A franchise agreement is licensure allowing franchisees to use the franchisor’s trademark in a limited way, limited time, and under limited conditions.  Any, use beyond what is called for in the franchise agreement is trademark infringement.

The case is Ghazi Ghori and Chooza, LLC.   https://www.pacermonitor.com/public/case/17827256/KFC_Corporation_v_Ghori_et_al  Assertions of the trademark infringement is probably again not unique in the case of the claims against former franchisees, but a noteworthy reminder of the claims available, liability exposure, and need for trademarking.
 

 
The Franchise Disclosure Document [FDD], is given to each prospective franchisee.  It contains countless required disclosures.  The disclosures includeseverything from who are the persons with franchise management and sale responsibilities, what fees are changed, what are the revenues and profits of the franchisor, and what if any, representations the franchisor makes regarding franchisee earnings.
What if something is missing?  What if something is inaccurate in the Franchise Disclosure Document?
The general answer, if there is a material inaccuracy in the Franchise Disclosure document, is rescission.  If the FDD contains misinformation, the common remedy is the franchisee is entitled to rescission.
Rescission is like a money back guaranty.  Rescission operates to undo the transaction- to put everything back the way it was if before the franchise agreement was signed.  That means the franchisee is entitled to be reimbursed the initial franchisee fee and a lot more.  If the franchisee bought inventory, paid travel expenses for the initial training, purchased equipment, and put a deposit on utilities, the franchisee may be entitled to compensation for all these things.  How much could this cost?  How much money may the franchise be entitled?  Look at the initial investment cost listed in item 7 of the FDD.  Yes, it is all those things and anything else the franchisee paid.

Does every inaccuracy, every omission in the FDD warrant rescission?  No, of course not.  It is up to a court, a trier of fact, and perhaps state enforcement agencies.  Cases go both ways.  In a case by the Georgia court of appeals, the answer was no.  The case is Legacy Academy, Inc., et al. v. Doles-Smith Enterprises, Inc., et al.  The facts of the case revealed an accuracy in the Franchisor’s cash flow statement in the FDD.  And, that the FDD contained an inaccuracy in the Franchisor’s litigation history.  The case arose when the franchisee notified the franchisor it was unilaterally terminating the franchise agreement.  And, the franchise discontinued paying royalties, de-branded and continued business operations.  The franchisee was upset, because it was not turning a profit.  The franchisor sued for failure to pay royalties. The franchisee counter-sued saying it was entitled rescission of the franchise agreement.

The lower courts agreed and awarded the franchisee 350,000 dollars in negligent misrepresentations and 40,000 dollars in negligence.  But, the Appellate court reversed saying that the errors and omissions in the franchisor’s cash flow statement and the litigation history did not cause the franchisee to lose money.  The errors in the FDD did not depreciate or lessen the value of the franchise; therefore, the franchisee was not entitled to damages for negligent misrepresentations.  The damages that the franchisee suffered where consequential and not connected the franchisor’s errors in the FDD.  This left the franchisee with damages solely for negligent, which were offset by royalty payments that the franchisee failed to pay and were due.  It was almost a wash.  The franchisee nor the franchisor got a large payout.
Interesting didee of a case.  It shows that when it comes to errors in the FDD, the court can go either way.  The risk of the errors in the FDD can cost 40,000 dollars or 400,000  dollars or nothing.  It is all in how the court decides and there is no predictability.

Franchisor liability for employment claims has stolen the spot light from another big source of Franchisor liability- liability to customers.  In recent cases of McDonalds and other unfortunate cases, franchisors are being found liable to employees for wages and hours, discrimination and other work related claims.
But there is another big source of the liability that faces franchisors.  It is not new.  It is not uncommon.  And, it is very real.  It rides on the same principals as employee claims.  The source of the liability is customer, third party tort claims.  Customers or other third parties are injured from a slip and fall, bad food, unperformed services, and many other claims.  The customers or other persons sue the franchisee, but they also in the same law suit sue the franchisor.  The basis for the claim lies in the control that franchisors have over franchisee.
In one such case a Florida jury has awarded 10.1 million dollars to a victim of the car accident caused by a Domino driver to be paid by the Franchisor.  Why? How?  The jury said that the franchisor had control and therefore was liable for the accident.  Domino discontinued  its 30 minute delivery guarantee, but continues to offer incentives for speedy deliveries and consumer satisfaction.

This sends   the historic message that in practice and in the franchise agreement, cautions need to be taken to protect third party liability by limited Franchisor control.  How is that   possible when attempting to create good quality assurances and uniformity?  Here are some suggestions;
 

1. Give suggestions, choices to meet objectives.
2. State the goal, not the means to the goal.
3. Adopt standards and guidance from recognized trade groups, associations, or governmental entities rather than creating your own.