You May Need More Capital To Offer and Sells Franchises in California

There are no hard and fast rules about how much capital or money a franchisor is required to have in the bank.  If a franchisor has limited amounts of funds in the bank, a state may require the franchisor to include a risk factor on the state cover sheet of the franchise disclosure document [FDD].  For new franchisors or franchisors that have limited amount of funds, a state may require a franchisor to defer initial franchise fees, initial escrow fees, or secure a bond. 

Based on a new policy, California is requiring Franchisors to have additional capital.

However, based on recent comment letters and conversations with the examiners in California, California requires something new.  Based on a new policy, California requires Franchisors to have additional capital.  The amount required is still convoluted.  However, when registering in California, franchisor should plan on having an amount equal to the initial franchise fee in the bank.  Without sufficient funds in the bank, the state of California may refuse the franchise registration application. 

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The New and Expanded Franchise State Cover Page

On May 19, 2019, the NASAA [North American Securities Administrators Association] Membership issued instructions for the new Franchise Disclosure Document [FDD] state cover page.  The state cover sheet is expanding.  It is now 3 pages, not just one.  The pages include:

  • How to Use This Franchise Disclosure Document
  • What You Need to Know About Franchising Generally
  • Special Risk(s) to Consider About This Franchise

The first page, How to Use This Franchise Disclosure Document, is a table with 8 questions in the first column and in the second column, a cross-reference in the franchise disclosure document.  A narrative above tables states the mission of the table. The narrative reads:


Here are some questions you may be asking about buying a franchise and tips on how to find more information:

The question includes:

  1. How much can I earn?
  2. How much will I need to invest?
  3. Does the franchisor have the financial ability to provide support to my business?
  4. Is the franchise system stable, growing, or shrinking?
  5. Will my business be the only [XYZ] business in my area?
  6. Does the franchisor have a troubled legal history?
  7. What’s it like to be [an XYZ] franchisee?
  8. What else should I know?

The next page, What You Need to Know About Franchising Generally, is 7 general statements about franchising on the topics including:

  1. Continuing responsibility to pay fees.
  2. Business model can change.
  3. Supplier restrictions.
  4. Operating restrictions.
  5. Competition from franchisor.
  6. Renewal.
  7. When your franchise ends

The final page, special risk factors page, is kin to the risk factors required by the prior version of the state cover sheet. 

Franchisors must comply with the new state cover page requirements by January 1, 2020.

Is a Franchise Default Notice Grounds for Wrongful Termination?

The liability for the wrongful termination of a franchise agreement can be considerable, lost profit for the remainder of the franchise term and perhaps other damages. 

Here is the facts Franchisor requests licensee to remodel the franchise location to conform to current standards.  Licensee does not.  Franchisor sends franchisee a default notice for failing to update the location.  Licensee still does not update.  Franchisor sends the licensee a notice of termination, files a complaint in court staying the termination.  Licensee de-brands and continues to operate under a new name. 

Can the Franchisor be held liable for wrongful termination? 

The case is Buffalo Wild Wings, Inc.,  v. BW-3 of Akron, Inc., et al.[i]   No, said the court.  Since the Licensee closed the business, de-branded, and opened under a different name, the Licensee abandoned the business.  The Franchisor never terminated the license.  The Franchisor is not liable for wrongful termination.

Interesting case, but would the come be different if the franchisor had not stayed the termination?   


[i] No. 17-4291

Business Franchise Guide – Explanations, Laws, cases, rulings, new developments ¶16,378

Buffalo Wild Wings, Inc., Plaintiff/Counter-Defendant-Appellee v. BW-3 of Akron, Inc., et al.

Free is Not a Violation of a Franchise Non-Compete Covenant

The enforceability of a non-competition covenant is based on state law.  Generally, and perhaps uniformly, non-competitions are disfavored under the law.  Hence they are very narrowly construed. 

Restrictive covenants on employment may not be used to bar individuals from entire fields of work simply to limit the employer’s competition.

e.g., RLM Commc’ns, Inc. v. Tuschen, 831 F.3d 190, 196–97 (4th Cir. 2016)

A case out of Maryland involving Senior Helpers provides a real-life example[i].  Franchisee signs a Senior Helpers franchise agreement barring the use of Senior Helpers confidential information and engaging in a competitive business post the termination of the franchise agreement.  Competitive business under the franchise agreement is defined as Any home health care or in-home care agency or business that offers or provides non-medical care, companionship services, personal assistant services.

 Franchisee sales its Senior Helpers franchise to another franchisee and starts a business offering  dementia care training and consultation to senior care facilities and family members of individuals with dementia.

[A} a non-compete provision restricting a former employee from working directly with similar businesses was overbroad and thereby unenforceable because the restriction was not tethered to actual work the employee had performed for the employer)


Seneca One Finance, Inc. v. Bloshuk, 214 F. Supp. 3d 457, 461-62 (D. Md. 2016)

Senior Helpers sues for the breach of the non-competition.  In promoting its services and  preparing treatment plans, Senior Helpers includes information and education about dementia.  Hence,  dementia care training and consultation to senior care facilities and family members of individuals with dementia is a violation of the non-competition.

The court rejected this deduction.  Senior Helpers franchises offer companionship services and assistance.  Senior Helpers offers dementia education free to promote its services, and  incorporated dementia education into their treatment plans without charging.  Senior Helpers does not charge for dementia education.  Senior Helpers cannot bar others from selling and competing based on a service they do not charge. 


[i] SH Franchising, LLC d/b/a, Senior Helpers v. Newlands Homecare, LLC, et at. Civil Action No. CCB-18-2104 Business Franchise Guide – Explanations, Laws, cases, rulings, new developments ¶16,353

How Much Can Franchisees Be Charged?

It shall be an unfair or deceptive act or practice or an unfair method of competition and therefore unlawful and a violation of this chapter for any person to sell, rent, or offer to sell to a franchisee any product or service for more than a fair and reasonable price.  


RCW 19.100.180(2)(d)

One long hot button issue in franchising is charges, profits, and rebates that franchisors receive from franchisee purchases.  In addition to being the brand owner, franchisors may also be the supplier of goods or services to franchisees.  Franchisors have the right to be paid for service and value tendered.  But on the flip side, exorbitant charges can render the franchisee unprofitable and uncompetitive in the market place. 

Within ever contract, including franchise agreements and supplier agreements, there is implied a duty of good faith and fair dealing.   This can translate into to not charging unreasonable fees.  The obligation of good faith and fair dealing is not written in the agreement, but rather is an implied obligation in every agreement.  It is assumed. 

Washington state’s franchise law has codified into law the obligation of good faith and fair dealing.  In pertinent part, the codification is quoted above.  The Washington law says it is  “unfair or deceptive act or practice or an unfair method of competition……to sell, rent, or offer to sell to a franchisee any product or service for more than a fair and reasonable price.

A test of what is a fair and reasonable price was challenged in the case of Brewer v. Money Mailer, LLC.  The court declined to state a bright line rule about what is an unreasonable price.  But did say:



Selling printing services to a franchisee at more than twice what those services cost violates this provision.


ORDER GRANTING IN PART BREWER’S MOTION FOR SUMMARY JUDGMENT – 5

The court’s in its order granting summary judgment solely looked at the franchisor’s actual cost of services and the fee charged franchisees.  The court did not, and it is unknown if the parties present evidence regarding of fair market valve or competitor pricing for like services.  The court, in hand, disregarded per se the franchisor’s argument that it provided considerable benefit for the fees charged franchisees.


As a matter of law, huge markups in the price of a product or service that a franchisee is required to purchase from the franchisor are simply not permitted.

Id.

The take away is when determining fees charged franchisee.  Look at the cost.  Irrespective of the benefits bestowed or competitor pricing, the fees charged franchisee must be reasonable something less than twice the actual cost. 

Who owns this Franchise?

It is not uncommon for a prospective franchisee to purchase and sign a franchise agreement before forming a limited liability company or corporations.

Again, not uncommon and it is not a big deal.  However, it is important to make sure to transfer the rights and obligations under the Franchise Agreement [and to the preserve the non-compete and guaranty by individual franchisees] to the newly formed franchisee business entity.  A consent to transfer agreement between the individual franchisee, newly formed business entity and the franchisor should be signed when the business entity is formed.

Yes, even though it is a transfer from a franchisee individual to a business entity that the franchisee owns, the franchisor needs to consent to the transfer.  The consent to transfer conveys the rights under the franchise agreement to the business entity.  Without the consent, the franchisee business entity never becomes obligated under the franchise agreement.  Without the consent to transfer, the franchisee business is not obligated to pay royalties, to follow system standards, or follow any other obligations under the franchise agreement. 


Yes, even though it is a transfer from a franchisee individual to a business entity that the franchisee owns, the franchisor needs to consent to the transfer.

The potential outcomes are not good.  Hence the case of the In re: Meena, Inc.[i], In this case, two individuals purchased 3 franchises from GNC.  The individuals later formed a corporation.  A consent to transfer was never signed.  The franchise agreements remained under the names of the individual franchisees.  In purchasing the franchises, the individuals signed money security agreements collateralizing the franchised business assets. 

The money security agreement went delinquent and unpaid after the issuance of termination notices, extensions by the franchisor, the franchisees individually and the franchisee business entities filed bankruptcy.  The franchisor was in a pickle.  There was a money security agreement signed by individual franchisees, but the franchisee business entity owned the assets.  The franchisee business collateral was not attachable; the assets were not owned by the individual persons that signed the money security agreement.   The assets were owned by the franchisee business entity.


[i] Debtor. In re: Desa of NY, Inc., Debtor. In re: SDA, Inc., Debtor. In re: Choudry Sajid Javaid and Gulmeena Javaid, Debtors. ¶16,304. U.S. Bankruptcy Court, E.D. New York. Case Nos. 8-18-74693-reg, 8-18-74694-reg, 8-18-74695-reg, 8-18-74804-reg. Dated November 6, 2018.

What Franchisors Need to Do Before Advertising


You have your Franchise Disclosure Document [FDD] updated, and you are ready to sell franchises.  Before advertising, there may be one other step that you need to take.  The following states require that your franchise advertisements be submitted for review before publication or distribution.

·      California ·      Indiana ·      Maryland
·      Minnesota ·      New York ·      North Dakota
·      Rhode Island

·      South Dakota

·      Washington

The word advertisement in this context is used loosely.  For purposes of state review of advertisements, an “advertisement” includes virtually any document or letter given or sent to a prospective franchisee before or during the sale of the franchise, including, but not limited to, any

  • Brochures;
  • Photographs;
  • e-mails or letters sent or given to prospective franchisees;
  • newspaper, magazine, radio or television ads;
  • leaflets, photographs or brochures left in the company’s office;
  • signs or pictures in the office directed at selling franchises; and even
  • recorded telephone messages.

Advertisements in newspapers or other publications of general, regular and paid circulation which have had more than ⅔ of their circulation outside the state during the past 12 months, and radio or television programs originating outside the state, are NOT required to be submitted for pre-publication approval.
However, a newspaper or magazine article about the company that was originally published in another state or in a newspaper or magazine with more than ⅔ of its circulation outside the state must be submitted for approval if you mail copies to prospective franchisees in a state that does require pre-publication approval.

When is Franchise Transferee Bond?


One of the inalienable rights to owning your own business is the ability to transfer and sell your business. The sale and transfer of a business can be tenuous with many moving parts.  In the franchise world, this already tenuous transaction is further complicated.  Once a franchise seller and prospective franchisee buyer come to deal, the franchisor must approve the sale.
When approving the prospective franchise buyer, the franchisor will review the sales agreement, vet the prospective franchisee buyer, and set stipulations to the sale.  Common stipulations, among other things, includes payment of a transfer fee and payment any outstanding debt.
In some extenuating situations, there may be an urgency to the transaction because of health or family issue, finances of the franchisee, and other general life issues.  The formalities and the work-through of the sales process can be arduous.  However, the push to forgo the formalities and work-throughs should be thwarted.  Failure to do so may yield an inability to protect the franchise business and the franchise brand.
Hence the case of Rocky Mountain Chocolate Factory v. Timothy Arellano et al.  Franchisee and a buyer, defendant Arellano entered into protracted sales negotiations.  A sale agreement was sent to the franchisor, Rocky Mountain Chocolate Factory [RMCF].  Franchisor RMCF approved the franchise transfer pursuant prerequisite conditions, including among other things, the payment of delinquent amounts owed totaling $25,000.  The prospective franchisee buyer took over the operation of the franchise prior to the sale of the franchise being perfected or franchisor giving approval. Franchisor RMCF accepted and filled orders for inventory from the prospective franchisee buyer, Arellano, that had taken over the store.
The sale negotiations broke down.  No one wanted to pay the delinquent $25,000 owed to the franchisor.  Franchisor terminated the franchise agreement for failure to pay the $25,000.  But, by this time the prospective buyer and defendant Arellano has taken over the franchise business.  Despite the termination, Arellano refused to cease business operations or de-brand the business.  Franchisor sued Arellano in the franchisor’s home state of Colorado.  It was a dead stop, brick wall.  Franchisor does not have personal jurisdiction over Arellano because Arellano never signed the franchise agreement or anything else.
Hoping nothing goes wrong and bending does not always work out for the best.  When working through a transfer process, it is important to follow procedures carefully.  There are lots that can go wrong and remember until the buyer signs on the dotted line; there is not much that can be enforced.

When Can You Recognize Initial Franchise Fees?


As part of franchise disclosures, franchisors are required to disclosure financials.  The financials included in the franchise disclosure document [FDD] must be prepared in accordance with U.S. GAAP standards, which are set by the Financial Accounting Standards Board [FASB].
GAAP Standards were recently updated by the FASB.  One of the changes called into question how franchisors recognized initial franchise fees in their financials.  Instead of being able to include and recognize the entire initial franchise fee as revenue, franchisors would have to amortize the initial franchise fee over the life of the franchise agreement.
Per an article in Franchise Times:

There were a lot of changes (which you can read about here) but one of the trickiest was how initial franchise fee revenue was to be recognized……So instead of being able to take those funds into income in year one, to be spent on site selection help, training, equipment or anything else, it looked as if most of the fee revenue would have been recognized over time, which wouldn’t have been consistent with how franchisors work in practice. http://www.franchisetimes.com/news/December-2017/FASB-Clarifies-Confusing-Revenue-Recognition-Language/

This would hit hard against the franchisor’s financials in year one.  Franchisor revenues would be lower at a time when the cost to franchisors for startup cost for such things as training, site selection, and prospect franchisee vet are highest.  As a result, there would a lower bottom line for franchisors on paper and higher hard cost.
The FASB is giving a little relief.  A quote of staff issued FASB highlighted in the Franchise Times states:

One of the most prevalent questions from the franchising industry involves determining whether or not pre-opening activities constitute a distinct performance obligation. Under current GAAP, franchisors generally recognize the initial fee when the location opens and recognize the subsequent royalty stream over time. Because industry-specific GAAP exists, franchisors historically have not had to assess whether the pre-opening services are a separate deliverable. In making this determination under the new standard, the first step for the franchisor is to determine if the pre-opening activities contain any distinct services. If none of the pre-opening services are distinct, then the initial fee would be part of the transaction price for the combined performance obligation of the license and services and, thus, recognized over the entire license period.  http://www.franchisetimes.com/news/December-2017/FASB-Clarifies-Confusing-Revenue-Recognition-Language/

For a link to the full link to the FASB handout.  Visit the link above.
Franchisor financials are big deal.  Franchisor financials matter when prospective franchises consider the brand.  And, it is used by state examiners to determine if initial fees must be deferred or escrowed or alternatively a surety bond is required.

When does a Franchise Claim Becomes Stale?


As the old adage goes nothing lasts forever.  Under the Federal Trade Commission [FTC] Franchise Disclosure Rule, Franchisors are required to provide prospective franchisees with accurate and complete disclosures.  Failure to provide complete and accurate franchise disclosures can provide fertile ground for franchisee claims of unfair or deceptive trade practices.  But, a claim of a franchise disclosure violation should not be left to age and ferment on the counter like a loaf of bread. It will become stale.
The case is Haigh et al. v. Superior Insurance Management Group, Inc. out of the North Carolina.  Five franchisees sued their franchisor, Superior Insurance Management Group [Superior Insurance] for unfair or deceptive trade practices, breach of contract, breach of the covenant of good faith and fair dealing, breach of fiduciary duty, and declaratory judgment.  Superior Insurance moved to the dismiss claims of-of unfair or deceptive trade practices claiming the statute of limitation had run.

When the period of time specified in a statute of limitations passes, a claim might no longer be filed, or, if filed, may be liable to be struck out if the defense against that claim is, or includes, that the claim is time-barred as having been filed after the statutory limitations period. 

https://en.wikipedia.org/wiki/Statute_of_limitations
In North Carolina, a claim of unfair or deceptive trade practices must be brought in 4 years or the claim is time-barred.  The franchisee plaintiff signed their franchise agreements at issue between 2009 and 2011, clearly beyond the 4-year statute of limitations.  The court held that

‘Superior Insurance’s failure to provide the disclosure and the resulting Franchise Rule violation were necessarily apparent to the plaintiffs before they signed their franchise agreements[i].

Franchisee waited too long to bring franchise disclosure disclaims.  If the franchisees were harmed by inaccurate or incomplete disclosures in the franchise disclosure [FTC], they would have brought the claims earlier.
Each state has their own statutes of limitation for unfair or deceptive trade practices.  And, that the statutes of limitations for unfair or deceptive trade practices, do not apply to breach of contract, breach of the covenant of good faith and fair dealing, and breach of fiduciary duty.  These claims have their own statute of limitations.  It is well serving if a claim arises, to raise it.  And inverse if a claim is raised, look at the date when the events occurred.
If the statute of limitations has expired or passed, it is as if the wrongdoing [if any] did not occur.  There will be no recovery, no money damages awarded.
[i] No. 17 CVS 2582 Business Franchise Guide – Explanations, Laws, cases, rulings, new developments ¶16,072
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