Category: 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.

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[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.

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.

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.

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
http://www.wkcheetah.com/#/read/6b7c7cbc7cdf1000b20dd8d385ad169402e!csh-da-filter!WKUS-TAL-DOCS-PHC-%7B4A1F7BEF-FFD4-4348-9D22-81311C5BA95F%7D–WKUS_TAL_11587%23wkus3855179a1c868c1d7818c62702944aab?searchItemId=&da=WKUS_TAL_11587

Years after the franchise agreement was signed franchisor designated and began to require franchisees to purchase windows from a designated supplier.  The designed window supplier charged franchisee higher window prices than other window buyers.  Franchisee discovered that franchisor derived a large part of the revenues from designated suppliers including the designated window supplier.
Franchisee filed a complaint in court against the franchisor and the designated window supplier alleging a violation of the Robinson-Patman Act; violations of the Sherman Antitrust Act; and violations of the Racketeer Influenced and Corrupt Organization Act [RICO].  The case is Bendfeldt v. Window World, Inc.

The Robinson-Patman Act provides in pertinent part:
It shall be unlawful for any person engaged in commerce…to discriminate between different purchasers of commodities of like grade and quality…where the effect of such discrimination may be substantially to lessen competition or tend to create monopoly in any line of commerce or to injure, destroy, or prevent discrimination with any person who either grants or knowingly receives the benefit of such discrimination or with customers of each of them…

The franchisee could prove that it was paying high prices than other window buyers in the Midwest and Nationally.  But, the franchisee did not produce evidence showing that franchisee lost sales to any local competitor which purchased the windows at lower prices.

A Sherman Act prohibits A tying arrangement that
is ‘defined as an agreement by a party to sell one product but only on the condition that the buyer also purchases a different (or tied) product.’ Tying suppresses competition in two ways: ‘First, the buyer is prevented from seeking alternative sources of supply for the tied product; second, competing suppliers of the tied product are foreclosed from that part of the market which is subject to the tying arrangement.’” It's My Party, Inc. v. Live Nation, Inc., 811 F.3d 676, 684 (4th Cir. 2016) (internal citations omitted). The Amended Complaint alleges that WW's “‘license’ for use of its trademarks, trade dress and business methods was the ‘tying’ product and that [AMI's] windows and associated materials served as the ‘tied’ product.” (Am. Compl. ¶119.) No. 5:17CV39-GCM Business Franchise Guide - Explanations, Laws, cases, rulings, new developments ¶16,048 http://www.wkcheetah.com/#/read/2f4740607cda1000940090b11c18cbab01a!csh-da-filter!WKUS-TAL-DOCS-PHC-%7B4A1F7BEF-FFD4-4348-9D22-81311C5BA95F%7D--WKUS_TAL_11587%23wkusd11363f92971876f09323a8ab40c1a1f?searchItemId=&da=WKUS_TAL_11587

The franchisee could not show that the franchisor and the designated supplier had market control [dominance] .

Rico
 “When pled as RICO predicate acts, mail and wire fraud require a showing of: (1) a plan or scheme to defraud, (2) intent to defraud, (3) reasonable foreseeability that the mail or wires will be used, and (4) actual use of the mail or wires to further the scheme.” Wisdom v. First Midwest Bank, of Poplar Bluff, 167 F.3d 402, 406 (8th Cir. 1999). “[T]he term ‘scheme to defraud’ connotes some degree of planning by the perpetrator, [and] it is essential that the evidence show the defendant entertained an intent to defraud.” Atlas Pile Driving Co. v. DiCon Fin. Co., 886 F.2d 986, 991 (8th Cir.1989) (alterations in original) (quoting United States v. McNeive, 536 F.2d 1245, 1247 (8th Cir.1976)). No. 5:17CV39-GCM Business Franchise Guide - Explanations, Laws, cases, rulings, new developments ¶16,048 http://www.wkcheetah.com/#/read/2f4740607cda1000940090b11c18cbab01a!csh-da-filter!WKUS-TAL-DOCS-PHC-%7B4A1F7BEF-FFD4-4348-9D22-81311C5BA95F%7D--WKUS_TAL_11587%23wkusd11363f92971876f09323a8ab40c1a1f?searchItemId=&da=WKUS_TAL_11587

There was no fraud.  The franchisor did not deceive the franchisee.  The franchisee knew that the franchisor could designate suppliers.  And, the franchisee know it would have to buy from the suppliers that franchisor designated.

The Bendfeldts [Franchisee] knew from the moment they signed their agreements that WW [Franchisor] could change the number and identity of approved window suppliers. They admit that they agreed to buy windows only from WW-approved suppliers: In other words, Plaintiffs [Franchisee] were on notice that WW [Franchisor] could designate one approved window supplier if it wished to do so. No. 5:17CV39-GCM  Business Franchise Guide – Explanations, Laws, cases, rulings, new developments ¶16,048 http://www.wkcheetah.com/#/read/2f4740607cda1000940090b11c18cbab01a!csh-da-filter!WKUS-TAL-DOCS-PHC-%7B4A1F7BEF-FFD4-4348-9D22-81311C5BA95F%7D–WKUS_TAL_11587%23wkusd11363f92971876f09323a8ab40c1a1f?searchItemId=&da=WKUS_TAL_11587

In short, all of the franchisee’s claims regarding designated suppliers failed.  It is not unlawful for franchisors to designate new or different supplier after signing the franchise agreement.  And, it is, not unlawful for the franchisor to derive revenues from designator supplier sales to franchisees.
It may make a franchisee or all franchisee mad.  It may increase franchisees’ operating cost.  But, these things alone are not sufficient to be unlawful.  More is required to show required for wrongdoing.

Perhaps without exception, franchise agreements include post-termination non-competes and non-solicitation.

A non-compete prevents the franchisee from owning or working for a business that competes with the franchise.

A non-solicitation prevents the franchisee from contacting the customers of the franchise business to offer products or service that are offered by the franchise business.

There are non-competes and non-solicitations that span during the franchise agreement and post the termination, expiration, or transfer of the franchise.  The enforceability of the franchise agreement’s non-compete and non-solicitation is dependent on state law.  Except for the case of California, non-competes and non-solicitation are enforceable if the duration of the non-compete is reasonable as to time and duration.
The general rule is that a non-compete and non-solicitation is only enforceable against the signers of the non-compete and non-solicitation.  However, this case provides an all too common exception.  The case is The Maids Int’l, Inc. v. Maids on Call, LLC. 
In this case, Plaintiff franchisor and Defendant franchisee entered into franchise agreements for the operation of the a The Maid franchises.  Franchisor terminates the franchise agreements for under-reporting gross revenues and failure to pay royalties.
Post the termination of the franchise agreement, franchisee’s daughter opened a business called Two Sisters that offers maid services at the same location and used the same Facebook page email as the former franchise business.  The location which the Two Sisters operated continued to bear the signage of the former franchise business.  Two Sister used the same vehicles that were registered to the former franchise.  The form franchisee sent a retirement letter to its customers that said:

SARA, STACEY and MILLIE are ready to take over. (They really have been running the business for many years)………..most everything will remain the same,”

No. 8:17CV208 Business Franchise Guide – Explanations, Laws, cases, rulings, new developments ¶16,047 http://www.wkcheetah.com/?window=document&cpid=WKUS-Legal-Cheetah#/read/2f4740387cda1000ac1c90b11c18cbab017!csh-da-filter!WKUS-TAL-DOCS-PHC-%7B4A1F7BEF-FFD4-4348-9D22-81311C5BA95F%7D–WKUS_TAL_11587%23wkusa59bc1eda5dc7d31154eda7cfd249493?searchItemId=&da=WKUS_TAL_11587

The court found privity and connectivity between the franchisee and Two Sisters.  Therefore, despite Two Sisters being a separate corporation with different owners, the non-competition and non-solicitation under the franchise agreement were enforceable again Two Sisters.  The court ordered Two Sister [in addition to the Franchisee and franchisee owners] to:

• Stop using the franchise marks- i.e., remove the signage
• Stop offering offer and providing service in violation of the non-compete
• Stop soliciting the franchise business customers

An extraordinary outcome.  Would there have been the same outcome if Two Sister had not been owned in part by the franchisee’s daughter?
 
 

There is no set way franchise disputes must be settled.  Sure, there are some state laws that require the laws where the franchise business is located to prevails and the alike.  But, there is no per se way that franchise disputes must be resolved.  The franchisor in drafting the agreement can require mediation, arbitration, litigation and any combination thereof.
However, once decided, the language in the franchise will dictate [except for the state law limitations]; therefore, it behooves one to read and re-read to ensure proper steps are followed.  Failing to do so, will result in one spinning his/her wheels.
Hence is the case of World of Beer Franchising, Inc. v. MWB Development I, LLC, et al.  Under the franchise agreement entered into between the parties’ disputes were to be resolved via non-binding mediation and arbitration, except in disrupts regarding the trademark and in which case a junction through the court may be sought so long as a petition for non-binding mediation was petitioned contemporaneously.

NOTHING IN THIS AGREEMENT WILL PREVENT YOU OR WE FROM OBTAINING TEMPORARY RESTRAINING ORDERS AND TEMPORARY OR PRELIMINARY INJUNCTIVE RELIEF FROM A COURT OF COMPETENT JURISDICTION. HOWEVER, YOU AND WE MUST CONTEMPORANEOUSLY SUBMIT A DISPUTE FOR ARBITRATION ON THE MERITS.

A dispute regarding the trademark and other issues ensued.  Franchisee was buying services and products from unapproved suppliers.  The franchisor and franchisee agreed to a mutual termination, but franchisee continued business under the trademark after the mutual termination of the franchise agreement.
The franchisor filed a petition for an injunction in court.  The court denied the injunction on the basis that no petition for non-binding mediation was filed.  This case is a reminder that once in writing alternative dispute resolution [mediation and arbitration clauses], even post the termination of the franchise agreement, shall be enforced to the fullest extent permitted by law.

Under numerous state laws, franchisees are entitled to notice prior to termination.  The amount of the time varies by states.  It could be 30, 60, or even 180 days.
Who owns the franchise business between when the franchisee is given notice, and the franchise business is terminated.  That question was posed in the case of Charter Practices Int’l, LLC, and Med. Mgmt. Int’l, Inc. [Banfield] v. John M. Robb [Franchisee].
Banfield gave Franchisee notice of termination.  Pursuant to Connecticut law, a 60-day notice was required and given.  The Termination Notice stated that Banfield would assume the daily operations of the franchise business until the termination date.  When questioned by the press, Banfield instructed personnel to state:

Dr. Robb no longer owns a Banfield hospital.

But, is that true?  Who owns the franchise business post a notice of the termination, but prior to termination.  The court’s decision turned on the expressed language in the franchise agreement.
The franchise agreement gave Banfield the right to step in and operate the franchise business in the event of default.  However, this provision deemed that the franchise business would still be owned by the franchisee and the revenues derived from the franchise business during the franchisor’s operation accrued to the franchisee.
This deem of ownership is important.  Franchisee, citing Connecticut’s Law requiring a 60-day notice of franchise termination, argued that Banfield’s takeover of the operation of the franchise business violated the Connecticut Law.  Franchisee’s argument was rejected.  Banfield gave Franchisee a 60-day notice of termination and Banfield’s exercising of step-in rights did not violate the Connecticut Law because the Franchisee still owned the franchise business during the step-in period.  Banfield’s personnel press response was a misstatement and inaccurate.

Yes.  It is back.  The Small Business Administration franchise registry is back.  Franchisors must be on it in order for your prospective franchisee to get funding.  Wait, I miss spoke.  It is an SBA franchise directory, not the registry, the Directory.
The Directory is not optional.  Unlike in the past, where franchises could be approved as part of the franchisee loan process, franchises must be pre-registered.

Under these changes, Lenders and CDCs will no longer have to review franchise or other brand documentation for affiliation or eligibility.

The criteria for being in the Directory is very straightforward. To be in the Directory, Franchises must meet the FTC definition of a franchise. The Directory does not replace the need for the standard of SBA Addendum.  Franchisors will still be asked to the sign the Standard SBA Addendum.
The Directory will contain the following information:

• Whether the brand meets the FTC definition of a franchise;
• An SBA Franchise Identifier Code, if applicable;
• Whether an addendum to the franchise agreement is needed; and
• Whether there are additional issues the SBA Lender must consider with respect to the brand.

The Directory will be administered by FRANdata and found on the SBA website at www.sba.gov/for-lenders.  Franchisors will be required to register on the Directory annually.  The Directory requirement won’t go into effect until January 1, 2018, but franchisors can register now.
SBA notice regarding the directory can be found at http://www.frandata.com/wp-content/uploads/2017/10/5000-17009.pdf.