Litigation is notoriously expensive in the United States. An ounce of prevention is worth a pound of cure. Here are 10 ways for franchisors to minimize litigation risks in the United States:
1. Know and follow franchise disclosure laws
Under the Federal Trade Commission’s Franchise Rule, which applies to the entire United States, franchisors must provide prospective franchisees with a copy of a Franchise Disclosure Document (“FDD”) containing required items at least 14 days before the prospective franchisee signs a binding agreement or makes a payment (or earlier upon request, and note that there are some exemptions.) Some states require franchisors to provide prospective franchisees with an FDD earlier. Failing to comply with franchise disclosure requirements can lead to (1) private litigation by franchisees and prospective franchisees, (2) enforcement actions by government regulators, and (3) limitations on a system’s ability to grow. The remedies for a franchise disclosure violation vary by state and can include rescission and restitution, damages, treble damages, costs, attorney’s fees, interest, and more. Thus, franchisors should know and follow the franchise disclosure laws.
2. Know and follow franchise registration laws
At least fourteen states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin) require franchisors to register their franchise offerings with the state before offering or selling franchises in that state, unless exempt. In addition, a number of states require franchisors to file a notice with the state business opportunity administrator to exempt the franchise offering from the state’s business opportunity act. Like franchise disclosure violations, franchise registration violations can lead to (1) private litigation by franchisees and prospective franchisees, (2) enforcement actions by government regulators, and (3) limitations on a system’s ability to grow. Again, the potential remedies are serious, so franchisors should know and follow the franchise registration laws.
3. Invest adequate resources to develop a top-notch franchise agreement and franchise disclosure document
The franchise agreement and FDD are the very foundation for the franchise system. Well-drafted documents can eliminate some litigation, and make it easier to prevail more quickly in other litigation. Seemingly small differences can mean the difference between winning a case on an early motion to dismiss and going all the way to trial.
4. Be careful with FPRs
Financial performance representation or ‘FPRs’ are a common source of litigation between franchisees and franchisors. FPRs are “any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.” Franchisors must decide whether to include an FPR in their FDD. If they include one, it must be supported by written substantiation and be made in the required format. In the sales process, franchisors cannot make any FPRs except those in the FDD (with narrow exceptions).
5. Know and follow State Relationship Laws
At least twenty-one states (Arkansas, California, Connecticut, Delaware, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Tennessee, Virginia, Washington, and Wisconsin) have laws addressing various aspects of the franchise relationship relating to default, franchisee termination, and post-termination obligations. Some states also have industry-specific franchise relationship laws. In general, these ‘state relationship laws’ restrict the ability of a franchisor to terminate or refuse to renew a franchise or regulate other aspects of the relationship between the franchisee and franchisor. While the state laws vary, they can require ‘good cause’, notice, and an opportunity to cure before terminating franchise agreements. They override contradictory provisions in Franchise Agreements. When implementing a termination or non-renewal, franchisors must follow these laws. Franchisors must gather supporting evidence of contract breaches and send compliant default and termination notices.
6. Take the long view on franchise terminations
Franchise terminations often lead to litigation, which can have short-term costs. However, for the long-term health of the franchise system, franchisors often must terminate non-compliant franchisees. Franchisors must preserve the value of the system for the remaining franchisees, as well as encourage compliance by other franchisees by demonstrating that noncompliance has consequences.
7. Limit unnecessary franchisor control over franchisees and franchisees’ employees
One of the hottest litigation issues facing franchising today is under what circumstances, if any, a franchisor will be deemed a joint employer with its franchisee for purposes of the National Labor Relations Act (the federal statute which governs unions and other matters), the Fair Labor Standards Act (the federal statute which governs overtime pay, minimum wage, and other matters), and other federal and state laws. While the franchise industry waits for further guidance from the courts, the National Labor Relations Board, and other agencies, franchisors should consider revisiting their documents and adjusting their practices. While there is no one-size-fits-all solution for all franchise systems, franchisors should consider revising their franchise agreements and operations manuals to:
- state that the franchisor does not have direct or indirect control of – or the right or authority to control – the hiring, firing, disciplining, scheduling, or supervising of the franchisee’s employees; the franchisee has exclusive control over such matters;
- provide that the franchisee exclusively has the duty to comply with federal and state labor and employment laws;
- state that there is no employer or joint employer relationship between the franchisor and franchisee or between the franchisor and the franchisee’s employees;
- not require particular employee handbooks;
- recommend that the franchisee obtain independent legal and human resources advice;
- directly tie operational requirements to the maintenance of product and brand quality;
- eliminate any unnecessary reserved control;
- ensure indemnification and insurance provisions cover labor and employment law violations, and acts and omissions of franchisees and franchisees’ employees; and
- require franchisees to carry EPL insurance, and police this requirement.
Franchisors should be particularly cautious about providing any software that makes staffing or scheduling recommendations, and – if franchisors do provide such software – make it clear that any recommendations are optional. Critically, franchisors should consider training field personnel to avoid involvement with franchisee employment issues.
8. Impose and enforce insurance requirements on franchisees
Franchise agreements (and related operations manuals) should contain specific insurance requirements stating the minimum types and minimum amounts of insurance that franchisees must carry. The insurance provisions should require that the franchisor be listed as an additional insured.
Equally importantly, franchisors should have a system in place to ensure that franchisees are following the insurance requirements. At minimum, franchisors should require franchisees to provide certificates of insurance on an annual basis, proving compliance.
9. Consider an arbitration clause with class waivers
Under current U.S. Supreme Court precedent, courts will usually enforce in most franchisor-franchisee disputes arbitration clauses that require that arbitration occur on an individual basis. This can help franchisors avoid costly franchisee class actions.
10. Select franchisees carefully and develop strong franchisor-franchisee relationships
Successful franchisees are less likely to be in litigation with their franchisor. Franchisors should select franchisees with the operational qualifications and financial resources that facilitate success. Then, franchisors should cultivate strong franchisor-franchisee relationships through open communication. Franchisors should strive to ensure that the franchisor and the franchise system continually provide value to the franchisees in return for their royalties and other payments.
About the author
Karen Marchiano is Of Counsel in the Silicon Valley office of the international law firm DLA Piper
