Franchise Litigation: Fact, Fiction & Prevention

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Litigation in Franchising © 2021 iFranchise Group.

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Failure – Franchisees who are doing well in their businesses seldom sue their franchisor. Franchisees who are failing will blame the franchisor, not themselves.

Lack of honesty and transparency – “Fraud” is the basis for the majority of all lawsuits.

Lack of effort/support – Franchisees that are failing want to see a genuine concern and concerted effort to help. People seldom sue those that they feel are on their side.

Promises that are not kept – Nothing will offend a franchisee’s sense of fairness faster than the perception that they cannot trust their franchisor.

Poor communications – Franchisees want open and honest communications. They also want a franchisor that will listen to what they have to say.

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Franchise law in the 1970s was new

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Like all law, it is defined by “case law”

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Decisions rendered in the last two decades have better defined the law and reduced litigation ◦ ◦ ◦ ◦

Series of Series of Series of Series of

lawsuits involving marketing funds lawsuits involving territory disputes lawsuits involving “good faith” lawsuits involving “duty of competence”

◦ Series of lawsuits involving dual distribution 

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As cases are resolved by the courts, the lawyers drafting the contracts get smarter Far fewer litigation cases on these issues today

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Contract violations ◦

But a franchise contract is so one-sided this is almost impossible to find grounds within the contract

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“Periodic visits”

Franchise law violations ◦

Preventable by retaining qualified franchise counsel

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Compliance systems and checklists

Fraud in the sales process ◦

This is the basis for most franchisee lawsuits

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It is largely preventable

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Survey by independent industry source indicated that only 27% of franchisors had any litigation  Most of this litigation was with larger companies

 Companies like McDonald’s are targeted for frivolous lawsuits and lawsuits unrelated to franchising  McDonald’s, with 30,000+ contracts had only six pending lawsuits. Big Target. Litigation rate of 0.02%  Examples:

 A group claiming that the way they make chicken is unhealthy  Group suing them for making their children obese  Group suing them for beef tallow in cooking oil  A group suing them and others for collection of tax on bottled water  One suit by a JV partner  One pending franchisee lawsuit from a franchisee who owes $3 million in unpaid royalties

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The Litigation Trade Off: Franchising Versus Company-Owned Growth Liability Type Franchise Contract Liability

Well-Executed Franchising

Company-Owned Growth

X

Employment Liability

X

Property Lease Liability

X

Equipment Lease Liability

X

Workers Comp Liability

X

Slip and Fall Liability

X

Vicarious Liability Can require third party to insure you against liability Can insure against internally

Usually not*

You always have liability for your agents

Yes – franchisee

No

Yes

Yes

* Not Responsible for acts of an independent contractor (franchisee) relative to third parties. Exceptions are when a) you create an agency and/or b) if you are negligent. © 2021 iFranchise Group. All rights reserved.

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Litigation Avoidance

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 Limiting

your liability:

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Have your attorney review franchise marketing materials and ads

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Have your attorney review any form letters or correspondence

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Train sales staff on what is appropriate in communications

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Be selective in the franchise sales process

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Selecting qualified franchisees will help reduce a franchisor’s litigation:  Does the candidate have prior experience in the franchisor’s industry?  Does the candidate have prior business ownership experience?  Has the candidate hired and managed people before?  Is the candidate adequately capitalized?  How strong is the candidate’s credit history?  Will the candidate be opening a franchise in an established or a new market for the franchisor?  Has the candidate initiated litigation against others in the past?

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Marketing and Sales Best Practices

Limiting your liability: 

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Be sure the basic rules in the sales process are followed: o

Always tell the truth

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Only say what is in the FDD

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Document that the truth was told

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Franchisee verification at signing

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Continually train, test, and monitor sales force

Mystery shop your franchise sales force using an outside firm to ensure legal compliance – will also be a great report to have if you ever do have litigation.

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Legal Best Practices 

Limiting your liability: o

Be sure your FDD is kept current

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Develop a system to track state renewals and ensure compliance for each franchisee

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Conduct appropriate background checks

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Develop and monitor a system (at closing) for verifying and documenting that no inadvertent disclosures were made

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Train your franchise sales force on an annual basis on legal compliance

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Accounting and Auditing Best Practices 

Limiting your liability: o

Make sure that the audit is begun on a timely basis and that auditors finish on a timely basis so you do not “go dark” on franchise sales

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Install a system for tracking and documenting that each franchisee is maintaining proper insurance coverage

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Install a system for tracking and documenting that all franchisee licensing is kept current

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Install a system for documenting appropriate franchise background checks, financial diligence, representations.

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Operational Support 

Limiting your liability: o

Have a standard compliance checklist for field support that does not leave room for interpretation

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Make sure your support staff document everything and keep a detailed file on each franchisee including all correspondence, contracts, FA, FDD, etc.

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Supplement field support visits with Secret Shopper Programs

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Document all franchisee communications using Contact Management Software

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Train your staff on a regular basis on appropriate franchisee communication and interaction, as well as best practices communications techniques – especially emails!

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Develop a Field Support Manual for identifying problems and maintaining best practices

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Limiting your liability: ◦ Document your requirements and process that the franchisee must follow ◦ Ensure the franchisee conducts and documents their own due diligence ◦ “Approving” versus “accepting” the franchisee’s site ◦ Ensure the franchisee retains a qualified real estate attorney ◦ Review each lease to ensure your lease requirements have been met prior to execution

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Best practices for managing the fund include: ◦ Account for advertising monies separately ◦ Audit the fund annually ◦ Seek input from franchisees on how the marketing fund should be spent ◦ Don’t spend fund monies on initiatives that you know most franchisees won’t support ◦ Be conservative when allocating overhead expenses against the fund ◦ Be transparent in terms of sharing accounting information relative to the fund with your franchise owners

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Liability for the actions taken by someone else (franchisee or franchisee’s employees) ◦

A customer sues the franchisor because a franchisee “made the coffee too hot” and the customer was burned

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An employee sues the franchisor because the franchisee sexually harassed an employee

The Law is on Your Side! ◦

Technically speaking, you are not liable for the actions of a third-party independent contractor

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Third party needs to create a nexus through either the franchisor’s negligence or by claiming that an “agency” was created

Be sure that the franchisee is clearly identified as an independent contractor ◦

Signage in a location

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Use of name on business cards, letterhead, etc.

Develop a best-in-class Operations Manual Insurance ◦

Franchisee should carry and name franchisor as a co-insured

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Have system for tracking franchisee insurance compliance

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You can carry your own insurance on top of this

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Limiting your liability: ◦ A good Operations Manual can help you avoid vicarious liability ◦ A bad Operations Manual can be a franchisor’s worst nightmare ◦ Operations Manuals must provide you with adequate brand control but should not be too prescriptive – a fine line ◦ Must avoid creating an inadvertent “agency” relationship ◦ Must avoid potential areas of negligence or take great care when prescribing actions ◦ Should cross-reference regulations and not cite them ◦ Should be updated annually and reviewed by professionals and attorney.

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Hire experienced franchise legal counsel

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Strong contracts that “under-promise”

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Train franchisees thoroughly

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Make franchisee success and good franchisee relations your priority Create an attitude of franchise support – and do not tolerate an attitude of “us vs. them” Communicate with franchisees frequently and through a variety of methods

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Solicit franchisee input (advisory councils, etc.)

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Have dispute resolution mechanisms in place

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