New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

As franchise counsel I am a strong proponent of “disclosure” – the more of it, the better. Quality disclosures contained in your FDD serve a critical role in mitigating future litigation risk and expense. So, when it comes to FDD disclosure exemptions, we typically proceed with extreme caution. Nevertheless, in the appropriate circumstance, franchisors should consider or at least be aware of potential tools available to them when it comes to available exemptions to the disclosure mandates of the Federal Franchise Rule.

One "grouping" of potential FDD disclosure exemptions relate to transactions involving sophisticated investors, insiders and large franchise investments. These "potential" exemptions, should be evaluated and considered under the following circumstances:

• "Large Franchise Investment". The "Large Franchise Investment" exemption applies to franchise transactions involving a franchisee initial investment  of at least $1 million exclusive of unimproved land and franchisor (including affiliates) financing.  Application of this exemption is dependent upon an analysis of the transaction, satisfaction of the dollar volume criteria and the requirement that the franchisee sign a disclosure acknowledging that the franchise sale was exempt from the Franchise Rule.

• "Large Franchisee Entities". The "Large Franchisee Exemption" applies to franchise sales transactions involving prospective franchisees that are corporate entities, possess a minimum net worth of $5 million and possess no less that 5 years of prior business experience.  By combining both net worth and prior business experience requirements, this exemption is intentionally limited corporate franchisees that possess a predicate level of sophistication.

• "Insiders of the Franchisor". The "Insider Exemption" applies to franchise sales to the owners, directors, and managers of the predecessor entity of the franchisor.  That is, this exemption applies to the officers, owners and managers of a business before it became a franchisor.  These prospective franchisees must possess at least two years experience in the franchisors business and, at the time of becoming a franchisee, have maintained their insider status.These "sophisticated investor" exemptions are an important tool for franchisors to consider and beware of One such exemption relates to “Large Franchisees”.

The foregoing "sophisticated investor" exemptions constitute a critical tool for franchisors to be aware of when planning certain non-traditional franchise sales transactions and when evaluating potential litigation strategy.  Application of the foregoing exemptions requires a fact specific analysis of factors and legal criteria - including applicable rules and regulations associated with each exemption) .  The key, however, is to be aware of this potential "tool". 

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The maintenance of a "current and updated" FDD represents one of the primary regulatory requirements imposed on a franchisor.  Failure to maintain a current FDD and/or renewed state registration will result in either lost franchise sales (since franchises cannot be sold) or litigation exposure (in the event that sales are made during a period of non-compliance).  Although the timing of the FDD updating process is well understood (and not often disputed) it is nevertheless important for franchisors and their management team to recognize the significance of maintaing a "current FDD" and the timing of when an FDD must be updated.  

Starting with the premises that the information and disclosures contained in a franchisor's FDD must be current, under the federal franchise rule, Franchisors are required to update their FDD under the following three circumstances:

• Annually (Mandatory).  Franchisors must update their FDD no less frequently than annually.  Annual revisions and updates to an FDD must occur within one hundred and twenty (120) days from the close of the franchisor's fiscal year;

• Quarterly (If Material Change Occurs). If events or circumstances materially change information or disclosures contained in the FDD then the FDD must be revised.  The revisions will be attached to the current FDD and must be reported "within a reasonable time" from the close of the franchisors most recent fiscal quarter;

• Immediately (When dealing with Item 19). When providing a prospective franchisee with a disclosure document a franchisor must also immediately notify the prospective franchisee of any and all material changes that the franchisor knows or should have known about respecting any Item 19 financial performance representations contained in the FDD.

Knowing when to update your FDD is not a complex process, however it does require organization and the implementation of safeguards to ensure that your financial performance representations (if any) are continuously monitored and that your management team discusses and evaluates the status of your FDD disclosures on a regular basis. 

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Many times, "start-up" franchisors (and, too often, some established franchisors) overlook the necessity of maintaining a thorough operations manual that is both "current and relevant" to the particular franchise system. That is, many times operations manuals are viewed as an "afterthought" or a"generic" obligation to be sourced out to third party vendors.

Much more than a "generic resource", your operations manual must be drafted, updated and maintained as an integrated extension of your franchise agreement and FDD disclosures. Recognizing the critical importance of a properly prepared and integrated operations manual, startup and established franchisors should consider the following:

• Franchise agreements are typically drafted and structured to integrate and obligate franchisees to abide by both current "and future" operational requirements set forth in the operations manual. If the franchise agreement is drafted properly, the operations manual should create "contractual flexability", allowing the franchisor to modify elements of the franchise system through amendments and supplements to the operations manual.

• Your operations manual must serve as a thorough blueprint to provide franchisees with detailed "how to" information respecting each and every administrative and operational element of the franchise system.  

Examples of "administrative obligations" include (a) the franchisees royalty and financial reporting obligations, (b) franchisees financial record retention obligations, and (c) system requirements for point of sale systems. 

Examples of "operational obligations" include (a) franchisees obligations respecting the management of the franchise business, (b) requirements for management and control of inventory and supplies, (c) building and construction plans and specifications, (d) training programs and obligations, and (e) operational elements respecting the day-today management and operation of the franchised business.

• The preparation of your operations manual cannot be a task that you simply "outsource". While it is prudent to obtain the advice and input of a qualified consultant (including your franchise attorney), the operations manual must directly reflect and embody "your" direct understanding and knowledge about the franchised business. "You" must be the primary contributor and driving force behind the preparation and development of your operations manual.

• Your operations manual must be consistent with your franchise agreement and FDD. Review with your franchise lawyer the content of your operations manual to ensure that there is consistency with your franchise agreement. Ensure that your training programs are extensively identified in the operations manual and properly disclosed.

• Your operations manual should be constantly updated, refined and clarified to reflect the constant and continuous evolution and growth of your franchise system. 

Your operations manual is critically important to the long-term success of your franchise - treat it as such.
 

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 Franchise agreements drafted for common law countries tend to be longer and more comprehensive than franchise agreements used in civil law countries. Franchisors based in the United States often use their common law agreements in civil law countries without localization, reasoning that a more comprehensive agreement is all that is needed to protect them in a civil law system. However, when considering this approach, franchisors and their counsel need to be aware that a more comprehensive franchise agreement alone may not be enough to protect them in a civil law system. Recently, when discussing this issue with Kenneth A. Goss, Esq., in house counsel to a franchisor experienced in franchising in countries under common law, civil law and Islamic law systems, Mr. Goss explained shared some general principles common to many civil law systems from the perspective of a common law practitioner. The following is the first of Mr. Goss' two part guest post on this important topic:

Common Law verses Civil Law.

There are two dominant legal systems in the world today - the common law and the civil law. In addition to the specific franchise disclosure, relationship and other laws applicable to franchising in any specific country, franchisors in the United States should carefully consider the different approach each system takes to contract law before using a common law franchise agreement in a civil law country. This series looks at some characteristics typical of most civil law systems. Part I of this series compares common law and civil law systems generally and Part II takes a closer look at what affect a civil law system will have on a common law franchise agreement.

Common law and civil law systems are similar in principle but differ considerably in the methodical approach each takes with respect to statutes and interpretation. Both common law and civil law systems are rooted in liberal philosophy, which has the purpose of protecting and advancing individual rights. In this regard, common law and civil systems are more akin than, for example, Islamic law, which is based on religious teachings and is regarded as the word of God. However, a major difference between common law and civil law systems is the priority given to sources of law. Specifically, the common law gives priority to jurisprudence over legislation and the civil law gives priority to legislation over jurisprudence. As a result, there are considerable differences between common law and civil law systems in style, terminology, interpretation, conception and emphasis on certain elements over others, all of which are relevant for a franchisor that is thinking about operating between the two systems.

Common Law Systems

Most U.S. based franchisors are familiar with operating in a common law system. The common law is the Anglo-American legal tradition based on unwritten usage and custom that derives its authority from the legal opinions of judges. The common law was adopted by each of the United States, except Louisiana, and has spread to India, Australia, most of Canada and other countries formerly part of the British commonwealth.

In common law systems, the judiciary has the power to make law and each court is bound to apply precedent to cases with similar fact patterns as they arise. This means that the judiciary in a common law system has the power to create new rules for cases with novel fact patterns where the legislature has not enacted a statute addressing the specific issue. The power of a court to make law in a common law system is typically constrained by precedent and is a function reserved to the highest courts of appeal. 

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For the start-up and established franchisor alike, as your franchise system evolves continuous consideration must be given to your franchise agreement and "the legal rights that you reserve for your franchise system".  That is, basic to every franchise agreement are the "reservation clauses" identifying and  establishing alternative channels of distribution and legal rights  that are not granted, conveyed or licensed to your franchisees.  These reserved rights typically address alternative channels of  distribution and markets that are expressly reserved to the  franchisor.  Examples include internet sales, mail order sales, captive market accounts and licensed products sold through alternative sales channels.

Chances are that your "existing franchise agreement" contains reservation clauses.  However, have you recently reviewed these legal provisions?  Are the reservation clauses contained in your franchise agreement generic, or do they account for your future plans for expansion? When evaluating your franchise agreements and future plans for expansion, discuss with your franchise attorney and staff:

• Potential distribution and sale of private label products;
• Potential expansion and development of alternative franchise systems;
• Licensed distribution and sale of signature products and services through non-franchised outlets; and
• Your current and future plans for internet and/or mail order based sales.

There are other points but they are all based on the fundamental fact that you must be constantly evaluating your franchise agreement to ensure that it matches where your franchise is today and where it may be ten years from now.  Avoid the generic.

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Has the United States economy changed?  Are we in a "new economy"?

Yes, undoubtedly yes.   In fact there are so many new facets to our economy - some good, some questionable and some bad - that you don't need me to tell you that the economy has changed.  Ultimately, where our economy "ends up" is still undecided and, in large measure, will be decided by political and economic factors yet to be determined. But, no matter where we end up, one thing is clear: our economy has been and will remain fundamentally altered. 

So, what are some of the characteristics of this evolving "new economy" and what do franchisors need to know?

• Opportunity Still Exists - Although there are elements of economic turmoil - opportunities still exist.  For the start-up franchisor the current  level of economic instability may indeed constitute a competitive advantage and opportunity to level the playing field and compete with the "big players".   More than ever, technology is abundant and relatively cheap. Competitive tools such as the internet, automated database systems, point of sale systems and social networking have created the opportunity for small competitors to compete at the highest levels and take on much larger competitors who may be distracted by franchisee defaults, litigation and over leveraged balance sheets.

• A Renewed Focus on Franchisee Profitability is Critical.  Prior to the current economic cycle (and the 10 years prior to that) capital was abundant with consumers and prospective franchisees being afforded access to easy credit.  In many instances, franchise system sales and franchisee investments were, in large measure, fueled (or at least inflated) by consumers and franchisees who simply spent more than they could afford.  System growth was focused on the incremental "gross sales and royalties" generated by franchisee expansion.  Insufficient resources were placed on franchisee profitability (compared to gross sales) and, in the current economic cycle, franchisee default rates are increasing at a substantial rate. A renewed focus on franchisee profitability (even if it comes at the expense of gross sales) is more critical than ever as consumers and capital markets remain in retreat. 

• Other Factors. As you are well aware, there are many other facets to this "new economy", including the impact of the declining credit markets on franchisee financing.  In our future and continuing posts about franchising and the new economy we will discuss franchisee financing and other issues that franchisors are confronting.   

This story is evolving rapidly...

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From a franchisors perspective litigation is a critical "cost factor" that must be contained and mitigated.  When consulting with franchisors (both start-up and established) one issue that provides good reason for concern is the ability of "franchisee associations" to sue you directly.  Traditionally, the issue of "standing" - that is the right to sue another individual or company - requires that, in commercial transactions, the parties possess a direct relationship and "privity" with one another.  When dealing with certain associations (including franchisee associations) the courts have expanded the concept of "privity" and have afforded certain associations the right to sue even where a direct relationship may not exist.  That is, although you may have no dealings or contractual relationship with a "franchisee association", the "association may nevertheless possess the legal right to sue your company.  Considering the significance of this issue and to better address the question of - why? - that franchisors rightfully ask, the following is a brief review and summary of some of the case law involving a franchisee association's right to sue (My comment follows at the end):

[Guest Post: Kenneth A. Goss, Esq.] 

Franchisors that have experienced litigation from franchisee associations may wonder how a franchisee association has a right to bring a lawsuit against a franchisor. Here is the brief answer.

First, a little background and let's assume we are only talking about federal court, where many franchise cases are brought. Under Article III of the United States Constitution and applicable federal law, a franchisee association must have standing to bring a lawsuit against the franchisor. Standing simply means that the franchise association has the right to file a lawsuit under the particular facts of the case. In the franchise relationship, franchisees themselves may have standing to sue a franchisor because of privity of contract. Privity of contract simply means that a franchisee can enforce its franchise agreement by a lawsuit against the franchisor and vice versa. However, a franchisee association may be a separate entity, not a party to a franchise agreement with the franchisor and, therefore, not in privity of contract with the franchisor. How then can a franchisee association bring suit against a franchisor?

The simple answer is that courts have said they can. Courts have held that an association, which otherwise itself would lack standing to sue, nevertheless has standing to bring suit on behalf of its members when (1) its members would otherwise have standing to sue in their own right; (2) the interests it seeks to protect in the lawsuit are germane to the association's purpose; and (3) neither the claim asserted nor the relief requested requires the participation of the individuals in the lawsuit. See, for example, Clark v. McDonald's Corporation, 213 F.R.D. 198 (2003). If a franchisee association meets this test, then it can bring suit against a franchisor on behalf of its members.

[My take on this issue:  When evaluating the factors as to a franchisee association's "standing to sue", one serious point of attack in challenging the association's "right to sue" or, at least, limiting the relief sought by the association exists in the third factor - point (3), above. That is, although franchisee association's possess a "right to sue" this right is limited to claims and relief "that do not require the individual participation of your individual franchisees".  If the franchisee association's claims extend to "monetary damages" - a claim that "requires the participation of individual franchisees - then the association may have exceeded its legal standing.  Claims that fall within the association's standing typically involve claims where the association seeks "declaratory judgment and injunctive relief.  When faced with association litigation, franchisors must challenge standing at every reasonable opportunity.]

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Customer promotions / "sweepstakes" are a popular marketing tool for promoting franchise systems sales and growth. However when considering the implementation of these marketing programs, franchisors and lawyers need to be aware of "hidden pitfalls" and regulations associated with both federal and state regulation.   Recently when discussing this issue with Kenneth A. Goss, Esq. - an in-house franchise to a national franchisor - Mr. Goss raised some interesting points that I believed would be helpful to our readers.  The following is Mr. Goss'  guest post on this important topic:

(Guest Post: Kenneth A. Goss, Esq.) The issue of franchise system promotions involving "consumer oriented" sweepstakes is an issue that franchisors and franchise lawyers must carefully evaluate and are a powerful and effective marketing tool franchisors often used to increase franchise system sales of its product. However, a franchisor that does not comply with applicable law risks possible litigation, administrative action and criminal penalties if,  for example, the franchisors seemingly innocuous sweepstakes turns out to be an illegal lottery governed by state gambling laws.  The following is a brief overview of some of the important factors that franchisors should consider before conducting a sweepstakes.

A sweepstakes is defined by federal law as a game of chance for which no consideration is required to enter. Typically, franchisors use sweepstakes to incentives consumers to buy a particular product by offering customers a chance to win a prize. There is no single uniform law applicable to sweepstakes. Instead, franchisors interested in conducting a nationwide sweepstakes face having to comply with both federal law and the law in each state where the sweepstakes will be conducted.

A starting point in evaluating a sweepstakes is the federal Deceptive Mail Prevention and Enforcement Act (the "DMPEA"). The DMPEA applies to sweepstakes entries sent through the mail, which, in most cases, is necessary to satisfy the "no consideration" element of a sweepstakes. The DMPEA states that any sweepstake entry is deemed "non-mailable" if it does not "clearly and conspicuously" disclose certain information including, among other things, the terms and conditions, the sponsor and sponsor's address, the odds of winning, and all relevant particulars about the prize(s) being offered. The DMPEA gives district courts the authority to enjoin a franchisor that fails to comply.

After evaluating the DMPEA, franchisors and franchise legal counsel must evaluate applicable law in each state in which the franchisor intends to conduct the sweepstakes. While state law will vary, at a minimum, franchisors will be required  to issue official rules and disclose the terms and conditions of the sweepstakes. Florida, New York and Rhode Island each require sponsors of sweepstakes to register with the state if the total retail value of all the prizes is greater than a certain dollar threshold. Florida and New York also require the posting of a bond and submission of winner lists. California and Texas regulate sweepstakes to the point where compliance in those states may be cost prohibitive to most franchisors. In each case, records must be kept in accordance with applicable law.

State laws applicable to sweepstakes vary widely from state to state. The good news for franchisors is that many of the requirements overlap, meaning that a franchisor with a properly structured sweepstakes can be compliant in more than one jurisdiction and realize the marketing benefits that sweepstakes can have for a franchise system. 

Information about Kenneth A. Goss, Esq. and Disclaimer.

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While "franchisee failure" may be inevitable for a select percentage of franchisees and, in may cases, may have nothing to do with the franchise system (i.e., a franchisee who refuses to roll up his or her sleeves and commit to hard work), one thing that this economic downturn has exposed is the fact that many franchisees (too many) are not "raving fans" of the franchise system(s) in which they operate.  In speaking with franchisors and franchisees over the past number of months, one critical issue that appears to be adding to this disconnect may be franchisor implemented policies designed to generate additional franchisor revenue through "non-franchisee" channels of distribution.  When evaluating your franchise system and the potential for generating additional system revenues, one critical resource that is often overlooked is "existing franchisees".  Recently, after reading Ken Blanchard and Sheldon Bowles  insightful book, "Raving Fans - A Revolutionary Approach to Customer Service", it became clear to me that too many franchisors are overlooking a critical asset and opportunity: revenue growth generated by existing franchisees who are converted to "raving fans".

Again, while not all franchisees are right for every franchise system and while certain franchisees may never "get it", as a franchisor, I believe that you must develop the systems, procedures and policies that will turn your franchisee base into "raving fans".  Following the advice of Mr. Blanchard and Mr. Bowles, you should start by assessing and understanding:

(a)  What you expect from your franchisees;

(b)  What your franchisees want from you; and 

(c)  How to deliver what your franchisees want "plus" an extra one percent.

Evaluating and understanding these factors / answering these questions, can only help to further refine and improve your franchise system.  The incremental sales (in terms of franchise unit growth and gross revenue) that could be generated by franchisees that are "raving fans" could prove substantial and, in my opinion, represents a critical resource that many are overlooking.  If you have not read "Raving Fans", I strongly recommend it.

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If you are a successful franchisor or entrepreneur (of a non-franchised business), chances are that you place great priority on the development of your "intellectual property" such as your trademarks, trade designs and innovations that may be the subject of a patent. While successful business owners and entrepreneurs are great at innovating and creating "intellectual property", sometimes, mistakes are unnecessarily made respecting the protection of your "intellectual property.

When evaluating the development and protection of your intellectual property, the following are some factors that you should be aware of and considering as you manage your critical intellectual property assets:

Intellectual property is a "Two-Sided Coin" and is not limited to just "One Thing".  That is, your view toward your intellectual property assets should be expansive and involve the recognition that you are not just limited to "trademarks" or "patents".  Many of the key intellectual property assets that comprise your business may be afforded an array of protections involving trademarks, patents and a  broad array of "common law" protections associated with "trade secrets", "customer lists", "production sources" and other confidential components that drive your business.  The key is to properly structure your legal approach to these assets and afford them the maximum protection possible.  For example:

- Have your key employees with access to confidential information about customers and production sources signed limited but enforceable confidentiality agreements;

- Do you review with your corporate counsel the current usage of your trademarks to ensure that your trademark registrations are current and that supplemental applications are not warranted;

- Have your production sources signed off on confidentiality agreements respecting key components or processes involved in the production of your proprietary products and supplies; 

-Have you evaluated key product designs to determine whether or not your product may benefit from a "design patent.

As you are certainly aware there are many more issues and considerations concerning the protection of your intellectual property assets.  However, the basic and extremely limited point I wish to convey that the creativity that you put into developing the unique intangible assets that drive your business should also be applied toward the active management and protection of these assets.  Set a plan and actively discuss the protection of these critical assets with your corporate counsel. 

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Part of the “Franchisor Basics” Series

Under the Federal Franchise Rule franchisors are required to disclose their “Financial Statements” in Item 21 of the Franchise Disclosure Document. All financial statements must be prepared in accordance with Generally Accepted Accounting Principals ("GAAP") and in all but an extremely limited number of situations involving a start-up franchisor, a franchisor’s financial statements must be “audited”.   In the franchise regulations (16 CFR Parts 436 and 437) FTC provides detailed information respecting a franchisor's "Item 21" disclosure requirements, including:

•  Financial statements must be audited by an independent certified public accountant and prepared in accordance with GAAP;

• Financial statements must be prepared in a "tabular" format providing for a comparison between current and prior fiscal years; and 

• Financial statements must include (a) Balance Sheet for the prior two (2) fiscal years and (b) Statement of Operations, Stockholders Equity and Cash Flows for each of the franchisor's prior three (3) fiscal years. 

Other provisions apply for "start-up" franchisors (a topic that will be discussed in future posts) and the disclosure of the financial statements of a franchisor's "affiliates". 

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In an effort to expand the information provided at the New York Franchise Law Blog and, hopefully, the timeliness and value of this information for our readers and subscribers, we will now be featuring a continuing series of succinct fact based articles (in addition to our commentary and reports) focused on the "basics of franchising", comprised of "Franchisor Basics" and "Franchisee Basics".

These articles will serve as a valuable reference tool to our readers and, as always,  it is important that you discuss the specifics of your franchise system, disclosure obligations and franchise decisions with your franchise attorney.

As always, we appreciate and welcome the comments and suggestions that we have been fortunate to receive from our readers. Please let us know if there are any specific franchise topics that you like us to address.  Thanks.

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