Exemptions and Exclusions. There are various exemptions adopted under federal and state laws, but they are far from uniform. Some provide for exemption from registration and disclosure; others from registration only. Among the more typical exemptions are those for high net worth franchisors, often paired with an experience component; sophisticated franchisee exemptions, based on the franchisee's net worth, experience, or investment; and fractional franchises, which involve situations in which the franchised business comprises a small part of the franchisee's overall business.
Business Opportunity Laws. Even more states have enacted laws regulating business opportunities, sometimes referred to as seller-assisted marketing plans. The FTC now has a separate Business Opportunity Rule. Many of these laws contain exemptions for franchises, conditioned on annual or one-time filings and compliance with the FTC Rule's requirements. Like franchise laws, business opportunity laws are broad in the transactions they cover and their registration and disclosure requirements are generally less uniform across states than those in the franchise arena. The transactions covered involve payment of a fee for products or services to conduct a business in which the seller makes at least one of several types of representations. Representations that a purchase price is refundable, or on issues like earning power, site assistance, or marketing plans, can all trigger coverage of business opportunity statutes.
FDD Disclosure Format. Franchisors must present information on 23 different disclosure topics in their FDDs: the franchisor and its parents, predecessors, and affiliates; the business experience of its principal officers, directors, and managers; litigation; bankruptcy; initial fees that the franchisee must pay; other fees; an estimate of the franchisee's initial investment; restrictions that the franchisor imposes on products and services; the franchisee's obligations during the relationship; financing that might be available through the franchisor; the franchisor's obligations to provide assistance and information about advertising, computer systems, and training; the territorial rights that the franchisee will receive; the franchisor's trademarks; its patents, copyrights, and proprietary information; the franchisee's obligation to participate in the actual operation of the franchise business; restrictions on what the franchisee may sell; information about renewal, termination, transfer, and dispute resolution; any public figures who endorse the franchise; optional financial performance representations; information about outlets and franchisees; the franchisor's financial statements; a list of contracts required of the franchisee; and a receipt form.
There are a number of sources to consult in preparing a franchise disclosure document. In addition to the FTC Rule itself, there is the FTC's Statement of Basis and Purpose, an information-rich analysis down to its instructive footnotes. The FTC also issued a Compliance Guide in May 2008 that contains sample answers. The FTC staff respond to questions that arise periodically through interpretive opinions and FAQs on its website (https://www.ftc.gov/business-guidance/resources/amended-franchise-rule-faqs).
The Role of NASAA. Founded in 1919, the North American Securities Administrators Association is the oldest international investor protection organization and consists of 67 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, the U.S. Virgin Islands, Puerto Rico, Canada, and Mexico. The role of its Franchise and Business Opportunities Project Group is important in promoting uniformity and working with the FTC on interpretations of disclosure requirements. NASAA amended the UFOC Guidelines in July 2008 to adopt the FTC's disclosure format and to overhaul the registration process and forms. In 2009, NASAA issued its latest Commentary on disclosure requirements in an easily accessible question-and-answer format. Most recently, in September 2009, the Statement of Policy on Uniform Franchise Delivery Requirements was issued by NASAA to encourage states to adopt the same timing and cooling-off periods as the FTC Rule requires.
Specific Registration and Disclosure Issues. Financial performance representations (FPR), formerly referred to as "earnings claims," are an optional disclosure and refer to information given to a prospective franchisee from which a level or range of sales, income, or profit may be ascertained. Except for limited circumstances, a franchisor is restricted from providing this information unless it makes an FPR disclosure in its FDD. Only 30 percent to 40 percent of franchisors actually do make this disclosure. A franchisor that does not make an FPR in its disclosure document is limited to referring prospects to its existing franchisees or to the prospective franchisee's own advisors to ferret out this information.
Consequences of Violations of the Law. The FTC is authorized to bring suit for injunctions and restraining orders against violators of the FTC Rule. By administrative action, the FTC can issue an order requiring a franchisor to cease and desist from further violations of the Rule. While there is no private right of action under the Rule, the FTC may bring actions on behalf of franchisees, and can seek civil and criminal penalties. As with state statutes, liability may extend to officers, directors, and control persons of the franchisor individually.
State franchise statutes also provide for both civil and criminal remedies against both the franchisor and the persons responsible for violating the law. With respect to civil actions, state laws recognize private remedies, including equitable relief and rescission.
Violation of state registration laws and relationship statutes may give rise to administrative enforcement proceedings. Regulators have the power to obtain orders suspending franchise sales during the course of a proceeding and may seek damages, rescission, attorneys' fees, fines and penalties, costs, and other remedial measures.
Franchise relationship statutes may provide franchisees with various remedies including an obligation to repurchase unsold inventory, equipment, and other assets, in addition to damages, injunctive relief, and attorneys' fees. There is some case law limiting a franchisor's right to obtain damages where the franchisor has terminated the franchise agreement.
Issues in the Franchise Relationship
Following is a summary of some of the hot-button issues that have occupied franchisors, franchisees, and the courts over the past decade.
Encroachment. Franchisors almost always retain the right to deliver the goods and services associated with the brand through other outlets, whether owned by the franchisor or another franchisee. Franchisors also may distribute goods through alternate channels of distribution such as the Internet, mail order, catalog sales, or sales of branded products through supermarkets. Franchisees have challenged such rights as encroachment upon their franchise rights.
The high-water mark for encroachment claims probably came with the decisions in Scheck v. Burger King, 756 F. Supp. 543 (S.D. Fla. 1991) and Vylene Enterprises, Inc. v. Naugles, Inc., 90 F.3d 1472 (9th Cir. 1996) (citing Scheck with approval). Scheck held that even where a franchisor provided a nonexclusive territory to a franchisee, the franchisor did not necessarily retain an unfettered right to place other units in the surrounding area unless that right was expressly retained. The reasoning in Scheck was later disavowed in Burger King Corp. v. Weaver, Bus. Franchise Guide (CCH) ¶ 10,762 (S.D. Fla. 1995), but the case continues to be cited and encroachment disputes are common.
Inconsistent results have been obtained in cases challenging the franchisor's use of alternate channels of distribution, usually turning on the specific language in the franchise agreement. Internet sales by franchisors also have proven nettlesome. Emporium Drug Mart, Inc. v. Drug Emporium, Inc., Bus. Franchise Guide (CCH) ¶ 11,966 (AAA 2000), although only an arbitration award, is often cited to support franchisee claims. In other circumstances, Internet sales have been upheld.
Systemwide Change. Franchise relationships are usually long-term relationships that, with renewals, can span generations. As times change, franchisors change their systems to remain competitive: systemwide changes are usually established by changes in the operations manual. Franchisees are not always happy with systemwide changes dictated by the franchisor and this issue is often litigated. Generally, the right of franchisors to make changes in their systems has been upheld. The franchisor's right to change the system may be limited where it directly benefits the franchisor at the franchisees' expense.
Antitrust Issues. At one time, the battle between franchisors and franchisees was waged primarily in the antitrust arena. Following the decision in Siegel v. Chicken Delight, 448 F.2d 998 (9th Cir. 1971), which found a required purchase of restaurant equipment to be an unlawful tie, such issues were commonly litigated in franchising. This argument was firmly rejected in Queen City Pizza, Inc. v. Domino's, Inc., 124 F.3d 430 (3d Cir. 1997), where the court held that Domino's could eliminate other authorized suppliers and designate itself as the sole authorized supplier of pizza ingredients without creating an unlawful tie.
Not a Fiduciary Relationship. Courts for the last 25 years have held that the franchise relationship is not a fiduciary relationship.
Vicarious Liability. Franchisors are often sued by persons who allege that they were injured on franchised premises. Generally, franchisors are not liable for such claims if they do not control the day-to-day operations of the franchised location.
Noncompetition. A frequent source of contention in the franchise relationship arises from covenants against competition. State law varies widely on this issue. Generally, in-term covenants are considered to be enforceable, with post-term covenants enforceable in some states and against strong public policy in others. See, e.g., Scott v. Snelling & Snelling, Inc., 732 F. Supp. 1034, 1042 (N.D. Cal. 1990).
In some states, covenants will be enforced if they impose reasonable geographical or temporal limits on competition. Some states will blue-pencil defective noncompetition provisions to bring them into compliance with the law, while others decline to do so. The best resource on the state laws is Covenants Against Competition in Franchise Agreements, Second Edition, published by the American Bar Association.
Trade Secrets and Trade Dress. Franchisors may freely enforce their rights to protect trade secrets and trade dress. Many states have adopted the Uniform Trade Secrets Act. The Act generally protects information, methods, and processes that have independent economic value because they are not generally known to the public, and where there have been reasonable efforts to maintain secrecy.
Transfer of System by the Franchisor. Franchisors generally retain an unlimited right to sell franchise systems. Franchisees have frequently challenged these sales, with little success. In Century Pacific v. Hilton, 528 F. Supp. 2d 206 (S.D.N.Y. 2007), the court held that a franchisor had the right to exercise its contractually retained right to sell the Red Lion franchise system, despite franchisee claims that they had been promised it would never be exercised.
Violation of Brand Standards. Where franchisees fail to adhere to minimum brand standards, franchisors may bring suit to terminate the franchise. The right to do so may be limited by both contractual and statutory limitations, including notice and an opportunity to cure. Suit also may be brought against a terminated franchisee for continued use of trademarks. Such suits are usually brought under the Lanham Act.
The FTC has indicated that it will enforce the requirements of the Franchise Rule in the United States and its territories. Some states, such as New York, however, have laws with broad jurisdictional provisions that could extend to international transactions. Franchisors expanding into other countries also have to contend with an increasing number of non-U.S. jurisdictions that regulate franchising, as well as with laws on such wide-ranging matters as commercial agency, technology transfer and language, choice of law, and venue restrictions.
In the 40 years since the first franchise law was enacted, the law of franchising has burgeoned into a complex international web of statutes, regulations, and cases. As will become apparent after reading the other articles in this issue, the field of franchise law draws upon a wide range of disciplines and contains many traps for the unwary.