August 01, 2016 article

Franchise Law: Representing a Franchisor at Trial

By Kevin M. Shelley and David J. Kaufmann

Most commercial litigators would tell you that litigating a franchise dispute is no different than litigating any other commercial dispute. Like most business relationships, the relationship between a franchisor and franchisee is generally governed by a written agreement. How different can a franchise case be? 

Actually, a franchise case can be very different. The business and legal underpinnings of a franchise relationship are uniquely complex and must inform counsel’s approach to the litigation and, more specifically, trial. In this article, we provide a brief summary of the business and legal foundations of the franchise relationship and offer our suggestions on how best to leverage the various aspects of the franchise relationship at trial.  

What Is Franchising?

Franchising is a means of establishing a network of independently owned businesses that sells products or services under a common brand name and trademark. It is a system of marketing and distribution in which an independent business (the franchisee) is granted—in return for a fee—the right to market the goods and services of another (the franchisor) in accordance with the franchisor’s established standards and practices, and with its assistance. The economic underpinnings of franchising center around brand names and the public’s perception of quality and uniformity associated with those brand names. Through franchising, the economic burdens of establishing a regional, national, or international chain are shared between the franchisor and its franchisees.  

To oversimplify, it is the franchisor that develops the business unit model—what products and services will be sold from each unit, where the unit should be situated, how the unit should be built and equipped, how the unit should be operated, and what type of marketing or advertising will be engaged in—along with selecting and adopting for use throughout the network its all-important brand identity. And it is the franchisee who, in return for the payment of a fee to the franchisor, acquires the right and assumes the obligation actually to build and operate a network unit under the franchisor’s brand name. The entire expense of developing, opening, and operating a franchise unit—buying or leasing the real estate, erecting and equipping the business premises, hiring and paying all personnel, paying for all inventory, and being financially liable for all aspects of that unit—is typically borne solely by the franchisee.  

While the history and explosive growth of the franchising business model is beyond the scope of this article, it is sufficient to note that franchising over the past 30 years has accelerated to a point where it currently dominates certain industries entirely (such as guest lodging, real estate brokerage, quick-serve restaurants, and convenience stores) and has propelled itself to the forefront not only of the American economy but, increasingly, the global economy as well. According to a report prepared by PricewaterhouseCoopers for the International Franchise Association, franchising companies and their franchisees account for over $1 trillion in annual U.S. retail sales—along with $304 billion in payroll, 9 million jobs, and $802 billion of output. PricewaterhouseCoopers, Economic Impact of Franchised Businesses, Volume 3 (Int’l Franchise Ass’n Educ. Found. 2008).  

Given the explosive growth and prevalence of franchising in the modern economy, ever increasing numbers of commercial litigators are likely to encounter a franchise dispute in their practices. Indeed, apart from the world famous franchise systems such as McDonald’s, Subway, Hilton, and Dunkin’ Donuts, many distributorship, licensing, or other business relationships—regardless of how they are characterized or identified—may actually constitute “hidden franchises”; that is, relationships that meet the legal definition of a franchise set forth in various federal, state, or international franchise statutes and are therefore subject thereto. Indeed, such hidden franchises, and their counsel, may not know that there are three distinct bodies of law governing franchising in the United States: federal and state franchise registration/disclosure laws, state franchise relationship laws, and federal and state business opportunity laws. 

Franchise-Specific Statutes, Rules, and Regulations

Both the federal government and 15 states have laws, rules, or regulations requiring franchisors—prior to offering or selling a franchise—to prepare and disseminate to prospective franchisees a prospectus-type disclosure document (commonly referred to as the Franchise Disclosure Document, or FDD) containing all material information necessary for such prospects to make informed investment decisions. In addition, 21 states and 2 territories have enacted what are commonly referred to as “franchise relationship” laws, which typically address the substance of the franchise-franchisee relationship by governing when, and under what circumstances, a franchisor may terminate a franchise agreement or refuse to renew a franchise; the minimum advance notice of franchise termination or expiration that must be given to franchisees; and, in some cases, certain other aspects of the franchisor-franchisee relationship, such as fair dealing, discriminatory treatment, market protection, and encroachment. Finally, 26 states have adopted “business opportunity” laws that are not franchise specific but nonetheless affect franchising. While a detailed discussion of this statutory framework is well beyond the scope of this article, it is important to generally understand that a franchise relationship and the parties’ respective rights and obligations are governed not only by their franchise agreement but by these franchise-specific statutes, rules, and regulations as well. 

Franchising and the Common Law

Franchisors and franchisees do not operate solely under franchise-specific statutes, rules, and regulations. They are subject to traditional bodies of statutory and common law that govern business in general and certain specific non-franchise relationships, all of which predate the advent of franchising. However, the unique structure of the franchise relationship conflicts, in some important ways, with traditional common-law and statutory principles. For example, the “control” exerted by a franchisor over its franchisees to maintain the uniformity and high quality of goods and services offered by franchisees through franchised outlets, which control is virtually mandated by the Lanham Act to protect the franchisor’s ability to control its trademarks, can be used to create any number of legal duties, rights, and relationships. Under the traditional “control test,” for example, a franchisor may be liable for the acts, errors, or omissions of one of its franchisees through the imposition of vicarious liability. This is only one example of the many potential conflicts between the franchise business model and generally applicable statutory and common-law principles.  

Franchisor-Franchisee Disputes

Franchise networks are not immune from disputes. In the unfortunate event of litigation between a franchisor and one or more of its franchisees, counsel must undertake a comprehensive review not only of the parties’ franchise agreement but also the circumstances under which it was entered into and the parties’ rights and obligations established by applicable statutory and common law. Typically, actions commenced by a franchisor against a franchisee involve one or more of the following areas: unpaid royalties, advertising contributions, or other fees; in-term or post-term non-compete provisions; use and disclosure of confidential information; failure to report revenue in order to artificially reduce royalties, advertising contributions, and other payments to the franchisor; compliance with applicable law and system standards, including standards relating to quality, cleanliness, health, safety, and welfare of customers; and post-termination de-identification and closure of the franchised unit. Typical claims asserted by franchisees against their franchisor concern failure to provide support, territorial encroachment, violation of applicable state registration and disclosure statutes, violation of applicable franchise relationship laws, wrongful termination or nonrenewal, and the ever-popular breach of the implied covenant of good faith and fair dealing. 

Trial Tips for Franchisor Counsel

With this background, we present the following suggestions on how best to represent a franchisor at trial.  

1. Educate the judge about franchising. Although franchising is ubiquitous in the modern economy, the legal aspects of the relationship are not well known by most people (including attorneys and judges). Indeed, even judges presiding over commercial cases are rarely presented with sophisticated franchise-specific cases for trial, and in virtually no court in the country is there a judge who routinely hears franchise cases. As a result, while a judge may be competent and even sophisticated in his or her understanding of general commercial law, it is unlikely that the judge has a sophisticated understanding of the legal and business underpinnings of a franchise relationship. Because these legal and business issues will be central to nearly every trial between a franchisor and its franchisee, counsel must take every opportunity to educate the judge in advance of and during trial. Counsel must communicate to the judge  

• the applicable statutory framework in which the parties’ franchise agreement arose;
• the existence of and content of the franchisor’s legally required pre-sale disclosure document and the parties’ franchise agreement;
• the nature of the “control” exerted over the franchisee by the franchisor to protect its trademarks and system;
• the franchisor’s responsibility to maintain and enforce its uniform standards throughout the system for the benefit of the franchisor and all other franchisees;
• the impact that noncompliance with the system by a franchisee has on the entire system and all of the franchisees within it; and
• the impact that an adverse determination of the issues presented at trial will have on the franchisor, its system, and its remaining franchisees.

Franchisor counsel should seek to educate the court on these principles, as applicable, from the very beginning of the action through trial, including, as appropriate, through pleadings, motions to dismiss or for summary judgment (or both), motions in limine, pretrial memoranda, opening statements, testimonial evidence, closing statements, and post-trial memoranda. 

2. Educate the jury about franchising. Although you have a much shorter time period in which to accomplish this goal, it is likewise crucial to educate the jury, if there is one, about the fundamental legal and business underpinnings of the franchise relationship. To the extent counsel participate (either directly or indirectly through the submission of voire dire questions to the court), jury selection is a good opportunity to begin to educate potential jurors about the nature of the parties’ franchise relationship.  

Certainly, in opening argument, franchisor counsel should explain the nature of the franchise relationship, generally, and the nature of the relationship between the parties. Counsel should emphasize, when applicable, that the franchisee was duly disclosed well in advance of the franchise sale with a Franchise Disclosure Document (FDD) (which imparts virtually all information a prospective franchisee would find material to its investment decision) and a sample franchise agreement, and that the franchisee then reviewed and signed the franchise agreement, which established the entirety of the parties’ rights and obligations with respect to each other (to the extent not superseded by statute). Counsel’s description of the parties’ franchise relationship in the opening statement is the prism through which all of the testimony and evidence received at trial will be viewed by the jury. In addition, it is important for franchisor counsel to inform the jury at the outset that this case affects not only the franchisor and the franchisee in the courtroom but also the entire franchise system, specifically the entirety of all other franchisees that have made substantial investments in, and earn their living from, the franchised system.  

It is important to move away from the David versus Goliath stereotype and get the jury to understand that an adverse verdict will affect not merely the impersonal franchisor entity but also numerous other franchisees who support and indeed constitute the franchise system. In other words, franchisor counsel should make very clear to the jury that its verdict will affect the entire franchised system and not merely the (perhaps sympathetic) individual franchisee sitting in the courtroom. 

3. Use experts at trial. We believe it is essential to provide expert testimony at trial concerning the unique nature of the franchise business relationship. Independent experts can provide compelling information about the structure of the franchise relationship and the effect of the dispute on the entire franchise system. Further, jurors view such experts as independent from, and not beholden to, the franchisor offering the testimony at trial. 

4. Present evidence of the applicable franchise agreement provisions forcefully. Typically, particular terms and conditions set forth in the parties’ franchise agreement will be compelling, if not controlling, evidence in a franchisor-franchisee dispute. Also typically, because these agreements are drafted by the franchisor, they usually favor the franchisor’s position. However, handing a 50-page, single-spaced franchise agreement to a juror is not compelling. For that reason, we would suggest that counsel use whatever presentation methods are available to bring attention to the specific franchise agreement provisions applicable to the issues presented at trial. There are several ways to bring attention to the provisions at issue: having a physical enlargement of the provision on an easel in the courtroom; presenting the provision on a large screen, with the ability to highlight, blow up, and otherwise manipulate the controlling language; and providing a hard copy of the agreement with applicable provisions highlighted. Remember, the average attention span of most jurors—indeed, most citizens—is decreasing, and their familiarity with viewing information on screens in increasing. We strongly encourage the use of visual presentations, even when presenting the otherwise dry evidence of the terms and conditions of the franchise agreement. 

5. Cross-examine the franchisee’s principal and operators. Obviously, the nature of the cross-examination of the franchisee’s principal and operators is somewhat dependent on the issues presented in the case. Franchisor counsel need to elicit appropriate testimony concerning the breach of the parties’ franchise agreement or other wrongful act or omission from which the action arose. However, in nearly all cases, it is critical to establish in the mind of the judge and jury that the franchisee is not a poor, defenseless individual in battle with a huge franchisor entity of unlimited resources such that the franchisee should not be held responsible for all of the terms and conditions contained in the lengthy franchise agreement prepared by the franchisor and imposed on the poor franchisee on a “take it or leave it” basis.  

One way to do that is to demonstrate, through cross-examination testimony, the nature of the offer and sale of a franchise. As noted above, federal and state law requires a franchisor to prepare and deliver an FDD to the prospective franchisee in advance of the execution of the franchise agreement. The FDD contains a detailed description of the franchise system and the parties’ respective rights and obligations under the offered franchise agreement. The FDD also attaches a copy of the proposed franchise agreement and any other agreements to be entered into by the prospective franchisee. Thus, at trial, a franchisor counsel should ask the franchisee whether  

• the franchisee received the FDD;
• whether the franchisee read the FDD;
• whether the FDD disclosed facts relevant to the dispute (identifying such relevant disclosures for the jury);
• whether it attached the prospective franchise agreement;
• whether the franchisee actually read the attached specimen franchise agreement;
• whether the franchisee thereafter received the actual franchise agreement from the franchisor;
• whether the franchisee read and reviewed the franchise agreement and whether he or she reviewed it with an advisor or attorney; and
• whether the franchisee signed the franchise agreement.

This line of questioning will likely elicit admissions that the franchisee was advised three times in advance of the franchise sale of the details governing the dispute: once, in narrative form, in the FDD; a second time in the specimen franchise agreement included in it; and a third time in the operative franchise agreement that the franchisee received and ultimately signed. At this point, it will be difficult for the franchisee to contend that he or she did not understand and agree to the terms and conditions that are essential to the issue presented at trial. In short, the FDD and the parties’ franchise agreement should be extensively reviewed during cross-examination of the franchisee, both to educate the judge and jury on their contents and to establish that the franchisee has a certain level of sophistication and awareness of the terms and conditions they contain. 

6. Introduce graphic evidence of noncompliance in standards cases. One of the most important things a franchisor can accomplish at trial is to enforce system-wide standards of operation, because uniformity of operation under the franchisor’s trademark is the foundation of a successful franchise system (and a lack of uniformity is the beginning of the end of an unsuccessful system). The system-wide standards are often comprehensive and extremely detailed, and when a franchisee materially disregards the proffered standards of operation, a franchisor must be prepared to take any and all steps necessary to obtain compliance, including termination (which often results in litigation and ultimately a trial concerning the franchisee’s noncompliance).  

At the trial, the franchisor must be prepared to present graphic evidence of the franchisee’s noncompliance to justify termination. Minor, intermittent variations from the franchisor’s systems, especially when they do not affect the public’s perception of the brand, will rarely justify termination, regardless of what the franchise agreement provides. However, when the noncompliance materially affects the franchisee’s ability to comply with its obligations under the franchise agreement and, even more compellingly, when it adversely affects the consuming public’s perception of the franchised location (and therefore all locations within the franchise system), termination is justified. In such circumstances, it is trial counsel’s responsibility to present evidence at trial to persuade the judge and jury that the noncompliance not only constitutes a material breach of the parties’ franchise agreement but, left unchecked, will materially and adversely affect the entire franchised system. For example, in the quick-serve restaurant sector, the most important system-wide standards relate to health and safety, both in the restaurant as a whole and in connection with food preparation. When system standards are not met, the public’s health, safety, and welfare are threatened, and if a customer becomes ill as a result of patronizing the restaurant, the system as a whole will be adversely affected.  

As a result, if a franchisee has failed the franchisor’s routine inspections or has failed a department of health or other governmental agency inspection, the franchisor must gather vivid evidence of such noncompliance. Testimony and reports by independent inspectors, health department officials, and the franchisor’s managers must be presented, together with photographic or video evidence of noncompliance. In such cases, pictures are indeed worth a thousand words, and video even more so. (No one who saw the well-publicized video of rats in a New York City quick-serve restaurant in 2007 will soon forget it.) Also, the franchisor should present detailed operational standards, usually set forth in its operations manual and other materials delivered to the franchisee, and tie those obligations directly to provisions in the franchise agreement. Finally, franchisor counsel should present the testimony of other, nearby franchisees that the adverse publicity and customer experience in the noncompliant franchisee’s location has directly and adversely affected their businesses. 

7. Introduce non-reliance representations/disclaimers and integration provisions in the franchise agreement. Many claims asserted by franchisees involve allegations that representations or provisions made by the franchisor to the franchisee prior to or at the time the parties executed the franchise agreement differed from the terms of the franchise agreement and induced the franchisee to execute the franchise agreement. Anticipating such claims, most franchisors insert into their franchise agreements non-reliance representations and disclaimers and integration provisions, which essentially state that the franchisee did not receive, and did not rely on, any extra-contractual representations or promises in connection with its execution of the franchise agreement.  

Courts are divided on the issue of whether such contractual provisions bar, as a matter of law, franchisee statutory fraud claims or other claims based on extra-contractual representations or promises. However, even if, arguendo, the court does not dismiss such claims as a matter of law based on these contractual provisions, it is very helpful to elicit testimony from the franchisee that he or she read the franchise agreement before signing and therefore reviewed and accepted these provisions in the franchise agreement. During such testimony, counsel can highlight these provisions to the jury, which will seriously undercut the credibility of the franchisee’s claim that he or she relied on extra-contractual representations or promises. Thus, even if reliance is a fact issue, the very existence of these provisions, when properly presented to the jury, will minimize the likelihood of any factual finding of reasonable reliance by the franchisee.

Conclusion

Of course, effective representation at trial depends in large part on the issues presented and the available evidence. However, franchise counsel should approach every franchisor-franchisee trial with a plan to educate the judge and jury about the legal and business underpinnings of the relationship between the parties. We suggest that only with such an understanding can the judge and jury fully understand the evidence and decide the issues presented. 

Keywords: litigation, solo practitioners, small firms, franchisor-franchisee litigation, trial 

Kevin M. Shelley and David J. Kaufmann are partners in the New York City, New York, law firm of Kaufmann Gildin & Robbins LLP.


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