This country-specific Q&A provides an overview to franchise and licensing laws and regulations that may occur in the United States.
It will cover pre-offer, registration and other requirements; ongoing relationships; renewals and terminations; and general considerations.
This Q&A is part of the global guide to Franchise & Licensing. For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/index.php/practice-areas/franchise-and-licensing/
Is there a legal definition of a franchise and, if so, what is it?
Franchising in the United States is regulated at both the federal and state level.
At the federal level, franchising is regulated by the Federal Trade Commission (the “FTC”) under the FTC Franchise Rule – 16 C.F.R. §436.1 et seq. (the “FTC Rule”), which applies to franchise opportunities in each of the 50 states, Washington D.C., and all U.S. territories. The FTC Rule defines a “franchise” as a continuing commercial relationship created by any arrangement where:
- the franchisee obtains a license to operate a business identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services or commodities that are identified or associated with the franchisor’s trademark or that must meet the franchisor’s quality standards;
- the franchisor exercises, or has the right to exercise, significant control over, or gives the franchisee significant assistance in, the franchisee’s method of operation; and,
- the franchisee, as a condition of obtaining or commencing the franchise operation, is required to make payments to the franchisor or an affiliate aggregating $570 or more at any time prior to or within six months after commencing operation of the franchisee’s business.
Thus, a business arrangement meets the FTC Rule’s definition of a franchise if it involves: (i) the grant of a trademark; (ii) the franchisor exerts or has the authority to exert significant control or assistance over the operation of the business; and, (iii) the franchisee is required to pay the franchisor or its affiliate a fee.
While on the state level there is no single uniform definition of a “franchise,” the various state definitions largely resemble the FTC Rule’s definition of a franchise. Specifically, the federal “grant of a trademark license” and “payment of a fee” elements are fundamentally the same at the state level. State franchise laws, however, replace the middle definitional element of “substantial assistance or control” either with the requirement that there be a “marketing plan prescribed in substantial part by the franchisor” or, in a minority of states, “a community of interest between the parties.”
Importantly, notwithstanding the foregoing, under New York’s franchise registration and disclosure law, a “franchise” will exist if there is the: (i) payment of a fee, and either (ii) the grant of a trademark license or the existence of a marketing plan/system prescribed in substantial part by the franchisor. Based on New York’s two-prong approach, in the absence of an applicable exemption, trademark license agreements in New York may be subject to the application of New York’s franchise registration and disclosure law.
Are there any requirements that must be met prior to the offer and/or sale of a franchise? If so, please describe and include any potential consequences for failing to comply.
The Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”), which regulates franchising at the federal level, requires franchisors to prepare a franchise disclosure document (“FDD”) and furnish it to prospective franchisees no less than 14 days before any contract is signed or any monetary consideration is exchanged. The FDD must take the particular format specified by the FTC and must contain various disclosures concerning the franchisor, the franchisee’s investment and the material terms governing the contractual arrangement between franchisor and franchisee. Together, the information disclosed in the FDD and the uniform prescribed format of the FDD (which format facilitates a brand-against-brand offering comparison) are designed to enable a prospective franchisee to make an informed investment decision. The FTC Rule’s pre-sale disclosure obligation applies to the offer and sale of franchise opportunities in each of the 50 states, Washington D.C., and all U.S. territories.
Notwithstanding the 14 day pre-sale waiting period prescribed by the FTC Rule, certain state laws require that the FDD be furnished to prospective franchisees earlier in the sales process. By way of example, New York requires prospective franchisees to be disclosed at the earlier of the first personal meeting or 10 business days before the execution of the franchise or other agreement or the payment of any consideration. Also, Michigan requires prospective franchisees to be disclosed at least 10 business days before the execution of any binding franchise or other agreement or the payment of any consideration, whichever occurs first.
In addition to the pre-sale disclosure obligation under the FTC Rule, the following 14 states have their own franchise registration and disclosure laws that impose additional requirements on franchisors: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. In order to offer and/or sell franchises in these states, a franchisor must first file for registration (or an exemption therefrom) and secure state approval.
Further, 26 states (Alabama, Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia and Washington) have enacted “business opportunity” laws that do not specifically regulate franchising but, rather, regulate the sale of opportunities to engage in new business ventures (which, by definition in many cases, includes franchises). Most of these business opportunity laws prohibit the sale of business opportunities unless the seller gives potential purchasers a pre-sale disclosure document that has first been filed with a designated state agency. The disclosures required by state business opportunity laws differ from and are usually less onerous than those required by the FTC Rule and state franchise laws. Unlike the franchise registration and disclosure laws, however, some business opportunity laws impose security bonding requirements on the offeror to cover certain investor losses.
In many states, franchise offerings are explicitly excluded from business opportunity law coverage if the franchisor complies with federal or state franchise sales laws, rules and regulations. In other states, however, even if the franchisor complies with applicable franchise laws, the offering will nevertheless be regulated by business opportunity laws if the franchisor makes certain representations during the course of selling a franchise. Further, in some states (e.g., in Connecticut, Georgia, Louisiana, Maine, North Carolina and South Carolina), franchise offerings fall outside the definitional scope of business opportunity laws where the franchisor is licensing a federally registered or state-registered trademark.
Consequences for Failure to Comply
Failure to comply with the FTC Rule’s pre-sale disclosure obligation constitutes an unfair or deceptive trade practice under §5 of the Federal Trade Commission Act of 1914, as amended (the “FTC Act”) and could subject a franchisor to investigations, enforcement actions and fines of up to $40,000 per violation. While there is no private right of action under the FTC Rule, a franchisee who was not properly disclosed or who purchased a franchise relying upon misleading or incomplete information may be able to bring claims against its franchisor under applicable state franchise laws (assuming the particular state at issue has a registration and disclosure law and statutorily prohibits misleading and/or fraudulent disclosures).
In addition, many states (including states with no franchise laws or regulations of their own) have enacted statutes, colloquially referred to as “Little FTC Acts,” which render illegal any conduct that would be violative of the FTC Act and the regulations promulgated thereunder (including the FTC Rule). Unlike the FTC Act and the FTC Rule, however, these Little FTC Acts often confer private rights of action upon aggrieved franchisees (either expressly by statute or by virtue of case law that has conferred standing under such statutes) instead of reserving those rights to governmental authorities alone. Thus, if a franchisor violates the FTC Rule, the franchisee may attempt to hold the franchisor liable under such state Little FTC Acts, which typically permit the franchisee to sue for damages, rescission (i.e., essentially nullifying the franchise agreement and restoring the franchisee to the same position it would be in had it never acquired the franchise) and legal fees and expenses, as well as under applicable state franchise registration and disclosure laws.
Are there any registration requirements for franchisors and/or franchisees? If so, please describe them and include any potential consequences for failing to comply. Is there an obligation to update existing registrations? If so, please describe.
There are no federal or state franchise laws that impose requirements, such as registration on franchisees; such requirements are only imposed on franchisors.
On the federal level, the Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”) requires franchisors to prepare and disseminate a Franchise Disclosure Document (the “FDD”) to prospective franchisees; it does not, however, require any sort of filing or registration.
In contrast, 14 states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin) have enacted laws requiring that a formal filing or registration be submitted to the state prior to any offer or sale in that state. In 10 of these states, franchise law administrators conduct an in-depth review of a franchisor’s FDD, financial statements and other related materials and information submitted in connection with the filing in order to determine whether it will approve the franchisor’s registration (Indiana, Michigan, South Dakota and Wisconsin typically require a “notice only” filing and ordinarily do not subject the FDD to an in-depth review). In connection with this review process, the franchise law administrators will often issue so-called “comment letters” requiring the franchisor to make changes to its FDD or related offering documents, and may sometimes impose other conditions that the franchisor must satisfy (such as, by way of example, requiring that the franchisor agree to defer collection of initial fees if the administrator believes that the franchisor is not adequately capitalized to satisfy its initial pre-opening obligations to its franchisees) in order to secure state registration. In addition to the foregoing, these state laws also empower administrators to deny, suspend or revoke a franchisor’s right to offer and sell franchises in their respective states if the franchisor’s FDD does not comply with the standards prescribed by law; the financial condition of the franchisor makes it uncertain that the franchisor will be able to fulfil its duties to prospective franchisees; or, any of the franchisor’s employees, managers, owners, or others individuals involved in the operation or sale of franchises has a criminal or other record of misconduct that is believed to pose an unacceptable risk.
Potential Consequences for Failing to Register
All states with franchise registration and disclosure laws make it unlawful to offer or sell a franchise prior to registration of the franchise offer with the state, unless an exemption is available (and properly perfected). These state laws grant franchise administrators broad enforcement powers. In the event an administrator learns that a franchisor has illegally sold one or more franchises without properly securing state registration (or an exemption therefrom), it may: (i) refuse to register the franchisor in that state in the future; (ii) issue a stop order to prevent the franchisor from conducting any further illegal offers or sales in the state; (iii) levy fines and bring civil actions (which can include injunctions to stop further violations); (iii) seek restitution and damages on behalf of injured franchisees; and/or, (iv) impose criminal penalties such as fines and/or jail time (however, it would likely take a truly extreme and unique situation for a criminal action to be pursued). In addition, certain registration states provide aggrieved franchisees with private civil rights of action against their franchisors (and in some states, also against the franchisors’ officers, directors and other employees). In such cases, aggrieved franchisees may assert claims for actual damages, rescission (i.e., essentially nullifying the franchise agreement and restoring the franchisee to the same position it would be in had it never acquired the franchise), and in some cases, punitive damages.
Requirement to Update Registration
Once a franchisor has prepared its initial FDD pursuant to the FTC Rule and filed and registered such FDD as required under the state franchise registration and disclosure laws mentioned above, in order to continue offering and selling franchises, the franchisor must revise and update the FDD at least annually. In addition, both the FTC Rule and state franchise registration and disclosure laws require franchisors to amend their FDD upon the occurrence of any material change (the required time for making such amendment ranges from promptly after the material change to quarterly, depending upon the materiality of the change). For purposes of the FDD, a material change includes any fact, circumstance or set of conditions that has a substantial likelihood of influencing a reasonable franchisee or a reasonable prospective franchisee in the making of a significant decision relating to a franchise business or which has any potential significant financial impact on a reasonable franchisee or reasonable prospective franchisee. Examples of material changes that would affect the information contained in an FDD include: (i) closing or failing to renew a substantial portion of the franchisor’s franchises; (ii) a significant change in the franchisor’s corporate structure or management; (iii) a material adverse change in the franchisor’s financial condition; (iv) a material change in the terms of the offering itself; (v) the commencement of litigation or arbitration alleging certain types of claims against the franchisor or its principals; or, (vi) a change of the franchisor’s address. In most states which have enacted franchise sales laws, the occurrence of an event requiring the amendment of a franchisor’s FDD, or the annual amendment requirement imposed in connection with franchise registration renewal, requires the franchisor to immediately cease offering and selling franchises until the amended FDD is prepared and re-registered (where necessary).
Are there any disclosure requirements (franchise specific or in general)? If so, please describe them (i.e. when and how must disclosure be made, is there a prescribed format, must it be in the local language, do they apply to sales to sub-franchisees) and include any potential consequences for failing to comply. Is there an obligation to update and/or repeat disclosure (for example in the event that the parties enter into an amendment to the franchise agreement or on renewal)?
Pre-Sale Disclosure Requirements
The Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”) requires franchisors to prepare a franchise disclosure document (“FDD”) and furnish it to prospective franchisees no less than 14 days before any contract is signed or any monetary consideration is exchanged. A number of states also impose pre-sale disclosure requirements on franchisors, some of which mirror the FTC Rule and others of which differ slightly. In particular, certain state laws require that the FDD be furnished to prospective franchisees earlier in the sales process. By way of example, New York requires prospective franchisees to be disclosed at the earlier of the first personal meeting or 10 business days before the execution of the franchise or other agreement or the payment of any consideration. Also, Michigan requires prospective franchisees to be disclosed at least 10 business days before the execution of any binding franchise or other agreement or the payment of any consideration, whichever occurs first.
The Franchise Disclosure Document
The FTC Rule specifies certain information that is required to be disclosed to prospective franchisees in the FDD, the style of writing that such disclosures must take, as well as the particular format with which the FDD must comply. The FDD is designed to provide a prospective franchisee with sufficient information as to determine whether or not it wishes to invest in acquiring a franchise.
The FDD consists of required federal and state cover pages and 23 substantive “Items,” each of which seeks to elicit information pertaining to a particular subject or a related group of subjects.
The first page of the FDD must be the FTC Rule Cover Page, which sets forth the franchisor’s name, type of business organization, principal business address, telephone number, email address, primary homepage address and a sample of the primary business trademark or service mark that franchisees will use in their businesses. A brief description of the franchised business follows, along with a recitation of certain federally prescribed language. FTC Rule Cover Page also must include the FDD’s Issuance Date (i.e., the date on which the FDD was finalized).
Following the FTC Rule Cover Page is the State Cover Page, which is mandated by NASAA’s (the North American Securities Administrators Association, Inc.) Franchise Guidelines and thus required by all franchise registration and disclosure states. This State Cover Page advises prospective franchisees that registration of a franchise does not infer government recommendation of the franchise or verification of the information contained in the subject FDD and includes certain standard franchise warnings and standard and individualized “risk factors.” Finally, the franchisor must include the Issuance Date at the bottom of the State Cover Page. If the franchisor is registering in multiple states, it must include the “State Effective Date Page” which contains effective dates of the franchisor’s registrations in all franchise registration states where the franchisor is registered. It is of note that NASAA recently adopted a new 3-page format for the State Cover Page which takes effect January 1, 2020, which (among other changes) contains an instruction guide for how to use the FDD.
The FDD then presents the substantive disclosures required by the FTC Rule and non-preempted state franchise registration and disclosure law provisions in a series of 23 “Items.” Generally, these Items describe: (i) the franchisor and its management, its and their background and experience (including any litigation or bankruptcy history), the franchise system and the franchise offering at hand (Items 1-4); (ii) the fees which the franchisee will have to pay to the franchisor and its affiliates in connection with acquiring and operating the franchise, the initial costs the franchisee will incur in connection with establishing and operating its franchise and the financial arrangements between the parties, including restrictions as to sources of products and services (Items 5-10); (iii) the obligations, prohibitions and provisions of the franchise arrangement (i.e., territorial grants/prohibitions, the franchisor’s pre-opening and ongoing obligations to the franchisee, restrictions on uses of the franchisor’s proprietary marks and confidential information, restrictions on products or services that may be sold, etc.) (Items 11-18); (iv) the historic and/or projected financial performance of the system, the size of the franchise system (including company-owned and franchised units) and the franchisor’s financial statements (Items 19-21); (v) the material contracts that the franchisee will have to sign to acquire the franchise (Item 22); and, (vi) a form evidencing the franchisee’s receipt of the FDD (Item 23).
The FDD must be written in “plain English,” defined as a manner easily understandable by a person unfamiliar with the franchise business, incorporating short sentences; definite, concrete, everyday language; active voice; and, tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives.
Although a franchisor is permitted to offer unit franchises, area development franchises and multi-unit franchises in one single FDD, it is not permitted to offer subfranchise rights or area representation rights in that same FDD.
Requirement to Repeat Disclosure
If a franchisor makes any unilateral material changes to the form of its agreements disclosed in its FDD, the changed agreement must be furnished to the prospect for review no less than 7 calendar days prior to execution. It is helpful to note that changes to the agreements that are made at a prospective franchisees request and/or that are necessary in order to merely “fill in the blanks” of an agreement (i.e., name, entity type, address, etc.) do not trigger the 7-day rule. However, if a franchisor is relying on the former, it would be wise to include a specific representation to that effect in the amended documents.
In contrast to the foregoing, if a franchisee desires to amend the franchisor’s form of agreement based on negotiations that it initiates with the franchisor and for the franchisee’s own benefit (i.e., not a unilateral material change made by the franchisor), this does not trigger the 7-day re-disclosure obligation discussed immediately above.
Potential Consequences for Failing to Comply
The failure to comply with the federal and/or state pre-sale disclosure obligation could subject a franchisor to investigations, enforcement actions and fines of up to $40,000 per violation, as well as (depending on the particular state at issue) damages, rescission and legal fees and expenses.
If the franchisee intends to use a special purpose vehicle (SPV) to operate each franchised outlet, is it sufficient to make disclosure to the SPVs’ parent company or must disclosure be made to each individual SPV franchisee?
A franchisor is required to disclose all “prospective franchisees” with its franchise disclosure document (“FDD”). The term “prospective franchisee” is defined as “any person (including any agent, representative, or employee) who approaches or is approached by a franchise seller to discuss the possible establishment of a franchise relationship.” Because the Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”) permits representatives of a prospective franchisee to accept delivery of the FDD on the prospective franchisee’s behalf, a franchisor may properly effect delivery of its FDD to a SPV’s parent company as its representative. In addition, in situations where a franchisee forms separate SPVs to operate multiple outlets, prior disclosure to the actual owner of that SPV (whether an individual or entity) would be sufficient to satisfy the franchisor’s disclosure obligation.
What actions can a franchisee take in the event of mis-selling by the franchisor? Would these still be available if there was a disclaimer in the franchise agreement, disclosure document or sales material?
Franchisee Actions in Event of Mis-Selling
In the event that a franchisor failed to comply with applicable franchise laws in offering or selling a franchise, and the franchisee would like out of the franchise relationship, its options vary depending on the particular state at issue. While there is no private right of action under the the Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”), a franchisee who was not properly disclosed or who purchased a franchise relying upon misleading or incomplete information may be able to bring claims against the franchisor under certain state franchise laws (which also require that prospective franchisees be furnished with a franchise disclosure document (the “FDD”) prior to the offer or sale of a franchise in such state, and which prohibit disclosures that are misleading or fraudulent). In particular, the laws of California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin each statutorily afford franchisees a private right of action to sue for damages or for rescission (i.e., essentially nullifying the franchise agreement and restoring the franchisee to the same position it would be in had it never acquired the franchise).
In addition, many states (including states with no franchise laws or regulations of their own) have enacted statutes, colloquially referred to as “Little FTC Acts,” which render illegal any conduct that would be violative of the Federal Trade Commission Act (the “FTC Act”) and the regulations promulgated thereunder (including the FTC Rule). Unlike the FTC Act and the FTC Rule, however, these Little FTC Acts often confer private rights of action upon aggrieved franchisees (either expressly by statute or by virtue of case law that has conferred standing under such statutes) instead of reserving those rights to governmental authorities alone. Thus, if a franchisor violates the FTC Rule by failing to timely furnish a franchisee with a compliant disclosure document (or otherwise), the franchisee may attempt to hold the franchisor liable under such state Little FTC Acts. Notably, Little FTC Acts typically permit the franchisee to sue for damages, rescission and legal fees and expenses.
Effect of Disclaimers
Incorporating disclaimers into franchise agreements may, in certain circumstances, help a franchisor defend itself from franchisee claims. However, such contractual disclaimers are not always dispositive and, under many franchise laws, are outright illegal.
While the the FTC Rule does not prohibit integration clauses or contractual waivers, it does prohibit franchisors from disclaiming, or requiring a prospective franchisee to waive reliance on, representations made in their FDDs. Because of this, it is quite common for franchisors to include in their franchise agreements: (a) provisions disclaiming responsibility for any unauthorized financial performance representations or claims made by its salesmen during the franchise sales process and (b) franchisee representations stating that the franchisee was properly disclosed with the FDD. Importantly, however, a franchisor may not disclaim an actual authorized representation made by its salespeople or included in its FDD, nor may it require or permit the franchisee to waive its right to receive timely disclosure of an FDD (any such waiver would be deemed invalid and unenforceable).
In addition, most state franchise laws specifically prohibit franchisors from committing any “fraudulent” and/or “unlawful” practices in connection with the offer and/or sale of franchises. Examples of such “fraudulent” and/or “unlawful” practices include the following: the intentional making of an untrue statement of a material fact; the intentional omission of a material fact the absence of which renders another statement misleading; a scheme or artifice to defraud; an act or practice which would or does operate as a fraud or deceit; a violation of any franchise registration or disclosure law or any rules or regulations promulgated thereunder; and, an attempt to compel franchisee to waive the statutory rights afforded to it under state franchise registration and disclosure laws.
Would it be legal to issue a franchise agreement on a non-negotiable, “take it or leave it” basis?
Yes. In fact, it is fairly common for a franchisor to provide prospective franchisees with the form of franchise agreement disclosed in the franchisor’s disclosure document on a “take it or leave it” basis.
Notwithstanding the foregoing, there may be particular characteristics of the prospective franchisee, franchisor and/or franchise sale that make the franchise agreement ripe for negotiation. By way of example, if a franchisor is just first launching its franchise system, and the prospective franchisee would be the first (or one of the first) to sign a franchise agreement, the franchisor may be more open to negotiating the terms of its agreement as a trade-off for establishing its experience and credibility. In addition, if a prospective franchisee is willing to purchase development rights for multiple franchises or acquire the existing franchised business of a struggling and/or poorly operated outlet, it may have greater leverage to negotiate more favourable franchise terms. While not always true, as a rule of thumb, the more established a franchisor and franchise system, the more likely it is that the franchise agreement will only be offered on a “take it or leave it” basis.
How are trademarks, know-how, trade secrets and copyright protected in your country?
In the United States, trademarks, know-how, trade secrets and copyrights are protected by federal and state statute, as well as by common law.
A trademark is created by virtue of its owner’s use of the mark in connection with a certain set of goods or services thereby resulting in “common law” rights in the mark. Neither federal nor state registration is required in order to create a trademark; however, given that a franchisor’s trademark is the very essence of its franchise system and brand value, it is highly recommended that a franchisor seek trademark registration as step one in its franchising journey. Registration serves to both put the general public on notice that the franchisor claims ownership of the mark and also to provide the franchisor with presumptive rights to the mark in the event it becomes necessary to protect the mark against infringers.
Trademark protection in the United States is afforded on both a federal and state level. While, pursuant to the Lanham Act (also known as the Trademark Act of 1946), a federal registration gives the registrant, except for prior uses in any given market, protective rights throughout the entire United States of America (and, in fact, requires that the mark in question be used with goods or services in interstate commerce (i.e., across state lines)), on the state level, trademark registration only protects a subject trademark in the particular state within which registration was accomplished (and within which the mark is used with goods or services).
On the international level, while a trademark federally registered in the United States of America only provides protection therein, pursuant to the Paris Convention it may sometimes allow for an early priority date in other counties in which registration is sought. Further, under the Madrid Protocol (to which the United States of America is a party), trademark holders can ensure protection for their marks in multiple countries through the filing of one application with a single office, in one language, with one set of fees, in one currency. While each country retains the right to grant or deny protection of a mark, once the trademark office in a designated country grants protection, the mark is granted the same protection as if such application was filed directly with the United States Patent and Trademark Office (the “USPTO”).
Notwithstanding any common law rights in, or federal and/or state registration of, a trademark, it is still possible for an owner to unintentionally lose the right to its mark. In order to maintain trademark registration in the United States, an owner must be able to prove continued use of the mark in the identical and consistent form originally filed with the USPTO. If it cannot, the USPTO may refuse to renew the owner’s registration and/or the owner may lose its presumptive rights to the mark. So, for example, if a franchisor trademark owner engages in “naked” or uncontrolled licensing (i.e., it fails to exercise control over third parties using its marks and/or fails to require third parties to enter into written trademark license agreements delineating clear quality control provisions), it may lose control of its marks and therefore risk ownership thereof. As well, a trademark owner must actively monitor the use of its trademarks and enforce its rights therein in order to maintain ownership. By way of example, if a franchisor trademark owner learns of a third-party infringing use of its marks and takes no action (such as, by way of example, sending a cease and desist letter or commencing a legal action against the user), its presumptive ownership could be lost.
Know-how and Trade Secrets
While a franchisor’s trademark may be the face of its franchise system, its trade secrets and know-how are the soul. These trade secrets and know-how can include any confidential information which is used in the franchisor’s business and gives the brand an opportunity to obtain an economic advantage over competitors who do not know or use such information. It may include a formula, pattern, compilation, program, device, method, technique or process.
On a statutory level, until relatively recently, the protection of trade secrets was only regulated at the state level, which varied from state to state and which required litigants to resolve their disputes in state court. However, in 2016 the United States enacted the Defend Trade Secrets Act, which created a federal private right of action for trade secret misappropriation and access to federal courts to resolve disputes. While the Defend Trade Secrets Act does not pre-empt state law and plaintiffs can (if they so desire) still choose to litigate in state court and under state law, the Defend Trade Secrets Act served to strengthen and provide uniformity in U.S. trade secret protection. Importantly, in order to seek protection under the Defend Trade Secrets Act, a plaintiff must demonstrate that it has taken reasonable measures to keep such information secret; the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information; and the trade secret is used in, or intended to be used in, interstate or foreign commerce.
In addition, trade secrets may be protected by court order. By way of example, a court can order an injunction to cease misappropriation; order a misappropriating party to take overt steps to maintain secrecy; order the payment of a royalty to the owner; and/or, award damages, court costs, and reasonable attorneys' fees. Importantly, if a trade secret owner fails to maintain the secrecy of its supposed trade secret or if the supposed misappropriator independently discovers the information or the information becomes generally known to the public, the owner will lose all rights to such trade secrets.
Copyrights are protected in the United States on the federal level under The Copyright Act of 1976 (the “Copyright Act”), which prevents the unauthorized copying of a work of authorship. The Copyright Act provides that a copyright is established when the author “fixed the copy for the first time,” so long as the work is original to the copyright owner. Importantly, this Copyright Act is limited to copying the actual work itself; it does not protect the ideas that underlie the work. Similar to trademark registration, copyrights are not required to be registered in the Copyright Office in the Library of Congress. However, registration is a pre-requisite for instituting a lawsuit to protect against copyright infringement, and may lay the grounds for an award for statutory damages and attorneys’ fees. In addition, registration serves to provide notice to the general public of the fact of such ownership. The United States has copyright relations with most countries throughout the world and, as a result of these agreements, generally honours such other citizen’s copyrights.
Although it is less common for franchisors to register their copyrights, it is nevertheless recommended that a franchisor claims copyright in its manuals and other written materials (and that such manuals and other written materials recite such claim).
Are there any franchise specific laws governing the ongoing relationship between franchisor and franchisee? If so, please describe them, including any terms that are required to be included within the franchise agreement.
Franchise registration and disclosure laws are only one element of the regulatory scheme governing franchising in the United States. 23 U.S. jurisdictions (Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Rhode Island, South Dakota, Virginia, Washington, Wisconsin, the District of Columbia, the U.S. Virgin Islands and Puerto Rico), have enacted “franchise relationship” statutes to regulate ongoing franchisor conduct in relationships with franchisees.
Each franchise relationship statute varies from the others in material ways and there are no uniform standards. The general thrust of the statutes, however, is to prohibit certain practices that are considered to be “unfair” or “unjust”. Thus, most of the states and territories with franchise relationship laws limit a franchisor’s right to do one or more of the following: (i) terminate or fail to renew a franchise without good cause; (ii) interfere with the right of free association among franchise owners; (iii) disapprove the transfer of a franchise without good cause; (iv) discriminate among similarly situated franchisees regarding charges, royalties and other fees; and, (v) place new facilities too close to existing franchises.
Where a franchise registration state also features a relationship law and/or otherwise governs the continuing relationship between the franchisor and franchisee, it will require that certain provisions be included and/or others excluded from a franchisor’s franchise agreement. These changes are often effected through a series of state-specific addenda to the franchise agreement that are approved by each respective state and applicable to residents of and/or franchised businesses to be located in such states. By way of example, many state registration laws prohibit franchisors from requiring its franchisees to consent to venue for litigation outside of such state. So, if a franchisor designates New York as the venue for all litigation under its standard form of franchise agreement, the State of Minnesota may nevertheless require the franchisor to strike such provision for Minnesota franchisees and instead include the following language “Minn. Stat. §80C.21 and Minn. Rule 2860.4400J prohibit Franchisor from requiring litigation to be conducted outside Minnesota. In addition, nothing in the disclosure document or agreement can abrogate or reduce any of Franchisee's rights as provided for in Minnesota Statutes, Chapter 80C, or Franchisee's rights to any procedure, forum or remedies provided for by the laws of the jurisdiction.”
Are there any aspects of competition law that apply to the franchise transaction (i.e. is it permissible to prohibit online sales, insist on exclusive supply or fix retail prices)? If applicable, provide an overview of the relevant competition laws.
It is often of great and legitimate importance to a franchisor to regulate: (i) the source of supply of its products, their components and operational elements (such as technology); (ii) the method by which its branded products and services are distributed to the general public; and, (iii) the price of products and services that are charged by branded outlets in the system. Franchisors are generally free, so long as the franchise agreement grants them the contractual right to do so, to regulate sources and the authorized methods for distributing products and services (i.e., by requiring participation in systemwide supply contracts and/or by prohibiting online sales).
However, a franchisor’s regulation of its franchisees’ resale prices requires a 3-fold analysis. First, is the regulation of resale pricing permissible under federal law? Second, is the regulation of resale pricing permissible under the particular states in which such pricing regime is applicable? And third, does the franchise agreement grant the franchisor the contractual right to regulate such pricing and, critically, was such right properly disclosed in the franchisor’s disclosure document?
On the federal level, for nearly a century resale price maintenance (“RPM”), otherwise known as “price fixing”, was deemed a per se violation of Section 1 of the Sherman Act (the United States principal antitrust law). While there were certain exceptions to this absolute ban on RPM, those exceptions were narrow.
But 22 years ago, in State Oil Co. v. Kahn, 522 U.S. 3, 100 (1997), the U.S. Supreme Court eliminated the per se rule against maximum RPM programs, instead subjecting such programs to a liberal “rule of reason” analysis (i.e., determining whether there is a reasonable justification for same). Thus, a franchisor without market power may require its franchisees to charge no more than a specified resale price for goods or services. And in 2007, in a dramatic reversal of its own nearly century old doctrine, the U.S. Supreme Court, in Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877 (2007), eliminated the per se rule against minimum RPM programs, holding that such programs must similarly be analysed under the liberal “rule of reason” standard. Noting the possible anticompetitive dangers of its decision, the Supreme Court in Leegin stated that lower courts in future cases, when analysing price maintenance conduct under the rule of reason, should in particular consider: (i) the number of competing manufacturers using the practice in a product category; (ii) the source of the restraint (manufacturer vs. retailer); and, (iii) the manufacturer’s market power.
Thus, federal antitrust law now permits franchisors to influence, or even prescribe, their franchisees’ retail prices so long as they can cite one or more economic justifications for doing so (i.e., meeting competition, preventing consumer confusion and customer anger resulting from advertised prices not being available consistently throughout the franchise network, etc.).
Notwithstanding the federal statutory and decisional antitrust law described above, many states have their own antitrust laws, which are not preempted by federal antitrust law. While some of these statutes, and the cases construing them, are consistent with the federal “rule of reason” analysis, others continue to prohibit RPM programs (maximum, minimum or both) as per se unlawful. As such, there currently exists a disparity between federal law and certain state laws governing RPM.
Many of the state antitrust statutes contain a “harmonization” provision, providing that the state law should be construed in harmony with judicial interpretations of comparable federal antitrust statutes (that is, the Sherman Act). In other states, the courts have ruled, even in the absence of a harmonization statute, that state statutes should be construed in harmony with judicial interpretations of federal antitrust statutes. However, a number of the larger states, such as California and New York, have taken a more independent approach. It is much more difficult to predict the outcome of an enforcement proceeding or civil action challenging the legality and/or enforceability of an RPM program in such jurisdictions.
Notwithstanding the foregoing, maximum resale price maintenance is generally not regarded as inflicting the same sort of consumer harm as minimum resale price maintenance and, thus, it would likely take the truly exceptional case, such as a maximum price used to disguise minimum price fixing, to trigger an antitrust challenge to a maximum resale price regime.
The question of whether a franchisor may establish a maximum RPM program has been addressed in a series of cases involving the Burger King and Steak N Shake franchisors, the decisions of which slightly diverge based on the court’s examination of the contractual language at issue.
The Eleventh Circuit and the U.S. District Court for the Southern District of Florida ruled, on three separate occasions, that Burger King Corporation (“BKC”) had the right to impose on franchisees maximum prices for its “Value Menu” items by virtue of the Burger King franchise agreement provision stating that the franchisor could make changes and additions to its operating system “…which BKC in the good faith exercise of its judgment believes to be desirable and reasonably necessary…”.
In the Eleventh Circuit case, Burger King v. E-Z Eating 41 Corp., 572 F.3d 1306 (11th Cir. 2009), the court affirmed the lower court’s determination that: “BKC has the right, under the parties’ franchise agreements, to require compliance with the Value Menu. The franchise agreements specifically require Defendants to adhere to BKC’s comprehensive restaurant format and operating system.” Id. at 13-14.
In a subsequent but entirely parallel case, National Franchisee Association v. Burger King Corporation, 715 F.Supp. 2d 1232 (S.D.Fla. May 20, 2010), the U.S. District Court for the Southern District of Florida issued two opinions. In the first - - rendered in May, 2010 - - the court held that under the above-quoted language of the Burger King franchise agreement, “…(plaintiff’s) claim that (the Burger King franchise agreement) does not grant BKC the authority to impose maximum prices…fails as a matter of law.”
However, since the subject Burger King franchise agreement language permitted Burger King to compel modifications of its system “which BKC in the good faith exercise of its judgment believes to be desirable and reasonably necessary…”, the court in its first decision granted Burger King’s motion to dismiss its franchisees’ claim that it did not have the authority under said franchise agreement to set maximum prices but let proceed the franchisees’ claim that Burger King’s imposition of the $1.00 double cheeseburger violated its contractual duty of good faith.
However, on that issue, too, Burger King prevailed. In its second decision, National Franchisee Association v. Burger King Corporation, Slip Copy, 2010 WL 4811912 (S.D. Fla, November 19, 2010), the Southern District of Florida held:
The purpose of Section 5 (of the Burger King franchise agreement) is to give BKC broad discretion in framing business and marketing strategy by adopting those measures it judges are needed to help the business successfully compete… (T)o adequately raise a claim of bad faith, Plaintiffs must allege some facts suggesting that BKC did not believe that the prices would be helpful to the businesses competitive position, but, for some other reason, deliberately adopted prices that would injure Plaintiffs’ operations. As currently pled, none of the allegations support such an inference of bad faith. Plaintiffs rely principally on their allegation that franchisees could not produce and sell (a double cheeseburger or a double hamburger) at a cost less than $1.00, and therefore that franchisors suffer “a loss” on each of these items sold. Even taken as true, there is nothing inherently suspect about such a pricing strategy for a firm selling multiple products. There are a variety of legitimate reasons where a firm selling multiple products may choose to set the price of a single product below cost. Among other things, such strategy might help build goodwill and customer loyalty, hold or shift customer traffic away from competitors, or serve as “loss leaders” to generate increased sales on other higher margin products.
In Stuller, Inc. v. Steak N Shake Enterprises, Inc. et al., 877 F. Supp. 2d 674 (C.D. Ill. 2012), the court, based on the subject franchise agreement language, reached a different conclusion in response to Steak N Shake’s attempt to compel one of its franchisees to follow its pricing directives. Steak N Shake, much like Burger King, relied on its franchise agreement’s rather standard “system modification” provision as entitling it to mandate franchisee prices (despite language of the franchisee’s existing franchise agreements which provided the franchisee the right to set its own menu pricing). Unlike the decision in Burger King, however, the Steak N Shake court held that this general “system modification” language was insufficient to entitle Steak N Shake to require its franchisees to adhere to prices established by the franchisor, observing that “[t]he agreements do not specifically address whether [Steak N Shake] can modify operational standards to require uniform pricing and promotions...[T]his Court finds that the undisputed extrinsic evidence demonstrates, as a matter of law, that the parties did not intend for the System to include pricing and promotion…The undisputed extrinsic evidence demonstrates that price and promotions were not part of the System. As such, [Steak N Shake] could not modify the System to require Plaintiff to following [Steak N Shake] pricing and promotions.” Accordingly, the Court granted plaintiff-franchisee’s motion for summary judgment, and enjoined Steak N Shake from implementing its pricing policy.
Notably, neither the Burger King decisions nor the Steak N Shake decision addressed the antitrust aspect of a franchisor compelling (or attempting to compel) its franchisees to observe fixed retail prices, whether under federal antitrust law (and its now prevailing “rule of reason” analysis) or under state antitrust laws. Rather, such decisions limited their analysis to the language of each respective franchise agreement.
Are in-term and post-term non-compete and non-solicitation clauses enforceable?
Franchisors necessarily provide franchisees with invaluable confidential business information, intellectual property, and trade secrets and therefore it is typical for franchisors to include non-competition covenants in their franchise agreements. These non-competition covenants are meant to ensure that the franchisee devotes the necessary time and attention to the franchised business and to protect the franchisor’s legitimate business interests such as (a) ensuring that the franchisor’s confidential information is not disclosed to a competitor (thereby damaging the value of, and the franchisor’s and other franchisees’ investment in, the brand) and (b) ensuring that the franchisee does not terminate its agreement just to continue operating a similar business under a different trademark (thereby obviating its need to pay the franchisor the duly owed royalty and other fees).
Courts have generally recognised the legitimacy of non-competition covenants and upheld the enforceability of same so long as they are: (i) reasonable in terms of type of restricted activity, geography and time and (ii) no more restrictive than reasonably necessary to protect the franchisor’s legitimate business interests (however, this generalization is not true in California, under which law non-competition covenants are typically found unenforceable, except under certain very limited circumstances). In particular, franchisors are often successful in enforcing covenants not to compete where they are limited to: (i) the term of the agreement and/or (ii) the two year period (1½ in the State of Washington) following the expiration or sooner termination of the agreement and limited to a 10 mile geographic radius surrounding the formerly franchised outlet as well as all other branded outlets in the franchise system.
Not all covenants not to compete are made equal, however, and whether a court will deem a particular covenant reasonable may depend on the particular factual circumstances at issue. Indeed, depending on the facts surrounding the particular franchise offering, the particular industry in which the franchised business will operate and the state at issue, certain franchisors have been successful in securing much longer restrictive periods and much wider restrictive geographic scopes.
Importantly, when drafting a non-competition clause, franchisors should be mindful of whether and how a court will modify a provision which it finds unreasonable and unenforceable. By way of example, certain courts may “blue-pencil” the provision, essentially rewriting the provision as it deems necessary in order to make the purportedly unreasonable restriction, reasonable. Other courts, however, will altogether strike an unreasonable covenant not to compete, so that the franchisor is left with no protection whatsoever.
Historically, it was common for franchisors to include employee non-solicitation provisions (a.k.a. no-poaching provisions) in their franchise agreements. These provisions essentially prohibit franchisees from hiring away the franchisor’s employees as well as from hiring away the employees of other franchisees. There are many reasons for the inclusion of these non-solicitation provisions; however, the most common cited reason it to protect each party’s investment in training employees. This is especially true in the context of managerial employees who are often required to attend the franchisor’s training program at a cost to the employer before commencing work. Without a non-solicit provision, franchisee A could invest significant time and money into training its employee, only to have that employee negotiate for higher pay and better benefits at franchisee B’s location, since franchisee B won’t have to spend time and money on training.
Notwithstanding the foregoing, the Federal Trade Commission (the “FTC”) and the United States Department of Justice (the “DOJ”) have recently been more aggressive in their prosecution of no-poaching agreements; particularly with respect to “naked” no-poach agreements. “Naked” no-poach agreements are agreements between competitors to refrain from recruiting, soliciting or hiring one another’s employees. They argue that these agreements are per se violations of Section 1 of the Sherman Act, because, according to the FTC and DOJ, these agreements inhibit employees from benefiting from a competitive market for their services. In challenging these clauses, the FTC and DOJ look at whether the no-poach agreement is a standalone agreement or part of a larger collaboration between the competitive companies. If it can be established that the inclusion of a no-poach condition was necessary to support a broader business purpose between the competitors, then the no-poach condition is not likely to be per se illegal and may not be illegal at all.
Beginning in July 2018, the attorneys general in at least 11 states began investigating the use of no-poach agreements in restaurant chain franchise agreements. By way of example, the Washington State Attorney General sent information requests to a number of franchisors asking, among other things, that they state whether any of their franchise agreements during the past 5 years had contained a no-poach provision; the reasons for having or changing a no-poach agreement during the last 5 years; and, an identification of each restaurant owned by the franchisor and franchisees in Washington. Shortly after this Washington investigation was announced, several major restaurant franchise chains agreed that they would not enforce their no-poach provisions and negotiated a settlement with the State of Washington to avoid any enforcement action.
In addition to regulatory action, a number of high profile class action complaints have been commenced against major fast food franchisors, arguing that no-poach provisions in the subject franchise agreements are illegal. (See Butler v. Jimmy John’s Franchise, LLC, et al, No. 18-133 (S.D. Ill. July 31, 2018)). Given the uncertainty of how these cases will be decided, franchisors should take caution in including these types of no-poach agreements in their franchise agreements.
Are there any consumer protection laws that are relevant to franchising? Are there any circumstances in which franchisees would be treated as consumers?
Most U.S. state consumer protection statutes apply only to consumer transactions, as opposed to commercial transactions such as the purchase of a franchise. Thus, in nearly all cases that the author is aware in which a franchisee asserted a claim against its franchisor under a state consumer protection statute arising from the purchase of a franchise, the claim has been dismissed.
That fact notwithstanding, U.S. franchise laws - - such as the Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”), which governs the offer and sale of franchises in all 50 states, Washington DC and all U.S. territories; the 14 U.S. states which have enacted laws requiring pre-sale registration and disclosure; and, the 23 U.S. jurisdictions which feature franchise relationship laws governing the on-going relationship between the franchisor and the franchisee - - may be construed as quasi consumer protection statutes, in that they serve to protect the franchisee. In addition, many states (including states with no franchise laws or regulations of their own) have enacted statutes, colloquially referred to as “Little FTC Acts,” which render illegal any conduct that would be violative of the FTC Act and the regulations promulgated thereunder (including the FTC Rule). Unlike the FTC Act and the FTC Rule, however, these Little FTC Acts often confer private rights of action upon aggrieved franchisees (either expressly by statute or by virtue of case law that has conferred standing under such statutes) rather than reserving those rights to governmental authorities alone. If a franchisor violates the FTC Rule, its franchisee may attempt to hold it liable under an applicable state Little FTC Act (if any).
Is there an obligation (express or implied) to deal in good faith in franchise relationships?
Most courts recognise the common law covenant of good faith and fair dealing, requiring parties to act honestly and observe commercial standards of fair dealing, in all commercial contracts. This common law covenant does not generally create obligations and restrictions where none exist. Instead, it requires the parties to perform their express contract duties in good faith.
Claims that franchisors have breached the implied covenant are typically asserted where the franchisee believes that the franchisor engaged in some act or practice that allegedly denied the franchisee the benefits of its franchise agreement or failed to exercise its contractual discretion reserved under the franchise agreement in a reasonable fashion. While these types of franchisee claims historically achieved success, in response, most savvy franchisors took action and updated their form franchise agreements in the following manner in an effort to defeat any future such claims: (i) wherever possible, expressly state that certain actions or omissions are required and/or prohibited (as mentioned above, the implied covenant is meant to address contractual ambiguities, rather than contravene express provisions); (ii) expressly state that the franchisor has exclusive and sole right to exercise its discretion (i.e., so the franchisee is on notice that the franchisor need not exercise its discretion reasonably); and/or (iii) replace the concept of “discretion” with the concept of the franchisor’s “business judgment” (i.e., in an attempt to provide franchisors with as much leeway as corporate executives under the corporate law concept of the “business judgment rule”).
Representing an unexpected turn of events, in a 2017 case out of California, Bryman v. El Pollo Loco, 2017 WL 9772377, Sup. Ct. (2017), the court completely uprooted this practice and declared that franchisor El Pollo Loco violated the implied covenant of good faith and fair dealing by placing a company-owned restaurant in close proximity to a franchised restaurant even though the parties’ franchise agreement explicitly permitted El Pollo Loco to do so. The court held that the subject franchise agreement’s grant of permission to El Pollo Loco to place company-owned restaurants anywhere, even proximate to franchisee Bryman’s restaurant, was “substantively unconscionable” and so one sided as to “shock the conscience.” Accordingly, it would be wise for franchisors to take caution when exercising even their express contractual rights and to weigh the likelihood of an implied covenant claim (though it should be understood that the Bryman case is at odds with precedent and is currently being appealed).
In addition, a number of states have gone a step further and enacted legislation specifically aimed at regulating the contractual relationship between franchisors and franchisees (via so called, relationship laws). These relationship laws mandate that certain minimal franchisee rights and franchisor obligations be imposed, regardless of whether such rights and obligations are expressly stated in the parties’ franchise agreement (and, in fact, often times contrary to what is stated in the parties’ franchise agreement). By way of example, the relationship laws of a number of states require that the franchisor have “good cause” to terminate a franchisee, and specify what types of defaults constitute “good cause” grounds for termination. Additionally, the relationship laws of a number of states provide that regardless of whether or not a franchise agreement grants a franchisee the right to renew upon expiration of its term, franchisors are required to grant their franchisees operating in such states the right to renew.
Are there any employment or labour law considerations that are relevant to the franchise relationship? Is there a risk that the staff of the franchisee could be deemed to be the employees of the franchisor? What steps can be taken to mitigate this risk?
Franchisor as Joint Employers of their Franchisees’ Employees
In 1984 The National Labor Relations Board (“NLRB”) promulgated its standard for who could be characterized as “joint employers” - - that is, two or more distinct entities nevertheless legally charged as co-employers of the same employee. Under that standard, if an entity exercised actual control over another entity’s employees (as opposed to merely possessing a reserved but unexercised right to exert control), then that entity could be deemed those employees’ “joint employer” (sometimes referred to as a “co-employer”) and, as a result, accrue legal responsibility for employee compensation, taxes, labour law violations and the other legal mandates and restrictions imposed on employers.
Mindful of this standard, franchisors often take great care to ensure that the level of control they exercise over their franchisees is limited to only the amount necessary to protect their trademarks and brand standards, whilst not crossing the line to oversee or control their franchisees’ day-to-day operations (if a franchisor otherwise were to, by way of example, participate in its franchisees’ hiring, firing, scheduling or payment of employees, it would likely be deemed the “joint employer” of its franchisees’ employees). As such, pursuant to the historic NLRB standard, virtually every franchisee is contractually deemed, and operates as, an independent contractor of its franchisor.
During President Obama’s administration, franchisors began confronting a concerted effort by the U.S. Department of Labor, the NLRB and certain state attorneys general to thrust direct liability upon them – as putative “joint employers” – for their franchisees’ wage-and-hour and labour law obligations and violations. Although the focus of these attacks has softened somewhat, given the change in the political landscape, franchisors should note that, as of the date of this writing, there is no clear and definite joint employer standard on which it may safely rely.
The thrust began in December, 2014 when the NLRB General Counsel issued complaints against McDonald’s Corporation (“McDonald’s”) and certain McDonald’s franchisees, alleging that those franchisees violated the rights of their employees and asserting that, as a “joint employer,” McDonald’s was equally liable for any violations of the National Labor Relations Act (“NLRA”) that may have transpired. Then, in the 2015 case of Browning-Ferris Industries (362 NLRB 186 (2015)), the NLRB announced a new “joint employer” standard, holding that a franchisor need only exert indirect control or even just reserve the right to control the terms and conditions of employment in order to qualify as a joint employer—even if the control was never actually exercised. The Browning-Ferris decision completely overturned years of precedent and sent shock waves through the franchise industry.
Notwithstanding the dramatic shift in the joint employer liability standard invoked by the NLRB beginning in 2014, there is evidence that the tide may again be turning. On September 14, 2018, the NLRB published a Notice of Proposed Rulemaking governing joint employer determinations. Under its proposed rule, “an employer may be found to be a joint employer of another employer’s employees only if it possesses and exercises substantial, direct and immediate control over the essential terms and conditions of employment and has done so in a manner that is not limited and routine. Indirect influence and contractual reservations of authority would no longer be sufficient to establish a joint employer relationship.” The NLRB’s consideration of its new joint employer standard is pending as of this writing (September, 2019).
Following the NLRB’s footsteps, on April 1, 2019, the U.S. Department of Labor released a Notice of Proposed Rulemaking which would furnish a definition of “joint employment” under the Fair Labor Standards Act. The Department of Labor proposal, if adopted, would be remarkably beneficial to franchisors in that it specifically states that a franchise relationship does not have any bearing on whether or not there is a joint employment relationship.
Steps that Can be Taken to Mitigate the Joint Employer Risk
As described above, the standard for determining joint employer liability has been a moving target for the last 5 years, and as of the date of this writing, there is no definite test upon which franchisors may take significant comfort relying. However, as a general best practice guide, it is prudent for franchisors to limit their control over their franchisees’ businesses to the greatest extent possible, instead focusing their control efforts on the standards believed most likely to affect their brand name and the goodwill associated therewith. In particular, the following steps are recommended:
- A franchisor should prohibit its franchisees from including the brand name in their business entity (corporation, LLC or other) names.
- A franchisor should require its franchisees to place a conspicuous notice of independent ownership on the premises of their franchised businesses, as well as on all of the following: employment applications, employee manuals, employment contracts, checks, etc. (which documents should specifically identify the franchisees’ business entity name, rather than the franchisor’s name or the brand name).
- A franchisor should distance itself from the hiring, firing, payment, scheduling and other involvement in its franchisees’ employment activities.
- A franchisor should distance itself from the training of its franchisees’ employees as much as possible, implementing (by way of example) train-the-trainer programs and/or management training programs (as opposed to direct employee training programs).
- If a franchisor is mandating particular point of sale or other software programs that include scheduling and/or other applications to manage labour force activities, such applications should be disabled so that the franchisor has no visibility or involvement in such programs.
Franchisor as the Employer of its Franchisees
On September 18, 2019, California Governor Gavin Newsom signed into law ‘California Assembly Bill 5’ or ‘AB-5,’ which takes effect on January 1, 2020 and which codifies the so-called ABC test for determining those types of relationships that are properly classified as an independent contractor relationship versus those types that should really be classified as employee-employer.
Under the ABC test, a worker is properly considered an independent contractor to whom a wage order (or other labour laws) does not apply only if the hiring entity establishes: (A) that the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact; (B) that the worker performs work that is outside the usual course of the hiring entity’s business; and, (C) that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
The distinction between an ‘employee’ versus an ‘independent contractor’ is an essential distinction in the franchise model. Virtually every franchisee is contractually deemed, and operates as, an independent contractor of its franchisor. Notwithstanding the importance of this distinction, since the vast majority of franchisors own and operate businesses identical to those of their franchisees, it is likely that most will fail part ‘B’ of the ABC test (i.e., that the worker performs work that is outside the usual course of the hiring entity’s business). Indeed, it is almost always the case that a franchisee does not perform work that is outside the usual course of its franchisor’s business.
If, pursuant to AB-5, a franchisee is now deemed to be an employee of its franchisor, the franchisor will not only become responsible for employment liabilities (i.e., franchisee wages; FICA contributions; unemployment insurance premiums; workers’ compensation premiums; Affordable Care Act mandates; wage-and-hour compliance; and, all of the other duties, requirements and prohibitions imposed by federal and state law upon employers), but also for all acts, errors and omissions of its franchisees under the doctrine of respondeat superior.
While AB-5 was not intended to target the franchise industry specifically, its language is broad and it has the power to dramatically shift the liability exposure for franchised businesses located in California and/or for franchisors whose franchise agreements are governed by California law.
Is there a risk that a franchisee could be deemed to be the commercial agent of the franchisor? What steps can be taken to mitigate this risk?
As a practical reality, franchisors frequently find themselves the subject of litigation in “vicarious liability” claims arising from harm sustained by third parties at franchised locations. This risk is inherent in having the franchisor’s brand name on the front door; often the injured third party is unaware that the franchised location is an independently owned and operated business and/or does not understand the legal and business distinction between a franchisor and franchisee. Other times, a franchisor is targeted by the injured third-party merely because it likely has (or is thought to have) deeper pockets than the independent franchisee.
From a legal perspective, however, a principal may be held vicariously liable for the acts, errors and/or omissions of its agent if the agent is acting under the control of the principal. In the franchising context, this traditional “control” test had been applied for many years to impose vicarious liability upon a franchisor as a result of the acts, errors and/or omissions of its franchisees. The thrust of these claims was that the franchisor had substantial “control” over its franchisee through the franchise agreement and operations manual (of course, such “control” is necessary not only to protect the franchisor’s trademarks, but is vital to the very nature of franchising, ensuring quality and uniformity across the entire system). However, over the past three decades, the law in this area has evolved. Most courts have shifted to what has been termed the “instrumentality” test when analysing vicarious liability issues in the franchising context. These courts have recognised that this overarching general “control” is necessarily inherent in the franchise relationship to protect the franchisor’s trademark and uniformity of customer experience, and therefore have taken the position that a franchisor may only be held vicariously liable where it actually controlled, or had a right to control, the daily operation of the specific aspect, or “instrumentality,” of the franchisee’s business alleged to have caused the harm. While this is the current trend in case law, the law varies state-by-state, and it is difficult to predict which standard any particular court would utilize in a given situation.
As such, franchisors must be careful to manage this dynamic, always aiming to balance (a) its oversight and control over a franchisee’s operation to ensure uniformity of customer experience with (b) the risk of being held vicariously liable based on its exercise of so much control that it is deemed the franchisee’s principal.
While not always dispositive, a carefully drafted franchise agreement can go a long way in mitigating this risk. By way of example, it is recommended that franchisees be required to place a conspicuous notice of independent ownership in the window of its franchised outlet, advising the public that the outlet is not owned and operated by the franchisor. A similar notice should be required on any other facilities of the franchisee’s business, as well as on all printed materials, business cards, stationery, marketing and advertising materials, signs and other written or electronic modes. In addition, it is recommended that the franchisee expressly agree to indemnify and hold the franchisor harmless from any claims arising from the franchisee’s operation of its franchised business or at its franchised outlet. This indemnification should further specially require the franchisee to reimburse the franchisor for any costs and fees (including attorneys’ fees) incurred in connection with a third-party action by virtue of statutory, "vicarious," "principal/agent" or other liabilities asserted against or imposed on the franchisor. Finally, in order to bolster the indemnification and reimbursement provisions, a franchisee should always be required to obtain and maintain insurance coverage of such types, nature and scope sufficient to satisfy its indemnification obligations, and the franchisor should be named as an additional insured thereunder.
Are there any laws and regulations that affect the nature and payment of royalties to a foreign franchisor and/or how much interest can be charged?
A franchisor is free to determine the royalties and other fees that it will charge its franchisees, so long as it properly discloses such amounts in its franchise disclosure document.
With respect to interest that may be charged, however, many states have enacted usury laws. These laws do not specifically target the franchising industry but nonetheless limit the amount of interest that may be charged on overdue payments. These state-mandated maximum interest rates vary depending on the circumstances surrounding the imposition of such interest (whether there was a written contract in place) and on the state at issue.
Is it possible to impose contractual penalties on franchisees for breaches of restrictive covenants etc.? If so, what requirements must be met in order for such penalties to be enforceable?
Under the law of most U.S. states, contractual penalties are unenforceable as against public policy. However, in situations where it will be difficult to calculate the amount of damages resulting from a particular breach, parties may preemptively agree that in the event of such breach, the non-breaching party will be entitled to recover liquidated damages in a particularly identified amount or in an amount calculated by a particularly identified formula. As long as the court determines that the imposition and amount of such liquidated damages constitute a good faith estimate of actual damages and not, alternatively, a penalty, the provision will generally be enforced (i.e., a liquidated damages provision does not obviate the requirement to mitigate damages altogether; it is supposed to take into account such reasonable mitigation).
For example, parties to a franchise agreement with a 10 year term may agree that in the event of termination, the franchisee will pay liquidated damages in an amount calculated by multiplying the remaining number of months in the term by the average monthly royalties paid to the franchisor under the agreement. But note, pursuant to the mitigation principal explained above, if the time remaining in the term was, for example 8 years, and a court determines that the franchisor could have found a replacement franchisee for the terminated outlet within 2 years, the court may deem the liquidated damages provision a penalty, rather than a good faith estimate of actual damages, and therefore unenforceable.
What tax considerations are relevant to franchisors and franchisees? Are franchise royalties subject to withholding tax?
Federal Tax Considerations for Franchisors
Generally, any person or entity that is engaged in trade or business in the United States, and earns income from such business, must pay taxes on that income. In particular, where a foreign franchisor enters into a franchise agreement with a U.S. franchisee who pays royalties and/or other fees based on or earned in connection with the franchise grant, the foreign franchisor has engaged in trade or business in the United States and therefore must pay taxes on its U.S. income, as well as whatever taxes may be imposed in its home country.
Notwithstanding the foregoing, the United States has entered into tax treaties with over 60 countries which, depending on where a franchisor is “permanently established,” may significantly reduce or eliminate withholding taxes altogether. While the particular tax benefits of such treaties vary significantly, a favourable treaty may result in a franchisor’s income being entirely exempt from paying withholding taxes (rather than the standard United States 30% withholding tax).
In general, it is recommended that a foreign franchisor carefully consider the following factors with its accounting advisors:
- Is there an international tax treaty between the franchisor’s home country and the United States?
- Are there withholding issues on payments both inbound and outbound from the franchisor’s home country?
- Who is the party responsible for paying the withholding tax, the United States franchisee or the foreign franchisor?
- Should a blocker corporation be created or just a pass through entity?
- How should the international tax structure be set up?
- Where must tax returns be filed? Do the foreign franchisor’s tax returns need to be filed in the United States or should the United States tax returns be filed in the foreign franchisor’s home country?
- Will the franchisor operate “remotely” (solely from its home country) or have an actual presence in the United States?
- What effect will the local performance of franchisee services have on tax issues relating to the franchisor?
- Are there foreign tax credits available for taxes paid abroad?
State Tax Considerations for Franchisors
It should also be kept in mind that franchisors are responsible for paying taxes to particular states within which they conduct business. The tax laws of each state, however, vary significantly; while some states impose a tax on the franchisee (who must withhold taxes and pay them to the state), others impose the tax directly on the franchisor.
In addition, franchisors doing business in California (as well as certain other states, such as New York, which are thought to likely follow suit) should pay close attention to how the recent promulgation of ‘Assembly Bill 5’ will affect their tax burden. Notably, California’s Assembly Bill 5 imposes a new test for determining those types of relationships that are properly classified as an independent contractor relationship versus those types that should really be classified as employee-employer. Under this new test, rather than the franchisor’s independent contractor (for which the franchisor is not responsible for employment liabilities), franchisees may be deemed the employees of their franchisors. As the employer of its franchisees, a franchisor may thereby become responsible for payroll taxes, Federal Insurance Contributions Act contributions, and a host of other employment liabilities.
State Tax Considerations for Franchisees
Franchisees are subject to the same obligation to pay taxes on their income as other types of businesses. While initial franchise fees paid in connection with a franchisee’s acquisition of a franchise are generally not fully tax deductible, continuing royalties are deductible in the year incurred.
Does a franchisee have a right to request a renewal on expiration of the initial term? In what circumstances can a franchisor refuse to renew a franchise agreement? If the franchise agreement is not renewed or it if it terminates or expires, is the franchisee entitled to compensation? If so, under what circumstances and how is the compensation payment calculated?
Except for those United States jurisdictions that have enacted laws regulating a franchisee’s right to renew and limitations and conditions imposed on a franchisor’s decision not to renew, renewal is a matter of contract law, determined by the express terms of the parties’ franchise agreement. Thus, if a franchise agreement provides the franchisee with a fixed term during which it may operate its franchise, the franchisee cannot later claim that it is entitled to more (or, rather, the franchisee can of course make such claim, but it will not find itself in a well-supported position). Alternatively, if the franchise agreement provides a franchisee with a right to renew upon the satisfaction of certain enumerated conditions, and the franchisee so complies, the franchisor will be prohibited from denying the franchisee the right to renew.
As mentioned above, however, certain U.S. states have enacted laws regulating renewal, ranging from limitations on a franchisor’s right to not renew; the process by which a franchisor must comply in order to not renew; and, concessions that the franchisor must make in connection with same. Where applicable, these statutory regulations may supersede the express terms of a franchise agreement.
From a process standpoint, some states impose requirements concerning the minimum notice that must be furnished to a franchisee whom the franchisor has elected not to offer renewal. The particular period of required advance notice varies from state to state, but ranges from 60 days prior to the expiration of the term to a full year prior to the expiration of the term. The intent behind these provisions is to afford the franchisee sufficient time to “wind down” its business operations.
Limitations on a Franchisor’s Right Not to Renew
Notwithstanding the express terms of a franchise agreement, certain state statutes impose limitations on a franchisor’s right not to offer renewal to a franchisee. These statutes require that certain specified conditions be satisfied prior to a franchisor exercising such right. While the particular conditions enumerated in these statutes vary greatly, one common theme that persists among them is the “good cause” pre-requisite. Specifically, the franchise laws of the following states require the franchisor to demonstrate “good cause” in order to refuse to renew the franchise relationship: Arkansas, California, Connecticut, Delaware, Hawaii, Indiana, Iowa, Minnesota, Nebraska, New Jersey, Puerto Rico, the Virgin Islands, and Wisconsin.
Unfortunately for franchisors, there is no single prevailing definition as to what constitutes “good cause,” and determining whether the franchisor has satisfied such prerequisite often requires the franchisor to make subjective analyses as to whether it had a legitimate business reason or the franchisee had failed to comply with material provisions of the franchise agreement. However, the following list includes typical “good cause” statutory triggers for non-renewal: (i) if the franchisee abandoned its franchise; (ii) if the franchisee failed to pay amounts owed within certain time periods enumerated by the particular state; (iii) if a franchisee is convicted of a crime; (iv) if the franchisee files for bankruptcy, makes an assignment (or attempts to make an assignment) for the benefit of creditors, or is otherwise insolvent; (v) if the franchisee fails to substantially comply with the franchise agreement or fails to comply with an essential provision of the franchise agreement; (vi) if the franchisee commits an act that impairs the franchisor’s trademark or brand name; (vii) if the franchisee’s continued operation of the franchised business represents a danger to public health or safety; and/or, (viii) if the franchisor decides to withdraw from the franchisee’s market (importantly, with no intent to capture the franchisee’s business and goodwill itself). However, this list is not exhaustive, and further, whether any or all of these examples are sufficient to satisfy a particular state’s definition of “good cause” requires an analysis of the laws of the particular state at issue.
Required Franchisor Concessions in the Event of Non-Renewal
Even in those instances where a franchisor is not statutorily restricted from failing to renew a franchisee, some states nevertheless require it to offer certain concessions to the franchisee in connection with same. By way of example, in Hawaii, Michigan and Washington, the franchisor must pay the franchisee fair market value, at the time of expiration, for the franchisee’s inventory, supplies, equipment, fixtures, and furnishings if purchased from the franchisor or one of its designated suppliers. Certain states also require the franchisor to compensate the franchisee for the value of its business and/or business assets. In the state of Illinois, for example, if a franchise agreement imposes and the franchisor intends to enforce a non-competition covenant, the franchisor may not refuse to renew a franchise agreement without repurchasing the franchise. The laws of Hawaii and Washington, on the other hand, require the franchisor to pay the franchisee for the loss of goodwill associated with the franchised business if the franchisor is taking over such business upon expiration or did not provide the franchisee with sufficient prior written notice regarding its intent not to renew.
While, as stated above, franchisors are largely free to set the terms governing renewal in their franchise agreements, it is fairly settled case law that where a state statute governs renewal, such state statute will supersede the language of a franchise agreement. Of course, where a particular state has no such statute governing renewal, it is equally settled law that the terms of the parties’ franchise agreement will control.
Are there any mandatory termination rights which may override any contractual termination rights? Is there a minimum notice period that the parties must adhere to?
Almost all of the 23 U.S. jurisdictions which feature franchise “relationship” laws (i.e., Alaska, Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Mississippi, Missouri, Nebraska, New Jersey, Rhode Island, South Dakota, Virginia, Washington, Wisconsin, the District of Columbia, the U.S. Virgin Islands and Puerto Rico) regulate termination of the franchise relationship by the franchisor. These statutes vary from state to state, but most require the franchisor to have “good cause” in order to terminate (though the definition of “good cause” varies) and to provide notice and an opportunity to cure in advance of termination.
While the definitions of “good cause” vary, they generally include a failure to comply with the lawful and material provisions of the franchise agreement. Some states go further and outline specific situations constituting “good cause” for termination, such as (depending on the particular state) a franchisee’s bankruptcy, abandonment of the franchised unit, failure to pay amounts due, material impairment of the goodwill of the franchise system or the franchise trademarks and/or repeated defaults of the franchise agreement.
In addition to requiring that the franchisor have good cause for termination, many state statutes also specify mandatory minimum cure periods and prior notice periods with which franchisors must comply. While the particular requirements of each state statute vary, three general trends exist. First, a number of states do not require a cure period at all but do require notice of termination (also known as a “wind down” period), varying from 60-120 days. Second, some states mandate a “reasonable” cure period but do not specify the particular period of time that is deemed reasonable. Finally, some states require a specific number of days that the franchisor must afford to the franchisee to cure, ranging from 30 to 90 days, depending on the state and the type of default at issue. Importantly, a number of these statutes specifically exclude incurable defaults. By way of example, the State of Washington permits termination without notice or opportunity to cure where the franchisee: (i) is bankrupt or insolvent; (ii) assigns the assets of the franchised business to creditors; (iii) voluntarily abandons the franchised business; or, (iv) is convicted of violating any law relating to the franchised business.
Given the varying particularities of each state’s laws, rules and regulations governing termination, before issuing a default or termination notice, a franchisor should always consider whether any (and if so, which) state laws may be triggered (by analysing where the franchisor is headquartered, where the franchisee is domiciled, where the franchised business is operated, and where the offer and sale originated from/was directed to); review such law (if any); and, determine whether there are procedural or other requirements with which the franchisor must comply in order to properly effectuate a default and/or termination notice. In those states where a franchisor’s right to immediately terminate if a franchisee commits an incurable default is not expressly addressed by state statute, or a franchisor believes a particular situation is so time sensitive that it would be imprudent to comply with statutory notice and/or cure provisions, the franchisor must ultimately weigh their urgency against the risk of a franchisee claim for unlawful termination.
Are there any intangible assets in the franchisee’s business which the franchisee can claim ownership of on expiry or termination, e.g. customer data, local goodwill, etc.
It is vital, and almost universal, for franchise agreements in the United States to specify that it is the franchisor (and not the franchisee) which owns all intellectual property associated with, arising out of, or developed in connection with the franchised business (including all trademarks, trade names, service marks, logos, emblems, etc.); all systems and methods of operating the franchised business; all customer data derived from the operation of the franchised business; and, all goodwill associated therewith or engendered by any of the foregoing. This standard contractual practice is well supported by federal law (specifically, by the Lanham Act), which provides that the use of a trademark inures to the benefit of the registered owner of the trademark.
Notwithstanding the foregoing, the laws of certain states require that franchisors compensate their franchisees in certain limited situations upon expiration or termination for the “local goodwill” developed by the franchised business. By way of example, in Washington, if a franchisor fails to provide sufficient advance notice of its intent not to renew the franchise agreement, it must compensate the franchisee for local goodwill engendered in connection with such franchisee’s use of the trademark and system. This requirement also applies in Connecticut and Illinois, but only in situations in which the franchisor also fails to agree not to enforce its covenant not to compete against the franchisee (if applicable). In addition, Hawaii requires franchisors to compensate the franchisee for such local goodwill where the franchisor refuses to renew the franchise agreement so that it can take over the franchisee’s formerly franchised business. Similarly, while the laws of Minnesota, Missouri, Mississippi, New Jersey and Virginia also require franchisors to compensate the franchisee for such goodwill, but in these states this requirement is hinged upon the franchisor’s unlawful termination of the franchise agreement.
Is there a national franchising association? Is membership required? If not, is membership commercially advisable? What are the additional obligations of the national franchising association?
There are various franchise associations in the United States but the most established and well known is the International Franchise Association (the “IFA”). Membership is not required; however, there are benefits to membership that may prove helpful. The IFA provides information on legal developments, networking opportunities, helps connect businesses with useful suppliers and access to new technologies and generally seeks to educate franchisors and franchisees on beneficial methods and business practices to improve franchising. There are no obligations related to participation in the IFA (other than yearly membership dues). However, the IFA has established a Code of Ethics - - serving as a framework for the best practice and ideals in franchise relationships - - with which it expects its members to comply. While the IFA oversees the relationships between members and their compliance with the Code of Ethics, the Code is largely a self-regulation program with no real enforcement mechanism; it mainly attempts to resolve disputes better members as they arise. Importantly, the Code is not intended to establish, and does not have the effect of establishing, standards to be applied by third parties, such as the courts.
Are foreign franchisors treated differently to domestic franchisors?
While U.S. franchise laws apply with equal force to foreign and domestic franchisors, certain requirements of U.S. franchise laws may represent hurdles for the foreign franchisor.
By way of example, the FTC Franchise Rule requires that franchisors prepare and disclose in their franchise disclosure documents audited financial statements that have been prepared in accordance with United States Generally Accepted Accounting Procedures (“GAAP”). While this requirement is intended to ensure that franchisees and state franchise examiners (who, in certain states, analyse and must pre-approve the franchise disclosure document prior to its use) are able to understand and rely upon the veracity of such financial statements, and not to particularly bias foreign franchisors, it may be difficult for a foreign franchisor to find in its own country an accountant who has knowledge of and is able to prepare compliant audited financial statements in accordance with U.S. GAAP. Also, in the event that a foreign franchisor already has audited financial statements that have been prepared in accordance with generally accepted accounting procedures in its home country, it will nevertheless have to undergo the time and expense to have a another set of audited financials prepared just for purposes of U.S. franchise law compliance (we note that, for this reason, it is often recommended that a foreign franchisor form a new U.S. entity to serve as the franchisor, and conduct an audit of such entity, rather than the existing operational foreign franchisor entity).
Further, United States law established to prevent money laundering and terrorism may impose certain additional hurdles to the foreign franchisor. For example, if a franchisor or its owners are based in a country in which the United States has imposed sanctions or such entities or individuals are on the United States Department of Treasury’s Office of Foreign Assets Control’s Specially Designated Nationals and Blocked Persons List, expansion into the United States would be forbidden. Also, while not only implicated foreign transactions, foreign franchisors should note that, pursuant to the United States Bank Secrecy Act, cash transactions over $10,000 USD and wire transactions over $3,000 USD are subject to additional scrutiny, and banking institutions are also under a specific obligation to inform the Internal Revenue Service of any other suspicious activity. This sort of monitoring and reporting process is intended to deter and discover any individual trying to avoid paying tax, or any flows of money linked to illegal activity, such as crime, money laundering, or funding terrorism.
Are there any requirements for payments in connection with the franchise agreement to be made in the local currency?
No. While a foreign franchisor will often (but not always) choose to establish a separate business entity formed in the United States to serve as the franchisor of its United States franchise system, and therefore require payments of royalties and other fees in local currency, this is not an actual requirement. A Foreign franchisor may require its United States franchisees to make royalty and other payments in the franchisor’s currency of choice. However, a foreign franchisor who is requiring payment to be made in foreign currency should be sure that its franchise agreement expressly provides for such currency requirement, clearly indicates how and according to which lending institution the currency conversion rate will be established, and provides for the imposition of any exchange controls that prohibit/impede such conversions.
Must the franchise agreement be governed by local law?
No. State laws - - not just franchise laws, but the common law of damages and the law of evidence - - vary in significant ways one to the other. For this reason, virtually every franchise agreement contains a “governing law” provision in which the parties agree upon which states’ law will govern disputes between them. A franchisor is free to designate whatever law it so desires to govern the franchise agreement and, in fact, many franchise agreements designate the law of the franchisor’s principal place of business as the governing law for the agreement and disputes arising from the relationship between the parties. As well, where the laws of a franchisor’s home state are unfavorable, it too can designate any other state law as governing (i.e. a California franchisor may designate New York law as controlling because it is “business friendly”).
However, the franchise agreement’s designation of “governing law” is not always entirely conclusive. Virtually every state franchise registration and disclosure law, as well as every state relationship law, contains an “anti-waiver” provision, prohibiting any attempt by a franchisor to compel its franchisee to waive the protections afforded by the statute (indeed, under most state franchise laws, seeking to compel such a franchisee waiver of the statute’s protection is itself an express statutory violation). What this means is that a franchisee will almost always be able to invoke the franchise law of its home state (whether the state of the franchisee’s residence or the state where the franchisee operates its franchised business) in any arbitration or litigation with the franchisor regardless of what the “governing law” provision of the subject franchise agreement says. For example, if the franchise agreement stipulates that California law will govern all disputes, a New York resident (whose franchise is situated in New York) will always have the right to invoke the New York Franchise Act’s rights, remedies and damages. Indeed, some state franchise administrators will refuse to register a franchisor’s disclosure document unless the franchisor first agrees to amend its franchise agreement to expressly provide that, regardless of the contract’s “governing law” provision, the franchisee can always invoke protection of the subject state franchise statute.
What dispute resolution procedures are available to franchisors and franchisees? Are there any advantages to out of court procedures such as arbitration, in particular if the franchise agreement is subject to a foreign governing law?
While litigation is the most traditional method to resolve contractual disputes, alternative dispute resolution mechanisms such as arbitration and mediation are becoming increasingly more common. Each mechanism has its own benefits and detriments, and there is no uniform procedure used.
By way of example, mediation of international franchise disputes is generally considered to be a cost and time efficient resolution procedure; however, it cannot provide immediate relief to an injured party. So, if a franchisor learned that its franchisee was misusing its marks or was operating in a manner that was a danger to public health or safety, mediation would not prove a useful resolution mechanism, as the mediator would be unable to issue a temporary restraining order to immediately resolve the situation as a judge would able to do in court. In addition, while parties may be able to successfully resolve their dispute through mediation, in the event they cannot, the process could just delay the foregone conclusion of litigation or arbitration, thereby serving as an inefficient use of the parties’ time and resources. Further, it should be noted that mediation is not an adjudicative process; that is, it does not actually decide or resolve a dispute. Instead, regardless of whether a party’s position has merit (and, in fact, even if it does not), the goal of mediation is for the parties to reach a settlement to avoid the time and cost of litigation. Accordingly, in the author’s opinion, it would be in the franchisor’s interest to either make mediation one sided - - that is mandatory for the franchisee to commence mediation prior to instituting an action, but not for the franchisor - - or, if mutual, including clear carve outs in the types of actions that are subject to mandatory mediation (such as misuse of the franchisor’s marks and claims subject to injunctive relief).
The use of arbitration as a mechanism for dispute resolution is increasing around the world. Arbitration is generally considered a more informal and time and cost efficient mechanism than litigation. However, in the author’s opinion, there are no real advantages to selecting arbitration over litigation and, in fact, the risks in arbitration (such as the arbitrary nature of the decision and lack of meaningful ability to appeal) far outweigh the perceived benefits (such as reduced cost and shorter timetable, neither of which is necessarily true in most commercial cases). Nevertheless, where parties do contractually agree to arbitrate disputes, it would be wise to ensure that the following issues are clearly addressed: the law that will govern the dispute; the parties’ relationship and the agreement to arbitrate itself; the venue and choice as well as the body of rules governing the arbitration; the number of arbitrators and the process for selecting such arbitrators; the language in which the proceeding will be conducted; and, a carve out for the types of actions that are not subject to arbitration (such as misuse of the franchisor’s marks and claims subject to injunctive relief).
Ultimately, parties to a contract are free to agree to whatever dispute resolution mechanism they prefer, whether litigation, arbitration, mediation, or some combination of all three.
Does local law allow class actions by multiple franchisees?
Yes. Class actions by multiple franchisees are permitted so long as the “class” of franchisees satisfy the federal and state requirements for certification (i.e., (i) the class must be so numerous that joinder of all members is impracticable, (ii) there must be questions of law or fact common to the class, (iii) the claims of the representative parties must be typical to the class, and (iv) the representative parties will fairly and adequately protect the interest of the class).
However, because it is often in a franchisor’s interest to require franchisees to litigate individually (thereby bearing the cost of litigation alone, rather than sharing them amongst the class), many if not all franchise agreements offered in the United States include so-called “class action waiver” provisions. These provisions essentially require the franchisee to agree to waive the right to initiate or participate in a class action against the franchisor in order to acquire the franchise. In addition to the potentially prohibitive cost to the franchisee associated with individually litigating a dispute, class action waiver provisions also reduce the risk of a “mega award” being imposed against the franchisor in the event that a case is heard by a hostile jury or adjudicated under unfavourable law.
Class action waiver provisions have often been the subject of litigation. In particular, franchisees claim that such provisions are unconscionable, in that they serve as an economic bar to pursuing a claim. Nevertheless, courts have concluded that such class waiver provisions are generally enforceable.
Must the franchise agreement and disclosure documents be in the local language?
The Federal Trade Commission (the “FTC”) Franchise Rule (the “FTC Rule”) requires that Franchise Disclosure Documents (each, an “FDD”) (which FDD incorporates franchise and other ancillary agreements) be written in “plain English.” Under the FTC Rule, plain English is defined as a manner easily understandable by a person unfamiliar with the franchise business, incorporating short sentences; definite, concrete, everyday language; active voice; and, tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives. Regardless of a statutory mandate to draft the FDD and franchise agreement in English, the foreign franchisor should keep in mind that a number of states require the FDD to be filed with, and approved by, the state prior to use; and those states would, of course, refuse to accept an FDD written in a foreign language.
Is it possible to sign the franchise agreement using an electronic signature (rather than a wet ink signature)?
Yes. In 2000, the Electronic Signatures in Global and National Commerce Act (“E-SIGN”) was enacted to give electronic signatures, contracts and records the same legitimacy as handwritten and hard copy documents. E-SIGN provides generally that a signature, contract or other record “may not be denied legal effect, validity, or enforceability solely because it is in electronic form.” E-SIGN defines an “electronic signature” as “an electronic sound, symbol or process attached to or logically associated with a contract or other record and executed or adopted by a person with the intent to sign the record.” E-SIGN does not provide any additional, specific standards for electronic signatures and contains no provisions dealing with the attribution of electronic records or signatures to the signatory.
All states have adopted laws concerning the use of electronic documents in commerce. The vast majority of the states, the District of Columbia and the U.S. Virgin Islands have adopted the Uniform Electronic Transactions Act (“UETA”) with certain state/territory-specific variations. By way of example, New York has not adopted the UETA, but it has enacted the Electronic Signatures and Records Act (“ESRA”). Like E-SIGN and the UETA, the ESRA also defines an “electronic signature” as “an electronic sound, symbol, or process attached to or logically associated with an electronic record and executed or adopted by a person with the intent to sign the electronic record.” The ESRA provides that “unless specifically provided otherwise by law, an electronic signature may be used by a person in lieu of a signature affixed by hand. The use of an electronic signature shall have the same validity and effect as the use of a signature affixed by hand.” The ESRA is very brief and does not provide any other authentication or attribution standards. Therefore, like E-SIGN, under the ESRA there is no requirement to follow a particular authentication process other than receipt of an electronic sound, symbol or process that is logically associated with the contract and given with intent that a record be signed. Therefore, a code or password system intended to be a signature to a record would create a valid electronic signature.
Because federal and state laws leave open the exact procedures needed to authenticate an electronic signature, the following steps are some “best practices” which may help ensure the incontestability of an electronic signature:
- Require the signer to show a clear intent to sign the document by typing their name or clicking an accept box.
- Include an express contractual provision indicating that the parties mutually agree to effect the transaction via electronic signature.
- Provide each party to the agreement with a fully signed copy of the document
Can franchise agreements be stored electronically and the paper version be destroyed?
Franchise agreements are permitted to be signed and stored electronically. In the event that a franchise agreement is signed manually, there is no hard requirement that the original signature versions be retained in hard copy. Although state laws concerning admissibility of evidence vary, and many still are of the belief that original copies hold more legitimacy, almost all states have generally adopted legislation that includes the language of the Uniform Rules of Evidence (“URE”) and/or the Uniform Photographic Copies of Business and Public Records as Evidence Act (“UPA”), accepting use of digital image copies of signed documents and permitting the destruction of original documents unless preservation is required by law. While there are a certain documents of which original signature copies are required to be kept (i.e., wills, promissory notes, deeds, etc.), franchise agreements are not among those types of documents. The only rule relevant to retention of franchise documents is the FTC Franchise Rule that requires that franchisors keep a copy of each materially different version of their FDDs and also a copy of the signed FDD Receipt for at least three years.
Please provide a brief overview of current legal developments in your country that are likely to have an impact on franchising in your country.
Employee Non-Solicitation (a/k/a No-Poaching) Provisions and Non-Competition Covenants
Recently, employee non-solicitation provisions (a.k.a. non-poaching provisions) commonly found in most franchise agreements have come under attack by franchisee employees, some members of Congress, the Federal Trade Commission (“FTC”) and the Antitrust Division of the U.S. Department of Justice (“DOJ”). Opponents of these provisions have argued that non-solicitation clauses in franchise agreements qualify as “naked” non-poaching agreements and therefore constitute per se violations of antitrust laws. “Naked” no poach agreements are agreements between competitors to refrain from recruiting, soliciting or hiring one another’s employees. They argue that these agreements are per se violations of Section 1 of the Sherman Act, because, according to the FTC and DOJ, these agreements inhibit employees from benefiting from a competitive market for their services. In challenging these clauses, the FTC and DOJ look at whether the no poach agreement is a standalone agreement or part of a larger collaboration between the competitive companies. If it can be established that the inclusion of a no-poach condition was necessary to support a broader business purpose between the competitors, then the no poach condition is not likely to be per se illegal and may not be illegal at all.
In 2016, the FTC and the DOJ published an “Antitrust Guidance for Human Resource Professionals” (“Guidance”) reminding (and probably in some cases, informing) human resources professionals: (i) how antitrust law applies to decisions they make about employee hiring and compensation, and (ii) the potential civil and criminal liabilities faced by employers and individuals who engage in activities that violate antitrust laws. However, this Guidance did not specifically address the “no poaching” and “no hiring” clauses found in franchise agreements. Instead the Guidance provided a broad stroke discussion of, among other things, the illegality of no poaching agreements. And it reiterated that “naked…no poaching agreements among employers, whether entered into directly or through a third-party intermediary, are per se illegal under the antitrust laws. That means that if the agreement is separate from or not reasonably necessary to a larger legitimate collaboration between the employers, the agreement is deemed illegal without any inquiry into its competitive effects.”
On January 19, 2018, the head of the DOJ, Assistant Attorney General Makan Delrahim, announced that it would begin bringing its first criminal cases involving alleged “no poaching” agreements in violation of the Sherman Act; however, as of August, 2019, the DOJ had not yet filed any such criminal prosecutions in connection with same. Rather, the DOJ has instead filed statements of interest in class actions filed by franchisees concerning these no-poach provisions. Perhaps the most notable of these actions relate to the brands Auntie Anne’s, Arby’s and Carl’s Jr. In each of these class-action complaints, the franchisees’ employees argued that the no-poach provision was a scheme to improperly keep wages down. In connection with these statements of interest, however, the DOJ stated its belief that these provisions should be analysed under the “rule of reason” and, in protecting a franchisor’s right to (in certain circumstances) maintain no-poach provisions, stated that most franchisor-franchisee no-poach provisions actually are legitimate and promote intra-brand competition. Ultimately, each of these cases settled.
Although the DOJ has not been actively pursuing criminal prosecutions, and appears at least marginally more sympathetic to the franchisors’ reason for incorporating no-poach provisions in their franchise agreements, the states (and particularly the State of Washington) have taken a much more aggressive, anti-franchisor and active approach in trying to end the use of no-poach provisions. After the DOJ’s announcement, the attorneys general of several states began investigating and commencing enforcement actions against no-poach agreements. The first and perhaps most vocal state attorney general on this subject has been Washington State Attorney General Bob Ferguson, who believes that the inclusion of such no-poach provisions is per se illegal. Mr. Ferguson began sending information requests to a number of franchisors asking, among other things, that they state whether any of their franchise agreements during the past five years contained a no-poaching agreement; the reasons for having or changing a no-poaching agreement during the last five years; and, an identification of each restaurant owned by the franchisor and franchisees in Washington. As of August, 2019, approximately 66 national chains have entered into binding agreements with Mr. Ferguson agreeing to remove such no-poach clauses from their respective franchise agreements.
Further, Washington Governor Jay Inslee signed HB1450 (the “Non-Compete Act”) into law on May 9, 2019, which provides that franchisors may not restrict, restrain, or prohibit a franchisee from soliciting or hiring one of the employees of the franchisor or another franchisee in the franchise system. It is also of note that, in addition to addressing the use of no-poach provisions, the Non-Compete Act also imposes new conditions on the use of non-competition agreements, including (among other restrictions) that: (i) they will not be enforced against employees making less than $100,000 per year or independent contractors making less than $250,000 per year and (ii) the period of non-competition cannot be more than 18 months post-employment (without clear and convincing evidence that such longer period is necessary to protect business interests). While this non-competition section of the Non-Compete Act is not specifically targeted against franchisors, it is clear that it will have a major impact.
In addition, in July, 2018, the attorneys general of California, Illinois, New York, Maryland, Massachusetts, Minnesota, New Jersey, Oregon, Pennsylvania, Rhode Island and the District of Columbia began sending information requests to a number of prominent fast food franchisors (including Dunkin’ Donuts, Arby’s, Five Guys, and Little Caesars) regarding the existence of no-poach provisions in their franchise agreements and whether they had been actively enforcing such provision, in response to which many franchisors subsequently entered into settlement agreements with the states to remove no-poach provisions from their existing contracts.