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Franchise Dealership and Distribution Law

What Is a Franchise ?

Franchising is a method of business expansion through the licensing of independent individuals (franchisee) to offer distribute or sell the franchisor’s product or service, to follow a format and a trade style created by the franchisor, and to the franchisor’s trademarks and trade names. In return, the franchisee is generally required to pay the franchisor a franchise fee and ongoing royalties.

Franchised businesses usually fall into three categories: Distributorships, Business Format Franchises, or Manufacturing Franchises. In a Distributorship, the franchisor licenses another businessman to sell the franchisor’s product exclusively. In a Business Format Franchise, the franchisee operates his business under the franchisor’s trade name and is generally required to follow standardized methods of operation prescribed by the franchisor. Finally, in a Manufacturing Franchise the franchisor transmits to the franchisee the essential ingredients or formula for making a product to be manufactured by the franchisee in accordance with the franchisor’s standards.

There are several critical issues a prospective franchisee must consider before entering into a franchise agreement, such as the amount of control the franchisor can exert over the franchisee, the product sold by the franchisor, and the type and amount of support and assistance to be provided by the franchisor. Zarco Einhorn Salkowski & Brito, P.A. has represented prospective franchisees all over the country for several years and has assisted them in evaluating franchise investments. If you are considering becoming a franchisee, please contact us to discuss how we can assist you.

Alternative Dispute Resolution

Many franchise agreements contain provisions requiring the parties to resolve their disputes through one or more alternative dispute resolution (ADR) procedures. In general, parties to a franchise dispute may have several options as to how to resolve their disputes. Mediation and arbitration are ADR procedures that may accompany and/or replace traditional court-based litigation.

The most common form of ADR is mediation. Many courts now require that parties to a lawsuit engage in mediation during the early stages of litigation. The purpose of mediation is to attempt to negotiate a compromise that is mutually agreeable to the parties. In general, mediation is a non-binding process unlike arbitration or court proceedings. The parties, through their representatives, meet with a neutral third person (the mediator), whose role is to assist the parties in achieving a resolution of their dispute. The mediator does not have the authority to require the parties to reach an agreement nor to enforce the terms of any agreement. Rather, the mediator acts as a facilitator, listening as each party presents its case, and speaking with each party individually about the strengths and weaknesses of its case in an attempt to convince the parties to compromise.

Arbitration is a dispute resolution procedure in which the parties agree to forego the Court system and allow a neutral third party (the arbitrator) to render a final and binding decision. Many franchise agreements require that the parties consent to binding arbitration as the sole method of resolving their disputes rather than pursuing their claims through the judicial system. The arbitration process closely resembles the judicial process: the parties engage in discovery, file motions with the arbitrator, and during the final hearing each side presents its case to the arbitrator, who ultimately renders a decision. Arbitration is often touted as a more efficient alternative to litigation, allowing the parties to avoid the costs associated with prosecuting a lawsuit and achieve a speedy resolution of the parties’ dispute. However, in practice arbitration is often more costly than litigation, and generally requires that the parties give up certain legal rights, such as the right to broad discovery, the right to have a jury determine the merits of their case, and the right to appeal the decision.

The attorneys at Zarco Einhorn Salkowski & Brito, P.A. have vast experience representing franchisees in mediation and arbitration. Please call or e-mail us if you wish to learn more about these ADR procedures, or if you want to discuss your rights under a dispute resolution provision.

Independent Franchisee Associations, Advisory Boards, and Counsels

As a result of the inherent differences between a franchisee and its franchisor with respect to negotiating power, resources and access to information pertinent to the operation of the franchise system, many franchisees create franchise associations to share information, resources and best practices, and to serve as a communication vehicle with the franchisor. As the old adage correctly points out, “there is strength in numbers.” Zarco Einhorn Salkowski & Brito, P.A. has represented numerous organizations whose goal has simply been to provide a unified “voice” for a group of franchisees within a franchise system. Typically, membership in these organizations comes about as a result of multiple franchisees experiencing similar circumstances and/or difficulties with the franchisor, the resolution of which has been unsuccessful on an individual basis.

These unified organizations offer several benefits to its members in addressing issues and resolving disputes with franchisors. For example, many franchisees that the firm has represented have experienced difficulty in communicating with other franchisees within their system for purposes of sharing experiences and discussing solutions to daily challenges that they face in operating the franchise. These organizations provide a structured forum for franchisees to meet one another and discuss solutions and best practices. Also, franchisees typically express concern to us about how their franchisor will react to them raising a sensitive issue individually. Fear of retribution and disparate treatment is common and, sometimes, well founded. These organizations permit franchisees to avoid being “targeted” by their franchisor given the number of members in the organization. In addition, there are obvious cost savings that a franchisee can benefit from by participating in these organizations. Many franchisees, which would otherwise be unwilling or unable to retain capable counsel to address an issue with a franchisor, are able to have these issues addressed effectively and efficiently as a result of their membership in the organization.

There are several issues that need to be addressed prior to the formation of one of these organizations, such as the purpose of the organization, the manner in which membership shall be established, whether the franchisor will be permitted to join through a representative, and how membership dues will be assessed. Zarco Einhorn Salkowski & Brito, P.A. has vast experience in forming these organizations. If you are considering the possibility of forming or joining a franchise association, advisory board and/or advisory counsel, please call us to discuss how such an organization can benefit you and the other franchisees in your franchise system.


Encroachment: Does the Impact Policy Provide Protection?

One of the most disputed issues within the franchise relationship is encroachment–where a franchisor seeks to saturate a particular geographic market with its brand, to its overall benefit but to the individual franchisee’s detriment by placing a new and competing business within such close proximity to an existing franchise such that the success of the existing franchise is jeopardized due to the negative impact on sales and diversion of traffic caused by the new operation. The franchisee ordinarily seeks the highest possible sales and highest possible profits per unit, and has a greater stake in the success or failure of a single unit than its franchisor who regards it as “one among many”–some of which may be expected to just break even, or even operate at a loss. A mature franchise system, in particular, strives toward the ultimate goal of market saturation to maximize its overall sales and royalty base, to minimize competition and increase brand recognition–and thereby, the value of its trademarks.

Although franchisors typically assert that the increased value of the trademark which market saturation produces will benefit the entire system, a franchisor’s gains may come at the expense of individual franchisees. The franchisor’s point of view overlooks the franchisee’s justifiable expectations of success in the market and his or her enduring obligations to pay royalty fees and other fees originally agreed to in the franchise agreement for the full term of the franchise agreement regardless of any financial decline resulting from the competing franchise. Of course, the franchisor still receives royalty fees as well as other fees from each of its franchisees, and, thus, has ample incentive to saturate the market without regard for the effect on any individual franchisee.

Virtually all hotel franchise agreements contain clauses on this subject, with varying disclaimers as to the franchisee’s geographic territory. In an attempt to create the perception that franchisees do, in fact, have certain geographical rights in which the franchisor will not place a competing unit, many hotel franchisors have implemented an impact policy to reflect a showing of good faith on the part of the franchisor. Such policy is to assist the franchisor and its franchisees in pursuing the important mutual goals of (i) avoiding an unfair depletion of the franchisee’s room revenues through same-brand competition; and (ii) expanding the various different flags of the franchisor.

Under the impact policy, a franchisee is granted an area of protection in which the franchisor will not generally grant hotel franchises for the same brand as the franchisee’s brand. In addition, the franchisee is granted the right to object to (and, possibly, to exclude) same-brand franchises that are proposed to be located outside of the franchisee’s area of protection, but within a specified radius from the franchisee’s hotel. However, a careful review of an impact policy unquestionably reflects that a franchisee is not really being provided with any protection under impact policy it is merely a “hollow” promise.

In principal, the impact policy appears to be a solution to encroachment as a franchisor grants an area of protection to the franchisee in which the franchisor will not place a same brand hotel as the franchisee’s brand. This prevents the franchisor from saturating the market with its product and negatively impacting the sales of the existing franchisee. Notwithstanding such policy, courts do not give any legal effect to the terms contained in the various impact policies implemented by hotel franchisors. The impact policy is precisely what it appears to be–a policy which has no legal effect as it is not contractually binding on the franchisor and franchisee. Rather, it is merely a guideline which many franchisors have implemented under the disguise of attempt to afford some protection to franchisees. As a policy, not only is it not contractually binding and not legally enforceable, but the franchisor also has the unfettered and sole discretion to modify, alter, retract or withdraw the policy at any given time. In fact, even though many hotel franchisors use the impact policy as a selling point to franchisees in order to convey to them that the franchisor is not permitted to place any competing units in the franchisee’s area of protection, franchisor’s routinely place competing units in close proximity to the existing franchisee’s hotel without incurring any legal liability.

In conclusion, before buying a franchise, a potential franchisee should seek the advice of an experienced franchise attorney to help balance the scales and to seek to implement contractual safeguards against any prospective over-reaching on the part of the franchisor. The franchisee and his/her/its counsel should evaluate the nature of the existing competition surrounding the proposed location, the franchisor’s Franchise Disclosure Document disclosures pertaining to any “area of protection” and the franchisor’s criteria and policies and procedures for site selection.


Fraud and Misrepresentation

Fraud and misrepresentation claims in the franchise context usually involve a franchisor that has provided its franchisee with an inaccurate picture of the franchise system. In general, such claims involve a franchisor that has overstated the amount of revenues and or sales that the franchisee can expect to earn, the success of the franchise system in general, and statements regarding the amount of support, training and/or assistance that the franchisor provides to its franchisees. Fraudulent statements and misrepresentations may include outright lies, half-truths and omissions that the franchisee relies on in making a decision regarding the purchase of the franchise. Occasionally, franchisors accuse their franchisees of fraud and/or misrepresentation. Typically, these claims are based on the franchisee’s failure to make accurate payments to the franchisor (i.e., underreporting royalties) and on misstatements made in the franchisee’s application.

In order to prove fraud or misrepresentation, the franchisee must establish that the franchisor made a misrepresentation to the franchisee, that the franchisor knew it was a misrepresentation, that the franchisor made such statement in order to induce the franchisee to act, that the franchisee actually relied on the statement and that the franchisee suffered injury or damage as a result. Additionally, the Federal Trade Commission (“FTC”) has set forth rules of disclosure meant to prevent franchisors from making fraudulent misrepresentations in order to induce a potential franchisee to invest in the franchise system. The FTC requires that the franchisor provide a potential franchisee with a document known as a Franchise Disclosure Document, in which the franchisor must disclose certain aspects of the franchise system, including earnings claims, the amount of fees that the franchisee will be required to pay and other details regarding the franchisor-franchisee relationship. Additionally, many states have enacted laws that address fraud and misrepresentation in the franchise relationship. A franchisee has many recourses available to him if a franchisor has made false statements regarding the franchise relationship. Zarco Einhorn Salkowski & Brito, P.A. has a vast amount of experience representing franchisees in cases involving fraud and/or misrepresentation.

Breach of Contract

Advertising and Marketing

A franchisor’s advertising and marketing objective is to promote public acceptance of the franchisor’s product or service. The advertising and marketing of a franchisor’s product is crucial to the success of the franchisor, and consequently, the success of its franchisees.

Generally, the franchisee is responsible for the advertising and marketing of the franchisor’s product. In some instances, franchisors require that the franchisee use its “best efforts” to develop the franchisee’s territory and demand that the franchisee submit all advertising and marketing materials to the franchisor for preliminary approval. Other franchisors require that the franchisee join with the franchisor in cooperative advertising ventures on a shared cost basis. The franchisor’s goal in every instance is to promote the franchisor’s product utilizing advertising and marketing material that is uniform, consistent, and recognizable by the public.

A potential franchisee should carefully consider the advertising and marketing demands of a franchisor before entering into a franchise agreement. If you are a franchisee or considering becoming a franchisee and have questions concerning the advertising and marketing demands of the franchisor, please contact Zarco Einhorn Salkowski & Brito, P.A. to discuss how we can assist you.

Liquidated Damages Clause

A “liquidated damages” clause provides the amount of, or formula for computing monetary damages in the event that one party breaches the contract. Instead of having a judge or jury calculate the amount of damages the injured party has suffered, the agreement itself sets forth the amount of money the breaching party must pay to the non-breaching party. In the hospitality industry, the liquidated damages are generally calculated based on the number of rooms in a property and the average amount of monthly royalty fees that a franchisee has paid during the prior two (2) to three (3) year period. Put another way, a franchisee’s liability for liquidated damages proportionately increases with the number of rooms in the property.

Liquidated damages clauses vary in form and much will depend on the specific language contained in the franchise agreement. The underlying purpose of a liquidated damages clause is to prevent the franchisee from leaving the system in search of greener pastures. It may benefit both parties when it avoids the expensive process of hiring accounting and finance experts to calculate the damages caused by the contract termination. This way, each party knows up front how much it will cost and the relationship. Problems arise when a franchisee is forced to change his or her mind because of material default on the part of a franchisor, such as lack of support and services and/or an inadequate or problematic reservation system.

Many states laws restrict the enforcement of a liquidated damages clause if it is determined by a court that the amount of liquidated damages appears to “unconscionable” and, thus, a penalty rather than a true measure of the amount of money that a franchisor will stand to lose as a result of a premature termination of the franchise agreement. In many of the jurisdictions where hotel franchisors are headquartered, the test for enforceability of the liquidated damages clause is solely based on the circumstances at the time the parties entered into the franchise agreement. In other words, just because circumstances have changed so that the liquidated damages may be disproportionate at the time of breach does not matter so long as it was a fair and reasonable estimate at the time the agreement was executed.

The courts also take into account the potential difficulty of estimating the amount of actual damages suffered by the non-breaching party. If the actual amount of damages can be readily calculated at the time the agreement is entered into between the parties, then the provision may constitute a penalty and be unenforceable. In the alternative, if it is difficult to calculate the actual amount of damages suffered, then the court may enforce the liquidated damages provision. For example, in most states, liquidated damages clauses are only enforceable if (1) the amount of liquidated damages bears a reasonable proportion to the probable loss and (2) the amount of the actual loss is incapable or difficult of precise estimation. If, however, the amount fixed is plainly or grossly disproportionate to the probable loss, the liquidated damages clause will be deemed a penalty and be unenforceable. Importantly, some states do not even permit the award of liquidated damages, irrespective of whether they are reasonable.

Undoubtedly the most difficult aspect of the law on liquidated damages to understand and accept is the fact that many of the key states (i.e., California, New York) totally disregard the actual impact of the liquidated damages resulting from the formula contained in the franchise agreement. So, if at the time of contracting, it would be difficult to determine how much money the franchisor would lose should you decide to leave the franchise system prior to the expiration of the agreement, then the court would not consider it a penalty. The liquidated damages amount then becomes a substitute for the actual but incalculable damages the franchisor incurs. If a franchisee takes over the franchise mid-term and there is already five or ten years of historical sales figures from the previous franchisee, it may not be that hard to determine how much the franchisor would lose in royalties. But it may still be difficult to determine at the time of contracting how long it will take the franchisor to replace a departing franchisee with another franchisee.

Due to the large corporate umbrellas covering several brands, many franchise agreements include choice of law clauses whereby the franchisor elects to have the agreement governed by the laws of the state where its headquarters is located. Due to the increase in the enforcement of the liquidated damages clause throughout the country, many states continue to experience an influx of litigation over this clause. Over the years, some franchisees have successfully challenged the liquidated damages clause by having it stricken as an unenforceable penalty. The law is still catching up to the magnitude of this problem and it is likely an area ripe for litigation until legislation is enacted.

Post Termination Obligations

A franchisor/franchisee relationship is governed pursuant to the terms of a written franchise agreement, which is often several years induration. During the franchise relationship, both parties are required to comply with their respective obligations under the terms of the franchise agreement. Under the terms of the franchise agreement, the franchisee is required to operate the franchise using the franchisor’s trademark, trade name, trade dress and other proprietary marks.

Upon the expiration and/or termination of the franchise relationship, a franchisee has a mandatory obligation to comply with the post-termination obligations set forth in the franchise agreement. The most important obligation upon termination is for the franchisee to immediately cease to use the franchisor’s proprietary marks and discontinue use of the system, including but not limited to, a removal of all of the distinctive features of the franchisor (i.e., signage). The franchisee can no longer identify itself as a franchisee of the particular franchise system or publicly identify itself as a former franchisee. In addition, a franchisee cannot continue to use the franchisor’s trade secrets, operating procedures, promotional materials or any of the franchisor’s proprietary marks. The franchisee is also required to immediately return to the franchisor a copy of all of the franchisor’s confidential manuals, together with any other materials containing the franchisor’s trade secrets and/or operating instructions or business practices.

Many franchise agreement state that if a franchisee has failed to comply with its post-termination obligations within thirty (30) days of termination, the franchisor or its agents may enter the premises at the franchisee’s expense and complete the de-identification process. Franchisors reserve this right in order to ensure that the franchisee’s continued and improper use of the franchise system does not dilute the franchisor’s trademarks.

It is imperative that a franchisee pay close attention to the post-termination obligations specified in the franchise agreement. A franchisee’s failure to promptly complete the de-identification process can subject the franchisee to liability under the federal Lanham Act, which governs the use of a third-party’s proprietary marks. Specifically, in the event that a franchisor is forced to initiate legal action against a former franchisee as a result of the former franchisee’s failure to de-identify the premises, the franchise can be held liable for up to three (3) times the damages suffered by the franchisor, as well as be required to disgorge all profits earned during the infringement period.

If you need further assistance in addressing your post-termination obligations under the franchise agreements, please call us to discuss this further. Zarco Einhorn Salkowski & Brito, P.A.’s attorneys regularly deal with post-termination issues throughout the country.

Underreporting and Related Issues

The obligation of a franchisee to pay royalties to the franchisor is an ever-present aspect of the franchise relationship. The franchisor collects royalties from the franchisees to fund the services which the franchisor must provide to the entire franchise system. Each franchisee pays a royalty for the benefit of participating in and receiving the benefits of the franchise system.

The amount of royalty payments that a franchisee must pay is generally calculated as a percentage of revenue earned from sales. A franchisee that underreports the amount of revenue earned or sales made and therefore pays the franchisor a smaller amount than is actually due is engaging in risky behavior. Franchise Agreements generally contain provisions that allow the franchisor to conduct audits and inspect the books and records of its franchisees. If the franchisor discovers the underreporting, the franchisor may simply allow the franchisee to pay the amount due and continue the franchise relationship. However, the franchisor may also decide to terminate the franchise agreement, particularly if the franchisee has underreported sales in the past.

If a franchisor is not providing its franchisee with the benefits of the franchise system (adequate training, support, advertising, etc.), the franchisee may resort to a royalty strike and cease paying royalties until the franchisor fulfills its obligations. This is a very dangerous strategy which no franchisee should pursue. Failing to pay royalties is a breach of the franchise agreement. A franchisee that does not pay royalties may be treated by the franchisor as having terminated the franchise agreement. The franchisor may then withdraw its permission for the franchisee to use the brand’s trademarks, and if the franchisee continues to use the trademarks without the owner/franchisor’s approval, he or she is infringing on the licensor’s property rights. In the end, the costs of not paying royalties will exceed the costs incurred in dealing with the consequences of such nonpayment.

A franchisee may not know how to handle a situation in which a franchisor is not living up to its obligations, or if a franchisee finds that it is not able to meet its royalty obligations. The attorneys of Zarco Einhorn Salkowski & Brito, P.A. have represented many franchisees dealing with these and other similar issues. If you wish to know more about your obligations to pay royalties, including your rights under your franchise agreement, please contact Zarco Einhorn Salkowski & Brito, P.A. to discuss the alternatives available to you.

Statutory Violations

The Franchise Disclosure Document

In order to enable franchisees to protect themselves before investing into a franchise, the Federal Trade Commission (“FTC”) issued the Franchise Rule. The Franchise Rule requires franchisors to furnish potential franchisees with a written disclosure document, or a Franchise Disclosure Document (“FDD”), providing twenty-three (23) categories of information about the franchisor, the franchised business and the franchise relationship.

The Franchise Rule requires the franchisor to provide a FDD to a prospective franchisee at the earliest of: (i) the first face-to-face meeting with the prospective franchisee at which the sale of a franchise is discussed; (ii) ten business days before the prospective franchisee pays any money to the franchisor; or (iii) ten business days before the franchisee signs any contract with the franchisor. The franchisor is also required to provide the prospective franchisee with all of the franchise contracts that he is required to sign, in the form in which they will be signed, at least (5) business days before he signs them. These two (2) delivery requirements may run concurrently; however, a prospective franchisee may not waive these requirements.

Fifteen (15) states have passed laws requiring franchisors to provide pre-sale disclosures to prospective franchisees. Eleven (11) of these states require that the FDD be filed with, and approved by, the state before the franchisor can offer to sell franchises in that state. The eleven (11) registration states are as follows: (i) California; (ii) Hawaii; (iii) Illinois; (iv) Maryland; (v) Minnesota; (vi) New York; (vii) North Dakota; (viii) Rhode Island; (ix) South Dakota; (x) Virginia; and (xi) Washington. The remaining four (4) states (i.e., Indiana, Michigan, Oregon and Wisconsin) have less stringent requirements.

Unlike the above states, the Franchise Rule does not require registration, filing, review or approval by the FTC. In the event that a franchisor does not comply with the Franchise Rule, the FTC has authority to seek penalties against the franchisor. Each of the fifteen (15) states has similar power to seek penalties if a franchisor offers or sells any unregistered franchises, fails to timely provide a FDD to a prospective franchisee or engages in any misrepresentation. Significantly, officers and directors of a franchisor can be held personally liable if they had knowledge or participated in the violation.

Private parties cannot sue for a violation of the Franchise Rule. Most of the registration states do, in fact, grant a private cause of action against the franchisor for violation of the statute. A prospective franchisee can successfully recover damages, obtain rescission of the franchise agreements and also recover attorneys’ fees and costs.

The FDD is the single most important document that a prospective franchisee receives from a franchisor. Zarco Einhorn Salkowski & Brito is well-versed in reviewing and analyzing the FDD with a prospective franchisee, and also assessing the pros and cons of the franchisor. If you are interested in a particular franchise, please call us to discuss and review the FDD and to assess the franchise system as a whole.

Statutory Violations

Franchises are regulated at both the Federal and State levels. The aim of these regulations is to protect investors in franchises and assure that investors receive sufficient information to make a reasoned choice.

Specifically, the Federal Trade Commission (FTC) has formulated the Franchise and Business Opportunity to a minimum Disclosure Rule. The Rule requires that sellers of franchises and other types of business opportunities conform standard of disclosure, and requires franchisors to furnish prospective franchisees with detailed information about the franchisor, the franchisor’s business, and the terms of the franchise agreement. The FTC permits franchisors to distribute to prospective franchisees a Franchise Disclosure Document (FDD) to comply with the FTC disclosure rules. Franchisors are also regulated at the State level. Franchise regulation at the State level may include franchise relations laws, franchise business opportunity laws, and franchise disclosure laws. The State franchise laws seek primarily to protect franchisees from perceived abuses and overreaching from franchisors. If you are a franchisee or considering becoming a franchisee and have questions concerning your rights as a franchisee, please contact Zarco Einhorn Salkowski & Brito, P.A. to discuss how we can assist you.

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