In a recent post on this site, I argued that (absent a specific agreement) there is no general requirement that the Awards issued in arbitration must remain secret and that:
Lawyers that try cases for a living know both intrinsically and anecdotally the risk of hearing frivolous arguments and perjury is much higher when the offending lawyers and witnesses believe their words will most likely remain secret. The deliberately mistaken belief that arguments can be made in secret, often heard from franchisors seeking one-sided advantage from secrecy, inevitably spawns the presentation of arguments that would be sanctionable if made in open court and which sometimes cross the line into moral outrage.
A perfect example of this was presented in a recently concluded Arbitration in which the Arbitrator rejected a $25 million damages claim being asserted by the Franchisor against a terminated Area Developer as being “disproportionate, unreasonable, unconscionable and grossly oppressive.” The same Arbitrator held that the Franchisor could not recover Liquidated Damages from the same Area Developer, which was also a franchisee of a failed unit, because the LD clause was an unenforceable penalty under the facts of the case.
I respectfully submit that in a court of law, in a trial open to the press and public and where the decision would be published and become a precedent for future cases, a franchisor would be very reluctant to make claims that are “disproportionate, unreasonable, unconscionable and grossly oppressive.” So why did Tilted Kilt Franchise Operating LLC (the proprietor of the TILTED KILT “breastuarant” pubs) feel free to make these “disproportionate, unreasonable, unconscionable and grossly oppressive” arguments in Arbitration? The apparent reason is this franchisor would prefer to argue in perceived secrecy, lest the world of prospective franchisees be clued in to how this franchisor and its attorneys (veteran members of the American Bar Association Forum on Franchising) prefer to operate.
Not only does the perception of secrecy spawn bad behavior, in this as in most areas of life, a deeper problem is that secrecy in arbitration serves by design to weaken the "common law" by creating a new brand of "private law" in which the same franchisor is free to repeat the same “disproportionate, unreasonable, unconscionable and grossly oppressive" arguments in its next arbitration. Injured from this intended secrecy are the next franchisees that might not have the same success defeating these claims as well as future franchisees who might buy into a brand without knowing it is dealing with a company that is all too willing to make arguments and claims that do indeed cross the line into moral outrage.
My colleague Jackie Condella and I are proud to have defeated these damage claims in this particular case and we would be delighted to share the elements of the arguments we made to benefit other franchisees facing similary ludicrous claims.
But there was another aspect of this decision we find equally troubling that we will address in a separate post.
Until then, lawyers committed to justice must work towards bringing arbitration awards into the light of day.
Court Rules Franchise Laws Reflect Fundamental State Policies That Cannot Be Disclaimed by Contract
Posted Tue, 2017-10-03 16:25 by Peter Lagarias
An Arizona court has ruled that franchise disclosure laws reflect fundamental state policies, which cannot be disclaimed by contract fine print in Zounds Hearing Franchising, LLC v. Bower.
Four franchisees of Zounds Hearing Franchising, LLC brought a group lawsuit in Ohio alleging that the franchisor violated the Ohio Business Opportunity Law by making earnings claims not in their disclosure document, making false statements, and by failing to provide a five-day cancellation right.
The franchisees had not fared well in their operations. Two were already out of business.
Zounds responded by moving to enforce multiple fine print provisions from its standard franchise agreement and then the fireworks began. Next, Zounds filed four lawsuits in Arizona seeking to enforce the one-sided provisions against each Ohio franchisee separately. The four separate Arizona lawsuits sought to enforce an individual action clause prohibiting group lawsuits, and to force individual mediations in Arizona as specified in another contract term written by Zounds. In the group lawsuit filed by the franchisees in Ohio, Zounds moved to dismiss under these many provisions, and alternatively invoked a venue provision requiring that suits be brought only on its home turf in Arizona. Zounds’ motion to transfer was granted by a federal judge in Ohio, and the case was sent to Arizona where the four individual actions were already pending.
Zounds next moved to enforce its individual action and Arizona mediation clauses and to apply Arizona law under the Arizona choice-of-law provision it had written into its franchise agreements. Arizona, unlike Ohio, had no franchise statute providing for a five-day cancellation notice, for mandatory earnings claims disclosures, and prohibiting false representations in franchise sales. Citing the Arizona choice-of-law clause, Zounds asked the court to dismiss the franchisees’ claims under Ohio law. Thus, the question was could the Ohio Business Opportunity Law claims survive the Arizona choice-of-law clause under a conflict of law analysis?
Senior United States District Judge Neil Wake said no; Zounds could not contract its way out of the laws which Ohio has enacted to protect its own residents in the sale of franchises. In a thorough opinion Judge Wake also explained why some previous cases denying enforcement of such choice-of-law clauses were correct, and why cases granting enforcement of choice-of-law provisions in such situations should not to be followed.
The decision is worth a careful reading. Here is a portion of what Judge Wake found as an “easy” decision:
Under choice-of-law principles, parties cannot circumvent by contract the investor protections a state provides to all within its boundaries, especially for its own residents . . . First, the franchise and the franchisees are both located in Ohio. In those circumstances, a foreign-domiciled franchisor may not “contract” out of the Ohio protections any more than an Ohio-domiciled franchisor could. There is no scenario in which another state would have a materially greater interest in having its less protective franchise laws applied than the more protective laws of the state in which the franchisee resides and the franchise operates.
The decision continued with a five-fold victory for the Zounds franchisees. Judge Wake refused to enforce the Arizona venue clause and ordered the case transferred back to Ohio. Judge Wake also voided the bar on joint suits by franchisees, allowing the franchisees to continue jointly rather than having to pursue four separate and prohibitively expensive individual lawsuits. Accordingly, Judge Wake ordered mediation of the four franchisees claims to occur jointly in Ohio rather than Arizona. And Judge Wake ordered Zounds to pay the franchisees’ attorney’s fees. The victory of the Zounds franchisees and their counsel was critical, given the cost of individual mediations in Arizona and possible dismissal of claims in Arizona. And at the end of the day, on an issue many franchisees have fought for years, the court came down clearly and definitively on their side. Franchisors should not be able to avoid state franchise and business opportunity disclosure laws enacted as important public policy to protect their citizens, by use of venue, choice-of-law, integration, no representation and no reliance provisions.
In addition to several new chapters addressing key concerns for franchise prospects and how the franchise business model has evolved over the years, I have also included the Franchise Glossary to provide readers with definitions for key terms they’ll see during the due diligence process. This is the first time the glossary, which is also found inThe Franchisee Workbook (a fill-in-the-blank step-by-step workbook that will help address everything a modern-day prospect will face during their franchise exploration process), is making an appearance in The Educated Franchisee.
As a teaser, I’d like to share with you 10 key franchise terms and definitions readers can find in the glossary that can help educate themselves about all aspects of franchising.
Franchise - The FTCFranchise Rule defines a “franchise” as an arrangement whereby a franchisor grants franchisees the right to operate a business that: 1) is identified with the franchisor’strademark; 2) is subject to the franchisor’ssignificant control and/or assistance; and 3) in exchange for which, the franchisee pays a “franchise fee” to the franchisor or its affiliate. Most state franchise lawsadopt a definition (except in New York, where any combination of elements 1 and 3, or elements 2 and 3, are enough to satisfy the state law definition of “franchise”).
Discovery Day - An event set up by the franchisor so that potential franchisees may learn more about becoming a franchisee. A discovery day typically takes place at the franchisors headquarters and is often the final step in the due diligenceprocess. It provides the opportunity to meet the management team, support team, and trainers face-to-face. Occasionally called “Meet The Team Day” or “Open House.”
Due Diligence - Usually undertaken by investors, but also customers, due diligencerefers to the process of making sure that someone is what they say they are and can do what they claim; i.e., investigation of a business (e.g., Does the product or system really work? Does the franchise really have customers?).
Financial Performance Representation - Any oral, visual, or written representation to a prospective franchisee or for general dissemination in the media which states or suggests a specific level or range of potential or actual sales, income, gross, or net profit. This information must be provided in Item 19 of the Franchise Disclosure Document. Previously called “Earnings Claim.”
Franchise Disclosure Document - The Franchise Disclosure Document (FDD) is the form for providing disclosure in the U.S. under the FTC Franchise Rule. Before the 2007 amendments to the FTC Franchise Rule, the principal format for providing disclosure in the U.S. was a document prepared under the “Uniform Franchise Offering Circular” (UFOC) format. The FDD provides extensive information about the franchisor and the franchise organization in a uniform format, which a prospective franchisee can use to compare different franchiseofferings. The FDD is meant to give a potential franchisee certain specified information to help make educated decisions about their potential investments. Also see “Disclosure Document” and “FTC Franchise Rule.” NOTE – The Educated Franchisee Resource Center, an extension of the print edition of the book, includes The FDD Exchange,an online Franchise Disclosure Document library with more than 2,500 FDDs from leading franchise brands in various industries.
Area Developer - The franchisor awards a single franchisee the right to operate more than one unit within a defined area, under a development agreement and based on an agreed-upon development schedule.
Master Franchisee - A system whereby a franchisor grants to a party (usually referred to as the Master Franchisee) the right to operate franchised businesses and to grant sub-franchises to third parties, within an agreed-upon geographic area. The Master Franchisee serves as if it were the “franchisor” within the sub-franchise territory, providing localized support services within the territory. The Master Franchisee typically retains a portion of the royalty as compensation for its services.
Operations Manual - The document detailing the operation of a particular franchised business. Operations manuals—also called franchise manuals—describe such items as: quality control requirements; recommended hours of operation and financial and management practices; the correct use of any trademarks or trade names; forms and written materials for use in business operations; payment of fees and royalties; approved suppliers; and so on. Increasingly, operations manuals also address other matters, such as systemwide policies concerning data, environmental and energy standards, health and safety matters, etc.
Royalty Fee - A regular and continuing payment made by the franchisee to the franchisor, often paid on a weekly or monthly basis. The royalty may be a percentage of sales, a fixed recurring fee, or a combination. Royalties commonly cover use of a trademark and trade name and also constitute a fee for services performed by the franchisor such as training and assistance, marketing, advertising, accounting, and so on. Also called “service fees” and/or “license fees.”
SBA-Guaranteed Loan - A program of financial assistance available to small business owners from the U.S. Small Business Administration (SBA). While the SBA seldom loans money directly to franchisees, an SBA guaranteed loan makes it easier for a qualified individual to borrow money from a commercial lending institution, such as a bank. Under the program, the loan is made directly by the bank to the franchisee. The SBA protects the bank against financial loss in the event of business failure.
The Franchise Glossary has almost 200 key terms that will help educate the reader on all of the ins and outs of the franchise process. The Educated Franchisee is now available for purchase through Amazon and in bookstores around the country.
Last fall, the North American Securities Administrators Association Inc. (NASAA) issued a notice of request seeking public comment on an updated proposed financial performance representations (or FPR) Commentary. The Federal Trade Commission's Amended Franchise Rule, 16 CFR Parts 436 and 437, permits a franchisor to disclose financial results in Item 19 of a franchise disclosure document (FDD) as long as the franchisor has "a reasonable basis" for the representation. The FTC Rule does not define what constitutes a "reasonable basis," and the FPR Commentary purports to provide more clarity by creating a set of guidelines that will govern the disclosure of financial results in Item 19 (including prohibiting certain disclosures) and what support or factual information franchisors must provide when making specific types of FPRs. Ultimately, the proposed FPR Commentary seeks to address various questions raised by franchisors, their representatives, and state franchise examiners regarding FPRs.
The FPR Commentary has not yet been formally approved by NASAA (which could occur at its Spring Conference in May 2017, or at its Annual Conference in September 2017), and thus will not likely be final and formally effective until the 2018 franchise registration and renewal period. It could still be modified from its current version. But some state franchise examiners have indicated that they plan on using the FPR Commentary as guidance when reviewing FPRs during the 2017 renewal period. (Indeed, because the FPR Commentary purports to clarify the "reasonable basis" requirement in the FTC Rule, it provides the examiners wide latitude to issue comments based on what they believe a "reasonable basis" entails.)
We therefore recommend that franchisors take a look at their FPRs this year to ensure that they comply with the FPR Commentary as currently written and consider the following modifications where necessary:
Medians/averages. Wherever franchisors provide an average or mean of numbers in the FPR (such as sales or number of years the outlets in the FPR were open), they must include the median figure for the information and vice versa. The theory behind this requirement is that the existence of outliers may skew both an average and a median.
High/low figures. In addition, where average and median figures are provided, franchisors must disclose the high and low figures in the sample set. For example, if a franchisor provides average monthly sales information in its FPR, the franchisor would need to add the highest and lowest monthly outlet sales in the sample set.
Subsets. Many franchisors disclose FPRs for subsets of outlets, often the best performing outlets (e.g., top 10 percent, top 20 percent). The FPR Commentary provides that a franchisor may not separately disclose the best performing outlets without also disclosing a subset of the corresponding lowest performers (e.g., bottom 10 percent, bottom 20 percent). Additionally, a franchisor may not base a subset on fewer than 10 outlets.
Gross sales based on company-owned outlets. The FPR Commentary states that if a franchisor has operational franchised outlets, it cannot make a gross sales FPR based on company-owned data alone. However, if the franchisor has no operational franchised outlets, the franchisor can make a gross sales FPR based solely on company-owned outlet data.
Gross/net profit based on company-owned outlets. Whether or not a franchisor has operational franchised outlets, a franchisor can make an FPR disclosing gross or net profit based solely on company-owned data. However, when using this company-owned data, franchisors must account for material financial and operational differences between company-owned outlets and operational franchised outlets in their FPRs. Wherever franchisees are likely to incur additional or higher costs, those costs must be described or added to the company-owned outlet P&Ls. Examples of these costs include imputed royalties, advertising fund contributions or other fees paid by franchisees if these fees are not otherwise paid by company-owned outlets or paid at a different rate than franchisees and other costs which franchisees incur which are not incurred in a company-owned outlet. The FPR Commentary states that this additional information must be presented in the same format as the rest of the FPR. In the past, franchisors have provided this information often in footnotes to the FPR. The FPR Commentary rules out the use of footnotes and states that if the FPR is provided in tabular format, this additional information must be included within or added to the end of the table.
Omission of outlets that have closed. Franchisors should clarify any sample sets, including by listing the number of outlets that are excluded from the sample set because they closed during the reporting period. Under a typical FPR, a franchisor may define the sample set as follows: (i) there were X outlets at year end; (ii) Y outlets were removed from the sample for the following reasons; and (iii) the sample set is X minus Y outlets. However, when clarifying that a franchisor can exclude from the sample set outlets that closed during the reporting period, the FPR Commentary provides that the franchisor must disclose: (1) the number of company-owned and/or franchised outlets that closed during the time period; and (2) the number of excluded outlets that closed during the same time period after being open less than 12 months.
Merging data. The FPR Commentary permits a franchisor to merge company-owned and franchised data in a single table but only if the franchisor also discloses the data from the company-owned and the franchised outlets separately. The only exception to this requirement is when the franchisor has a very small number of franchisees (less than 10) that the identity of the franchisees would be discernible. In such case, the data may be presented in the merged format only as long as the franchisor can represent that there is no material difference between the company-owned and franchised data.
Admonitions. The FPR Commentary requires the specifics of the form and substance of admonitions that franchisors may use in their FPRs. The admonition must be presented in a separate paragraph from the rest of the FPR and must be in bold type but may not be in capital letters, underlined or in larger type than the rest of the FPR. The form and substance of the admonition must be as follows (with modifications provided only to define the scope of the information provided):
"Some outlets have earned this amount. Your individual results may differ. There is no assurance that you'll earn as much."
If a franchisor chooses not to follow the FPR Commentary this renewal season and receives a comment from a state examiner who is following the proposed FPR Commentary, the franchisor must consider FTC Rule FAQ #38. In FAQ #38, the FTC addressed the question of what a franchisor must do if required by a state to modify an FPR and whether the unaltered FPR could still be delivered to prospective franchisees in other states. The FTC concluded that a failure to make any resulting changes to the FPR in all other states raises significant concerns about whether the FPR meets the requirements of the FTC Rule.
Therefore, if a franchisor chooses not to incorporate the language of the FPR Commentary during this renewal cycle and receives a comment from a state examiner requiring inclusion of additional/modified information in Item 19, the logic of FAQ #38 might be asserted to require that that franchisor incur the costs and burden of having to amend franchise registrations in all states in which the franchisor is registered based on these comments.