Source: https://iclg.com/practice-areas/franchise/franchise-2017/usa
Timestamp: 2017-08-18 16:27:12
Document Index: 418940734

Matched Legal Cases: ['art 436', '§1', '§12', '§13', '§15', '§80', '§16600', '§1051', '§1831', '§1836', '§1837', '§365', '§151']

Franchise 2017 | Laws and Regulations | USA | ICLG
Home Practice area Franchise Franchise 2017 USA
Franchising is a heavily regulated industry, and the patchwork of federal and state laws governing franchising is complex. On the federal level, the U.S. Federal Trade Commission (“FTC”) promulgated 16 C.F.R. Part 436 (the “FTC Franchise Rule”). Under the FTC Franchise Rule, any continuing commercial relationship or arrangement will be deemed a “franchise” if the terms of the contract (whether oral or written) meet the following three definitional elements:
(i) the franchisee will obtain the right to operate a business that is 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;
(ii) the franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provides significant assistance in the franchisee’s method of operation; and
(iii) as a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate. According to the FTC’s Compliance Guide, the required payment must be a minimum of at least $500 during the first six months of operations.
On the state level, the legal definition of a “franchise” varies. Under California, Illinois, Indiana, Iowa, Maryland, Michigan, North Dakota, Oregon, Rhode Island, Virginia, Washington, and Wisconsin laws, a “franchise” is defined as a contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:
(i) a franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services, under a marketing plan or system prescribed or suggested in substantial part by a franchisor;
(ii) the operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate; and
(iii) the person granted the right to engage in such business is required to pay to the franchisor or an affiliate of the franchisor, directly or indirectly, a franchise fee of $500 or more.
In Hawaii, Minnesota, Mississippi, Nebraska and South Dakota, a “franchise” is defined as an oral or written contract or agreement, either expressed or implied, in which:
(i) a person grants to another person, a licence to use a trade name, service mark, trademark, logotype or related characteristic;
(ii) there is a community interest in the business of offering, selling, or distributing goods or services at wholesale or retail, leasing, or otherwise; and
(iii) the franchisee is required to pay, directly or indirectly, a franchise fee.
Under this definition, “community interest” means a continuing financial interest between the franchisor and franchisee in the operation of the franchise business.
The definitions of a franchise in states like Connecticut, Missouri, New York and New Jersey, include only two of the definitional elements required by the states listed above. For example, in Connecticut a “franchise” is defined as an oral or written agreement or arrangement in which:
(i) a franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and
(ii) the operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, service mark, tradename, logotype, advertising or other commercial symbol designating the franchisor or its affiliate.
Under New Jersey’s statutory definition of a “franchise”:
(i) there must be a written agreement in which one person grants another a licence to use a trade name, trademark, service mark, or related characteristic; and
(ii) there must be a community of interest in the marketing of the goods and services being offered.
In New York, however, a franchise is established if there is contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:
(i) a franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor, and the franchisee is required to pay, directly or indirectly, a franchise fee; or
(ii) a franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor or its affiliate, and the franchisee is required to pay, directly or indirectly, a franchise fee.
Under the FTC Franchise Rule, franchisors are mandated to provide a prospective franchisee with material information (including, but not limited to, background information on the franchisor, the costs associated with operating a franchise and the legal obligations of the franchisor and franchisee) prior to the sale of a franchise. This material information must be disclosed in a Franchise Disclosure Document (“FDD”). Fifteen (15) states have registration and/or disclosure requirements that must be met before a franchise can be offered and sold in that state. Only eleven (11) of these states require that: (i) a state agency review the FDD; and (ii) the franchisor register its franchise programme with the state. In “registration states”, the franchisor and/or the disclosure document must be registered and approved by the appropriate state agency before the franchisor can commence any franchise sales activities in the state. Nineteen (19) states have promulgated laws that govern the various facets of the franchisor/franchisee relationship. Generally these relationship laws regulate, among other things, the franchisors’ ability to terminate or refuse renewal of the franchise agreement by requiring that a franchisor have “good cause” to terminate or not renew a franchise agreement. In addition to addressing termination and renewal, these relationship laws may also: (i) impose restrictions on transfer; (ii) grant franchisees the right to form an association with other franchisees in the same system; (iii) obligate the franchisor to repurchase inventory, etc. Twenty-eight (28) states have unfair trade practice acts that allow “consumers” to assert a private right of action for unfair trade practices. These statutes are commonly referred to as “Little FTC Acts” because they provide that a violation of the federal FTC Act or related regulations, including the FTC Franchise Rule, is automatically a violation of the state Little FTC Act. Twenty-five (25) states have business opportunity laws which extend the disclosure protections afforded to franchisees to consumers that purchase business opportunities, including franchisees. Under these laws, sellers are obligated to prepare and disclose certain information to prospective buyers prior to the consummation of a sale. Typically the information required to be disclosed by sellers under these business opportunity laws is not as extensive as the information that is required to be disclosed under federal and state franchise laws.
Most franchisors use business format franchising to expand their brand in different consumer markets. However, some franchisors, particularly foreign franchisors, looking to establish their presence in another country, like the United States, will appoint a single franchisee/licensee to develop, market and operate units under their brand. This form of expansion is more commonly referred to as master franchising. Under this form of expansion, master franchisees/subfranchisors are treated as franchisees for the purposes of disclosure and franchise registration laws. Thus, franchisors are required to provide prospective master franchisees/subfranchisors with an FDD.
The FTC Franchise Rule only has a pre-sale disclosure requirement; it does not impose registration requirements upon franchisors. However, as noted in the response to question 1.2 above, fourteen (14) states have franchise filing or registration laws, requiring a franchisor to either: (i) register their FDD; or (ii) file a notice of intent with the appropriate regulatory authority prior to any offer or sale of a franchise or multi-unit development rights within the state.
Any violation of the disclosure requirement under the FTC Franchise Rule constitutes a violation of the U.S. Federal Trade Commission Act, and grants the FTC the right to sue franchisors in federal court and seek any or all of the following remedies: (i) civil penalties of up to $11,000 per violation; (ii) injunctive relief with respect to violations of the FTC Franchise Rule, including barring franchise sales in the United States; and (iii) restitution, rescission, or damages on behalf of the affected franchisees. While the FTC can bring an action against franchisors that violate the FTC Franchise Rule, aggrieved franchisees do not have a private right of action under the Rule. However, the same is not true under state franchise disclosure laws, which allow an aggrieved franchisee to bring an action against the franchisor. These claims most commonly include actions for rescission of the franchise agreement and/or actions for actual damages (including reasonable attorneys’ fees and expenses).
While the FTC Franchise Rule does not directly address master franchising, the North American Securities Administrators Association, Inc. (“NASAA”) has adopted a Multi-Unit Commentary that provides franchisors with practical guidance concerning their disclosure obligations with respect to certain multi-unit franchising arrangements, including master franchising. The NASAA guidelines indicate that franchisors are required to prepare and provide master franchisees/subfranchisors with a FDD that is separate from the FDD the franchisor would use to sell single unit franchises and area development rights. Not only are franchisors required to abide by the same pre-sale disclosure and registration laws imposed on franchisors selling single unit franchise opportunities and multi-unit development rights to franchisees and area developers, but master franchisee/subfranchisors are also responsible for preparing and providing their own FDD in connection with their offer and sale of subfranchises and, where applicable, complying with state registration requirements.
The FTC Franchise Rule requires every franchisor to present an FDD to prospective franchisees. The FDD is a (usually) lengthy and (always) detailed document comprised of twenty-three (23) sections (referred to as “Items”) and accompanying exhibits. The FDD provides prospective franchisees with insight into, among other things: (i) the history of the franchisor (and any parent or affiliate), including any history of bankruptcy or litigation; (ii) the business experience of the franchisor’s principals; (iii) the recurring or occasional fees associated with operating the franchised business; (iv) an estimate of the initial investment in order to commence operations; (v) the products (and sources for those products) that the franchisor wants the franchisee to use and/or purchase in connection with the operation of the franchised business; (vi) any direct or indirect financing (along with the terms of such financing) being offered by the franchisor; (vii) a list of all of the franchisor’s word marks, service marks, trademarks, slogans, designs, and patents that will be used in connection with the operation of the franchised business; (viii) the territory in which the franchisee will operate, along with any rights retained by the franchisor to operate or cause a third party to operate in such territory; (ix) the exit strategies available to the franchisee and franchisor; (x) a description of how disputes are resolved; and (xi) the franchisor’s financial performance, etc.
Franchisors are not required by federal or state statute to provide prospective franchisees with any financial performance information. However, franchisors who elect to provide financial performance representations (such as past or projected revenues or sales, gross income, net income or profits) and representations about the actual or potential financial performance of its franchised and/or franchisor-owned “outlets” may do so in Item 19 of the FDD; provided that there is a reasonable basis for the information and that such information is properly disclosed. Depending on the nature of the representations, improper financial performance representations could give rise to a governmental or private cause of action under federal, state and/or common law.
There are several business and legal matters (other than registration and disclosure requirements) that franchisors should address before they offer and sell franchise opportunities or multi-unit development rights.
Trademark and Assumed Business Name Registration. One of the essential definitional elements of a franchise that is found in all federal and state franchise statutes is the ability to use the franchisor’s trademark in connection with the operation of the franchised business. With this fundamental element in place, franchisors should look to register all trademarks, service marks, trade names, logos, domain names, or other commercial symbols that will be used in connection with the franchise system, prior to offering and selling franchises. Additionally, franchisors should register any assumed business names under which they operate with the proper administrative agency, prior to offering and selling franchises, in order to protect their rights to use that particular assumed name.
Advertising Materials Related to the Sale of Franchises. Certain registration states require that franchisors submit for approval any materials that advertise the sale of franchises prior to the advertisement’s first publication in that state.
Registration of Franchise Brokers and Sellers. Certain states require franchisors to register their franchise sellers with the appropriate regulatory agency before that person is permitted to begin selling franchises or multi-unit development rights in that state. In these states, franchisors must file a Franchise Seller Disclosure Form for each franchise seller, which includes the seller’s name, business address and phone number, his or her employer, title, five-year employment history and information about certain relevant litigation and bankruptcy matters. In instances where a franchisor elects to use a franchise sales broker, two states (New York and Washington) require franchisors to file a separate registration form that provides the state with more detailed information about the broker. These states additionally require the broker to have a licence from the state prior to engaging in franchise sales activities in the state. A Franchise Seller Disclosure Form and/or Franchise Broker Registration Form must be submitted with each initial registration application, annual renewal application and any post-amendments to a franchisor’s FDD.
Membership in a national franchise association is not mandatory, but it is advisable. Many franchisors, individual franchisees and businesses that service the franchising industry are members of the International Franchise Association (“IFA”), which is the largest and oldest global franchising organisation. The IFA provides its members with a plethora of valuable information (including, but not limited to, the latest legal developments affecting the franchising industry, networking platforms, franchise opportunity information) relating to the franchising industry. Go to IFA’s website for more information: http://www.franchise.org. Many franchisees and franchisee associations are members of the American Association of Franchisees and Dealers. More information on the AAFD can be found at https://www.aafd.org. The AAFD has promulgated a code of Fair Franchising Standards which sets forth the AAFD’s view of requirements for a more “level playing field” between franchisors and franchisees.
The IFA has a Code of Ethics that can be found at http://www.franchise.org/mission-statementvisioncode-of-ethics. This Code of Ethics provides IFA’s members with a framework for the manner in which they are to act in their franchise relationships; however, this Code of Ethics does not have the force or effect of law.
No, federal and state law only require that the FDD be written in “plain English”.
Generally, there are no restrictions relating to foreign investment in a business in the United States. As such, restrictions are contrary to the general approach to free trade; it is typically countries with developing markets that seek to impose such “foreign investment” restrictions and regulations. However, the U.S. federal government does impose certain restrictions, including for example, the requirement for disclosure filings and/or imposing actual limits on foreign investment that may apply to certain industries or businesses, most notably those having a potential impact on national security (such as banking, technology, weapons manufacture, maritime, aircraft, energy, etc.). As typical franchise opportunities do not involve these industries, franchisors are not often affected by such restrictions.
As is frequently the case with other businesses, franchisors operating in the United States typically will utilise a corporation or limited liability company (“LLC”) as their preferred forms of business entity. While each type offers “limited liability” to its owners, choosing between the two will depend on the legal, financial and tax needs of the principals. If a franchisor chooses the corporate form, most often a “C corporation” is used. Income received by a C corporation is taxed at the entity level and profits are again taxed by the individual shareholders when distributions are made. Some businesses, typically small, closely held entities, for example franchisees, elect to choose “S corporation” status, for example. It is also important to note that foreign investors are prohibited from being owners of S corporations. LLCs offer greater flexibility than corporations in certain areas, including, for example, governance requirements, income allocation and transfer assets out of the entity. Both S corporations and LLCs are usually treated as “pass through” entities for tax purposes, where the entity’s profits flow through to the company’s owners, who pay taxes on their taxable income, proportionately to their ownership percentage. However, an LLC may elect to be treated as a C corporation for tax purposes.
While foreign franchisors are permitted to sell directly to prospective franchisees located within the United States, foreign franchisors usually choose to use one or more affiliates or subsidiaries to conduct their U.S. operations. However, if a U.S. franchisor is a wholly owned subsidiary of a foreign parent, then financial disclosures regarding the foreign parent will also have to be included in the U.S. franchisor’s “prospectus” (called the Franchise Disclosure Document or FDD, which is given to all prospective franchisees). Usually, franchisors (including foreign franchisors) find it useful to utilise a tiered “corporate” structure comprising a holding company and several subsidiary operating entities. For example, one operating entity may own the intellectual property rights associated with the franchise system; another might be the “franchisor entity” which would enter into the franchise (and other) agreements with franchisees; another might be a management company which could provide the various “franchisor” services to the franchisees; and yet another could purchase, sell or lease equipment to franchised or company-owned units. Typically, separate entities are formed in order to hold title to parcels of real estate or enter into leases.
In international franchising, franchisors usually establish a franchise network by utilising either (or sometimes both) the master franchise (or sub-franchisor) method and/or the area development method. Many franchisors, including foreign franchisors, do not only rely on selling single unit franchises. The more common approach is the master franchise method, where the master franchisee is granted the right to either develop the assigned territory itself or to sub-franchise the territory to other franchisees, with the master franchisee taking on “franchisor” obligations and typically receiving a significant share of the initial franchise fees and ongoing royalty payments paid by the franchisees within the territory. Alternatively, some franchisors, who wish to retain more control over their franchise network and don’t wish to share their franchise fees with a master franchisee, will grant territories to “area developers” who obligate themselves to develop their territories, but have no rights to offer sub-franchises to other franchisees. Since the U.S. is a large country with varying demographics and cultures, franchisors may utilise a combination of the master franchise and area development franchise arrangements to expand their franchise network. Another option is for the franchisor to enter into a “joint venture” with an independent company, presumably, a joint venture partner in the U.S. The partner may have significant experience in operating franchises or the ability to provide significant financial resources to the franchise system, or both. However, the “joint venture” approach has not been frequently utilised.
In the United States, new business entities are formed under state law and their formation documents (for corporations, the Certificate of Incorporation and for LLCs, the Articles of Organisation) are filed with the Secretary of State (or similar agency) in the state of formation. (In a small number of states, there are publication requirements for new business entities, most notably, in New York with respect to LLCs, LLPs and LPs.) Any new business entity formed in the United States is required to obtain a federal taxpayer identification number by filing Form SS-4 with the Internal Revenue Service. If the new entity will conduct business in multiple states, it will likely have to file an application in each state, other than the state of formation, in order to qualify to “do business”. In each state where the entity is authorised to “do business”, it must list an appointed “registered agent” who is located in the particular state upon whom service of process (e.g., lawsuit documents) may be served.
New entities must also register as an employer with their formation state’s department of labour and must withhold proper amounts of various taxes including, for example, income taxes and Federal Insurance Contribution Act (FICA) taxes (which include contributions to federal Social Security and Medicare programmes). A handful of states require certain initial reports and tax forms to be filed, as opposed to waiting to file an annual report. Finally, entities which are involved in certain industries or endeavours may have to obtain one or more licences or permits in order to have authority to properly conduct business in their particular industry.
In the U.S., “competition law” is generally referred to as “antitrust law”. Antitrust laws exist on both the federal and state levels. There are no antitrust laws that regulate the offer and sale of franchises, but antitrust laws may apply to franchises in certain limited circumstances. The FTC Rule (16 C.F.R. 436 et seq.), and statutes in certain states, are not generally considered “antitrust” or “competition” laws, but they do specifically regulate the offer and sale of franchises (discussed in section 1, above).
The major federal antitrust statutes that may apply to franchising are the Sherman Act (15 U.S.C. §1 et seq.) (generally prohibiting anti-competitive or monopolistic conduct), and the Clayton Antitrust Act (15 U.S.C. §§12 et seq.), including the Robinson-Patman Act (at 15 U.S.C. §13) (generally prohibiting anticompetitive price discrimination, exclusive dealing, and tying). The U.S. Dept. of Justice’s Antitrust Div., and the U.S. Federal Trade Commission (“FTC”), cooperate to enforce the federal antitrust laws, while the Clayton Act also authorises private rights of action.
In addition to the federal antitrust statutes, almost every state in the U.S. has enacted its own antitrust laws, which are usually based upon the federal antitrust statutes. However, while these state statutes may be similar, and look to federal law for guidance, there may be differences, and practitioners need to examine both the federal and state laws in the applicable jurisdiction to avoid any potential issues.
The FTC is also responsible for consumer protection enforcement for over 70 different laws, including the FTC Act, which contains a broad prohibition against “unfair and deceptive acts or practices”. See e.g. §15 U.S.C. 45 (“Unfair methods of competition in or affecting commerce, and unfair or deceptive acts or practices in or affecting commerce, are hereby declared unlawful”). Many states also have enacted similar statutory schemes prohibiting unfair or deceptive trade practices. Therefore, there may be circumstances where an offer or sale of a franchise constitutes an “unfair” or “deceptive” act or practice, under either federal law, or an analogous state law.
While antitrust was once a major area of interest for both franchisors and franchisees, courts in recent years have limited the applicability of antitrust laws in the franchise context. Traditionally vexing antitrust claims, such as franchisee complaints of price fixing (e.g.,franchisors setting maximum or minimum prices), exclusive dealing requirements (e.g., requiring franchisees to only deal with particular designated suppliers), or tying (e.g., requiring that franchisees purchase products or services not directly related to the trademarked franchised product or service), have dramatically fallen in the wake of court decisions in the last two decades. Many courts have narrowly restricted the applicable “market” for antitrust analysis in ways that exclude franchise relationships. In addition, courts now increasingly employ the “rule of reason” test in circumstances that would once have been considered per se violations of antitrust laws. In most franchise circumstances, a franchise agreement which clearly provides for (and an FDD which adequately discloses) contractual requirements to purchase certain goods or services, restraints on a franchisee’s ability to freely conduct business, or requirements that franchisees deal with specific vendors, will defeat most antitrust claims.
No. However, there is variation with respect to the enforceability of unlimited terms in specific states. Some states may be reluctant to enforce franchise agreements without a limited term. This may apply to franchise agreements without a specified duration, or automatic renewal agreements that continue in perpetuity (for example, an agreement that renews automatically every 10 years without any limit). On the other end of the spectrum, the New Jersey Franchise Practices Act (NJ Stat. 56:10-1 et seq.) requires a franchisor to automatically renew a franchise agreement, regardless of the stated term in the agreement, so long as a franchisee is in substantial compliance with the franchise agreement. Again, the franchise practitioner is well advised to review all applicable state laws in addition to federal law in connection with this issue.
No. As noted above, there are some states that may be hostile to enforcing agreements without any stated term, but there is no antitrust statutory restriction. The FDD must adequately disclose any required related product supply agreements, and the franchise agreement must clearly provide for it.
Federal antitrust law will prohibit the use of a minimum resale price (“MRP”) if the MRP causes an adverse effect on inter-brand competition under a “rule of reason” test (if it results in an unreasonable restraint of trade concerning competitors, based upon economic factors). Therefore, under federal law, MRPs are permitted, and courts have been reluctant to find violations where there is an economic justification for them, resulting in most cases being dismissed. However, there are state statutes that differ from the federal standard, and which prohibit the use of MRPs. Indeed, while federal law has generally adopted a “rule of reason” standard, state statutes may still consider MRPs to be per se unreasonable restraints of trade, instead of analysing them under the more permissive “rule of reason” test. This area of law is continuing to develop, and state laws may ultimately gravitate towards adopting the federal “rule of reason” analysis.
In general, federal antitrust laws do not require a franchisor to observe any minimum obligations when offering franchises in adjoining territories (or, for that matter, even when a franchisor itself operates in an adjoining territory). The FTC Rule does mandate that an FDD include a detailed disclosure of the rights conferred in any territorial grant, but there are no required obligations. Franchisees typically find it difficult to bring antitrust claims on this basis, as the antitrust laws will generally not consider the applicable “market” for antitrust analysis to be competing franchise locations, but rather the market for franchises generally, when the franchisee purchased the franchise. Further, there will generally be sufficient justification for “territory” competition under the “rule of reason” analysis to avoid federal liability under the federal antitrust laws. However, anti-competitive misconduct on the part of a franchisor that impacts inter-brand competitors could still result in liability, and more restrictive state antitrust statutes may also impose liability for anti-competitive conduct within a particular jurisdiction.
However, improper encroachment or unfair allocation of territories could lead to liability outside of antitrust law (discussed infra), such as for violation of the implied covenant of “good faith and fair dealing”, which many states automatically incorporate by law into every contract. In addition, certain state franchising statutes may restrict or prohibit unfair encroachment activity (see e.g. Minnesota’s Franchise Statute, MN Stat. §80C.14; and Rule 2860.4400, Unfair and Inequitable Practices).
What many franchise practitioners consider to be the “bottom line” in this regard, is that the provisions in the franchise agreement that address the franchisor’s right to operate directly, or to sell franchises, in what may be considered to be the franchisee’s area from which the franchise draws its customers, as opposed to any “protected territory” granted to the franchisee, must be crafted with great care.
In-term and post-term non-compete and non-solicitation of customer clauses are generally enforceable, and there is no prohibition against them under federal antitrust law. However, some states may prohibit or severely restrict post-termination non-competition clauses. California law, for example, generally voids any post-termination non-competition clauses (see e.g. CA B&P Code §§16600 et seq.). In states that restrict non-solicitation and non-compete clauses, the enforceability often depends upon factors bearing upon the reasonableness of the restriction, including whether it is necessary to protect legitimate business interests, whether the restriction is contrary to the public interest, and whether it is reasonable in geographic scope, the scope of business activity being restricted, and the duration of the restriction. For example, a post-term restrictive covenant that only restricts certain activities in direct competition with the franchisor in a small geographic area for one year, is far more likely to be enforceable than a broad covenant seeking to completely restrain all activity in a large area for many years.
On the international level, the United States is a party to the Paris Convention and Madrid Protocol (administered by the World Intellectual Property Organization – “WIPO”), which allows a trademark to be registered internationally with member nations through a uniform process (an “International Application”). Generally, under the Madrid Protocol, a trademark must first be registered “locally” in a member nation, approved, and then submitted to the WIPO for international approval and registration. Once approved at the WIPO level, the mark is submitted to the other member nations in which the mark holder seeks to obtain trademark protection. Each nation then examines the mark to determine whether or not it will grant approval. The process should not exceed 18 months.
In the United States, on the federal level, the United States Patent and Trademark Office (“USPTO”) is the agency responsible for registering trademarks. Applicants can file online with the USPTO, and should regularly check the online monitoring system throughout the process. The USPTO will initially determine if the application has met the minimum filing requirements. If so, it will assign an examining attorney to review the application and determine if any conflicting marks or other defects in the application prevent the application from being granted (which generally takes several months). If an issue with the application arises, the USPTO will issue a letter explaining the reason for refusal or deficiency (an “Office Action”), and the applicant must respond within six months, or the mark will be “abandoned”. If the mark is approved, the USPTO will “publish” the mark, and anyone wishing to challenge it will have 30 days to do so. If no objection is successful, the registration process (which differs slightly if the mark is currently “in use” or not) then continues to formal “registration”, which can take several more months. After a federal trademark is registered, the registrant must, periodically, take steps to renew the mark, and file “maintenance” documents, or risk cancellation. Significantly, a “declaration of use” must be filed between five and six years following registration, and a renewal application must be filed 10 years following registration and every 10 years thereafter (internationally filed marks under the Madrid Protocol follow a slightly different process).
Individual states also have their own trademark registration offices (with their own registration process). While individual state registration is better than not registering, or relying upon common law trademark rights (discussed below), franchisors are well-advised to seek federal registration of their mark(s).
Significantly, in the United States, unlike many jurisdictions, a party can also establish and acquire “common law” rights to a trademark through the usage of a mark in commerce. Common law rights to a mark may be superior to another party’s attempt to subsequently register the same or similar mark, especially if the common law mark is in use prior to the other party’s filing for registration, and the holder of the common law mark objects properly. However, common law rights are not well defined and are often limited by geographic scope and specific industries or markets.
Therefore, while trademarks do not have to be registered to obtain “common law” rights, franchisors are well-advised to proceed with federal registration with the USPTO, as federal registration acts as a “notice to the public” of the franchisor’s claim on the mark, which creates a legal presumption of nationwide ownership and the exclusive right to use the mark (in connection with the goods or services in the registration). Federal law, including the Lanham Act (15 U.S.C. §1051 et seq.), also grants significant legal remedies for federally registered marks (including, under certain circumstances, injunctive relief, treble damages and attorney’s fees). Further, once registered, the federal mark holder has a presumptive argument that it was “first in time” as of its registration (since all objections will either have been rejected, or deemed untimely). After federal trademark protection is granted, a “common law” mark holder will be extremely unlikely to overcome the federal registration.
A trademark holder in the United States is generally required to “police” its mark, by actively monitoring the market to discover infringement, and then to take action against infringers to protect its mark. A franchisor who fails to take timely action against infringers may lose its right to obtain any relief (due to, inter alia, affirmative defences of laches, acquiescence or waiver).
Confidential information, which can include know-how, trade secrets, and other business-critical information, may be protected by federal law or state common law.
On May 11, 2016, President Obama signed the Defend Trade Secrets Act of 2016 into law (see 18 U.S.C. §1831 et seq.) (“DTSA”). The DTSA provides federal protection to trade secrets, and creates a private civil right of action (which may be brought in federal court), for theft or misappropriation of trade secrets, under which an aggrieved party can seek damages, and for willful and malicious violation, double damages and attorney’s fees. A party may also seek injunctive relief, including an ex parte expedited seizure of the trade secret under certain circumstances. See 18 U.S.C. §1836. Importantly for foreign parties, the DTSA also may provide for extra-jurisdictional liability (reaching violators outside of the U.S.). See 18 U.S.C. §1837. Previously, trade secret litigation had to be generally brought pursuant to the applicable state common law, which varied from state to state.
Each state’s common law trade secret protection also applies. There is some variation between specific states, and some states additionally have statutory protection for confidential information or trade secrets. An important element in establishing common law rights to confidential information, is that the party seeking confidentiality must make a significant effort to maintain the secrecy of that information. Franchisors should therefore implement policies and procedures designed to protect against the dissemination of confidential information. Where applicable, franchisors should require franchisees to agree to non-disclosure agreements, and include strong and inclusive confidentiality provisions in their franchise agreements. These provisions must also be binding on franchisees’ agents and employees. Franchisors should also consider utilising other security measures, including password-protected computer systems, so as to maintain the “confidentiality” of information (such as client or customer information and lists) that the franchisor may wish to keep “confidential”.
Courts will generally enforce confidentiality agreements, and grant injunctive relief in appropriate circumstances, to prevent the theft or misuse of confidential information. Therefore, well-crafted franchise agreements will often include injunctive relief clauses to facilitate the protection of confidential information in court. New or prospective franchisors should be extremely mindful of confidentiality before discussing their “new concept”, their “secret sauce”, or other intellectual property with anyone (including potential investors or prospective business partners). Non-disclosure agreements should be entered into prior to having such discussions where a prospective franchisor has a trade secret or idea that is unique and worth protecting.
Publications by the franchisor, including operations manuals and policy and procedure manuals, may also be protected by federal copyright law (discussed below). In addition, a franchisor might consider applying for a federal patent with the USPTO if a franchisor has a unique invention or product, process, or design.
The U.S. is a signatory to many treaties and conventions concerning copyrights, including those overseen by the WIPO. Within the U.S., federal law protects both registered and unregistered copyrighted material. In addition, common law rights (or even statutory rights conferred by states), such as claims for misappropriation or unfair competition, may overlap with copyright law to protect information within publications.
Franchisors should be mindful that a wide variety of different publications and media, including operations manuals, advertisements, menus, or computer programs, may be protectable by copyright. Franchisors should be careful to draft clear agreements with agents or venders that designate “work for hire” copyright ownership to the franchisor for materials that are created for the franchisor (lest, for example, a franchisor inadvertently grant “ownership” of an expensive, custom-designed computer program, to a computer programmer).
The culture of the United States tilts decidedly towards protecting intellectual property rights, and punishing those who would misappropriate or engage in unauthorised usage or plagiarism of another’s intellectual property. Federal law often provides for additional damages, including exemplary (sometimes treble) damages, and attorney fees, for violations.
The Federal Trade Commission (“FTC”) may enforce its franchise disclosure rules by issuing cease and desist orders and, where recalcitrant franchisors still do not comply, by commencing an action in federal court to obtain an injunction and/or civil penalties. However, this is not a frequent occurrence and, importantly, the FTC Rule does not grant a private right of action to franchisees.
It is only under state law, either by virtue of state consumer fraud statutes (“Little FTC Acts”) or state franchise statutes, that aggrieved franchisees are empowered to commence a lawsuit against a franchisor and its control persons for disclosure violations. If a franchisee prevails in court, it may be entitled, under most state statutes, to an award that may include rescission, damages, costs, reasonable attorney’s fees and statutory interest. Rescission, which is designed to restore the rescinding party to the status quo ante, typically includes the restitution of any money already paid to the franchisor, as well as consequential damages. However, while rescission may be a remedy, it may only be available under limited circumstances (e.g., where the franchisor’s disclosure violation is wilful and material). In a few states, courts have discretion to award treble damages to plaintiff franchisees. State enforcement agencies may seek to impose civil and criminal penalties or obtain an injunction against a non-compliant franchisor. Given the variability between states, it is generally advisable to retain counsel that is knowledgeable in the individual state’s franchise law.
Pursuant to the FTC Rule and most state franchise statutes, a franchisor and sub-franchisor are jointly and severally liable for one another’s disclosure violations. Often, though, a franchisor will seek to shift full liability onto the master franchisee (sub-franchisor) by inserting an indemnification clause in the Master Franchise Agreement. Such clauses are generally enforceable, except under circumstances where state law may determine them to be against public policy (e.g., for intentional misconduct of the indemnitee). States in which registration is required (and good practice, generally) may require that the franchisee issue and register its own, separate, FDD, whereas an Area Development Agreement may be included in the franchisor’s FDD and state registration.
It depends. The FTC Rule prohibits disclaimer clauses that require franchisees to waive reliance on representations made in the FDD documents. Several states have enacted anti-waiver provisions which render unenforceable any provision in the franchise agreement that purports to waive a franchisee’s legal rights to recover damages for a franchisor’s pre-contractual misrepresentations. Moreover, if a franchisee is fraudulently induced to execute a franchise agreement, disclaimer clauses are generally unenforceable because the fraud is extraneous to the contract. However, disclaimer clauses may still effect a limited waiver, including with respect to unauthorised representations made during the pre-sale courtship process. Such provisions may also be useful to the franchisor in contesting a franchisee’s claim that it actually relied on the misrepresentation.
Courts are more likely to uphold a “no representation” or “no reliance” clause that disclaims a specific representation, than a general disclaimer or integration clause. For this reason, it is increasingly common for franchisors to require that its franchisees sign, along with the franchise agreement, a detailed questionnaire specifying that certain representations were/were not made prior to the sale.
Yes, class action lawsuits may be brought. However, franchisees are almost always required to relinquish any right to pursue a class action lawsuit against a franchisor by executing a franchise agreement with a class action waiver provision. The enforceability of such a provision varies between states, some of whose courts may deem such a provision to be unconscionable and, therefore, unenforceable. Typically, these provisions also include waivers applicable to class or group arbitrations, as well. Where franchisee groups have sought to have these arbitration waivers deemed unenforceable, courts, recognising the Federal Arbitration Act’s stated policy favouring arbitration as a means of dispute resolution, have enforced class action waiver provisions contained in arbitration provisions.
Choice-of-law provisions are generally enforceable except where a selection violates public policy or where, depending on the state law, there is either no substantial nexus between the chosen state and the parties or the transaction, or there is no reasonable basis for the parties’ choice. For practical reasons, it is uncommon for a franchise agreement to be governed by a foreign franchisor’s local laws. In any event, some U.S. states have enacted anti-waiver provisions, which effectively mandate application of the local state franchise laws no matter what the parties contract to in the franchise agreement.
Federal, state and U.S. common law provide an aggrieved franchisor with the right to bring an action for injunctive relief in local court and obtain emergency relief to protect its brand. For example, the Lanham (Trademark) Act and the Defend Trade Secrets Act of 2016 provide a franchisor with the federal right to sue in court for an injunction to protect its trademarks, trade secrets and confidential operations manual. Injunctions will usually only be granted where there is no adequate remedy at law and where, without an injunction, a party will suffer “irreparable harm”. Local courts may enforce final and valid foreign judgments in accordance with recognised principles of comity, but may vary from state to state. Though many states have adopted some version of the Uniform Foreign Money Judgments Recognition Act, such provisions only confer recognition upon foreign money judgments.
The U.S. is a huge market with urban, suburban and rural areas. It is not one homogenous real estate market. Even within these variant areas, there are wide differences with respect to commercial leasing conditions. As such, there is no typical length of term for a commercial lease in the U.S. The term may vary widely depending on a variety of factors including the local market, the type of premises, general economic conditions, the particular landlord, lender requirements, franchisor requirements, etc. That being said, it is fairly common to have leases for retail spaces to be 10 years or more. Tenants may also seek to incorporate one or more option terms in their initial lease. Some franchisors and some franchisees (who are represented by experienced counsel) will prefer to have the term of the franchise agreement (with renewals) coincide with or be “coterminous” with the term of the lease being entered into (with options). Generally, there are no statutory rights regarding a tenant or franchisee’s rights to hold over at the end of the lease’s contractual term.
Yes, landlords are generally aware that franchisors may wish to reserve rights in their franchise agreements which will enable the franchisor, an affiliated entity or another approved franchisee to “step into” the franchisee/tenant’s shoes and take an assignment of the lease in the event that either the franchisee’s lease is terminated by the landlord, or the franchisee’s franchise agreement is terminated by the franchisor. Some landlords will simply consent to such a provision in a three-party rider or addendum to the lease which is signed by the franchisor, franchisee/tenant and the landlord. Other landlords may require franchisors to cure any defaults (including outstanding rent/additional rent) before the franchisor or another franchisee can take over the lease. However, landlords may resist agreeing to such a provision outright, while others may seek to obtain financial concessions from the franchisor in return for agreeing to such a provision. For example, some landlords may require the franchisor to provide either a full or partial guarantee of the lease as a condition for consenting to such a lease provision.
Typically, no. While U.S. federal law restricts foreign ownership of certain federal oil, gas and mineral leases, and authorises the blocking of certain foreign acquisitions of U.S. companies with respect to certain industries potentially impacting on national security, energy resources and critical infrastructure, such restrictions are generally inapplicable to most franchising opportunities in the U.S. Under federal law, foreign owners or investors of U.S. real estate are subject to U.S. tax to the same extent as domestic owners.
While the U.S. commercial real estate market is very large and cannot be considered homogeneous, it has continued to recover from the “great recession” of 2008 through 2012. In certain metropolitan areas, the real estate market has recovered fairly well and it is not uncommon for landlords to charge premiums for “class A” and desirable locations. However, in many other areas of the country, including more suburban and rural areas, where the real estate market (and the local economies generally) have not recovered to the same extent, it is common for tenants to obtain a period of free rent and/or tenant improvement allowances to ensure that improvements to the premises are made and that the cost for such improvements are shared by the landlord and tenant.
Yes. The franchise agreement can regulate how online orders are allocated. However, a franchisor should take great care to adequately delineate how such online orders will be handled in both the FDD and franchise agreement, as well as in any required analogous state disclosure document. Unless a territory is truly “exclusive”, franchisors should avoid words like “exclusive” territory to avoid confusion, and make sure that prospective franchisees are put on notice as to the extent of their territory with respect to online orders. Similarly, as e-commerce continues to mature, prospective franchisees who are purchasing a franchise should review the territorial protections and online market clauses in the FDD and franchise agreement with great care. Access to the online market can significantly impact the profitability of a franchise, and both franchisor and franchisee should be clear about each other’s rights.
From an antitrust perspective (see section 3, above), unless the franchisor has exerted significant control over the inter-brand market for the relevant product or service, such requirements are extremely unlikely to violate anti-competition laws, since under a “rule of reason” analysis, with the relevant “market” under antitrust analysis generally not being applicable to franchisees, such practices will not be considered to be antitrust violations.
No. A franchisor may require within the franchise agreement that a franchisee utilise a specific domain name, and return usage of that domain to the franchisor after expiration of the franchise. It is advisable that a franchisor disclose domain name requirements within the FDD, and that the franchise agreement clearly set forth any post-termination requirements with respect to domain names. The Internet Corporation for Assigned Names and Numbers (“ICANN”) regulates the usage of domain names, and franchisors may seek transfer of a domain name under ICANN’s Uniform Domain-Name Dispute-Resolution Policy (“UDRP”) proceedings to effectuate the transfer of a domain name. Notably, where a franchisee’s domain utilises a franchisor’s protected trademark within the domain name, the UDRP is far more likely to require transfer back to the franchisor, even if a dispute arises (and the usage of a protected trademark in the domain name may give a franchisor additional Lanham Act claims).
Franchisors may consider having franchisees agree in writing to transfer their domain rights to a specific domain at the time of termination of the franchise, or alternatively, control the rights to a specific domain themselves, and grant the franchisee a licence to utilise the sub-domain during the franchise relationship. Notably, if a franchisor does not take steps to timely effectuate the transfer of a domain name, or object to a former franchisee’s continued use of a domain in violation of an agreement, it opens itself up to laches, acquiescence and waiver arguments (see e.g. American Express Marketing and Development Corp v. Planet Amex et ano., NAF UDRP Proceeding, Claim No. FA1106001395159 (Jan. 6, 2012) (domain would properly stay with franchisee, as franchisor “acquiesced to the use of its mark in the Respondent’s domain name for at least a period of several years”).
Franchisee practitioners should carefully review the franchise agreements’ expiration and termination provisions, and the requirements concerning post-termination/expiration domain usage. At the conclusion of a multi-year franchise relationship, a domain may be an integral part of a business’ e-mail addresses, server addresses, and contact information for clients and vendors. If the franchisee seeks to remain in business and rebrand following de-identification, the loss of a domain name can present significant hurdles if not adequately prepared for.
Yes. While federal law in the United States, through the Amended FTC Franchise Rule, governs the requirements that franchisors must follow regarding providing proper disclosure to prospective franchisees, no federal law governs any aspect of the franchisor-franchisee relationship after the parties enter into a franchise agreement. However, approximately half of all states in the United States (and U.S. territories of Puerto Rico and the U.S. Virgin Islands) have “relationship laws” which govern one or more aspects of the franchisor-franchisee relationship. Beginning in the 1970s, these relationship statutes were enacted by state legislatures in an attempt to combat some of the significant perceived abuses being perpetrated by franchisors against prospective franchisees. These laws vary considerably, both in terms of the breadth of issues that are addressed, as well with respect to the specific provisions and restrictions which are contained within them. Some relationship laws are part of the state’s franchise registration or disclosure statute; some states have separate disclosure/registration laws and relationship laws; and other states have relationship laws but no disclosure laws.
Relationship laws typically address the franchisor’s ability to terminate or fail to renew the franchise. Most relationship laws require a franchisor to have “good cause” before it is permitted to terminate, or not renew, a franchisee’s franchise. (Where applicable, these laws will override inconsistent provisions in the franchise agreement; for example, a provision stating that the agreement will expire at the end of the term, if the franchisee has no right to renew, may be unenforceable.) While some relationship laws define “good cause”, others do not, leaving this determination to the courts. However, good cause generally exists if the franchisee has breached a material obligation of the franchise agreement. Typically, under relationship laws, the franchisor is required to provide the franchisee with written notice (for example, between 30 and 90 days, which is often significantly longer in duration than what is provided for in the franchise agreement) within which to cure the alleged default and to avoid termination, although in instances where the default involves the franchisee’s failure to pay money owed to the franchisor, the permitted notice/cure period is often considerably shorter. However, for certain defaults which are perceived to be egregious, including, for example, a threat to the public’s health and safety (often, for example, in a food-related franchise), and/or are “uncurable” (for example, seriously impairing the reputation to the franchisor’s brand), or where certain exigent circumstances are present (for example, the franchisee’s insolvency or bankruptcy, the franchisee’s loss of its right to occupy its premises), the franchisor is statutorily permitted to terminate the franchisee’s franchise agreement, either immediately, or with a much shorter notice and cure period than what might otherwise be required. As applicable relationship laws supersede whatever provisions are contained in the franchise agreement, franchisors, and their counsel, need to be aware of any applicable relationship laws when evaluating how to handle a franchisee’s default and/or potential termination. Many relationship laws also cover a variety of other aspects of the franchise relationship including, for example, transfer restrictions, limits on the franchisor’s encroachment (e.g., a franchisor’s ability to open a new unit in the vicinity of the franchisee’s location), the right of franchisees to “freely associate” (e.g., the franchisee’s right to participate in a “franchisee association” together with other franchisees in the franchise system), limits on post-term non-competition restrictions; and requiring that a franchisor act in good faith or with reasonableness when dealing with its franchisees.
Almost all franchise agreements provide that the franchisor may terminate the franchise if the franchisee becomes insolvent or if it files for bankruptcy. However, under the U.S. Bankruptcy Code, a contractual provision permitting the franchisor to terminate the franchise agreement in the event of the franchisee’s bankruptcy may not be enforceable (see 11 U.S.C §365(e)(1)(A)). If a franchisee files for bankruptcy before its franchise agreement and/or its unexpired lease have been properly terminated, such agreement(s) become(s) part of the debtor/franchisee’s (“debtor”) “bankruptcy estate”. While a franchise agreement or lease may be terminated quickly if the debtor (franchisee) rejects them, if a debtor in a Chapter 11 reorganisation wishes to assume its franchise agreement or lease, it is unlikely that the franchisor will be able to quickly terminate these agreements so long as the debtor was not in default of these agreements at the time the bankruptcy petition was filed. The bankruptcy court might approve the assumption of these agreements if the debtor/franchisee is able to otherwise perform their respective terms, the agreement(s) appears to be in the best interests of the estate, and the assumption is supported by reasonable business judgment. However, if the debtor/franchisee was in default of its agreement(s), it is more difficult for it to assume them. In that case, the debtor will likely have to: (i) cure, or provide adequate assurance that the trustee will promptly cure, such defaults; (ii) compensate, or provide adequate assurance that it will promptly compensate, another party for any actual pecuniary loss that the party may suffer as a result of such default; and (iii) provide adequate assurance with respect to the future performance of such agreement(s).
The “joint employer” doctrine is a concept in employment law. It expands the definition of “employer” to include additional persons or entities that exert sufficient control over the “terms and conditions” of employment (directly, or even indirectly), so that they will be considered a “joint” employer by law. In the past few years, regulators charged with enforcing various employment laws (particularly the National Labor Relations Board (“NLRB”)), have increasingly been applying the “joint employer” doctrine in the franchise context, and finding franchisors jointly liable for employment law violations committed against franchisees’ employees. Therefore, the joint employer doctrine can operate as an exception to the general rule that a franchisor and a franchisee are independent contractors, and expose the franchisor to liability for employment law violations. Notably, the joint employer doctrine only applies in connection with violations of employment law (for example, violations of the Fair Labor Standards Act, 29 U.S.C. 201 et seq., or National Labor Relations Act, 29 U.S.C. §151 et seq.).
Applying the joint employer doctrine in the franchise context is troublesome, because the franchisor-franchisee relationship, by its very nature, requires a franchisee (and its employees) to adhere to the franchised system or business model, and to follow certain designated procedures. The hallmark of liability under the joint employer doctrine is the exercise of sufficient control over employees so as to be considered an employer. A franchisor may discover that by too closely regulating what the franchisee’s employees do, in trying to keep the franchise system uniform, it will be considered liable for employment law violations as a “joint employer”. Trouble areas include (but are not limited to) setting “required” work hours, mandating and controlling employee time-tracking software, becoming involved in employees’ wage and salary levels, training “line” employees, becoming involved in hiring or firing, setting employment practices and policies, and resisting the unionisation of employees.
Franchisors are well-advised, wherever possible, to avoid exerting excessive control over the terms and conditions of employment of their franchisees’ employees, while balancing such needs against maintaining system standards. While the joint employer doctrine provides no “bright line” rules, as it utilises a multi-factored test (or “totality of the circumstances”), and the law is still evolving, franchisors can and should take steps to help avoid being considered a joint employer. One good rule of thumb has been for franchisors to continue to maintain system standards and employee practices that have to do with the end product or service (sometimes called “control of outcomes”), but to distance themselves from directly engaging in setting policies or procedures regarding how a franchisee’s employees are managed in order to produce the end product or service (sometimes called “control of means”). For example, a franchisor of a sandwich shop can dictate in its “operations manual” precisely how a franchisee’s employees must assemble and produce its sandwiches, but should not become directly involved in training, hiring, filing, or setting hours and pay rates for the low-level employees producing those sandwiches.
Franchisors have been be found vicariously liable for the acts or omissions of its franchisees (or its franchisees’ employees). However, vicarious liability, as a general rule, will only attach where a franchisor exerts so much control over the franchisee’s performance of the process or activity that is being complained of, that courts will find that the franchisor should be held responsible. Almost every jurisdiction has found that general operational manuals or enforcement of a franchisor’s general franchise system will not, by itself, lead to vicarious liability. In contrast, where a franchisor has mandated a particular practice or policy that is directly responsible for the harm, there is a significant risk that vicarious liability will attach.
Franchisors need to balance their needs to provide guidance to their franchisees, including the promulgation of detailed policies and procedures, against exerting so much control over the day-to-day operations of franchisees that they open themselves up to a risk of vicarious liability. Where detailed specific controls are not necessary to maintain quality control or the franchised system, they should be avoided. Franchisors can also seek to minimise potential damages by having an appropriate indemnity provision in their franchise agreement, as well as requiring that franchisees maintain adequate insurance coverage, and naming the franchisor as an insured party, especially where necessary to protect against particular liability concerns.
So long as the overseas franchisor and the franchisor’s country are not subject to any U.S. economic sanctions, U.S. law does not impose any exchange control restrictions on the transfer of money by a U.S.-based franchisee to a foreign franchisor. However, under the Bank Secrecy Act, a U.S. financial institution that wires payment in excess of $10,000 must comply with certain reporting requirements.
Payments made by a U.S. taxpayer to a foreign franchisor in exchange for the right to use its intellectual property (e.g., trademarks, copyrights) and technology qualify as “royalty” payments for tax purposes and are subject to a 30% withholding tax rate. If the U.S. has an income tax treaty with the franchisor’s country of residence, the foreign franchisor will benefit from either a reduced withholding tax rate or a full exemption. Management service fees are similarly subject to a 30% withholding tax, except where reduced by tax treaty.
Typically, no. It is standard for a U.S. franchisee to operate its business using the local currency. Major banks can usually wire franchise fees or royalties on behalf of a U.S. franchisee to the foreign franchisor using the foreign currency. Notwithstanding this, however, it is typical for a foreign franchisor to conduct its franchise business in the U.S. either through a U.S. subsidiary or a Master Franchisee.
Yes, there is some risk that an agency relationship (actual or apparent) will be found and that the franchisor will be held vicariously liable for harm directly caused by the franchisee. In analysing whether an actual principal-agent relationship exists, courts examine the degree of control exerted by the franchisor over the franchisee’s general day-to-day operations and/or over the specific conduct of the franchisee that caused the harm. Courts may find apparent agency if it determines that a plaintiff: (a) reasonably believed the subject franchisee to be an agent of the franchisor; and (b) reasonably relied upon such belief to its detriment. See also section 10, Joint Employer Risk and Vicarious Liability, supra.
To minimise possible exposure, the franchisor is generally advised to include in the franchise agreement: (a) a provision stating that the franchisee is an independent contractor and not an agent of the franchisor; (b) an indemnification and contribution clause; and (c) a provision requiring the franchisee to maintain an insurance policy that covers the franchisor as an additional insured. The franchisor can further protect itself by requiring that its franchisee post notices of independent ownership on its store signage, in its advertisements, etc.
Many states incorporate by common law an implied covenant of good faith and fair dealing into every contract, including franchise agreements, within its jurisdiction. The implied covenant of good faith and fair dealing typically means that where one party may be free to exercise its discretion, it should not do so in a manner that deprives the other party of the benefit of the contract. It should not enrich itself unfairly, or act in an overly arbitrary or capricious manner, so as to eliminate the other party’s benefit of the bargain.
The implied covenant of good faith and fair dealing cannot conflict with an express contractual term. Therefore, a well-drafted franchise agreement will usually address most significant issues with sufficient particularity to minimise the application of the implied covenant of good faith and fair dealing. However, issues do arise, especially where the exercise of discretion is involved and a franchise agreement is silent on the point in question. Good faith and fair dealing is a fact-driven analysis, and even well-drawn contracts may not anticipate every contingency.
Requiring good faith and fair dealing is not the same thing as requiring a franchisor to sacrifice its own economic self-interest in favour of the franchisee. The general rule is that parties are free to enter into contractual provisions as they wish, especially if both parties are sophisticated and represented by counsel. A franchisee may knowingly enter into a bad economic arrangement, and if the contract is clear, the implied covenant of good faith and fair dealing will not be allowed to contradict the express terms of the agreement.
In addition to common law “good faith” requirements, there are state franchise statutes that require good faith conduct on the part of a franchisor (see franchise “relationship” statutes, discussed at question 9.1, supra). Additionally, a franchisor’s conduct, if it is sufficiently unfair, may become “unfair and deceptive” under other statutes (such as the FTC Act, discussed supra in section 3).
While there may not be a blanket requirement in the United States that a franchisor conduct itself at all times with fairness and reasonableness, franchise systems that take unfair advantage of their franchisees may find themselves unable to sell new units if their franchisees are unsuccessful or unhappy. In the highly competitive United States franchise marketplace, negative reviews by franchisees can have a real impact upon franchisors, especially since franchisors must disclose when their units close or fail (in the FDD). Therefore, while there may not be a legal requirement to act fairly and reasonably in every instance, franchisors should think carefully before putting immediate economic gains before the long-term health of the system.
Eighteen (18) states (and Puerto Rico) have promulgated laws that govern the various facets of the franchisor/franchisee relationship (“relationship laws”). Generally these franchise relationship laws will, among other things: (i) regulate the franchisors’ ability to terminate or refuse renewal of the franchise agreement; (ii) impose restrictions on transfer; (iii) grant franchisees the right to form an association with other franchisees in the same system; (iv) prohibit franchisors from treating similarly situated franchisees differently without cause; and (v) obligate the franchisor to repurchase inventory upon termination or non-renewal of the franchise. Franchise relationship laws differ from state to state, but they share the common goal of trying to prohibit franchisors from unfairly terminating or refusing to renew the franchise agreement.
In addition to state franchise relationship laws, there are federal and state laws that govern franchise relationships in specific industries, such as: gas station operations; automobile dealerships; hardware distributors; real estate brokerage; farm equipment machinery dealerships; recreational vehicle dealerships; and liquor, beer and/or wine distributorship. For example, under the Federal Petroleum Marketing Practices Act, gas station franchisors or refiners cannot terminate the relationship without good cause. Good cause means that the franchisee has not complied with the terms of the agreement or has committed other acts that injure the franchisor. In the event that a franchisor elects not to renew a franchise agreement, the franchisor (under certain circumstances) must either: (i) offer to buy the franchise, if the franchisee owns the station; or (ii) give the franchisee the opportunity to purchase the premises from the franchisor, if the franchisor owns the station.
Typically, a franchisee’s right to renew its franchise agreement is conditioned on, among other things, the franchisee executing the franchisor’s then-current form of franchise agreement, which may contain terms that are materially different than the terms of the franchisee’s current franchise agreement. Under the FTC Franchise Rule, if the renewal franchise agreement contains materially different terms, then the franchisor must adhere to the pre-contract disclosure requirement and provide the renewing franchisee with its then-current FDD.
Generally, states recognise that parties are free to contract the length of the term of their franchise relationship and any renewal(s) thereof. However, some states have promulgated franchise relationship laws that restrict a franchisor’s ability to refuse to renew a franchise agreement by requiring that the franchisor: (i) have “good cause” or “just cause” for termination; or (ii) provide franchisees with at least ninety (90) days’ (and in some cases, six (6) months’) prior notice of the franchisor’s intent to not renew the franchise agreement. While these relationship laws were initially enacted to protect franchisees from arbitrary terminations or non-renewal of the franchise relationships, they have also caused the possibility of a perpetual franchise relationship which may go against one party’s (or both parties’) intent.
Franchisees are generally not entitled to any compensation or damages due to a franchisor’s failure to renew a franchise agreement. However, California, Hawaii, Illinois, Iowa, Michigan, Washington and Puerto Rico each have franchise relationship laws that require franchisors to repurchase a franchisee’s business assets. In Iowa, a franchisor must repurchase the assets at fair market value as a going concern, and in Washington, franchisors must compensate for goodwill, unless the franchisor agrees (in writing) to not enforce the non-competition provision.
Yes. Franchisors typically provide in their franchise agreement that franchisees are not permitted to transfer or assign any interest in the franchise agreement (or in the ownership interest in the franchisee) without the written consent of the franchisor. Franchisors in the U.S. are permitted to impose reasonable restrictions (typically, referred to as “conditions”) in connection with a proposed transfer of the franchised business. Examples of common conditions which are imposed on transfers include: (a) requirements imposed on the existing franchisee (such as being current in all of its financial obligations to the franchisor, not being in default of the franchise agreement, the payment of a transfer fee, and the delivery of a general release in favour of the franchisor); and (b) requirements imposed on the transferee franchisee such as entering into the franchisor’s “then current” franchise agreement, meeting certain financial criteria, and completing the franchisor’s required initial training programme.
Many franchisors also require a provision that they will have a “right of first refusal” with respect to proposed transfers of the franchised business to third parties. This right is frequently waived.
A relatively small number of state relationship laws impact on a franchisor’s ability to impose restrictions on the transfer of a franchise’s business. For example, some relationship laws provide that it is an unfair or deceptive act for a franchisor to refuse to permit a transfer without good cause. Others permit a franchisor to reject a proposed transfer if the transferee fails to satisfy the franchisor’s then-current requirements, as long as the franchisor’s refusal is not arbitrary or capricious. Other relationship laws require the franchisor to provide a timely response to a franchisee’s request to transfer and if the franchisor denies the request, it must provide the franchisee with a “material” reason for the rejection such as the proposed transferee’s failure to meet the franchisor’s standard requirements relating to financial ability, business experience or character. Other relationship laws provide that in the event of the death or disability of the franchisee, the franchisee’s spouse or heirs will have a reasonable time to elect to operate or own the franchised business if the individual satisfies the franchisor’s then-current standards and requirements.
Many franchise agreements contain provisions which provide that the franchisor, under certain circumstances, has a right to “step in” and take over the operation and management of the franchised business. This may be for a limited period of time, for example, where a principal owner passes away and the franchised business has no manager in place to properly manage the business. Other times, the franchisor may seek to assert “step-in” rights where a franchisee is failing financially, has abandoned the franchised business, or where the franchisee (or its owner) has engaged in egregious conduct such as defrauding the franchisor or has been found guilty of a felony or crime of moral turpitude which is likely to negatively affect the brand’s reputation or goodwill.
While there are no registration requirements or formalities that must be complied with in connection with enforcing “step-in” rights (other than notice requirements contained in the franchise agreement), the franchisee and/or the landlord will often object to or seek to frustrate the franchisor’s attempts to assert “step-in” rights. In such case, the franchisor would most likely not be permitted to use any form of “self-help” (under governing state law) and it is likely that it would be forced to seek injunctive relief in the courts. Where the franchisee files for bankruptcy protection before a franchisor has an opportunity to try to enforce its “step-in” rights, the bankruptcy filing may result in an “automatic stay” (protecting the debtor/franchisee). Under those circumstances, the franchisor would have to petition the bankruptcy court to seek to enforce its “step-in” rights, but this process could take weeks or even months.
Franchisors do not generally use powers of attorney in attempting to enforce “step-in” rights provided for in the franchise agreement, as doing so may lead to an improper (or even illegal) use of “self-help”. However, upon the transfer or termination of the franchised business, franchisors are permitted to use powers of attorney, in order to provide for the orderly (and peaceful) transfer of telephone numbers, fax numbers, and internet domain names, etc., used by the franchised business.
The authors would like to thank Leonard Salis, Michelle Murray-Bertrand and Avi Strauss for their invaluable contribution to the writing of this chapter. Len is a partner at the Richard L. Rosen Law Firm with a practice focused on franchise law and on transactional matters generally (Email: ls@rosenlawpllc.com); Michelle is a Corporate Associate at the firm, focusing in particular on corporate law (Email: mmb@rosenlawpllc.com); and Avi is an Associate whose main area of practice is litigation (Email: as@rosenlawpllc.com).