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How Does a Franchisor Prove Damages in Litigation Against a Franchisee?

Friday, July 9th, 2010

In representing franchisor clients against defaulting franchisees, it is imperative to give adequate thought to how the franchisor is going to prove its damages that resulted from a franchisee’s breach of the franchise agreement. When confronted with this issue, I most often utilize a financially competent representative of the franchisor to testify with regard to that amount of monetary damage suffered by the franchisor. The franchisor’s representative must be able to prove the damage by evaluating the franchisee’s financial statements, including revenues and/or profits, expenses, and royalties paid to the franchisor, and then determine what sums the franchisor would have earned either during and/or after the franchise term had it not been for the franchisee’s breach.

In order to testify convincingly and thoroughly, the franchisor’s representative must be able to analyze the franchisee’s financial numbers and draw a conclusion from such numbers. Therefore, a chief financial officer of a small franchisor, or an auditor or accountant of a larger franchisor, is an ideal representative in these instances, provided that the representative has been with the company long enough to be able to testify knowledgeably with regard to the details of the franchisor’s system.

Generally, a well-prepared franchisor representative will be permitted to testify as to the value or the projected profits of a franchised business provided the representative has a sufficient foundation for the analysis and opinion, including particular knowledge of the financial issues presented by virtue or his or her position in the franchisor company. This simply means that a franchisor representative may opine on the issue of lost profits where they know the franchisor and franchisee’s business and financial system intimately, and have the professional ability to analyze the franchisee’s financial statements.

To see how a franchisor SHOULD NOT approach the issue of proving its damages against a franchisee, see Lifewise Master Funding v. Telebank, 374 F.3d 917 (10th Cir. 2004), which in essence holds that a company’s witness as to damages must have personal knowledge of all items factored into his opinion in order for the opinion to be admissible. The court concluded that a business owner or executive may give “a straightforward opinion as to lost profits using conventional methods based on [the company's] actual operating history.” However, because in this case the witness lacked personal knowledge of the factors used in the damages analysis, the opinion was inadmissible.

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Must Read: The Federal Trade Commission (FTC) Franchise Consumer Guide

Monday, June 21st, 2010

Below please find a link to the FTC “Buying a Franchise: A Consumer Guide,” which is a must read for all prospective franchisees. Here is the link: http://www.ftc.gov/bcp/edu/pubs/consumer/invest/inv05.shtm.

While the information contained in the FTC Franchise Guide is no doubt basic to a franchise professional or franchisor representative, the Franchise Guide unquestionably provides useful information to prospective franchisees who often times know very little about the franchise sales process, federal and state franchise registration and disclosure laws, or the franchisor/franchisee relationship. Without a doubt it is an excellent foundation for a prospective franchisee’s due diligence.

Some topics addressed in the FTC Guide are: where to look for franchise opportunities, what makes up the Franchise Disclosure Document (FDD), to be aware of unauthorized financial performance representations/earnings claims from a franchisor if not found in the FDD, and where to obtain additional sources of information during the due diligence phase, including obtaining the assistance of experienced franchise counsel.

I strongly encourage any prospective franchisee reading this blog to click on the above link and download a copy of the FTC Guide.

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Franchise Law and Future Royalties

Wednesday, June 16th, 2010

Case law on the subject of a franchisor’s ability to collect future royalties, that is, royalties for the remainder of the term of the franchise agreement, is conflicting. Courts across the country have been unable to agree on when a franchisor may collect future royalties.

While guaranteeing the collection of future royalties from a terminated franchisee is impossible, there is one obvious but often overlooked way to increase the likelihood that a court or arbitrator will find in the franchisor’s favor when faced with the issue. That is, to disclose to the franchisee in the FDD, and include language in the franchise agreement, stating with specificity the franchisor’s policy on collecting future royalties. State for what period of time the franchisee willl be responsible for such royalties, ie for a certain number of months, or until the end of what would have been the franchise term. Also include what amount the franchisee will be expected to pay, for instance the average royalties paid by the franchisee over the past 6 or 12 months, or whatever time period the franchisor seeks to use.

Including specific and detailed language in the FDD and franchise agreement will not guarantee that a franchisor prevails with regard to a future royalties claim. However, NOT including such language will in my view guarantee that the franchisor loses such a claim.

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FTC Franchise Rule Requires Audited Financials Except for Start-Up Franchisors

Tuesday, June 15th, 2010

A franchisor client recently asked me for clarification on the revised FTC Franchise Rule, specifically, whether audited financials are mandated by the FTC Rule in non-registration states, or whether less restrictive and less costly “reviewed” or “compiled” financials will suffice. The answer is clear that the revised FTC Rule does indeed require audited financials, with an exception for start-up franchisors:

Item 21: Financial Statements.

(1) Include the following financial statements prepared according to United States generally accepted accounting principles, as revised by any future United States government mandated accounting principles, or as permitted by the Securities and Exchange Commission. Except as provided in paragraph (u)(2) of this section, these financial statements must be audited by an independent certified public accountant using generally accepted United States auditing standards. Present the required financial statements in a tabular form that compares at least two fiscal years.

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Problems with arbitration – PART 2

Monday, February 22nd, 2010

Last week I wrote Part 1 of this blog on the problems I have encountered with arbitration. Please see that post if you have not read it. What follows is Part 2 of the reasons that I advise my franchise and business clients why they should be wary of automatically including an arbitration clause in any franchise agreement or other contract that they execute:

4. Judges are generally more experienced, more versed in the law, and otherwise more qualified to hear disputes than most arbitrators. While not every judge is equally qualified, most judges have been vetted by their local and state bar organizations, and either elected by voters or appointed by politicians. Judges have a track record that can be reviewed and relied on. Judges in most courts serve on a rotational basis, hearing different types of cases and thereby gaining differing experiences. Judges have resources like law clerks to research the law for them. So while judges may lack technical expertise in a certain area, they make up for that my relying heavily on the attorneys and evidence presented in a given matter. Whatsmore, judges must construe existing law to base their rulings on, or else risk being overturned on appeal. Arbitrators, on the other hand, are in most cases practicing or retired attorneys with a specific area of expertise who have asked to be appointed to serve. Many times, an arbitrator will have only a peripheral knowledge of the subject of the arbitration, yet without the experience, knowledge of the law, or resources to ensure that his or her ruling is correct on the law. This set of circumstances can often times lead to inconsistent or downright baseless arbitrator’s decisions.

5. Judges produce formal opinions reciting the law relied on and applying the law to the facts to reach a decision. Many arbitrators, meanwhile, can issue awards without including their specific legal reasoning for an award. For purposes of appeal, judges are required to produce formal opinions citing the issues, facts, law and conclusion in an orderly fashion. This allows parties to focus many times on a distinct area for appeal, and allows appeals courts to easily review the court’s basis for a decision. Conversely, many arbitrators are required to issue only a narrowly written award unless otherwise agreed to by the parties. Even then, an arbitrator issuing a “reasoned award” may not satisfactorily explain the evidence relied on, the law used and how the arbitrator’s conclusion was arrived at. This not only makes it difficult for the parties to decipher how a particular arbitration award was arrived at, but more importantly, makes the record for appeal nearly impossible.

6. Even if an arbitrator issues a reasoned award, the right to appeal an arbitration award is extremely narrow when compared to a party’s ability to appeal a court ruling. In most instances, losers at trial have the right to appeal the merits of a court’s decision to a higher court “de novo”, using almost any substantive or procedural issue available to them. The basis of an appeal of an arbitration award however is severely limited, and many times requires the appealing party to clear such high hurdles as proving fraud, corruption of the arbitrator, or the arbitrator exceeding his or her powers. The difficulty of appeal, when combined with the erratic decisions of some arbitrators, is another reason to forego arbitration in favor of litigation, except in a specific set of circumstances discussed with and approved by my client.

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Current Problems with Arbitration Clauses in Franchise and Other Agreements – PART 1

Saturday, February 20th, 2010

I frequently tell my franchise and business clients to be wary of automatically including an arbitration clause in a franchise agreement or other contract they execute. Several years ago it was savvy for a business owner or franchisor to include mandatory arbitration in their agreements. Now, many of the reasons that supported the inclusion of arbitration clauses have been diminished, making the inclusion of mandatory arbitration in many contracts a questionable strategy at best. I now advise my business and franchise clients against arbitrating disputes for the following reasons:

1. Arbitrations are not “cost-savers” like they used to be thanks to the multiple fees associated with the process. Unlike judges, arbitrators are paid by the parties on an hourly basis. It is therefore in an arbitrator’s financial interest for the case to reach a hearing, regardless of the claim’s merits. In addition, many hearings go on much longer than necessary, allowing witnesses and testimony with questionable relevance to be heard. As a result, arbitrator’s fees can be quite significant for even routine business disputes. The arbitrator’s fees are of course in addition to the fees that business clients pay to their own attorneys for handling the matter, plus the hefty filing fees that many arbitration forums charge as well. For example, the American Arbitration Association, the preeminent arbitration forum in the U.S., charges filing fees ranging from $300 to $2,500.00 for commercial arbitration disputes. Contrast these expenses with trials and other court hearings, where judges have no financial interest in prolonging a case, and filing fees are minimal.

2. The distribution of who pays the arbitrator’s and other fees can disfavor the party bringing the action. The filing party, known as the Claimant, will be responsible for paying not only the arbitration filing fees, but also its portion AND the other party’s portion of the arbitrator’s fees mentioned above should the defending party, called the Respondent, refuse to pay its share of such fees. In such a case, the Claimant must pay all fees in order for the matter to go on, yet the Respondent remains entitled to participate in the arbitration process. If the Claimant fails to pay all of the fees owed to the arbitrator, the arbitrator will likely suspend or dismiss the action entirely. Because there is no incentive for a Respondent to pay its share of an arbitrator’s compensation or other fees, the absurd ersult of the Claimant paying all fees happens more than one would think. Combined with the fees a Claimant must pay to its own attorney, it is easy to see why a business owner would question the use of arbitration in the first place.

3. Arbitrators have far more discretion to rule than judges, sometimes in spite of the evidence presented. The arbitration process is much less formal than a trial. While some informality saves the parties time and expense and speeds up the process, the biggest informality can alter the entire outcome, namely, the fact that the rules of evidence do not apply to arbitration. As a result, arbitrators are free to allow documents and testimony that is questionable as to veracity and authenticity into evidence, even though such evidence would not be permitted in a court of law. In plain terms, an arbitration hearing can literally turn into a free for all, with the arbitrator allowing all kinds of testimony and documents to be factored into an award. This sort of setting can severely hurt a business client who is relying strictly on the language of documents and the actions of the parties, while in turn favoring a party hoping for chaos, basing its case on hearsay and unsupported and unreliable accusations. [Tune in to PART 2 next week]

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A Non-Compete Can Be Enforced Even When Lacking Geographic Limitation

Tuesday, December 8th, 2009

Maryland law is well settled that a non-compete must be reasonable in geographic scope and duration in order to be held enforceable. However, Maryland courts will enforce a covenant not-to-compete that does not contain a geographic limitation in certain narrow and limited circumstances. The U. S. District Court for the District of Maryland stated in Intelus v. Barton and Medplus, Inc., 7 F. Supp. 2d 635 (1998) that every non-compete must be examined to determine reasonableness based on the specific facts at hand, even non-competes that fail to contain a finite geographic limitation. The Intelus court stated:

“Competition unlimited by geography can be expected where the nature of the business concerns computer software and the ability to process information. . . Because of the broad nature of the market in which Intelus operates, a restrictive covenant limited to a narrow geographic area would render the restriction meaningless.”

In determining the reasonableness of a non-compete that does not contain a geographic limitation, Maryland courts will consider the nature of the industry and the national and perhaps global nature of the competition. In Intelus, the court concluded that the restriction was reasonably related and limited to Intelus’s need to protect its good will and client base, and therefore upheld the enforceability of the non-compete.

In Hekimian Labs, a Florida federal court, interpreting Maryland law, found that where “testimony indicated that competition within the business of remote access testing is such that the whole world is its stage” and “that there are only about 20 companies that compete in this business, and they do so on a worldwide basis,” then “to confine the restrictive covenant to a specified geographical area would render the Agreement meaningless.”

The Florida Court concluded that if the agreement did contain a geographical restriction, the offending party would only need to move outside of this restricted area and the damage to the harmed party would be the same. Because of the national and international scope of the competition between the parties, the absence of a specified geographic limitation was reasonably necessary for the protection of the party attempting to enforce the non-compete, and the covenant was upheld.

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Maryland Courts May Grant Injunctive Relief Even when an Arbitration Clause Exists

Tuesday, December 8th, 2009

Maryland law permits a party to request injunctive relief from a Maryland federal or state court even when a contract states that all disputes must be referred to arbitration. The Court of Appeals of Maryland held in Brendsel v. Winchester Construction Company, Inc., 898 A.2d 472 (2006) that:

“[A]n interlocutory mechanics’ lien is in the nature of a provisional remedy, not much different than an interlocutory injunction or attachment sought to maintain the status quo so that the arbitration proceeding can have meaning and relevance, and the predominant view throughout the country is that the availability of such remedies by a court is permitted by the Federal and Uniform Arbitration Acts and is not inconsistent with the right to enforce an arbitration agreement.”

In its ruling, the Maryland Court of Appeals focused on the need for courts to have the ability to preserve the status quo by granting injunctive relief while a dispute is sent to arbitration. Without this ability, the Court held, a ruling by an arbitrator could very well be immaterial, as the damage done to a party could by that time be irreparable.

The Maryland Court of Appeals’ holding finds support from the Fourth Circuit in Merril Lynch et al. v. Bradley and Collins, 756 F.2d 1048 (1985):

“Accordingly, we hold that where a dispute is subject to mandatory arbitration under the Federal Arbitration Act, a district court has the discretion to grant a preliminary injunction to preserve the status quo pending the arbitration of the parties’ dispute if the enjoined conduct would render that process a “hollow formality.” The arbitration process would be a hollow formality where “the arbitral award when rendered could not return the parties substantially to the status quo ante.” Lever Brothers, 554 F.2d at 123.”

Therefore, Maryland courts are permitted to intercede and grant injunctive relief in spite of an arbitration clause where the absence of such relief would cause the arbitration to be nothing more than a “hollow formality.”
This power exists even when a contractual provision states that the parties must refer all disputes to arbitration.

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What is the definition of a franchise?

Thursday, June 4th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

I am often asked by prospective franchise clients what exactly is the definition of a franchise? The issue is an important one, since franchising is a regulated industry. It is regulated on a federal level by the Federal Trade Commission (FTC), and on a state level by some, but not all, state regulatory agencies. Compliance with existing federal and state regulation makes the business of franchising more complicated, and therefore more expensive to be involved in.

The Federal Trade Commission Franchise Rule, 16 CFR 436, defines a franchise as:

any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

(1) 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;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) 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.”

So the three criteria of a franchise, simply stated, are: 1) party A operates a business using the trademark of party B; 2) party B has significant control over how party A operates the business, or party B provides significant assistance to party A in the operation of the business; and 3) party A pays a fee to party B. All three of these conditions must be present in order for the business to be considered a franchise.

While the FTC’s definition of a franchise seems straightforward, the complexity surrounding what is a franchise can be found mainly in the second prong of the definition, through the FTC’s use of the terms “significant degree of control” and “significant assistance”.

Often times where party B provides party A with training, operational support, and/or manuals, the assistance/control will be deemed to be significant enough so as to meet the definition of a franchise. The problem arises when party B exerts “some” assistance or control, but does not go so far as to offer training, operational support or manuals.

The FTC has issued several advisory opinions on this subject, which opinions can be found at http://www.ftc.gov/bcp/franchise/netadopin.shtm. Specifically on this issue, the FTC stated in 1998 that:

“In your letter, you contend that the Licensor does not require any operational standards, nor does it impose controls over the licensees’ entire method of operation. For example, the Licensor will not approve sites, control hours of operation or production techniques, or dictate accounting practices. Rather, you contend that the limited controls are designed to protect the franchisor’s rights and value in its proprietary information and to verify that license fees are properly calculated. We disagree.

You correctly state that the Commission will not consider as significant those controls designed solely to protect the franchisor’s trademark rights under federal and state trademark law, such as display of the mark requirements or right of inspection. 44 Fed. Reg. at 49968. We also note that reasonable covenants not to compete, which are common in franchise systems, are frequently used to protect proprietary information. However, the exclusive sales territories imposed by the Licensor appear to go beyond mere trademark protection and pertain to the licensee’s entire method of conducting its business. Such restrictions have the potential to cause serious economic harm by limiting the licensees’ market and ultimately limiting the licensee’s profitability. See 44 Fed. Reg. at 59660-62. Indeed, the Final Interpretive Guides specifically list “restrictions on customers” and “location or sales area restrictions” among the types of controls over a franchisee’s method of operation that will be deemed significant.” Id. at 49967.”

The FTC, as well as any state regulatory agency, focuses solely on the substance of the relationship, not terminology, when examining the issue of what is a franchise. It is irrelevant how the parties characterize one another, whether as a license, independent contractor, subcontractor, joint venture, or distributorship relationship.

Please also be advised that certain states define a franchise slightly differently than the FTC definition cited above. Therefore, when facing the question of whether your business meets the definition of a franchise, proceed with extreme caution, and consult a knowledgeable franchise attorney.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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Reviewing a Franchise Agreement – Tips for a Non-Franchise Attorney (Part 3)

Friday, May 29th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

Continued from Part 1 & Part 2

The practice of franchise law is a niche area when it comes to the representation of franchisors.  Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law.

There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed at the idea of reviewing a franchise agreement and advising a prospective franchisee. With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.

9. Recovery of Attorney Fees.  The issue of the recovery of attorney fees spent by either party when a dispute arises between a franchisor and franchisee is a topic that must be looked at carefully when reviewing a franchise agreement.  Fees paid to attorneys are costly in even the simplest of matters, and such fees can escalate dramatically as the disputes get more complex and the parties involved get more acrimonious towards one another.  It is a priority when reviewing the franchise agreement to determine whether the recovery of attorney fees is addressed in the agreement, and if so, who has the right to recover such fees and how.  There are several different methods by which franchisors address the recovery of attorney fees.  The most popular method for recovering attorney fees is through the use of a “prevailing party” clause, which enables the winner of a lawsuit or arbitration to collect its attorneys’ fees from the losing party, provided the judge or arbitrator chooses to enforce such language.  This type of clause is popular with franchisors who believe it is useful as a deterrent to franchisees who may otherwise attempt to bring questionable actions against the franchisor.  Other franchisors choose the opposite route and simply state that either party to a dispute is responsible to pay its own attorney fees and costs.  A third type of clause is the one-sided franchisor attorney fees clause, which states that if the franchisor is forced to bring an action to enforce its rights under the agreement, or is forced to defend itself from an action brought by a franchisee, the franchisor is entitled to recover its fees as long as it prevails in the action.  This language gives the franchisor the best of the prevailing party language without having to share the benefit with a franchisee.   This one-sided type of clause is frowned upon by some courts due to the lack of mutuality between the parties.  However, rather than rely on a court to strike the language down, it is recommended that a franchisee’s attorney look to change this language to make it mutual for both parties at the outset.

  • Recovery of Attorney Fees. The issue of the recovery of attorney fees spent by either party when a dispute arises between a franchisor and franchisee is a topic that must be looked at carefully when reviewing a franchise agreement.  Fees paid to attorneys are costly in even the simplest of matters, and such fees can escalate dramatically as the disputes get more complex and the parties involved get more acrimonious towards one another.  It is a priority when reviewing the franchise agreement to determine whether the recovery of attorney fees is addressed in the agreement, and if so, who has the right to recover such fees and how.  There are several different methods by which franchisors address the recovery of attorney fees.  The most popular method for recovering attorney fees is through the use of a “prevailing party” clause, which enables the winner of a lawsuit or arbitration to collect its attorneys’ fees from the losing party, provided the judge or arbitrator chooses to enforce such language.  This type of clause is popular with franchisors who believe it is useful as a deterrent to franchisees who may otherwise attempt to bring questionable actions against the franchisor.  Other franchisors choose the opposite route and simply state that either party to a dispute is responsible to pay its own attorney fees and costs.  A third type of clause is the one-sided franchisor attorney fees clause, which states that if the franchisor is forced to bring an action to enforce its rights under the agreement, or is forced to defend itself from an action brought by a franchisee, the franchisor is entitled to recover its fees as long as it prevails in the action.  This language gives the franchisor the best of the prevailing party language without having to share the benefit with a franchisee.   This one-sided type of clause is frowned upon by some courts due to the lack of mutuality between the parties.  However, rather than rely on a court to strike the language down, it is recommended that a franchisee’s attorney look to change this language to make it mutual for both parties at the outset.
  • Territory. Some franchise systems grant franchisees “exclusive” territories, meaning that these franchisees are protected from competition from other franchisees, and in many respects from the franchisor as well, inside this designated territory.  Though it depends on the industry, many franchisees view a protected territory as a must.  The franchisee believes this market protection will allow its business to flourish, and an agreement that does not contain a protected exclusive area will cause the franchised business to fail.  There are several opinions on either side of this argument but hardly an exact answer.  As an attorney preparing to advise your franchise client, you must review the franchise agreement in order to understand what the franchisor is offering in the way of territories.  While doing so you must keep the following questions in mind:  Does the franchisee understand that even with a protected territory, he will still most likely be competing against several, if not dozens, of competitors from other brands inside an exclusive franchise territory?  How does the franchisee view the theory of market saturation that the more of a particular brand, product, or service a customer sees, the more popular and acceptable the brand becomes?   Given the choice, would the franchise client prefer to be a franchisee of a system that grants enormous exclusive territories to each franchisee, but with small number of total franchisees overall?  Or would the client prefer a franchise system that grants smaller or even no territories, but where the number of franchisees, and thus the number of outlets at which the product or service is available, is much greater?    In conjunction with the idea of exclusive territories, make sure to pay attention to the language of the franchise agreement discussing the franchisee’s right to advertise and sell products and services in areas located outside the franchisee’s territory that are not owned by other franchisees of the system.  Just as important, also pay attention to any language that reserves to the franchisor the right to compete with the franchisee inside the franchisee’s territory, especially when it comes to the sales of products over the internet.

Conclusion: As mentioned above, the above tips address only some of the issues that you should be aware of when reviewing a franchise agreement.  A diligent attorney reviewing a franchise agreement will often find several other issues that are material to the prospect’s decision to purchase a franchise.  In addition, please note that this paper does not discuss registration or disclosure issues in the state of Maryland or elsewhere.  The Maryland Franchise Registration and Disclosure Law requires  each franchisor to register its FDD with the Securities Division of the Maryland Attorney General’s Office prior to making an offer of sale of a franchise in the state of Maryland or to a Maryland resident.  In addition, the revised FTC Franchise Rule mandates that 14 days pass between the day a prospect is given an FDD and the day a franchise agreement is executed and/or a prospect pays money to a franchisor.  In the event you have a question regarding a franchise registration or disclosure issue, consult an experienced franchise attorney.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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