Franchise Lawyer Blog

A potential client called the other day and described a potential business venture to me. He said that he wanted to structure it as a license rather than "getting involved in all of the complications of franchising."

As an aside, we have written on the topic of franchising vs. licensing previously.

Recently, the American Bar Association's Forum on Franchising's Listserv, which we have discussed before , featured a long chain of emails on the same subject, during which many opinions were offered as to what defines a license and a franchise, as well as the gray area between them, and whether those definitions can be manipulated to one's benefit.

However, one writer offered the clearest bit of advice. He suggested that his esteemed colleagues, being lawyers, were focusing on the legalities of the situation to the exclusion of everything else, including good business sense. He proposed that the proper approach is to look at the business being contemplated and decide what is the best model for its expansion. Forget the law, don't even talk to your lawyer unless he is able to not miss the forest for the trees. When that business model is clearly established, then apply the tests to determine whether or not it needs to be structured as a licensing arrangement or a franchise system.

More often than not, the situation will call for a franchise model. This is because the three prong tests that we have discussed before identify three elements that most successful business models will want to include. The three prong test identifies (i) a fee as a condition for entry into the business; (ii) the use of a trademark; and (iii) a marketing plan or system. It's sometimes hard to imagine how to license a trademark, while properly protecting your rights by controlling its use, without qualifying oneself as a franchise.

But if the model calls for a franchise, we tell our clients not to look for a way around it but rather to embrace it. As franchise regulation evolves and the models become more refined, it continues to establish itself as an extremely efficient means of exponentially expanding the number of units of a particular business.
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I attended a breakfast meeting for small firms at the ABA Forum on Franchising a couple of years ago and my table's topic was technology. I have always thought of myself as relatively savvy on technology issues, but I was startled at how little I knew about some of the concepts that were discussed at that table. It made me realize that many lawyers are totally fascinated with technological advances to the practice of law. One of the reasons for this is that new technology means you get to buy new stuff, frequently cool new stuff with an intriguing gadget type quality. With all of that in mind, I was sent an article by Suzane Smith of the online publication Court Reporter Schools, entitled "Top 20 iPhone Apps for Busy Attorneys." I have an iPhone and I find it enormously useful in my day to day activities, including my law practice. I keep my calendar, contacts and email on it. I recently started using a free Voice Memo application ('app") which is extremely useful for keeping track of stray thoughts or even dictating a letter. I have not tried any of the other apps mentioned, but I will undoubtedly end up using some of them. The key to the iPhone is harnassing its usefulness while maintaining one's focus, so that I do not find myself trying to review a document, while simultaneously reading my email, instant messaging my son, texting my daughter, listening to music and playing Blackjack.

Most franchised businesses are small businesses, by some definition. Financing a small business has always been a difficult proposition, particularly a start-up small business. And that has never been more true than today, when frozen credit markets, uncertain loan standards and skittish loan officers have made it virtually impossible for a small business to obtain credit.

In the past, the U.S. Small Business Administration ("SBA") has been able to lend assistance in this area. The SBA guaranties qualified loans from approved lenders, making it easier for banks to extend credit to certain franchisees. The SBA has actively engaged itself in the franchising industry with the creation of The SBA Franchise Registry. The Franchise Registry, found at a website managed by FRANdata, describes itself as "a national online listing of franchise systems whose franchisees receive expedited loan process when applying for financial assistance from the U.S. Small Business Administation (SBA)." The SBA preapproves the franchise agreement and, effectively, the franchise system. The website observes that membership on the Registry is not a prerequisite for obtaining an SBA loan, but then it notes that some SBA lenders will not process a loan for a franchise system that is not represented on the Registry.

The SBA requirements that have developed over the years as being necessary for a system to obtain qualification have frequently been a source of controversy. Recent posts on the Listserv for the ABA Forum on Franchising have discussed an SBA requirement that the SBA will not approve a loan in a system where franchisees are subject to Electronic Funds Transfers (EFT) by the franchisor, because this does not leave the franchisee with sufficient control over its own business to qualify as an independent small business. Naturally, this has given rise to cries of outrage from franchisor counsel that preventing the use of EFT and similar electronic/internet monitoring devices strips the franchisor of necessary protections that are commonly used in this day and age.

A recent email to the ListServ from the IFA commented on that organization's lobbying efforts to gain recognition in Washington that the SBA loan guarantee is frequently the only way a fledgling franchise can obtain financing. The IFA and other franchisor advocates have argued that the rules relating to the loan guarantee programs need to be updated and improved to take into acount frozen lending markets and rapidly developing tools being used within franchise systems, tools which sometimes blur the line between control and independence.

If you are a franchisor interested in facilitating credit for your franchisees, we suggest you look into the SBA program, at the website noted above. If you are a potential franchisee, we suggest you go to the actual Franchise Registry and see if the system you are interested in is represented there.

We will keep abreast of developments in this area and provide further advice down the road.

A quick follow up:

Demonstrating that we know a trend when we see one, the most recent IFA Smartbrief received today refers to more articles concerning the ebb and flow in franchising caused by this economic climate. The flow is caused by the human tide of employees and business developers that have been jettisoned by the conventional economy. The ebb is caused by the increasingly constrained credit markets, which are making it difficult for businesses to get the financing needed to start-up or survive.

Our last entry discussed these topics. Today's IFA Smartbrief refers to an article in the Orlando Sentinel that examines the local economy in Florida and finds that many people who have been left unemployed by corporate downsizing are looking to make new careers through franchising. As we noted in our last blog, this need for immediate employment is creating a trend towards business-format franchises and other low cost to entry franchises that will provide immediate returns.

The Smartbrief also refers to an article in The Boston Globe that reports on developments in Massachusetts with similar observations: people forging ahead with business development in the franchising space, concentrating their efforts on the grassroots level, finding local trends that are cost conscious in a way that appeals to local wallets.

However, both articles make reference to the credit crunch. The Orlando Sentinel notes that FRANdata reports a 27% decline in franchise borrowing over the past few months, undoubtedly because of the lack of available credit. This trend could make it impossible for even the most savvy, driven business visionary to get her idea off the ground.

We have written previously about the unusual position that the franchising model may end up occupying in this recession. We have suggested that franchising may not be affected as severely by the recession and that franchising may offer opportunities to those forced out of areas of the more conventional economy.

We posited in all of those earlier writings that only time would tell. Our recent issue of IFA Smartbrief, the informative newsletter of the International Franchising Association, contains a couple of stories that suggest that these views are beginning to gain traction, albeit with some nuances.

The May 26 issue of the IFA Smartbrief refers to an article in The Palm Beach Post that paints a guardedly optimistic picture of franchising prospects in a recessionary economy. The article states that franchising has always grown in prior recessions, based upon the flow of laid off personnel from traditional jobs who decide to start their own businesses. The author cautiously notes that this recession is different in that it comes accompanied by a severe credit crunch, which makes it difficult to finance a new business enterprise. In fact, the IFA itself has measured a 1.2% decline in franchises in 2009 so far, the first decline in recorded history. However, a 1.2% decline in an economy that has retracted as much as this one may be viewed as a positive.

The IFA Smartbrief also highlights a recent article from The Charlotte Observer in a similar vein, which makes some observations on the flight of down-sized refugees from the corporate world into entrepreneurial small business. The article makes a somewhat grimmer assessment of this trend. It notes a severe contraction in six figure jobs and observes that while the Kauffman Foundation Study finds a national increase in new businesses, much of this growth is in lower income franchises, such as child care and retail services, suggesting that people are creating jobs out of necessity, rather than finding great business opportunities.

We recommend you to the Smartbrief (contact ifa@smartbrief.com) for actual hard news about how franchises and franchising is faring in this economy. With respect to our earlier writings, there does appear to be a shift in emphasis towards franchising, but entry may be harder than forecast because of the credit crunch. Moreover, the desperation of unemployment may be driving people to lower cost to entry and lower income franchising opportunities.

Franchisors and franchisees each have a vested interest in determining the prices of the goods or services being sold at franchised locations. These concerns and the manner in which they are addressed frequently bring the franchise world into contact with the labyrinthian world of legal antitrust restrictions.

One basic form of price control is minimum retail prices; that is, the franchisor and/or its suppliers establishing a pricing floor beneath which their products cannot be sold. The motivations behind this device are many: to maximize profits; to prevent dilution of the value of the good and/or services; to encourage competition, etc. For 96 years, vertical minimum price agreements; i.e., agreements running up and down from franchisees/retailers to manufacturers/distributors/franchisors, were considered per se illegal under Section 1 of the Sherman Act as anti-competitive price fixing. Per se illegality means they are automatically illegal regardless of the circumstances.

Then in 2007 came the case now referred to as Leegin. In Leegin, the United States Supreme Court ruled that vertical price restraints should hereafter be judged by "the rule of reason," overruling the 1911 case of Dr. Miles Medical Co. v. John D. Park & Sons Co. Justice Anthony Kennedy's majority opinion held that "Dr. Miles had erred by treating vertical minimum price agreements between manufacturers and retailers as analogous to horizontal price-fixing agreements between sellers."

Since then, commentators have been divided on the impact of Leegin. While the decision has been recognized as affording companies, including franchisors, greater flexibility in imposing minimum retail price maintenance programs, it has been noted that it is not clear how state laws will be affected by the federal decision or even if the states will follow it at all. Many states have laws as restrictive as the Sherman Act but not identical to it.Only time will tell how the individual states continue to enforce their laws intended to prevent anti-competitive behaviour.

On the other hand, some business commentators have noted a willingness on the part of manufacturers, and presumably franchisors and their suppliers, to "embrace their newfound pricing power." Some of have expressed concern that this will feed inflation.

The effect of the case will bear close scrutiny for some time. Congress continues to look at the effect of the Leegin decision on consumer prices. Many legal commentators warn that determining that vertical minimum price maintenance is not per se illegal is not the same thing as saying that it is per se legal; in other words, the rule of reason analysis can still find that the conduct violates the Sherman Act. For that reason, franchisors and their manufacturers and suppliers are urged to implement any such pricing structures with a carefully thought out plan that takes into account the specifics of the Supreme Court's decision.

Not all franchises succeed and some industries are inherently riskier than others. Perhaps none is more risky than start-up restaurants. Although the risks and obstacles to success in these types of ventures are well known, it is human nature to look for someone (other than yourself) to blame when failure occurs. In the franchising universe, sometimes the franchisor is to blame. But not always.

A United States District Court in Georgia has ruled in favor of a franchisor, Raving Brands, in a lawsuit filed against it last year by a group of franchisees. The franchisees had each claimed fraud and misrepresentations against the former franchisor in the purchase of a Mama Fu franchise. Mama Fu's is a restaurant serving pan-Asian cuisine.

The federal judge ruled that there are natural risks associated with the acquisition of a franchise, particularly a restaurant, and that it was these economic conditions that caused the failure of the franchisees' locations, not any misrepresentations by the franchisor. The court found that the franchisor had clear intentions of building a chain as successful as their hugely popular Moe's Southwest Grill. But various conditions prevented that from happening. Franchisee lawyers take issue with the decision, noting that clear evidence was presented demonstrating some misrepresentations in the sale of the concept.

Raving Brands has since sold the system to Murphy Adams Restaurant Group. That franchisor continues to push the sale of updated models of its franchise.

A recent news item reported that the Burger King franchisor entered into a multi-million dollar settlement for a personal injury suit. Why was the Burger King franchisor ultimately liable for an accident that took place on the premises of one of its franchisees? The legal principles affecting that question should be of great concern to any franchisor.

The basis for this claim and others like it rest in a variety of legal concepts founded on the notion of vicarious liability; that is, liability imposed upon a party because of the actions of another. The claims are usually based on the doctrine of respondeat superior, which provides that the franchisor, as master, is liable for the acts of its servants and agents, in this case the franchisee. Other cases present the argument as one of "ostensible agency," the franchisee effectively acts as agent on behalf of the franchisor and so any liability created by the franchisee becomes the franchisor's.

The key element to determine is the degree of control; whether the franchisor had the right to control the conduct of the franchisee that caused the injury. Ironically, retaining control over the business environment is typically viewed as being of vital importance to a franchisor's business success. In this context, control becomes a double-edged sword.

It has been recommended that this exposure can be reduced by including disclaimers and waivers of control within the franchise agreement. Too often, the issue of franchisor liability for franchisee actions are covered in standardized clauses covering liability and indemnification that are inserted into franchise agreements without much thought. However, a carefully written agreement will seek to retain control in certain vital areas (financial reporting, for instance), while disclaiming or waiving any degree of control over certain day to day operations of a franchisee that might give rise to liability.

We have written extensively on the role the franchising model can play in a recessionary economic environment, most recently on January 22. While there is some evidence that franchising is a viable alternative model in uncharted economic waters, there are also significant risks.

Although we have previously offered some evidence that franchising business models are weathering the storm better than the market as a whole, it is too early to draw any final conclusions.

To continue the discussion, we refer you to a piece in that vein recently posted on MSNBC.com, titled "When Career Turns Down, Franchising is an Option," by Eve Tahmincioglu, which discusses how "some laid-off workers turn to franchising."

If you are reading this blog, you are most likely engaged in a search for information or sources of information regarding franchising or more specifically, franchise law. Of course, I could gratuitously point out that information relating to franchising is readily available by picking up the phone and talking to any of the lawyers at this firm, but if you are a professional who is looking to immerse him or herself in the field of franchising, you might consider attending the Legal Symposium of the International Franchise Association, held in Washington, DC on May 17 to the 19th.

The Legal Symposium is a gathering place of the franchise legal community and franchise executives that provides more than just an esoteric discussion of franchising law. It is intended as a business oriented program that provides an opportunity for the franchising legal community, including many in-house attorneys, to present and discuss topics of current concern. The Legal Symposium Task force has made a conscious effort to incorporate the participation of more in-house counsel and franchise executives, to give the meeting a business oriented feel that distinguishes it from the more scholarly atmosphere of its ABA counterpart.

This year's Symposium will focus on the unprecedented challenges facing the global economy and the inevitable effect on the franchising world of the nearly simultaneous crash of the real estate and stock markets. The legal community must view itself as a source of advice and innovative solutions that will help franchised businesses not only survive this harsh environment, but perhaps find opportunities to thrive in these difficult times. There are a number of presentations available at the Symposium in this vein.

However, it is important to not let economic anxiety overshadow the need to examine some real legal developments. There are other presentations that will address recently developing issues such as the rule changes governing financial performance representations in the Franchise Disclosure Document ("FDD") and the effect of the new FDD form on registration requirements. There will be much discussion regarding general issues that have come up in the past year regarding disclosure under the newly amended FTC rule and the new FDD. There are also presentations of interest on trademark and antitrust issues and numerous other legal issues. This firm's Julianne Lusthaus will participate in a panel discussion on "boilerplate clauses" in franchise agreements, an area that gives rise to many issues in interpretation and enforcement.

This event and the ABA's Franchise Forum in October are the two primary legal gatherings for franchise law practioners. If you are the type of attorney who is engaged on a consistent basis in the franchise practice with a "hands-on" approach to the businesses involved, this Symposium could be of particular interest to you.

Contact us on our contact sheet if you have any questions concerning this discussion or any other matter.

As we never get tired of saying, franchise law is ever changing and evolving. This is partially because the business model itself is constantly in flux as new industries are explored. But this is also true because the law governing franchising has recently changed in dramatic fashion and is in the process of being interpreted in practice and in court. Since July 2008, the Uniform Franchise Offering Circular ("UFOC") has been replaced by the Franchise Disclosure Document ("FDD"), with new regulations associated with those new documentary requirements. We have discussed these changes in depth on our website.

All attorneys try to stay up to date with trends in the law, but in franchising it is necessary to be particularly vigilant. Most practioners are familiar with the standard resources: treatises, textbooks, case law. We thought it worthwhile to mention a few other sources of valuable information.

One of the more interesting ways to stay abreast of legal developments is to join the American Bar Association's Forum on Franchising and participate in that Forum's "listserv," which is an email discussion group that provides a remarkable amount of information on a current basis on questions that are arising in the franchise practice. Recent discussions have concerned "evergreen renewal" clauses and the practice of offering variations on initial franchise fees from one franchise sale to another.

Another valuable source of current information is the ABA's Franchise Law Journal, which can be obtained on the ABA's website. The FLJ is a quarterly. The most recent issue provides an interesting prognostication of what is in store for the franchise industry for 2009, as well as its regular collection of current cases in franchising and distribution, an invaluable resource for how to avoid trouble in creating franchise documentation.

To see the types of franchise disclosure document ("FDD") that are actually being filed, either in order to review a particular filing or to get a sense for the drafting and terminology in use, one can refer to the filings made with the State of California, which are a public record. That record covers nearly the entire franchise universe, as nearly everyone in business gets to Califronia sooner or later. In order to do so, access Cal-EASI. Once there, click on the tab entitled: Access to Securities Filings ("Cal-Easi).. Once at the database main page, you will be able to search for franchise and securities filings by corporate name, federal tax ID numbers, document type and other searchable categories.

The above items have offered insight on areas that actually come up for the franchise practioner and would be of interest to anyone active in the business.

When a franchisor sues a franchisee to obtain judicial blessing of a notice of default and termination—on the franchisor’s own initiative, or because the franchisee challenges the validity of the termination—typically the franchisor will include a cause of action for trademark infringement and move early, perhaps immediately, for a preliminary injunction enjoining the franchisee from continuing to use the franchisor’s intellectual property. Such an injunction, if granted, effectively shuts down the franchisee, inasmuch as it is the use of the franchisor’s intellectual property that the franchisee is paying for, principally.

The franchisor’s argument to the court, as it must be, is that the continued use of its trade marks, et cetera, by the franchisee allegedly in default is a violation of both contract and law that will cause the franchisor irreparable harm. This is probably true if the default at issue concerns a system violation concerning heath, safety, or the quality of goods or services provided by the franchisee.

But what if the default is simply an alleged failure to pay money, or the like? The franchisor might be likely to prevail on this cause of action, and in the end would be entitled to terminate the franchise agreement (and the included license to use its marks), but there is no harm to the public during the pendency of the action. If the doughnuts are the same as they ever were, for example, then there is no risk of consumer confusion, the sine qua non of trademark protection. Accordingly there is, arguably, no reason to enjoin the franchisee’s use of the marks pending trial of the action.

To the contrary, injunction would require the franchisee to go dark, almost always ruining its business. Therefore, even if trial reveals that the franchisor is not entitled to judgment, potentially irremediable damage to the franchisee will have been done—damage that an injunction bond might not adequately protect against.

The law is, for better or worse (that is, better for franchisors, worse for franchisees), that a franchisor is entitled to stop a franchisee from using the franchisor’s marks even while it remains to be decided by a court whether the franchisee has defaulted in its obligations under its franchise agreements. But should it be so?

Continue reading "Dollars to Donuts: The Dark Side of Trademark Injunctions in Franchise Actions" »