Additional Franchisor Liability From Franchisee Employees

Over the past several years franchisees have been claiming that they have employee based claims against the franchisor. This has been especially prevalent in the janitorial and other service based franchises. Now we are getting cases where employees of franchisees are making claims that they are employees of the franchisor in certain cases.

 

Generally franchisors have been able to say that they are a separate entity from the franchisee and therefore cannot be liable to employees of the franchisee. But recently in New York, employees of Domino's Pizza franchisees were able to amend their complaint against the franchisee employers to also include Domino's, the franchisor, for violations of the Fair Labor Standards Act and the New York Labor Law. This case is Cano v. DPNY, Inc.

 

While this case is still pending and the franchisor may not be held liable in the end, it is concerning that the court did not dismiss the amended complaint, as expected. Some of the reasons the court gave for not dismissing the amended complaint are based on the following actions by Domino's:

 

1) Domino's promulgated compensation policies and implemented them through the Domino's PULSE system which included tracked hours, wages and payroll records. These were submitted to the franchisor for review.

 

2) Domino's created management and operation policies and practices that were implemented at the restaurants by providing materials for use in training store managers and employees, provided posters and directions for employee's tasks and monitored that performance through required computer hardware and software.

 

3) Domino's developed and implemented hiring policies.

 

This is just one more reason for a franchisor to have their franchise attorney review their policies, including their operations manuals, to ensure that they are limiting their exposure to liability.

Multi-Unit Development Arrangements

There are three types of agreements used when a franchisor desires to expand through multi-unit as opposed to single unit development: Master Franchise Agreement, Area Representative Agreement and Area Developer Agreement. Before exploring some of the basic elements of each arrangement, it is important to note that there may be franchise registration requirements associated with entering into any of these agreements and it is important to speak with a qualified attorney who can help you understand the impact of each type of arrangement.

Master Franchise

This type of multi-unit development is most often seen with international expansion. In this type of arrangement, the franchisor will delegate nearly all pre-sale and post-sale obligations to the master franchisee who essentially acts as a sub-franchisor. However, while most of the franchisor’s obligations are delegated, most franchisors will retain the right to ultimately approve or reject sub-franchisee candidates and specify the format for the FDD and the Franchise Agreement. The reason for this is that in the event the Master Franchise Agreement is terminated, a franchisor needs to agree with the obligations and requirements imposed on both the sub-franchisee and the franchisor.

If you are a franchisor seeking to expand through a Master Franchise Agreement, or a franchisee looking to purchase a Master Franchise Agreement, there are some key provisions that need to be addressed in the agreement. Among the provisions to be aware of:

·         Is the master franchisee required to sign the sub-franchise agreements;

·         Is there a strict development schedule;

·         Is the master franchisee allowed to develop his/her own franchise units;

·         How are the currency issues handled;

·         How are taxation matters handled;

·         Is there a translation requirement;

·         What is the term;

·         Are there country-specific franchise laws that must be followed;

·         At the expiration of the term of the Master Franchise Agreement, what happens to the then-current sub-franchisees, their territories and their agreements;

·         What is the royalty and other fee splitting arrangement (if any); and

·         What is the territory and is it exclusive.

Area Representative

In this type of arrangement, the franchisor typically delegates only certain pre-sale and post-sale obligations. The typical area representative relationship is one where the area rep helps to advertise and promote the franchise opportunity in a specific market, engages potential franchise candidates and helps provide operational support and guidance to the any franchisee resulting from the area rep’s efforts.

Key provisions to be aware of in this type of arrangement include:

·         What is the territory and is it exclusive;

·         What specific post-sale obligations and services are to be performed by the area rep on the franchisor’s behalf;

·         If there are current franchisees in the territory, will the area rep perform the services and obligations to them or only to new franchisees;

·         What is the term;

·         What is the compensation/fee arrangement; and

·         Does the franchisor have the right to open and operate company-owned units in the territory without compensation to the area rep.

Area Developer 

This type of multi unit development arrangement is most closely aligned with single unit franchising and is a common form of development. Here, the third-party developer agrees and commits to develop and operate a specified number of units in a designated territory. This arrangement is most commonly used in a domestic market where there is a low or non-existent franchisor presence.

Key provisions to be aware of in this type of arrangement include:

·         What is the term and time frame for developing the units;

·         What is the territory and is it exclusive;

·         Are additional franchise units outside the development schedule allowed;

·         What is the price per franchise unit developed; and

·         What happens to existing franchise units of the area developer if the Area Development Agreement is terminated.

With each type of multi-unit arrangement there are several additional factors to consider. It is important to have a clear idea of why you are seeking either to expand through multi-unit development or to purchase a multi-unit development agreement, and to discuss these ideas and plans with qualified professionals. 

The Accidental Franchisor

Recently I heard a conversation between attorneys regarding a business transaction they were in the middle of setting up for a client. The client wanted to do a series of LLCs or joint ventures with various partners. The client would contribute the business concept and name and the other “partners” would contribute money and time to operate the businesses. What these attorneys did not understand is that they were setting up a franchise system for their client.

 

Very often a business will be structured without realizing that the structure is a franchise. A franchise exists if the definition of a franchise is met, not if the franchisor knew they were selling a franchise. In this case, the client’s business transaction has all three definitional elements of a franchise: 1) Use of a trademark (the use of the client’s business name); 2) A marketing plan, substantial support, or community of interest between the franchisor and franchisee (the contribution of the business concept by the client); and 3) Payment of a fee (the financial contribution by the partners).

 

Because the client’s business transaction is a franchise, the client is required to comply with federal and state laws regarding the sale of a franchise, prior to entering into the business. This means that before entering into these partnerships, the client would be required to provide the financial “partner” with a disclosure document discussing information about the business and trademark, background information on the client and its business and affiliates, and other “partners” or franchisees of the client.

 

There are serious consequences for selling a franchise without complying with the franchise laws and regulations. These consequences include rescission of the business transaction, damages and attorney’s fees, plus the potential of fines or other penalties from state or federal agencies. In some cases, the transaction can be seen as criminal.

 

Next time you are setting up a business concept that has any of these elements (trademark, marketing plan, and/or fee), it is worth the time and cost to consult a franchise attorney to make sure that you are not an accidental franchisor.

Financing your Franchise

If you are considering purchasing a franchise, one major hurdle to overcome is how to fund the new business. If you have tried to obtain a loan or refinance a business, you know the lending environment today is very different from what it was even 5-6 years ago. In essence, it is harder to obtain financing, even for those with great credit ratings. There is money out there, but it harder to access that it was previously.

When looking at funding the new business, you first need to evaluate all the financing options available and determine which will be the best route for you to take. Because lack of sufficient capital in the initial stages of starting a business (whether your own concept or a franchise) is one of the leading reasons businesses fail, you want to make sure to have adequate financing in place before you purchase. The International Franchise Association (IFA) has a dedicated website to help you look at all available funding options to help you choose which option(s) is right for you: http://franchise.org/IFACreditAccess.aspx.

Below is a brief overview of some of the financing options available to franchisees:

1. Cash. Obviously, if you have enough cash, you have greater options both with conventional financing options, and in quickly getting your business started. As they say, cash is king. But you don’t want to make the mistake of using all your cash up front and not having the ability to access additional capital or to obtain financing down the road.

If you don’t have the cash available, you may want to consider taking on a partner who does have sufficient capital. This is a risk that you will have to carefully weigh when determining if a person is the right partner for you and the business.

2. Veteran Programs. If you in the military and close to retirement, or are the spouse of an active member of the military, you may qualify for the Patriot Express Pilot Loan Initiative. This program is an SBA-guaranteed loan program in which the SBA guarantees up to 85% of the loan, up to $500,000 at the SBA’s then-current lowest rates. The SBA website contains eligibility criteria and requirements.

In addition, the IFA has started the VetFran program to help honorably discharged military personnel finance their purchased franchise. Franchisors who participate in the VetFran program will typically offer reduced initial fees and/or reduced ongoing and other initial expenses.

3. SBA Loans. This option is especially viable if you are looking at a franchise system that has registered on the SBA Registry. The process to obtain financing is faster and easier with a registered franchise system.

4. 401(k) and IRA. This is a risky option, but has its advantages if properly done. Before moving forward with this option you should speak with a qualified tax attorney or accountant who can discuss the tax implications in using retirement funds.

5. Equipment Leasing. Remember, you don’t always need to purchase everything up front. If the franchisor allows you to lease, this can be a great alternative.

6. Conventional Loans/Commercial Lending. This type of funding is often difficult to obtain because your credit score is the most important factor in determining to grant or deny a loan. Even then, a great credit rating will not often overcome a high debt to income ratio. You will often need to put 20-30% down in order to qualify.

7. Franchisor Financing. This option is rarely made available. However, if it is, the financing and terms will be set out in Item 10 of the FDD.

8. Other Options. In addition to the above there are home equity loans, signature credit lines and online loan portals. 

Franchisor Control and Liability Issues

One area of a franchise system that must carefully be examined by franchisors is the amount of control exerted over both franchisees and the franchise system. Courts are increasingly finding ways to impose liability on the franchisor for the actions or omissions of the franchisee. As a rule of thumb, a franchisor is able to exercise the amount of control necessary to protect the brand, goodwill, trademark and quality control of services and products. Overstepping this can lead to devastating consequences.

When examining the possibility of imposing liability on a franchisor, the courts look at both the franchise agreement and the actions of the franchisor. The greater the level of control in the day-to-day operations or the details of the franchisee’s business, the greater the likelihood of imposing liability on the franchisor. For example, becoming involved in the hiring and firing of a franchisees employees can lead to imposition of liability, dictating the exact method of how floors should be cleaned, at what times and with which products can lead to liability, as can having security cameras on the franchisee’s premises that the franchisor continually monitors.

There are generally three types of liability imposed: vicarious liability, liability in a co-employer relationship, and liability in that the franchisor acts as the actual business instead of the franchisee. For the last type of liability, the courts looks at whether a franchisee can and will reasonably and justifiably believe the franchisor actually controls the operations of the business, and not the franchisee.

Avoiding the above-types of liability and other possible liabilities requires a franchisor to make careful considerations. Clearly maintaining a level of control is a necessity in a franchise system. However, the issue of control and the imposition of liability will continue to be a litigated issue. Franchisors should exercise caution when expanding controls, and should speak with a qualified franchise attorney to help them understand if the controls exerted stay within the acceptable levels of control or if they carry with them the possibility of liability. 

Helpful Resources:

Franchisor Liability for Franchisee Actions

Franchise Registration Process

Initial Registration

For new and existing franchise systems, registration states can create a headache if the registration process is not handled correctly. The process can be time consuming and expensive, especially if not handled correctly the first time.

There are 14 registration states: California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. The initial registration fees vary from $125 to $750. In each of these 14 states, a franchisor must not only comply with the FTC Disclosure Rule, but must also comply with the individual state rules which often impose additional disclosures and restrictions on the franchisor. Simply put, if you are interested in taking your franchise system into one of the above 14 states, you are restricted from offering or selling to either an individual residing in that state, or to an outside individual looking to franchise within that state.

As a baseline, all franchisors must comply with the FTC Disclosure Rule and have appropriate and compliant documents before offering or selling a franchise. From there, a franchisor can add state-specific addenda or create a state-specific FDD for registration purposes.

Depending on the registration state, registration is either immediate (meaning once the state receives the FDD packet and required documentation, the franchisor can begin to offer and sell in that state) or the registration will take time, after an examiner has reviewed all the provided documents to make sure they are compliant with state law. Often a state examiner will provide the franchisor with a list of issues that need to be addressed and corrected (a “Comment Letter”) before the state can register the franchise for offers and sales.

Renewal

Once a franchise is registered in a state, that registration is generally effective for a one-year period, after which the franchise must be renewed, for a fee, in that state in order for the franchisor to continue to offer or sell there. However, not all registration states count this “year” in the same way. Some states have an expiration one year from the date of registration. Other states have an expiration date of 90-120 days from the end of the franchisor’s fiscal year end. Your registration letter will provide the date of expiration. You should calendar this date and be aware that it might be sooner than expected.

Renewal is also required in all non-registration states. The difference is that once the disclosure documents have been updated (including an updated audit) then the franchisor can generally begin offering and selling franchises in non-registration states. (The one caveat here is that if the state is a business opportunity state, you must make sure you file the appropriate exemption before selling in that state.)

Exemptions from Registration

Both the FTC and Registration States provide limited exemptions to registration. These vary from state to state. In most instances, the exemption only removes the registration requirement, not the disclosure requirement. You will still need to have accurate and up to date documents, and to comply with the timelines for disclosure.

If you are looking at taking your franchise system into a registration state, you should speak with a knowledgeable franchise attorney to ensure compliance with state-specific laws and regulations.

The Multi-Unit Franchise Agreement

According to FranData (a franchise services firm), approximately 50% of all franchise businesses are part of a multi-unit franchisee. The clear trend in franchising right now is for a franchisor to find the prospective franchisee with the experience, capital and desire to develop more than a single franchise unit in a territory.

The Multi-Unit franchisee provides many advantages to a franchisor including:

·         Opening franchise units in a more planned and strategic manner

·         Fewer franchisees to manage and oversee

·         Accelerated growth

·         Reduction in training and other initial obligations

·         Faster new market penetration

While the multi-unit development may look like the best way to grow a franchise system, there are some cautions to both the prospective multi-unit franchisee and the franchisor.

Prospective Franchisee

Any prospective franchisee looking at the option of purchasing a multi-unit development agreement should consider their current: 1) experience not only in the industry of the franchise system, but their experience in successfully running a business; 2) access to sufficient capital; 3) current infrastructure or ability to develop the infrastructure to handle the development obligations, operations and administration of all the franchise units.

One clear advantage of the multi-unit option is the ability for a franchisee to leverage success, and the possibility to combine certain operations.

Franchisor

When determining whether a prospective multi-unit operator is going to work within a franchise system, a franchisor should examine the franchisee’s abilities on several fronts, including: 1) whether she/he has strong management experience; 2) do they have experience in the underlying industry; 3) their financial capacity to meet the development and ongoing operational obligations; and 4) a demonstration of their ability to fulfill the development obligations.

Many franchisors will find it beneficial to look to their current franchisees and ask high performing single unit operators if they would like to develop additional franchise units. Another key place to find successful multi-unit franchisees is from another franchise system. If looking to another franchise system, a franchisor should look at the prospective franchisee’s current compliance, reliability and reputation in the franchise system, as well as where they are in that development schedule. This last point is important because while it may appear a prospective franchisee has sufficient capital, if they are in the middle of their development obligations for another franchise system, the capital may not be sufficient to carry them through both development obligations.

When setting out the obligations for a multi-unit franchisee, a franchisor should also be aware of the ability on a functional level to meet the development obligations (i.e. is real estate available at the right price, how easily can the permits be obtained, what type of capital is needed from both the franchisee and the franchisor). In addition, the size of the territory will often determine the development speed and number of units in the development schedule.

More helpful information on multi-unit franchising can be found at:

International Franchise Association (IFA)

NASDAQ Community Board