Putting “Secrets” in the FDD: A Franchisor Nondisclosure Trap

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The Federal Trade Commission mandates disclosure of “any material action involving the franchise relationship during the last fiscal year” under Item 3 of the Franchise Disclosure Document (“FDD”), which must be provided to all prospective franchisees. But as a recent opinion of the U.S. Court of Appeals for the Seventh Circuit illustrates, this seemingly innocuous requirement is tinder for litigation when complying with it violates the nondisclosure provisions of a settlement agreement -- and the aggrieved party seeks $20 million in liquidated damages.

Plaintiff had owned an Indiana brokerage company that operated as a franchisee of Keller Williams for approximately 10 years, and also served as a regional director for the franchisor. The parties’ relationship soured, however; her job was terminated in 2010, and the franchise relationship ended the following year.

Litigation ensued. In 2012, the parties resolved the lawsuit and entered a settlement agreement. The agreement prohibited the parties from disclosing its terms to third parties (with limited exceptions for disclosures to tax professionals, insurance carriers and government agencies). A violation of the agreement’s nondisclosure provisions would trigger a “liquidated damages” clause of $10,000 per violation.

About three months after the settlement, Keller Williams issued a new FDD to approximately 2,000 existing or potential franchisees and other interested firms or persons. In Item 3 of the new FDD, Keller Williams described the lawsuit in detail and  disclosed the amounts paid to the plaintiff.

The plaintiff then sued for breach of contract -- seeking $20 million ($10,000 x 2,000 claimed “violations”) in liquidated damages.

Keller Williams successfully defended the action by challenging the liquidated damages clause as constituting an unenforceable penalty clause. It is worth noting, though, that the trial court and Seventh Circuit (which affirmed the lower court) did not hold the plaintiff could not have obtained actual damages for the breach (or, for that matter, liquidated damages, if the agreement’s liquidated clause had not been so onerous); the evidence provided by the plaintiff of actual damages “was virtually none.”

The takeaway for franchisors: In any settlement agreement with a franchisee, always include an exception for required FDD disclosures when drafting nondisclosure clauses.

[Caudill, et al. v. Keller Williams Realty, U.S. Court of Appeals for the Seventh Circuit, No. 15-3313]

New Law Limits Franchisors’ Joint Employer Liability Exposure In Wisconsin

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In an environment where franchisors are increasingly concerned about being deemed “joint employers” with their franchisees, the Wisconsin Legislature has provided some welcome relief. It has enacted legislation that provides franchisors with assurances that they will not be treated as an “employer” of the employees of a franchisee for purposes of Wisconsin laws pertaining to unemployment insurance, worker’s compensation, employment discrimination, minimum wage and wage payments, merely because the franchisor retains rights of quality control under the parties’ franchise agreement.

2015 Wisconsin Act 203 adopts the definition of “franchisor” found in the Code of Federal Regulations. Such franchisors may still be treated as an employer of its franchisee’s employers in the following situations: (a) the franchisor has agreed in writing to assume that role; or (b) the franchisor has been found by the applicable department or division of state government to have exercised a degree of control over the franchisee or the franchisee’s employees that is not customarily exercised by a franchisor for the purposes of protecting the franchisor’s brand.

Recent rulings and policy initiatives of the National Labor Relations Board and U.S. Department of Labor have suggested that indirect rights to control another entity’s employees may be sufficient to support a finding that a joint employer relationship (i.e., that more than one entity is an employer of an individual employee) exists. But under the federal Lanham Act, franchisors must impose quality control standards in order to maintain the integrity and enforceability of their trademarks. These quality control standards may be considered to constitute such indirect control.

The dilemma faced by a franchisor in this environment: if the franchisor enforces quality control to protect the trademark and brand, it risks having joint employer liability imposed and being held liable for acts of its franchisees’ employees (for whom, in the vast majority of cases,  the franchisor has no legal or contractual right to control); if it does not, it weakens the strength of its marks. The Wisconsin bill provides assurance to franchisors offering franchises in the state of Wisconsin that enforcement of quality control standards will not result in an imposition of joint employer liability under Wisconsin law. 

Crowdfunding Comes To The Franchise World

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We’ve been curious to see whether crowdfunding would find the world of franchising.  Traditionally, the solicitation of investors through general advertising has been severely restricted under federal and state securities law; these limitations also apply to crowdfunding, or seeking capital contributions through online solicitation of the masses. The JOBS Act of 2012 sought to remove some of these restrictions, under the theory that both investors and businesses seeking capital could benefit from this new internet marketplace, as long as certain protections are in place.

Now Fund A Franchise, has begun to accept applications from prospective franchisees and invite investors to provide funding in a manner similar to that deployed by Kickstarter. It appears that Fund a Franchise is the first crowdfunding platform organized to cater to the franchising market.

Fund a Franchise requires that a prospective franchisee complete an application and be accepted into the program. The prospective franchisor must agree that it will consider a franchisee capitalized at least in part through the crowdfunding program.  The prospective franchisees pay a monthly fee to be listed on the site and have access to a “deal room”; investors may participate at no charge.  Investments may be made in the form of equity or debt.

Crowdfunding has the potential to match individuals who wish to open a franchised business, but lack the necessary capital investment to do so, with investors who might be willing to take a chance on a franchising opportunity.  But several questions and issues occur to us, including:

  • Will franchisors agree to participate?  Generally, franchisors generally want to limit the number of owners of a franchisee.  If the franchisee has too many owners, it may not be clear who has the right to make decisions on behalf of the franchisee.   Many franchisors may be reluctant to approve a franchisee that raised capital through contributions from numerous individuals.  A franchisor would be more likely to accept a franchisee that consists of one manager/entrepreneur providing primarily services to the start-up business and a single sophisticated investor whose principal contribution is capital.  The Fund a Franchise website suggests that several franchisors are willing to participate, but none are large systems.
  • Will a manager/entrepreneur and investor(s) who are brought together online be compatible?  Such arrangements generally succeed when there is a great deal of trust established among the parties; written contracts can only go so far.
  • At this time, only accredited investors (generally, individuals with over $1 million in assets or with income in excess of $200,000 in each of the last two years) can participate in crowdfunding on Fund a Franchise and similar platforms.   This places a significant constraint on the number of persons who are eligible to invest through the site.  The prohibition against participation by non-accredited investors will end when the SEC finalizes regulations permitting such investments, but these regulations are not likely to be in place before early 2016.
  • Using Fund a Franchise will not avoid legal fees; the site requires users to retain a securities lawyer (although the site will apparently provide referrals to such counsel upon request).

(Note:  This post is provided for information purposes only; we make no recommendation as to the advisability of utilizing Fund a Franchise or any other investment platform or investing in any business.  You should consult legal counsel and your financial advisor before entering any such arrangement)

Eroding Exclusivity: The Saga of JCP, Macy's and Martha Stewart

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Some observations on the ongoing trial in New York Supreme Court involving Macy’s, J.C. Penney (“JCP”) and Martha Stewart Living Omnimedia (“MSLO”), as the dispute pertains to the franchise and distribution industry:

  • Carveouts to exclusivity clauses should be viewed warily by the party purportedly receiving exclusive rights.  In the Macy’s/JCP/MSLO dispute, MSLO had granted Macy’s the exclusive right to market certain products (such as cookware and bedding) sold by MSLO. The exclusivity clause in the Macy’s/MSLO agreement, however, contained an exception permitting MSLO to sell the products via the internet, television or at any retail store branded with the Martha Stewart Living name and operated by the company or its affiliates or which “prominently” featured the brand.   JCP acquired a minority interest in MSLO; the parties then sought to utilize the exception to Macy’s exclusive retail sale rights by placing MSLO “boutiques” inside JCP stores to sell those same products.
  • Exceptions to exclusivity clauses can be found in many franchise agreements (e.g., outlets located within the territory, but inside airports or malls) and distribution and sales representative agreements (e.g., internet sales, house accounts or national accounts).  If an exception is overly broad or vague, the exception can severely erode the expectation of exclusivity.