Franchise and Trade Regulation Update - August 2014
Appeals Court Upholds "Silent Fraud" Jury Verdict Under Franchise Investment Law
By: David L. Cahn, Esq.
Take-away: If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee. Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.
The case: A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.
The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.
As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.
None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD. In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.” In fact, neither statement was accurate.
The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation. However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.
After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.” The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.
In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation. The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.
Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:
Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.
The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD. Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.
The appellate court agreed with the jury, not the trial judge.
There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision. However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury. As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.
In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD – particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.
For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)
That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor. It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.
What's the Value-Add of a "Full Service" Law Firm?
Personal Observations from a Lawyer in the Trenches
By: David L. Cahn, Esq.
Over the past decade I have been a solo legal services provider, then managing member of a boutique firm, and then a part of a much larger firm, Whiteford Taylor & Preston, since 2011. So I have really seen the legal profession from all sides—and of course, like all lawyers, I have heard the grumbles from clients about “big law firms.”
So maybe my three-faceted experience in providing legal services will help you gain some perspective as well.
When I first joined WTP, I seemed to be “on an island” (or at least a skinny peninsula), receiving referrals from people in the franchising world, but not from within the firm. No one else at WTP did any franchising work, and at first it seemed as if none of the firm’s clients did either. However, three years later, the landscape has changed. I know my new colleagues and they know me, and the connections between us have grown stronger. As a result, I see the value of WTP’s attorneys for clients who originally hired me and my value for clients who originally hired other WTP attorneys.
Just in the past eight months, other WTP lawyers have provided the following services to clients who originally hired me:
- negotiated purchase of an office building, including environmental assessments and preparing standard lease for tenants;
- maintained compliance with U.S. government contracting requirements;
- negotiated a settlement with the I.R.S. regarding disputed taxes owed;
- negotiated a construction contract;
- negotiated the resolution of trademark disputes (not between franchisor and franchisee);
- screened and secured protectable trademarks; and
- secured copyright protection for valuable computer software.
In addition, senior WTP attorneys have provided me with valuable advice on issues such as the tax consequences of business entity structures and transactions, preparing agreements among owners of a company (such as an LLC Operating Agreement) and with key management employees, and handling disputes between majority and minority owners of companies. All of this insight has helped me provide more sophisticated and creative insights to clients.
On the flip side, on behalf of WTP clients who originally hired other attorneys of the firm, so far during 2014 I have worked on the following projects:
- prepared wholesaler and retailer agreements for a consumer products manufacturer;
- negotiated an exclusive North American distribution agreement with a European manufacturer of construction equipment;
- prepared and negotiated an exclusive U.S. distribution agreement for the sale of a unique product in the precious metals industry;
- advised national trade associations on antitrust law compliance in their dealings with members and outside suppliers;
- advised a provider of online ordering services with the contracts necessary to expand into providing delivery of the ordered products;
- negotiated the terms of terminating a franchise agreement, on behalf of an unhappy and struggling franchisee; and
- prepared exclusive distribution and sales agency agreements for a European company entering the U.S. market.
The attorneys for whose clients I have provided those services have practice focuses in areas such as international trade, taxation, securities, intellectual property litigation, and business litigation.
The Takeaway: if you hire any of the attorneys of WTP, you have our team behind you with a wide variety of experience in working with clients on a wide variety of industries, as well as in virtually every area of the law that impacts business. We serve companies and entrepreneurs doing business between New York and Virginia, with connections to provide additional services as needed throughout the rest of the United States and in foreign countries. That is a long way from the boutique existence at Franchise & Business Law Group!
Maybe this analogy comes more easily to me because of my area of practice, but, looking back at my years as a lawyer, I think it’s rather like the difference between opening a corner diner and investing in a franchise restaurant. With a good franchise, you have wind in your sails. The franchisor puts years of experience and investment behind you, in the form of a team of experts, a well-known brand, and savvy choices, so you don’t have to research and invent the product from scratch.
Enforcing Quality Standards in Hotel Franchise Agreements
By: David L. Cahn, Esq.
Take-away. A franchisor’s diligence in conducting and documenting quality assurance inspections is as important as ever, particularly if the franchisor seeks to exercise its ultimate weapon – termination of the franchise agreement. Prudent inspection and documentation practices are particularly crucial in the many U.S. states and territories that have statutes requiring a showing of “good cause” in order for a franchisor to terminate a franchise agreement. In such states, a franchisor must furnish evidence demonstrating that the franchisee failed to substantially comply with the material and reasonable franchise requirements; otherwise, a court may well restore the franchise rights and order money damages to the franchisee.
The Case. Pooniwala v. Wyndham Worldwide Corp., a May 2014 decision by the U.S. District Court for the District of Minnesota, is an exemplary demonstration of how a franchisor establishes that one of its franchisees repeatedly violated quality assurance standards so that there was “good cause” to terminate the franchise agreement under state law. The franchisor’s in this case diligently conducted and documented regular quality assurance (“QA”) inspections.
The Facts. Minn. Stat. Section 80C.14, part of the Minnesota Franchise Act, allows a franchisor to terminate an agreement if the franchisor can show “good cause” for termination. Good cause means failure by the franchisee to substantially comply with the material and reasonable franchise requirements imposed by the franchisor, including “any act by or conduct of the franchisee which materially impairs the goodwill associated with the franchisor's trademark, trade name, service mark, logotype or other commercial symbol.”
Pooniwala involved franchise agreements for two hotels, one a “Super 8,” and the other a “Travelodge.” The franchisee alleged that the franchisors, both of which are affiliated companies within the Wyndham Hotel Group, took retaliatory action against the franchisee because of a lawsuit between the franchisee and Ramada Worldwide Inc., its fellow Wyndham Group affiliate. The franchisors, for their side, argued that their attempts to terminate the franchise agreements were not retaliatory actions, but rather that the franchisee had repeatedly violated QA standards found in the respective franchise agreements, giving each franchisor good cause for termination.
The first attempted termination involved a Super 8 hotel facility in Roseville Minnesota. The franchise agreement for the Roseville Super 8 included quality assurance requirements, as well as provisions allowing Super 8 to inspect the facility to ensure that it was operating in compliance with Super 8’s system standards and QA requirements. The franchisee had failed six consecutive QA inspections at the Roseville Super 8. Each inspection was followed by a letter indicating that the franchisee had received a failing score on the QA inspections. The letters also gave the franchisee notice that it had sixty days to cure the QA deficiencies, the failure of which could result in termination of the franchise agreement. Finally in September 2013 Super 8 notified the franchisee that the franchise would terminate on December 29, 2013, unless the hotel passed a final QA inspection. The franchisee failed that final inspection, and shortly thereafter Super 8 informed the franchisee that termination would take effect on the originally scheduled termination date.
The second termination was for a Travelodge hotel facility in Burnsville, Minnesota. The Burnsville Travelodge agreement contained similar QA requirements, and the franchisee failed eight consecutive QA inspections, receiving letters documenting the failures following each inspection. Finally the franchisee received notice of termination for the Travelodge franchise. The notice described QA deficiencies, and stated that termination would take effect in ninety days, but that another inspection would be scheduled to determine whether the QA violations had been cured. The franchisee failed that inspection, and as a result Travelodge informed the franchisee that termination would take effect on the originally scheduled date.
Preliminary Injunction. It is not a wonder that motions for preliminary injunction are commonplace in hotel franchise termination cases. With the great potential for loss of good will among customers, employees and suppliers, franchisees will not want to give up their rights to franchise logos or their presence on a franchisor’s reservation system. In Pooniwala, the franchisee sought an order for preliminary injunction to stop the franchisors from terminating the franchise agreements before the court heard the case on its merits.
In deciding whether to grant a preliminary injunction, courts have to balance the harm to the two sides. They also consider the requesting party’s likelihood of success on the merits in the underlying claim--here, violation of the good cause requirement of the Minnesota Franchise Act.
In Pooniwala, the court denied the franchisee’s motion for preliminary injunction and ordered it to go ahead with its post-termination obligations, such as removing the franchised brands’ signage. The court found that, given the many QA inspection failures at the two hotels, and the fact that the franchisees had continuing franchise relationships with Wyndham Hotel Group affiliates at other hotel properties, the franchisee did not demonstrate an adequate likelihood of success of proving that the termination was without good cause. Further, the court held that, while the franchisee would suffer obvious harm through loss of the franchise rights, the franchisors were also suffering continuing, irreparable harm as long as the franchisee’s hotels continued to operate under their trademarks while not maintaining brand quality standards.
Conclusion. Hotel franchise agreements typically provide for substantial liquidated damages if the franchisor terminates for cause, meaning that the Pooniwala franchisees are likely to owe hundreds of thousands of dollars. In other franchise cases, the terminated franchisee may be forced to cease operating a similar business due to a covenant not to compete.
The stakes are high, and franchisors can expect a fight. So if they decide to take the drastic step of terminating for cause, they had better have their “ducks in a row.” In Pooniwala, the Wyndham Hotel Group franchisors showed how this is done.
Nicholas Cintron, a law clerk at the firm and a 2016 J.D. candidate at Wake Forest University Law School, contributed to the preparation of this article.