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Franchise and Trade Regulation Update - December 2011

Date: December 12, 2011

Is That Really My Problem? Case Highlights Need to Verify Franchise Disclosure Data
By: David L. Cahn, Esq.

A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.

Misrepresentations in Franchise Disclosures
The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.

In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.

The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”

The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.

Jurisdiction in Maryland and Application of New York Franchise Sales Law
The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.

Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.

The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.

The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.

The takeaways:

  1. Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.
  2. If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.
  3. New York needs to amend its law to exempt out of state franchise sales from its registration requirements.

Can They Really Do That? Franchisees' Liability for Lost Future Royalties after Store Failure
By: David L. Cahn, Esq.

In its recent decision of Meineke Car Care Centers, Inc. v. RBL Holdings, LLC, et al., Case No. 09-2030, Bus. Franchise Guide (CCH) ¶ 14,586 (decided April 14, 2011), the United States Court of Appeals for the Fourth Circuit provided valuable guidance on one of the most important legal issues for franchisors and franchisees. Specifically, if a franchisee closes franchised businesses that it can no longer afford to operate, can its franchisor obtain a judgment for “lost future royalties” that it would have earned had the businesses continued to operate?

In this Meineke case, the trial court had granted summary judgment dismissing the franchisor’s claim, on the bases that: (1) the franchise agreement did not state that the franchisee would be liable for royalties even if the business closed, and (2) even if Meineke had the right to seek lost future profits due to the franchisee’s closure of the stores, the claim failed because Meineke could not prove that it was “reasonably certain” that such profits would have been realized if the stores had not been closed. The U.S. Court of Appeals disagreed on both points and remanded the case for trial on Meineke’s claim.

On the first point, the court held that the parties are not required to specify in the Franchise Agreement all categories of potential damages each could seek as a result of the other’s breach. Rather, the standard is whether, at the time of entering into the agreement, “lost profits may reasonably be supposed to have been within [the parties’] contemplation as a probable result of [the franchisee’s] premature closure of the Shops.” A specific statement in the Franchise Agreement that the franchisee would be liable for all royalties throughout the term of the agreement would have been powerful evidence of the parties’ understanding when they signed the contracts. However, it was not the only admissible evidence of the parties’ “contemplation” on that issue, and therefore a factual dispute on that point existed – making it an issue for the jury to decide.

On the second point, the court emphasized that the royalties payable to Meineke were calculated from a percentage of the Stores’ gross revenue, not net profits. The court found that Meineke had demonstrated “with reasonable certainty” that, except for the franchisee’s breach of the agreements by closing the Shops, some revenue and therefore some lost royalties would have been realized. Thus, a trial was necessary to determine the amount of those lost “profits” with reasonable certainty.

However, at the trial, it would be relevant in making that determination how long it would have been “commercially feasible” to continue to operate each of the Shops, based on its historical net profits to the owner. In other words, the fact finder’s decision of how long it was “commercially feasible” to expect the franchisee to keep the doors open would determine the amount of the lost future royalties damages.

The takeaways:

  1. the only way that a franchisee and its personal guarantors can be sure that they will not be liable for lost future royalties if the franchise fails is to insist upon language in the franchise agreement eliminating (or limiting) the franchisor’s right to those damages.
  2. if a franchised store ceases operations and truly “goes dark” due to ongoing net operating losses, at trial on a claim for lost future royalties the franchisor will need to be able to demonstrate that it was “commercially feasible” for the franchisee to remain open and, if so, provide some reasonable basis for the fact finder to determine how long the store should have remained open.

Given the uncertainty and fact intensive nature of such a case, it is probably in the best interests of both the franchisor and the franchisee to directly address the issue in the written agreement the franchisor’s right to “lost future royalties” and an agreed upon method to calculate those “damages.”

Two recent guilty pleas announced by the U.S. Department of Justice’s Antitrust Division highlight an underappreciated area of serious legal liability – price coordination in violation of the Sherman Act.


Talking to Your Competitors Can Be Risky
Criminal Price-Fixing Conspiracy Convictions Highlight Dangers
By: David L. Cahn, Esq.

On August 24, 2011, the Justice Department announced the guilty plea of Great Lakes Concrete, one of four Iowa companies that sell “ready-mix concrete” for construction projects. The companies have pled guilty to reaching agreements regarding their respective price lists and project bids, and then accepting payment for those sales at prices artificially increased due to collusion. The press release emphasizes the maximum fine that may be imposed for the conviction, which is the greater of $100 million, twice the gain derived from the crime or twice the loss suffered by the victims of the crime. In addition, the president of Great Lakes Concrete was sentenced to serve a year and a day in prison.

On August 31, 2011, the Justice Department announced a guilty plea by a California company, Sabry Lee (U.S.A.) Inc., in “a global conspiracy to fix the prices of aftermarket auto lights.” The company is the U.S. distributor for a Taiwanese producer of the auto lights, which are most commonly installed in vehicles after collisions. The alleged conspiracy was apparently between several Taiwan-based manufacturers of auto lights and their U.S. distributors, who “met and agreed to charge prices of aftermarket auto lights at certain predetermined levels” and “issued price announcements and price lists in accordance with the agreements reached, and collected and exchanged information on prices and sales of aftermarket auto lights for the purpose of monitoring and enforcing adherence to the agreed-upon prices.” Executives of two of the U.S. distributor companies have pled guilty to price-fixing charges, and the second-ranking officer of one of the Taiwan manufacturers was arrested in the U.S. and has been indicted.

While the press release leads one to believe that the executives in these cases knowingly intended to fix prices at artificially high levels, it is quite possible that at least some of them were not completely aware of the legal implications of their conversations. However, any communications between competing companies concerning prices are legally risky.

The takeaway: Business people should seek pricing intelligence from customers, service providers, or independent websites -- but not from direct communications with their competitors. This is particularly true for industries in which formal competitive bidding is common or in which a relatively small number of companies make a large percentage of the total sales.

Beyond that basic rule, certain types of communications and collaborations between competitors are permitted and even encouraged by U.S. antitrust law. Each situation needs to be analyzed based on the particular facts and reasons for your collaborative effort.