July 2015 Archives

When researching a franchise, either as buyer, prospective franchisee, or credit analyst, one item of a franchisor's FDD is worth serious attention: how many locations have been sold but are not opened?

The opposite of churning franchisees, is SNO'ing them: selling them a location or territory, which never opens, and then scooping the franchisee fee.

Depending on the terms of the franchise agreement, the franchisee fee is usually not refundable. At best, if you have been SNOed, you might be entitled to partial refund. (Various class actions have litigated this issue.)

The SNO data is found in Item 20 in the FDD, a document hardly every reviewed by any of the public, analysts or prospective franchisees.

Yet, it provides valuable information to those willing to look. With all this public information, why does pre-sale churning continue?

(When information is public, but bad inferences are being made despite the public information being available, it is normal to suspect that people are simply not paying attention to the information that is available. The law generally doesn't accept this an excuse for getting the wrong end of the contract.)

Here are three examples of the type of SNO information that is revealed in the FDD.

1. From the 2010 MRI International FDD.

Management Recruiters International has a clean and informative item 20. The first thing you see is this:

You can see that the system has contracted from 903 to 828 in 3 years. Something to ask about.

Table 5 has a helpful column for the number of SNO's.

We go to the bottom of table 5 and find out that there are zeros SNOS, but 30 projected new outlets.

All in all, a pretty clear picture with some obvious follow up questions that need to be asked. One is, how many of those projected outlets did get opened? (And remember to document the questions and answers.)

2. Auntie Anne's Pretzel's Item 20 from the 2010 FDD.

We can see that there was growth in the system from 2007 to 2009, from 667 to 741.

Next, we are given some SNO data.

The trend of SNO's from 2007 to 2009 appears to be getting better, with more stores opening than being sold.

Finally, let's look at Aunite Anne's Table 5.

Ok, we have 12 SNO's and another 27 projected opens. Nothing too alarming here, but again worth a couple of follow up questions.

3. Kiddie Academy's Item 20 from their 2011 FDD.

The data is not presented as cleanly as the Auntie Anne's or MRI Item 20 data, which may not be the franchisor's fault. But, there is a very important detail, filed in an later amendment, which we will get to shortly.

Here is Table 1 from Kiddie Academy.

Alright, this is not entirely clear. But, it appears there has been decent growth from 2007 to 2010, from 77 units to 106.

But, when we read the amendment, a number of startling details emerge to counter-act this rosy picture of growth.

This states that approximately 21% of the system was allowed to leave! Voluntary termination, but the franchise territory did not remain part of the system!

Well, that certainly must be a very interesting story - and a prospect would want to track down all the details behind this "voluntary termination". You would certainly want to meet the franchisee who had this much bargaining power on termination - he took his territories with him. Sort of like losing the war but imposing sanctions on the victor! Extremely agile bargaining on behalf of the franchisee. Not so much by the franchisor.

Let's look at the SNO data.

This is downright scary: 34, or almost 35% of the existing units, are SNOs. This sounds like a franchisor who is desperate to replace royalties lost in the "voluntary termination". There could be other explanations, but this is a huge big detail story to run down with the franchisor. (Perhaps, the length of time to open these stores takes longer than a year? Could be, and you have to checking this.)

In Conclusion - Remember Charlie Brown, Lucy, and the Football.

The cartoon below should be a reminder to all prospective franchisees not to rely on the legal skills of a beagle.

Read and understand the item 20 data instead. If you don't want to read it, and your current business lawyer doesn't want to get paid to read it for you, then consider hiring an attorney who specializes in this area.

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Throughout the United States franchisors have been able to enforce choice of law and venue selection provisions in their franchise agreements with few exceptions. A few states have proactively limited venue selection, but in the absence of rule or statute the U S Supreme Court has exonerated venue selection in the franchisor's home state as reasonable (Burger King leading case). On the issue of choice of law the primary confrontations have been over post termination covenants not to compete.

One state, California, prohibits them by statute (but see the Schlotzky's case where the California court permitted a restriction against making the Schlotzsky sandwich that was held to have secondary meaning as a source identifier for Schlotzskys).

Elsewhere when a franchisor chose its own state as the choice of law and the law of its home state was more permissive about use of post termination restrictive covenants, the question was whether the more expansive permitted use infringed the public policy of the franchisee's state. In those instances courts customarily reduce the scope of the covenant to the point at which the confrontation with public policy is eliminated.

The current direction of the law on post termination restrictive covenants, except in California, is simply to enforce them. The franchise can be old to the point of moribund and the market can already be so flooded with direct competition that enforcement of the covenant really bestows no material benefit to the franchisor other than a vendetta interest. Competent drafting of restrictive clauses today usually tie the clause in with the protection of confidential information and the non disclosure clause.

Venue selection has received little attention except for the rare prohibitory statute or rule.

Most large franchisors have now expanded extensively into foreign markets. Many of them still keep the domestic venue selection clause that facially requires franchisees in foreign countries to come to the United States and litigate or arbitrate disputes in the franchisor's home town. Just such a situation arises now in the context of an American franchisor requiring its European Community franchisees to resolve disputes here in America.

The agreement also prevents class treatment of disputes and groups as joint complainants. The EU franchisees would have to come to America one at a time and hire a USA lawyer to have their disputes sorted out by a court or arbitrator.

In the situation of poorly performing franchise systems, the franchisees' position is that this makes dispute resolution effectively unavailable to EU franchisees. This is, to be certain, part the purpose of this contractual configuration. This article offers a road map through the issues that will have to be dealt with if EU franchisees decided to attempt to defeat the USA venue selection clause.

INHERENT PRO FRANCHISOR BIAS IN THE USA

Over the last 25 years franchise law produced from decisions in dispute resolution has become more and more favorable to franchisors. Part of the reason for this tectonic shift may be attributed to the fact that every time a major court resolves a significant issue in favor of a franchisee, lawyers representing franchisor groups immediately redraft applicable franchise agreement provisions to circumvent that ruling. The "draft around" exercise has paid off handsomely for franchisors, and one would indeed be foolish not to avail itself of that technique. That is one reason lawyers go to annual seminars where they receive the benefit of the shrewd draftsmanship of the industry's best and brightest nit pickers. There is actual biblical precedent for this, but that is better left for drinking parties.

For these reasons alone, EU franchisees would win a substantial tactical and perhaps strategic advantage if they first found a way to defeat the international venue selection clause and were then able to have their disputes with their franchisors resolved in their own courts and arbitration resources, in their own languages and in context of the fairness balancing influences of their own countries and cultures.

Inasmuch as there is now no significant history of franchise litigation in EU countries, there is an opportunity for EU courts to approach franchising issues free of the pro franchisor bias so pervasive in the USA. How might one go about accomplishing that What are the issues and salient fact patterns relevant to confrontation of international venue selection provisions

THE ISSUES AND THE FACT PATTERNS

In the USA the ruling case law is that a franchisor may compel dispute resolution in its home jurisdiction under the law of its home jurisdiction. That is long established law. The rationale is that the franchisor ought to be able to operate its system in accordance with one set of legal principles and requirements and avoid the vagaries of local law that on the whole provide no significantly better legal climate than the law of the franchisor's home jurisdiction.

Even in this system, franchisors are required to provide a section of their disclosure package (FDD) that deals with state specific law that may affect the enforceability of various provisions of the franchise agreement. The shibboleth is that the essence of uniformity lies in its variables. There is essential uniformity, but not absolute uniformity from state to state.

Recognizing that the International Franchise Association spends a fortune every year to lobby franchisor favorable positions in every jurisdiction, nationally and internationally, one must begin by acquiring command of the jurisdictional trends and precedents in the EU countries relating to franchising dispute management to ascertain the extent to which there remains a meaningful opportunity to defeat an international venue selection provision under any circumstances at all. This involves the EU itself and the individual member states.

If the matter remains unsettled, then where does one initiate a proceeding seeking to upset a particular venue selection provision One thing is certain. One does not go to any USA court to try to achieve this.

It would be a total waste of resources with an almost guaranteed adverse result. This may mean a race to raise the question first, as one tribunal might not wish to devote its resources to an important question that is already before another tribunal. If the first tribunal decides the issue in a manner and pursuant to a rationale with which the EU tribunal would be comfortable, the ability to seek consideration of the matter before a potentially more sympathetic body is simply lost.

For this reason, I am somewhat surprised that USA court determination of these issues has not already been sought by the USA franchising community via declaratory judgment actions in American courts. By the time this article circulates, that tactic may be initiated as a possible means to preempt EU rulings on it. L'audace! L'audace! Toujours l'audace!

The salient fact issues will be distance, language, economic preclusion of a right to fair adjudication and the equities of the particular fact pattern before the court. It will be essential that the franchisee(s) in the case be essentially compliant even though contentious. You don't take a scoundrel to a court seeking fairness and equity.

If the initiator is a group of franchisees, it would be worthwhile to screen out the bad apples and proceed on behalf only of the more platinum plaintiffs/complainants. How that screening is accomplished is a subject for a totally separate article all by itself. Underlying every technical decision is an inherent, even though unspoken, issue of whether the party seeking relief is deserving of the relief.

With respect to the issue of distance, be mindful that a venue selection clause in an American franchise agreement may impose a more than 3,000 mile distance disadvantage, and that has not been the basis of an unreasonability ruling in a USA court. Distance from the EU to the east coast of the USA may not be much more than that. For this reason one should never raise the distance issue in isolation, but in every case in combination with language and other issues.

Consideration should be sought in light of the fact that the USA franchisor does not deem it inconvenient in any economic or distance sense to franchise its business in the EU as well as comply with EU and member state laws and regulations applicable to franchising there.

The distance and language issues should always be raised in combination with the franchisor's willingness to subject itself to EU and member state laws that enable and permit the enterprise from which the franchisor derives substantial financial benefit. That will go a long way toward blunting franchisor arguments before a European tribunal but probably not here in America.

The other crucial fulcrum of decision in this project will be the economic argument (which also would not prevail in the USA.) In the USA the concept of business risk, its assumption when you buy a franchise, not being a child or other person in need of special attention and protection in any business to business transaction tend to foreclose sympathy for "the downtrodden" in the sense of poor unprofitable franchise owners.

These so called victims, when applying to purchase the franchise, portrayed themselves to be financially and experientially capable of accepting the risks. Moreover, there are competent pre-investment due diligence assistance resources if they are not themselves astute at small business investment vetting. Additionally, the fact that the franchise agreements are in every instance rather draconian does not affect the pitch of the playing field in this discussion.

If you sign an agreement that permits the opposite party to take financial advantage of the situation and you do not expect that to happen, you are simply a fool. Actually, very few of these investors ever avail themselves of really competent pre-investment due diligence assistance at a meaningful level of competence simply because the services are not cheap. But that is their choice freely made.

There are escape hatch clauses in every franchise agreement plus a pre closing escape hatch questionnaire that further disable claims of being taken advantage of even when they have been taken advantage of in many cases and know about that before they sign the agreement.

So in the USA the "Oh poor me" gambit is usually worthless. Whether EU or member state tribunals are more receptive to the "poor me" arguments than USA courts remains to be seen. Ultimately, the USA is absolutely the worst place in the world to try franchise fraud and abuse cases today. There is no downside to trying to escape to another jurisdiction for resolution of disputes.

What constitutes an actionable complaint is probably different in the USA than elsewhere also. Notions of good faith and fair dealing are litigated here every year, and every year courts seem to find ways to deny their application other than lip service. What we just yawn at here in the USA could be a major offense against any fairness concept under EU or member state law. Equitable considerations are essentially worthless in the USA in business to business disputes. The free market means just that - the wild west.

Where then is the touchstone combination of circumstances in the making of a competent economic/predation case for escaping a venue selection and a choice of law provision in a franchise contract between an American franchisor and an EU franchisee I suggest the following approach.

Take seriously into account that an American court would accord no significance to the fact that the franchisee(s) are from another country and use another language. There will be absolutely no respect for a position that is a function of nationality. EU franchisees should make that clear to the EU or member state tribunal and suggest that a USA franchisor not be accorded preferential treatment.

The contract will have been drafted in the USA and will be in English.

There will be a local language version, but in the event of a disparity of meaning in any provision there will probably be a clause that says the English language version rules.

The EU franchisees will have been at a decided disadvantage in almost every instance when the "deal" was originally made.

One should suggest to the tribunal that one of the purposes of the EU and member state commercial law structure includes taking into account every way in which the EU party may have been disadvantageously positioned and make compensation for that by at least placing disputes before an EU or member state tribunal and applying the law of the franchisee's home country.

THE ECONOMIC POSITIONS

Usually the situation at hand will involve franchisees who invested in a franchise opportunity upon the stated or obviously implied representation that the franchised business model was a proven business concept capable of being operated by an investor acceptable to the franchisor with a positive financial performance profile.

If it is the case that the franchisees in the EU country are, as a group, unable to succeed in the business as licensed, that should be strong evidence that the opportunity was not investment worthy for this country/market and that the franchisor had no business selling it in the EU. If it is also the case that the franchisees in the USA are not doing well, that should be considered a strengthening of the conclusion that the transaction was not investment worthy in the beginning, much as a court would deal with a security that was not investment worthy.

There is a duty in all jurisdictions relevant to this discussion that the seller disclose material information that would cause a potential investor to make a negative investment decision.

In the face of such evidence, the franchisor should never be allowed to impose upon the EU franchisees an obligation to submit disputes to an American dispute resolution resource. The franchisees will be economically preempted from obtaining justice as a matter of simple economics, and no company selling investments should ever be allowed to put a victimized investor to that disadvantage. The argument that this requires prejudgment of the ultimate issue does not meet logical criteria here because we would be litigating jurisdictional issues and the findings would be for that limited use only.

In the USA the same standard is used in deciding whether preliminary relief should be granted in the course of deciding the issue whether the party seeking relief has "a likelihood of ultimate success on the merits. Taking this approach in protecting EU franchisees would not be a departure from American legal standards, and because of that the American franchisor should have no grounds to complain.

There is a countervailing argument available to franchisors in this instance. Regardless where EU franchisees must litigate their disputes, they will have to come up with resources to hire competent counsel, very few of which in the USA will accept them as clients on a contingent fee arrangement. In the EU contingent fee arrangements are much less condoned than in the USA.

The same requirements exist in the USA, and the cost of really competent representation is not going to be that different than in the EU. Depositions can be held in the locales of the witnesses, eliminating travel of everyone internationally before there is actually a trial. In each event the franchisees will need to create a common fund to share litigation costs, so there is no venue difference on that issue.

The adverse economics issue must be presented in a logical connection to other important issues rather than as a stand alone basis for decision.

If in addition to such a scenario (or even without it for that matter) the EU franchisee(s) can make a case of post execution abuses that materially adversely impacted the ability of the franchisees to make a reasonable financial return, that alone should make out a case that the franchisor is perfectly willing to engage in predatory practices no matter the impact upon the franchisees. A comparison of the measurable relationship cost as stated in the FDD to the actual costs, including extraneous revenues from franchisee operations not quantifiable from the information provided in the FDD, should serve to show that a franchise portrayed in the FDD as having a relationship cost of 15 % of gross sales actually has a relationship cost of from 20% to 25%. That would be very strong evidence of predation by the franchisor. Ten to fifteen percent of gross sales usually will equate to a negative impact of from 30 % to 50% of net profit. That is more than substantial impact to justify an EU or member state tribunal refusing to enforce a venue/choice of law provision in a franchise agreement.

How one goes about preparing such a case and obtaining evidence of sufficient quality is not part of this article, as that will vary with each case. Suffice it to say that counsel with very extensive experience in preparing and trying lawsuits involving franchise fraud and abuse should be tasked with assisting EU counsel in the entire proceeding. Knowing the theories and the art of expressing the theories effectively will not suffice without a record of competent evidence to support them.

As always, you can call me, RIchard Solomon, at 281-584-0519.

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Many of our start-up business clients ask whether they should spend part of their limited resources on obtaining a federal trademark.

The answer: it depends on the type of business you will have an where you plan to practice that business. Understand that trademark rights arise automatically by operation of law based on a company's use of the mark in a geographic area--registration, itself, does not create any trademark rights and, therefore, is not a prerequisite for obtaining protectable trademark rights.

There are many benefits of registration of a mark on the U.S. Patent and Trademark Office's principal register, though, not the least of which is nationwide priority over all later, conflicting marks.

Our advice, then, is that federal registration often makes sense for businesses that hope to distribute their goods or services outside of their immediate local area. Further, we recommend that our clients make that investment before they start building significant brand equity in their company or product name.

After all, no one wants to spend years establishing and growing a business, only to discover that someone else in another part of the country where you hope to expand adopted your business name and can use it to compete with you in that region.

Even if you don't--or financially can't--pursue trademark registration initially, it is an essential part of your start-up due diligence to investigate whether your proposed name or mark infringes on someone else's existing trademark.

An experienced trademark attorney can assist you in this effort and help avoid the situation where you invest resources in a brand, only to receive a trademark cease and desist letter from a party with prior and superior trademark rights in your name, requiring you to abandon the brand you have worked to establish.

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Kathleen Hart is a Georgia attorney, focusing her practice in corporate law, including intellectual property and franchise matters.

Her firm, Andersen, Tate & Carr, P.C., works with all manner of clients in business and personal matters, providing "big firm" sophistication with suburban law firm attention and service.

Website: www.atclawfirm.com

Blog: www.andersentatecarr.wordpress.com

Copyright © 2012, Kathleen Hart & Andersen, Tate & Carr, P.C.

Bad Earnings Claims in Item 19

Liar Number Two does provide earnings claims information in Item 19 which is not reliable for the following reasons, among others:

Especially if the franchisor is a relatively new franchisor, numbers are inherently less reliable if there are none of the franchised stores in the market you intend for your location. That stores seem to be doing well in one part of the country means nothing if you aren't going to be in those markets, for many reasons.

If your intended location is 'out of the loop' geographically, your support and advert economies won't be the same either. The advert economies associated with several stores all in one market are important expense issues. If you need a penetration level for your advert message that can be effectively afforded only by a group of stores sharing the budget, the numbers in Item 19 will be significantly out of whack for you.

If the stores are only a few years old, the system has not had time to 'prove' itself. Many things change in a franchise system as the franchisor decides to mandate changes without first proving them out in test market in company owned stores. Without that prove-out test market, every change is just a crap shoot.

If the franchise is one in which a major segment of your cash flow is not paid directly to the franchisee, but is paid first to the franchisor who then makes deductions and, supposedly, passed the net of those deductions on to the franchisee, you are dealing with a thief. Anyone who can come between you and your cash flow will always find ways to nick you. Channeling the money in that manner is the hallmark of the crooked franchise.

If company owned stores' financial information is part of the mix that went into the earnings claim data, that is being done only because those company owned stores are performing better than franchisee owned stores. That skews the earnings claims and makes them false as applied to what you would be doing if you were to buy the franchise. One way the liar reassures you is to say that the stores are identical to the kind of stores that you would be operating as a franchisee. The may be identical in the sense that the sell the same products or services, but they are not identical in any sense relating to financial performance prospects for any franchised store.

If the working capital requirements do not include money for you to live on until you reach break even, then the working capital number in the total investment required disclosure is inadequate. If it doesn't say that living expenses are included in working capital, then living expenses are not included. If it does say that living expenses are included in working capital, you need to have that broken out. The odds are that you are being short changed.

If the earnings claims say that the information was compiled in accordance with generally accepted accounting principles, that is probably not true, and it is a hallmark of misrepresentation. The purpose of making that statement is to make the numbers seem more reliable than they are. There is no other purpose to make that statement. Ask to see substantiation of the Item 19 information. If they won't show it to you before you sign a franchise agreement, it's a scam. If they tell you stories like they can't show it to you before you sign the contract because it's a trade secret, you know you are dealing with hard core crooks.

If after you make adjustments for royalties, advertising fund requirements, lease and other occupancy expenses for the area where you intend to locate, insurance expenses for your area, labor expenses for your area, state and local taxes for your area, and every other expense you can think of, you end up with less than 15% of gross sales as your pre tax net income, you are just buying a job, not a real business, and there will be no room for any adverse change in any significant expense item.

One thing that is never covered in the earnings claims data is the cost of borrowed money -- the interest and the principal payments that you will have to make every month. You need to add that information to the equation. You will be told that that money comes out of the non cash deductions on your tax return -- the depreciation and amortization expenses that are not actual cash payments.

You need to figure out whether that is correct arithmetic or not. If the total of all payments to the franchisor, other than for goods you have to buy from them, approaches 10% of gross sales, then the franchisor has an effective 40% share of your total potential pretax net profit (if you do as well as the earnings claims data suggests) with no investment risk in your business.

Moreover, the franchisor's income expectation from your business is a function of gross sales and does not require that you make any profit at all before those payments are owed. If you can't find a better way to get into that business, you might be better off keeping your day job. There are some exceptions to this statement, but they are very rare.

Conclusion

If Item 19 of the UFOC states that no one is authorized to provide any information regarding sales or profits other than what is stated right there in Item 19, and the sales person does provide other or additional information regarding prospective profitability, then you ought to be able to recognize that you have just been lied to in Item 19.

And it is important to recognize that the same techniques of arranging for third parties to provide the earnings claims information, or approving or praising the pro forma information in your business plan, also make the disclaimer in Item 19 a falsehood, just as in the instance of the franchisor who claimed not to provide any earnings claim information at all.

Franchisors who provide sales information in Item 19, but who do not provide additional profitability information there, and whose employee or sales representative provides the additional information to enable a profitability estimate to be prepared, or who arrange for a third party to provide it, or who do it by approving or praising your business plan pro forma, are also lying to you when they deny that such information is provided as part of their franchise sales procedure.

They know that you are not buying any business opportunity in order to achieve sales numbers, and that it is only profit potential that you are seeking. They also know that by using only gross sales numbers in the 'official' statement made in Item 19, they don't have to tell you how many of their franchisees are achieving that level of profit performance. Gross income isn't net income. DUH!

These are just a few of the many issues that you will encounter in trying to figure out where the ball is being hidden in the Item 19 disclosures. The inventiveness of the crooked mind is limitless. Regulations can't protect you. You have to protect yourself.

You cannot allow yourself to sign contracts in which you agree that something that happened, and that you ought to know happened if you were paying attention, did not happen.

You have to go through what was said to you and see whether the contract is requiring you to agree that something that was an important consideration to you in making your investment decision did not in fact ever happen. If things important to you are excluded, either by not being provided for in the contract or by your having to pretend that they never happened, you are dealing with a thief.

That's another reason always to take careful notes on everything that is said to you, orally or in some brochure or written on a cocktail napkin. Being alert and diligent throughout the sales process can save you hundreds of thousands of dollars in lost investment, lost profits and attorney fees and expenses.

If you really want to know how the system is performing, you should include as part of your due diligence contacting business brokers in cities where this franchisor has franchised stores located, and finding out whether any of them are for sale.

If you agree to sign a confidentiality agreement that says you are using access to the financial information only in connection with your effort to find a business to buy, you will be able to find out which of this franchisor's franchisees is trying to sell the franchised business and get access to the federal tax returns and the profit and loss/operating statements and balance sheets for the past five years. Compare that to what the franchisor is telling you in Item 19.

Do the same thing with businesses in the same business that are for sale and that are not affiliated with this franchisor. No one ever overstates profitability on their tax return.

When someone tells you things that you could figure out are untrue if you just pay attention, and you then sign a contract in which you agree that they didn't tell you that, and you later find out that there are many things that are not as they were described to be, after you have parted with your investment funds and taken on a lot of debt and other liabilities, is it realistic for you to expect to find an effective remedy in a lawsuit or in arbitration?

As always, you can call me, RIchard Solomon, at 281-584-0519.

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"Financial Claims" could mean one of two things. The first possible meaning of "financial claims" is what's known as earnings claims or earnings projections that can be (but are not required to be) contained in a Disclosure Document.

This type of financial performance data is typically data that represents how certain franchisees in the system are performing financially. It can represent average performance, low/medium/high performance, and so on. This data can be verified in one of (or a combination of) three ways.

The first thing to do is gain an understanding of the data and carefully read the wording in the Disclosure Document that explains the basis of the data: this wording will tell you whether the data presented is only representative of, for example, franchisees that have been in the system for 5 years or more, or with territories of a certain size, and so on.

The second way to verify the data is by doing a little bit of due diligence. A list of all existing franchisees, as well as recently closed franchisees, should be included in the Disclosure Document. Call those franchisees, both current and past, and ask them if their performance is representative of that contained in the Disclosure Document.

If you feel you need more verification, a third way to verify the data is to attend at the franchisor's headquarters and ask to see the actual data that has been summarized in the Disclosure Document.

The second possible meaning of "financial claims" in this question could mean any claims the franchisor has made about its own performance.

This is verified by reviewing the franchisor's financial statements that are included as an exhibit to the Disclosure Document. Anyone not familiar with financial statements would be well-advised to have an accountant or other qualified financial advisor review the statements.

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