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Problems with arbitration – PART 2

Monday, February 22nd, 2010

Last week I wrote Part 1 of this blog on the problems I have encountered with arbitration. Please see that post if you have not read it. What follows is Part 2 of the reasons that I advise my franchise and business clients why they should be wary of automatically including an arbitration clause in any franchise agreement or other contract that they execute:

4. Judges are generally more experienced, more versed in the law, and otherwise more qualified to hear disputes than most arbitrators. While not every judge is equally qualified, most judges have been vetted by their local and state bar organizations, and either elected by voters or appointed by politicians. Judges have a track record that can be reviewed and relied on. Judges in most courts serve on a rotational basis, hearing different types of cases and thereby gaining differing experiences. Judges have resources like law clerks to research the law for them. So while judges may lack technical expertise in a certain area, they make up for that my relying heavily on the attorneys and evidence presented in a given matter. Whatsmore, judges must construe existing law to base their rulings on, or else risk being overturned on appeal. Arbitrators, on the other hand, are in most cases practicing or retired attorneys with a specific area of expertise who have asked to be appointed to serve. Many times, an arbitrator will have only a peripheral knowledge of the subject of the arbitration, yet without the experience, knowledge of the law, or resources to ensure that his or her ruling is correct on the law. This set of circumstances can often times lead to inconsistent or downright baseless arbitrator’s decisions.

5. Judges produce formal opinions reciting the law relied on and applying the law to the facts to reach a decision. Many arbitrators, meanwhile, can issue awards without including their specific legal reasoning for an award. For purposes of appeal, judges are required to produce formal opinions citing the issues, facts, law and conclusion in an orderly fashion. This allows parties to focus many times on a distinct area for appeal, and allows appeals courts to easily review the court’s basis for a decision. Conversely, many arbitrators are required to issue only a narrowly written award unless otherwise agreed to by the parties. Even then, an arbitrator issuing a “reasoned award” may not satisfactorily explain the evidence relied on, the law used and how the arbitrator’s conclusion was arrived at. This not only makes it difficult for the parties to decipher how a particular arbitration award was arrived at, but more importantly, makes the record for appeal nearly impossible.

6. Even if an arbitrator issues a reasoned award, the right to appeal an arbitration award is extremely narrow when compared to a party’s ability to appeal a court ruling. In most instances, losers at trial have the right to appeal the merits of a court’s decision to a higher court “de novo”, using almost any substantive or procedural issue available to them. The basis of an appeal of an arbitration award however is severely limited, and many times requires the appealing party to clear such high hurdles as proving fraud, corruption of the arbitrator, or the arbitrator exceeding his or her powers. The difficulty of appeal, when combined with the erratic decisions of some arbitrators, is another reason to forego arbitration in favor of litigation, except in a specific set of circumstances discussed with and approved by my client.

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Current Problems with Arbitration Clauses in Franchise and Other Agreements – PART 1

Saturday, February 20th, 2010

I frequently tell my franchise and business clients to be wary of automatically including an arbitration clause in a franchise agreement or other contract they execute. Several years ago it was savvy for a business owner or franchisor to include mandatory arbitration in their agreements. Now, many of the reasons that supported the inclusion of arbitration clauses have been diminished, making the inclusion of mandatory arbitration in many contracts a questionable strategy at best. I now advise my business and franchise clients against arbitrating disputes for the following reasons:

1. Arbitrations are not “cost-savers” like they used to be thanks to the multiple fees associated with the process. Unlike judges, arbitrators are paid by the parties on an hourly basis. It is therefore in an arbitrator’s financial interest for the case to reach a hearing, regardless of the claim’s merits. In addition, many hearings go on much longer than necessary, allowing witnesses and testimony with questionable relevance to be heard. As a result, arbitrator’s fees can be quite significant for even routine business disputes. The arbitrator’s fees are of course in addition to the fees that business clients pay to their own attorneys for handling the matter, plus the hefty filing fees that many arbitration forums charge as well. For example, the American Arbitration Association, the preeminent arbitration forum in the U.S., charges filing fees ranging from $300 to $2,500.00 for commercial arbitration disputes. Contrast these expenses with trials and other court hearings, where judges have no financial interest in prolonging a case, and filing fees are minimal.

2. The distribution of who pays the arbitrator’s and other fees can disfavor the party bringing the action. The filing party, known as the Claimant, will be responsible for paying not only the arbitration filing fees, but also its portion AND the other party’s portion of the arbitrator’s fees mentioned above should the defending party, called the Respondent, refuse to pay its share of such fees. In such a case, the Claimant must pay all fees in order for the matter to go on, yet the Respondent remains entitled to participate in the arbitration process. If the Claimant fails to pay all of the fees owed to the arbitrator, the arbitrator will likely suspend or dismiss the action entirely. Because there is no incentive for a Respondent to pay its share of an arbitrator’s compensation or other fees, the absurd ersult of the Claimant paying all fees happens more than one would think. Combined with the fees a Claimant must pay to its own attorney, it is easy to see why a business owner would question the use of arbitration in the first place.

3. Arbitrators have far more discretion to rule than judges, sometimes in spite of the evidence presented. The arbitration process is much less formal than a trial. While some informality saves the parties time and expense and speeds up the process, the biggest informality can alter the entire outcome, namely, the fact that the rules of evidence do not apply to arbitration. As a result, arbitrators are free to allow documents and testimony that is questionable as to veracity and authenticity into evidence, even though such evidence would not be permitted in a court of law. In plain terms, an arbitration hearing can literally turn into a free for all, with the arbitrator allowing all kinds of testimony and documents to be factored into an award. This sort of setting can severely hurt a business client who is relying strictly on the language of documents and the actions of the parties, while in turn favoring a party hoping for chaos, basing its case on hearsay and unsupported and unreliable accusations. [Tune in to PART 2 next week]

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A Non-Compete Can Be Enforced Even When Lacking Geographic Limitation

Tuesday, December 8th, 2009

Maryland law is well settled that a non-compete must be reasonable in geographic scope and duration in order to be held enforceable. However, Maryland courts will enforce a covenant not-to-compete that does not contain a geographic limitation in certain narrow and limited circumstances. The U. S. District Court for the District of Maryland stated in Intelus v. Barton and Medplus, Inc., 7 F. Supp. 2d 635 (1998) that every non-compete must be examined to determine reasonableness based on the specific facts at hand, even non-competes that fail to contain a finite geographic limitation. The Intelus court stated:

“Competition unlimited by geography can be expected where the nature of the business concerns computer software and the ability to process information. . . Because of the broad nature of the market in which Intelus operates, a restrictive covenant limited to a narrow geographic area would render the restriction meaningless.”

In determining the reasonableness of a non-compete that does not contain a geographic limitation, Maryland courts will consider the nature of the industry and the national and perhaps global nature of the competition. In Intelus, the court concluded that the restriction was reasonably related and limited to Intelus’s need to protect its good will and client base, and therefore upheld the enforceability of the non-compete.

In Hekimian Labs, a Florida federal court, interpreting Maryland law, found that where “testimony indicated that competition within the business of remote access testing is such that the whole world is its stage” and “that there are only about 20 companies that compete in this business, and they do so on a worldwide basis,” then “to confine the restrictive covenant to a specified geographical area would render the Agreement meaningless.”

The Florida Court concluded that if the agreement did contain a geographical restriction, the offending party would only need to move outside of this restricted area and the damage to the harmed party would be the same. Because of the national and international scope of the competition between the parties, the absence of a specified geographic limitation was reasonably necessary for the protection of the party attempting to enforce the non-compete, and the covenant was upheld.

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Maryland Courts May Grant Injunctive Relief Even when an Arbitration Clause Exists

Tuesday, December 8th, 2009

Maryland law permits a party to request injunctive relief from a Maryland federal or state court even when a contract states that all disputes must be referred to arbitration. The Court of Appeals of Maryland held in Brendsel v. Winchester Construction Company, Inc., 898 A.2d 472 (2006) that:

“[A]n interlocutory mechanics’ lien is in the nature of a provisional remedy, not much different than an interlocutory injunction or attachment sought to maintain the status quo so that the arbitration proceeding can have meaning and relevance, and the predominant view throughout the country is that the availability of such remedies by a court is permitted by the Federal and Uniform Arbitration Acts and is not inconsistent with the right to enforce an arbitration agreement.”

In its ruling, the Maryland Court of Appeals focused on the need for courts to have the ability to preserve the status quo by granting injunctive relief while a dispute is sent to arbitration. Without this ability, the Court held, a ruling by an arbitrator could very well be immaterial, as the damage done to a party could by that time be irreparable.

The Maryland Court of Appeals’ holding finds support from the Fourth Circuit in Merril Lynch et al. v. Bradley and Collins, 756 F.2d 1048 (1985):

“Accordingly, we hold that where a dispute is subject to mandatory arbitration under the Federal Arbitration Act, a district court has the discretion to grant a preliminary injunction to preserve the status quo pending the arbitration of the parties’ dispute if the enjoined conduct would render that process a “hollow formality.” The arbitration process would be a hollow formality where “the arbitral award when rendered could not return the parties substantially to the status quo ante.” Lever Brothers, 554 F.2d at 123.”

Therefore, Maryland courts are permitted to intercede and grant injunctive relief in spite of an arbitration clause where the absence of such relief would cause the arbitration to be nothing more than a “hollow formality.”
This power exists even when a contractual provision states that the parties must refer all disputes to arbitration.

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SBA Franchise Page

Wednesday, November 18th, 2009

This link http://www.sba.gov/smallbusinessplanner/start/buyafranchise/index.html
has a wealth of information related to purchasing a franchise, sponsored by the U.S. Small Business Administration (SBA).

At the link you will find an overview of what franchising is and some tips on purchasing a franchised business; a Consumer Guide to Purchasing a Franchise; links to the American Franchisee Association (AFA) and International Franchise Association (IFA); two Frequently Asked Question pages; and a Guide on how to purchase an existing franchise from a franchisee.

This is an excellent source for persons seeking information on the world of franchising.

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Five Questions Every Franchise Owner Should Ask

Monday, November 2nd, 2009
Questions

Questions

Every franchisee, before purchasing a franchise, receives from the franchisor a Federal Disclosure Document (“FDD”), which includes the franchise agreement that will eventually be executed by the franchisor and franchisee. This article contains five questions every franchisee should ask when reviewing a franchise agreement.

  1. Minimum Royalty Fees. Does the franchise agreement require the payment by the franchisee of minimum monthly or yearly royalty fees, regardless of the amount of actual revenue the franchisee generates? At the end of a month or year, a franchisee may have to write the franchisor a check to cover the minimum franchise fee if the royalty fee paid by the franchisee fell short of the minimum royalty fee called for in the franchise agreement. This is certainly a fact that all franchisees must be aware of prior to execution of the franchise agreement.
  2. Termination by Franchisee. Does the franchise agreement allow the franchisee to terminate the agreement without cause, or upon a material breach of the agreement by the franchisor? A franchisee’s right to terminate the franchise agreement is arguably the most important right granted to a franchisee, since a franchisee may be able to terminate an agreement if its business gets into financial trouble or if the franchisor fails to comply with its obligations under the franchise agreement. The right to terminate will also permit a distressed franchisee to avoid the fees and other obligations owed to the franchisor before disaster strikes.
  3. Post-Termination Non-Competition Covenant. Does the franchise agreement contain a post-termination covenant not-to-compete, and if so, is it reasonable? A post-termination covenant not-to-compete is the franchisor’s attempt to prohibit a franchisee from competing with the franchisor during the period immediately following termination or expiration of the franchise agreement. Courts across the country have held that in order to be enforceable, a non-competition covenant must be reasonable in scope and duration. In other words, a non-compete that prohibits competition for 10 years, or across the entire United States, will most likely be held unreasonable and therefore unenforceable. A franchisee must pay careful attention to the language of a non-compete prior to signing.
  4. Dispute Resolution. Carefully review the franchise agreement to determine exactly how and where disputes with the franchisor must be resolved. With regard to how, some franchise agreements call for arbitration, others litigation, and some a mix of both procedures. With regard to where, most franchise agreements call for dispute resolution in the home jurisdiction of the franchisor. Some but not all state laws allow the franchisee to sue or arbitrate in its home state, regardless of what the franchise agreement says. Because of the added expense a franchisee must bear in the event of a dispute being held in a place other than the franchisee’s home state, a franchisee whose state does not add such a protection must be aware of this fact and possibly add language allowing the franchisee to sue or arbitrate in its home state.
  5. Territory. Some franchise agreements grant a franchisee an “exclusive” territory. This means that the franchisee is protected from competition from other franchisees and the franchisor as well inside this exclusive territory. Most franchisees view a protected territory as a must, believing that such market protection will allow the franchisee’s business to flourish. With that in mind, read the “Territory” section carefully in order to determine exactly what is being granted. Can the franchisor compete with the franchisee in the territory? Are there development or sales quotas that must be met in order to retain exclusive territory status? Can supermarkets or other wholesalers compete with the franchisee? These and other questions must be answered to gain a complete understanding of the issue.

Interested in Learning More? Have  Questions?

Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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What is the definition of a franchise?

Thursday, June 4th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

I am often asked by prospective franchise clients what exactly is the definition of a franchise? The issue is an important one, since franchising is a regulated industry. It is regulated on a federal level by the Federal Trade Commission (FTC), and on a state level by some, but not all, state regulatory agencies. Compliance with existing federal and state regulation makes the business of franchising more complicated, and therefore more expensive to be involved in.

The Federal Trade Commission Franchise Rule, 16 CFR 436, defines a franchise as:

any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:

(1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark;

(2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and

(3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.”

So the three criteria of a franchise, simply stated, are: 1) party A operates a business using the trademark of party B; 2) party B has significant control over how party A operates the business, or party B provides significant assistance to party A in the operation of the business; and 3) party A pays a fee to party B. All three of these conditions must be present in order for the business to be considered a franchise.

While the FTC’s definition of a franchise seems straightforward, the complexity surrounding what is a franchise can be found mainly in the second prong of the definition, through the FTC’s use of the terms “significant degree of control” and “significant assistance”.

Often times where party B provides party A with training, operational support, and/or manuals, the assistance/control will be deemed to be significant enough so as to meet the definition of a franchise. The problem arises when party B exerts “some” assistance or control, but does not go so far as to offer training, operational support or manuals.

The FTC has issued several advisory opinions on this subject, which opinions can be found at http://www.ftc.gov/bcp/franchise/netadopin.shtm. Specifically on this issue, the FTC stated in 1998 that:

“In your letter, you contend that the Licensor does not require any operational standards, nor does it impose controls over the licensees’ entire method of operation. For example, the Licensor will not approve sites, control hours of operation or production techniques, or dictate accounting practices. Rather, you contend that the limited controls are designed to protect the franchisor’s rights and value in its proprietary information and to verify that license fees are properly calculated. We disagree.

You correctly state that the Commission will not consider as significant those controls designed solely to protect the franchisor’s trademark rights under federal and state trademark law, such as display of the mark requirements or right of inspection. 44 Fed. Reg. at 49968. We also note that reasonable covenants not to compete, which are common in franchise systems, are frequently used to protect proprietary information. However, the exclusive sales territories imposed by the Licensor appear to go beyond mere trademark protection and pertain to the licensee’s entire method of conducting its business. Such restrictions have the potential to cause serious economic harm by limiting the licensees’ market and ultimately limiting the licensee’s profitability. See 44 Fed. Reg. at 59660-62. Indeed, the Final Interpretive Guides specifically list “restrictions on customers” and “location or sales area restrictions” among the types of controls over a franchisee’s method of operation that will be deemed significant.” Id. at 49967.”

The FTC, as well as any state regulatory agency, focuses solely on the substance of the relationship, not terminology, when examining the issue of what is a franchise. It is irrelevant how the parties characterize one another, whether as a license, independent contractor, subcontractor, joint venture, or distributorship relationship.

Please also be advised that certain states define a franchise slightly differently than the FTC definition cited above. Therefore, when facing the question of whether your business meets the definition of a franchise, proceed with extreme caution, and consult a knowledgeable franchise attorney.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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Reviewing a Franchise Agreement – Tips for a Non-Franchise Attorney (Part 3)

Friday, May 29th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

Continued from Part 1 & Part 2

The practice of franchise law is a niche area when it comes to the representation of franchisors.  Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law.

There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed at the idea of reviewing a franchise agreement and advising a prospective franchisee. With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.

9. Recovery of Attorney Fees.  The issue of the recovery of attorney fees spent by either party when a dispute arises between a franchisor and franchisee is a topic that must be looked at carefully when reviewing a franchise agreement.  Fees paid to attorneys are costly in even the simplest of matters, and such fees can escalate dramatically as the disputes get more complex and the parties involved get more acrimonious towards one another.  It is a priority when reviewing the franchise agreement to determine whether the recovery of attorney fees is addressed in the agreement, and if so, who has the right to recover such fees and how.  There are several different methods by which franchisors address the recovery of attorney fees.  The most popular method for recovering attorney fees is through the use of a “prevailing party” clause, which enables the winner of a lawsuit or arbitration to collect its attorneys’ fees from the losing party, provided the judge or arbitrator chooses to enforce such language.  This type of clause is popular with franchisors who believe it is useful as a deterrent to franchisees who may otherwise attempt to bring questionable actions against the franchisor.  Other franchisors choose the opposite route and simply state that either party to a dispute is responsible to pay its own attorney fees and costs.  A third type of clause is the one-sided franchisor attorney fees clause, which states that if the franchisor is forced to bring an action to enforce its rights under the agreement, or is forced to defend itself from an action brought by a franchisee, the franchisor is entitled to recover its fees as long as it prevails in the action.  This language gives the franchisor the best of the prevailing party language without having to share the benefit with a franchisee.   This one-sided type of clause is frowned upon by some courts due to the lack of mutuality between the parties.  However, rather than rely on a court to strike the language down, it is recommended that a franchisee’s attorney look to change this language to make it mutual for both parties at the outset.

  • Recovery of Attorney Fees. The issue of the recovery of attorney fees spent by either party when a dispute arises between a franchisor and franchisee is a topic that must be looked at carefully when reviewing a franchise agreement.  Fees paid to attorneys are costly in even the simplest of matters, and such fees can escalate dramatically as the disputes get more complex and the parties involved get more acrimonious towards one another.  It is a priority when reviewing the franchise agreement to determine whether the recovery of attorney fees is addressed in the agreement, and if so, who has the right to recover such fees and how.  There are several different methods by which franchisors address the recovery of attorney fees.  The most popular method for recovering attorney fees is through the use of a “prevailing party” clause, which enables the winner of a lawsuit or arbitration to collect its attorneys’ fees from the losing party, provided the judge or arbitrator chooses to enforce such language.  This type of clause is popular with franchisors who believe it is useful as a deterrent to franchisees who may otherwise attempt to bring questionable actions against the franchisor.  Other franchisors choose the opposite route and simply state that either party to a dispute is responsible to pay its own attorney fees and costs.  A third type of clause is the one-sided franchisor attorney fees clause, which states that if the franchisor is forced to bring an action to enforce its rights under the agreement, or is forced to defend itself from an action brought by a franchisee, the franchisor is entitled to recover its fees as long as it prevails in the action.  This language gives the franchisor the best of the prevailing party language without having to share the benefit with a franchisee.   This one-sided type of clause is frowned upon by some courts due to the lack of mutuality between the parties.  However, rather than rely on a court to strike the language down, it is recommended that a franchisee’s attorney look to change this language to make it mutual for both parties at the outset.
  • Territory. Some franchise systems grant franchisees “exclusive” territories, meaning that these franchisees are protected from competition from other franchisees, and in many respects from the franchisor as well, inside this designated territory.  Though it depends on the industry, many franchisees view a protected territory as a must.  The franchisee believes this market protection will allow its business to flourish, and an agreement that does not contain a protected exclusive area will cause the franchised business to fail.  There are several opinions on either side of this argument but hardly an exact answer.  As an attorney preparing to advise your franchise client, you must review the franchise agreement in order to understand what the franchisor is offering in the way of territories.  While doing so you must keep the following questions in mind:  Does the franchisee understand that even with a protected territory, he will still most likely be competing against several, if not dozens, of competitors from other brands inside an exclusive franchise territory?  How does the franchisee view the theory of market saturation that the more of a particular brand, product, or service a customer sees, the more popular and acceptable the brand becomes?   Given the choice, would the franchise client prefer to be a franchisee of a system that grants enormous exclusive territories to each franchisee, but with small number of total franchisees overall?  Or would the client prefer a franchise system that grants smaller or even no territories, but where the number of franchisees, and thus the number of outlets at which the product or service is available, is much greater?    In conjunction with the idea of exclusive territories, make sure to pay attention to the language of the franchise agreement discussing the franchisee’s right to advertise and sell products and services in areas located outside the franchisee’s territory that are not owned by other franchisees of the system.  Just as important, also pay attention to any language that reserves to the franchisor the right to compete with the franchisee inside the franchisee’s territory, especially when it comes to the sales of products over the internet.

Conclusion: As mentioned above, the above tips address only some of the issues that you should be aware of when reviewing a franchise agreement.  A diligent attorney reviewing a franchise agreement will often find several other issues that are material to the prospect’s decision to purchase a franchise.  In addition, please note that this paper does not discuss registration or disclosure issues in the state of Maryland or elsewhere.  The Maryland Franchise Registration and Disclosure Law requires  each franchisor to register its FDD with the Securities Division of the Maryland Attorney General’s Office prior to making an offer of sale of a franchise in the state of Maryland or to a Maryland resident.  In addition, the revised FTC Franchise Rule mandates that 14 days pass between the day a prospect is given an FDD and the day a franchise agreement is executed and/or a prospect pays money to a franchisor.  In the event you have a question regarding a franchise registration or disclosure issue, consult an experienced franchise attorney.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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Reviewing a Franchise Agreement – Tips for a Non-Franchise Attorney (Part 2)

Wednesday, May 27th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

Continued from Part 1

The practice of franchise law is a niche area when it comes to the representation of franchisors.  Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law.

There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed at the idea of reviewing a franchise agreement and advising a prospective franchisee. With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.

  • Termination by Franchisor. The standard franchise agreement includes several breaches that, if committed by the franchisee, allow the franchisor the right to terminate the agreement.   When reviewing the sections dealing with termination, make sure to identify which defaults allow for a cure period, that is, a time by which the franchisee may correct the default and thus avoid termination, and which breaches permit the franchisor to terminate the franchise agreement without providing the franchisee an opportunity to cure.  A franchisee is unable to cure some breaches as a matter of course, such as abandonment of the franchised business, unauthorized transfer of the franchised business, and repeated breaches of the franchise agreement, and thus in these situations automatic termination is appropriate.  However, there are many common breaches found in franchise agreements where it is possible for a franchisee to cure, yet the franchise agreement nonetheless allows the franchisor to terminate the agreement at its discretion.  It is in the attorney’s best interest therefore to notify the client of the different classes of breaches, and if warranted, negotiate with the franchisor to move some breaches from the automatic termination section to the termination-after-cure section.  Finally, on the subject of termination, an attorney reviewing a franchise agreement should also pay close attention to the length of time granted to cure a breach, and attempt to lengthen the cure period where possible.
  • Termination by Franchisee. Some, but not all, franchise agreements allow for the franchisee to terminate the agreement by providing a certain amount of notice to the franchisor.  This can arguably be the most important right granted to a franchisee, since a franchisee that has the right to terminate an agreement if the business gets into trouble can simply cut its losses, notify the franchisor of its desire to terminate the agreement, take the franchisor’s signs down, and cease running the business.  Many times, this will allow a distressed franchisee to avoid the fees and other obligations owed to the franchisor before disaster strikes.  Otherwise, a franchisee that abandons the franchised business prior to the agreement’s natural expiration could be exposed to a claim by the franchisor for breach of contract combined with a claim for “future royalties.”   “Future royalties” is a still-emerging theory of franchise law that holds that a franchisee that unilaterally ceases operation of its franchise prior to expiration can be held liable to the franchisor for the royalties and other fees the franchisee would have paid during the entire term remaining on the franchise agreement.  While this legal theory is complex and depends on a thorough review of the facts of each case, it is certainly an issue for attorneys to think about when reviewing a franchise agreement.  What is clear is that a franchise agreement that allows a franchisee to unilaterally walk away from the franchise can negate this cause of action from being raised and in the end potentially save a distressed franchisee from a costly fight.  For an excellent discussion of the future royalties issue by the Texas Court of Appeals applying Georgia law, see Progressive Child Care Systems v. Kids ‘R’ Kids International, Inc. and Vinson, 2008 Tex. App. LEXIS 8416; see also Choice Hotels International, Inc. v. Okeechobee Motel Joint Ventures, et al., Civil Action No. AQ-95-2862 (D. Md. 1998); Burger King Corp. v. Barnes, 1 F. Supp. 2d 1367 (S.D. Fla. 1998) Sparks Tune-Up Centers, Inc. v. Addison, Civ. Action No. 89-1355 (E.D Pa. 1989).
  • Post-Termination Non-Competition Covenant. In many states, including Maryland, a court will hold valid and enforceable a non-competition covenant that is “reasonable” in the activity it restricts, as well as in its geographic scope and duration, absent extenuating circumstances.  According to Maryland caselaw, a “reasonable” post-termination covenant not-to-compete  will restrict a franchisee from competing for one or two years, within 25 or 50 miles in geographic scope, in the business that is identical or similar to the franchised system.  Naturalawn of America, Inc. v. West Group, LLC et al., 484 F. Supp. 2d 392, 399-400 (D. Md. 2007); see also Merry Maids, L.P. v.Kamara, 33 F. Supp. 2d 443, 445 (D. Md. 1998). The opinion of most franchisors is that a franchise system cannot remain viable if a franchisee is allowed to compete against the franchisor after termination of a franchise agreement.  Therefore many franchisors view the inclusion of a post-term covenant not-to-compete in a franchise agreement as non-negotiable. An exception to this stance may exist where a prospective franchisee has had prior experience owning the business before approaching the franchisor.  In some instances it may be possible to negotiate the non-compete out of the agreement, since the main objectives of the non-compete, ie.  to protect the franchisor’s system for operating the business along with the goodwill built up using the franchisor’s marks, are somewhat diminished when a prospect operated a competitive business prior to purchasing the franchise.  The argument goes that the inclusion of a non-compete would fail to put the parties in the positions they occupied before entering into the franchise agreement, in the same way as when a franchise is sold to a franchisee with no prior experience running the business.  .   A second scenario to look for when reviewing non-compete language is whether the non-compete covenant applies upon natural expiration of the agreement.  The court in the Naturalawn of America case cited above indicates that a non-compete will be enforced against a franchisee upon expiration of the agreement simply because, in the court’s opinion, “expiration of an agreement is a more specific type of termination.”  Naturalawn of America, Inc., 484 F. Supp. at 401.  The enforcement of a non-compete upon the natural expiration of a franchise agreement could have enormous consequences on an uninformed franchise client who suddenly finds himself prohibited from continuing in business as an independent, despite the fact that the franchisee was a model franchisee during the life of the franchise agreement and exited the system in good standing with the franchisor.   A careful review of the agreement and negotiating a change, or at minimum advising the client of the post-expiration covenant prior to signing, is therefore essential to providing the necessary information to allow the client to make an informed decisions as to whether to purchase the franchise.  .
  • Assignment; Sales of Assets to Third Party; Franchisor right of refusal. Franchisors uniformly reserve the right to approve an assignment of the franchise agreement by a franchisee to a third party, or a sale of the franchisee’s assets to a third party, and to prohibit such transfers and sales that the franchisor does not ultimately approve of.  These rights are rarely negotiable, since franchisors take extremely seriously the approval of the persons and companies that will be holding the franchisor’s trade name and marks out to the public.  One exception where negotiation is possible, however, is the form of the franchisor’s right of first refusal.  Basically, many franchisors retain an option to either purchase the assets of the franchised business, purchase the franchise itself, or both, on the same terms and conditions the franchisee has agreed to with a bona fide buyer.  A franchisor’s right of first refusal can be problematic to a franchisee for a number of reasons.  First, the franchisee has to have a bona fide offer from a third party, one that is final and agreed to on every point so that it can be taken to a franchisor for a decision.  Next, potential purchasers can be hesitant as a result of the period — 60 – 90 days is standard — that the franchisor has to decide on whether to match the offer.  Some purchasers will balk at the possibility of having to wait while the franchisor contemplates, only to find out that the opportunity to purchase the business or the assets was indeed exercised by the franchisor, thereby leaving the third party searching for a new business to purchase once again.  Therefore, an attorney will best serve his client’s interests by removing the right of first refusal altogether, and if unsuccessful, at least shortening the time period granted to the franchisor to decide on the offer so as to make the delay tolerable.

Check back for more tips in Part 3 of this series.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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Reviewing a Franchise Agreement – Tips for a Non-Franchise Attorney (Part 1)

Tuesday, May 26th, 2009

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

or ray@mckenzie-legal.com

The practice of franchise law is a niche area when it comes to the representation of franchisors.  Franchise attorneys draft complicated, tedious Franchise Disclosure Documents that must comply with the Federal Trade Commission Revised Rule as well as certain state disclosure law.  It is the Federal Disclosure Document (“FDD”), which includes the franchise agreement that will eventually be executed by the franchisor and franchisee, that is disseminated by franchisors to prospective franchisees for review prior to the offer of sale of a franchised business in this country.  It is the drafting and filing of the FDD in franchise registration states across the country that relies upon the expertise of a franchise attorney.

There is no reason, however, for a competent business attorney familiar with basic contract law to feel overwhelmed at the idea of reviewing a franchise agreement and advising a prospective franchisee.  You will hear many business owners say they have reviewed a franchise agreement and feel like they have a “pretty good idea” about what is contained there.  However, attorneys have spent a lifetime being taught that the difference between having a “pretty good idea” and being absolutely, legally, sure, can be quite costly.  It is therefore up to the attorney to advise the client as to exactly what the franchise agreement states, which will allow the client to make a fully informed decision using the legal expertise you provide.  With that in mind, here are ten tips for the non-franchise attorney to keep in mind when reviewing a franchise agreement.

  • Term. The term of a franchise agreement varies, as it depends almost entirely on a business judgment made by the franchisor when drafting the FDD and franchise agreement.  Some franchisors prefer shorter terms, so that franchisees are asked to execute new franchise agreements every few years.  Other franchisors prefer the stability of having their franchisees committed to longer franchise agreements, without having to undertake the risk that a franchisee will prefer to leave the franchise system rather than re-up with the franchisor.  Franchisees’ preference as to the length of a franchise agreement varies as well, with some franchisees preferring to enter into a short-term agreement in case the business does poorly or the franchisee is simply not sure that the business is one that he wants to be involved in long term.  Just as many franchisees, however, especially where a large capital investment is required, prefer the security and predictability of a longer term, which allows the franchisee to focus on growing the business without the underlying concern of franchise agreement renewal and expiration issues.  Bearing in mind the client’s stated business objectives and the franchise’s possible pitfalls, it is up to the attorney to advise the client as to what length of term best suits the client’s goals and needs, and negotiating such term into the franchise agreement.
  • Fees. Many franchise agreements require the payment of an initial franchise fee.  This fee is an up-front fee due at the time the prospect purchases the franchise.  Some franchisors will offer to finance this fee over a period of time, while others require the lump sum payment to be made without making any financing available.  In addition to an initial franchise fee, franchisors usually require in the franchise agreement that the franchisee pay ongoing royalty and advertising fees to the franchisor during the term of the agreement.   Royalty and advertising fees are usually paid monthly, and can be a percentage of the business’s gross revenue, a flat fee, or a combination of the two.  One of the issues to watch for with regard to ongoing fees is whether the franchisor requires the franchisee to pay a minimum royalty fee either monthly or annually, without regard to the amount of actual revenue the franchisee generates.  Think of it as an alternative minimum tax for franchisees.  At the end of a month or year, a franchisee may have to write the franchisor a check to cover the minimum franchise fee if the royalty fee paid by the franchisee, based on a percentage of the franchisee’s revenue, fell short of the minimum royalty fee called for in the franchise agreement.  This is unquestionably an issue that an attorney must make sure to bring to the attention of a franchisee prior to executing a franchise agreement.
  • Renewals/Subsequent Agreements. Pay careful attention to the language regarding renewals and subsequent agreements. The term “renewal” is a misnomer, since technically most franchisors do not allow the franchisee to simply renew the existing agreement as-is.    Rather, most franchisors grant existing franchisees the opportunity to enter into a “then-current” franchise agreement, provided the franchisee is in good standing.  The “then-current” agreement will naturally contain terms differing, in some respects materially, from the previous agreement offered by the franchisor.  This is the franchisor’s way of making sure that it does not get stuck with a stale agreement, whether it be in the fee structure or numerous other areas that the franchisor may wish to change over time.  Some items to pay specific attention to when reviewing subsequent agreements include: whether a renewal fee is called for; whether the right to execute subsequent agreements goes on indefinitely, or instead if only a set number of renewals are allowed; whether the agreement calls for execution of the franchisor’s then-current franchise agreement, which may include terms materially different from the existing agreement; whether there is a cap on how much the franchisor can raise fees in subsequent agreements; what is the term of the subsequent agreement; and, what, if any, improvements, changes, renovations, and upgrades are required of the franchisee prior to a subsequent agreement being offered by the franchisor.

Check back for more tips in Part 2 of this series.

Need a Franchise Attorney? Contact Raymond McKenzie at 301-330-6790 or ray@mckenzie-legal.com

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