A Minnesota distributor of burners is not a franchisee of the manufacturer of the burners under the Minnesota Franchise Act (“MFA”), held a federal district court in Minnesota in an action in which the distributor attempted to enjoin the manufacturer from terminating the contract between the parties. In Louis DeGidio, Inc. v. Industrial Combustion, LLC, the court found that while the distributor satisfied the first two requirements of the definition of “franchise” by using the manufacturer’s trade name and purchasing goods from the manufacturing, the distributor failed to prove the last requirement; the payment of a franchise fee.

In practice, a franchise fee is often paid as a flat fee or royalty fees based on sales, but it can also be paid indirectly through various requirements the franchisor imposes. In Minnesota, requirements that can constitute a franchise fee include “(i) requiring a party to purchase an unreasonable minimum of inventory; (ii) mandatory fees for required training; and (iii) charging inflated prices for parts.”

In this case, the parties had a contract which, among other provisions, required the distributor to “maintain minimum stock at its place of business for the efficient sale, service and repair of [the manufacturer’s] products” and required the manufacturer to provide training when the distributor deemed necessary. The manufacturer sold the inventory to the distributor at cost and the distributor was not required to attend training.

The court held that requiring a minimum stock for promoting efficient operations did not constitute an unreasonable minimum of inventory. Further, the training fee was not mandatory since training was not mandatory, and selling goods at cost did not constitute inflated prices. Therefore, the distributor did not pay the manufacturer a franchise fee. As a result, the distributor was not a franchisee and not entitled to the protections of the MFA. Therefore, the distributor could not enjoin the manufacturer from terminating the contract.

As many readers may know, the FTC Rule on Franchising’s definition of franchise contains three basic definitional elements: (1) license of a trademark, (2) payment of a fee, and (3) provision of assistance or exertion of control. Additionally, twenty-six states regulate the offer and sale of franchises. Of those twenty-six states, eight define a franchise by incorporating a requirement that a “community of interest” exist between the parties, instead of the assistance/control element of the FTC Rule. This blog post contains refresher on the New Jersey Franchise Practices Act (NJFPA) and its interpretation of this definitional element. New Jersey courts have construed the element narrowly by focusing on the interdependence between the parties. Courts have primarily focused on the perceived abuse that franchisors may exert after a franchisee has made substantial investment in its business.

First, in Neptune T.V. & Appliance Service, Inc. v. Litton Microwave Cooking Products, Division Litton Systems, Inc., the Superior Court of New Jersey held that however “broad, elastic and elusive” the concept of community of interest is, it does not cover relationships that lack the “symbiotic character of a true franchise arrangement and consequent vulnerability of the alleged franchisee to the unconscionable loss of his tangible and intangible equities.” More than a mere sharing of profits is necessary in order to satisfy the element.

Second, in Colt Industries Inc. v. Fidelco Pump & Compressor Corp., the United States Court of Appeals for the Third Circuit relied on Neptune to conclude that a relationship that had equal bargaining power, no advertising requirement for the distributor and no sales quotas lacked the requisite community of interest to qualify as a franchise under the NJFPA, despite the requirement that the distributor provide warranty service for the manufacturer.

Again in New Jersey American, Inc. v. Allied Corp., the Third Circuit, citing Colt and Neptune, ruled that a company that assembled brake pads was not in a franchise relationship with its supplier of brake lining pads affirming that the NJFPA only applies to those business relationships that are particularly susceptible to the types of abuses a franchisor can exert over its franchisees. The seller was not subject to the “whim, direction and control of a more powerful entity whose withdrawal from the relationship would shock a court’s sense of equity” where the seller relied on many brake manufacturers for its supply, most of which are readily available to fill the supplier’s void, and the seller could not demonstrate any “franchise-specific” investment in capital equipment or goodwill.

The Third Circuit struck again in Cassidy Powell Lynch, Inc. v. SnyderGeneral Corp. and found a franchise relationship did not exist where there was a lack of control by the supplier and franchise-specific investment required in the distributorship agreement. The court concluded that unequal bargaining power did not exist because the knowledge and customer base the distributor acquired during the term of the agreement was not franchise specific and the distributor’s reliance on the supplier was self-imposed.

The NJFPA saga took a different turn in the Supreme Court of New Jersey’s decision in Instructional Systems, Inc. v Computer Curriculum Corp. The court found that the distributor established a base of clients in an area where no clients existed before the relationship and the manufacturer restricted the distributor from offering competing products and obligated the distributor to devote the entirety of its energies on development and sales of the manufacturer’s computers. As a result, the court held the distributor had established an interdependence between the parties sufficient to satisfy the community of interest element and thereby a franchise relationship.

Most recently, the United States District Court for the Eastern District of Pennsylvania interpreted the NJFPA narrowly, holding the statute did not apply. In Southern States Cooperative, Inc. v. Global AG Associates, Inc., the court discussed Cooper, Cassidy, Colt and Instructional and focused on whether the non-exclusive local retailer made substantial franchise-specific investments and whether it was required to do so under the terms of the underlying dealer agreement. Notably, the retailer voluntarily participated in the dealer’s advertising program and purchased large amounts of inventory.

Overall, the courts interpreting the NJFPA have established a fairly high bar to surpass in creating a franchise relationship where one was not initially contemplated. Holdings under the NJFPA have established a heavily fact-dependent inquiry with few definitive guidelines. The only successful claimant was the distributor in Instructional that demonstrated it had created an established base of clients where none existed before and was essentially forced to devote the entirety of its efforts to this one product because of the restriction on the sale of competing products. This seems ripe for the post-contract opportunistic behavior the NJFPA seeks to prevent. If you are seeking to avoid franchise designation under the NJFPA a client should focus on limiting the interdependence of the licensee/distributor and allow such party to establish its own business venture. Limiting franchise-specific expenditures will your cause as well. A carefully drafted license/distribution agreement will go a long way in helping you avoid the NJFPA clutches of evil!

Recently, we lauded the Department of Labor’s return to the control test of joint employment. Perhaps presciently, we wondered whether the NLRB would follow the same course.

The latest turn in the NLRB case involving McDonald’s and the “Fight for $15” group should give us the answer to that question – but not just yet. The McDonald’s case, you may recall, represents the last vestige of the Obama administration’s expansive view of joint employment. The Fight group, backed by the Service Employees International Union, filed an action in the NLRB seeking, among other things, a finding that McDonald’s is the joint employer of its franchisees’ employees.

In December, the NLRB order the ALJ to accept a settlement in the case that included back pay, but crucially, excluded any finding of joint employment. But wait!, screamed the Fight group, two of the NLRB members should have recused themselves from the decision. The group filed a motion to reopen the case and for reconsideration. That led to the ALJ’s action, on January 23, holding approval of the settlement “in abeyance” pending Board action on the Fight group’s motion.

In other words, the book isn’t closed in the NLRB . . . yet.

The Franchise and Distribution Section of the Georgia Bar met for business and pleasure last December. We heard from two exceptional presenters – Lindsay Morgan of Greenberg Traurig LLP and Tad Low of Moe’s Southwest Grill –  on the growing market in off-premises (take-out, delivery, and catering) restaurant sales, who presented us with a wealth of data and advice.

First, the lay of the land. Delivery as a share of restaurant sales (excluding catering and bars) was slightly above 6% in 2016, but is estimated to comprise over 10% of sales in 2022. While consumers are ordering more food each year online, they are projected to use third-party restaurant platforms far more than they will use restaurants’ own apps or websites. These two trends (more delivery, but ordered through third parties) should concern restaurateurs because delivery and packaging take a nasty bite out of profits. Consider, for example, that deliveries rarely include beverages, which offer high margins, but do require additional costs in packaging and delivery. Restaurants, but especially franchisors, also have legitimate concerns about brand damage when third party deliveries make mistakes get attributed to the point of origin.

Nonetheless, off-premises programs can be profitable for franchisors. The franchise systems that will adapt and capitalize on growing off-premises trends are those that develop a thoughtful, deliberate, and tailored approach to their aggregator agreements, program design and implementation, and manual and franchise agreements. As Ms. Morgan and Mr. Low explained, franchisors can conceptualize a five-pillar approach consisting of: 1) profitability, 2) provider selection, 3) participation and enforcement, 4) provisions, and 5) perception.

The first pillar, profitability, can be approached in many ways. Aside from the obvious, negotiating for lower fees, restaurants can limit delivery menu options, increase pricing in delivery menus, outsource food production to ghost kitchens, or internalize or privateer delivery to reach the desired profit margin.

When it comes to choosing a provider, the big players are Uber Eats, Doordash, Grubhub, and Postmates. Getting these third-parties to negotiate terms and conditions may be difficult for smaller to mid-size franchisors, but software compatibility is another, separate issue that should not be overlooked. And as is always the case in our modern world, access to data is incredibly valuable.

Each franchisor must determine for itself whether to mandate or incentivize participation in an off-premises program. Many might find a carrot and stick approach works best. While enforcement is not difficult to comprehend, incentives require more creativity, and should be unique to each system. A franchisor could provide a royalty grace period to offset delivery commission, offer rebates on required packaging or point of sale products, or defer the timeline for other capital expenditures for franchise units that remodel to accommodate off-premises sales.

As for provisions, franchise agreements must grant the franchisor the right to require 1) provision of off-premises services or 2) general system-wide changes. An Off-Premises Program is best implemented through a franchise’s manual because it can be revised to apply to all units at once and can allow for detail and flexibility in implementation. Still, a franchisor should not implement a Program without reviewing its franchise agreement, especially provisions on territory, data and confidential information, and definitions of royalties and gross sales.

The fifth pillar, perception, addresses the integrity of brand. How can the system’s off-premises program ensure the brand won’t suffer? For example, tamper-resistant packaging and time-stamps are possible solutions, but franchisors should anticipate such problems when negotiating with the provider.

In summary, food-service franchisors must adapt to the growing trend in off-premises consumption, but they should not jump in without a thorough plan.

Copyright: / 123RF Stock Photo

Franchise systems, and many licensing arrangements, contain anti-poaching provisions. These provisions are being tested under the antitrust laws as being anticompetitive. This article will discuss the benefits and burdens of including such provisions in your agreements.

These “no-poach” or “anti-poaching” clauses are fairly standard provisions that restrict franchisees from soliciting or hiring employees of the franchisor or another franchisee of the same franchise system. Formerly enforced by courts as legitimate efforts to prevent cannibalization of employees from one franchisee to another, they are now the subject of scrutiny by 16 state Attorneys General and at least 7 federal district court cases. District Judge Anita Brody denied a motion under 12(b) (6) for dismissal of such an antitrust claim in Fuentes v. Royal Dutch Shell PLC, 2019 US. Dist. Lexis 224708 (EDPA November 25, 2019).

The no-poach provisions were previously justified as strengthening inter-brand competition and promoting a uniform, non-competitive environment among the franchisees. Recent critics have argued that the data shows no-poach clauses might suppress employee wages and mobility. These arguments are data driven, so antitrust analysis is necessary to sort through the issues.

I am unconvinced that a no-poach clause is a per se violation of the antitrust laws. Moreover, I am of the opinion that no-poach clauses are rarely enforced by anyone. The mechanics of enforcing such a clause, one franchisee against another or the franchisor, is rarely warranted.

If the clause is important to a system, I would probably recommend that the clause remain as it does not appreciably impact wages. But franchisors and licensees should expect more scrutiny of such clauses and be willing and prepared to defend such clauses. In some systems, I have recommended a system-wide statement that the clause will not be enforced, or an amendment of the Operations Manual to the same effect. In other systems, I have suggested that no action be taken as to existing franchise agreements. I generally recommend that in the new form of franchise agreement that a specific decision be made why such a clause should be included, with the suggestion that it not be included unless necessary. Franchisors should review their current agreements with counsel to decide whether it is necessary to defend such a clause if challenged.

 

In 2014, David Weil assumed the reins at the Department of Labor’s Wage and Hour division. Dr. Weil, an economic scholar, set his sights on the concept of joint employment. In academia, his work focused on what he termed a “fissured” employment model, one in which a worker’s economic position depended not only on his immediate employer, e.g., the franchisee, but on another company, e.g. the franchisor. The economic reality of the relationship, according to Dr. Weil, meant that the franchisee and franchisor were joint employers of the franchisee’s employees. The DOL put Dr. Weil’s views into practice and applied an expanded definition of joint employment to labor statutes. The NLRB quickly followed suit, opining that a joint employer such as a franchisor was subject to the NLRA.

The abrupt change in policy rocked the franchise industry and touched off a long period during which the industry’s very existence appeared to be threatened by state and federal employment laws. The DOL’s final rule on joint employment, published January 16th, calls a truce in the federal fight.

The final rule, which becomes effective on March 16th, returns to the pre-2014, widely accepted definition of joint employment that focuses on the putative joint employer’s ability to control the employee – hiring and firing, routine supervision and control, salary. Importantly, indicia typical of a franchise relationship are excluded from factors to be considered in the analysis. Whether the business relationship is a franchise, whether a franchisor exercises quality control, and whether the franchisor offers assistance to the franchisee, are irrelevant to the analysis.

Of course, no news is ever entirely positive. The final rule is in the context of the FLSA; whether other agencies, such as the NLRB, will be guided by the rule, and to what extent federal courts will interpret and apply the rule are unknown. And the federal action does nothing to ameliorate the uncertainties at best, and risks at worst, of California’s AB 5 legislation, which codified the problematic A-B-C test defined in the by now infamous Dynamex decision. As additional states consider and/or enact AB 5 type legislation, franchising’s battlefield thus turns to the states.

In a recent opinion, the Texas State Office of Administrative Hearings (SOAH) disagreed with a Texas franchisor that claimed rent and other fees received from its franchisees were mandated by fiduciary duty to flow through to other entities and therefore not taxable revenue.

The Franchise Agreement and the Franchise Disclosure Document of the franchisor, an automotive maintenance and repair business with more than 150 franchises located nationwide, detail specific costs the franchisee is required to pay the franchisor, including the fees for rent, training, marketing, IT support, and software. The franchisor subleases the locations to, and collects rent from, the franchisees. There was no evidence establishing the amount the franchisor pays to third parties for services, such as software. Furthermore, the Franchise Agreement contained an Independent Contractor clause, indicating, in part, the terms of the agreement should not be construed to create an agency relationship. 

Nonetheless, the franchisor claimed that it had a fiduciary duty to distribute rent payments and other fees to the third parties. Therefore, those collected fees constitute flow-through funds and were not taxable revenue under Texas Tax Code §171.1011(f). Fiduciary duties arise either as a matter of law, such as in a trustee relationship, or informally, such as in a moral or personal relationship of trust and confidence. However, ordinary contractual duties do not rise to the level of a fiduciary relationship. The SOAH found the franchisor’s duties to pay rent and other fees to third parties were ordinary contractual duties and did not rise to the level to those of a fiduciary.

The franchisor also claimed that the payment of rent and other fees on behalf of the franchisee was mandated by law. Similarly, the SOAH found that the payments were governed by ordinary contractual duties and were not mandated by law.

Because the payment of rent and fees on behalf of the franchisees did not amount to a fiduciary duty and was not mandated by law, the franchisor was not entitled to exclude the collected fees from revenue and was required to pay taxes on the collected fees.

 

More and more states are launching online portals allowing franchise systems to file initial registrations, exemptions, renewals and amendment applications electronically.    The Indiana Secretary of State, Securities Division launched the Indiana Securities Portal  exactly one year ago.  According to the Indiana Division, the implementation has been very successful and the feedback over the past year has been very positive.   As a result, the Division decided that the portal will be the sole filing mechanism for a number of filings reviewed by the Division beginning in the new year.

Mark your calendars!  Effective January 1, 2020, franchise exemption requests and registration registrations and all amendments, supplemental materials and associated payments will only be accepted electronically through the Indiana portal.   Any filing, amendment, supplemental material or associated payment received outside of the portal after 1/1/2020 will be returned to filer with instructions to use the portal.     Questions about this new procedure can be directed to the Securities Division here.

Indiana joins Minnesota, Rhode Island, Utah, Washington and Wisconsin as the list of states that accept or require online filings for franchise registrations, renewals and amendments.    Many of these states, like Washington, concluded that eliminating the need to make any paper or other physical submissions conserves time and resources of the applicant and the division.

If you have not yet made the switch to paperless in Indiana, then be sure to notify the paralegals, attorneys and staff tasked with preparing and submitting these filings.   Renewal seasons is right around the corner!

The new year is often a time when successful entrepreneurs with thriving business concepts start looking to expand their brand using a franchise business model.  Franchising is an excellent way to grow a business rapidly, penetrate new markets, and leverage investment from the capital infusion and energy of franchisees.    However, there are a few very important steps we always recommend to clients committed to pursuing franchising before deciding to take the plunge.  With 2020 on the horizon, let us provide you with a list of tips to get you ready to launch!

  •  Develop a Profitable Business.  While this step may seem obvious, many businesses decide to franchise before having at least one business unit with at a few years of strong operating and financial performance that can provide prospective franchisees with proof of concept.  You also have to consider whether your business concept is likely to be profitable for franchisees after taking into account ongoing royalties, advertising, technology, and other fees.
  • Research Competitors in the Industry.   Do competitive analysis of not just franchise systems that directly compete in a certain industry sector but concepts with similar financial models.  For example, if you are a remediation service franchise, then a prospective franchisee may be comparing a cross range of service-based mobile models with similar price-points (lawn care, handy work, painting, or dryer vent cleaning, for example).
  • Organize the How-To.     Any sustainable franchise system will need to provide its franchisees with an Operations Manual that includes the processes, procedures, and methods of the franchise system concept.    The Operations Manual is the go-to resource for franchisees and key topics include: business overview, initial training, marketing and advertising, approved suppliers, required equipment, site selection (if applicable), inventory, and customer service.
  • DRILL DOWN on the Costs.   Remember that launching a franchise system is a new business in and of itself.    You will may need capital or financing to ensure you have the infrastructure in place to support your franchisees and the necessary business advisers retained to assist in the process (accountants, attorneys, potential franchise consultants, and new personnel, like trainers).
  • Confirm Your Trademark.  You should confirm that your business owns a federally registered trademark, and, if necessary, take steps to federally register all trademarks associated with the brand.  Franchise counsel should include this as part of a comprehensive package to get new systems prepared to franchise.

The beginning of a calendar year is often an excellent time to launch a new franchise system from a regulatory and accounting perspective.   If your fiscal year is 12/31, then  launching in the beginning of a calendar year provides you an entire year of use before annual updating is required.  This saves time and money, two things many start-ups don’t have in excess.   If you are ready to move forward, then discussions with an attorney with experience in franchising is an appropriate next step.

 

New York passed a cybersecurity and data breach law, effective October 23, and it expands many cybersecurity requirements to not only businesses operating in New York, but also those operating outside of the state. The SHIELD Act, as it is called, expands the scope of the current law by requiring covered entities to adopt a comprehensive data protection program and comply with additional data breach notification requirements.

The SHIELD Act expands the definition of private information to include biometric information and bank account or credit/debit card numbers, regardless of whether a password or security code is associated. Additionally, private information also now includes a username or email address in combination with a password or security question that would allow someone to access an online account.

The compliance requirements have also been expanded. If a business is not defined as “small”, it must designate and train employees to be responsible for compliance; require any third-party providers be capable of maintaining cybersecurity practices, with this requirement in the contract; perform risk assessments and monitor the effectiveness of the cybersecurity program; have safeguards in place to respond to attacks or failures; have processes for the disposal of private information; and update the cybersecurity program.

Obviously, franchisors and franchisees operating in New York must review the components of the SHIELD Act to ensure compliance. Moreover, employers who are not located in New York may still be required to comply with the SHIELD Act if they solicit or accept applications from a New York resident, if private information is part of this process. This is one area in particular where the Act could impact a non-New York franchisor. Many franchisors accept franchise applications from across the country, including from residents of New York. Although the franchisor may not be defined as an employer, it is a good practice for franchisors to review their cybersecurity systems to ensure compliance with the New York SHIELD Act. Moreover, any franchisees operating in this state must review the components to ensure they are following it.

Cybersecurity issues and data privacy laws are only going to become more complex, and the cost of compliance will likely increase. At the same time, this is a small price compared to the possible issues should there be a breach.