The North American Securities Administrators Association, Inc. (“NASAA”) is proposing to revise the instructions in the NASAA Franchise Registration and Disclosure Guidelines (the “Guidelines”) that outline policies and procedures regarding the preparation of a franchise disclosure document (“FDD”). Specifically, NASAA has set forth a proposal for public comment that replaces the “State Cover Page”  to the FDD with three separate pages titled “How to Use this Franchise Disclosure Document”, “What You Need to Know About Franchising, Generally”, and “Special Risks to Consider about This Franchise.”

Currently, the Guidelines require that the State Cover Page include certain standard “risk factors” about the franchised business being offered under the FDD, including dispute resolution procedures, governing law, and personal guaranty requirements. Additionally, registration state examiners may, in their discretion, mandate that additional information be included as additional risk factors, such as the franchisor’s financial condition and operating history. In putting this information on the second page of the FDD, NASAA and the state examiners hope to put prospective franchisees on alert of certain factors that are likely important in their decision-making process.

The first new page, “How to Use this Franchise Disclosure Document”, would require a franchisor to disclose, in table format, certain questions a prospect might have and the corresponding Item in the FDD where that information is contained. Similarly to Item 17 of the FDD that provides a summary of certain provisions in the Franchise Agreement, this page would provide prospects with a roadmap to the FDD. NASAA has noted that many prospects find the FDD overwhelming and this page would hopefully alleviate some of these concerns. However, we are concerned that some of the questions seem to put preconceived notions in a prospect’s head about disclosures contained in the FDD.

The second new page, “What You Need to Know About Franchising, Generally”, outlines certain “general” risks a prospect should be aware before entering into a franchise relationship. These additional risks include discussions on personal liability, additional investment requirements, operating and supplier restrictions, and renewal procedures. A franchisor would need to make these disclosures even if a particular factor was inapplicable to the underlying franchise offering. This seems to be counterintuitive and may only cause additional confusion for prospects and the franchisors that have to answer these questions.

The final new page, “Special Risks to Consider about This Franchise”, replaces the current “State Cover Page” and would, again, allow state examiners to require that certain additional risk factors applicable to the specific franchised business be included in the FDD.

Overall, while we believe the NASAA’s intentions are in the right place, these three pages could very well create more confusion due to the use of leading questions on the first page and disclosure of generalized risks without context on the second page. If approved in its current form, franchisors should be prepared to answer many questions about the information on these first two pages. Public comments on this proposal are due on July 13, 2018, so it is important to propose revisions if you have concerns, as we do! We will continue to watch and report on this development with interest.

In a closely watched 5 to 4 decision authored by retiring Justice Kennedy in South Dakota v. Wayfair, 585 U.S. ___ (2018), the U.S. Supreme Court reversed decades of Supreme Court precedent, giving state and local governments the right to collect sales taxes from out of state retailers on online sales made into the local jurisdiction.

The case involves Wayfair, a furniture and home company which sold products over the Internet into the state of South Dakota.  The law in question required the payment of a 4.5% sales tax by out-of-state retailers that make at least 200 sales or sales totaling at least $100,000 in South Dakota.

Prior to the Wayfair case, the standard, from two Supreme Court cases named Bellas Hess and Quill, was that a company had to have a physical presence in the state in order to be required to pay local tax.  A “physical presence” was something like a retail outlet, employees or property in the jurisdiction.

The Supreme Court stated, overruling decades of precedent, that the physical presence rule is unsound and incorrect. The Court noted that the rule has become removed from economic reality as technology has advanced.  The Court stated that the physical presence rule creates market distortions and puts local businesses and others at a competitive disadvantage given the new online marketplace.

The court concluded that, if a retailer establishes a substantial nexus with a state, that state can tax the sales in that state.  In this case, they concluded that the South Dakota law’s requirements of number of sales or total value satisfies the substantial nexus requirement.

This case has attracted much attention. Nonetheless, it is not surprising. Readers of this blog might recall that several years ago, the Supreme Court refused to hear an appeal of an Iowa law that required the collection of income taxes from franchisors on royalties for the use a franchisor’s intangible intellectual property by its franchisees within the physical confines of the state of Iowa.  The US Supreme Court let stand a ruling that such use presents “a sufficient connection to Iowa to justify the imposition of income taxes.” To us, this sounds an awful lot like the new “substantial nexus” test for the imposition of sales taxes.

Given that so many states rely on sales tax revenue for huge portions of their budgets and state governments have a strong aversion to new income taxes, this green light from the Supreme Court means that other states are likely to take a hard look at their laws and consider the enactment of laws calling for the collection of online sales taxes like the one in South Dakota. At the same time, for the franchise world, the related issue of whether the presence of franchisees in a state constitutes a substantial nexus for taxes on royalties will be closely watched by the franchise industry.

This information does not constitute legal or tax advice.  You should, of course, consult an attorney or tax adviser regarding any taxation issues you might have, as each situation is unique.

Almost every year at the IFA Annual Legal Symposium in Washington D.C., a panel of distinguished franchise attorneys and state regulators will discuss best practices in drafting a franchise disclosure document in compliance with the FTC Franchise Rule.   This year was no different and the workshop “Thorny FDD Disclosure Issues” offered a number of best practices and tips to help draft an FDD that is compliant with federal rule and state law and will breeze through the state registration process:

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  1. Item 2 (Business Experience). Franchise systems often have a difficult time determining what officers to disclosure. The panelists reminded attendees that when making this decision, the franchisor should ask themselves whether “an individual’s involvement in either sales or operations is such that a franchisee would rely on his or her expertise, formulation of policy, or control of the system.”
  2. Item 3 (Litigation). Remember that the FTC Rule requires that all material terms to a settlement must be disclosed regardless of whether the settlement agreement is confidential. Legal counsel should remind franchise system clients of this fact so they are not surprised when state regulators demand the information be included in Item 3.
  3. Item 6 (Other Fees). Remember to distinguish between negotiated discounts in initial fees verses other fees. Item 5 requires disclosure of discounted initial fees during the last fiscal year but Item 6 does not require the disclosure of discounted royalty deals.
  4. Item 8 (Restrictions on Sources of Products and Services). Item 8 requires franchisors to disclose the precise basis by which a franchisor receives consideration for required purchases or leases made by the franchisees. State regulators interpret this as a requirement to specify a percentage or flat fee amount per item. For example, “franchisor receives a rebates of $300 for each oven purchased.”

With such resources as the FTC Compliance Guide, FTC Frequently Asked Questions and NASAA Disclosure Guidelines, it would seem like there should be nothing up for debate when it comes to FDD drafting.   After attending this workshop, however, it is clear that there are always new tips to learn.

 

Each year in Washington D.C., the IFA joins forces with the International Bar Association’s Franchising Committee (IBA) to hold the IBA/IFA Joint Conference immediately after the IFA Legal Symposium. This was my first year attending. As our international franchise practice grows, I found it a rewarding opportunity to educate myself about the latest issues facing international franchise practitioners. The most fascinating andlively discussion was held during an interactive workshop entitled “Disruptive New Technologies and Franchising.”

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During the workshop, the panel walked through how international brands like McDonalds allow franchisees to utilize GrubHub, Doordash and UberEats to deliver hot food to consumers at a low cost. The most technical discussion revolved around calculating the royalty fee on third party delivery services. These services impose an average charge of 20% of the menu price for delivery. Does the franchisor charge royalties on gross revenue or does it collect royalties on a different calculation taking into consideration the service charges? Franchisors looking to collect royalties on the full price argue that the service fees are just like any other expense associated with operating the franchise. However, the economic reality is that the narrow profit margins in the food industry make it difficult for franchisees to turn any profit from these sales.

While the panelists discussed many issues, the most interesting addressed delegating responsibility for data security breaches.  The form of service agreements between these delivery services and franchisees are often 5-7 pages at most. Most require the restaurant to maintain responsibility for customer personal data and indemnify the delivery service for data breaches. However, franchisees use the delivery system’s software platforms to collect customer data giving delivery service’s like GrubHub and UberEats access to the physical location, likes, dislikes, eating and spending habits. What happens when these delivery services decide to launch their own restaurant concepts in direct competition of the franchise systems? This is exactly what the delivery service, Deliveroo, did last year.

These and other concerns raise the question of whether the benefits, if any, to using these disruptive technologies, outweigh the hassle and risk exposures.

The International Franchise Expo (IFE) starts TODAY (May 31st) and runs through Saturday, June 2nd at the Javits Center in New York City.  The IFE is one the largest franchise expo in the country.  This is an opportunity for franchise systems to market their brands face to face with prospective franchisees and for prospective franchisees to research brands and investigate potential franchise opportunities.  Megan B. Center, Associate, Fox Rothschild LLPHowever, the IFE is not simply an franchise sales expo.  The IFE offers many additional opportunities as well.  For example, many franchise brands attend the expo to walk the floor and obtain valuable information on potential competitors.  There are social and networking opportunities for vendors in the evening.

However, most importantly, the IFE also offers educational workshops during the day tailored to every potential attendee.  Prospective franchisees will find workshops with tips and traps on buying a franchise.  Emerging franchise systems will find workshops on improving franchise sales, best practices for multi-unit operators, and avoiding franchise disputes.  Established brands can find resources on expanding internationally and tips on tasking your system to the next level.   Megan Center and Alex Radus of our franchise practice group will be presenting a workshop at the IFE on Thursday at 12:30 pm entitled the “Top 10 Provisions to Never Negotiate in a Franchise Agreement” where they will discuss the potential long-term effects of seemingly Alexander S. Radus, Associate, Fox Rothschild LLPharmless revisions to franchise agreement provisions featuring the most common arguments franchisees will make and how and why to rebut them.    For those franchise industry practitioners looking for credits towards obtaining a CFE (Certified Franchise Executive) designation from the Institute of Certified Franchise Executives, then the IFE workshops are an opportunity to do so.

The cost to attend the IFE is very affordable. If you have not registered to attend the IFE yet, then you can do so here.

 

I recently attended a very informative panel discussion at this year’s IFA Legal Symposium in Washington D.C. earlier this month on addressing data security risks in franchise systems. The panel, consisting of two attorneys with Bank of America Merchant Services provided some good tips and takeaways for franchise systems:

  1. Do tabletops.   Your franchise system should have a data response plan in place for various potential breach scenarios and practice the plan regularly by conducting tabletop exercises. The last thing you want an executive officer of your brand doing after a breach is googling “Is it illegal to secretly pay $100,000 in Bitcoin to a hacker?”

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  2. Consider Standardization of POS Systems. While franchise systems may be reluctant to impose additional requirements in fear of vicarious liability claims, the potential exposure for data breach liability may outweigh those considerations. Engage a consultant to find weak spots in your system. Move away from the hodgepodge of various POS Systems and require all franchisees upgrade to current technology. Unless there is an overriding business need to maintain customer data, consider whether it is possible to have franchisees process data directly with vendor – instead of franchisor’s network. Consider advance technologies like point-to-point encryption and tokenization.
  3. Wait to Register Domain Name. If there is a breach and the franchise system will design a site for customers to determine if data was compromised and obtain instructions on credit monitoring, then do not register a domain name too far ahead of the public release of the breach. It may be a tip off to watchful third-parties who may publicize the breach before you are ready.
  4. Collaborate Efforts. When a breach initially happens, it is not helpful to immediately point fingers. Collaborate your response efforts with the franchisees. Telling a franchisee it is their responsibility and not helping to mitigate damage and address the issues does not help the brand.

Franchise systems have a unique set of potential hurdles when it comes to data breaches but with good policies and practices, brands can reduce risk exposure to protect both the franchisor and franchisees.

In Lomeli v. Jackson Hewitt, Inc., the United States District Court in the Central District of California held that the plaintiff, Luis Lomeli (“Lomeli”), had submitted enough evidence to hold the franchisor (“Jackson Hewitt”) vicariously liable for potential class actions due to a franchisee’s preparation and submission of fraudulent tax returns. The most concerning part of this decision is that the Court held that Jackson Hewitt could be directly liable for the fraud claims. This decision is another lesson in the necessity of leaving a certain level of discretion to a franchisor’s franchisees.

Under the direct liability claim, the Court examined Jackson Hewitt’s level of involvement in the submission of a franchisee’s tax returns. Specifically, the Court noted that the franchisee was required to use Jackson Hewitt’s proprietary software to submit the fraudulent tax returns and that Jackson Hewitt controlled the software. Further, despite the fact that Jackson Hewitt had approved the submission of a tax return for Lomeli mere days before, Jackson Hewitt approved a second submission for Lomeli with a markedly different tax return. As such, Jackson Hewitt had and controlled the information that gave rise to the fraudulent filing of the tax returns. To make matters worse, Jackson Hewitt had recently run an advertising campaign touting its 100% accuracy guarantee and superiority to “mom and pop” tax preparers. The Court held that these affirmative statements to the public had the explicit purpose of engendering their trust. Further, Jackson Hewitt could not run these advertisements to convince consumers to use them and then immediately turn around and dismiss any reliance on them. As such, Lomeli could proceed with its fraud claim directly against Jackson Hewitt.

As a secondary claim if the direct liability claim fails, the Court examined the level of control Jackson Hewitt exerted over certain areas of the operation of the franchise to determine vicarious liability. In holding that Jackson Hewitt could be vicariously liable for Lomeli’s fraud claim, the Court highlighted Jackson Hewitt’s ability to hire, direct, supervise, discipline or discharge the franchisee’s employees, the required use of Jackson Hewitt’s Code of Conduct for employee relations and required attendance by franchisee’s employees at training sessions aimed at preventing the specific harm claimed by Lomeli. The Court noted that Jackson Hewitt’s control of the instrumentality that caused the harm, the hiring of tax preparers, directly contributes to its vicarious liability.

Unfortunately for Jackson Hewitt (and franchisors everywhere), Jackson Hewitt could be 100% liable for the filing of the inaccurate and fraudulent tax returns.

 

The fight against joint employment of franchisors and franchisees took a small hit when the Western District of Pennsylvania (“Court”) chose to allow a franchisee’s employee’s suit to proceed. In Harris v. Midas, et. al., the plaintiff, Hannah Harris (“Harris”), convinced the Court that she had proffered enough evidence to allege a plausible basis to hold the franchisor (“Midas”) as a joint employer and vicariously liable for the franchisee’s conduct with respect to Harris’ sexual harassment claims against her franchisee employer.

In the instant case, the Court looked at three factors commonly employed to evaluate joint employer liability. First, the Court examined Midas’ authority to hire and fire employees, promulgate work rules and assignments and set conditions of employment. While the Court noted that Midas did not have the authority to hire or fire employees, the Court held that Midas could establish work policies. Specifically, the Court pointed to the provisions of the Franchise Agreement that require franchisees to comply with all lawful and reasonable policies imposed by Midas. Those policies specifically include those policies governing the training of personnel. Further, Harris noted that Midas provided guidance to its franchisees on the creation of its employee handbook and the inclusion of a sexual harassment policy, further exerting its control to influence these workplace policies.

Second, the Court held that while Midas did not exert control over the day-to-day supervision of employees, under the Franchise Agreement, Midas had the authority to do so. Notably, the Court cited Midas’ ability to require employees to attend additional training programs. Further, Midas trained the franchisee who, in turn, trained its employees on the Midas system. Lastly, the Court noted Midas’ ability to visit and inspect the franchisee’s location as further evidence of Midas’ potential influence over the day-to-day supervision of the franchisee’s employees. The Court’s reliance on these provisions is worrisome because many franchisors use similar language to protect the uniformity of the brand.

The last factor, Midas’ control over employee records, the Court again made a stretch to connect the dots. The Midas Franchise Agreement stated that Midas has the right to audit and examine the franchisee’s books and records, which, the Court held, could be interpreted to include personnel files if read as broadly as possible.

Furthermore, Harris argued that Midas was vicariously liable for the franchisee’s conduct because the franchisee was essentially acting as Midas’ agent. The Court agreed holding that the terms of the Franchise Agreement are so generally phrased as to provide Midas broad discretionary power to impose nearly any restriction or control it deems appropriate.

While the case at hand is at the initial phase and will likely be subject to further scrutiny, it demonstrates another avenue that courts are using to impose joint employer liability. Here, the Court is relying upon the broad and sweeping provisions of the Franchise Agreement that Midas is using to protect its brand and franchise system. The fine line franchisors must continue to tread between exerting just enough control to ensure proper maintenance of the franchise system but not enough to cause joint employer liability continues.

 

Below is a Guest blog post authored by our own Michael Viscount:

A concern for franchisees is the impact on license agreements for intellectual property when the licensor files bankruptcy and seeks to shed itself of burdensome obligations under license agreements. The impact on the licensee is different depending on the type of IP licensed. And, to further complicate matters, with regard to impact on trademarks the results can be different depending upon where the licensor files for bankruptcy.

Registered trademark symbol on a red backgroundRejection of Executory Contracts – An Overview

The scenario arises because Section 365 of the U.S. Bankruptcy Code allows the debtor party to reject certain contracts that are burdensome.

License agreements can be rejected, and this includes licenses for trademarks and other intellectual property. Under Section 365, when a license is rejected, the debtor party is excused from all obligations.

In 1985, in a case involving intellectual property licensed by Lubrizol Enterprises, the 4th Circuit Court of Appeals in Virginia allowed the rejection of the license agreement and ruled that the rejection by the licensor terminated the licensee’s right to use the intellectual property.

As can be imagined, this caused a stir in the business community, particularly in sectors like the franchise business.

In reaction, Congress amended Section 365 by adding subsection (n) to give licensees of certain types of intellectual property protection – under 365(n) the licensee of IP can either treat the license as terminated or continue to use the IP for the balance of the term of the contract provided all royalties are paid without the right of set off, and without the ability of the licensee to receiver any support from the licensor.

Impact on Trademark Licenses

When Congress amended Section 365 by adding 365(n), it also defined what it meant by the term intellectual property. The definition found at Bankruptcy Code Section 101(35A) does not include a reference to trademarks. The result is that cases are all over the board on whether trademark licenses have the protection from rejection codified in Section 365(n).

Some bankruptcy courts in the 4th Circuit and elsewhere hold that since the definition of IP does not include trademarks, the 4th Circuit’s analysis in Lubrizol dictates that the rejection of a trademark license terminates the rights of the licensee to use the trademark, i.e., no 365(n) protection. Courts in other jurisdictions hold that to treat trademark licenses differently cannot be supported, and these courts find equitable reasons to allow licensees to continue to use trademarks after license rejection.

The equitable approach was discussed in the 3rd Circuit’s 2010 ruling in Exide Techs. The 3rd Circuit did not decide the issue in Exide. But in a concurring opinion, Judge Ambro wrote that bankruptcy courts can fashion equitable protections for rejected trademark licensees. That judge is a former business bankruptcy lawyer whose opinions on bankruptcy are often cited favorably, and his concurrence in Exide was applied by at least one judge in New Jersey to support the equitable protections approach.

In 2012, the 7th Circuit weighed in in a case involving the bankruptcy of Sunbeam Products, when it held that the rights of the trademark licensee “do not vaporize” by rejection. The 7th Circuit rejected the analysis of the 4th Circuit in Lubrisol setting up a clear circuit split.

In 2016, a case from New Hampshire, involving licenses for all sorts of IP granted by Tempnology, LLC, started in the Bankruptcy Court, went to a 3-judge Appellate Panel and then to the full 1st Circuit. By the time the Tempnology case got to the full circuit court of appeals, two judges had ruled against the trademark licensee (Bankruptcy and BAP dissent) and two others had ruled in favor. The Bankruptcy Appellate Panel majority of two judges relied heavily on the 7th Circuit’s analysis in Sunbeam in finding that trademark licensees have the same protections as licensees of other IP.

In a split decision, the full 1st Circuit held that:

  1. Licensees of trademarks do not have protection under 365(n).
  2. It is not appropriate to craft equitable remedies to protect trademark licensees – rejecting the Judge Ambro approach
  3. The analysis of the 7th Circuit in Sunbeam was rejected
  4. The analysis of the 4th Circuit in Lubrizol was followed.
  5. The rights of the trademark licensee were rejected.

Conclusion

If you are a franchisee or other license holder and your franchisor/licensor files bankruptcy, until the Supreme Court resolves the split between the Circuit Courts, the outcome and impact on future rights to use trademarks may very well depend on the state in which you find yourself litigating the issues.

Michael J. Viscount Jr. is a partner in Fox’s Financial Restructuring & Bankruptcy Department, based in its Atlantic City and Philadelphia offices. He can be reached at 609.572.2227 or mviscount@foxrothschild.com.

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Each year the ABA Forum on Franchising Annual Meeting offers a regulatory roundup on state disclosure and registration issues consisting of a panel of franchise examiners from some of the most difficult registration states. This past year in Palm Desert regulators from California, Maryland and Washington offered their tips, tactics and recommendations for preparing and registering franchise disclosure documents compliant with federal and state law.   Some of the most interesting takeaways to keep in mind while you prepare your FDD include:

  1. Item 3. For any litigation matter that must be disclosed in Item 3 of the FDD make sure you include all pertinent facts even if the franchisor entered into a settlement agreement with the franchisee where the parties promise confidentiality. The franchisor must disclose the settlement terms regardless of any nondisclosure agreement.
  2. Item 5. Do not forget the 14 day rule requires that no money be paid or any agreements be signed until 14 calendar days pass. California regulator, Theresa Leets, panned the surprising number of FDDs that include territory deposit agreements, option agreements or other agreements requiring the payment of a fee that is not disclosed in Item 5 of the FDD and is collected even before an FDD is distributed.   Make it clear in Item 5 when you require any payment and make sure it does not run afoul of the 14 day rule or you will get comments from state regulators.
  3. Item 10. Be mindful of indirect financing to franchisees by affiliates if you are registered in California. Although franchisors are exempt from California’s Finance Lender Law when offering direct financing to franchisees, the same exemption does not apply to affiliates.
  4. Item 13. Be sure to include a description of all intercompany license agreements In Item 13.
  5. Item 21. Conduct due diligence on your accountant. Maryland Deputy Commissioner, Dale Cantone, reminds franchisors that just because someone has a shingle, you cannot assume he or she is licensed to perform audits. During the past year eager newly hired regulators in Maryland took it upon themselves to check the license status of franchisor’s financial statement auditors and found many were unlicensed. This causes huge issues for franchisors. Use a licensed certified public accountant.

Even seasoned practitioners and franchise systems can face pitfalls when registering with states so hopefully these tips should help speed that process along!