The Federal Trade Commission (“FTC”) has requested public comments on its Trade Regulation Rule entitled “Disclosure Requirements and Prohibitions Concerning Franchising” (the “Rule”). The Rule makes it an unfair or deceptive act or practice for franchisors to fail to give prospective franchisees a Franchise Disclosure Document, which is required to provide certain specific information about the franchisor, the franchise business, and the terms of the franchise agreement. The FTC is currently soliciting comments about the efficiency, costs, benefits, and regulatory impact of the Rule as part of its systematic review of all current Commission regulations and guides. Interested persons have the opportunity to submit written data, views, and arguments concerning the Rule to the FTC. The window for public comment is open until April 21, 2019.

The original Franchise Rule was issued in 1979. In 1995, the FTC decided to review the Rule, a process that took many years to complete. Finally, the review concluded that the Rule was still needed but could be improved, and amendments to the Rule were issued in 2007 (the “Amended Rule”), taking effect on July 1, 2008. The Amended Rule sought, among other changes, to reduce inconsistencies between federal and state pre-sale disclosure requirements and established a set of uniform disclosure requirements in a Franchise Disclosure Document (“FDD”). The Amended Rule is the one with which most practitioners are familiar, requiring franchisors to provide prospective franchisees with their FDD at least 14 calendar days before they make any payment or sign a binding agreement in connection with a proposed franchise sale. The FDD provides prospective franchise purchasers with 23 items of information material to their investment decision.

The FTC is now seeking comment on a number of issues, including the continuing need for the Amended Rule. Other questions from the FTC focus on whether the Amended Rule has been beneficial to franchisees and franchisors as well as the Amended Rule’s interaction with and impact on other regulations. Additionally, The FTC requests comments on whether the Amended Rule has been effective on preventing unfair and deceptive practices as well as the costs of compliance with the Amended Rule.

Members of the public may provide comments on the FTC’s questions, and public comments will be posted to the FTC’s website.

Last time we asked, given the high number of restaurant concept bankruptcies and money sloshing around in the sector, is there still more upside than downside in the restaurant franchising sector? We can find the answer by looking at where we have been. The U.S. economy is experiencing the second longest expansion in our lifetimes, after recovering from the greatest recession ever. We are still feeling the effects of economic stimulus, low interest rates, recent tax cuts and government deficit spending. This economic caffeine is about to be diluted. We can see it in the sales trends. We can see how to adjust to change by looking at the trends.

We are feeling good, and perhaps need to adjust to the rising headwinds. Top line revenues may appear to be rising, but that may be due to new delivery models. Some restaurants pay Grubhub and Doordash a high percentage of sales to deliver their products and increase volumes. Companies which build deliver and technology into their business increase their profits exponentially. The digital technology allow owners to gain knowledge regarding their customers by analyzing data coming from scan-to-pay systems, order-ahead applications, consumer facing technology and delivery arrangements. The better companies will know their customers better through the use of technology. They will use social influencers to drive customers from the internet to the store fronts.

Increased labor costs and management attention will also challenge restaurant growth, however, there are apps for this as well. Franchisee enterprise systems often can predict and manage labor schedules for franchisees. On resale and financing, technology is one of the strongest selling points, so it pays to invest in technology. Restaurants have even gone as far to provide platforms for their customers, that than relying on Facebook and LinkedIn. But even technology cannot hold back the tide of increased labor costs and responsibilities. Technology cannot eliminate competition through value meals, value pricing and giveaways.

The structural changes involve structuring how we invest in restaurant chains. Technology which educate the operators how to better cater to customers, and help adjust labor and menus will be in demand. Increases in efforts of the operators to improve the customer experience, as the internet has replaced word of mouth referrals. Finally, economic adjustment is needed, to build equity in the business to hedge against the overleveraging of hard assets.  You need that equity there when you need it, and you need to start building it now.

Imagine operating a single restaurant. The food keeps bringing them in, and prices are relatively stable. Consumer confidence is high, unemployment low, discretionary income rising, and people are going out more. Now multiply these variables as if we operated a chain of restaurants, and you will find small changes in any of these variables are multiplied exponentially and take a longer time to adjust for a restaurant chain. By looking across the industry, we can see that big changes may just be beginning, and we can join the change now.

Restaurants continue see investment money pouring in. Papa John’s and Jack in the Box are just two of many franchised restaurant chains undergoing due diligence for acquisition. Focus Brands, Inc., owner of Carvel, McAlister’s, Jamba Juice, Auntie Anne’s, Moe’s Southwest Grill, Schlotzkey’s and Cinnabon, bought Jamba Juice in September 2018 for approximately $200 million. On October 29, 2018, Focus Brands issued $300 million in additional bonds under it securitization facility with an interest rate of 5.184%.  The bonds are securitized by royalties and revenues from the other chains under the Focus Brands umbrella. Undoubtedly, unit economics support this financial engineering of debt, but it seems relatively easy to fund big spends for acquisitions. Is this special to the restaurant sector?

Big acquisition spends are not only prevalent for healthy companies but also distressed companies. Taco Bueno Restaurants, Inc. filed Chapter 11 on November 6, 2018 for its 140-unit company store and 29-unit franchised Mexican units. The reason it filed was because of falling earnings and underperforming restaurants. But Sun Holdings, a multi-concept franchisee listed as the 8th largest franchisee in the U.S., is the stalking horse bidder. Sun acquired the outstanding debt of $130.9 million for about half price and will inject $10 million into operations, and convert its debt claims into ownership of the company. Sun is doubling down on the franchised business.

Similarly, Papa Gino’s and D’Angelo’s filed Chapter 11 on November 6, 2018 for their 141 company owned branded locations, and was franchising 37 locations. It had once been as large at 370 units.  A stalking horse bidder, Wynnchurch Capital, acquired the senior debt of $18.5 million and the second lien position of $34.2 million. Wynnchurch has agreed to provide debtor in possession financing of $13.8 million. There is another $39.9 million in mezzanine financing held by Hartford Insurance Company and Brookside Mezzanine Fund.

Is there more capital available than good ideas and strong restaurant operators? Why are knowledgeable people placing bets on restaurant chains rather than home builders, car manufactures, and other industries? This abundance of capital has resulted and continues to result in the ongoing consolidation of Big Restaurant, franchisors and large franchisees able to leverage their assets and G & A costs. Family offices and private equity are increasing their investment in this sector because of the low barriers to entry and expansion. It allows retirees to buy franchises on credit, and consolidate their holdings to expand. Is there still more upside than downside?

We’ll answer that question in our next post.

Out-of-state franchisors beware of opening a franchise in New Mexico due to the recent decision in A&W Restaurants, Inc. v. Taxation and Revenue Department of the State of New Mexico and the potential for tax liability. The Taxation and Revenue Department of the State of New Mexico (“Dept.”) assessed over $29,000 in unpaid taxes against A&W Restaurants, Inc. (“A&W”) arising from its collection of royalty fees from several New Mexico franchisees.

In 2007, the New Mexico legislature amended the definition of “gross receipts” subject to the state gross receipts tax to include any money or value received from the grant of a franchise employed in New Mexico. Additionally, it removed from the definition of “gross receipts” any money or value received in connection with a trademark license agreement. Based on these definitions, A&W filed a protest seeking abatement of the gross receipts tax. During the course of the tax proceeding, A&W argued that the royalty fees were paid in connection with the trademark license provisions of the franchise agreements, omitting it from inclusion in the gross receipts tax. The hearing officer disagreed and upheld the Dept.’s assessment. A&W appealed the hearing officer’s decision.

The Court of Appeals in this case completed a thorough review of the amendments made by the New Mexico legislature and noted that the intent behind such revisions was to include royalty fees received in connection with franchise agreements subject to the gross receipts tax. Further, the New Mexico legislature wanted to exclude trademark license agreements but not franchise agreements that contain a trademark licensing provision. The Court noted, and A&W admitted, that a franchise agreement would not be entirely complete without a trademark license. With that, the Court upheld the hearing officer’s decision and held that A&W cannot separate out the trademark licensing provisions of the franchise agreement in order to avoid the gross receipts tax.

This decision serves as a reminder to ensure that your franchise agreement adequately protects you in this situation. It is important to keep your eye on similar legislative efforts in the future to appropriately plan for a franchisor’s potential tax liability.

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.”

48329671 – dish fast delivery flat isometric vector concept. mans hand takes a mobile phone with chef on it, that holds the dish on his hand. food delivery service.

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.

 

Restaurant operators and their financiers often need to predict the future. The operators, mostly from franchised brands, need to adapt to changing tastes and fashion. The financiers need to assess risk before making commitments or investments. Experts in these fields met together in November 2017 to test their assumptions.

Kevin Burke, Managing Director of Trinity Capital LLC, delivered a report which he summarized the economy for restaurants “As Good as it Gets.” The formal title was a very analytical “A Reversion to the Mean: What Happens When Industry Tailwinds End?” Burke’s basic conclusion is that things are great now, but the analytics show eventually the metrics will return to baseline, and this reversion to the mean predicts a slowdown of business and a tightening of credit.

You should in no way conclude that the credit punch bowl will be removed soon. Bankers are still enthusiastic about restaurants, and the chains are doing well. Current valuations of multiples of cash flow for merger and acquisitions average near historical highs of 10.6, and growing franchisors have multiples of double that. Leverage is at near historical highs of 5.3. These are multiples not seen nor sustained since 2007.  Private equity investment has slowed this year, and so have exits from their investments. Everyone looks fat and happy.

While there is still room for growth, current market conditions cannot last forever, and changes are coming via changing demographics. The discretionary spenders driving the restaurant renaissance are now the millennials. Millennials constitute the majority of the U.S. population. Their student loan debt is at all time highs. Less than half of the millennials make as much or more than their parents at the same age. The maturity cycle of millennials will have profound effects on the economy.

Millennials dine-in on delivery, according to Andrew Charles, Senior Analyst, Cowen & Co. Millennials are driving 30% of restaurant industry sales growth based on their delivery predilections. The largest demographic with the most demand for delivery is the 18-34 year-old, living in a major metropolitan area earning in excess of $100,000.00. Demand for delivery is less frequent in the suburbs and mid-size metro areas among 35-44 year-olds earning over $50,000 a year. Demand for delivery is lowest among those in small metro areas or small cities over the age of 45 years old earning less than $50,000.00 per year. Delivery users clearly prioritize convenience and time over the specific restaurant’s food. Based on the data, Charles predicts that the better a restaurant can meet the delivery demands of its customers, the more delivery will drive sales.

Looking at the data alone, this would suggest that restaurants have a great opportunity to expand their business by catering to millennials and providing delivery. However, the world is not that simple. When looking at the buying habits of millennials, they are now saving for houses and having children. For the past two years their restaurant spending as a group has trended down, and is predicted to fall as they invest in housing and their families. This will put a cap on growth and an emphasis on catering more to the millennial lifestyle of automation, convenience, delivery, healthful choices, as well as “foodie” choices.

Expect new entries in the artisan breads, foods and pizza categories. The “better pizza” will follow the “better burger” trend, with state of the art menu, delivery and payment systems. Expect menu changes in the casual dining sector to accommodate millennial tastes and the tastes of their children. Look for brands to tout their autonomous car, drone and other novel promises of delivery. Look for slumps in steak houses and casual dining as these brands need to adjust. Because of these trends, we are seeing a lot of activity in the mergers and acquisitions by strategic buyers ready to upgrade the brands to millennial friendly.

The millennials are the future, and the rest of us are merely tenants.

A recent decision in the United States District Court of Arizona (“Court”) could have far-reaching consequences to many franchisors based on the broad-sweeping principles the Court used in its reasoning. In Zounds Hearing Franchising, LLC et. al. v. Bower et. al., the Court answered the question of whether the Ohio Business Opportunity Purchasers Protection Act (BOPPA) trumps a choice of law and venue provision that provides for the application of law other than the State of Ohio.

Here, four franchisees filed suit against Zounds Hearing Franchising, LLC and Zounds Hearing, Inc. (collectively, “Zounds”) in the state court of Ohio for failure to comply with the five-day cancellation requirement under the BOPPA. Further, the aggrieved franchisees claim that Zounds made false, misleading and/or inconsistent representations than that contained in its FDD in connection with the sale of its franchises in violation of the BOPPA. Each Franchise Agreement provides that Arizona law governs the interpretation and enforcement of the Franchise Agreement and all disputes are subject to pre-suit mediation (at Zounds’ option) and venue in Arizona. As such, Zounds moved to remove the suits to Ohio federal court, which then transferred the suits to the instant Court.

In analyzing whether BOPPA should trump the provisions of the Franchise Agreement, the Court relied on the rules of the Restatement of Conflict of Laws. Specifically, the law of the state with the “most significant relationship” to the parties shall govern the agreement or, if the parties chose the law of another state, that state’s law shall govern. However, if the choice of law is contrary to a fundamental policy of the state with the most significant relationship, that state will presume to have the materially greater interest in its state law governing the agreement. In holding that Ohio has the most significant relationship to the parties, the Court noted that all of the franchises and franchisees were located in Ohio and it has a strong interest in protecting its residents, particularly where the underlying statute is designed to protect franchisees that are in an inferior bargaining position. Further, Arizona lacks a statute that protects purchasers of franchises, while BOPPA is directly on point to address the franchisees’ purported harm. Essentially, the franchisees would be left with little recourse against Zounds if Arizona law applied.

Further, the Court held that it is difficult to imagine that a statute that makes certain conduct a crime as being anything but the fundamental policy of the state. Additionally, the Ohio legislature amended the BOPPA in 2012 to explicitly state that any venue or choice of law provision that deprives an Ohio resident of protection thereunder is contrary to public policy, void and unenforceable further evidencing its intent. Lastly, the Court went so far as to say that even if a statute does not explicitly outline that it is fundamental policy of that state, a court still could deem it so by its very nature. Further, the lack of a non-waivability term does not doom the statute under this analysis. These principles may open the door to seemingly endless arguments about what constitutes the fundamental policy of a state.

As such, even though the parties agreed to the Arizona choice of law and venue provisions, the application of Arizona law would be contrary to the public policy of Ohio because Arizona does not have a statute that protects the rights of franchisee purchasers as does Ohio. Further, Ohio has a materially greater interest in the enforcement of its law because the franchisees are Ohio residents and the franchises are located therein.

In the alternative, Zounds filed a motion to compel mediation pursuant to the requirement for pre-suit mediation in Arizona in the Franchise Agreement. Here, the Court determined that the pre-suit mediation requirement violated the franchisees’ rights to Ohio venue because the mediation is “intimately bound up” with the franchisees’ right to sue under the BOPPA. Lastly, the Court determined that the mediations for all four franchisees could be joint despite the Franchise Agreement requiring that all proceedings arising out of the Franchise Agreement be decided on an individual basis. Here, the Court held that because pre-suit mediation was a “proceeding” (as argued by Zounds’ counsel), then the BOPPA prohibitions apply to the mediation requirement and the BOPPA specifically prohibits class action waivers. As such, the requirement to conduct pre-suit mediation was void in violation of the BOPPA. However, the parties conceded to conduct mediation during the course of the suit. As such, the Court required that the parties conduct joint pre-suit mediation. To take it a step further, the Court awarded the franchisees their attorneys’ fees because Zounds burdened the franchisees with a multiplicity of actions in a distant forum. Further, the Court cited the unequal provision in the Franchise Agreement that stated Zounds could recover attorneys’ fees upon a successful claim against a franchisee but did not afford franchisees with a reciprocal right. The Court noted that it would be a presumptive abuse of discretion not to award attorneys’ fees against an unsuccessful party who “used its superior bargaining position to impose such a term”.

Overall, this result could have substantial effects to any franchisor that currently has franchises in Ohio or has Arizona law as its choice of law. This decision suggests courts have wide latitude to determine whether another state has a substantial interest in the transaction and whether that state’s law should govern the agreement. Further, it is important to take note of the consequences this has on a franchisor’s ability to enforce non-binding mediation as a preliminary form of dispute resolution (and on an individual basis) and to collect attorneys’ fees (without a corresponding right afforded to the franchisee). Lastly, it would be prudent for all franchisors to review their franchise agreements in light of this decision.

 

Menu and chef
Copyright: yarruta / 123RF Stock Photo

The Trump administration is moving forward with an Obama-era initiative requiring certain food establishments to list calorie information on menus and menu boards, including food on display and self-service food. The FDA recently released new draft recommendations to help affected businesses comply with the menu labeling rule.

The rule implements the nutrition labeling provisions of the Patient Protection and Affordable Care Act of 2010, which are intended to give consumers direct, point-of-purchase access to nutritional information, including the calorie content of foods. When the rule was originally published, we blogged about its impact on restaurants and followed up with a report on the Small Entity Compliance Guide, which explains the rule’s requirements in a question/answer format.

The rule has met stiff opposition and enforcement has been delayed multiple times. Most recently, just four days shy of implementation, the deadline for compliance was extended to May 7, 2018. The extension was intended to give the FDA time to consider how to reduce the rule’s regulatory burden and increase flexibility, while providing consumers with nutritional information.

The FDA’s recent guidance is non-binding and addresses stakeholder concerns regarding implementation of the rule, including:

  • Clarifying calorie disclosure requirements for self-service food, including buffets and grab-and-go food;
  • Addressing the need for flexible methods to provide calorie disclosure information;
  • Explaining the criteria for distinguishing between menus and marketing materials;
  • Addressing how the FDA will assist covered establishments to comply with the rule, and how it will enforce compliance;
  • Expanding upon the “reasonable basis” standard that covered establishments must meet when disclosing nutritional information; and
  • Explaining the criteria for determining whether establishments (including franchises) and menu items are subject to the rule.

The FDA invites public comment on the draft guidelines through January 8, 2018.  We will continue to monitor developments and the rule’s effect on franchise systems.

The U.S. House Committee on Education and the Workforce recently approved the “Save Local Business Act” (HR 3441 – Byrne).  If enacted, the Act would limit joint employer liability by reversing the rule announced by the NLRB in Browning-Ferris Industries, 362 NLRB No. 186.  The Browning-Ferris decision departed from 30 years of precedent by issuing a new joint employer test with significant ramifications for the franchise model.  Under Browning-Ferris, a company (e.g., a franchisor) that has “indirect” or “potential” control over the employees of another company (e.g., a franchisee) may be considered a joint employer of those employees. The decision significantly expanded franchisors’ potential liability for matters related to their franchisees’ employees (including collective bargaining and employment torts).  Browning-Ferris is currently on appeal before the D.C. Circuit Court of Appeals.

The Save Local Business Act would amend the National Labor Relations Act and Fair Labor Standards Act to clarify that a person or company is a joint employer only if it “directly, actually, and immediately, and not in a limited and routine manner, exercises significant control over the essential terms and conditions of employment.” Essential terms and conditions include hiring employees, discharging employees, determining individual employee rates of pay and benefits, day-to-day supervision of employees, assigning individual work schedules, positions, and tasks, and administering employee discipline.

During its hearings, the Committee heard from franchise owners who described the impact of the Browning-Ferris rule on their business operations. Many legislators have specifically cited the franchise industry in announcing their support for the Act.  The Act’s passage would be a major win for the franchise model, which has been plagued with uncertainty over joint employer liability since the Browning-Ferris decision.