In our last post, we examined some of the types of risk that come with growth. In this post, we discuss some forms of diligence that may be used to better manage that risk.

Diligence on Legal Matters

Are there operating hour ordinances that might affect the business? How about limitations on operating hours or days by the landlord? For foreign expansion, the inquiry is whether it is even legal to sell the goods and services in the foreign market. In the Middle East, not every country allows pork or alcohol products to be sold.

Tradenames and trademark protection are essential, but do you know if there are similar names or businesses already in the market that will confuse your customers? Do prior users exist which could create a threat to your brand? In foreign countries, you need to know whether the name is available for protection and whether it must be registered before selling a franchise.

Does the new territory have different rules on regulation or disclosure? Are there local laws which require disclosures, require registrations, require preapproval of advertising, or permit rescission in the absence of compliance?  U.S. franchisors probably know the national rules, or can acquaint themselves easily with local counsel to learn the rules, but going cross-border requires local knowledge. One needs to know whether the local country franchise laws require or exempt registration, or approval, prior to offering a franchise. Jurisdictions which have special franchise laws often will require mandatory disclosures, or a “quiet period” between offer and acceptance.

The local rules on termination and renewal need to be explored. Some jurisdictions require franchises to be “evergreen” such that they never expire under the law until the franchisee commit a material breach. Some jurisdictions allow termination but require buy backs from the franchisee of inventory, or some type of compensation. Some jurisdictions allow enforcement of restrictive covenants and others invalidate the restrictions as anticompetitive. In some foreign countries, preregistration of intellectual property is required, and the property reverts to the franchisee after a period of operation. Mitigation of these risks need to be baked into the deal from the outset.

Reputational Due Diligence

A frequently overlooked aspect to development is whether the addition of this geography and operator (that is, franchisee) improve the reputation of the brand. One might first start by measuring a baseline of the reputation of the brand, then examining the reputation of the folks who are intended to help you expand the brand. News sources, media and social media sites associated with the shareholders, principals and officers should be reviewed. References should be requested and should be checked. In foreign countries, that might require the use of a translator and/or local investigator. Again, care needs to be taken that even the investigator complies with local laws–including privacy laws, which can be much more restrictive than at home in the U.S.

Financial Due Diligence

In the U.S., we can rely on credit reports, criminal records searches, and electronic searches. Cross-border, data and privacy laws create barriers to common search methods used in the US. The foreign search tasks will take longer and will require more cooperation from the prospect. Foreign data is difficult to assemble and may not be as robust even when it is available.

In conclusion, expansion always requires acceptance of risk, with its many considerations such as taxes, dispute resolution, the cost of compliance and serious consideration of governing law. Expert advice should also be sought when traveling into the unknown.

Growth can be expensive, but it is always more expensive when the expansion is taken without risk assessment. Whether domestic or foreign, many risks can be reduced or avoided by proper consideration of differences between where you are now, and where you want to go.

For illustration, the examples here will be for foreign expansion, but the same issues confront domestic expansion as well.

Many factors need to be taken into account in new territories. National chains offer localized products in particular territories. A hamburger franchisor offers biscuits in the South, and lobster rolls in the Northeast, and chili peppers on everything in New Mexico, even with all of its hamburger options. What are the consumer preferences in the new frontier or for Generation Z–which is bigger than either the Boomers or the Millennials?

Now imagine going global. In India, the hamburger giants need to remake their signature sandwiches because cows are sacred. In addition, the packaging must reflect at a distance whether the contents are vegetarian. Church’s Chicken is understandably called Texas Chicken in the Middle East to avoid offending the majority populations.

Logistics must insure that the quality and availability of the products is reliable, and the look and feel of the retail outlet reflects the brand. Brands need to insure the availability of products, fixtures, supplies and equipment. The goal is instant recognition of the brand. Freshness and quality is essential. You do not need headline risk if your food is not wholesome. Think of the baby formula scandals in China that resulted in global headlines.

In comparing risks to rewards, your ultimate goal is to generate more revenue and promote awareness of the brand. But what sort of investment do you need to incur before those goals are realized. Growth is never cheap and cheap growth is never good. You need to know the growth is suitable and sustainable.

What are the critical the legal and business issues you should be considering?  We’ll discuss those in our next post.

The Fox Rothschild associate team of Megan Center and Alex Radus recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement”. A summary of this presentation will be prepared in four separate blog posts. The first post focused on central themes of franchise negotiation, and the second post addressed protecting the confidentiality of franchise negotiations.

This installment details the first five of our top ten provisions to “never” negotiate.

1)           Signing “then-current” franchise agreement

  • Typical Provision: Upon transfer, renewal or purchase of an additional unit, the franchisee must sign the franchisor’s then-current form of franchise agreement.
  • Franchisee Argument: Franchisees want the same terms for the entire franchise relationship. Uncertainty increases investment risk and hinders growth.
  • Franchisor Argument: Franchisors spend time and money on continually developing and refining their form of franchise agreements. Franchisors need to rely on the uniform use and enforceability of their then-current franchise agreements. Franchisors cannot predict the future and, given that a renewal franchise agreement will be signed many years after the initial franchise agreement, franchisors need the flexibility to use their then-current form of franchise agreements at that time.
  • Compromise: Parties often agree not to change fees, territory and terms they initially negotiated. If any terms were negotiated due to the “newness” of the relationship, these generally lapse as the relationship matures.

2)           Reservation of Rights – Competitive Units or Brands

  • Typical Provision: Except for the franchisee’s right to operate in the territory, the franchisor reserves all other rights, including to open units in non-traditional venues (stadiums, shopping malls, etc.) and to operate competitive brands in the franchisee’s territory.
  • Franchisee Argument: Franchisees won’t want to compete with company units, which may have greater resources, preferred pricing from suppliers, and may not pay royalties. They may also seek locations near non-traditional venues to capitalize on that market.
  • Franchisor Argument: Franchisors are unable to predict every future business opportunity they may encounter and need flexibility for future growth. Franchisors cannot restrict the sale of the entire franchise system because one franchisee objects. Franchisors need to reach customers through every avenue possible, including non-traditional venues, which may increase brand exposure and visitation of a franchisee’s unit.
  • Compromise: Parties can mitigate competition risk by carving out venues near the franchisee’s location, or granting the franchisee a ROFR to purchase units in non-traditional venues.

3)           Right of First Refusal

  • Typical Provision: Except for the right to operate in the territory, the franchisee has no other rights to operate additional units (within or outside the territory).
  • Franchisee Argument: From the franchisee’s perspective, a right of first refusal (“ROFR”) to purchase additional units is optimal: if the investment is successful, the franchisee can double down, while avoiding the obligation to open additional units under a development agreement.
  • Franchisor Argument: Franchisors need to protect their right to make additional sales without having to check with franchisees. Franchisors will likely be starting out a relationship with a new franchisee and may be unsure as to whether this franchisee would be a good fit as a multi-unit owner.
  • Compromise: The parties can agree to a ROFR subject to certain stipulations. First, the ROFR should lapse if a franchisee refuses it more than a certain number of times. Second, the ROFR will only be available after the franchisee has been successfully operating a unit for a certain period of time. Lastly, it’s important to outline a process for how a franchisee can exercise this right, including a time period on the response.

4)           Marketing Fund

  • Typical Provision: The franchisee must contribute to a national marketing fund. The franchisor can spend the funds as it sees fit.
  • Franchisee Argument: Franchisees want assurances that marketing funds will be spent in their territories. They may also seek to limit the franchisor’s discretion via restrictions on the use of proceeds or oversight (including audits or formation of a franchisee advisory committee).
  • Franchisor Argument: Franchisors are in the best position to determine the most effective way to advertise the franchise system on a national basis. Franchisors need flexibility to promote the franchise systems, including ability to spend in any geographical region. The purpose of the marketing fund is to promote the brand on a national basis and the franchisee should focus its efforts on local advertising in its territory.
  • Compromise: If franchisors have an internal marketing team, they can offer franchisees additional marketing assistance free of charge. Alternatively, franchisors can waive a franchisee’s requirement to contribute to the marketing fund only after a certain number of units are open and operating. In exchange, the franchisee must expend the amount it would have contributed to the marketing fund on local advertising. That way, the funds are still being utilized to promote the brand.

5)           Renewal

  • Typical Provision: Franchisee has the right to renew the franchise agreement a limited number of times (1-2) if certain conditions are satisfied.
  • Franchisee Argument: Franchisees want unlimited renewals. They will argue that as long as they are in compliance with the franchise agreement, they should not lose their business, which is often a franchisee’s livelihood.
  • Franchisor Argument: Franchisors want to avoid creating an evergreen contract. An evergreen contract has an indefinite duration and is difficult to terminate. Franchisors need the ability to evaluate franchisees on a semi-regular basis to determine whether they are still a good fit for the franchise system.
  • Compromise: The parties may agree to longer renewal terms (e.g., one 10-year renewal term instead of two 5-year renewal terms). Clear renewal conditions and a cap on renewal costs will also help franchisees budget and prepare.

In the next installment, we’ll launch into the remaining top 10 provisions to “never” negotiate:

  1. Changing Marks/Renovations/Upgrades
  2. Termination/Cure Period
  3. Indemnification
  4. Assignment
  5. Personal Guaranty

Renewed Efforts to End No Poaching Provisions

Franchisors need to review their franchise agreements and take immediate action in response to the recent onslaught of legal action over “naked no poaching” provisions in franchise agreements.

In a typical franchise agreement, a franchisor will prohibit a franchisee from poaching its or its other franchisees’ employees during the term of the franchise agreement and for a period of time after the franchise agreement ends. Until now, these provisions were fairly commonplace. Franchisors argue these provisions are protect each franchisee’s investment of time and money in its employees, including general managers who sometimes participate in extensive training programs.

Critics of such provisions argue that the practice keeps wages for these employees low and that this is a manipulation of the market. Worker advocacy groups have long pushed for an end to this alleged “anti-competitive” practice. Economists generally agree that no poaching provisions have a negative impact on low-level employee wages.

Moreover, in October 2016, the U.S. Department of Justice (“DOJ”) and the FTC issued guidance that naked no poaching agreements are “per se” illegal–meaning that their very existence violates the law and sets companies up for criminal charges.  The DOJ further stated that it intended to criminally prosecute companies employing naked no poaching agreements. While most observers expected that the DOJ under Attorney General Jeff Sessions would retreat from this position, it has not, citing pro-competitive concerns. In fact, in April 2018, the DOJ initiated a criminal complaint against a number of companies respecting naked no poaching agreements. While the case settled with only civil penalties imposed, the DOJ expressly stated that it was reserving the criminal question and planned to “zealously enforce” the law.

Major Brands Settle After Attorney General Files Suit

In July, seven international brands agreed to no longer enforce the no poaching provisions in response to a lawsuit being led by the State of Washington Attorney General’s Office.

In August, eight more large brands followed this trend. Additionally, several state attorneys general, led by  Massachusetts Attorney General Martha Healy but including the AGs of California, Illinois, Maryland, Minnesota, New Jersey, New York, Oregon and Pennsylvania, have sent investigation letters to eight large international franchisors regarding each of their no poaching agreements.

This is only the beginning of the attack on no poaching provisions. In the past year, civil antitrust actions have been filed by employees of franchisees of several large international franchisors.

The potential liability under these actions could be substantial because the class sizes could be immense with treble damages and attorneys’ fees potentially being awarded in any franchisee employee victory.

McDonald’s Loses Bid to Dismiss

McDonald’s’ recent motion to dismiss was denied so the case against that company will proceed. The outcome of this case will be closely watched as a test case for this issue overall. The need to act is further supported by the fact that Senator Elizabeth Warren (MA) and Senator Cory Booker (NJ) are strong advocates of removing the “no poaching” provisions and have introduced legislation to make these acts illegal.

And the DOJ is bringing a criminal antitrust complaint against franchisors for what they call vertically assisted, horizontal conspiracies to fix labor rates, allegedly in violation of Section 1 of the Sherman Anti-Trust Act.

The time to address naked no poaching provisions is now. Franchisors should not wait until the update of your franchise disclosure document in 2019. If you need any assistance navigating through this process, the franchise team at Fox Rothschild is more than happy to assist.

The Fox Rothschild team of Megan Center and Alex Radus recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement.” A summary of this presentation is being presented in four separate blog posts.  The first post focused on the central theme of franchise negotiation from the perspective of the franchisor and franchisee.

This installment highlights a few practice pointers that can save time and money during the negotiation process and protect the confidentiality of your negotiations.  Installments three and four will examine the top ten things never to negotiate in in detail, including typical franchisee requests, franchisor counter-arguments, and common compromises.

When negotiating a franchise agreement, the franchisee should provide a memorandum of the terms he or she proposes to revise.  This can take many forms, from a formal letter of intent to an informal email.  The level of detail will vary, but at a minimum it should cover all of the franchisee’s requests and be thorough enough for the parties to begin negotiations and understand what they are agreeing to.  This process focuses the parties on the most impactful terms and identifies potential deal breakers early in the process, saving time and money.

Copyright: / 123RF Stock Photo

Once the negotiated terms are established, we suggest that they should preferably be included in an addendum to the franchise agreement, which will be attached to the franchisor’s standard form of franchise agreement.  We strongly encourage you to avoid revising the standard franchise agreement.  There are a few reasons for this.  First, it is generally easier and faster to draft and negotiate an addendum rather than redline the entire franchise agreement.  Second, sticking to an addendum will keep revisions focused and precise.  The franchisee’s attorney is likely to make more changes if he or she has the opportunity to redline the entire franchise agreement. Finally, when you need to review the negotiated terms of multiple franchise agreements, short addendums will be easier to review than redlined franchise agreements.

Finally, be sure to protect the confidentiality of your negotiations – but don’t go overboard.  Franchisees will talk to each other, which can be both good and bad.  You want your star franchisees to speak with new and prospective franchisees.  They’re in a great position to give advice that will boost performance, and to be a cheerleader for your system.  However, avoid permitting them to share negotiated terms, which can hurt morale and give new franchisees unreasonable expectations. For example, original or early franchisees may have obtain concessions that were appropriate for a startup system may no longer be appropriate at later stages of the brand’s development.  Moreover, you must be sure to understand the franchise laws of the states where you are offering franchises, which may require you to disclose negotiated terms in certain cases as briefly mentioned in our first post.  Also, as you probably know, disclosures and representations respecting financial performance are fraught with danger and should never be made by franchisees.

Your addendum should include a confidentiality provision that balances these considerations.  The negotiated terms, and the fact that you negotiated your franchise agreement, should be protected from disclosure.  After all, those are private terms between two business partners.  However, franchisors shouldn’t be so specific as to prevent franchisees from communicating in ways that benefit all members of the system.

In the next installment, we’ll launch into the first 5 of our top 10 provisions to “never” negotiate:

1.       Signing the “then-current” franchise agreement

2.       Reservation of Rights

3.       Right of First Refusal

4.       Marketing Fund

5.       Renewal

We, Megan Center and Alex Radus, recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement” and want to share the highlights of that presentation here.  This first of four blog posts will focus on central themes of franchise negotiation from the perspective of both the franchisor and franchisee.

With that, before we jump into the theme of negotiation, we want to briefly touch on the top ten provisions we will cover over the next few blog posts, which are as follows:

1.      “Then-current” form of Franchise Agreement

2.      Reservation of Rights

3.      Right of First Refusal

4.      Marketing Fund

5.      Renewal

6.      Changing Marks/Renovations/Upgrades

7.      Termination/Cure Period

8.      Indemnification

9.      Assignment

10.  Personal Guaranty

In each of the blog posts that follow, we will discuss the typical provision in a franchise agreement, the typical request by a franchisee, and how both a franchisee and franchisor may argue for its respective provision or revision.

By way of introduction, we want to briefly touch on why a franchisor may want to, or in certain circumstances be required to, negotiate provisions of its franchise agreement. First, economic factors may contribute to negotiation points. As the economy ebbs and flows, the sales of franchises often will follow. A franchisor may have to grant more concessions in a bad economy, or vice versa, in order to make a franchise sale.

Second, if an emerging brand, a franchisor may need to offer its original franchisees a more incentivized franchise package than an established franchisor would. Similarly, if a franchisor is trying to entice a multi-unit franchisee or a franchisee that has experience in operating other franchised businesses to join its franchise system, a franchisor may have to “sweeten the pot” and offer more concessions than it would a standard-single unit-franchisee.

Additionally, if a franchisor is expanding internationally, similarly to an emerging brand, a new franchisee will be developing the brand in an entirely different country, often with no brand recognition.  As such, it may need further incentives to take on this additional obligation.

Lastly, and perhaps most importantly, certain states require that a franchisor amend certain portions of its franchise agreement via a state law addendum. Generally, these changes relate to dispute resolution procedures, governing law, and termination procedures. Further, if you negotiate changes with franchisees in California, you are required to comply with the Negotiated Changes Law in California which mandates disclosure of all material revisions to the franchise documents granted to California franchisees to all California prospects for a year from the closing of the negotiated deal.

The next post in this series will focus on practice pointers if a franchisor chooses to, or is required to, negotiate a franchise agreement.

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?”

    47541066 – data breach level to maximum modern conceptual meter, isolated on white background
  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.

Last year at the ABA Forum on Franchising Annual Meeting, the programming included a seminar entitled “Between You and Me: A Toolkit to Counsel in and to Smaller Systems.” The purpose of the session was to provide new in-house lawyers an overview of some of the day-to-day legal conundrums that growing brands face and instructions on how to face such issues.

70454390 – high angle view of magnifying glass over background check form

One of the most interesting and important issues addressed during the panel discussion was the franchise application process. Growing brands are often eager to welcome any prospect willing to pay the initial franchise fee. However, all franchise systems have a reason to be selective in the application process. Once a brand meets that critical mass of 50-100 units, it can often afford to be more discerning. Below are some tips to ensuring that a franchise system only accepts the best:

  1. Confirm supporting documents for financing. A financing arrangement may be straightforward if the franchisee is obtaining traditional financing from an institutional lender. However, if a franchisee is expecting a capital investment from friends and family, then you should still require documentation. You do not want a situation where a franchisee is a few months into development and the investing sibling or uncle backs out of the deal.
  2. Do not just run a background check and throw it in a file. Make sure you thoroughly review the results. The panelist described some war stories about clients ordering a background check on owners but failing to analyze it. The background check revealed some serious red flags about the prospect. The franchisor then faced issues with the franchisee down the line that could have been avoided had the franchisor just reviewed the results in the first place.
  3. Always conduct a search of the lists maintained US. Treasury’s Office of Foreign Asset Control (OFAC). OFAC maintains a list of all people and entities whose assets are blocked by the US government as a result of sanctions. You can conduct your own search at no cost online and it takes under a minute.
  4. Request supporting documentation such as tax returns and account statements to verify assets. Dig deeper when evaluating a prospective franchisee’s financial wherewithal.
  5. Don’t forget to determine the applicant’s citizen or immigration status.

While there is no surefire way to avoid all problem or underperforming franchisees, developing a comprehensive screening process is one method in decreasing the number.

The National Restaurant Association recently released a new guide for restaurant operators looking for more information on how to increase their cybersecurity efforts.

In 2015, the National Restaurant Association released its first manual for restaurant owners called “Cybersecurity 101: A Toolkit for Restaurant Operators” [PDF] which outlined best practices on five core areas of cybersecurity planning. This past month, the National Restaurant Association built on this manual with the release of “Cybersecurity 201: The Next Step,” [PDF]  which provides restaurant-specific type guidance. The National Restaurant Association utilized the expertise of technology personnel from top multi-unit restaurant companies. The guide is a must-read for any franchise system in the food service space.

The guide takes the cybersecurity framework prepared by the National Institute of Standards and Technology (NIST) and adapts it for use in the restaurant hospitality industry. Restaurant franchise systems can learn how to apply the NIST standards by reviewing the real world hypotheticals.

18538865 – thief steals credit card and money. illustration in cartoon style

For example, there is “Sam” whose restaurant experiences a data compromise of customer credit cards. After a forensic team descends on his business, Sam quickly realizes how little he understands about who has access to his computer software, which vendors service his POS Systems and how often he upgrades hardware. The result? Sam lost loyal customers and was slapped with a hefty fine from his credit card processors.

In addition to three other nicely detailed case studies, the guide shows how almost 100 different NIST categories can be applied in a restaurant setting, grades cybersecurity action items from most to least urgent and provides a glossary of cybersecurity terms.  Even the most cyber savvy restaurant systems should find the guide full of useful information.

Many franchise agreements contain a provision that restricts a franchisee from hiring or soliciting the employees of the franchisor or other franchisees. A class action lawsuit that was recently filed in the Eastern District of Texas could require removal of this type of provision in the future. Though this suit is only at the initial complaint phase, the outcome of this case could help shape the future of franchisee restrictive covenants.

In Ion v. Pizza Hut, LLC, Kristen Ion (“Ion”) filed this complaint on behalf of similarly-situated managers of Pizza Hut restaurants. Ion claims that Pizza Hut, LLC (“Pizza Hut”) has colluded with all of its franchisees to engage in anticompetitive behavior in violation of the Sherman Act. Further, Ion claims that the restrictive provision is a naked restraint on competition and a per se violation of the antitrust laws.

The provision at issue, as seen in many franchise agreements, forbids a franchise owner from hiring or soliciting any employees of the franchisor, its units, or any other franchise. Ion claims that this restraint eliminated a franchisee’s incentive to offer competitive employment packages to management personnel and restricted the mobility of such personnel. Further, Ion argues that this restraint lowered salaries and benefits due to the limited job marketplace available to Pizza Hut personnel. Ion claims that the training she received from Pizza Hut is only transferable to other Pizza Hut units.

While Ion consistently refers to the fact that each Pizza Hut franchise is its own independent business that has the right to set its own wages for staff, in the same sentence, she argues that the franchisor and franchisees were “co-conspirators” in the endeavor to suppress those wages and mobility. Further, Ion cites to the continued practice of Pizza Hut and its franchisees to cut employee wages and hours through various policies and argues that this restriction is in furtherance of this purpose (as outlined in various news articles). Lastly, Ion claims that executive compensation and franchisee profit increased at the expense of its low-paid management personnel.

However, based on the facts in the complaint, it seems that Ion never attempted to find another job outside of the Pizza Hut franchise system to support her proposition. Further, the citations to commentary by scholars and professors on the topic logically leads one to assume that there is not yet a basis in prior case law for the requested remedy.

The outcome of this case could substantially and materially alter the scope of franchisee restrictive covenants. Any outcome in favor of Ion would trigger an immediate need for revisions to a franchise agreement that contains this restriction and it is important to keep watch of this case.