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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

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.