The CARES Act has amended the Bankruptcy Code to provide an expedited and easier version of a business bankruptcy proceeding. We now have “Subchapter 5” for small business and individual debtors. This process fulfills a sweet spot for small franchisors and franchisees. It anticipates a Chapter 11 type result, without the administrative headaches and expense, within 90 days of filing.

The purpose of this new section of the Bankruptcy Code is to allow business debtors and certain individuals with debts below $ 7.5 Million to reorganize their obligations under in a much less expensive and streamlined manner. Unlike the previous Chapter 11, the Subchapter 5 bankruptcy does not require voting on a plan of reorganization. Instead, like a Chapter 13 wage earner’s plan, the debtor’s disposable income is used to repay creditors. This eliminates the need for obtaining the consent of a class of “impaired” creditors as required under basic Chapter 11. It also relaxes some of the rules for administration of the Chapter 11 plan and the payment of United States Trustee quarterly fees. Certain individual debtors may also benefit from the elimination of the so-called “absolute priority rule” which prevented exemption of real or personal property in some cases.

The new “disposable income” requirement may mandate a minimum payment to creditors higher than what is now man under Chapter 11. Some of the normal Chapter 11 requirements, such as monthly operating reports, special Debtor in Possession bank accounts and supervision by special Trustees provide protection to creditors and parties in interest.

We anticipate a uptick in filings after the CARES Act funding and its forgiveness period expires. Because it provides a needed remedy for small business debtors and individuals concerned with the administrative burdens and expense of a Chapter 11 filing, we should be prepared to use Subchapter 5 to our advantage.

Franchisors should plan now to have a preset protocol for dealing with their franchisees who file Subchapter 5 because of the compressed deadlines. Franchisors can also suggest or aid struggling franchisees with Subchapter 5 to maintain their franchise during these uncharted times.

For franchisees and emerging franchisors, Subchapter 5 is a prescription to save their business from the economic consequences of the pandemic. There are also mortgage modifications provisions that will help guarantors of business debt to same their homes.

As these cases are filed, we will be compiling information and helpful advice in navigating the new bankruptcy world.

The Department of Justice backed off no-poach challenges in franchise agreements in 2019, but the state doubled down. The result? Washington state challenged a raft of no-poach/no-hire provisions in 225 franchise systems, resulting in agreements requiring franchisors to agree not to enforce the offending provisions not just in Washington but nationwide. On April 28, 2020, Washington AAG Rao declared victory, characterizing the DOJ’s approach as “somewhat misguided.”

Does Washington State’s victory celebration mean that other franchisors needn’t worry about enforcing such clauses? I think the answer is a clear NO. Although the Department of Justice has redirected its concern from no-poach/no-hire provisions in franchise agreements, Congress has not. Bills outlawing such provisions have been filed in the House and the Senate, e.g., H.R. 5710 and S. 2614. While the future of these legislative attempts is unclear, we can expect the efforts to continue. In addition, several states have enacted legislation prohibiting these provisions, and notably banded together to pursue settlements banning the enforcement of such restrictions in franchise agreements.

Perhaps most perilously, the federal-state tug of war over these provisions has sparked private litigation and a divergence of judicial views as to whether the restrictions are per se antitrust violations or whether their anticompetitive effects (and potential illegality) should be assessed under the more forgiving rule of reason or in between “quick look” analysis. Private litigation and the battle over the appropriate analysis is likely to continue.

And I’m not betting against Washington State cranking its enforcement engine back up.

Indiana issued a compliance alert covering four updates to the Indiana franchise laws to take effect on July 1, 2020. The changes (i) add a duty to update FDD within 30 days of a material change (ii) grant the ability to select specific annual registration termination dates, (iii) clarify the exemption coverage; and (iv) clarify that franchise fees are non-refundable.

Duty to Update Franchise Disclosure Document within 30 days of a material change.

Beginning on July 1, 2020, franchises registered with the Securities Division of the Indiana Secretary of State must file an amended disclosure statement within 30 days after the franchise has a “material change” as defined by I.C. § 23-2-2.5-13.1(b). Material changes include, but are not limited to:

  • termination, closing, failure to renew the franchise or purchase by the franchisor of either: ten percent (10%) of all franchises regardless of location or ten percent (10%) of franchises located in Indiana;
  • any reorganization or change of control, corporate name or state of incorporation;
  • any change in the franchise fees charged by the franchisor; and
  • significant changes in the obligations to be performed by the franchisor or a franchisee or the franchise contract or agreement.

The rule also provides for a “catch-all” granting the commissioner the ability to determine whether a change is material by rule adopted or order issued.

Grant the ability to select specific annual registration termination dates

A franchise may now request that its registration expire on a date sooner than one year from registration to allow the franchise to coordinate registration renewals across multiple states. I.C. § 23-2-2.5-18.

Clarification of the exemption coverage

The updated rule clarifies that the exemption to the registration rules for franchises that sell no more than one franchise within any 24 month period considers only franchises sold within Indiana. I.C. § 23-2-2.5-3.

Clarification that franchise fees are non-refundable

The updated rule clarifies that the filing fee registration by notification of the sale of franchises and for a registration renewal is non-refundable. I.C. § 23-2-2.5-43.

Longtime readers of this blog know that Memorial Day is special around here. Memorial Day, of course, is the day established by General John A. Logan, Commander in Chief of the Grand Army of the Republic, when we pause to remember, and honor, those who gave, as Abraham Lincoln so eloquently expressed it, the last full measure of devotion for their country. In this vein, not too long ago, the podcast 99% Invisible did a fascinating report on the history of, and the men who guard, the Tomb of the Unknown Solider at Arlington National Cemetery.  It is, in my humble opinion, very much worth a listen if you have some time this weekend.

But Memorial Day is plainly different this year. As we know all too well, almost 100,000 of our fellow citizens have died from an enemy that is silent and invisible to the naked eye, the Coronavirus. Many people who work in the franchise industry have been on the front lines, serving our country in delivering essential services. We thank them, along with all of the healthcare workers, EMS, police and fire first responders, meat packing plant employees, and others who have worked throughout in the face of the pandemic. We also feel deeply for the many systems, franchisors, franchisees, and employees of both facing the depths of the economic recession the pandemic has wrought. You have our thoughts and prayers.

So, before you head to socially distanced events this holiday weekend, I kindly ask that you join me–and Fox Rothschild–in pausing to remember those who have, in the past and now, truly given the last full measure of devotion to our Nation. As General General Patton wisely noted, “It is foolish and wrong to mourn [those] who died. Rather, let us thank God that such [people] lived.”

Yellow traffic light with yellow color, 3D rendering isolated on white background

Let’s posit you have operations in Pennsylvania, where I live, and those operations are in located in one of the Northcentral or Northwestern Counties (including Erie) that went to Yellow Phase on May 8th, one of the Southwestern Counties (including Pittsburgh) that went to Yellow Phase on May 15th, or one of the many counties going to Yellow Phase on June 5th. Now you’re probably trying to figure out just what Yellow Phase means, am I right? I’ve been trying to figure it out myself.

First, here’s is what NOT to do:  Don’t look at the color-coded chart the news media keeps showing. This is the equivalent of a sound bite.

Instead, there are two key documents you need to read and understand:  (1) the Pennsylvania Life Sustaining Business FAQs and (2) the Governor and Secretary of Health’s Guidance for Businesses Permitted to Operate in the COVID-19 Pandemic.

Note that, as of the time I am writing this blog post late on May 11th, the above links will take you to the most recent versions of the FAQs and Guidance. However, the FAQs in particular change often, and have been not redlined by the Commonwealth, so you should check them for updates regularly. At the same time, I recognize that the government has its hands full, so I’m trying to remain charitable. There is a link to the most current FAQs on the PA Department of Community and Economic Development homepage.

Turning to the documents, there are essentially two steps to deciding if you can reopen during the Yellow Phase:

Step One

Step One is figuring out if your business can in fact reopen. The keys here are FAQ Numbers 3 & 4 , which discuss what businesses cannot open under Yellow Phase.  Those businesses are:

  • Indoor recreation facilities (including bowling , arcades, racquetball and other indoor sports or training, go-kart racing, laser tag, pool halls, trampoline facilities, indoor mini golf, and other similar facilities).
  • Health and wellness facilities and personal care services  (including gyms, saunas, tattoo and piercing shops, tanning, spas, hair salons, nail salons, massage therapy, and other similar facilities). Swimming pools MAY OPEN in the Yellow Phase, so long as CDC guidelines are followed.
  • All entertainment venues (including casinos, theaters, concerts, museums, zoos, botanical gardens, racetracks, professional, semiprofessional, or amateur/membership sports teams or clubs, amusement and water parks, carnivals, playgrounds, and other similar facilities).
  • Indoor Shopping Malls, unless the location has an exterior entrance. So, if a location is in a mall, and it does not have a separate outside entrance, it cannot reopen in Yellow Phase.
  • Restaurants and Bars may only open for curbside pickup, takeout or delivery. This is the same as the Red Phase. HOWEVER, restaurants that have it, may open outside dining at 50% capacity and all parties seated a tables distanced at least 6 feet apart.

There is one very important caveat to this  list:  Even in Yellow Phase, if a business—or portions of a business—can continue to telework remotely, it must continue to handle those functions (such as billing, accounts payable and accounts receivable) remotely. See FAQs 7 and 12.

Step Two

Okay. So you’ve reviewed the FAQs and decided that you can reopen. What now? Assuming your business can reopen in Yellow Phase, Step Two is figuring out what has to be done to operate within the law.

FAQ number 6 says that a business permitted to operate must “strictly adhere to the” Guidance issued by the Governor and Health Secretary, unless that business is subject to a more stringent industry regulation. In that case, it must follow the more stringent regulation.

What does the Guidance say? It is very detailed and should be read thoroughly. Highlights include:

  • For Protection of Employees:
    • Clean and disinfect high-touch areas frequently.
    • Develop before reopening a detailed plan for when the business has been “exposed” to a probable or confirmed case of COVID-19, including a detailed cleaning plan after closing and waiting 24 hours and notification plans for employees in close contact with potential case of COVID-19.
    • Stagger work start and stop times.
    • Place limits on the number of persons in and use of common rooms.
    • Conduct meetings virtually unless in-person is absolutely necessary; limit necessary meetings to no more than 10 persons.
    • Provide access to soap, disinfecting wipes and hand sanitizer.
    • Provide face masks, and make masks mandatory at work site.
  • For Protection of Operations and Customers:
    • Conduct business by appointment only, if possible.
    • Limit number of people in location to 50% capacity, require all customers to wear face masks, unless under 2 years of age or with documented medical condition, and all customers must be socially distanced (minimum 6 feet apart).
    • Install shields at registers and checkout areas.
    • Encourage online ordering, curbside pickup and delivery.
    • Designate a specific time for high-risk persons, including those 65 and older, to utilize the business. Must have at least one such period per week.
    • Employees must have a handwashing break at least once every hour.
    • Shopping carts and/or handbaskets must be wiped down after every use.

Any business with inherently close contact between customers and employees is not permitted to reopen. So, if a music or art school-type franchise were to reopen, it would need to ensure instructors were safely masked  AND socially distanced from customers.

Additionally,  I have been recommending clients speak with their insurance agent and/or carrier about any requirements their insurance company may impose. You don’t want to reopen, get sued, and then receive a denial of coverage letter because the carrier imposed safety requirements you did not follow.

Finally, and perhaps of interest to the franchise community, there is special guidance for each of the construction industry, vehicle dealerships and real estate industry in Pennsylvania.

Of course, yellow means proceed with caution, and that is probably the best policy for right now. Good luck, everyone!

 

Surprise! On April 8th, FASB delayed for one year the implementation of the new ASC 606 revenue recognition standards for private companies,[1] citing the coronavirus pandemic. In addition to delaying implementation, FASB indicated it would investigate “how to reduce implementation costs relating to applying Topic 606 to initial franchise fees.” While the connection between implementation of the amended standard and the pandemic may be inexplicable, FASB’s reconsideration of ASC 606 is welcome news to franchisors.

The delay does create a bit of a conundrum, however. It’s renewal season, and many franchisors have already adopted the new ASC 606 standard; others have not. So, what will states accept as GAAP-compliant financial statements this year? Are both pre- and post-amended ASC 606 statements acceptable? Does the answer vary from state to state? Must financials disclose the specific approach to revenue recognition? The timing of FASB’s decision may deprive most franchisors from taking advantage of the extra year’s transition.

The Cliff Notes version of ASC 606 revenue recognition[2]

When FASB first announced the revised recognition standard for revenues derived from customer contracts (ASC 606) in 2016, franchisors energetically voiced opposition. The revised standard required franchisors to delay recognition of certain initial income from the sale of franchises. At the extreme, the standard appeared to require recognition of the entire initial franchise fee over the life of the franchise. The disproportionately negative impact on the start-up and smaller franchisors is undeniable.

However, FASB reacted to the strong voice of franchising and twice issued updates addressing the application of the new standards in franchise companies. On November 5, 2018, FASB issued an update clarifying the recognition of upfront franchise fees. Specifically, the Board explained that the initial franchise fee can be recognized immediately if the fee is “distinct” from franchisor’s pre-opening obligations (e.g, training), which are subject to deferred recognition. Asserting that all initial fees are distinct from performance obligations is likely to spark intense scrutiny by regulators. Then, amidst all the intensity of renewal season and finalizing financials, came the FASB’s decision to delay implementation for private companies.

FASB’s concern for the expense of implementing the revised standards in its April 8th meeting is welcome news. Under present FASB guidance, regulators expect to see:

  • An explanation of the method of adoption, whether full or retrospective
  •  If a modified retrospective is adopted, the cumulative catch up to retain earnings in disclosure and table form
  •  For initial franchise fees, a discussion of the five step process to revenue recognition and
  •  A disclosure as to whether the initial franchise fees are recognized upfront or over the term of the franchise agreement.

These are expensive and complicated changes! Indeed, the AICPA published a recommended schedule, detailing a year-long process of implementation.[3] Adoption is not a simple matter.

The Hobbesian choice . . . or, damned if you do and damned if you don’t

 So where’s the problem? Why shouldn’t FASB’s announcement be met with universal glee? Because we’re in renewal season, and most franchisors have already implemented the revised ASC 606 standards. Prior to April 8th, GAAP mandated revenue recognition consistent with the new standards. It was only after April 8th that compliance by private companies became optional for this reporting period. Usually the hare beats the tortoise, but sometimes it pays to wait. In this case, franchisors who have procrastinated may have (unknowingly) placed a good bet; if the FASB revises the procedures for implementation, the expense of implementation may decrease.

What form of GAAP compliant financials will be accepted this year? There is no clear cut answer. Because FASB only delayed implementation but did not substantively change the ASC 606 standards, renewals filed by franchisors before April 8th reflecting the new revenue recognition standards should be deemed GAAP compliant; even anecdotally, no state regulator has indicated that financials complying with ASC 606 standards must be restated to prior (legacy) standards. For a similar reason, if a franchisor is in an ongoing renewal process (e.g., renewal filed before April 8th but not yet complete), it’s logical that compliance with the new standards is a necessity. Although it defies logic, private entity franchisors that have adopted the new standards could, if they wished, revert to legacy revenue recognition standards via a pre- or post- effective or renewal filing.

In this case, procrastination pays off, and private entity franchisors that have yet to adopt the new revenue recognition standards are poised for instant gratification. When they are finally forced to adopt the ASC 606 standard, FASB may have developed a less burdensome and less costly process. At least, that’s what FASB’s announcement seems to promise.

The tortoise wins this race.

[1] The new standard became effective for fiscal years beginning after 12/15/2017 for public companies, and was scheduled for implementation by private companies for fiscal years beginning after 12/15/2018. The new implementation date for private companies is fiscal years beginning after 12/15/2020; the implementation date for public companies was not changed.

[2] For a more detailed analysis of ASC 606 revenue recognition rules in franchising, please review this podcast hosted by John and this slide deck from an IFA FBN program hosted by John.

[3] The AICPA October 2018 publication, directed to implementation by public entities, is titled “New Revenue Recognition Accounting Standard – Learning and Implementation Plan”

In a BIG win for brand owners, the U.S. Supreme Court has ruled that the plaintiff in a trademark infringement claim is not required to prove willfulness when seeking an award of a defendant’s profits under Section 1117(a) of the Lanham Act.

The high court’s unanimous decision in Romag Fasteners, Inc. v. Fossil Group Inc. settles a long-time split among the federal circuit courts regarding whether proof of a defendant’s willfulness is a prerequisite to securing a disgorgement of profits.

The Third, Fourth, Fifth, Seventh and Eleventh circuits, similarly to the Supreme Court, had not required a willfulness finding as a prerequisite to disgorgement of ill-gotten profits. However, the First, Second, Sixth, Eighth, Ninth, Tenth and District of Columbia circuits had applied a contrary rule. The Romag Fasteners decision settles the question for all trial courts, precluding a requirement that a brand owner show that the defendant acted willfully in the accused infringement.

Proving willfulness is particularly difficult for brand owners because it requires evidence of a defendant’s knowledge or intentions.

The legal question before the Supreme Court hinged on the precise text of several subsections of the Lanham Act.

For a trademark dilution claim §1125(c), the Lanham Act explicitly requires proof of willfulness as a precondition for a profits award. But it has never included such a requirement for a trademark infringement or unfair competition claim, such as the false or misleading use of trademarks under §1125(a).

In a trademark or unfair competition matter, under §1125(a), the Lanham Act creates a civil cause of action against any person who in the connection with any goods or services uses in commerce any word, term, name, symbol, or device, or any false or misleading description of fact, which is likely to:

  • cause confusion; or
  • cause mistake; or
  • deceive as to the affiliation, connection, or association of such person with another

The statutory text states that if a brand owner establishes likelihood of confusion, mistake, or deception under §1125(a), then the courts must look to §1117(a), which excludes any mention of willfulness and provides for the following types of monetary recovery: “(1) defendant’s profits, (2) any damages sustained by the plaintiff, and (3) the costs of the action.”

At oral argument, Justices Ruth Bader Ginsburg and Neil Gorsuch questioned why, if Congress had wanted to impose a willfulness requirement, it did not simply write one into the Lanham Act. Justice Ginsburg noted that the legislature actually included “willfulness” in other parts of the statute, but failed to include it within the statutory text in §1125(a).

In the April 23, 2020 opinion, Justice Gorsuch declared that the Lanham Act’s remedies provision for trademark violations “has never required such a showing of willfulness to win a defendant’s profits.” He cautioned lower courts to resist the temptation of reading such a requirement into a law, especially when Congress “included the term in question elsewhere in the very same statutory provision.”

Justice Gorsuch wrote, “we do not doubt that a trademark defendant’s mental state is a highly important consideration in determining whether an award of profits is appropriate,” but that such a consideration “is a far cry from insisting on the inflexible precondition” of requiring a finding of willfulness.

Pursuant to the decision, the judgment of the court of appeals was vacated, and the case was remanded for further proceedings. The plaintiff, Romag Fasteners, will now be able to go back to district court and seek an award that included defendants profits, which were argued to be $6.8 million.

If you have any questions relating to this ruling or brand protection or enforcement, please feel free to contact the primary authors of this post, Patricia M. Flanagan at pflanagan@foxrothschild.com or Alex L. Braunstein at abraunstein@foxrothschild.com, or any member of our Franchise & Distribution Practice Group team.

Yesterday, legislation adding an additional $310 Billion to the Payroll Protection Program (PPP) and $50 Billion to the Economic Injury Disaster Loan (EIDL) funds  passed the Senate, and passage in the House is imminent. But the new funds will disappear quickly!

The original massive PPP and EIDL appropriations evaporated in less than two weeks. Although those funds were designed to keep small businesses alive in the face of the COVID-19 pandemic, publicly traded companies and those with strong lender relationships were reportedly pushed to the front of the line. The International Franchise Association (IFA) reports that although 98% of franchisees applied for the loans, only 12% received PPP funding – despite approval of over 61% of franchisee applications.

Addressing the funding disparity, the new authorization specifically sets aside funds for smaller businesses and minority businesses. Equally important it earmarks $60 Billion for community development financial institutions, which appears to be designed to overcome the gating processes employed by established institutions to prioritize loan applicants during the first round of funding.

But this opportunity for franchisee and small businesses to reach PPP funds won’t last for long. It’s likely that the previously-approved borrowers will get the PPP funds first, so new applicants must ACT FAST! The newly-appropriated funds may disappear in 48 hours. And Senate leader McConnell has indicated that he does not intend to ask the Senate to consider additional rescue funds until sometime in May at the earliest.

With most non-essential businesses closed across the country, it is easy to forget we are two weeks away from the April 30th Franchise Disclosure Document (FDD) update deadline for franchisors with a calendar fiscal year end.   Some franchise systems are delaying the preparation and issuance of an updated 2020 FDD and corresponding state renewal registrations. However, we found most of our clients are updating their FDD consistent with past practice and filed renewals in those states requiring registration.

One of the trickiest issues to address this year is the inclusion of Item 19 Financial Performance Representations (FPRs). On one hand, the financial data used to prepare the FPRs is based on past performance in 2019 and prior years. Therefore, compiling Item 19 FPRs consistent with past practice and in compliance with the FTC Franchise Rule and NASAA guidance, should be business as usual. On the other hand, the COVID-19 pandemic is likely to impact unit operations in the coming months, maybe years.  Some hospitality and food based concepts may never fully recover. Should any franchise system include a FPR in its 2020-2021 FDD?  We discovered one state regulator already weighing in on the issue by providing the following comment to a renewal filing:

In Item 19, we note that the Franchisor presents a financial performance representation based on the past performance of outlets prior to the COVID-19 pandemic. We further note that to slow the spread of COVID-19, many businesses have been closed or are operating on a limited basis this year. These events may significantly impact the potential performance of the franchised business. In your response letter, please explain why the Franchisor believes that it is reasonable and not misleading to present a financial performance representation based solely on results from a period prior to the COVID-19 pandemic.

This comment raises a lot of questions.  We recommend a franchise system base its approach to FPRs this year on all pertinent factors applicable to that particular system. For example:

  • What industry does the franchise system operate?  Is it likely that the system can revert to pre-COVID-19 performance levels? If it is a childcare or healthcare based concept, then consumers will likely have a need to resume patronizing the franchised units. However, non-critical entertainment concepts where people socially gather in close quarters may not recover as quickly.
  • How long does it take from signing the franchise agreement to opening? If the average time from signing to opening is over 12 months, then it is possible that COVID-19’s impact on the economy when the franchise commences operations may be less severe.
  • What is consumer profile patronizing the units? Will these consumers have discretionary income in a post-COVID 19 economy?

However, it is impossible to predict the future and know how people are going to react once society resumes. Will people rush to resort hotels for respite? Can most afford to do so? Franchisors need to make the most logical decision based on the information they have now.

It may be reasonable to include a statement that addresses the issue without slipping into prohibited disclaimer territory. For example, a statement like “the financial data was compiled prior to the time of the COVID-19 pandemic and the temporary local and state governmental restrictions on operations” may be appropriate. This reminds the prospective franchisees of the origin of the data without renouncing the performance representations. Based on our experience with state regulators, language beyond this factual statement (for example, stating that the franchisor is unable to predict how COVID-19 may impact future unit performance) is unlikely to pass regulator scrutiny.

However, a blanket conclusion that all FPRs based on accurate data from 2019 are unreasonable or misleading in the COVID-19 pandemic era is problematic. My view is that (in most cases) a lot of value remains in providing FPRs to prospective franchisees. If FPRs are made in good faith and in compliance with the FTC Rule and NASAA Guidelines, then this historical data is more useful than hurtful for a franchisee. Further, it may help in reigning in a sales broker or agent who may have a tendency to make unlawful or misleading earning statements without proper Item 19 FPRs. A complete prohibition on inclusion of FPRs does not benefit these franchisees or provide them with the information to make an informed decision. Hopefully, state regulators will craft a uniform approach to this issue to avoid potential conflicting comments and requests.