Recent Decision - Lost Future Royalties Denied

Tip of the hat to Bruce Schaffer at Franchise Valuations for reporting on this case in his "The Franchise Valuation Reporter." Bruce is colleague from the American Bar Association's Forum on Franchising who focuses his expertise on valuation and damages, cyber crime, expert testimony, and tax nexus.

Our topic for this post is Lost Future Royalties - this has been the subject of my earlier posts: Franchisees - Damages Warning: Lost Future Royalties and Franchise Valuation through Damage Analysis.

The case is Mister Softee, Inc., Mister Softee Sales and Manufacturing, LLC, and Spabo Ice Cream Corp. v. Reza Amanollahi, 2016 WL 5745105D. New Jersey. Civ. No. 2:14-CV-01687(KM)(JBC) - As noted, the case involved a claim for lost future royalties and the decision followed the well-known but controversial decision in Postal Instant Press v. Sealy, 43 Cal. App. 4th 1704 (1996).  Postal Instant Press v. Sealy and cases that adhere to its rationale, hold that a franchisee cannot be liable for lost future royalties when the franchisor ELECTED to terminate the relationship even though the franchisee's act (ex, failure to pay royalties) gives rise to the termination.

After reviewing New York case law, the judge in Mister Softee concluded that summary judgment would be denied on Mister Softee's claim for lost future royalties: "Here, Mister Softee decided to terminate Amano's Franchise Agreements because Amano moved his trucks out of the Manida Street Depot and stopped making payments under the Truck Notes. Mister Softee faced a choice: terminate the Agreements, or remain within the Agreements and sue for the ongoing unpaid royalties. It chose the former."

So mark one up for FRANCHISEES on this controversial topic! (even though Mister Softee brings back many childhood memories while growing up in south Jersey) Thanks Bruce!

If you are planning to attend the American Bar Association's Annual Forum on Franchising in Miami on November 2-4 don't forget to drop into Show Me the Money! Maximizing Monetary Recovery in Franchise Cases, where I will join Bethany Appleby (Wiggin & Dana, LLP) for an informative session.

Franchise Disclosure Document - Dissected - Part Four

Now for the wrap-up of this series of posts. (If you missed Part One, Part Two, or Part Three, you can click on the hyperlinked text)

Although we could focus on many of the remaining FDD Items, Item 19 - Financial Performance Representations deserves our attention. Franchisors need to get it right and franchisees need to understand their right to additional information.

Before 2007, this item (under the old UFOC format) was labeled "Earnings Claims" and was much stricter than today's version. To encourage more franchise systems to provide financial performance information, the rules were loosened. Now, the Amended FTC Rule "permits a franchisor to provide information about the actual or potential financial performance of its franchised and/or franchisor-owned outlets, if there is a reasonable basis for the information, and if the information is included in the disclosure document." As a result, this disclosure has been given a wide berth.

When we dissect the language, we see that the information can simply be "potential" performance if there is a reasonable basis. Now the FTC Compliance Guide carries a section on the "Reasonableness of a Financial Performance Representation" (p.135) that I will let interested readers review on their own; but I want to focus on another requirement of Item 19.

To make a proper disclosure in compliance with the Rule, in addition to having a reasonable basis, a franchise system must have "written substantiation for the representation at the time the representation is made." However, in the FDD, a statement indicating that "written substantiation for the financial performance representation will be made available to the prospective franchisee upon reasonable request," need only appear. The FTC Compliance Guide notes that written substantiation means that the franchise system must have "supporting data underlying any representation..."

Much more could be said about the Item 19 requirements (see the Amended FTC Rule and the FTC Compliance Guide) but the take-away here is: franchisors must have the underlying data ready to produce and franchise-buyers should ask for it.

Although I must say in my years of practice, I have found that franchise-buyers are hesitant to request the information even when counseled to do so! Why? They don't want to appear uncooperative or distrustful. Maybe franchisors should be more aggressive in offering the data? After all, its supposed to be the reasonable basis on which buyers are encouraged to buy into the system!

The End!

Franchise Disclosure Document Dissected - Part Three

We pick-up our observations about the Franchise Disclosure Document (FDD) with Item 11 - Franchisor's Assistance. If you missed Part One or Part Two, you can click on the hyperlinked text. 

Item 11 is the most comprehensive in the FDD - and an important one for both sides of the franchise equation. Just a few insights here on some of the topics covered in Item 11:

Operations Manual - nearly every franchise system has an operations manual. The manual is the "bible" for the operating system - operational requirements are enforced through the franchise agreement. Item 11 mandates two alternative disclosures regarding the manual: either the Table of Contents must be provided OR the buyer must be given the opportunity to review the manual before purchasing. Few franchisors offer the opportunity for review and only provide the Table of Contents. TOC's are typically generic and offer little insight into the manual. Few franchise-buyers go further and rely on a cursory TOC review. This is an important piece! Franchise-buyers should request access to the manual and serious franchise systems should grant greater access (protected by a non-disclosure) before the sale. Little is gained by looking at the TOC.

Training - another important item is training. Item 11 discloses the Training Program in a Table format, covering the subject, hours in the classroom and on-the-job, and the training location. A generalized description of the program is usually offered and the instructional materials, along with the instructors' experience. Here is the observation: many times franchisors do not fully disclose required information about the instructors. It is not acceptable to simply refer back to Item 2 ("Business Experience" of the main officers). The name of each instructor and their length of experience "in the field" and with the franchise system is required. So franchisors, be proactive and offer the full information; franchise-buyers, make sure you get all the information.

Time Limit to Open - Item 11 discusses the amount of time franchise buyers will have to secure a lease and open the business. Everyone is interested in opening as soon as possible. But, some of the time-frames are too short, too unrealistic. In some markets getting a lease alone can take 6-12 months. This is really a negotiating point for the franchise agreement - seek to expand the deadline. Most franchisors are flexible on this point ... because they realize it may well take more time than they estimate.

Hopefully, one more part upcoming to finish the dissection!

Franchise Disclosure Document Dissected - Part Two

We continue our review of Franchise Disclosure Documents (FDD) from a few insights that have come my way over the years. Insights that may be of value to franchise purchasers and franchise companies alike. If you missed Part One, you can find it here. We will not cover every FDD item but focus on the highlights.

Today let's start with FDD Item 5:

• Initial Fees - this item covers the amount of money or fees paid directly to the franchise company at the beginning of the process. Typically referred to as the "initial franchise fee," this amount should be clearly indicated in Item 5 and match the corresponding amount or amounts disclosed on the Cover Page. On the Cover Page, the franchise company should have at least two amounts disclosed: the total estimated investment required that corresponds to the Item 7 chart (Estimated Initial Investment) and the amounts that must be paid to the franchisor to get started (Initial Fees), again matching the Item 5 amounts. If there is a development agreement fee or other initial charges due to the franchisor, those amounts must be disclosed and accurately reflected on the Cover Page. If the amounts don't match something is wrong.
• Estimated Initial Investment - Item 7 is arguably the most important item in the FDD. It is supposed to inform readers of the total expenditure to get started (so it should repeat the Item 5 amounts plus a variety of other expenses) and identify the working capital needed for at least the first three months. Franchisors are wise to  draft this section carefully and review it on an annual basis to ensure accuracy. Although it is an "estimate," grossly understated amounts could lead to disputes when a franchisee's experience is negative and the start-up estimate was below par. Franchise buyers should not stop at the Item 7 estimate. Asking other franchisees about their actual start-up cost and how it compared to estimate, is highly recommended. As an example, sometimes smaller items such as professional fees (attorneys and accountants) are under-estimated. Franchisees need to conduct due diligence on this important item. Finally, if there is a development program, a separate estimate should be provided for that.
• Financing - If the franchise company offers financing for start-up costs (including inventory and equipment) or assists with securing a loan, it should be explained in Item 10. Here is something I have encountered, especially with new franchise systems: no disclosure or indication of financing is provided in Item 10 but "to make a deal" a franchisor enters into an installment payment arrangement with a franchise purchaser for some of the initial fees or costs. This is financing! And the terms of any financing MUST be explained in Item 10.

More later!

Franchise Disclosure Document Dissected - Part One

After reviewing hundreds of Franchise Disclosure Documents (FDD), writing and developing dozens of FDDs, and practicing in this area for 30 years, a few insights have come my way. Insights that may be of value to franchise purchasers and franchise companies alike.

It is hard to fit them all into this space so I will address this in a series of posts and hit the highlights:

• The Trademark - arguably the most important "asset" in a franchise system, the primary trademark is required to appear on the Cover Page and to be discussed in Item 13. Franchise systems should always make sure the correct PRIMARY mark is used on the Cover Page. It would seem that the primary mark should be one that is registered on the USPTO's Principal Register. I see FDDs that display a registered mark in Item 13 but it is not the one on the Cover Page. Is this because the "registered" mark is not the primary mark or because the mark on the Cover Page is the primary but unregistered mark? Either way it is confusing. Plus, franchise buyers should be more comfortable when the primary mark that they will do business under is registered.
• Business Experience - FDD Item 2 requires disclosure of the business experience or "job experience" of the the main officers and directors - but only for the last five years! Franchisors that tell us where the officers went to high school and add flowery business accolades reveal an amateurish knowledge of the requirements, may face push-back from franchise-registration-state-examiners, and, in some states, create an unwanted "technical" violation. This five-year limit, however, should not stop franchise buyers from investigating the officers and directors. In the age of the internet, there are many sources for the background of individuals and businesses.
• Litigation - FDD Item 3 deals with certain lawsuits that the franchise system (parents, predecessors and affiliates) and its main officers are or have been involved in (different disclosure time-frames apply to different types of litigation). Some lawsuit descriptions, however, end with the statement "This case was settled by confidential settlement agreement" -- meaning, the reader is not informed of the outcome of the suit. Since the 2007 adoption of the Amended FTC Rule, this practice is not permitted. According to the Rule, settlement terms must be disclosed regardless of whether the agreement is confidential (unless the settlement was entered into before the company started franchising or before July 1, 2007). Again for franchise companies: push-back from state-examiners and unwanted "technical" violations may result. For purchasers: press for the information that is required by Rule,

Enough for now!

Franchise Resources at Your Fingertips

So from a franchise news perspective - or a franchise news perspective that inspires me to write a blog post - it has been a slow summer. Guess we all need a break from the routine ... and slow news gives me more time to focus on clients ... and uh to swim and ride my bike!

Well this may be a good time to blow my own horn while passing on a valuable resource to you.

In addition to this blog, I maintain a website at www.fddlawyer.com and at www.ohiofranchiselawyer.com.

While this site talks about my background and services, it also provides a Resource Page that you may find helpful.

There are links to most franchise and business opportunity laws, state administrators, legal resources and franchise associations. In addition, there are articles written over the years by yours truly. Feel free to bookmark the page and take advantage of the resources ... and best of all it is FREE!

Enjoy the summer! I'm off for a swim.

Defend Trade Secrets Act of 2015 - Protection Goes Federal

As most of you know, franchise systems have secrets - trade secrets that is! Those "secret sauce" things or special procedures that make the essence of the product or service ... well special and secret. 

When handled properly, franchisors and other trade secret owners have been able to protect those secrets under state law. Now with the adoption of the Defend Trade Secrets Act of 2015 on May 11, 2016, that protection has gone federal. Departing franchisees who "go rogue" and take the secrets with them could be explaining their actions to a federal judge.

According to the Congressional summary that explains the law: "This bill amends the federal criminal code to create a private civil cause of action for trade secret misappropriation.

Specifically, the bill authorizes a trade secret owner to file a civil action in a U.S. district court seeking relief for trade secret misappropriation related to a product or service in interstate or foreign commerce. It establishes remedies, such as an injunction and damages. The statute of limitation is set at five years from the date of discovery of the misappropriation.

A trade secret owner may apply for and a court may grant a seizure order to prevent dissemination of the trade secret if the court makes specific findings, including that an immediate and irreparable injury will occur if seizure is not ordered. A court must take custody of the seized materials and hold a seizure hearing within seven days."

Of course, because they operate nationwide or world-wide, franchisors will be able to take advantage of the new law, adding to their arsenal of legal protections. Terminated and abandoning franchisees (and their employees) must be even more vigilant in guarding the secrets that they were given.

Reviewing the Defend Trade Secrets Act of 2015 is important for anyone involved in franchising.