Common Franchise Disputes

No relationship is without its conflicts, and that goes double (at least) for business relationships. Of the disputes between franchisees and their franchisors particularly, many arise from allegedly noncompliant, improper, or inaccurate disclosures made by the franchisor before a franchise agreement is executed... from real or perceived “encroachment” or failure of the franchisor to support a franchisee... and from termination of a franchise by the franchisor—that is, from the beginning, in the middle, and at the (sometimes abrupt) end of the franchise.

Franchisor claims

The typical reasons why a franchisor might sue a franchisee are neither numerous nor extraordinary. Most often, when a franchisor sues a current or terminated franchisee it is simply to collect money owed. Franchise agreements typically require franchisees to pay royalty, advertising, and/or marketing fees. When a franchisee fails to pay these, the franchisor might seek judicial intervention to recover for breach of contract.

Franchisors might sue existing franchisees who do not abide by system standards. While this is often a last resort, a franchisor might have no choice but to sue to compel a non-compliant franchisee to enforce standards in order to maintain uniformity and consistency of operations among the franchisees. Otherwise, by allowing franchisees to flout brand standards, franchisors risk a rash of non-compliance by other franchisees who perceive the franchisor as lax in enforcing its standards.

A franchisor might also sue to enforce its intellectual property rights. A terminated franchisee that continues to use a franchisor’s trademarks, service marks, and/or trade dress can not just cause consumer confusion but can expose the franchisor to claims by customers injured or otherwise harmed at or by the terminated franchise(e). Compliant franchisees expect their franchisors to ensure the de-identification of terminated franchisees, often considered a blight on the system and often improperly competing for the compliant franchisees’ customers. Accordingly, a franchisor might assert unfair competition, trademark infringement, and even counterfeiting claims. A franchisor might seek injunctive relief, so that terminated franchisees are required to comply immediately with their post-termination de-identification obligations.

Franchisee claims

Claims by franchisees against their franchisors are, on the other hand, various and sometimes creative.

“Earnings claims”

An “earnings claim” refers to information given to a prospective franchisee by, on behalf of, or at the direction of the franchisor or its agent, from which a specific level or range of actual or potential sales, costs, income, or profit from franchised or non-franchised units may be easily ascertained. (In New York, for example, an earnings claim is any information that a franchisor seeks to impart to a franchisee that states, suggests, or implies what sales, income, or profits a franchisee can derive from the operation of a franchised business.) Such information comes in two forms: (1) a description of the past financial performance of franchised or non-franchised units; and (2) a projection of the future performance of those units. Therefore, an earnings claim can be either an actual statement or a projection of earnings.

Some states require that when a franchisor provides earnings claims they must be in writing in the offering prospectus. In addition, written earnings claims in the offering prospectus must (1) identify the units upon which the information was based, (2) have a reasonable basis, and (3) if an earnings claim is based on actual experience, disclose the percentage of franchised outlets in operation for the period covered by the earnings claim that have actually attained or surpassed the stated results.

Misleading initial investment costs

Another particular claim that a franchisee might make concerns the franchisor’s required (under some states’ laws) representation of the costs to start up a franchise. The rules of the New York State Department of Law regarding the contents of a franchise offering prospectus, for example, require a franchisor to disclose expenditures, and certain salient details thereof, relating to:

• Real property, whether purchased or leased;
• Equipment, fixtures, other fixed assets, construction, remodeling, leasehold improvements and decorating costs, whether purchased or leased;
• Inventory required to begin operation;
• Security deposits, utility deposits, business licenses, other prepaid expenses;
• Additional funds required to be expended by the franchisee before operations begin and during the initial phase of the franchise; and
• Other payments that the franchisee must make to begin operations.

A franchisee might claim, for example, that its franchisor did not base its calculations on data relevant to the place where the franchisee opened its business, or was using old data.

Encroachment

Encroachment is the term for the practice of a franchisor’s selling franchises to other franchisees too close to the units of an existing franchisee. Lawyers representing encroached-upon franchisees will, of course, bring an action against the franchisor under the terms of the franchise agreement if there is a provision intended to prevent encroachment, but will otherwise often allege a breach by the franchisor of the covenant of good faith and fair dealing implied in the franchise agreement.

Competition by franchisor (by alternative means)

A franchisor might, notwithstanding the existence of franchisee units in a particular geographic area, arrange for the sale of the franchise goods in a non-branded outlet. An ice cream franchise, for example, might sell its products to a supermarket, causing competition for its franchisee(s) in the neighborhood that the franchisee did not anticipate. Or, with the advent of the Internet and “e-tail,” a franchisor might sell the franchise product online. One or the other or both of these might be alleged by the franchisee to be a breach by the franchisor of an implied covenant of good faith and fair dealing, although the franchisee’s lawyer must review the franchise agreement carefully to determine whether the franchisor does not, in fact, have the express right to sell franchise products in either manner.

Failure to train/support

Franchisees expect to be trained in the particular business of the franchise and to be supported by the franchisor in their efforts to sell the franchise products/services. Franchisees expect this training and support to be ongoing, further, not merely lip service and not merely at the outset.

Modification of the system

A similar complaint of franchisees regards franchisors’ unilateral modification of the franchise business system, which can wreak havoc on franchisee’s operations. Franchisors have been known to re-brand the franchise business, requiring franchisees to expend not insignificant sums to change names. Or a franchisor might require a franchisee to renovate or refurbish one or more units, likewise putting the franchisee to great unexpected expense. These demands of a franchisor as well might be deemed breaches of the implied covenant of good faith and fair dealing.

System standards

Franchisors have the right to require franchisees to toe the line, but when a franchisor is inflexible, demanding strict compliance with system standards without any lenience, the franchisee who faces threats of default or termination for minor infractions or inadvertent errors might sue.

Advertising fund manipulation

Franchisors typically require franchisees to contribute to a common advertising fund, which fund is supposed to be used for the common good of the franchisees, specifically to purchase franchise advertising. Franchisees have alleged that their franchisors have used the advertising fund monies not for the intended purpose but instead for general corporate purposes, constituting a breach of contract, a breach of fiduciary duty on the part of the franchisor (for commingling assets), or both. Historically, claims of breach of fiduciary duty in such circumstances have not been successful, but the practitioner is well advised to consider the language of the contractual provision that addresses the advertising fund in each particular case.

Termination/Non-renewal

Franchisees typically invest substantial amounts of time and money in acquiring, developing, and operating their franchises. To protect these investments from arbitrary franchise termination or non-renewal, franchise “relationship laws” govern such events. These franchise relationship laws supercede the termination and renewal provisions in franchise agreements. Generally, relationship statutes forbid termination or non-renewal of a franchise except for “good cause” (sometimes termed “reasonable cause” or “just cause”), often defined as the failure by the franchisee to comply with any lawful provision of the subject franchise agreement after being given the opportunity to cure that failure. Some state franchise relationship laws apply this “good cause” standard only to termination; others apply it both to termination and to a refusal to renew the franchise. And many of the state franchise relationship laws require that, even if a franchisor has sufficient statutory grounds for franchise termination or non-renewal, the franchisor must, as a precondition, repurchase the subject franchisee’s inventory, supplies, equipment, and/or furnishings. State laws also typically prescribe a minimum advance notice of franchise termination or non-renewal, to afford a franchisee opportunity to cure defaults during the notice period and thereby avoid termination.

Transfer/Assignment

Some state franchise relationship statutes limit the right of a franchisor to control transfers of franchises or the assets of franchised businesses. Some states impose a defined “good cause” substantive standard that a franchisor must meet before it may lawfully deny a transfer request. Other jurisdictions provide that a franchisee may transfer the franchised business and franchise agreement provided that the transferee satisfies the reasonable current qualifications of the franchisor for new franchisees. In some states, a franchisor is permitted to reject a transfer when the proposed transferee will not agree to comply with all the obligations and requirements of the subject franchise agreement. Several franchise relationship laws require a franchisor and the transferring franchisee each to take certain procedural steps for the transfer to be valid. If a franchisor refuses to consent to a proposed franchise transfer, the franchisee (and/or the rejected transferee) may commence an action against a franchisor under a franchise relationship law, seeking (without limitation) preliminary and/or permanent injunctive relief, damages and attorneys’ fees.

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