UNDERSTANDING AND REVIEWING FRANCHISE AGREEMENTS, PART 1 & PART

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1 UNDERSTANDING AND REVIEWING FRANCHISE AGREEMENTS, PART 1 & PART 2 First Run Broadcast: October 18 & 19, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes each day) Though franchises often seem to clients like vehicles to assured success, they are nonetheless risky ventures. The task for lawyers advising clients about franchises is to counsel them about setting reasonable expectations and help them understand the practical implications of the franchise agreement. This is no easy task because these agreements a complex arrangement of restrictions, fees, operational requirements, intellectual property protections and reporting periods. But understanding how these agreements work and the range of what s negotiable and what s not is essential to client success. This program will provide you with a real world guide to the framework of franchise law, practical due diligence of franchise opportunities, and reviewing and negotiating the most important provisions of franchise agreements. Day 1 October 18, 2016: How to read a franchise agreement spotting key provisions and red flags Phases of franchise review due diligence, negotiation of agreement, and lease work Setting and counseling clients about realistic franchise expectations Practical guide to reading/understanding a Franchise Disclosure Document (FDD) Framework of franchise law and relationship of federal/ftc regulations to state regulation Day 2 October 19, 2016: Review of major economic and non-economic provisions in franchise agreements Determining what s truly negotiable and what s not Scope of territory rights within in it and the opportunity to expand Tiers of fees, royalties and marketing expenses Operating standards and covenants and negotiating for local modification Transfer and exit issues when a franchisee wants out Speakers: H. Michael Drumm is the founder and member of a Drumm Law, LLC in Denver, Colorado, where he has an extensive franchise, trademark and business transactional practice. He works with franchisors across industries nationwide helping them draft, file and renew their franchise Disclosure Documents and franchise agreements. He has a specialty representing craft breweries to help them trademark their brands and protect their intellectual property. He has been repeatedly honored by Franchise Times magazine as a Legal Eagle and has been designated by the International Franchise Association as a Certified Franchise Executive. Mr. Drumm received his BSBA from the University of Missouri-Columbia and his J.D. from the University of Texas School of Law.

2 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Understanding & Reviewing Franchise Agreements, Part 1 Teleseminar October 18, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER October 11, 2016 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # Address Understanding & Reviewing Franchise Agreements, Part 2 Teleseminar October 19, :00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER October 12, 2016 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:

4 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: October 18, 2016 Seminar Title: Understanding & Reviewing Franchise Agreements, Part 1 Location: Credits: Program Minutes: Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

5 Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: October 19, 2016 Seminar Title: Understanding & Reviewing Franchise Agreements, Part 2 Location: Credits: Program Minutes: Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

6 Franchise Agreements: From Soup to Nuts H. MICHAEL DRUMM

7 Franchise Attorney

8 A Brief History of Franchising -Became common as a business model in the middle of the twentieth century. -The establishment of the interstate highway system led to a perceived need by travelers for consistent, reliable experiences on the road with familiar brands. -During the fifties and sixties, restaurant and motel companies rushed to meet these needs, and franchise companies like Holiday Inn, McDonald s, and Howard Johnson s became some of the most recognizable names in the country.

9 What is a Franchise? Under the Federal Trade Commission s Franchise Rule (16 C.F.R. 436 et seq.), a franchise is a contract or agreement between two or more persons in which: Trademark. The business involves distribution of goods or services substantially associated with the franchisor s trademark or trade name; Required Payment. The franchisee pays at least $540 within the first six months for the right to enter into a franchise agreement, including a payment for goods and services; and Significant Control or Assistance. The franchisor exercises significant control over, or provides significant assistance in, franchisee s method of operation) State definitions vary

10 What is a Franchise? All three of the definitional elements must be met before a business opportunity will be considered a franchise The name which the parties give to their relationship is not determinative as to whether the relationship is or is not a franchise As a result, contractual language stating that the agreement does not create a franchise relationship is ineffectual to ensure that result

11 Franchise Regulation Due to its regulation, some practices that are standard in other business transactions may be illegal in the franchise context Failing to timely deliver a Franchise Disclosure Document to a potential buyer Terminating a contract without first providing notice and an opportunity to cure

12 What is a Disclosure Law? Disclosure laws require franchisors to prepare a Franchise Disclosure Document (or FDD ), which is similar to a securities disclosure, and provide that document to prospective franchisees The contents of the FDD generally are governed by a combination of state and federal laws, which have been refined into a uniform set of rules circulated by the North American Securities Administrators Association ( In general, an FDD must be given to a prospect 14 calendar days before the franchisor receives any payment, or requires the franchisee to sign any contract, relating to the franchise.

13 What is a Registration Law? Registration means that, before a franchisor can sell in a the state, it must file its Franchise Disclosure Document with the applicable regulatory authority The regulator will review and, in some instances, comment on the FDD and require the franchisor to make changes. Registration must be renewed annually. If a franchisor is not registered in a jurisdiction that requires registration, it cannot sell franchises in that jurisdiction.

14 What is a Relationship Law? Governs elements of the franchisee-franchisor relationship For example, among other things, some relationship laws: Limit the circumstances under which a franchisor can terminate or refuse to renew the franchise contract; Prevent, or provide protections against, unequal treatment between franchisees; Protect the rights of franchisees to form independent associations; or Require the franchisor to buy back inventory previously sold to the franchisee

15 FTC s Franchise Rule Governs all franchisors operating anywhere in the United States and its territories Purpose is to prevent fraud in the franchise relationship Disclosure law only There is NO national registration requirement. The FTC will only review an FDD after receiving complaint(s), and even then will only do so rarely. As a result, if offer / sale is made in non-registration states, the FDD will not first be reviewed by a governmental entity No federal relationship law

16 FTC s Franchise Rule Must furnish FDD to all prospective franchisees 14 calendar days before signing a binding agreement or accepting payment F/K/A Uniform Franchise Offering Circular or UFOC Amended Franchise Rule (July 1, 2008) Plain English Rule no legalese or technical jargon permitted in the FDD FDD must be updated once a year (within 120 days of franchisor s fiscal year end); more frequently upon the occurrence of a material change to the information disclosed in the FDD

17 FTC s Franchise Rule The Franchise Rule does not provide individuals with the right to sue franchisors for violation of the Franchise Rule Common law fraud claims or unfair trade practices claims can be brought based on misrepresentations in FDD or noncompliance with the Franchise Rule

18 Franchise Registration States 14 states have franchise registration and disclosure laws. Oregon has a disclosure law only (no registration requirement) Broadly speaking, a state s registration or disclosure law may be implicated where: The franchisor is located within that state; The prospective franchisee lives in that state; or The contemplated franchise will be located in that state

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20 Franchise Registration States Before any offer of a franchise is made, franchisor must register the offering with the state Registration lasts for one year; in some cases, expires within days after the franchisor s fiscal year end. In other cases, expires one year after registration. Certain exemptions apply per statute (but federal law differs)

21 Negotiated Changes California and Wisconsin are the only states that specifically regulate the disclosure of negotiated terms. If the franchisor has negotiated changes, franchisees are entitled to a list of such changes which could be beneficial in the current negotiation process.

22 Franchise Laws A franchisor must furnish a disclosure document to all prospective franchisees before signing a binding agreement or accepting payment Franchisor is a person who offers franchises Includes subfranchisors and area representatives / regional developers Unlawful to offer to sell a franchise with a document that contains an untrue statement of material fact or to make a material omission Potential civil and criminal liability for knowing violations

23 Franchise Laws Aggrieved individuals can sue for damages resulting from violation; if violation was willful, can seek rescission of franchise contract Many state registration / disclosure laws authorize franchisees located in the state to sue in their own state court Contractual forum selection clauses overridden Joint and several civil liability for every person who controls franchisor, officers, directors, and employees who materially aid the franchisor in committing the violation Unless they lacked knowledge or reason to know

24 The Franchise Disclosure Document It contains 23 items of information that the Federal Trade Commission (FTC) has determined to be important to prospective franchisees. The FDD is not a legally binding agreement, franchisee attorneys should carefully review the franchise agreement as that is the binding document that controls the relationship.

25 The Franchise Disclosure Document The proposed franchise agreement will be included; disclosures in the FDD should match the terms in the contract Item 17: Tabular summary of key contract terms Item 1: History of the company (how long has it been in business?) Item 2: History of the key officers and employees Item 3: Litigation history Items 5, 6, and 7: Fee and investment information

26 The Franchise Disclosure Document Item 8: Restrictions on sources of products and services Is franchisor exclusive supplier? Or does it name third party sources? Item 10: Financing offered by Franchisor Item 11: Assistance offered by Franchisor Prior to opening (including training program) After opening Item 12: Territory Is one offered? Consider carve-outs

27 The Franchise Disclosure Document Item 13: Trademark Registered vs. not registered Indemnification; defense of franchisee s use of marks Item 14: Patents and copyrights Registered vs. not registered Item 15: Obligation to Participate in Operations Active vs. passive ownership

28 The Franchise Disclosure Document Item 19: Financial Performance Representations All franchisors are permitted but not required to make FPRs Some franchisors don t make them. If they do, the FPRs MUST be included in Item 19 Providing FPRs not contained in Item 19 = presumptive violation of Franchise Rule Item 20: System / franchisee information Number of outlets, company-owned and franchise-owned Growth / shrinkage over last 3 years Names / contact information for existing franchisees

29 Franchise Agreements Major Economic Provisions -Tiers of fees, royalties and marketing expenses Major Non-Economic Provisions -Operating standards and covenants -Territory = Is it exclusive?

30 Franchise Agreements: Non- Negotiable Documents? Most franchise agreements are generally not negotiable Franchisor wants uniformity in system; different deals cause complexity in administration Also, different / better / sweetheart deals can cause resentment Generally, the newer the system, the more likely the franchisor is to negotiate

31 Confirm Franchisor s Willingness to Negotiate Certain franchisors refuse to negotiate. Some states penalize franchisor for not being willing to negotiate. If a franchisor is willing to negotiate, it is the franchisee attorney s responsibility to guide its client on what is important.

32 Negotiation Process Just Because It helps the negotiation process to have valid reasons for the requested changes for the franchise agreement rather than asking for them just because. Pointing out valid business reasons for requested changes makes it more difficult for the franchisor to reject such requests

33 Negotiable Items There are certain items of the franchise agreement that are usually non-negotiable. Non-negotiable items include personal guarantees, royalties, advertising fund contributions, and initial franchise fees.

34 Recognize the Negotiable Items These items include: Right of First Refusal on Additional Territories Right of First Refusal on New Brands Additional Training Trademark Infringement Indemnification Pre-approved Transferees Extra Renewal Terms Deadline Extensions Cure Provisions Financing of the Initial Franchise Fee Tiered Royalty Deferred Royalty Removal of Franchisor s Right of First Refusal

35 Recognize the Negotiable Items These items include: Deferred Advertising Fund Contributions (especially important in new systems) Reasonableness in All Franchisor Approval Commercially Reasonable Caps on Product Purchases Required by Franchisor Commercially Reasonable Caps on Inventory Levels Addition of Material to Defaults Elimination of Cross Defaults Arbitration or Litigation

36 Recognize the Negotiable Items These items include: Waiver of Trial By Jury Waiver of Punitive Damages Commercially Reasonable Lease Addendum Termination Fee Addendum Terms in Renewal and Transfer Agreement Same Royalty, Advertising Fee and Territory in Renewal Agreements

37 Addendum Franchisors rarely make changes to the actual franchise agreement. Most negotiated changes are written as Addenda to the franchise agreement.

38 FA: Potential Pitfalls Non-competes Nearly all franchise agreements contain some form of post-termination non-compete Surprising number of franchisees are not aware that these provisions exist and try to operate independently after termination or expiration

39 FA: Potential Pitfalls Purchasing Power Some systems have had problems with this (Quizno s?) Zees may end up paying more

40 FA: Potential Pitfalls Purchasing Power Item 8 Supplier restrictions Few prospective franchisees understand Disclose the franchisee s obligations to purchase or lease goods, services, supplies, fixtures, equipment... related to establishing or operating the franchise business either from the franchisor, its designee, or suppliers approved by the franchisor, or under the franchisor s specifications.

41 FA: Potential Pitfalls Purchasing Power Item 8 Example: You may be required to purchase other fixtures, furnishings, and/or equipment from our approved or designated suppliers or us or our affiliate. Prospective Franchisee Interpretation: I m sure if I find better deals, I can purchase from those sources. It s my business, right? What it really means: You buy from whom we tell you to buy.

42 FA: Potential Pitfalls Renewal Agreement Terms (including Territory and fees may be different) Cross Default Multiple agreements?

43 Deal Breakers It is helpful to provide franchisor with a list of provisions you want to discuss. Identifying the deal breakers may speed up the process and save the franchisee time and money.

44 Operations Manual If properly prepared, should help mimic Zors past success Provide guidelines for aspects of the business such as store layout, vendors, advertising, etc. Clearly lays out Zor s expectations for Zee

45 Operations Manual Potential Pitfalls: Zors can generally revise Ops manuals at any time and Zees will be required to comply with all changes Revisions to Ops manuals may even be done through s to Zees or posts on an intranet, so Zees should be sure to stay on top of these

46 Buying a Franchise A good brand with a track record of success Ability to use the brand s experience and name recognition for your benefit Operational support and marketing assistance Purchasing power Cooperative Advertising

47 Due Diligence Sales process What is said vs. Reality: We are a family. We are a family until a private equity firm buys us out and then you re on your own. We will support you every step of the way. We will support you as we deem necessary in our sole discretion. You will benefit from our knowledge and experience. We will give you an operations manual and some initial training, but good luck after that.

48 Due Diligence Item 20 of the Franchise Disclosure Document lists the names of all current and former franchisees as of the end of the franchisor s previous fiscal year. Prospective franchisees should reach out to these franchisees and gather as much information on the franchisor as they are able.

49 Due Diligence Questions to ask of current/former franchisees: What do you get that makes it worthwhile to pay franchise fee and royalties? Are you getting value in the system (e.g., operations)? The brand? Does the franchisor offer support? Is it proactive? Does it respond to requests for support? Does it respond to questions? For those that closed, why did they close? What issues did they face? How is relationship with franchisor? Financial performance?

50 Practice Tips What should you do when a prospective franchisee asks you for advice? Does a state s registration law apply? Where is the franchisee domiciled? Where is the franchisor headquartered? Where will the franchisee s business be located? Where is the offer made / accepted?. Registration states: verify that the franchise is registered California, Minnesota, Virginia, Washington and Wisconsin: online databases

51 Practice Tips Keep in mind that franchise contracts are one-sided as of necessity System stability demands that franchisor retain strong controls Similar to a commercial lease Registration states: verify that the franchise is registered California, Minnesota, Virginia, Washington and Wisconsin: online databases

52 Exit Plan. The Franchise Agreement Does it have a franchisee termination provision? What will you be on the hook for monetarily? Has there been a breach of the Franchise Agreement? Did the Zor or the franchise broker make promises to you before the Agreement was signed that never panned out? If so, how?

53 Exit Plan. In franchise law there are different hurdles: Disclaimers regarding representations made prior to signing of the Franchise Agreement that are included in the FDD and/or Franchise Agreement Required waivers of items like collective actions, punitive damages and jury trials Zor may have wide discretion under the contract

54 Exit Plan. In franchise law there are different hurdles: Franchise Agreements often include liquidated damages provisions Contract law may provide Zor with rights to lost future royalties

55 Exit Plan. Exit strategies: Oh the Possibilities Sell to third party Sell to family member Sell to Zor Shut down upon expiration

56 Disputed/Litigated Issues Majority of clients complain of some sort of misrepresentation -Financial performance representation, promised support, promised national accounts, etc. Key issue is usually whether disclaimers apply -Statutory anti-waiver provision -Boilerplate? -Specific to alleged misrepresentation? -Who made the misrepresentation?

57 Disputed/Litigated Issues Disclaimers Vary One line: There have been no agreements, understandings, representations, or statements made other than those provided in this agreement. Multi-page: Questionnaires asking franchisees to confirm no representations made about potential earnings, number of customers, profitability of existing franchisees, etc.

58 Disputed/Litigated Issues Fraud by omission -Financial performance representations outside of FDD, -Even if disclaim misrepresentations, did not include required information (e.g., number who met or surpassed results, reasonable basis, whether part of a subset, etc.)

59 Importance of a franchise attorney Industry-specific knowledge Insight into the reputation of a Zor and/or the experiences of other franchisees in the system

60 Importance of a franchise attorney Familiarity with terms that are standard to Franchise Agreements and how these may affect Zees Territorial provisions (Exclusive? Not exclusive?) What about internet sales? Catalog sales? Other brands owned by franchisor or affiliate? Right to terminate for minor defaults (even if cured)?

61 Importance of a franchise attorney Familiarity with what terms in Franchise Agreements may indicate overreaching by a Zor Excessive liquidated damages No territorial rights Unfair dispute resolution Overreaching restrictive covenants

62 Importance of a franchise attorney Franchise law is not general business law Federal regulations and state statutes may impact terms in Franchise Agreement Dispute resolution provisions may not be enforceable in some states Liquidated damages may not be enforceable Choice of law may not be enforceable

63 Resource Links FTC s Franchise Rule: FDD Franchise guidelines (registration states North American Securities Admin. Association)

64 Questions? H. Michael Drumm