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2011 Lawsuits through the Eyes of DLA Piper

WASHINGTON – As we are now well into 2012, a look back at last year’s pertinent legal cases is important for franchisors and their attorneys. DLA Piper presented its top 11 cases of 2011 last December, those that “provide guidance to business considerations for franchisors.” Perhaps franchisees and their counsel should also pay close attention to these legal decisions.

The webinar session was presented by Barry Heller, Scott McIntosh and John Verhey. The cases (and attorneys) are in no order of priority.

Earnings Claims

Q: If franchisors make an Item 19 FPR [financial performance representation], do they also need to disclose other material financial information in the FDD?

A: 7-Eleven, Inc. v. Spear

Pointers: Item 19 of the Franchise Disclosure Document provides considerable flexibility in making financial performance representations, as long as there is a reasonable basis. This case shows franchisors that writing detailed explanations and disclaimers are important. It illustrates that publishing financial performance representations for a system’s franchise units continue to be good legal protection against alleged earnings claims violations.

Future Royalties

Q: Can franchisors recover future royalties (and advertising fees) from a terminated franchisee?

A: Meineke Car Care Center, Inc. v. RLB Holdings, LLC

Pointers: This case shows how important it is for franchisors to provide an express provision in the franchise agreement for the recovery of future royalties and advertising fees (e.g., liquidated damages provision).

State laws are critical when it comes to a franchisor being able to enforce its contract in recovering its lost profits from a closed down franchise. Franchisors should include future advertising fees as part of their claim. They should consider reducing the claim period as evidence of mitigation. In order to maximize the possibility of a legal win, franchisors should characterize the franchisee as terminating the franchise relationship and causing the stoppage of future royalties.

Terminations (Notice Provisions)

Q: Is it worth noticing what a franchisor’s notice provision actually says?

A: Grosso Enterprises, Inc. v. Domino’s Pizza, Inc., LLC

Pointers: The Grosso case illustrates how franchisors should pay close attention to notice provisions and strictly comply for default and termination purposes. Franchisors should review procedures and potential franchise agreement requirements for notifying franchisees of operations manual system standards changes. Companies should limit the use of email notices to franchisees unless receipts can be obtained.

Income Tax Liability (Out-of-State)

Q: Can a state assess an income tax against a franchisor, which has no physical presence on the state, merely because it receives royalties from franchisees in the state?

A: KFC Corp. v. Iowa Dept. of Revenue

Pointers: Franchisors need to be aware of the requirement to pay income taxes based on royalties received from franchisees in Iowa. The Iowa Department of Revenue intends to continue to identify out-of-state franchisors who have not filed in Iowa and to send notices. Iowa’s policy in the past has been to assess tax retroactively for 10 years with interest (but exercising discretion not to seek penalties).

Iowa has a voluntary disclosure program allowing taxpayers to report corporate income tax liability for the past five years with a waiver of penalties. It may not be available to a taxpayer once he/she has been contacted by Iowa Department of Revenue. First, franchisors should consider whether there was any overpayment of taxes to any other states as a result.

Price Setting

Q: Can franchisors control the prices of products that franchisees sell?

A: Stuller, Inc. v. Steak N Shake Ent. Inc.

Pointers: Before implementing any policy to set prices, franchisors should check the language of the franchise agreements and the disclosure documents of the existing franchisees. If nothing in them expressly grants the right to set, or prohibits setting, the franchisees’ prices, franchisors should look for provisions that allow them to make changes to the system, to standards or specifications. They should check whether “system” includes “prices.”

Franchise companies should consider the economic effect on franchisees and set the price bearing in mind that potential effect. Franchisors should adhere to that price in any company-owned units. And they must add language to their current franchise agreement to indicate that setting the maximum and minimum prices is part of the rights they have, as part of their right to change standards and the system.

Violation of Non-compete

Q: How much of a connection must a former franchisee have to the competing business for a violation of a non-compete obligation?

A: Victory Lane Quick Oil Change, Inc. v. Darwich, et al

Pointers: Franchisors should try to get the facts before alerting franchisees to possible violations. They should discover as many links as possible between signatories and the competing business. Companies should draft non-compete clauses to cover a broad range of involvement with competing business. But franchisors must watch state law (e.g., “in any capacity”).

Renewals

Q: Must franchisors renew a franchise based In New Jersey even if the franchise agreement contains no renewal right?

A: BP Products NA, Inc. v. Hillside Service, Inc. et al.

Pointers: Franchisors must be careful in terminating or non-renewing franchises based in New Jersey. They should show failure by the franchisee to comply with franchise terms to end relationship consistent with New Jersey Franchise Practices Act. If a company decides to set up different arrangement, it should offer attractive alternatives that will induce franchisees to choose them. Franchisors must also watch New Jersey choice of law clauses in agreements with non-New Jersey franchisees.

Using Different Standards for Franchisees

Q: Can franchisors apply different standards to different franchisees?

A: Danforth & Assoc., Inc. v. Coldwell Banker Real Estate, LLC

Pointers: Franchise firms should remember state franchise statutes with anti-discrimination provisions - Hawaii, Illinois, Indiana, Minnesota, and Washington. Differences in standards or treatment of franchisees should be based upon reasonable distinctions and should not be arbitrary.

Class Action Arbitration

Q: Will franchisors be faced with a class action in arbitration?

A: AT&T Mobility LLC v. Conception

Pointers: Franchisors should include “no class action” as part of arbitration clause. They should consider including a clause stating: “If class arbitration allowed, then the case should be litigated in court.” It will most likely be enforced under Federal Arbitration Act. See Arbitration Fairness Act.

Advertising Council

Q: What are your rights vis-à-vis your advertising council?

A: KFC National Council & Advertising Cooperative, Inc. v KFC Corp.

Pointers: Franchisee input on marketing, advertising and other system functions can be very valuable to system strength and growth. However, as the party ultimately responsible for overseeing marketing, advertising, system growth, and system change, franchisors need to retain ultimate control. Franchisors should ensure that agreements with Franchise Advisory Committees and any organizing documents do not impair franchisors’ ability to maintain control over advertising strategy or other key system aspects.

Workers’ Compensation Provisions

Q: Can franchisors be responsible for providing worker’s compensation to employees of their franchisees?

A: Doctors’ Assoc., Inc. v. Uninsured Employers’ Fund

Pointers: This case shows that it may be helpful for franchisors to have company-owned units owned by a different corporate entity. Companies should include language in agreement confirming that the franchisor is in business of franchising rights, not in the business of providing the underlying services or products. The court rejected blanket exclusion of franchisor-franchisee relationship, but suggested franchisors could protect themselves by including certain provisions in agreements and enforcing them.

Franchise firms should include provisions regarding workers’ compensation insurance in franchise agreements: They should require franchisees to maintain workers’ compensation at all times; require franchisee to name franchisor as a named insured; requiring notice from workers’ compensation insurance carrier to provide advance notice of expiration, cancellation, termination or modification of policy; and permit franchisor to inspect franchisee’s business records to be certain insurance premiums are paid when due. Franchisors should enforce the provisions.

NOTE:  For more detail information concerning cases’ facts, claims, arguments and court rulings, click below:

Slideshow of top franchise cases of 2011, DLA Piper (pdf)

Next: Important court decisions in 2012


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