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Under the FTC Franchise Rule, a franchisor is required to disclose in Item 6 of its Franchise Disclosure Document (FDD) all recurring or occasional fees associated with operating a franchised outlet.These fees include all payments made directly to the franchisor or an affiliate, or collected by the franchisor or affiliate for the benefit of a third party. Franchisors must state in Item 6 each type of fee, the amount of the fee, and the due date, as well as any formula used to compute the fee. If a fee may increase during the franchise term, the franchisor must disclose the maximum amount of the increase or the formula used to determine the increase.
The Item 6 disclosure thus serves two primary purposes:
Allows a prospective franchisee to understand and anticipate the fees that it will be required to pay as a franchisee, and
Prevents the franchisor from unilaterally imposing new, undisclosed fees or increasing current fees in the absence of proper disclosure in Item 6.
Item 6 is one of the few "forwarding looking" elements of the Franchise Rule in that it assures the franchisee that the fees and charges it will pay over the life of the franchise agreement will be limited to those disclosed in Item 6 and reserved in the franchise agreement.
Unfortunately, some franchisors have chosen to disregard the Franchise Rule and the franchise agreements they have drafted by imposing new fees during the franchise relationship that were not disclosed in Item 6 of the FDD. These franchisors have tried to invoke the sometimes sweeping discretion reserved to them under the franchise agreements to change system standards, specifications and requirements, and to increase to financial burden on the franchisees. A very recent example of this can be found in Bird Hotel Corp. v. Super 8 Motels, Inc.,2010 WL 572741, Bus. Franchise Guide (CCH) ¶14,337 (D.S.D., 2010).
In Bird Hotel, Super 8 Motels began charging its franchisees a five percent fee on gross room sales to customers participating in the Super 8 TripRewards loyalty program. This new five percent fee was in addition to a two percent gross room sales fee which franchisees had been paying pursuant to the original terms of the franchise agreement.
The franchisees argued that Super 8's authority to change its customer loyalty program does not extend to imposing a five percent fee on gross room sales to TripRewards members. Super 8 argued that the new fee is not prohibited under the franchise agreement, which permits Super 8 to impose additional expenses upon franchisees and to revise its franchise operations, including its rules of operation.
The U.S. District Court for the District of South Dakota (Piersol, Ch. D.J.) held that Super 8 had breached the franchise agreement, which clearly does not permit Super 8 to impose the new five percent fee upon its franchisees. The Court described the new fee as "a unilateral revision of the terms of the contract and not, as argued by Super 8, to a revision of the system standards and rules of operation." The Court further found that even if Super 8 had retained the right to change its system standards and rules of operation and its customer loyalty program detailed therein, it may not unilaterally impose a fee for the operation of that program greater than what is provided for in the language of the franchise agreement, which provided that franchisees would be charged a two percent fee for participating in the customer loyalty program.
Significantly, the Court remarked that even if the franchise agreement had not been clear and unambiguous, the Court nevertheless would have found Super 8 to be in breach of the franchise agreement, based on its Item 6 disclosures. The Court observed that, through its Item 6 disclosure, Super 8 represented to class action members and to the Federal Trade Commission that "[r]ecurring fees are limited to a royalty of 4% of gross room revenue, payable to Super 8 Motels, Inc. and 2% of the gross room revenue payable to the Super 8 Advertising and Reservation Fund. There are no other royalties or fees." The Court concluded that the Item 6 disclosures indicated that the parties did not anticipate that Super 8 would be permitted under the terms of the franchise agreement to impose the additional five percent recurring fee.
A jury trial concerning the amount of the franchisees' damages in Bird Hotel had been scheduled for June 29, 2010, but the parties have reported the case as having been settled. Public disclosure of the amount of the settlement is anticipated to occur during the next two weeks. The franchisees are seeking reimbursement of the sum of the loyalty program fees they have been required to pay, which they calculate was $3,418,112.34 as of the end of June 2009, approximately one year ago.
In our view, the Bird Hotel decision should serve as a wake-up call to all franchisors that, to be legal, any new or increased fees must first have been disclosed to franchisees in Item 6 of the FDD and reflected in the franchise agreement. Franchisors who disregard these requirements may well find themselves in the unenviable position facing Super 8 today: negotiating with class counsel over claimed multi-million dollar damages.
About the authors: This article was written by franchisee attorneys Eric Karp, partner, and by David Meretta, associate, of Boston-based law firm Witmer, Karp, Warner & Ryan LLP. Mr. Karp is listed in the International Who's Who of Franchise Lawyers 2004-2005, published by Law Business Research. He serves as counsel to numerous franchisee associations in such chains as McDonald's, Pearle Vision, Domino's Pizza, Denny's, TCBY Yogurt, Jackson Hewitt, Woodcraft, Portable On Demand Storage, and Colors on Parade. An adjunct professor at Babson College in its MBA program on franchising, Mr. Karp also serves on the Board of Directors of the American Franchisee Association (AFA). Since 1996 Mr. Karp has served on the Franchise Project Group of the Franchise and Business Opportunities Committee of the North American Securities Administrators Association. Mr. Karp has also provided advice and assistance to the U.S. House Judiciary Committee and its staff on proposed federal legislation on franchising.
Mr. Maretta received his undergraduate and law school education from the University of Michigan and is admitted to the state bars of Michigan and Massachusetts. He has clerked for the Hon. Lawrence M. Glazer of the 30th Judicial Circuit Court of Michigan.