Franchisee Attorneys Share Advice

At the 34th Annual ABA Forum on Franchising, held in Baltimore in October, two veteran franchisee attorneys led a session in which they discussed key issues that all franchisee attorneys must understand. Complemented with extensive input from attorneys in the audience, Julie Cowan Lusthaus, partner, Einbinder & Dunn, LLP (New York, NY), and Peter Silverman, partner, Shumaker, Loop & Kendrick, LLP (Toledo, OH), set forth the basics for protecting franchisees' rights and interests.

Franchise Acquisitions

Lusthaus and Silverman began the presentation by evoking the classic situation that all franchisees attorneys face: A prospective franchisee calls or comes in for a meeting, eager to purchase a business. He or she is under a tight deadline to make a decision because the franchise sales representative has said that another buyer is ready to jump on the opportunity. The attorney's first job is to induce realism and calm into the discussion. “Franchisees have been told that they have to take the deal ' that another buyer is lined up,” Lusthaus said. “But I have never had a client lose a deal over a purported deadline to buy the franchise.”

Other times, the prospect tells the attorney that he has already decided to purchase the franchise, but he understands that the contract contains a few items that “need to be looked at,” said Lusthaus. She advised against giving the prospect a cursory review, unless perhaps the buyer is a sophisticated client who already owns franchise units in the same brand.

Working through the FDD, the attorney should focus on areas that might raise red flags about the franchise brand or might create requirements that the prospective franchisee cannot meet. For example, Silverman said that a large amount of litigation disclosed in Item 3 could reflect poor relations between franchisor and franchisees or a struggling system. Through a show of hands, nearly half of audience members at the session went a step further ' indicating that they do not rely on the data in Item 3 anyway, believing it to be inadequately disclosed.

Item 7 disclosures that cover the estimate of the franchisee's initial investment prior to and during startup also can provide an incomplete picture, said Lusthaus. “Clients should be cautioned not to rely too heavily on Item 7 information and to conduct their own due diligence,” she said. “Item 7 is only a general estimate. Are the numbers accurate for the location they are seeking to buy?”

Furthermore, many Item 7 disclosures include operating cost estimates for only a three-month period, implying that franchisees will reach a cash flow break-even after that time. Yet, the same FDDs often state that it typically takes 18-24 months for a franchisee to become profitable, said Lusthaus.

One audience member added: “Don't rely on Item 7. If you do, you are going to have a bankrupt client.”

Earnings projections also commonly require discussion between a franchisee prospect and his/her attorney. “Has the prospect been given verbal Financial Performance Representations (“FPRs”)?” asked Lusthaus. “Explain the rules. Maybe you should tell them not to sign the waiver [about reliance only on the written FDD], though they might lose the deal. Keep in mind that verbal FPRs might be a bad sign that the franchisor is more interested in selling franchises than in building a brand.”

While it's difficult for franchisees to negotiate individual terms in the franchise agreement, Lusthaus said that a few concessions may be found. For example, the terms for a renewal of the contract might be less sensitive for franchisors than other aspects of the contract. “Pay attention to the years in the renewal. Do they mesh with your client's life plans and intent to operate the business?” she said. “Other terms for the renewal, such as a cap on fees or territorial rights, also can be negotiated.”

The other area where franchisors might be relatively flexible is on mandatory upgrades and modifications to franchises. “If the contract says that the franchisor can require modifications at any time and at any cost ' watch out,” she said. “Negotiate a cap.”

That advice is especially timely in today's economy when so many franchisees lack the cash to complete mandatory upgrades during this recession. Inability to make those upgrades is a growing source of litigation, according to Jeffrey S. Haff, partner, Dady & Gardner (Minneapolis), who spoke in a different session at the ABA Forum. “You will see cases ' I'm seeing them ' in which franchisees literally cannot do what franchisors are telling them to do,” said Half. “I have one client who has 33 units and was told to remodel them at a cost of $500,000 each.”

Terminations

Silverman led the discussion about how to support franchisees when they are facing termination. He posited a common scenario of a franchisee contacting an attorney to say that he has been unhappy with the franchise and stopped paying royalties, thus incurring a violation of his agreement and pending termination.

“First, ask your client what his goal is, what he wants to get out of the situation,” said Silverman. A franchisee who wants to just end the contract is in a very different position than one who wants to keep operating a unit but with concessions from a franchisor.

“Next, you need to quickly understand what has happened, and also to convey to the franchisee how dire the situation is. Franchisees have no idea how many things a franchisor can do to shut them down, from closing a point-of-sale system to Lanham Act claims, and much more,” he said. “Make the franchisee understand that the options the franchisor has are severe, and it will be costly to fight them.”

For example, a franchisee who wants to open a similar business can expect to spend a minimum of $25,000 to $30,000 to defend against a franchisor's non-compete claims, Silverman said.

The franchisee's attorney needs to quickly obtain as many documents as possible pertaining to the situation and to review them. “You should be able to go through them in a few hours and see if the franchisor followed its rules for the termination or where you have a chance to fight it,” Silverman said. “This is also a way to match up the franchisee's story that he's telling you with the documents.”

Silverman added that it's crucial to keep the franchisee off “gripe sites” that have proliferated online.

While the franchisee is mulling his options, Silverman suggested making a call to the franchisor's attorney to ask for breathing room. “I'll usually ask for 48 hours so that I can familiarize myself with the case, and I'll usually get it, unless the cause of the termination is a health-and-safety issue,” said Silverman. “The franchise bar is small, and this is a great advantage for all of us. A franchisor's counsel prefers to work with a knowledgeable franchisee lawyer.”

Establishing a bridge with the franchisor and its attorney also can make mediation more productive, said Silverman. He estimated that mediation resolves disputes about half of the time ' a figure that audience members confirmed. “Even in mandatory mediation, you can adjust from the letter of the contract by talking with the franchisor's counsel,” he said. “You can talk with them on the phone first or you can ask to conduct a small amount of discovery. Franchisors will usually accommodate your request if it's reasonable and they see you are moving to a resolution.”

Kevin Adler is associate editor of FBLA.

At the 34th Annual ABA Forum on Franchising, held in Baltimore in October, two veteran franchisee attorneys led a session in which they discussed key issues that all franchisee attorneys must understand. Complemented with extensive input from attorneys in the audience, Julie Cowan Lusthaus, partner, Einbinder & Dunn, LLP (New York, NY), and Peter Silverman, partner, Shumaker, Loop & Kendrick, LLP (Toledo, OH), set forth the basics for protecting franchisees' rights and interests.

Franchise Acquisitions

Lusthaus and Silverman began the presentation by evoking the classic situation that all franchisees attorneys face: A prospective franchisee calls or comes in for a meeting, eager to purchase a business. He or she is under a tight deadline to make a decision because the franchise sales representative has said that another buyer is ready to jump on the opportunity. The attorney's first job is to induce realism and calm into the discussion. “Franchisees have been told that they have to take the deal ' that another buyer is lined up,” Lusthaus said. “But I have never had a client lose a deal over a purported deadline to buy the franchise.”

Other times, the prospect tells the attorney that he has already decided to purchase the franchise, but he understands that the contract contains a few items that “need to be looked at,” said Lusthaus. She advised against giving the prospect a cursory review, unless perhaps the buyer is a sophisticated client who already owns franchise units in the same brand.

Working through the FDD, the attorney should focus on areas that might raise red flags about the franchise brand or might create requirements that the prospective franchisee cannot meet. For example, Silverman said that a large amount of litigation disclosed in Item 3 could reflect poor relations between franchisor and franchisees or a struggling system. Through a show of hands, nearly half of audience members at the session went a step further ' indicating that they do not rely on the data in Item 3 anyway, believing it to be inadequately disclosed.

Item 7 disclosures that cover the estimate of the franchisee's initial investment prior to and during startup also can provide an incomplete picture, said Lusthaus. “Clients should be cautioned not to rely too heavily on Item 7 information and to conduct their own due diligence,” she said. “Item 7 is only a general estimate. Are the numbers accurate for the location they are seeking to buy?”

Furthermore, many Item 7 disclosures include operating cost estimates for only a three-month period, implying that franchisees will reach a cash flow break-even after that time. Yet, the same FDDs often state that it typically takes 18-24 months for a franchisee to become profitable, said Lusthaus.

One audience member added: “Don't rely on Item 7. If you do, you are going to have a bankrupt client.”

Earnings projections also commonly require discussion between a franchisee prospect and his/her attorney. “Has the prospect been given verbal Financial Performance Representations (“FPRs”)?” asked Lusthaus. “Explain the rules. Maybe you should tell them not to sign the waiver [about reliance only on the written FDD], though they might lose the deal. Keep in mind that verbal FPRs might be a bad sign that the franchisor is more interested in selling franchises than in building a brand.”

While it's difficult for franchisees to negotiate individual terms in the franchise agreement, Lusthaus said that a few concessions may be found. For example, the terms for a renewal of the contract might be less sensitive for franchisors than other aspects of the contract. “Pay attention to the years in the renewal. Do they mesh with your client's life plans and intent to operate the business?” she said. “Other terms for the renewal, such as a cap on fees or territorial rights, also can be negotiated.”

The other area where franchisors might be relatively flexible is on mandatory upgrades and modifications to franchises. “If the contract says that the franchisor can require modifications at any time and at any cost ' watch out,” she said. “Negotiate a cap.”

That advice is especially timely in today's economy when so many franchisees lack the cash to complete mandatory upgrades during this recession. Inability to make those upgrades is a growing source of litigation, according to Jeffrey S. Haff, partner, Dady & Gardner (Minneapolis), who spoke in a different session at the ABA Forum. “You will see cases ' I'm seeing them ' in which franchisees literally cannot do what franchisors are telling them to do,” said Half. “I have one client who has 33 units and was told to remodel them at a cost of $500,000 each.”

Terminations

Silverman led the discussion about how to support franchisees when they are facing termination. He posited a common scenario of a franchisee contacting an attorney to say that he has been unhappy with the franchise and stopped paying royalties, thus incurring a violation of his agreement and pending termination.

“First, ask your client what his goal is, what he wants to get out of the situation,” said Silverman. A franchisee who wants to just end the contract is in a very different position than one who wants to keep operating a unit but with concessions from a franchisor.

“Next, you need to quickly understand what has happened, and also to convey to the franchisee how dire the situation is. Franchisees have no idea how many things a franchisor can do to shut them down, from closing a point-of-sale system to Lanham Act claims, and much more,” he said. “Make the franchisee understand that the options the franchisor has are severe, and it will be costly to fight them.”

For example, a franchisee who wants to open a similar business can expect to spend a minimum of $25,000 to $30,000 to defend against a franchisor's non-compete claims, Silverman said.

The franchisee's attorney needs to quickly obtain as many documents as possible pertaining to the situation and to review them. “You should be able to go through them in a few hours and see if the franchisor followed its rules for the termination or where you have a chance to fight it,” Silverman said. “This is also a way to match up the franchisee's story that he's telling you with the documents.”

Silverman added that it's crucial to keep the franchisee off “gripe sites” that have proliferated online.

While the franchisee is mulling his options, Silverman suggested making a call to the franchisor's attorney to ask for breathing room. “I'll usually ask for 48 hours so that I can familiarize myself with the case, and I'll usually get it, unless the cause of the termination is a health-and-safety issue,” said Silverman. “The franchise bar is small, and this is a great advantage for all of us. A franchisor's counsel prefers to work with a knowledgeable franchisee lawyer.”

Establishing a bridge with the franchisor and its attorney also can make mediation more productive, said Silverman. He estimated that mediation resolves disputes about half of the time ' a figure that audience members confirmed. “Even in mandatory mediation, you can adjust from the letter of the contract by talking with the franchisor's counsel,” he said. “You can talk with them on the phone first or you can ask to conduct a small amount of discovery. Franchisors will usually accommodate your request if it's reasonable and they see you are moving to a resolution.”

Kevin Adler is associate editor of FBLA.