Vicarious Liability

Perhaps a little background would be helpful here for those not familiar with franchising and trademark law. Under federal and state franchise law, there are essentially three elements that must be present for a franchise relationship to exist. First, there must be a trademark association between a licensor and a licensee. Technically, there need not be a trademark license, generically speaking, but, the bottom line is that the licensee's operations must be recognized by the operation's customers as being related to the franchisor.

Second, some sort of consideration, described as a “franchisee fee,” must be paid by the licensee to the licensor. The fee might be, among other possibilities, an up-front payment or royalties paid over time. Of course, rarely would someone allow another party to use its marks absent some sort of remuneration. Thus, the fee element is almost always present when a trademark association exists.

The third test is much harder to enunciate. Under the Federal Trade Commission's Franchise Rule, 16 C.F.R. ' 436, the franchisor must be imposing significant control over the licensee, or providing significant assistance. Under some of the state franchise laws, the control aspect is often put in terms of prescribing or suggesting a “marketing plan” for the licensee, or, alternatively, there must exist a “community of interest” between the licensor and licensee. Due to the wording differences, there are certain nuances and implications in the various state laws and regulations; in practice, a court will examine closely how much control the licensor exerts over the licensee or how much help the licensee receives from the licensor in determining whether this third test has been met.

Vicarious Liability

Stepping back for a moment, take careful note that the trademark element must be present for the relationship to be a franchise. Thus, franchise law and trademark law are joined at the hip. Now take a look at the law on vicarious liability. As the materials handed out in conjunction with the program point out, for a franchisor, vicarious liability may exist when a licensor exerts too much control over the licensee such that society has decided that the licensor should be held accountable for the acts of the licensee. Various rationales are often used to support the licensor's liability ' actual agency, implied agency, and apparent agency, among others. The point is that by definition, when establishing a franchise relationship, there will always be a question of whether the requisite control is present to make the franchisor liable for the acts of its franchisees. On one side of his brain, the lawyer's predilection is to advise his client to be careful about how many rights the franchisor can exert in overseeing its franchisees' activities.

If a general rule could be formulated here, it would be: Stay out of the franchisee's day-to-day operations; try to make the public aware that the franchisee is an independent operator; do not get involved in hiring decisions of the franchisee; and create a trail of suggestions, rather than requirements, for the franchisee to follow. Many courts have said that either actual control or the right to control a franchisee will put the franchisor on a path to vicarious liability. This is particularly true under tort law, and may often be true in matters of contract.

The other side of the equation relates to trademark law. The purpose of a trademark has varied over time. Historically, it has been a representation of source identification or quality standards. As business has become more service- rather than product-oriented, many experts now consider a trademark or service mark as identifying an experience rather than being a quality or product source identifier. Whatever view one may take as to the role of a mark, the Lanham Act, which is the primary source of trademark law in the United States, makes clear that one must protect what the mark stands for, or risks losing it. In other words, the franchisor is expected to police the quality standards represented by the mark and enforce its rights against those using the mark, but not adhering to standards. In order to do so, the licensor must put controls over its licensees. Thus, from a franchisor's perspective, the issue boils down to a matter of degree.

Most case law suggests that controls generated as being necessary (as distinguished from helpful) by trademark law do not create sufficient control to impose liability on the franchisor for the franchisee's conduct. Establishing and policing controls that are essential under trademark law do not cause the franchisor to cross the line. For example, imposing and policing quality standards and maintaining audit and inspection rights most likely fall into this category. But the black or white line then moves quickly into the gray zone. Imposing hours of operation, providing training programs, approval rights over websites or real estate, rights to approve employment, mandating that certain security systems or lighting be installed, pricing controls, and mandating that products must be purchased from approved sources are all factors suggesting that control may have gone well beyond simply protecting one's mark. These factors also suggest that the arrangement is a franchise.

The problem is further exacerbated by the fact that many judicial decisions addressing vicarious liability are fact-based ' that is, the outcome of a case has a high correlation to the particular facts in a particular decision and will serve as a weak precedent. And then, the case law in states may vary from jurisdiction to jurisdiction. As implied earlier, the test for applying vicarious liability on a franchisor in some jurisdictions might require an exercise of control. In some jurisdictions, simply having the right to control will suffice to make a franchisor vicariously liable.

Unlike contract law, where often there is some predictability of outcome, when it comes to predicting vicarious liability for purposes of tort law, that predictability may be more resemblance to fortune-reading or astrology.

Agreements and Risk

So, how do the lawyer and his client deal with this? Many lawyers and their clients may be overly timid on the issue of how much control to provide to the franchisor. They may want to use terms like “suggest” and “recommend” and provide programs that will “educate” in their franchise agreements. All these helpful hints are nice, but they do not really further the real objective here: to promote and protect the brand.

There are two critical factors in deciding what decisions should be made as to the level of control: Uniformity and risk.

Uniformity is a critical element of franchising. The customer in Boston expects to have a very similar experience to what the customer in Los Angeles may experience. The experiences do not necessarily have to be identical ' a Bostonian might expect to find a lobster offering on the menu, while the mellow Californian would be happier to see sprouts and avocado on a burger. But in either case, there will be substantial overlap among the chain's outlets (be they franchised or company operations) as to appearance, menu selection, and even pricing (although one must be careful not to violate the applicable antitrust laws). In order to achieve this, the franchisor will provide construction plans to be followed, offer training courses, have an operations manual, and impose quality or source restrictions on its franchisees. Although each of these impositions may enhance the likelihood of vicarious liability, each imposition also plays a significant factor in making a brand successful.

At the same time, the franchise lawyer must also focus upon risk probability and the ensuing consequences. For most franchisors, the value of its brand may be its most important asset. Interestingly, this value may not even appear as having any worth on the franchisor's balance sheet. Nevertheless, when franchisors go to sell their concept or take it public, one of the most critical questions will be, how well protected is the brand? Loose and unenforced control rights will cause prospective purchasers of an interest in the franchisor to attribute less value to the brand.

What often goes unnoticed in performing this analysis is risk allocation. A loose franchise agreement puts the brand at risk. The pertinent question here is: Is escape from vicarious liability worth the potential damage? If so, how can the risk be shifted? The answer to this last question is simple: insurance.

Insurance

Today, virtually any risk can be insured ' the primary challenge is to keep the cost of the insurance manageable. In some situations, the risk is very definable ' for example, the risk of a hotel guest being attacked in a parking lot. There are studies that demonstrate that better lighting reduces the risk in such situations. Nevertheless, many franchisors do not mandate better security; they only suggest it. Is this a wise decision? Most franchise agreements require franchisees to indemnify the franchisor for most risks arising out of the franchise's operations, including, implicitly, damages incurred as a result of parking lot incidents. Moreover, the franchisee will be required to have general liability insurance naming the franchisor as an additional insured, and similarly, the franchisor will have its own insurance. In this light, why not put tighter controls on the franchisee? Do not suggest “mandate” (unless the insurance cost is substantially increased by this greater level of control). Wouldn't it be better for a franchisor and the franchise system to avoid headlines such as “Acme Hotel visitor murdered in parking lot”?

A more intriguing situation is where an unfortunate act by a franchisee has widespread, real impact on the brand. In the hotel incident above, it is not that likely that an attack in Seattle would have an impact on the brand in Miami. But take the example of a food-borne illness. I have read that when the Jack in the Box e-coli incident occurred in 1993, hamburger sales dropped by as much as 25% in the Greater Northwest in the following months. This was true not only for the Jack in the Box chain, but for its competitors as well. If sustained, this level of loss would wipe out many franchisees' profits and put their continuing operations in jeopardy.

While most food franchisors are likely to have insurance covering this risk to some degree, would it not be in the franchisor's interest to put as much control as possible over the franchisee on matters of hamburger preparation? This is one reason that franchisors insist that their units only purchase certain menu items, such as meat, from approved suppliers; their products must meet certain standards, and their menu offerings must be prepared in accordance with strict, well-defined procedures. Somewhere along the way, someone determined that quality and safety control trumps vicarious liability in many situations.

When it comes to a choice between brand protection and vicarious liability, the facts favor brand protection. Vicarious liability is often quantifiable, and, many times, an insurable risk of brand value resulting from brand denigration may not be.

Rupert M. Barkoff is a partner resident in the Atlanta office of Kilpatrick Townsend & Stockton, where he chairs the firm's franchise practice. He is co-editor-in-chief of “Fundamentals of Franchising,” a primer on franchise law published by the ABA. This article also appeared in New York Law Journal, an ALM sister publication of this newsletter.

At the recently held annual program of the American Bar Association's Forum on Franchising, there was an interesting program addressing the subject of vicarious liability. The primary issue discussed was when is a franchisor's control over a franchisee ' required to protect the franchisor's trademark rights and to create a viable franchise system with the desired level of uniformity or minimum standards ' so great that the franchisor risks being held vicariously liable for the actions of its franchisees? Cohen, Meretta and Wall, When Is Control by Franchisors Out of Control?, 2011 ABA 34th Annual Forum on Franchising (2011).

It is an interesting question, for the franchisor-oriented lawyer constantly finds himself (or herself) in a dilemma. Much like a poker player, to succeed in determining how much control to grant his client within the franchise agreement, the lawyer is essentially drawing to an inside straight. If either the lawyer's franchise agreement or the client's conduct demonstrates excessive control, the client may find itself vicariously liable for the acts of its franchisees. But if the franchisor does not exert enough control, it risks losing its trademark rights.

Background

Perhaps a little background would be helpful here for those not familiar with franchising and trademark law. Under federal and state franchise law, there are essentially three elements that must be present for a franchise relationship to exist. First, there must be a trademark association between a licensor and a licensee. Technically, there need not be a trademark license, generically speaking, but, the bottom line is that the licensee's operations must be recognized by the operation's customers as being related to the franchisor.

Second, some sort of consideration, described as a “franchisee fee,” must be paid by the licensee to the licensor. The fee might be, among other possibilities, an up-front payment or royalties paid over time. Of course, rarely would someone allow another party to use its marks absent some sort of remuneration. Thus, the fee element is almost always present when a trademark association exists.

The third test is much harder to enunciate. Under the Federal Trade Commission's Franchise Rule, 16 C.F.R. ' 436, the franchisor must be imposing significant control over the licensee, or providing significant assistance. Under some of the state franchise laws, the control aspect is often put in terms of prescribing or suggesting a “marketing plan” for the licensee, or, alternatively, there must exist a “community of interest” between the licensor and licensee. Due to the wording differences, there are certain nuances and implications in the various state laws and regulations; in practice, a court will examine closely how much control the licensor exerts over the licensee or how much help the licensee receives from the licensor in determining whether this third test has been met.

Vicarious Liability

Stepping back for a moment, take careful note that the trademark element must be present for the relationship to be a franchise. Thus, franchise law and trademark law are joined at the hip. Now take a look at the law on vicarious liability. As the materials handed out in conjunction with the program point out, for a franchisor, vicarious liability may exist when a licensor exerts too much control over the licensee such that society has decided that the licensor should be held accountable for the acts of the licensee. Various rationales are often used to support the licensor's liability ' actual agency, implied agency, and apparent agency, among others. The point is that by definition, when establishing a franchise relationship, there will always be a question of whether the requisite control is present to make the franchisor liable for the acts of its franchisees. On one side of his brain, the lawyer's predilection is to advise his client to be careful about how many rights the franchisor can exert in overseeing its franchisees' activities.

If a general rule could be formulated here, it would be: Stay out of the franchisee's day-to-day operations; try to make the public aware that the franchisee is an independent operator; do not get involved in hiring decisions of the franchisee; and create a trail of suggestions, rather than requirements, for the franchisee to follow. Many courts have said that either actual control or the right to control a franchisee will put the franchisor on a path to vicarious liability. This is particularly true under tort law, and may often be true in matters of contract.

The other side of the equation relates to trademark law. The purpose of a trademark has varied over time. Historically, it has been a representation of source identification or quality standards. As business has become more service- rather than product-oriented, many experts now consider a trademark or service mark as identifying an experience rather than being a quality or product source identifier. Whatever view one may take as to the role of a mark, the Lanham Act, which is the primary source of trademark law in the United States, makes clear that one must protect what the mark stands for, or risks losing it. In other words, the franchisor is expected to police the quality standards represented by the mark and enforce its rights against those using the mark, but not adhering to standards. In order to do so, the licensor must put controls over its licensees. Thus, from a franchisor's perspective, the issue boils down to a matter of degree.

Most case law suggests that controls generated as being necessary (as distinguished from helpful) by trademark law do not create sufficient control to impose liability on the franchisor for the franchisee's conduct. Establishing and policing controls that are essential under trademark law do not cause the franchisor to cross the line. For example, imposing and policing quality standards and maintaining audit and inspection rights most likely fall into this category. But the black or white line then moves quickly into the gray zone. Imposing hours of operation, providing training programs, approval rights over websites or real estate, rights to approve employment, mandating that certain security systems or lighting be installed, pricing controls, and mandating that products must be purchased from approved sources are all factors suggesting that control may have gone well beyond simply protecting one's mark. These factors also suggest that the arrangement is a franchise.

The problem is further exacerbated by the fact that many judicial decisions addressing vicarious liability are fact-based ' that is, the outcome of a case has a high correlation to the particular facts in a particular decision and will serve as a weak precedent. And then, the case law in states may vary from jurisdiction to jurisdiction. As implied earlier, the test for applying vicarious liability on a franchisor in some jurisdictions might require an exercise of control. In some jurisdictions, simply having the right to control will suffice to make a franchisor vicariously liable.

Unlike contract law, where often there is some predictability of outcome, when it comes to predicting vicarious liability for purposes of tort law, that predictability may be more resemblance to fortune-reading or astrology.

Agreements and Risk

So, how do the lawyer and his client deal with this? Many lawyers and their clients may be overly timid on the issue of how much control to provide to the franchisor. They may want to use terms like “suggest” and “recommend” and provide programs that will “educate” in their franchise agreements. All these helpful hints are nice, but they do not really further the real objective here: to promote and protect the brand.

There are two critical factors in deciding what decisions should be made as to the level of control: Uniformity and risk.

Uniformity is a critical element of franchising. The customer in Boston expects to have a very similar experience to what the customer in Los Angeles may experience. The experiences do not necessarily have to be identical ' a Bostonian might expect to find a lobster offering on the menu, while the mellow Californian would be happier to see sprouts and avocado on a burger. But in either case, there will be substantial overlap among the chain's outlets (be they franchised or company operations) as to appearance, menu selection, and even pricing (although one must be careful not to violate the applicable antitrust laws). In order to achieve this, the franchisor will provide construction plans to be followed, offer training courses, have an operations manual, and impose quality or source restrictions on its franchisees. Although each of these impositions may enhance the likelihood of vicarious liability, each imposition also plays a significant factor in making a brand successful.

At the same time, the franchise lawyer must also focus upon risk probability and the ensuing consequences. For most franchisors, the value of its brand may be its most important asset. Interestingly, this value may not even appear as having any worth on the franchisor's balance sheet. Nevertheless, when franchisors go to sell their concept or take it public, one of the most critical questions will be, how well protected is the brand? Loose and unenforced control rights will cause prospective purchasers of an interest in the franchisor to attribute less value to the brand.

What often goes unnoticed in performing this analysis is risk allocation. A loose franchise agreement puts the brand at risk. The pertinent question here is: Is escape from vicarious liability worth the potential damage? If so, how can the risk be shifted? The answer to this last question is simple: insurance.

Insurance

Today, virtually any risk can be insured ' the primary challenge is to keep the cost of the insurance manageable. In some situations, the risk is very definable ' for example, the risk of a hotel guest being attacked in a parking lot. There are studies that demonstrate that better lighting reduces the risk in such situations. Nevertheless, many franchisors do not mandate better security; they only suggest it. Is this a wise decision? Most franchise agreements require franchisees to indemnify the franchisor for most risks arising out of the franchise's operations, including, implicitly, damages incurred as a result of parking lot incidents. Moreover, the franchisee will be required to have general liability insurance naming the franchisor as an additional insured, and similarly, the franchisor will have its own insurance. In this light, why not put tighter controls on the franchisee? Do not suggest “mandate” (unless the insurance cost is substantially increased by this greater level of control). Wouldn't it be better for a franchisor and the franchise system to avoid headlines such as “Acme Hotel visitor murdered in parking lot”?

A more intriguing situation is where an unfortunate act by a franchisee has widespread, real impact on the brand. In the hotel incident above, it is not that likely that an attack in Seattle would have an impact on the brand in Miami. But take the example of a food-borne illness. I have read that when the Jack in the Box e-coli incident occurred in 1993, hamburger sales dropped by as much as 25% in the Greater Northwest in the following months. This was true not only for the Jack in the Box chain, but for its competitors as well. If sustained, this level of loss would wipe out many franchisees' profits and put their continuing operations in jeopardy.

While most food franchisors are likely to have insurance covering this risk to some degree, would it not be in the franchisor's interest to put as much control as possible over the franchisee on matters of hamburger preparation? This is one reason that franchisors insist that their units only purchase certain menu items, such as meat, from approved suppliers; their products must meet certain standards, and their menu offerings must be prepared in accordance with strict, well-defined procedures. Somewhere along the way, someone determined that quality and safety control trumps vicarious liability in many situations.

When it comes to a choice between brand protection and vicarious liability, the facts favor brand protection. Vicarious liability is often quantifiable, and, many times, an insurable risk of brand value resulting from brand denigration may not be.

Rupert M. Barkoff is a partner resident in the Atlanta office of Kilpatrick Townsend & Stockton, where he chairs the firm's franchise practice. He is co-editor-in-chief of “Fundamentals of Franchising,” a primer on franchise law published by the ABA. This article also appeared in New York Law Journal, an ALM sister publication of this newsletter.