USA Trends and Developments Contributed by: Richard L. Rosen, Leonard S. Salis and Dennison D. Marzocco, Rosen Karol Salis, PLLC
What Can Go Wrong as a Franchise Owner? Even well run, reputable franchise systems carry real risk for the individual owner, as is the case with any business. Common problem areas include the follow - ing. Pre-sale misrepresentations Under the Federal Trade Commission (FTC) Franchise Rule, as well as various state laws, franchisors must give prospective franchisees a Franchise Disclosure Document (FDD) covering 23 “Items” relating to the system’s history, litigation record, development costs (Item 7), fees, and, if the franchisor chooses to provide it, financial performance data in Item 19. A mature system that does not share any performance informa - tion can be sending a warning sign, particularly if the franchisor’s franchisees make unflattering comments to prospective franchisees, 12 to 15 of whom should be reached out to before they commit to the franchise. Misrepresentations made in the FDD, or informally by a sales representative or broker, are frequently the basis of costly legal claims against franchisors when the franchised business does not perform as prom - ised. Runaway fees Royalties, marketing fund contributions, technol - ogy charges, and required purchases from approved suppliers can add up well beyond the franchisee’s expectation at the outset, particularly as franchisors pass along rising costs from inflation, tariffs or supply disruptions. Franchisees should carefully read Item 6 when reviewing an FDD and negotiate appropriate caps, if possible. Escalating operational requirements Mandatory suppliers, point-of-sale systems, and brand standards can become more financially demanding over time. Personal guaranty and lease exposure Many franchisors require a full personal guaranty from franchisee principals and, often, their spouses, cover - ing every obligation under the franchise agreement. Liquidated damages Many franchise agreements provide for liquidated damages provisions that are triggered in the event of
the termination of the franchise agreement. This could cause the franchisee to be on the hook for specific damages calculated by a formula, which is typically a multiple of royalties and marketing fund fees over a defined period of time. Many of these risks can be reduced through the kinds of negotiated terms described above, and negotiating territory, fee and guaranty protections before signing is far easier than trying to fix them after the business is operating. What If I Have a Problem and the Franchisor Will Not Help? Under many state laws, franchise agreements gener - ally include an implied duty of good faith and fair deal - ing. This means that a franchisor cannot use its con - tractual discretion to unfairly deny the franchisee the benefit of the deal. That duty has real limits, though, because the covenant does not override clear, express terms of the franchise agreement. What the agree - ment actually says, and what it does not say, matters when a dispute arises. When a franchisor is unrespon - sive to a legitimate problem, franchisees have several options, although none will necessarily guarantee a quick resolution or apply to every situation. Alternate dispute resolution As discussed above, a well-negotiated agreement channels disputes through negotiation and mediation before arbitration. Even when a franchisor is simply unresponsive, it is usually worth formally invoking that process rather than escalating straight to a demand letter or lawsuit. Mediation is confidential and non- binding, and costs to engage are typically not exces - sive, while preserving every right to escalate if it does not work. State franchise laws with private rights of action 15 states, including California and New York, require franchisors to register their disclosure documents and provide franchisees with the right to sue over viola - tions of those laws. California’s Franchise Investment Law and New York’s Franchise Sales Act (NYFSA) both allow a franchisee harmed by a registration or disclosure violation to recover damages, and where the violation was wilful (and material, in the case of the NYFSA) to offer rescission and reasonable attor -
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