Franchise

The Legal Risks of Owning a Franchise

In Franchise Your Business, author and franchise consultant Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever -- franchising. Siebert shares decades of experience, insights, and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, Siebert describes a few of the potential legal risks you face when you become a franchisor.

We regularly hear concerns from companies that franchising is just too litigious. But litigation isn't inevitable. In fact, about three-quarters of all franchisors don't report any litigation in their franchise disclosure documents (FDDs), according to FRANdata research. And there's a good deal of anecdotal evidence to suggest that of those that do report litigation, many are either larger companies (more relationships create more opportunities for conflict) or simply bad franchisors.

The fact is, much of the litigation that was seen in early franchising is no longer an issue. Historically contested issues, such as use of advertising funds, territorial disputes, good faith and fair dealing, and a franchisor’s duty of competence, have largely faded away as court rulings have set precedents and established case law. Franchise lawyers have learned how to write their contracts in a way that will largely avoid such litigation.

Today, a franchise agreement drafted by an experienced franchise attorney is almost always a very one-sided document in favor of the franchisor, and it's usually presented to the franchisee on a take-it-or-leave-it basis. They are substantially non-negotiable. In fact, most franchise agreements today are written in such a way that it's almost impossible for a decent franchisor to be sued for contract violations.

Mitigating Franchisee Litigation Exposure

When it comes to contract disputes, the two issues that remain ripe for litigation are violations of franchise law and fraud in the sales process. In fact, the vast majority of the claims we see between franchisee and franchisor are really centered on one of these two issues (or sometimes both).

But the good news is that these issues are relatively easily inoculated against.

Avoiding violations of franchise law and accusations of fraud are largely a matter of education, diligence, and hiring an experienced franchise attorney. The following checklist will provide you with the basics:

Work with your franchise attorney to train all your salespeople on franchise law and make sure they go through refresher training once a year. As part of that training, have them take a test on the basic tenets of franchise law to ensure they have a good understanding of the issues. Keep these tests for your files.

Be sure your training includes all the following issues:

  • The importance of the franchisee screening and selection process
  • Where you are registered to sell franchises and what questions the salesperson needs to ask to determine if the proper registrations are in place
  • When they must make disclosure
  • The proper format for making disclosure (electronic, paper, etc.) and documenting that disclosure
  • What can and cannot be said in the sales process, especially when it comes to FPR issues
  • Remaining consistent with the franchise disclosure document (FDD) in the sales process
  • How to comply with the 14-day rule for FDDs and the sev­en-day rule for modified franchise agreements
  • How to document conversations and write bulletproof emails
  • When they should contact your attorney with questions

Provide similar if less intense training to nonsales staff that will instruct them how to handle franchise sales leads without violating franchise laws and ensure they understand how to hand off these leads to people who are trained to properly answer their questions.

Designate someone in your company as your compliance officer. The compliance officer should be the go-to person for questions about franchise law and should make sure all registrations are kept current.

Be sure everyone on your staff is scrupulously honest. Mystery shop your sales force once every year or two and keep a record of the results.

Ask every franchisee in their closing interview about any representa­tions that were made during the sales process. Many franchisors use a written closing checklist, and some have gone as far as videotaping those interviews. If you find a problem, stop and call your attorney immediately.

Document all communications with franchisees and prospective franchisees. Simple contact management software costs less than $400, so an electronic system is best.

Finally, institute a no-tolerance policy if you find any infractions. Be sure your staff knows they'll be mystery shopped. And be sure to include something in their employment agreement stating that violations of franchise law and/or misrepresentations made to prospective franchisees are grounds for immediate termination.

Vicarious Liability Concerns

Aside from litigation that might result from your contractual relationship with your franchisee, there is also the issue of vicarious liability -- the liability a franchisor may incur due to the actions of their franchisees or their franchisee’s employees.

Vicarious liability may become an issue when a franchisor unintentionally creates an “agency relationship” with its franchisees (or their employees) by exercising control over their activities. And under the doctrine of respondeat superior, the party in control is responsible for the acts of its subordinates.

The good news when it comes to issues of vicarious liability is that the law is on the side of the franchisor. The franchisee is, in fact, an independent business owner and as such, they're in control of their actions and the actions of their employees.

So how is an agency relationship created?

Usually it stems from the franchisor’s desire to be overly prescriptive about the way in which franchisees conduct their day-to-day business. In essence, the franchisor must be cognizant of the line between controls that impact brand standards and those that do not.

Much of this type of liability is avoidable. Start by insisting that all franchisees clearly indicate (with signs, on letterhead, in advertising, etc.) that they are independent licensees. By requiring franchisees to hold themselves out as independent contractors, and remembering to treat them as such, the franchisor will take an important step toward insulating itself from the acts of its franchisees.

Aside from relying on the requirements of the franchise agreement, one of the best ways to avoid vicarious liability is to be sure your franchise agreement, operations manual, and training programs are all properly and consistently written to specify the nature of the relationship. The operations manual should be written by someone with an understanding of how this liability can be inadvertently created.

A good operations manual will provide very specific direction in areas that impact brand standards but exercise less control over areas that do not. For example, a franchisor would want to specify the use of a certain piece of equipment if it had an impact on the consumer’s brand experience. However, if there were ready substitutes for that equipment that would provide the same brand experience, the franchisor could allow it (including an approval process for substitutes), thereby reducing the amount of control being exercised and reducing its potential for liability.

Once the operations manual is written, have it reviewed by your attorney to ensure it properly addresses this issue. Well-written legal documents and manuals, along with appropriate internal processes, will allow you to minimize the potential for vicarious liability claims.

Beyond these tools, you'll typically want to require your franchisees to carry comprehensive general liability insurance coverage that will name you as a coinsured on the policy. This will provide you with an extra level of protection. Be sure your compliance officer routinely obtains and checks your franchisees’ insurance certificates. Of course, you may also choose to carry your own insurance that will cover you in the event of a third-party action.