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Franchisors: Litigation Risk Can be Minimized

Avoiding a legal visit from a franchisee attorney begins with a solid contract foundation.

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One of the largest misconceptions about is that the is fraught with litigation. You've heard the horror stories: Franchisees suing franchisors. McDonald's hit with a multimillion-dollar lawsuit because its coffee was too hot. The Big Bad Wolf is outside the door, in the form of a franchisee attorney, huffing and puffing and threatening to blow your house down.

And, in truth, it can be scary. Litigation is a fact of life in , and to ignore that fact is the business equivalent of building a straw house--good shelter, but not for the long run.

Without an experienced franchise lawyer overseeing your contracts and incorporating case law, you leave yourself open to being sued. Still, franchising offers built-in techniques, and specific laws exist to protect you from many lawsuits. That said, litigation is much less of a concern in the franchising world than it is in other forms of business expansion.

A House of Bricks
First, start with the basics. Build a good legal foundation for your business and you can prevent many problems down the road.

The franchise agreement is usually presented to the franchisee on a take-it-or-leave-it basis. A typical agreement drafted by a franchise attorney is almost always very one-sided in favor of the franchisor. And as franchise law evolves, these documents typically become even more bullet-proof.

Here's how it happens: As franchise-related cases are adjudicated, the attorneys for both sides clarify potential gray areas through judicial precedents that might exist. This case law becomes a precedent in future disputes. Experienced franchise attorneys are constantly reading through franchise-related cases, making adjustments to their franchise agreements, so they are even more favorable to their franchisor clients.

Decades ago, when franchise law was in its relative infancy, case law that attorneys could turn to when drafting these documents was scarce. In fact, many franchise agreements were drafted by attorneys with little to no experience. But over the last several decades, this case law has been established. Contract law cases in areas such as the proper use of advertising funds, territory and encroachment provisions, good faith and fair dealing, and the "duty of competence" owed by a franchisor have all been the subject of this type of litigation. Today, experienced franchise attorneys use this established case law to draft contracts that anticipate and aid in the prevention of litigation in these areas.

Of course, there are no guarantees against litigation. But with many of yesterday's causes of action eliminated, most of today's contract-specific litigation revolves around two basic issues: fraud in the sales process, or a lack of compliance with franchise laws. Avoiding fraud in the sales process is a function of making sure that your sales process is open, honest and thoroughly documented. To maintain an effective compliance program, you must retain qualified franchise counsel who can train you on all compliance issues.

Vicarious Liability
No discussion of liability within the context of franchising is complete, of course, without some mention of vicarious liability--the liability that a franchisor may accrue for the acts of its franchisees. In essence, vicarious liability can accrue to the franchisor when the franchisor inadvertently creates an agency relationship with its franchisees or its employees.

In a nutshell, the biggest liability is the franchisor's desire to be overly prescriptive with the way in which franchisees conduct their day-to-day business. For example, one franchisor was recently held liable because of specifying that the franchisees use a particular drop-safe which, at least in the eyes of the jury, was said to have contributed to a beating received by an employee who couldn't open the safe for a robber.

While a complete legal treatise on this subject is beyond the scope of this column (and the competence of this author), it's worth noting that much of this liability is also avoidable. The savvy franchisor will start by insisting that all franchisees clearly indicate (with signs, on letterhead, etc.) that they're an independent licensee of the franchisor. By treating them as independent contractors and requiring them to acknowledge that fact, the franchisor is insulated from the acts of its franchisees.

The best way to avoid these issues is to be sure that your operations manuals and training programs are written properly. An operations manual is best written by a professional with an understanding of how liability can be created; once written, it should always be reviewed by your attorney for this reason.

Today's savvy franchisor will typically require their franchisees to carry specific insurance coverage that will also name the franchisor as a co-insured on the policy to provide a third level of protection.

Trading One Wolf for Another
Of course, every contract you sign has some potential for liability--even if that contract is very one-sided. And some level of vicarious liability is always possible if you let others use your name--even if you've minimized that exposure.

But it's important for the company considering franchising as a growth strategy to understand the liability trade-off associated with other forms of growth. The minimally-increased potential liability that occurs when someone franchises doesn't happen in a vacuum. For most, the decision to franchise competes with other expansion strategies that typically have more potential for liability than franchising.

Consider the alternative of corporate-owned growth. While a franchisor may have some limited contractual liability, under most circumstances, it will have no employment liability. No liability. No sexual harassment liability. And since the franchisee is responsible for the investment, in most cases there is no contingent liability on facility leases or other vendor contracts. No potential liability for personal injury in the workplace--for either employees or customers. In a well-run and well-documented franchise company, all of that liability is assumed by the franchisee.

So when it comes to the liability trade off, you trade some minimal contractual liability for a significantly reduced amount of employment and workplace liability.

All growth comes at a cost, and part of that cost is becoming a bigger target. If you have 1,000 franchisees, the odds are that one of them will not be happy with you.

But litigation isn't inevitable. Industry source recently stated that 73 percent of franchisors reported no litigation of any kind in their disclosure documents. And while there's no verifiable, statistical data on the 27 percent of franchisors that did report litigation, its likely that many of those franchisors were either larger (more relationships will create more opportunities for conflict) or simply bad franchisors.

Dave Hood, my partner and the president of the iFranchise Group, helped grow one of the country's largest and most successful franchisors from around six units to more than 650. And in his ten years at that company, they were never sued by any of their franchisees. Not once. And that didn't happen by accident.

Franchising is all about relationships. The best franchisors are open and honest in their communications, and they communicate often. They sincerely want their franchisees to succeed, while being transparent and fair in their decision-making.

And while they'll build their contracts as if they were brick houses, they'll recognize that the best contracts are those that get locked in a file cabinet never to be seen again.

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